Two Anti-Keynesian myths

This is mainly of interest to economists, but given the importance of these issues, I have tried to write it in an accessible manner.

Stephen Williamson, in commenting on this post, remarks acidly that

“Part of what defines a Keynesian (new or old), is that a Keynesian thinks that his or her views are "mainstream," and that the rest of macroeconomic thought is defined relative to what Keynesians think - Keynesians reside at the center of the universe, and everything else revolves around them.”

In that post I was careful to distinguish between academic research and policy. Of course macroeconomists research many things, and only a minority are using New Keynesian models, and probably even some of those do not really need the New Keynesian bit. That is the great thing about abstraction. Working with what can be called ‘flex price’ models does not imply that you think price rigidity is unimportant, but instead that it can often be ignored if you want to focus on other processes. So in terms of research I talked about the significant divide being between mainstream and heterodox. In terms of research, mainstream macroeconomists talk the same language.

I used the term anti-Keynesian in the context of macroeconomic policy, and in this context I was not talking about academics, but the set of economists involved with macro policy. They could be academics, but they could be working for central banks, a finance ministry, or an international organisation like the IMF or OECD. For this group, I think we have good reason to believe that the large majority are not anti-Keynesian.

Just look, for example, at any central bank publication discussing recent movements in output. This will typically focus on movements in components of aggregate demand: consumption, investment etc. The reason is a belief that output in the short run is demand determined. That, for me, is the defining feature of Keynesian analysis. If you look at the core models used in central banks (which, unlike models used by academics, need to be ‘horses for all courses’) the same will be true.

Now Nick Rowe and David Glasner suggest that this view is not uniquely Keynesian - I could equally call it monetarist, for example. But what then are the criteria you will use to restrict the Keynesian set today? Different views about unconventional monetary policy? Different views about the efficacy of fiscal policy at the zero lower bound? This seems way too narrow. People have views about the relative merits of fiscal policy for all kinds of reasons, which may be very context specific, so this does not look like a good method of defining a label for economists today.  

Yet not everyone is a Keynesian using my deliberately broad definition. The only logical way to make sense of statements like those discussed here, for example, is to imagine we are in a world where output is determined from the supply side, so if one particular component of demand, like government spending on goods and services, goes down its impact on output will be offset by some means. That is an anti-Keynesian view. My first anti-Keynesian myth is that among economists involved with policy this is not a minority view.

The second myth is that all you need to justify this anti-Keynesian view is to observe that wages and prices move in response to booms and recessions. For example Roger Farmer points to negative inflation following the Great Depression. Language can be confusing here. As an analogy, suppose someone has been ill, and you ask them whether they are now better. Do you mean better than they were (but still ill), or completely recovered? For us to take an anti-Keynesian view, we do not just require prices to move, we require them to move by just the amount needed so that we can ignore demand. So, for example, in an open economy under fixed exchange rates, for a devaluation to have no demand impact requires prices to immediately rise by the same amount. Prices will begin to rise for sure, but ‘flexible prices’ means more than that.

If we take a simple closed economy, then ‘flexible prices’ is short for the real interest rate (nominal rates less expected inflation) always being at its ‘natural level’, which is the level that ensures demand matches supply. This immediately tells you that we are not just talking about price flexibility, but also monetary policy. Imagine in this economy there is a negative demand shock, caused by a fall in government spending. In this economy, the immediate impact is that firms will reduce output as well as prices. To offset this, the natural interest rate will fall to increase private consumption. Will the actual real interest rate do the same? This could happen without prices changing if the central bank cut nominal rates by exactly the required amount. It could happen without the central bank doing anything to nominal rates if expected inflation rose by exactly the required amount. Or it could be some combination of the two.

One justification for assuming that the real interest rate is always at its natural level is that monetary policy is super efficient, moving nominal rates to always offset the impact of demand shocks. For some reason this is not an argument anti-Keynesians usually make. The alternative justification is that, conditional on whatever monetary policy does, prices move by just the amount required to give you the expected inflation rate necessary to generate the natural real interest rate, and therefore offset the demand shock.

This becomes clear when nominal interest rates are stuck at the zero lower bound. In that case, the natural real interest rate is large and negative, but monetary policy cannot get there because nominal interest rates cannot be negative. For flexible prices to get you to that real rate you would need expected inflation to be significantly positive. (We now believe there is no independent Pigou effect (or real balance effect) that will save the day.) As Roger shows, actual inflation from 1929 to 1933 was persistently negative. One must presume that inflation expectations were also negative. So clearly although prices were moving, they were not moving in the way required for the anti-Keynesian view to hold. Far from casting doubt on the Keynesian story, falling prices during the Great Depression show how unrealistic the anti-Keynesian view is.

Speaking as an Old New Keynesian …

Labels are fun, and get attention. They can be a useful shorthand to capture an idea, or related set of ideas. But is there really a New Old Keynesian school of thought? I don’t think so. Here are a couple of bold assertions, which I think I believe, and which I will try to justify. First, in academic research terms there is only one meaningful division, between mainstream and heterodox. (Of course the heterodox divide themselves up into various ‘schools’, but their size is small and their influence is also small.) Second, in macroeconomic policy terms I think there is only one meaningful significant division, between mainstream and anti-Keynesians.

But before trying to justify these statements, I want to defend being a killjoy. As I said, putting people into categories can be fun - why spoil it by taking the exercise seriously? Two reasons. First, I want to make some points which do not get said often enough on economics blogs. Second, labels can lead to confusion or worse. Just think about the label Keynesian. Any sensible definition would involve the words sticky prices and aggregate demand. Yet there are still some economists (generally not academics) who think Keynesian means believing fiscal rather than monetary policy should be used to stabilise demand. Fifty years ago maybe, but no longer. Even worse are non-economists who think being a Keynesian means believing in market imperfections, government intervention in general and a mixed economy. (If you do not believe this happens, look at the definition in Wikipedia.)

So what do I mean by a meaningful division in academic research terms? I mean speaking a different language. Thanks to the microfoundations revolution in macro, mainstream macroeconomists speak the same language. I can go to a seminar that involves an RBC model with flexible prices and no involuntary unemployment and still contribute and possibly learn something. Equally an economist like John Cochrane can and does engage in meaningful discussions of New Keynesian theory (pdf). [1]

Of course all academic macroeconomists have their own idea of how the world actually works and will probably do research using models that roughly conform to that. Yet I think you would be hard put to draw meaningful boundaries here. Take John Quiggin’s Old/New Keynesian post, for example (which followed this from Tyler Cowen). He characterises New New Keynesians as those still working with DSGE models who are now attempting to add financial frictions. He wants to argue (and labels New Old Keynesian) the idea that following this recession, there “is no unique long-run equilibrium growth path, determined by technology and preferences, to which the economy is bound to return. In particular, the loss of productive capacity, skills and so on in the current depression is, for all practical purposes, permanent.” Now listening with my mainstream ears, this sounds like a combination of hysteresis effects and endogenous growth, which sounds interesting. Yet I also think we can learn a lot from adding financial frictions to DSGE models. Does this make me a middle aged Keynesian?

What I suspect Quiggin is getting at here is that New New Keynesians are still following a microfoundations research programme (using DSGE), whereas he would not. Now many mainstream macroeconomists, myself included, can be pretty critical of the limitations that this programme can place on economic thinking, particularly if it is taken too literally by microfoundations purists. But like it or not, that is how most macro research is done nowadays in the mainstream, and I see no sign of this changing anytime soon. (Paul Krugman discusses some reasons why here.) My own view is that I would like to see more tolerance and a greater variety of modelling approaches, but a pragmatic microfoundations macro will and should remain the major academic research paradigm.

When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term. [2] Why do I use the term anti-Keynesian rather than, say, New Classical? Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.

What is incoherent about believing in pretty flexible prices, you might ask? Two things. First, as I have argued before, with the demise of the Pigou effect flexible prices do not get you out of a deficient demand problem at the zero lower bound when there are inflation targets. Second, the evidence that prices are not flexible is so overwhelming that you need something else to drive you to ignore this evidence. Or to put it another way, you need something pretty strong for politicians or economists to make the ‘schoolboy error’ that is Says Law, which is why I think the basis of the anti-Keynesian view is essentially ideological.

Of course there are a huge number of policy debates in macroeconomics, and you can attach labels to those if you like. Should we use fiscal stimulus at the zero lower bound, for example. Was austerity a good idea? However, anti-Keynesians aside, I don’t think these debates reveal large fault lines in economic thinking. Economists do not rigidly line up on one side or another, and some even change their mind over time as the facts change. It is possible to have serious discussions about the effectiveness of monetary policy, the dangers of high debt etc. The only group where a discussion can fail to get off the ground is with those who contend that aggregate demand is always irrelevant.

[1] Heterodox economists might argue that they have to be bilingual - they are able to speak mainstream, even if they prefer not to among friends. Those more critical might detect a reluctance to get past certain words.

[2] An alternative, and more positive, way to define the anti-Keynesian group is that they believe macroeconomic outcomes are essentially efficient, and so intervention by a government (or central bank, beyond providing a nominal anchor) is not required. This difference might be important in placing someone like Roger Farmer (who I’m glad to see now has a blog), who is not an anti-Keynesian under this positive definition, but might be using my more negative criteria.

Was the UK government’s use of North Sea Oil a scandal?

Aditya Chakrabortty of the Guardian thinks so, as do many on the left. The evidence appears at first sight quite strong, if we compare the UK to Norway. The Norwegian government invested the proceeds from its share of North Sea oil in a sovereign wealth fund, and as a result each Norwegian citizen is currently about $150,000 richer. The fund holds on average 1% of the world's shares. In contrast, there is no equivalent UK sovereign wealth fund, but just a lot of UK government debt. QED?

Not so fast. The opposing argument can also be stated in an equally compelling way. Why should the government decide on what to do with the oil revenue? The democratic thing to do with the money is to give it to the people, and they can decide what to do with it. To the extent that they choose to invest it, so the argument goes, individuals are much better at making good investment decisions with their own money than the government is. Seen this way, the complaints from the left are just another example of the paternalistic belief that the state knows better what is good for people than people themselves. What Mrs Thatcher’s government did was allow individuals to create their own wealth from North Sea Oil revenues, if they so wished.

There are essentially two issues here: one involving distribution between generations, and the other distribution between individuals. Few would argue that the generation who paid taxes in the 1980s deserved exclusive rights to the benefits of North Sea Oil: most would agree that this resource should also benefit future UK generations. Now the current generation could look after future generations by investing rather than consuming a large part of the revenues. The standard macroeconomic model assumes this happens to some extent (agents care about their children etc), although in a way that heavily discounts the welfare of future generations. Did they do this?

It is difficult to know for sure, but when I looked at the evidence from current accounts and net national wealth here, it was hard to believe that most of the UK’s North Sea Oil money was invested. So on this occasion at least, the Norwegian government appears to have looked after the interests of future generations rather better than the average 1980s UK taxpayer did. Whether that is because these taxpayers were selfish or badly informed I have no idea. (For a fascinating account of how a sovereign wealth fund might be useful in a world with selfish agents and animal spirits, see these papers (pdf, pdf, pdf) by Roger Farmer.)

The other problem with the defence of the UK government’s approach is more straightforward. If North Sea Oil revenue was used to reduce taxes, this means that the revenue was distributed unequally rather than democratically. Those who didn’t pay any taxes at the time received nothing. Those that paid the most taxes, which of course means those with the highest incomes, received most. An alternative would have been to distribute equal oil ‘dividends’ to each citizen, for example as the US state of Alaska has done. (For more general discussion of how best to handle resource discoveries, see some of the papers produced by OxCarre.)

So was the UK government’s policy a scandal? One definition of scandal is “an action or event regarded as morally or legally wrong and causing general public outrage”. Well, general public outrage it did not cause: giving the majority of people at least some money rarely does, and that those who were better off got most was a feature of the decade. On the other hand the fact that so little of the wealth was left for future generations, in contrast to the ‘statist’ Norwegian alternative, does seem to pose serious problems for neoliberalism, as well as the core intertemporal macroeconomic model.

 

New Keynesian models and the labour market

Do all those using New Keynesian models have to believe everything in those models? To answer this question, you have to know the history of macroeconomic thought. I think the answer is also relevant to another frequently asked question, which is what the difference is between a ‘New Keynesian’ and an ‘Old Keynesian’?

You cannot understand macro today without going back to the New Classical revolution of the 1970s/80s. I often say that the war between traditional macro (Keynesian or Monetarist) and New Classical macro was won and lost on the battlefield of rational expectations. This was not just because rational expectations was such an innovative and refreshing idea, but also because the main weapon in the traditionalists armoury was so vulnerable to it. Take Friedman’s version of the Phillips curve, and replace adaptive expectations by rational expectations, and the traditional mainstream Keynesian story just fell apart. It really was no contest. (See Roger Farmer here, for example.)

I believe that revolution, and the microfoundations programme that lay behind it, brought huge improvements to macro. But it also led to a near death experience for Keynesian economics. I think it is fairly clear that this was one of the objectives of the revolution, and the winners of wars get to rewrite the rules. So getting Keynesian ideas back into macro was a slow process of attrition. The New Classical view was not overthrown but amended. New Keynesian models were RBC models plus sticky prices (and occasionally sticky wages), where stickiness was now microfounded (sort of). Yet from the New Classical point of view, New Keynesian analysis was not a fundamental threat to the revolution. It built upon their analysis, and could be easily dismissed with an assertion about price flexibility. Specifically NK models retained the labour leisure choice, which was at the heart of RBC analysis. Monetary policymakers were doing the Keynesian thing anyway, so little was being conceded in terms of policy. [1]

So labour supply choice and labour market clearing became part of the core New Keynesian model. Is this because all those who use New Keynesian models believe it is a good approximation to what happens in business cycles? I doubt it very much. However for many purposes allowing perfect labour markets does not matter too much. Sticky prices give you a distortion that monetary policy can attempt to negate by stabilising the business cycle. The position you are trying to stabilise towards is the outcome of an RBC model (natural levels), but in many cases that involves the same sort of stabilisation that would be familiar to more traditional Keynesians.

This is not to suggest that New Keynesians are closet traditionalists. Speaking for myself, I am much happier using rational expectations than anything adaptive, and I find it very difficult to think about consumption decisions without starting with an intertemporally optimising consumer. I also think Old Keynesians could be very confused about the relationship between aggregate supply and demand, whereas I find the New Keynesian approach both coherent and intuitive. However, the idea that labour markets clear in a recession is another matter. It is so obviously wrong (again, see Roger Farmer). So why did New Keynesian analysis not quickly abandon the labour market clearing assumption?

Part of the answer is the standard one: it is a useful simplifying assumption which does not give us misleading answers for some questions. However the reason for my initial excursion into macro history is because I think there was, and still is, another answer. If you want to stay within the mainstream, the less you raise the hackles of those who won the great macro war, the more chance you have of getting your paper published.

There are of course a number of standard ways of complicating the labour market in the baseline New Keynesian model. We can make the labour market imperfectly competitive, which allows involuntary unemployment to exist. We can assume wages are sticky, of course. We can add matching. But I would argue that none of these on its own gets close to realistically modelling unemployment in business cycles. In a recession, I doubt very much if unemployment would disappear if the unemployed spent an infinite amount of time searching. (I have always seen programmes designed to give job search assistance to the unemployed as trying to reduce the scaring effects of long term unemployment, rather than as a way of reducing aggregate unemployment in a recession.) To capture unemployment in the business cycle, we need rationing, as Pascal Michaillat argues here (AER article here). This is not an alternative to these other imperfections: to ‘support’ rationing we need some real wage rigidity, and Michaillat’s model incorporates matching. [2]

I think a rationing model of this type is what many ‘Old Keynesians’ had in mind when thinking about unemployment during a business cycle. If this is true, then in this particular sense I am much more of an Old Keynesian than a New Keynesian. The interesting question then becomes when this matters. When does a rationed labour market make a significant difference? I have two suggestions, one tentative and one less so. I am sure there are others.

The tentative suggestion concerns asymmetries. In the baseline NK model, booms are just the opposite of downturns - there is no fundamental asymmetry. Yet traditional measurement of business cycles, with talk of ‘productive potential’ and ‘capacity’, are implicitly based on a rather different conception of the cycle. A recent paper (Vox) by Antonio Fatás and Ilian Mihov takes a similar approach. (See also Paul Krugman here.) Now there is in fact an asymmetry implicit in the NK model: although imperfect competition means that firms may find it profitable to raise production and keep prices unchanged following ‘small’ increases in demand, at some point additional production is likely to become unprofitable. There is no equivalent point with falling demand. However that potential asymmetry is normally ignored. I suspect that a model of unemployment based on rationing will produce asymmetries which cannot be ignored.

The other area where modelling unemployment matters concerns welfare. As I have noted before, Woodford type derivations of social welfare give a low weight to the output gap relative to inflation. This is because the costs of working a bit less than the efficient level are small: what we lose in output we almost gain back in additional leisure. If we have unemployment because of rationing, those costs will rise just because of convexity. [3]

However I think there is a more subtle reason why models that treat cyclical unemployment as rationing should be more prevalent. It will allow New Keynesian economists to say that this is what they would ideally model, even when for reasons of tractability they can get away with simpler models where the labour market clears. Once you recognise that periods of rationing in the labour market are fairly common because economic downturns are common, and that to be on the wrong end of that rationing is very costly, you can see more clearly why the labour contract between a worker and a firm itself involves important asymmetries - asymmetries that firms would be tempted to exploit during a recession. 

Yet you have to ask, if I am right that this way of modelling unemployment is both more realistic and implicit in quite traditional ways of thinking, why is it so rare in the literature? Are we still in a situation where departures from the RBC paradigm have to be limited and non-threatening to the victors of the New Classical revolution?

[1] When, in a liquidity trap, macroeconomists started using these very same models to show that fiscal policy might be effective as a replacement for monetary policy, the response was very different. Countercyclical fiscal policy was something that New Classical economists had thought they had killed off for good.

[2] Some technical remarks.

(a) Indivisibility of labour, reflecting the observation (e.g. Shimer, 2010) that hours per worker are quite acyclical, has been used in RBC models: early examples include Hansen (1985) and Hansen and Wright (1992). Michaillat also assumes constant labour force participation, so the labour supply curve is vertical, and critically some real wage rigidity and diminishing returns.

(b) Consider a deterioration in technology. With flexible wages, we would get no rationing, because real wages would fall until all labour was employed. What if real wages were fixed? If we have constant returns to labour, then if anyone is employed, everyone would be employed, because hiring more workers is always profitable (mpl>w always). What Michaillat does is to allow diminishing returns (and a degree of wage flexibility): some workers will be employed, but after a point hiring becomes unprofitable, so rationing can occur.  

(c) Michaillat adds matching frictions to the model, so as productivity improves, rationing unemployment declines but frictional unemployment increases (as matches become more difficult). Michaillat’s model is not New Keynesian, as there is no price rigidity, but there is no reason why price rigidity could not be added. Blanchard and Gali (2010) is a NK model with matching frictions, but constant returns rules out rationing.

[3] I do not think they will rise enough, because in the standard formulation the unemployed are still ‘enjoying’ their additional leisure. One day macroeconomists will feel able to note that in reality most view the cost of being unemployed as far greater than its pecuniary cost less any benefit they get from their additional leisure time. This may be a result of a rational anticipation of future personal costs (e.g. here or here), or a more ‘behavioural’ status issue, but the evidence that it is there is undeniable. And please do not tell me that microfounding this unhappiness is hard - why should macro be the only place where behavioural economics is not allowed to enter!? (There is a literature on using wellbeing data to make valuations.) Once we have got this bit of reality (back?) into macro, it should be much more difficult for policymakers to give up on the unemployed.

References (some with links in the main text)

Olivier Blanchard & Jordi Galí (2010), Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment,  American Economic Journal: Macroeconomics, vol. 2(2), pages 1-30

Hansen, Gary D (1985) “Indivisible Labour and the Business Cycle” Journal of Monetary Economics 16, 309-327

Hansen, Gary D and Wright, Randall (1992) “The Labour Market in Real Business Cycle Theory” Federal Reserve Bank of Minneapolis Quarterly Review 16, 2-12.

Pascal Michaillat (2012), Do Matching Frictions Explain Unemployment? Not in Bad Times, American Economic Review, vol. 102(4), pages 1721-50.

Shimer, R. ‘Labor Markets and Business Cycles’, Princeton, NJ: Princeton University Press, 2010.