Krugman, Keynes & Keynesians
Paul Krugman’s address to the Cambridge conference on Keynes makes for interesting reading – I’d highly recommend it and agree with much of his analysis.
But leaving aside the macroeconomic argument, I’m actually more interested in what he says towards the beginning about Keynes and ‘Keynesians’.
“I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, that all those who have invoked the great man’s name on behalf of quasi-equilibrium models that push this insight into the background, from John Hicks to Paul Samuelson to Mike Woodford, have violated his true legacy.
Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed, while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: ―The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand.”
I agree that there is a divide in the ‘Keynesian school’, but I’d argue it is actually a three way divide – Chapter 12ers, Book 1ers and, the largest grouping, those who haven’t actually read the General Theory.
Krugman defines himself as a Book 1er and this is very much the mainstream amongst ‘Keynesian’ economists – Joseph Stiglitz would be another. In an LRB review of Skidelsky’s (superb) ‘The Return of the Master’, last year he wrote that Skidelsky (a Chapter 12er) has ‘gone astray’ by focusing too much on Keynes’ definitions of risk and uncertainty, the core of a Chapter 12 argument.
In a letter to the LRB, Paul Davidson (editor of the Journal of Post-Keynesian Economics) took issue with this writing that:
“For Keynes the inability of firms and households to ‘know’ the economic future is essential to understanding why financial crashes occur in an economy that uses money and money contracts to organise transactions. Firms and households use money contracts to gain some control over their cash inflows and outflows as they venture into the uncertain future. Liquidity in such an economy implies the ability to meet all money contractual obligations when they fall due. The role of financial markets is to assure holders of financial assets that are traded on orderly markets that they can readily convert these liquid assets into cash whenever additional funds are needed to meet a contractual cash outflow commitment. In Keynes’s analysis, the sudden drying up of liquidity in financial markets, occasioned by sudden drops of confidence, explains why ‘unfortunate collisions’ occur – and have occurred more than a hundred times in the last 30 years, according to Stiglitz.
By contrast, Stiglitz implicitly accepts the orthodox view that all contracts are made in real terms, as if the economy were a barter economy. Consequently people’s need for liquidity is irrelevant. Stiglitz indicates that he and Bruce Greenwald have explained that financial markets fail ‘because contracts are not appropriately indexed’, i.e., contracts in our economy are denominated in money terms rather than ‘real’ terms. He suggests that if only such contracts were made in real, rather than monetary, terms we would not suffer the ‘unfortunate collisions’ of economic crisis. If only we lived in a classical world, where contracts would be denominated in real terms! But in a money-using economy, this is impossible.”
I’d agree with much of that and argue that Keynes’ focus on the nature of uncertainty and it impacts a capitalist economy is actually one of his two major contributions to economic thought. The other being his work on international economics and preserving a role for action by nation-states, rather than his better known theories on fiscal policy.
I agree with Krugman that a simple IS/LM model or Samuelson Cross is sometimes a lot more useful as an aid to macro policy making than a complex DSGE model. As Charles Goodhart, a former Chief Economist of the Bank of England, once commented a DSGE model “excludes everything I am interested in”. Wilhem Buiter is correct to argue that:
“Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability. So the economics profession was caught unprepared when the crisis struck.”
But even if a simple IS/LM model is less likely to lull us into a false sense of security about the limits of our knowledge than a full blown DSGE model, it still has it limits.
Keynes’ focus on uncertainty, I’d argue, actually directs us away from the ‘mechanical’ thinking of imagining that policy makers can easily influence the economy by pulling certain levers – thinking that is now, oddly enough, most associated with those who now call themselves ‘Keynesian’.