Ideology and Demand Denial

Thanks to Chris Dillow and then others, my post Mistakes and Ideology in Macroeconomics was widely read and commented on. As Chris pointed out, it is possible to think in terms of mechanisms or complete models. My post was about one mechanism, consumption smoothing, which the texts I was looking at appeared to ignore. Many responses were along the lines of ‘what the authors of these texts had in mind is a model of this type, and in this type of model fiscal policy will be ineffective’. I’m happy to pursue this, not because I would be presumptuous enough to imagine I know what the authors ‘really meant’, but because I think it strengthens the idea that antagonism towards fiscal policy in the current situation has ideological roots rather than a sound basis in macroeconomic theory.

The most widely suggested model is one where there is never any demand problem: we are always at ‘full employment’. Then, of course, increasing one component of demand will have no direct effect on output, and higher taxes will have some negative impact on supply. Expansionary fiscal policy would be quite inappropriate in these circumstances.

If that is the argument, then I would insist on asking just how it is that the economy is always at full employment. The standard response, which is that prices are flexible, is not enough when we hit a zero lower bound for interest rates. As a suggested in another post, the ‘self correction mechanism’ by which demand shocks never impact on output requires a combination of price flexibility and monetary policy. (Actually, price flexibility is not even necessary – if the monetary authorities effectively targeted the output gap, for example.) This mechanism fails when we hit a zero lower bound.

Now an argument that said that the current recession was the result of a large negative supply shock rather than a demand shock, and we hit the zero lower bound because central banks misunderstood this fact, makes perfect sense in theory – it is just a little difficult to square with the facts, as many have pointed out. But this is a contingent argument. What the debate over fiscal policy has revealed is an underlying generic antagonism towards Keynesian analysis.

There is an asymmetry here. Keynesian economists do not deny that productivity or other supply side shocks can often be important. On the other side there appears to be, among many at least, a belief that Keynesian economics is never relevant. What this amounts to is what Krugman and others call demand denial. Yet the basis in economic theory for demand denial appears very unclear. Say’s Law, or maybe some kind of quantity theory with fixed velocity, would do it – but these were really bad ideas that the profession dismissed many decades ago.

Demand denial seems both surprising (an individual firm facing a fall in demand will reduce output), and hardly something to feel passionate about. So demand denial genuinely puzzles me. Keynes had a number of thoughts on this, as the following from the General Theory shows (‘it’ in the first sentence is a theory that involves demand denial).

That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commanded it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

Now beautiful though this passage is, a good deal has changed since 1936. New Keynesian theory is a ‘consistent logical superstructure’, so there is no intellectual prestige involved in denying its relevance (except, perhaps, to fellow believers). Yet two sentences still ring true. The first is the idea that austerity is virtuous. Some of the popular discourse around fiscal policy has moral overtones, perhaps stemming from the idea that governments, like individuals, have to practice self control. Now while I think seeing economics as a morality play is generally unhelpful, in the case of fiscal policy there is a problem of deficit bias: governments over the last few decades have tended, on average, to spend too much or tax too little. (Some particular evidence, and a fairly comprehensive discussion of reasons for deficit bias, can be found here. For lots of data, go here, click on ‘subject: Real GDP Growth’ and select the historical debt database.) However deficit bias is a long term problem and a recession is not the time to start dealing with it. 

The final sentence from Keynes also still rings true.  One explanation for demand denial is that it has ideological roots. In the real world we have the problem of ensuring aggregate demand matches supply, and this requires state intervention – normally monetary policy.  For those who want to argue that state intervention in the economy is generally a bad thing, it is embarrassing to acknowledge that there is one area where it is essential. But I get no joy in seeing ideology mess with economics, and so I would be more than happy to be convinced that there was another explanation for demand denial.