Monday 6 October 2014

More asymmetries: Is Keynesian economics left wing?

In the textbooks it is suggested that Keynesian economics is what happens when ‘prices are sticky’. Sticky prices sound like prices failing to equate supply and demand, which in turn sounds like markets not working. Hence whether you believe in Keynesian theory depends on whether you think markets work, so it obviously maps to a left/right political perspective.

Reality is rather different. Suppose we start from a position where firms are selling all they wish. Aggregate demand equals aggregate supply. If then aggregate demand for goods falls, perhaps because consumers or firms are trying to rebuild their balance sheets after a financial crisis, producers of these goods will start to reduce output, and lay off workers. The idea that they would ignore the fall in demand and just carry on producing the same amount is ludicrous. So output appears to be influenced by aggregate demand at least in the short run, which is at the heart of what most economists think of as Keynesian theory.

So where do sticky prices come in? Here we have to go back to the textbooks, and to an imaginary world where the monetary authority fixes the money supply. Firms, in an effort to stimulate demand for their goods, cut prices. Lower prices mean people do not need to hold so much money to buy goods. However if the nominal money supply is fixed, interest rates will fall to encourage people to hold more money. The textbooks encourage us to think of a market for money, with interest rates as the price that equates supply and demand. Lower interest rates provide an incentive to consumers and firms to increase demand, which in turn raises output.

Now suppose that firms carry on cutting prices as long as they are selling less than they would like. The process just described will continue, with interest rates getting lower and aggregate demand rising in response. The process stops when firms stop cutting prices, which means aggregate demand has increased back to its original level. Suppose further that prices adjusted very quickly. This mechanism would work very quickly, so we would only observe aggregate demand being below supply for very short periods. If prices were extremely flexible, we could ignore aggregate demand altogether in thinking about output. Hence aggregate demand matters only if ‘prices are sticky’.

Note that this correction mechanism is quite complex, and some way from the simple microeconomic world of the market for a single good. But we need to move back to the real world again. Monetary authorities do not fix the money supply; they fix short term interest rates. So they are directly in charge of the correction mechanism that is at the heart of this story. If central banks had some way of knowing what aggregate supply was, and also had perfect knowledge of aggregate demand and how interest rates influenced it, they could make sure aggregate demand equalled supply without any need for prices to change at all. Equally, if prices were very flexible but the monetary authority always moved nominal rates in such a way as to fail to stimulate aggregate demand, aggregate demand and therefore output would not return back to equal aggregate supply. Demand would still matter, even with flexible prices.

Once you see things as they are in the real world, rather than as they are portrayed in the textbooks, the importance of aggregate demand (and therefore of Keynesian theory) is all about how good monetary policy is, and not about sticky prices. If monetary policy was perfect, then Keynesian theory would only be used by central banks in order to be perfect, and everyone else could ignore it. Of course for many good reasons monetary policy is not perfect, and so Keynesian theory matters.

We could re-establish the link between Keynesian theory and price flexibility by assuming the monetary authority follows a rule which would make policy perfect if and only if prices moved very fast, but the key point remains. The importance or otherwise of Keynesian theory depends on monetary policy. It is not about market failure. Keynesian economics is not left wing, but it is about how the economy actually works, which is why all monetary policymakers use it.

It is also common sense, which is why I’m often perplexed by those who dispute Keynesian ideas. Now maybe they are confused by the strange world portrayed in textbooks, but even if they think it is all about ‘sticky prices’, the evidence that prices are slow to adjust is overwhelming, so it is hard to dispute Keynesian theory on those grounds. Yet a whole revolution in macroeconomic theory was based around a movement that wanted to overthrow Keynesian ideas, and build models where this correction mechanism I described happened automatically. The people who built these models did not describe them as assuming monetary policy worked perfectly: instead they said it was all about assuming markets worked. As a description this was at best opaque and at worst a deliberate deception.

So why is there this desire to deny the importance of Keynesian theory coming from the political right? Perhaps it is precisely because monetary policy is necessary to ensure aggregate demand is neither excessive nor deficient. Monetary policy is state intervention: by setting a market price, an arm of the state ensures the macroeconomy works. When this particular procedure fails to work, in a liquidity trap for example, state intervention of another kind is required (fiscal policy). While these statements are self-evident to many mainstream economists, to someone of a neoliberal or ordoliberal persuasion they are discomforting. At the macroeconomic level, things only work well because of state intervention. This was so discomforting that New Classical economists attempted to create an alternative theory of business cycles where booms and recessions were nothing to be concerned about, but just the optimal response of agents to exogenous shocks.

So my argument is that Keynesian theory is not left wing, because it is not about market failure - it is just about how the macroeconomy works. On the other hand anti-Keynesian views are often politically motivated, because the pivotal role the state plays in managing the macroeconomy does not fit the ideology. Is this asymmetry odd? I do not think so - just think about the debate over climate change. Now of course it is true that there are a small minority of scientists who do not believe in manmade climate change and who are not politically motivated to do so, and I’m sure the same is true for Keynesian theory. But to claim that the majority of anti-Keynesian views were innocent of ideological preference would be like – well like trying to pretend that monetary policy has no role in stabilising the business cycle.

There are of course many differences between climate change denial and anti-Keynesian positions. One is the extent to which the antagonism has infiltrated the subject itself. Another is the extent to which the mainstream wants to deny this influence. I do wonder if the unreal view of monetary policy that remains in the textbooks does so in part so as to not offend a particular ideological position. I do know that macroeconomics is often taught as if this ideological influence was non-existent, or at least not important to the development of the discipline. I think doing good social science involves recognising ideological influence, rather than pretending it does not exist.

  

20 comments:

  1. Paul Krugman blog August 2, 2013 'Models and Mechanisms (Wonkish)':

    'Take the most widely used model in all of economics, supply and demand — and yes, it is a model, not a law of nature or a mystical truth. When we talk about supply and demand, we’re talking largely about the notion that a rising or falling price can bring the quantity people want to sell into line with the quantity people want to buy; we even sometimes call it the “price mechanism”. Supply and demand as a model then adds the proposition that prices will in fact rise or fall to achieve this outcome — but that’s not quite the same thing as the price mechanism itself. And woe unto the economist who forgets that his claim that supply and demand get balanced must operate through the price mechanism.'

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  2. I'm confused. Monetary policy can only change overall interest rates, that are the same for all kinds of loans. Independent if you want to buy an apple, a pear, or an orange, or if you want to employ somebody to water your apple trees or pick the pears. In actual markets prices change relatively to each other. The central bank can only tune some overall activity level, which means that it is impossible for monetary policy to 'perfectly' adapt demand, to supply, for every product, without prices also having to adapt.

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    1. I'm confused why you thought I was saying anything different. Monetary policy deals with the macro problem, relative prices in markets generally deals with the micro.

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    2. As written, if macro and micro are really distinct topics,the argument here is that monetary policy does influence relative prices and thus does not have a distributional impact.

      This seems to me some of the purest and a right-wingnut propaganda.

      Contradicted not only by a mountain of arguments and evidence, but even by the speeches of Mervyn King, that at some late point in the day was starting to muse whether his monetary policy wasn't perchance redistributing to the wealthy.

      I am waiting expectantly for the statement that "Monetary policy deals with the macro problem, relative prices in markets generally deals with the micro." actually means that monetary policy does affect relative prices :-).

      BTW I think I think that I understand our blogger is trying to keep riding two horses, but that is sometimes a bit too acrobatic even for an academic.. :-)

      Hint for some readers as to the core issue here: "distributional impact" Economics means "class war" and earns immediate excommunication. :-)

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    3. OOPS, correection:

      «As written, if macro and micro are really distinct topics,the argument here is that monetary policy does NOT influence relative prices and thus does not have a distributional impact.»

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  3. From a continental perspective an economic approach which shows, that Say's Law doesn't hold and that deficient demand of the private sector can be compensated by government spending calls for a state that plays an active role in the economic process. Both, left wing and conservative politicians could advocate active fiscal policy while liberals and libertarians would be reluctant to plead for active fiscal policy. As far as monetary policy is concerned one could argue that a monetary policy rule which allows the central bank to consider the situation on the labour market and is not strictly tied to price level stability is a little more left wing.

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  4. The question of whether or not Keynesianism is left-wing or not depends on the framework you're working with. If you think of right wing as something close to libertarianism then keynesianism is surely left. If you consider leftwing as something akin to communism then keynesianism is clearly right wing because it assumes that there is a market. In most cases both of these assumptions are wrong.

    In most of Europe the right wing supports the welfare state and habitually uses a range of subsidies and targeted taxes to implement policy. All european countries let the state run healthcare and most have tuition free higher education. If that is not a rejection of the notion that makrets work then what is?

    In the actual world there is a tendency towards keynesianism being used by left wing parties but it is just a tendency. The canadian right wing government used stimulus to fight the recession while the French left wing has a rather anti-keynesian economic program. In Germany and the Netherlands Left-Right alliances are implementing austerity.

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    1. «If you think of right wing as something close to libertarianism then keynesianism is surely left. If you consider leftwing as something akin to communism then keynesianism is clearly right wing because it assumes that there is a market. In most cases both of these assumptions are wrong.»

      The left-right wing debate is not one among wise and impartial philosopher kings who split hairs in two like here about the assumptions... And left/right is not about markets, that's just the usual dissembling frippery, like the debate about the size of the state.

      It is a political argument, that is primarily a distributional one, about who gets more, as to the practical consequences for various vested interests as to which markets operate to whose benefit and which size of the state delivers higher income and power to whom.

      As to this the view of Keynes as left-wing is that he advocates policies that result in higher employment and wages and also lower rents for property owners (hello, "euthanasia of the rentier"). But Keynes is also viewed as right-wing as the intention behind that is to optimize the returns to businessmen rather than rentiers by boosting utilization of productive capital and correcting depressions into recessions at the cost of higher employment and wages for hired help.

      Put in a much grosser way, Keynes looks left-wing to tories, just fine to whigs and right-wing to labourists.

      Not because of markets or size of government but because he envisions markets and governments that work to the benefit of businesses rather than rentiers or workers.

      BTW I was thoroughly amused the first time I read him referring to "capitalism" as "the Manchester system" as if it was a bizarre novelty from far up North.

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  5. A good example of this is the claim that extended unemployment insurance puts upward pressure on wages, by not allowing them to fall as fast or as much without it, but that they are falling is evidence of a macro problem.

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  6. In the post-war era (1945-1980), all American presidents were Keynesian. Under Republican Dwight D. Eisenhower, the highest income tax bracket was raised to 91% and he built the US interstate highway system.

    According to idiots today he would be considered a "socialist."

    Although economic policies have moved to the free-market far-right of the economic spectrum over the past 30 years - with disastrous consequences - that doesn't move the economic spectrum itself.

    The Keynesian mixed-market system is in the center of the left-right spectrum. It can be left-leaning (social democracy) or right-leaning. It can incorporate ideas across the political spectrum.

    Although largely abandoned by Anglo Saxon countries, the mixed market system is still popular in Europe. Germany's mixed-market economy is the most competitive on the planet. Unfortunately, they are too competitive which is dragging the euro-zone down (because of the common currency other countries are expected to deflate their way to competitiveness: utter boneheaded economics.)

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  7. "the evidence that prices are slow to adjust is overwhelming"

    I presume you mean that we often observe M rising by 10% while P is unaffected.
    Alternate explanation of sticky prices: When the central bank issues 10% more money, it gets 10% more assets (mainly bonds) in exchange, so the value of money is unaffected. It's just like a firm that issues new stock in exchange for new assets, leaving share price the same.

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  8. Good post Simon.

    I would put a right-wing spin on it, and not even mention Keynes:

    The government is in charge of property rights and monetary policy. If you are in charge of something, "doing nothing" is meaningless. There are 1,001 different ways of "doing nothing".

    If the government screws up property rights, you can't expect the free market to work well.

    If the government screws up monetary policy, you can't expect the free market to work well.

    So we all need to discuss the real questions: what is the best system of property rights?, and what is the best monetary policy?

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    1. "If the government screws up monetary policy, you can't expect the free market to work well."

      The free-market libertarians had their man heading The Fed during the "Bush boom". He was a personal disciple of Ayn Rand. He believed in Friedmanian helicopter money. He was vociferously opposed to banking regulations and regulations on "financial innovation" derivatives that caused the bubble and 2008 financial meltdown.

      But because Alan Greenspan was a complete failure in managing the economy -- believing the best approach to asset bubbles is to let them form and burst, then clean up the mess -- free-marketeers now want to throw him under the bus and call him "government." How pathetic.

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  9. "Equally, if prices were very flexible but the monetary authority always moved nominal rates in such a way as to fail to stimulate aggregate demand, aggregate demand and therefore output would not return back to equal aggregate supply. Demand would still matter, even with flexible prices."
    Typically, a central bank would control nominal interest rates through open market operations (lets ignore interest on reserves and the like for the time being) by changing the real money supply. However, in a world with flexible prices, isnt real money supply (M/P) beyond the control of the central bank and determined completely by the real side of the economy? In other words, if prices are perfectly flexible, it is not obvious what control the central bank has over real (or even nominal) interest rates? I am a bit unclear about this..

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    1. Let r be real and i be nominal interest rates.

      An increase in the level of M would have no effect on either r or i.

      An increase in the growth rate of M would increase i but have no effect on r (in a simple model). Because it will increase the expected inflation rate.

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    2. thanks Nick, this was helpful

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  10. Libertarian economists have an incentive (perhaps very strong if they're strongly libertarian), to deny or discount anything that makes government action or a government role look more attractive. And for many this is to the point of regularly grossly misleading or outright lying. You see this widely from Keynsian economics to monetary economics to global warming to the smart computer/robot revolution. Here is a comment I recently left at the Growth Economics blog:

    To put it more concisely, if you admit that computers/robots are going to get really good, and so for most people to be able to have a market wage above minimum they’re going to have to have a lot of education and training — at least — this means that a lot more government will be needed to avoid massive unemployment and poverty. Libertarians don’t want people to want, and vote for, a lot more government, so they deny this — It’s not that difficult a problem. If people just make an effort they can get around it. No need for big increases in spending on education and Heckman style early human development, nothing to see here, move on,…

    To a strong libertarian we shouldn’t even have government paid for K-12, let alone unemployment insurance, social security, and medicare. That’s all government taking away peoples freedom, forcing them to pay for these things. Anything that makes government action and expansion look more attractive and necessary to the voters they have a strong incentive to deny and discount, from Keynesian economics to active monetary policy, to massive computer/robot substitution.

    at: http://growthecon.wordpress.com/2014/10/03/meta-post-on-robots-and-jobs/#comments

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  11. Could one say, then, that there are essentially two alternative paths to arguing that Keynesian theory is irrelevant, based on economic theory (however motivated)?

    On one line of argument, monetary authorities are assumed to target a monetary aggregate, i.e. a quantity (as under monetarism), which is combined with the premise of price flexibility. In this case, demand always equals supply in virtue of an automatic adjustment mechanism.*

    The second line of reasoning, essentially RBC theory, uses price flexibility and rational expectations theory to argue that booms and recessions are merely reflections of the optimal response of agents to exogenous shocks.

    If so, and I don't claim that this contradicts Prof. Wren-Lewis's argument (since the combination of price flexibility and bad monetary policy targeting interest rates still leaves demand relevant), it would seem that at least for anti-Keynesian views, the premise of price flexibility is central. This, in turn, would explain the vehement denials of the 'overwhelming evidence' from this camp.

    *A related, but more openly political argument (Friedman) is that although money is non-neutral in the short-run (ie prices are sticky), lags and incompetency etc. mean that entrusting governments with discretionary authority over the money-supply/interest-rates will have destabilizing consequences for the economy.

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  12. What is left wing or right wing?

    If you assume that it is right wing anything that promotes the rule of finance capital, preventing the central bank to intervene to reduce interest rates, or the "discipline" in the factories through unemployment it is reasonable to consider Keynesian economics left wing.

    I think that you know Kalecki's "Political aspects of full employment", http://economie.politique.free.fr/liens/Kalecki_1943.pdf

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  13. All I know is that Barrack Obama spent the US economy (not individuals, the economy) completely into abject penury, by following the Keynesian dogma, of government stimulus during a downturn or recession. The stupidity of the that concept, is beyond the pale. Borrowing every cent of 7 Trillion dollars and pissing it against a tree (a metaphor, folks) through "shovel ready" government projects, where zero long term jobs or wealth is created through innovation and entrepreneurship, is so "Left Wing", that to even ponder its Left Wingness, begs the question of the ability of the ponderer to actually be able to think. Keynesian economics are not only Left Wing, they are just plain stultifyingly, stupid.

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