What have Keynesians learnt since Keynes?

                That is the question asked by RobertWaldman (9th Feb) in a comment on my post, and also in a dialog with Mark Thoma. I’ll not attempt a full answer – that would be much too long – and Mark makes a number of the important points. Instead let me just talk about one episode that convinced me that one part of New Keynesian analysis, the intertemporal consumer with rational expectations, was much more useful than the ‘Old Keynesian’ counterpart that I learnt as an undergraduate.

                In the mid 1980s I was working at NIESR (National Institute for Economic and Social Research) in London, doing research and forecasting. UK forecasting models at the time had consumption equations which included current and lagged income, wealth and interest rates on the right hand side, using the theoretical ideas of Friedman mediated through the econometrics of DHSY (Davidson, J.E.H., D.F. Hendry, F. Srba, and J.S. Yeo (1978). Econometric modelling of the aggregate time-series relationship between consumers' expenditure and income in the United Kingdom.Economic Journal, 88, 661-692.) While the permanent income hypothesis appealed to intertemporal ideas, as implemented by DHSY and others using lags on income to proxy permanent income I think it can be described as ‘Old Keynesian’.

As the decade progressed, UK consumers started borrowing and spending much more than any of these equations suggested. Model based forecasts repeatedly underestimated consumption over this period. Three main explanations emerged of what might be going wrong. In my view, to think about any of them properly requires an intertemporal model of consumption.

1) House prices. The consumption boom coincided with a housing boom. Were consumers spending more because they felt wealthier, or was some third factor causing both booms? There was much macro econometric work at the time trying to sort this out, but with little success. Yet thinking about an intertemporal consumer leads one to question why consumers in aggregate would spend more when house prices rise. (I don’t recall anyone suggesting it changed output supply, but then the UK is not St. Louis.) Subsequent work (Attanasio, O and Weber, G (1994) “The UK Consumption Boom of the Late 1980s” Economic Journal Vol. 104, pp. 1269-1302) suggested that increased borrowing was not concentrated among home owners, casting doubt on this explanation.

2) Credit constraints. In the 1980s the degree of competition among banks and mortgage providers in the UK increased substantially, as building societies became banks and banks starting providing mortgages. This led to a large relaxation of credit constraints. While such constraints represent a departure from the simple intertemporal model, I find it hard to think about how shifts in credit conditions like this would influence consumption without having the unconstrained case in mind.

3) There was also much talk at the time of the ‘Thatcher miracle’, whereby supply side changes (like reducing union power) had led to a permanent increase in the UK’s growth rate. If that perception had been common among consumers, an increase in borrowing today to enjoy these future gains would have been the natural response given an intertemporal perspective. Furthermore, as long as the perception of higher growth continued, increased consumption would be quite persistent.

Which of the second two explanations is more applicable in this case remains controversial -see ‘Is the UK Balance of Payments Sustainable?’ John Muellbauer and Anthony Murphy (with discussion by Mervyn King and Marco Pagano) Economic Policy Vol. 5, No. 11 (Oct., 1990), pp. 347-395 for example. However, I would suggest that neither can be analysed properly without the intertemporal consumer. Why is this a lesson for Keynesian analysis? Well in the late 1980s the boom led to rising UK inflation, and a subsequent crash.  Underestimating consumption was not the only reason for this increase in inflation – Nigel Lawson wanted to cut taxes and peg to the DM – but it probably helped.

So this episode convinced me that it was vital to model consumption along intertemporal lines. This was a central part of the UK econometric model COMPACT that I built with Julia Darby and Jon Ireland after leaving NIESR in 1990. (The model allowed for variable credit constraint effects on consumption.) The model was New Keynesian in other respects: it was solved assuming rational expectations, and it incorporated nominal price and wage rigidities.

As I hope this discussion shows, I do not believe the standard intertemporal consumption model on its own is adequate for many issues. Besides credit constraints, I think the absence of precautionary savings is a big omission. However I do think it is the right starting point for thinking about more complex situations, and a better starting point than more traditional approaches.

One fascinating fact is that Keynes himself was instrumental in encouraging Frank Ramsey to write "A Mathematical Theory of Saving" in 1928, which is often considered as the first outline of the intertemporal model. Keynes described the article as "one of the most remarkable contributions to mathematical economics ever made, both in respect of the intrinsic importance and difficulty of its subject, the power and elegance of the technical methods employed, and the clear purity of illumination with which the writer's mind is felt by the reader to play about its subject. " (Keynes, 1933, "Frank Plumpton Ramsey" in Essays in Biography, New York, NY.)  I would love to know whether Keynes ever considered this as an alternative to his more basic consumption model of the General Theory, and if he did, on what grounds he rejected it.