Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 12 February 2012

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. 


  1. Question: how much do you know about the "post Keynesian" school of economics? Also: how seriously do you take post Keynesian ideas? How seriously does the mainstream academic economic community take them?

    If you are familiar with post Keynesian ideas (e.g. anything by Paul Davidson, Steve Keen, Hyman Minsky, Wynne Godley, Joan Robinson etc) then what is your take on them? If you don't take them seriously, why not?

    Sorry if I sound presumptuous but IANAE and most of the economic reading I have done has been in post Keynesian textbooks (which spend a lot of time explaining why "New Keynesian" and "neoclassical" economics are useless at best and harmful at worst).

    I would like very much to read an intelligent critique of post Keynesian ideas from a neoclassical or New Keynesian perspective. Are you in a position to provide one?

  2. Thanks for the link. Clearly I was not clear. I asked abot Keynes not about " old Keynesian models". It has often been argued that there is a big difference between so called Keynesian economics and the economics of Keynes. For example Keynes discussed precautionary saving.

    The economics of Keynesis much much more different from contemporary new Keynesian models than are old Keynesian models. Much of it was informal discussion in English. The models only appeared either when the matter was settled or when Keynes couldn't think of anything much to say ( all he said about theprice level and inflation was that the equations he wrote were useless as the parameters were not constants ... Also hesuggested in a footnote that the part of the book full of pointless equations could be skipped at low cost).

    One way in which your model definitely differs from theeconomics of Keynes is that you consider intertemporal choice assuming rational expectations. I ask, often, what is the justification for the rational part. I notice no himt of faith in rationality in you discussion of the actual episode. The defence of the rationality assumption is that it is needed to model ( at least to mofel with any discipline) and, whilre false Might be useful. But the switch from informal discussion to formal modelling with rational expectations is considered to be progress. Assuming something agrred to befalse because it Might be useful should be followed by an open minded assessment of whether it has been useful. I detect no such assessment in your post.

  3. is the short answer to the question: "monetary policy"?

    [I have no idea what Keynes actually had to say on the matter, it just strikes me that a lot of modern macro using NK models is concerned with monetary policy, so hopefully that represents progress]

    1. Keynes was highly concerned with monetary policy - maintaining low long term interest rates

  4. Thanks again for linking to me. I am actually quite flattered as my contribution is the standard complaint typical of non economists and surly undergraduates.

    I hope my comments above make it clear that I have no particular objection to you, your work of new Keynesians. I object to mainstream economic theory.

  5. Thank you for this post--it gives me some good reasons to think the New Keynesian program has produced something besides Calvo pricing. On Keynes and Ramsey, my recollection is that Ramsey does not consider an intertemporal agent who lives forever to be a credible or interesting object of analysis? I'd not be surprised if Keynes, teleported to the present, would say, (like Marx), "I am not a Keynesian." For example, the canonical NK DSGE model lacks investment--the centerpiece of his thinking.

  6. Keynes didn't reject it. If you look at Chapters 8 and 9 of the General Theory, Chapter 8 essentially deals with the exogenous variables in the consumer's intertemporal budget constraint and Chapter 9 with the intertemporal utility function, just not set out in mathematical form. Keynes' focus on income as the prime determinant of consumption was based on empirical arguments: that other factors change slowly and that the elasticity of consumption with respect to those factors was small. In terms of the traditional C = C0 + cY consumption function, these factors are in the intercept - determinants of what Keynes called the propensity to consume, as distinct from the marginal propensity to consume (which term first appears in Chapter 10 of the General Theory, by the way). We're blogging our way through the General theory at the Cocktail Party Economics blog: . Haven't reached Ch 8 yet.

  7. Sorry to split thecomment, I am messing with an iPad which I do not understand.

    I havetwo things still to say. The first is that it may appear that I dismiss the claim that something useful has been achieved not by Keynesian macro in particular, but rather the whole of theoretical macro based on mathematical models. Yes. Except for the word "macro". I am asking if economic theory has accomplished anything if judged based on its interaction with evidence and not based on the assumption that it is good in itself. My impression is that I often here predictions that it will be useful, but find no examples of plausible claims that it has been useful.

    I tried to ask for a prediction whichhasbeen confirmed. Here the alternative I have in mind is atheoretic reduced form ... oK I mean a VAR.

    Back to Keynes vs Keynesians. One benefit from the developement testing and rejection of the super simple PIH is that it reminded us of many issued ignored in old Keynesian models. Reminded. Those issues were discussed by Keynes. Based on analysing roughly no data without a computer, he concluded that the effect of e.g. Expected future income growth was small and could safely be neglected. This is a testable hypothesis. As far as I know, ithasn't been rejected.
    The stylised fact is that coutries with rapid GDP growth have low ratios of consumption to GDP ( given the high correlation of S and I it is natural to guess the direction of causation is S causes growth). It seems to me that this well known fact constitutes some evidence against the idea that expectable future income growth causes a high ratio of consption to current income. My sense is that a simple glance at the data suggest that Keynes was wrong and modern macro is more wrong, getting the sign wrong.

  8. Keynes was only praising a young shcolar that had an untimely death. There is no possible connection between Ramsey's savings driven, Say's Law model, and Keynes Principle of Effective Demand. That he rejected intertemporal savings is clear in the GT chapter 16. He says: "An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand." If you use Ramsey you're not Keynesian.


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