Keynes

By Roger E. A Farmer

In the FT’s Economists’ Forum, Benn Steil wrote a stimulating piece in which he argued that Keynes was wrong. His argument is that interpretations of Keynesian economics are all based on the assumption that wages and prices are sticky. But wages and prices are not sticky. Ergo - Keynes was wrong. Mr. Steil and I are in complete agreement that the Keynesians, interpreted in this way are, to use a technical term, out to lunch. But that does not imply that Keynes was wrong. At least not entirely wrong. Far from it.

My emeritus colleague, Axel Leijonhufvud, made a distinction in his 1966 book, on Keynesian Economics and the Economics of Keynes, between Keynes and the Keynesians. He meant that orthodox Keynesian interpretations of the General Theory, that began with influential papers by John Hicks in England and Alvin Hansen in the US, got it all wrong.

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment.

He was right on all three counts. But he was wrong about something else. Keynes thought that consumption depends on income. Two decades of research on the consumption function, following world war two, led to a different conclusion. Consumption, and this is two thirds of the economy, depends not on income but on wealth. This is no small matter: the theory of the multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point.

Keynes was a pragmatist first and a social scientist second and the General Theory is, to say the least, ambiguous. Economists have debated its meaning for more than half a century in an attempt to reconcile Keynes with microeconomic principles. The orthodox contender for this reconciliation is the ‘neo-classical synthesis’ which holds that the economy is Keynesian in the short-run because prices are `sticky’. It is classical in the long-run when prices have found their right level.

However, there was always an undercurrent of thought that rejected the neo-classical synthesis. UCLA economists such as Axel Leijonhufvud and Robert Clower and post-Keynesians including Paul Davidson and Hyman Minsky argued that Keynes did not rest his argument on sticky prices. But if Keynesian economics is not about sticky prices then how is one to reconcile the main message of the General Theory with the established body of microeconomic theory?

In two forthcoming books, and in an National Bureau of Economic Research working paper, I provide a reconciliation of Keynes with microeconomics that does not rely on sticky prices. I explain there, how any unemployment rate can persist forever. The market does not provide participants with enough prices to allow them to decide if a given number of jobs should be filled by many unemployed workers chasing a small number of vacancies: Or by many vacancies chasing a small number of unemployed workers. In classical economics, the free market contains a self-correcting mechanism. Rational individuals chasing profit opportunities will guide the economy back towards full employment. In my interpretation of Keynesian economics, there are missing markets. As a consequence, any unemployment rate can persist forever as an equilibrium in which no firm makes excess profit. Each equilibrium is accompanied by a different value for the stock market.

Why is this important? The neo-classical synthesis implies that, to restore full employment, we simply need to realign nominal prices with nominal demand. This can be done either with monetary policy to stimulate private spending or with fiscal policy to replace private spending with public spending. But if income depends on wealth then fiscal policy may be less effective than the Keynesians claim.

An extreme form of the argument that fiscal policy will be ineffective has been made by Robert Barro of Harvard University and Eugene Fama of the University of Chicago. Barro and Fama claim that one extra pound of government expenditure will crowd out a pound of private expenditure.

Barro calls this argument Ricardian since its intellectual heritage can be traced to the English economist David Ricardo. Is the Ricardian position correct? Not entirely, since the logic of the Ricardian argument requires that rational forward looking households fully internalize the future tax burden of current fiscal profligacy.

This seems unlikely since lives are short and not everyone cares for their descendents. But my calculations in a recent paper suggest that the US economy may be much closer to the Ricardian position than advocates of fiscal stimulus would like to admit.

Does this mean that I agree with Barro and Fama? No: And Yes. There are two questions. First: Is the economy self-correcting? Here I side with Keynes. Second: Is fiscal policy the answer? Here I side with Barro and Fama. This leaves me with the nightmare conclusion that the free market may lead to very bad outcomes sometimes but fiscal policy cannot do much about it.

The prospects for a stimulus package are not entirely gloomy. My calculations suggest that a bond financed fiscal stimulus will increase employment although the multiplier is much closer to 0.6 than 1.5 as some Obama administration economists have argued. But that is splitting hairs. A more important objection to the fiscal stimulus is that there is no guarantee that it will restore confidence in the stock market and, if that does not happen, the government will have to keep running up larger deficits just to keep the economy from falling further into a depression. This is clearly unsustainable since the additional debt must eventually be paid back through an increase in taxes.

Where does this leave us? Keynes was right about three key points. 1) High unemployment can persist forever because the market is not self-correcting. 2) Confidence matters. 3) Government can and should intervene to fix things. But the orthodox Keynesians are wrong: fiscal policy cannot provide a permanent fix to the problem of high unemployment. We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention. That is the main message of my forthcoming books.

Roger E. A. Farmer is professor of economics and vice-chair for graduate studies, University of California Los Angeles

May 27, 2009 6:12pm in Crisis, Economists, Keynesianism | Comment