Category Archives: Keynesian Economics

How Economics Survived the Economic Crisis – Robert Skidelsky * Good enough for government work? Macroeconomics since the crisis – Paul Krugman.

Unlike the Great Depression of the 1930s, which produced Keynesian economics, and the stagflation of the 1970s, which gave rise to Milton Friedman’s monetarism, the Great Recession has elicited no such response from the economics profession. Why?

The tenth anniversary of the start of the Great Recession was the occasion for an elegant essay by the Nobel laureate economist Paul Krugman, who noted how little the debate about the causes and consequences of the crisis have changed over the last decade. Whereas the Great Depression of the 1930s produced Keynesian economics, and the stagilation of the 1970s produced Milton Friedman’s monetarism, the Great Recession has produced no similar intellectual shift.

This is deeply depressing to young students of economics, who hoped for a suitably challenging response from the profession.

Why has there been none?

Krugman’s answer is typically ingenious: the old macroeconomics was, as the saying goes, “good enough for government work.” It prevented another Great Depression. So students should lock up their dreams and learn their lessons.

A decade ago, two schools of macroeconomists contended for primacy: the New Classical or the “freshwater” School, descended from Milton Friedman and Robert Lucas and headquartered at the University of Chicago, and the New Keynesian, or “saltwater,” School, descended from John Maynard Keynes, and based at MIT and Harvard.

Freshwater-types believed that budgets deficits were always bad, whereas the saltwater camp believed that deficits were beneficial in a slump. Krugman is a New Keynesian, and his essay was intended to show that the Great Recession vindicated standard New Keynesian models.

But there are serious problems with Krugman’s narrative. For starters, there is his answer to Queen Elizabeth II’s nowfamous question: “Why did no one see it coming?” Krugman’s cheerful response is that the New Keynesians were looking the other way. Theirs was a failure not of theory, but of “data collection.” They had “overlooked” crucial institutional changes in the financial system. While this was regrettable, it raised no “deep conceptual issue” that is, it didn’t demand that they reconsider their theory.

Faced with the crisis itself, the New Keynesians had risen to the challenge. They dusted off their old sticky-price models from the 1950s and 1960s, which told them three things. First, very large budget deficits would not drive up near zero interest rates. Second, even large increases in the monetary base would not lead to high inflation, or even to corresponding increases in broader monetary aggregates. And, third, there would be a positive national income multiplier, almost surely greater than one, from changes in government spending and taxation.

These propositions made the case for budget deficits in the aftermath of the collapse of 2008. Policies based on them were implemented and worked “remarkably well.” The success of New Keynesian policy had the ironic effect of allowing “the more inflexible members of our profession [the New Classicals from Chicago] to ignore events in a way they couldn’t in past episodes.” So neither school, sect might be the better word, was challenged to re-think first principles.

This clever history of pre- and post-crash economics leaves key questions unanswered.

First, if New Keynesian economics was “good enough,” why didn’t New Keynesian economists urge precautions against the collapse of 2007-2008? After all, they did not rule out the possibility of such a collapse a priori.

Krugman admits to a gap in “evidence collection.” But the choice of evidence is theory-driven. In my view, New Keynesian economists turned a blind eye to instabilities building up in the banking system, because their models told them that financial institutions could accurately price risk. So there was a “deep conceptual issue” involved in New Keynesian analysis: its failure to explain how banks might come to “underprice risk worldwide,” as Alan Greenspan put it.

Second, Krugman fails to explain why the Keynesian policies vindicated in 2008-2009 were so rapidly reversed and replaced by fiscal austerity. Why didn’t policymakers stick to their stodgy fixed-price models until they had done their work? Why abandon them in 2009, when Western economies were still 4-5% below their precrash levels?

The answer I would give is that when Keynes was briefly exhumed for six months in 2008-2009, it was for political, not intellectual, reasons. Because the New Keynesian models did not offer a sufficient basis for maintaining Keynesian policies once the economic emergency had been overcome, they were quickly abandoned.

Krugman comes close to acknowledging this: New Keynesians, he writes, “start with rational behavior and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges.” Such tweaks enable New Keynesian models to generate temporary real effects from nominal shocks, and thus justify quite radical intervention in times of emergency. But no tweaks can create a strong enough case to justify sustained interventionist policy.

The problem for New Keynesian macroeconomists is that they fail to acknowledge radical uncertainty in their models, leaving them without any theory of what to do in good times in order to avoid the bad times. Their focus on nominal wage and price rigidities implies that if these factors were absent, equilibrium would readily be achieved. They regard the financial sector as neutral, not as fundamental (capitalism’s “ephor,” as Joseph Schumpeter put it).

Without acknowledgement of uncertainty, saltwater economics is bound to collapse into its freshwater counterpart. New Keynesian “tweaking” will create limited political space for intervention, but not nearly enough to do a proper job. So Krugman’s argument, while provocative, is certainly not conclusive. Macroeconomics still needs to come up with a big new idea.

*

Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in history and economics, is a member of the British House of Lords. The author of a three-volume biography of John Maynard Keynes.

Project Syndicate

Oxford Review of Economic Policy, 2018

Good enough for government work? Macroeconomics since the crisis

Paul Krugman

Abstract:

This paper argues that when the financial crisis came policy-makers relied on some version of the Hicksian sticky-price IS-LM as their default model; these models were ”good enough for government work’.

While there have been many incremental changes suggested to the DSGE model. there has been no single ‘big new idea” because the even simpler lS-LM type models were what worked well. In particular, the policy responses based on lS-LM were appropriate.

Specifically, these models generated the insights that large budget deficits would not drive up interest rates and, while the economy remained at the zero lower bound, that very large increases in monetary base wouldn’t be inflationary, and that the multiplier on government spending was greater than 1.

The one big exception to this satisfactory understanding was in price behaviour. A large output gap was expected to lead to a large fall in inflation, but did not. If new research is necessary. it is on pricing behaviour. While there was a failure to forecast the crisis, it did not come down to a lack of understanding of possible mechanisms, or of a lack of data, but rather through a lack of attention to the right data.

I. Introduction

It’s somewhat startling, at least for those of us who bloviate about economics for a living, to realize just how much time has passed since the 2008 financial crisis. Indeed, the crisis and aftermath are starting to take on the status of an iconic historical episode, like the stagflation of the 1970s or the Great Depression itself, rather than that of freshly remembered experience. Younger colleagues sometimes ask me what it was like during the golden age of economics blogging, mainly concerned with macroeconomic debates, which they think of as an era that ended years ago.

Yet there is an odd, interesting difference, both among economists and with a wider audience, between the intellectual legacies of those previous episodes and what seems to be the state of macroeconomics now.

Each of those previous episodes of crisis was followed both by a major rethinking of macroeconomics and, eventually, by a clear victor in some of the fundamental debates. Thus, the Great Depression brought on Keynesian economies, which became the subject of fierce dispute, and everyone knew how those disputes turned out: Keynes, or Keynes as interpreted by and filtered through Hicks and Samuelson, won the argument.

In somewhat the same way, stagflation brought on the Friedman Phelps natural rate hypothesis, yes, both men wrote their seminal papers before the 1970s, but the bad news brought their work to the top of the agenda. And everyone knew, up to a point anyway, how the debate over that hypothesis ended up: basically everyone accepted the natural rate idea, abandoning the notion of a long-run trade-off between inflation and unemployment. True, the profession then split into freshwater and saltwater camps over the effectiveness or lack thereof of short-run stabilization policies, a development that I think presaged some of what has happened since 2008. But I’ll get back to that.

For now, let me instead just focus on how different the economics profession response to the post-2008 crisis has been from the responses to depression and stagflation. For this time there hasn’t been a big new idea, let alone one that has taken the profession by storm. Yes, there are lots of proclamations about things researchers should or must do differently, many of them represented in this issue of the Oxford Review. We need to put finance into the heart of the models! We need to incorporate heterogeneous agents! We need to incorporate more behavioural economics! And so on.

But while many of these ideas are very interesting, none of them seems to have emerged as the idea we need to grapple with. The intellectual impact of the crisis just seems far more muted than the scale of crisis might have led one to expect. Why?

Well, I’m going to offer what I suspect will be a controversial answer: namely, macroeconomics hasn’t changed that much because it was. in two senses, what my father’s generation used to call ‘good enough for government work”. On one side, the basic models used by macroeconomists who either practise or comment frequently on policy have actually worked quite well, indeed remarkably well. On the other, the policy response to the crisis, while severely lacking in many ways, was sufficient to avert utter disaster, which in turn allowed the more inflexible members of our profession to ignore events in a way they couldn‘t in past episodes.

In what follows I start with the lessons of the financial crisis and Great Recession, which economists obviously failed to predict. I then move on to the aftermath, the era of fiscal austerity and unorthodox monetary policy, in which I’ll argue that basic macroeconomics, at least in one version, performed extremely well. I follow up with some puzzles that remain. Finally, I turn to the policy response and its implications for the economics profession.

II. The Queen’s question

When all hell broke loose in financial markets, Queen Elizabeth II famously asked why nobody saw it coming. This was a good question but maybe not as devastating as many still seem to think.

Obviously, very few economists predicted the crisis of 2008-9; those who did, with few exceptions I can think of, also predicted multiple other crises that didn’t happen. And this failure to see what was coming can’t be brushed aside as inconsequential.

There are, however, two different ways a forecasting failure of this magnitude can happen, which have very different intellectual implications. Consider an example from a different field, meteorology. In 1987 the Met Office dismissed warnings that a severe hurricane might strike Britain; shortly afterwards, the Great Storm of 1987 arrived, wreaking widespread destruction. Meteorologists could have drawn the lesson that their fundamental understanding of weather was fatally flawed which they would presumably have done if their models had insisted that no such storm was even possible. Instead, they concluded that while the models needed refinement, the problem mainly involved data collection that the network of weather stations, buoys, etc. had been inadequate, leaving them unaware of just how bad things were looking.

How does the global financial crisis compare in this respect? To be fair, the DSGE models that occupied a lot of shelf space in journals really had no room for anything like this crisis. But macroeconomists focused on international experience, one of the hats I personally wear, were very aware that crises triggered by loss of financial confidence do happen, and can be very severe. The Asian financial crisis of 1997-9, in particular, inspired not just a realization that severe l930s-type downturns remain possible in the modern world, but a substantial amount of modelling of how such things can happen.

So the coming of the crisis didn’t reveal a fundamental conceptual gap. Did it reveal serious gaps in data collection? My answer would be, sort of, in the following sense: crucial data weren’t so much lacking as overlooked.

This was most obvious on the financial side. The panic and disruption of financial markets that began in 2007 and peaked after the fall of Lehman came as a huge surprise, but one can hardly accuse economists of having been unaware of the possibility of bank runs. lf most of us considered such runs unlikely or impossible in modern advanced economies, the problem was not conceptual but empirical: failure to take on board the extent to which institutional changes had made conventional monetary data inadequate.

This is clearly true for the United States, where data on shadow banking on the repo market, asset-backed commercial paper, etc. were available but mostly ignored. In a less obvious way, European economists failed to pay sufficient intention to the growth of interbank lending as a source of finance. In both cases the institutional changes undermined the existing financial safety net, especially deposit insurance. But this wasn’t a deep conceptual issue: when the crisis struck, I’m sure I wasn’t the only economist whose reaction was not ‘How can this be happening?” but rather to yell at oneself, ‘Diamond Dybvig, you idiot!’

(The Diamond-Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks’ mix of illiquid assets (such as business or mortgage loans) and liquid liabilities (deposits which may be withdrawn at any time) may give rise to selffulfilling panics among depositors.)

In a more subtle way, economists were also under-informed about the surge in housing prices that we now know represented a huge bubble, whose bursting was at the heart of the Great Recession. In this case, rising home prices were an unmistakable story. But most economists who looked at these prices focused on broad aggregates say, national average home prices in the United States. And these aggregates, while up substantially, were still in a range that could seemingly be rationalized by appealing to factors like low interest rates. The trouble, it turned out, was that these aggregates masked the reality, because they averaged home prices in locations with elastic housing supply (say, Houston or Atlanta) with those in which supply was inelastic (Florida or Spain); looking at the latter clearly showed increases that could not be easily rationalized.

Let me add a third form of data that were available but largely ignored: it’s fairly remarkable that more wasn’t made of the sharp rise in household debt, which should have suggested something unsustainable about the growth of the 2001-7 era. And in the aftermath of the crisis macroeconomists, myself included (Eggertsson and Krugman, 2012) began taking private-sector leverage seriously in a way they should arguably have been doing before.

So did economists ignore warning signs they should have heeded? Yes. One way to summarize their (our) failure is that they ignored evidence that the private sector was engaged in financial overreach on multiple fronts, with financial institutions too vulnerable, housing prices in a bubble, and household debt unsustainable. But did this failure of observation indicate the need for a fundamental revision of how we do macroeconomics? That’s much less clear.

First, was the failure of prediction a consequence of failures in the economic framework that can be fixed by adopting a radically different framework? It’s true that a significant wing of both macroeconomists and financial economists were in the thrall of the efficient markets hypothesis, believing that financial overreach simply cannot happen or at any rate that it can only be discovered after the fact, because markets know what they are doing better than any observer. But many macroeconomists, especially in policy institutions, knew better than to trust markets to always get it right especially those who had studied or been involved with the Asian crisis of the 1990s. Yet they (we) also missed some or all of the signs of overreach. Why?

My answer may seem unsatisfying, but I believe it to be true: for the most part what happened was a demonstration of the old line that predictions are hard, especially about the future. It’s a complicated world out there, and one’s ability to track potential threats is limited. Almost nobody saw the Asian crisis coming, either. For that matter, how many people worried about political disruption of oil supplies before 1973? And so on. At any given time there tends to be a set of conventional indicators everyone looks at, determined less by fundamental theory than by recent events, and big, surprise crises almost by definition happen due to factors not on that list. If you like, it’s as if meteorologists with limited resources concentrated those resources in places that had helped track previous storms, leading to the occasional surprise when a storm comes from an unusual direction.

A different question is whether, now that we know whence the 2008 crisis came, it points to a need for deep changes in macroeconomic thinking. As I’ve already noted, bank runs have been fairly well understood for a long time; we just failed to note the changing definition of banks. The bursting of the housing bubble, with its effects on residential investment and wealth, was conceptually just a negative shock to aggregate demand.

The role of household leverage and forced deleveraging is a bigger break from conventional macroeconomics, even as done by saltwater economists who never bought into efficient markets and were aware of the risk of financial crises. That said, despite the impressive empirical work of Mian and Sufi (2011) and my own intellectual investment in the subject, I don’t think we can consider incorporating debt and leverage a fundamental new idea, as opposed to a refinement at the margin.

It’s true that introducing a role for household debt in spending behaviour makes the short-run equilibrium of the economy dependent on a stock variable, the level of debt. But this implicit role of stock variables in short-run outcomes isn‘t new: after all, nobody has ever questioned the notion that investment flows depend in part on the existing capital stock, and I’m not aware that many macroeconomists consider this a difficult conceptual issue.

And I’m not even fully convinced that household debt played that large a role in the crisis. Did household spending fall that much more than one would have expected from the simple wealth effects of the housing bust?

My bottom line is that the failure of nearly all macroeconomists, even of the saltwater camp, to predict the 2008 crisis was similar in type to the Met Office failure in 1987, a failure of observation rather than a fundamental failure of concept. Neither the financial crisis nor the Great Recession that followed required a rethinking of basic ideas.

III. Not believing in (confidence) fairies

Once the Great Recession had happened, the advanced world found itself in a situation not seen since the 1930s, except in Japan, with policy interest rates close to zero everywhere. This raised the practical question of how governments and central banks should and would respond, of which more later.

For economists, it raised the question of what to expect as a result of those policy responses. And the predictions they made were, in a sense, out-of-sample tests of their theoretical framework: economists weren’t trying to reproduce the historical time-series behaviour of aggregates given historical policy regimes, they were trying to predict the effects of policies that hadn’t been applied in modern times in a situation that hadn’t occurred in modern times.

In making these predictions, the deep divide in macroeconomics came into play, making a mockery of those who imagined that time had narrowed the gap between saltwater and freshwater schools. But let me put the freshwater school on one side, again pending later discussion, and talk about the performance of the macroeconomists, many of them trained at MIT or Harvard in the 1970s, who had never abandoned their belief that activist policy can be effective in dealing with short-run fluctuations. I would include in this group Ben Bernanke, Olivier Blanchard, Christina Romer, Mario Draghi, and Larry Summers, among those close to actual policy, and a variety of academics and commentators, such as Simon Wren-Lewis, Martin Wolf, and, of course, yours truly, in supporting roles.

I think it’s fair to say that everyone in this group came into the crisis with some version of Hicksian sticky-price IS-LM as their default, back-of-the-envelope macroeconomic model. Many were at least somewhat willing to work with DSGE models, maybe even considering such models superior for many purposes. But when faced with what amounted to a regime change from normal conditions to an economy where policy interest rates couldn’t fall, they took as their starting point what the Hicksian approach predicted about policy in a liquidity trap. That is, they did not rush to develop new theories, they pretty much stuck with their existing models.

These existing models made at least three strong predictions that were very much at odds with what many inhuential figures in the political and business worlds (backed by a few economists) were saying.

First. Hicksian macroeconomics said that very large budget deficits, which one might normally have expected to drive interest rates sharply higher, would not have that effect near the zero lower bound.

Second, the same approach predicted that even very large increases in the monetary base would not lead to high inflation, or even to corresponding increases in broader monetary aggregates.

Third, this approach predicted a positive multiplier, almost surely greater than 1, on changes in government spending and taxation.

These were not common-sense propositions. Non-economists were quite sure that the huge budget deficits the US ran in 2009-10 would bring on an attack by the ‘bond vigilantes’. Many financial commentators and political figures warned that the Fed’s expansion of its balance sheet would ‘debase the dollar’ and cause high inflation. And many political and policy figures rejected the Keynesian proposition that spending more would expand the economy, spending less lead to contraction.

In fact, if you‘re looking for a post-2008 equivalent to the kinds of debate that raged in the 1930s and again in the 1970s, a conflict between old ideas based on pre-crisis thinking, and new ideas inspired by the crisis, your best candidate would be fiscal policy. The old guard clung to the traditional Keynesian notion of a government spending multiplier somewhat limited by automatic stabilizers, but still greater than 1. The new economic thinking that achieved actual real-world influence during the crisis and aftermath-as opposed, let’s be honest, to the kind of thinking found in this issue mostly involved rejecting the Keynesian multiplier in favour of the doctrine of expansionary austerity, the argument that cutting public spending would crowd in large amounts of private spending by increasing confidence (Alesina and Ardagna, 2010). (The claim that bad things happen when public debt crosses a critical threshold also played an important real-world role, but was less a doctrine than a claimed empirical observation.)

So here, at least, there was something like a classic crisis-inspired confrontation between tired old ideas and a radical new doctrine. Sad to say, however, as an empirical matter the old ideas were proved right, at least insofar as anything in economics can be settled by experience, while the new ideas crashed and burned. Interest rates stayed low despite huge deficits. Massive expansion in the monetary base did not lead to infiation. And the experience of austerity in the euro area, coupled with the natural experiments created by some of the interregional aspects of the Obama stimulus, ended up strongly supporting a conventional, Keynesian view of fiscal policy, Even the magnitude of the multiplier now looks to be around 1.5, which was the number conventional wisdom suggested in advance of the crisis.

So the crisis and aftermath did indeed produce a confrontation between innovative new ideas and traditional views largely rooted in the 1930s. But the movie failed to follow the Hollywood script: the stodgy old ideas led to broadly accurate predictions, were indeed validated to a remarkable degree, while the new ideas proved embarrassingly wrong. Macroeconomics didn’t change radically in response to crisis because old-fashioned models, confronted with a new situation, did just fine.

IV. The case of the missing deflation

I’ve just argued that the lack of a major rethinking of macroeconomics in the aftermath of crisis was reasonable, given that conventional, off-the-shelf macroeconomics performed very well. But this optimistic assessment needs to be qualified in one important respect: while the demand side of economy did just about what economists trained at MIT in the 1970s thought it would, the supply side didn’t.

As I said, the experience of stagflation effectively convinced the whole profession of the validity of the natural-rate hypothesis. Almost everyone agreed that there was no long-run inflation unemployment trade-off. The great saltwater freshwater divide was, instead, about whether there were usable short-run trade-offs.

But if the natural-rate hypothesis was correct, sustained high unemployment should have led not just to low inflation but to continually declining inflation, and eventually deflation. You can see a bit of this in some of the most severely depressed economies, notably Greece. But deflation fears generally failed to materialize.

Put slightly differently, even saltwater, activist-minded macroeconomists came into the crisis as ‘accelerationists’: they expected to see a downward-sloping relationship between unemployment and the rate of change of inflation. What we’ve seen instead is, at best, something like the 1960s version of the Phillips curve, a downward-sloping relationship between unemployment and the level of inflation and even that relationship appears weak.

Obviously this empirical failure has not gone unnoticed. Broadly, those attempting to explain price behaviour since 2008 have gone in two directions. One side, e.g. Blanchard (2016), invokes ‘anchored’ inflation expectations: the claim that after a long period of low, stable inflation, price-setters throughout the economy became insensitive to recent inflation history, and continued to build 2 per cent or so inflation into their decisions even after a number of years of falling below that target. The other side. e.g. Daly and Hobijn (2014), harking back to Tobin (1972) and Akerlof er a1. (1996), invokes downward nominal wage rigidity to argue that the natural rate hypothesis loses validity at low inflation rates.

In a deep sense, I’d argue that these two explanations have more in common than they may seem to at first sight. The anchored-expectations story may preserve the outward form of an accelerationist Phillips curve, but it assumes that the process of expectations formation changes, for reasons not fully explained, at low inflation rates. The nominal rigidity story assumes that there is a form of money illusion. opposition to outright nominal wage cuts, that is also not fully explained but becomes significant at low overall inflation rates.

Both stories also seem to suggest the need for aggressive expansionary policy when inflation is below target: otherwise there’s the risk that expectations may become unanchored on the downward side, or simply that the economy will suffer persistent, unnecessary slack because the downward rigidity of wages is binding for too many workers.

Finally. I would argue that it is important to admit that both stories are ex post explanations of macroeconomic behaviour that was not widely predicted in advance of the post-2008 era. Pre-2008, the general view even on the saltwater side was that stable inflation was a sufficient indicator of an economy operating at potential output, that any persistent negative output gap would lead to steadily declining inflation and eventually outright deflation. This view was, in fact, a key part of the intellectual case for inflation targeting as the basis of monetary policy. If inflation will remain stable at, say, 1 per cent even in a persistently depressed economy. it’s all too easy to see how policymakers might give themselves high marks even while in reality failing at their job.

But while this is a subjective impression, I haven’t done a statistical analysis of recent literature, it does seem that surprisingly few calls for a major reconstruction of macroeconomics focus on the area in which old-fashioned macroeconomics did, in fact, perform badly post-crisis.

There have, for example, been many calls for making the financial sector and financial frictions much more integral to our models than they are, which is a reasonable thing to argue. But their absence from DSGE models wasn’t the source of any major predictive failures. Has there been any comparable chorus of demands that we rethink the inflation process, and reconsider the natural rate hypothesis? Of course there have been some papers along those lines, but none that have really resonated with the profession.

Why not? As someone who came of academic age just as the saltwater freshwater divide was opening up, I think I can offer a still-relevant insight: understanding wage and price-setting is hard, basically just not amenable to the tools we as economists have in our kit. We start with rational behaviour and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges; this approach has generated big insights in many areas, but wages and prices isn’t one of them.

Consider the paths followed by the two schools of macroeconomics.

Freshwater theory began with the assumption that wage and price-setters were rational maximizers, but with imperfect information, and that this lack of information explained the apparent real effects of nominal shocks. But this approach became obviously untenable by the early 1980s, when inflation declined only gradually despite mass unemployment. Now what?

One possible route would have been to drop the assumption of fully rational behaviour, which was basically the New Keynesian response. For the most part, however, those who had bought into Lucas-type models chose to cling to the maximizing model, which was economics as they knew how to do it, despite attempts by the data to tell them it was wrong. Let me be blunt: real business cycle theory was always a faintly (or more than faintly) absurd enterprise, a desperate attempt to protect intellectual capital in the teeth of reality.

But the New Keynesian alternative, while far better, wasn’t especially satisfactory either. Clever modellers pointed out that in the face of imperfect competition the aggregate costs of departures from perfectly rational price-setting could be much larger than the individual costs. As a result, small menu costs or a bit of bounded rationality could be consistent with widespread price and wage stickiness.

To be blunt again. however, in practice this insight served as an excuse rather than a basis for deep understanding. Sticky prices could be made respectable just allowing modellers to assume something like one-period-ahead price-setting, in turn letting models that were otherwise grounded in rationality and equilibrium produce something not too inconsistent with real-world observation. New Keynesian modelling thus acted as a kind of escape clause rather than a foundational building block.

But is that escape clause good enough to explain the failure of deflation to emerge despite multiple years of very high unemployment? Probably not. And yet we still lack a compelling alternative explanation, indeed any kind of big idea. At some level, wage and price behaviour in a depressed economy seems to be a subject for which our intellectual tools are badly fitted.

The good news is that if one simply assumed that prices and wages are sticky, appealing to the experience of the 1930s and Japan in the 1990s (which never experienced a true deflationary spiral), one did reasonably well on other fronts.

So my claim that basic macroeconomics worked very well after the crisis needs to be qualified by what looks like a big failure in our understanding of price dynamics but this failure didn’t do too much damage in giving rise to bad advice, and hasn’t led to big new ideas because nobody seems to have good ideas to offer.

V. The system sort of worked

In 2009 Barry Eichengreen and Kevin O’Rourke made a splash with a data comparison between the global slump to date and the early stages of the Great Depression; they showed that at the time of writing the world economy was in fact tracking quite close to the implosion that motivated Keynes’s famous essay ‘The Great Slump of 1930’ (Eichengreen and O’Rourke, 2009)

Subsequent updates, however, told a different story. Instead of continuing to plunge as it did in 1930, by the summer of 2009 the world economy first stabilized, then began to recover. Meanwhile, financial markets also began to normalize; by late 2009 many measures of financial stress were more or less back to pre-crisis levels.

So the world financial system and the world economy failed to implode. Why?

We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, refiected institutional changes since the 1930s. Shadow banking and wholesale funding markets were deeply stressed, but deposit insurance still protected at good part of the banking system from runs. There never was much discretionary fiscal stimulus, but the automatic stabilizers associated with large welfare states kicked in, well, automatically: spending was sustained by government transfers, while disposable income was buffered by falling tax receipts.

That said, policy responses were clearly much better than they were in the 1930s. Central bankers and fiscal authorities officials rushed to shore up the financial system through a combination of emergency lending and outright bailouts; international cooperation assured that there were no sudden failures brought on by shortages of key currencies. As a result, disruption of credit markets was limited in both scope and duration. Measures of financial stress were back to pre-Lehman levels by June 2009.

Meanwhile, although fiscal stimulus was modest, peaking at about 2 per cent of GDP in the United States, during 2008-9 governments at least refrained from drastic tightening of fiscal policy, allowing automatic stabilizers, which, as I said, were far stronger than they had been in the 1930s to work.

Overall, then, policy did a relatively adequate job of containing the crisis during its most acute phase. As Daniel Drezner argues (2012), ‘the system worked’-well enough, anyway, to avert collapse.

So far, so good. Unfortunately, once the risk of catastrophic collapse was averted, the story of policy becomes much less happy. After practising more or less Keynesian policies in the acute phase of the crisis, governments reverted to type: in much of the advanced world, fiscal policy became Hellenized, that is, every nation was warned that it could become Greece any day now unless it turned to fiscal austerity. Given the validation of Keynesian multiplier analysis, we can confidently assert that this turn to austerity contributed to the sluggishness of the recovery in the United States and the even more disappointing, stuttering pace of recovery in Europe.

Figure 1 sums up the story by comparing real GDP per capita during two episodes: Western Europe after 1929 and the EU as a whole since 2007. In the modern episode, Europe avoided the catastrophic declines of the early 1930s, but its recovery has been so slow and uneven that at this point it is tracking below its performance in the Great Depression.

Now, even as major economies turned to fiscal austerity, they turned to unconventional monetary expansion. How much did this help? The literature is confusing enough to let one believe pretty much whatever one wants to. Clearly Mario Draghi’s “whatever it takes’ intervention (Draghi, 2012) had a dramatic effect on markets, heading off what might have been another acute crisis, but we never did get a clear test of how well outright monetary transactions would have worked in practice, and the evidence on the effectiveness of Fed policies is even less clear.

The purpose of this paper is not, however, to evaluate the decisions of policy-makers, but rather to ask what lessons macroeconomists should and did take from events. And the main lesson from 2010 onwards was that policy-makers don’t listen to us very much, except at moments of extreme stress.

This is clearest in the case of the turn to austerity, which was not at all grounded in conventional macroeconomic models. True, policy-makers were able to find some economists telling them what they wanted to hear, but the basic Hicksian approach that did pretty well over the whole period clearly said that depressed economies near the zero lower bound should not be engaging in fiscal contraction. Never mind, they did it anyway.

Even on monetary policy, where economists ended up running central banks to a degree I believe was unprecedented, the influence of macroeconomic models was limited at best. A basic Hicksian approach suggests that monetary policy is more or less irrelevant in a liquidity trap. Refinements (Krugman, 1998; Eggertsson and Woodford, 2003) suggested that central banks might be able to gain traction by raising their inflation targets, but that never happened.

The point, then, is that policy failures after 2010 tell us relatively little about the state of macroeconomics or the ways it needs to change, other than that it would be nice if people with actual power paid more attention. Macroeconomists aren’t, however, the only researchers with that problem; ask climate scientists how it’s going in their world.

Meanwhile, however, what happened in 2008-9, or more precisely, what didn’t happen, namely utter disaster, did have an important impact on macroeconomics. For by taking enough good advice from economists to avoid catastrophe, policy-makers in turn took off what might have been severe pressure on economists to change their own views.

VI. That 80s show

Why hasn’t macroeconomics been transformed by (relatively) recent events in the way it was by events in the 1930s or the 1970s? Maybe the key point to remember is that such transformations are rare in economics, or indeed in any field. ‘Science advances one funeral at a time,’ quipped Max Planck: researchers rarely change their views much in the light of experience or evidence. The 1930s and the 1970s, in which senior economists changed their minds, eg. Lionel Robbins converting to Keynesianism, were therefore exceptional.

What made them exceptional? Each case was marked by developments that were both clearly inconsistent with widely held views and sustained enough that they couldn’t be written off as aberrations. Lionel Robbins published The Great Depression, a very classical/Austrian interpretation that prescribed a return to the gold standard, in 1934. Would he have become a Keynesian if the Depression had ended by the mid-1930s? The widespread acceptance of the natural-rate hypothesis came more easily, because it played into the neoclassical mindset, but still might not have happened as thoroughly if stagflation had been restricted to a few years in the early 1970s.

From an intellectual point of view, I’d argue, the Great Recession and aftermath bear much more resemblance to the 1979-82 Volcker double-dip recession and subsequent recovery in the United States than to either the 1930s or the 1970s. And here I can speak in part from personal recollection.

By the late 1970s the great division of macroeconomics into rival saltwater and freshwater schools had already happened, so the impact of the Volcker recession depended on which school you belonged to. But in both cases it changed remarkably few minds.

For saltwater macroeconomists, the recession and recovery came mainly as validation of their pre-existing beliefs. They believed that monetary policy has real effects, even if announced and anticipated; sure enough, monetary contraction was followed by a large real downturn. They believed that prices are sticky and inflation has a great deal of inertia, so that monetary tightening would produce a ‘clockwise spiral’ in unemployment and inflation: unemployment would eventually return to the NAIRU (non-accelerating inflation rate of unemployment) at a lower rate of inflation, but only after a transition period of high unemployment. And that’s exactly what we saw.

Freshwater economists had a harder time: Lucas-type models said that monetary contraction could cause a recession only if unanticipated, and as long as economic agents couldn’t distinguish between individual shocks and an aggregate fall in demand. None of this was a tenable description of 1979-82. But recovery came soon enough and fast enough that their worldview could, in effect, ride out the storm. (I was at one conference where a freshwater economist, questioned about current events, snapped ‘I’m not interested in the latest residual.’)

What I see in the response to 2008 and after is much the same dynamic. Half the macroeconomics profession feels mainly validated by events-correctly, I’d say, although as part of that faction I would say that, wouldn’t I? The other half should be reconsidering its views but they should have done that 30 years ago, and this crisis, like that one, was sufficiently well-handled by policy-makers that there was no irresistible pressure for change. (Just to be clear, I’m not saying that it was well-handled in an objective sense: in my view we suffered huge, unnecessary losses of output and employment because of the premature turn to austerity. But the world avoided descending into a full 1930s-style depression, which in effect left doctrinaire economists free to continue believing what they wanted to believe.)

If all this sounds highly cynical, well, I guess it is. There’s a lot of very good research being done in macroeconomics now, much of it taking advantage of the wealth of new data provided by bad events. Our understanding of both fiscal policy and price dynamics are, I believe, greatly improved. And funerals will continue to feed intellectual progress: younger macroeconomists seem to me to be much more flexible and willing to listen to the data than their counterparts were, say, 20 years ago.

But the quick transformation of macroeconomics many hoped for almost surely isn’t about to happen, because events haven’t forced that kind of transformation. Many economists myself included are actually feeling pretty good about our basic understanding of macro. Many others, absent real-world catastrophe, feel free to take the blue pill and keep believing what they want to believe.

The New Keynesian fiscal rules that mislead British Labour – Bill Mitchell.

The British Labour Party is currently leading the Tories in the latest YouGov opinion polls (February 19-20, Tories 40 per cent (and declining), Labour 42 per cent (and rising). They should be further in front, given the disarray of the Conservatives as they try to negotiate within their own party something remotely acceptable about Brexit.

When there is this degree of political capital available, in this case for the Labour Party, a party should use it to redefine policy agendas that have gone awry. To build a narrative that will advance their cause for the future decades.

British Labour has a chance to break out of its recent Blairite neoliberal past and present a truly progressive manifesto to the British people that will force the Tories to move closer to the centre and squeeze the extreme right-wing elements.

In part, under Jeremy Corbyn and John McDonnell, Labour is making progressive noises on a number of fronts. But ultimately, where it really matters, the macroeconomic narrative, they are remaining firmly neoliberal and this will blight their chances of pursuing a truly progressive agenda.

One of the glaring mistakes the Labour Party has made is to accept advice from neoliberal economists (so-called New Keynesians) who have instilled in them a need for fiscal rules. This is an analysis of the sort of advice that Jeremy Corbyn and John McDonnell are getting and why they should ignore it.

l have written about fiscal rules in the past. There is only one fiscal rule that a progressive government should adhere to and I outlined that in this blog post The full employment fiscal deficit condition (April 13, 2011).

See also the suite of blog posts Fiscal sustainability 101 Part 1 Fiscal sustainability 101 Part 2 Fiscal sustainability 101 Part 3 to learn how Modern Monetary Theory (MMT) constructs the concept of fiscal sustainability.

The discussion in those blog posts rejects fiscal rules that are defined exclusively in terms of financial ratios, the type that the neoliberals use to reduce the scope of government and bias policy towards austerity and elevated levels of labour underutilisation.

I wrote about the madness in the British Labour Party signing up to neoliberal ’fiscal rules’ in this blog post, British Labour Party is mad to sign up to the ’Charter of Budget Responsibility’ (September 28, 2015).

One discussion paper that seems to have influenced the Shadow Chancellor in entering these type of neoliberal agreements was published on May 20, 2014 as Discussion Paper No. 429 from the National Institute of Economic and Social Research.

The NIESR paper Issues in the Design of Fiscal Policy Rules was written by Jonathan Portes (who is the Director of the NIESR) and an Oxford academic, Simon Wren-Lewis.

l have noticed that SWL seems to get involved with vituperative exchanges with Twitter participants who challenge him on matters relating to Modern Monetary Theory (MMT). He seems to think it is smart to label people, who refuse to accept his New Keynesian blather on Twitter, as being plain dumb.

SWL was a member of Labour’s economic advisory committee that John McDonnell formed after becoming the Shadow Chancellor. He later fell out with Corbyn it seems and urged the Party to dump Corbyn as leader and install Owen Smith instead.

On July 26, 2016, he wrote that “What seems totally clear to me is that given recent events a Corbyn-led party cannot win in 2020, or even come close.”

Well that prediction might still be relevant in 2020, but the last national election outcome, where Corbyn went close (even with many of the Blairites in his own party whiteanting him) suggested that SWL hasn’t much grip on reality.

Anyway, we digress.

In their discussion of issues that arise in the design of fiscal rules, Portes and SWL fail to mention the concept of full employment in the NIESR article. Their discussion is pitched entirely in terms of ‘financial ratios’.

It is hard to see that the general public will be enamoured with a government that delivers a target fiscal deficit (for example) but at the expense of elevated levels of unemployment and poverty. Fiscal policy has to relate to things that matter.

The belief (assertion) that by running fiscal surpluses or getting a public debt below some threshold will automatically deliver prosperity (jobs for all, growing real wages, first-class public services, etc) is one of the greatest con jobs that mainstream economists have foisted upon us. Fiscal policy has to relate to targets that matter like jobs, wages growth, and the like.

Depending on what the external and the private domestic sectors are doing (with respect to spending and saving), a fiscal deficit of 10 per cent of GDP might be appropriate just as a fiscal deficit of 2 per cent, or even a fiscal surplus of 4 per cent. Context matters not some particular ratio.

As an aside, the NIESR was a foremost Keynesian research group after being founded in 1938, as the academy was embracing the rejection of neoclassical thinking (which has morphed into the modern day neoliberalism) and recognising the positive role that government fiscal policy could play.

lts capacity to engage in quantitative research to support policy was valuable.

In more recent times, it has declined and is part of the neoliberal misinformation machine. The Keynesian roots has become New Keynesian, which eliminates all the meaningful insights of the original.

I have been asked by a lot of people to comment on the NIESR paper (cited above) and I have been reluctant to do so, given how flawed it is.

But given it has been so influential in framing the way in which the British Labour Party hierarchy thinks about macroeconomics, l have decided to consider it. It is hard to discuss the paper though in non-technical terms accessible to my broad readership, given the way it is framed. So at times, this essay will disappear into jargon. Not much though. I am trying to bring the message as fairly and simply as I can, so as to demonstrate the stupidity of the analysis but not be unfair (misrepresent) the authors.

Generally, the NIESR paper falls into the realm of what I call fake knowledge.

The simple response is that it spends several pages outlining the theory of optimal debt and fiscal policy then admits such a thesis “undeveloped”.

Not to be discouraged by the inability of the ‘optimal theory’ to say anything definitive about the real world, the authors, then proceed to draw conclusions from the theory anyway, which just amount to standard assertions.

Wren-Lewis just should stick to Twitter. He seems to like that. It would save us the time reading the other stuff. in effect, the substantive conclusions from the paper have no basis in theory and could have been tweets.

Let me explain why.

The motivation of the authors is to discuss what might be a “simple rule to guide fiscal policymakers”.

They point out that central bankers have used the “Taylor rule for monetary policy”, which is a simplification in itself. But I won’t get bogged down in discussing whether decision-making in central banks has or had become so mechanistic. It has not been but that is another story.

Mainstream monetary economists certainly teach students that central banks operate in the mechanistic way described by the Taylor rule, which is just a formula the textbooks claim is used to set interest rates.

But then these characters also teach students that central banks can control the money supply, that the money multiplier is responsible for determining how the monetary base scales up into the broad money supply, that expanding bank reserves will allow banks to make loans more easily, that expanding bank reserves is inflationary and al st of the litany of lies.

None of the central propostions that are taught to macroeconomics students in this regard are valid. They are fake knowledge, a stylised world of how these neoliberal economists want to imagine the real world works because they can then derive their desired policy regimes from it.

In the real world central banks and commercial banks do not function in this way.

Some of these monetary myths spill over into the analysis presented by Portes and SWL, which I will indicate presently.

Their motivation is to “search for such a rule” that might apply to fiscal policy, although they conclude at the outset that “one single simple rule to guide fiscal policy may never be found”.

They surmise that this is because:

1. “basic theory suggests that fiscal policy actions should be very different when monetary policy is constrained in a fundamental way. They cite the case of the so-called zero lower bound” as constraining fiscal policy options. In fact, no such constraint exists. Whether interest rates are zero or something else, the currency-issuing government has the same capacities and options.

There is no evidence that monetary policy suddenly becomes effective as a counter-stabilising tool at some positive target policy rate and should be preferred over fiscal policy.

The authors also suggest that the exchange rate regime will constrain fiscal policy. This is correct, which is why Modern Monetary Theory (MMT) theorists argue against pegged arrangements, they reduce the sovereignty of the government.

If a nation pegs its exchange rate then it strictly loses its sovereignty because the central bank has to conduct monetary policy with a view of stabilising the external value of the currency, which then limits the flexibility of domestic policy.

That is why the Bretton Woods fixed exchange rate system collapsed in August 1971. It biased nations running external deficits towards elevated levels of unemployment and crippling interest rates, which proved to be politically unsustainable.

2. Portes and SWL then say: “The second reason why a fiscal equivalent of a Taylor rule may be elusive also reflects national differences, but in this case differences in political structure.”

Here we get the bizarre notion introduced that theory describes an “optimal policy” but that ”there may be a trade-off between rules that mimic optimal policy, and rules that are effective in countering deficit bias” because politicians cannot be trusted to exhibit the ‘correct’ degree of austerity and instead become drunk on net spending (their concept of a “deficit bias”).

These ‘deficit drunk’ governments are labelled “non benevolent” because they allegedly trash the future of our children. Heard that one before? Sure you have, along with ‘governments running out of money’, ‘tipping points’, etc. To solve the problem of these ‘deficit drunk’ governments, Portes and SWL think technocratic constraints are needed to prevent governments responding to the desires of the population as represented by their mandate.

Of course, imposing technocratic constraints against a democratically elected government has become a major characteristic of the neoliberal era. Portes and SWL fit right in with that trend.

All this is part of the ‘depoliticisation’ trend that has seen elected governments shed political responsibility for key decisions that have damaged the well-being of the vast majority of people in their nations by appealing to ‘external’ authorities.

The ‘we had to do it, we had no choice’ ruse, the ‘Dennis Healey, we had to borrow from the IMF because we were running out of money‘ ruse, the ‘we need to outsource fiscal policy to economic experts because politicians just want votes’ ruse.

These external authorities might be so-called independent central banks (even though they are not independent see later), the IMF, and fiscal boards (such as the Office of Budget Responsibility in the UK).

We examine that trend in our new book Reclaiming the State: A Progressive Vision of Sovereignty for a Post-Neoliberal World (Pluto Books, September 2017)

Further, the term ‘deficit bias’ is loaded. Portes and SWI would claim that continuous fiscal deficits illustrate this bias. However, in most nations, such continuity is necessary to support the saving desires of the non-government sector, while sustaining full employment.

There would be no ‘bias’ there. Just responsible fiscal practice. I will discuss that in more detail presently. Refer back to the blog post The full employment fiscal deficit condition.

Further, the so-called New Keynesian ‘optimum‘ is unlikely to have any relevance for the well-being of the population, and, in particular, the most disadvantaged citizens in society.

The standard New Keynesian ‘model’ didn’t even have unemployment in it.

If you understand the dominant New Keynesian framework, which has become the basis for a new consensus emerging among orthodox macroeconomists like Portes and SWL, then you will know the following.

1. The basic New Keynesian approach has three equations which in themselves are problematic. They claim authority based on the microfoundations that are alleged to represent rigourous optimising behaviour by all agents (people, firms, etc) captured by the model structure.

2. Because the ‘optimal’ theory, specified in the basic structure (Calvo pricing, rational expectations, intertemporal utility maximising behaviour by consumers, who face a trade-off between consumption and leisure, etc) cannot say anything much about real world data, the empirical models are modified (adjustment lags are added, etc). As a result ad hocery enters the applied domain where substantive results that are meant to apply to policy are generated.

3. But it is virtually impossible to builds these ‘modifications’ into their theoretical models from the first principles (intertermporal optimisation, etc) that they start with.

4. Which means that like most of the mainstream body of theory the claim to micro-founded ‘rigour’ is unsustainable once they respond to real world anomalies (of their theory) with ad hoc (non rigourous) tack ons.

5. The results they end up producing in empirical papers are not ‘derivable’ from first-order, microfounded principles at all. Their claim to theoretical rigour fails, At the end of the process there is no rigour at all. It becomes a false authority that they hide behind to justify their assertions.

The Portes-SWL paper is no exception.

Further, the ’Great Moderation’ was considered a move closer to the New Keynesian utopia (‘the business cycle’ was declared ‘dead’, for example).

Yet all we witnessed during this period in the 1990s and up to the onset of the GFC, was the redistribution of national income capital as real wages failed to keep pace with productivity growth, increased inequality and private debt, elevated levels of unemployment, the emergence of underemployment, and the dynamics being put in place which manifested as the GFC.

And, the burden of the GFC was not borne by the banksters or the top-end-of-town. Their criminality largely escaped unscathed while millions of workers lost their jobs and many became impoverished.

The belief that one can derive ‘optimal’ rules from a New Keynesian model that have any relevance to people or the world we live in is another characteristic of the neoliberal era. My profession basically went from bad to worse over this period.

However, none of that reality discourages Portes and SWL, who begin their analytical section by outlining this so-called New Keynesian “Optimal debt policy”.

Two propositions enter immediately:

1. taxes impose costs in terms of social welfare because they “are distortionary”. This means that they prevent people from making ‘optimal’ decisions.

The microeconomic theory these authors rely on claims that tax distortions include workers not working hard enough because the imposition of taxes create incentives for them to take more leisure.

This is a body of theory that also says unemployment is a choice workers make when the real wage (after tax) is so high that they prefer to take leisure instead of working. No problem, the workers are ‘optimising real income’ by being unemployed leisure is part of this ‘real’ income measure in these models.

If you thought that sounded like nonsense then you are right. Quits do not behave countercyclically, which would be required if unemployment was a choice made by workers.

Further, the research evidence suggests that the imposition of taxes does not alter the desire of workers to offer hours off work in any significant way.

For a start, most workers do not have continuous (hours) choices available to them. They work 40 hours (or whatever) or not at all.

But this is a digression.

Further what about carbon taxes and other similar taxes, which, even in the mainstream theory, correct market failure and enhance efficiency?

2. Then we read the “government would like to minimise these costs [from the taxes] but they need taxes to pay for government spending and any interest on debt.

Which is an absolute lie in terms of the intrinsic nature of a monetary system where the national government issues its own currency.

It is a convenient lie because they rely on it to derive the results in their paper. They also need this ‘optimality’ smokescreen to persuade politicians to take the results seriously as if their ‘assumptions’ are, in reality, natural constraints on governments.

The lie also implicitly biases the reader to accepting the ‘lower’ taxes are better than higher taxes, a proposition that depends on other assumptions they choose not to disclose because they are smart enough to know that that would push the discussion into the ideological domain and these characters want us to pretend that economics is ‘value free’ and everything they are writing is derivable from ‘optimal’ theory.

One of the first lectures an economics student is forced to endure contains assertions that there is a divide between what mainstream economists call ‘positive’ economics (value free) and ‘normative’ statements (value laden).

Mainstream theory holds itself out as being ‘positive’ and then blames dysfunctional outcomes on the ‘normative’ interventions of policy makers, who choose to depart from the ‘optimal’ world of positive economics.

If you thought this was an elaborate joke played on the students then you would be correct.

And in terms of the above, the correct statement would be that governments impose voluntary constraints on themselves, engineered by conservative ideologues. They have created accounting processes that ‘account‘ for tax receipts into, say Account A, which they then ‘account’ for their spending from. A sort of administrative fiction to give the impression that the tax receipts provide the wherewithal for government spending.

But anyone knows that these institutional practices can be altered by the government whenever they choose (unless they are embedded in constitutions and then it takes more time).

The reality is that unlike the assertion on of Portes and SWL (which drive their overall results):

Governments do not need taxes to pay for government spending. That is an ideological constraint designed to limit spending. Intrinsically, a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.

Modern Monetary Theory (MMT) tells us that taxation serves to create real resource space (idle non-government productive resources), which governments can then bring into productive use to fulfill its elected socio-economic mandate. That taxation reduces the inflation risk of such spending but does not ‘fund’ it.

The fact is that a currency-issuing government can purchase anything that is for sale in its own currency including all idle labour.

MMT also recognises other roles for taxation such as taxes on bads designed to divert consumers or producers away from these goods and services. But that is another story.

Further, a government never needs to issue debt to ‘fund’ deficits.

That is another institutional practice that carries over from the fixed-exchange rate, gold standard days. It is no longer necessary and an understanding of MMT leads one to realise it is largely an exercise in the provision of corporate welfare that should be abandoned.

The point is that if you build ‘economic models’ based on these voluntary constraints, as if they are intrinsic constraints, then the results turn out radically different to the outcomes of an analytical exercise where you assume, correctly, that the government does not need taxes to ‘fund’ spending or to issue debt to fund deficits. Then the mainstream results largely collapse.

I suspect the authors in question implicitly know this. If they don’t then you can draw your own conclusions.

*

The paper I am using to represent the New Keynesian approach has, by all indications, been somewhat influential in the formation of the macroeconomic approach currently being espoused by the British Labour Party. In that sense, the critique aims to disabuse the Labour politicians and their apparatchiks of building policy options based on fake economic knowledge, and, instead, embrace the principles of Modern Monetary Theory (MMT), which provides an accurate depiction of how the monetary system actually operates and the policy options for a currency-issuing government such as in Britain, and the likely consequences of deploying these options.

The one major lesson that comes out is that the New Keynesian approach is an elaborate fraud. It plays around with so-called ‘optimising’ models asserting human behaviour that no other social scientist believes remotely captures the essence of human decision-making, and then derives conclusions from these models that are claimed to apply to the world we live in. Prior to the GFC, these ‘models’ didn’t even consider the financial sector.

The fact is that nothing of value in terms of specifying what a government should do can be gleaned from a New Keynesian approach. It is barren.

Above, we noted that one discussion paper that seems to have influenced the Shadow British Chancellor was published on May 20, 2014 as Discussion Paper No. 429 from the National Institute of Economic and Social Research.

The NIESR paper Issues in the Design of Fiscal Policy Rules was written by Jonathan Portes (who at the time of writing was the Director of the NIESR before he was ‘let go’) and an Oxford academic, Simon Wren-Lewis.

Here I begin by examining the way that the authors try to use the New Keynesian theory as an authority for specific policy conclusions, which they essentially admit (not in those words) cannot, in fact, be derived from the ‘optimal’ theory.

To specify what they call the ‘optimal’ state, Portes and SWL write out some simple mathematical expressions and note: that the government must satisfy its budget constraint (there is no default), and we ignore financing through printing money.

It is interesting that in defending the New Keynesian position against say Modern Monetary Theory (MMT), proponents make a claim for superiority based on their mathematical reasoning and the apparent absence of such optimising mathematics in MMT.

When useful, MMT uses formal language (mathematics) sparingly. Mostly, propositions can be established without resort to mathematics, which avoids creating a wall of comprehension that most people cannot break down.

Further, there is nothing sophisticated about the mathematics that New Keynesians use. It is just simple calculus really, the sort that I learned as an undergraduate studying mathematics. Hardcore mathematicians laugh at the way economists deploy these tools and parade them as if they are generating something deep and meaningful.

We move on.

Note that while the imposition of taxes is deemed a “cost” by Portes and SWL (discussed in earlier), their ‘model’ doesn’t allow the interest payments on the debt to be a ‘beneflt’. They are silent on that. Conveniently so.

Anyway, the equation they write out which captures the constrained optimisation process is claimed to be an ex ante financial constraint, akin to the financial constraints facing a household that must earn income, borrow, reduce savings or sell assets in order to spend.

As we know, the ‘household budget analogy’ applied to a currency-issuing government is wrong at the most elemental level.

Nothing relating to the experience of a household (the currency user) is relevant to assessing the capacities of or the choices available to such a government (currency issuer).

Further, why do they ignore “financing through printing money”? Not that “printing money” is a term that could be associated with the real world practice of government spending anyway.

They ignore it because it would not allow them to generate the results they desire.

The reality is that these so-called ‘budget constraints’ do not depict real ex ante financial constraints. They are, at best, ex post accounting statements, meaning they have to add up. There is nothing much more about them than that.

They may also reflect current institutional practice which is a political rather than an intrinsic financial artifact.

But, if the authors were to be stock-flow (accounting) consistent (which most mainstream models are not meaning they deliberately leave things out and that flows do not accumulate properly into the corresponding stocks), then they would have to include the change in bank reserves arising from central bank monetary operations associated with fiscal policy (for example, crediting banks accounts on behalf of the government).

But those operations are absent in their approach, which means their analysis is incomplete in an accounting sense. Conveniently so.

Of course, one of the glaring omissions of the New Keynesian models that people learned about after the GFC was that they didn’t even have a financial sector embedded in their basic structure. But that is also another story again.

The upshot of Portes and SWL’s mathematical gymnastics, simple though they are, is that the ‘optimal’ fiscal policy requires “tax smoothing”, so that:

if for a period government spending has to be unusually high (classically a war, but also perhaps because of a recession or natural disaster), it would be wrong to try and match this higher spending with higher tax rates. Instead taxes should only be raised by a small amount, with debt increasing instead, but taxes should stay high after government spending has come back down, to at least pay the interest on the extra debt and perhaps also to bring debt back down again.

So, they are saying:

1. Taxes are necessary to fund government spending but temporary deficits (to cope with wars or deep recessions) should be funded by debt.

2. When economic activity improves, there should be a primary fiscal surplus (”taxes at least pay the interest on the extra debt”) and spending should be cut to allow that outcome.

3. Public debt should be a target policy variable (the lower the better) but in the short-term is a “shock absorber to avoid sharp movements in taxes or government spending”.

4. This is a ‘deficit dove’ construction. We will have austerity but it will be delayed.

The questions one needs to ask is under what conditions would a primary surplus be a responsible state for a government to achieve? Portes and SWL want the primary surpluses to be a target goal for government. But such a target is unlikely to be a desirable state.

Remember, a primary fiscal balance is the difference between government spending and taxation flows less payments on outstanding public debt.

One could imagine a situation where a government would sensibly run a primary surplus or even an overall fiscal surplus (inclusive of interest payments on public debt) if it was accompanied by a robust external surplus, which was pumping net spending in the economy and financing the desire of the private domestic sector to save overall.

Then a fiscal surplus would be required to prevent inflationary pressures from emerging. But it would also be consistent with full employment, the provision of first-class public services, and the fulfillment of the overall saving desires by the private domestic sector. Think Norway.

That is not remotely descriptive of where the UK (or most nearly all nations) are at or have been at in recent decades.

The absurdity of the reasoning that arises from the sort of economic framework that Portes and SWL deploy is illustrated when they start tinkering with the parameters of the ‘model’ to see what transpires.

The exercise is trivial. The model has some equations with parameters that link the variables that describe the equation structures. The parameters are conceptual but to get certain results one has to make assumptions about their values (at the most basic level whether they are positive or negative or above or below unity, etc).

Then one muses about what specific assumptions imply for the results.

One such tinkering by Portes and SWL generates an interpretation that taxes:

gradually fall to zero. How can this happen, given that the government has spending to finance? The answer is that debt gradually declines to zero, and then the government starts to build up assets. Eventually it has enough assets that it can finance all its spending from the interest on those assets, and so taxes can be completely eliminated.

Which then raises the question of how the government gets access to any of the real resources that are available for productive use in the society.

If taxes are zero, why would people offer their labour (and other resources) for the public use? And, how will government make non-inflationary real resource space in order for them to spend (command real resources from the non-government sector)?

But discussing those issues will take us away from the main focus.

In essence, none of their mathematical ‘cases’ (the scenarios they defined with differing parameter values) can be established in reality. This is a common problem of this sort of economic reasoning.

What happens next? They ditch the ‘optimal’ results derived from the calculus and start making stuff up asserting their ‘priors’.

So as not to spoil their story, the authors just assert that “there are two reasons for believing that policy should aim to steadily reduce debt in normal times” even if the ‘optimal’ condition indicates the opposite.

First, they introduce the standard argument that “shocks may be asymmetric” with “large negative shock”(s) not being offset in the other direction.

This is a sort of ‘war chest’ argument. That a government will not be able to respond fully in a major downturn if it starts with high levels of public debt.

Why? It will not be attractive to bond investors, it will run out of money, etc.

Tell that to Japan! Fake knowledge.

Second, they write that:

large negative shocks like a financial crisis might mean that we enter a liquidity trap, so that fiscal expansion is required to assist monetary policy, while large positive shocks could be dealt with by monetary rather than fiscal contraction. There is no equivalent upper bound for interest rates, so prudent policy would reduce debt in normal times to make room for the liquidity trap possibility.

This is the standard mainstream claim that monetary policy is the more effective counter-stabilising (and preferred) policy, except in a deep recession when interest rates are cut to zero and have no further room to fall.

So to counter that ineffectiveness when rates are zero, fiscal policy has to be used. But, in general, monetary policy should be prioritised.

But then the same assertion follows. So that fiscal policy can be on standby for those times when interest rates are zero, the government should have low levels of outstanding debt.

Why? The same argument. It will not be able to fund a new fiscal stimulus if it hasn’t eliminated the impacts from a previous stimulus exercise.

That is a plain lie.

The authors just assert that the capacity of a government to net spend is inversely related to the current stock of outstanding debt.

Why? No reason can be derived from their ‘optimal’ models to justify that assertion.

And, again, tell that to Japan!

The post-GFC period has demonstrated that ’monetary policy’ is not a very effective counter-stabilising tool. Governments that used fiscal policy aggressively in the GFC resumed growth much more quickly than those that didn’t. The stimulatory effects of monetary policy are, at best, ambiguous.

Further, the truth is that the capacity of the government to spend is in no way constrained by its past fiscal stance whether it be surplus, balance or deficit.

A surplus today does not mean that the government is better placed to run a deficit tomorrow. It can always run a deficit if the non-government spending and saving decisions push it that way.

The same goes for outstanding debt, which under current institutional arrangements, will be influenced by the shifts in the flows that make up fiscal policy.

But the level of debt doesn’t constrain or alter the government’s ability to net spend.

The authors might claim that bond markets will rebel and stop funding the deficits. Even if the recipients of this corporate welfare decided to cut off their noses to spite their faces and stopped buying the debt that would not alter the government’s capacity to spend.

First, if it persisted in the unnecessary practice of issuing debt, it could instruct the central bank to set the yield and buy all the debt that the private bond markets didn’t want at that (low to zero) yield. Including all of it!

In other words, the government can always play the private bond markets out of the game if it chooses. Even in the Eurozone, where the Member States are not sovereign, the ECB has demonstrated it can set yields at whatever level it chooses. It can drive yields on long-term public debt into the negative! Who would have thought? No New Keynesian that is for sure. They think deficits ‘crowd out’ private investment spending via higher rates (see below).

Second, the government can also alter a rule or two or change legislation that embodies these voluntary accounting constraints that I noted earlier. That is the right of the legislature and beyond the power of bond markets!

In another one of their musings about parameter values, Portes and SWL tell us that:

there is an additional reason why it might be desirable to eliminate government debt completely, and that is because it crowds out productive capital. In simple overlapping generation models, agents save to fund their retirement, and this determines the size of the capital stock. If agents have an alternative means of saving, which is to invest in government debt, then this debt displaces productive capital.

Really now!

Again, the authors are just rehearsing the standard and deeply flawed mainstream macroeconomic theory, which has the loanable funds model of financial markets embedded.

According to this specious approach, savings are finite and investment competes for the scarce resources. The ‘interest rate’ on loans then brings the two into balance.

The logic then says if there is a shift in the investment demand outwards (capturing in this instance the entry of the government bond to compete with corporate bonds), then the interest rate has to rise to ration off the higher demand for loans, given the finite supply (savings). Wrong at the most elemental level.

First, savings are not finite. They rise with income and if net public spending increases (rising deficit) then national income will rise and so will saving.

Second, and more importantly, real world banks do not remotely operate in a loanable funds way. They will generally extend loans to creditworthy borrowers. This lending is not reserve constrained. Banks do no wait around for depositors to drop their cash off, which they can then on lend.

Loans create deposits (liquidity). Not the other way around, as is assumed by the ‘crowding out’ argument which these authors introduce to their analysis.

So even if the government is selling debt to the non-government sector, the banks still have the capacity (under our current system) to increase private investment.

Further, there is the standard ideological assertion that public spending is ‘less efficient’ (unproductive) compared to “productive capital” (private investment).

The research evidence doesn’t support that assertion. it is just a made up claim to justify privatisation and cuts to government activities.

It has been used to justify the handing out of millions of dollars of public funds to investment bankers, lawyers, accountants etc to sell off public assets at well below market prices to grasping private investors.

We have a long record now of how disastrous most of these selloffs have been from the perspective of the quality, scope and affordability of services that were previously provided by the state.

The next furphy that Portes and SWL introduce is the intergenerational equity argument aka government debt imposes burdens on our grand kids claim.

They claim that lower debt will mean that “Future generations will enjoy a world with lower distortionary taxes, while the current generation will bear the cost of achieving that goal.”

Again, this conclusion follows their assumption that taxes pay back the debt so deficits today force future generations to incur higher costs.

Refer to the previous discussion of the actual role of taxes in a flat monetary system.

The reality is that each generation chooses its own tax and public spending profile via the political process. The way in which intergenerational inequities occur is via real resource utilisation.

We can kill the planet and the kids will then miss out. Alternativelv. we can ensure the kids get access to first-class public infrastructure (education, health, recreation, etc) and have jobs to go to when they develop their skills and knowledge.

Then the kids benefit from today’s fiscal deficits.

But after all of their tinkering with mathematical coefficients (which I have only skimmed here), the authors admit that the “analysis of the optimum long run target for government debt is undeveloped” but:

the case for aiming for a gradual reduction in debt levels seems to be reasonably strong in practice, particularly given the currently high levels of debt in most countries

In other words, the mathematical reasoning leads to nothing definitive so we will just assert things anyway.

It helps economists like this gain promotion as academics and other status that they might enjoy such as picking up ’Inside Job’ type commissions and misrepresenting ideological reports as independent research.

Remember Mishkin in Iceland?

Please read my blog Universities should operate in an ethical and socially responsible manner for more discussion on this point.

I make that comment generally rather than specifically about the authors (Portes and SWL) in question. I don’t know what they do on the side.

So, after all that, what have Portes and SWL to fall back on? Not much. Assertion based on false assumptions.

That doesn’t stop them though.

In Section 3, they still claim ‘authority’ from the discussion on optimal fiscal rules to make the following assertion:

It follows from the previous section that a welfaremaximising government would in general be expected to follow fiscal policies which broadly satisfied the following conditions: a gently declining path of debt over the medium term, but with blips in response to shocks broadly stable tax rates and recurrent government consumption.

Noting it doesn’t follow at all from any results about “welfaremaximising” behaviour that they present. The simple optimising model presented, by the authors’ own admission, is “undeveloped” and incapable of any definitive result.

The results that they claim were derived from the “previous section” are assertions.

But their point is clear. They claim that OECD governments (in general) have not followed these rules and instead the public debt ratios have “steadily increased since the 1970s”, which is evidence of what they call “deficit bias”.

Their claim then is that for various reasons, governments have been acting contrary to “welfare-maximising” behaviour meaning they are acting badly.

Simple isn’t it. Make up a benchmark using flawed assumptions that you know does not apply in the real world. Then label any departures from that fantasy world ‘bad’ and QED, you can then claim in the ‘real world’ that the government is behaving badly.

However, one can contest the benchmark.

If public debt is such an issue, why is the 10-year bond yield for Japanese government bonds at 0.058 per cent (at the time of writing) and why did ‘investors’ pay the Japanese government for the privilege of buying that debt (negative yields) at certain times last year?

Moreover, why are ‘investors’ agreeing to negative yields on all government bond maturities from 1-Year to 8-Years at present.

Further, back in the 1990s, the financial commentators and mainstream macroeconomists were claiming the outstanding Japanese government debt was the mother of all ticking time bombs and they have used this scare tactic long and hard for decades across all nations.

I recall reading some commentator claiming long ago Japan was facing the “mother of all debt-bunnies”, whatever that meant. I guess the ‘bunnies’ hopped away somewhere.

I have gone back through the records I keep and found regular references over the last 27 years to the impending insolvency of Japan because it is violating the economists’ notion of welfare maximising’ debt behaviour.

Across the Pacific, the US was apparently “near to insolvency” on Thursday, September 26, 1940.

Here is an Associated Press story from The Portsmouth Times (Ohio), which was headlines in the New York Times on the same day.

The story quotes one Robert M. Hanes, who at the time was the President of the American Bankers’ Association:

“The evangelists of the new social order are undermining the confidence of the American people in political and economic freedom.

It is a matter of grave concern that we have come to accept deficit financing as a permanent fiscal policy. We not only proceed from year to year on an unbalanced federal budget, but we have permitted the compounding of the federal debt to a huge total which threatens the entire country.

Unless we put an end to deficit financing, to profligate spending, and to indifference to the nature and extent of government borrowing, we shall surely take the road to dictatorship.

By subtle propaganda, special pleading and similar devious device The American people are being persuaded to surrender more and more of their independence to the direction and control of government. This is an evil that feeds on itself.

Deficits and borrowings call for continually larger taxation, which must be met by private enterprise.”

We can find similar remarks throughout history. And, yet, nothing happens. I guess you can cut the Americans some slack such is their penchant for OTT way of doing things.

The point is these economic models that claim public debt should be minimised to prevent costly tax burdens are pie-in-the-neoliberaI-sky sort of stuff.

Further, higher public debt to GDP ratios means that the nongovernment sector has more risk free debt as a proportion of GDP than previously and corresponding income flows.

ARE WE AS BRAVE AS LABOUR IN THE 1930s?- Bryan Gould.

New Zealanders like to think that we are, in most respects, up with – if not actually ahead of – the play. Sadly, however, as a new government is about to emerge, there is no sign that our politicians and policymakers are aware of recent developments in a crucial area of policy, and that, as a result, we are in danger of missing out on opportunities that others have been ready to take.

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The story starts, at least in its most recent form, with two important developments. First, there is the now almost universal recognition that the vast majority of money in circulation is not – as most people once believed – notes and coins issued on behalf of the government by the Reserve Bank, but is actually created by the commercial banks through the credit they advance, using bank entries rather than cash, and usually on mortgage.

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The truth of this proposition, so long denied, is now explicitly accepted by the Bank of England, and was – as long ago as 1994 – explained in a letter written by our own Reserve Bank to an enquirer, and stating in terms that 97% of the money included in the usually used definition of money known as M3 is created by the commercial banks.

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The proposition is endorsed by the world’s leading monetary economists – Lord Adair Turner, the former chair of the UK’s Financial Services Authority and Professor Richard Werner of Southampton University, to name but two. These men are not snake-oil salesmen, to be easily dismissed. They have been joined by leading financial journalists, such as Martin Wolf of the Financial Times.

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The second development was the use by western governments around the world of “quantitative easing” in the aftermath of the Global Financial Crisis. “Quantitative easing” was a sanitised term to describe what is often pejoratively termed “printing money” – but, whatever it is called, it was new money created at the behest of the government and used to bail out the banks by adding it to their balance sheets.

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These two developments, not surprisingly, generated a number of unavoidable questions about monetary policy. If banks could create billions in new money for their own profit-making purposes, (they make their money by charging interest on the money they create), why could governments not do the same, but for public purposes, such as investment in new infrastructure and productive capacity?

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And if governments were indeed to create new money through “quantitative easing”, why could that new money not be applied to purposes other than shoring up the banks?

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The conventional answer to such questions (and the one invariably given in New Zealand by supposed experts in recent times) is that “printing money” will be inflationary – though it is never explained why it is miraculously non-inflationary when the new money is created by bank loans on mortgage or is applied to bail out the banks.

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But, in any case, the master economist, John Maynard Keynes, had got there long before the closed minds and had carefully explained that new money could not be inflationary if it was applied to productive purposes so that new output matched the increased money supply. Nor was there any reason why the new money should not precede the increased output, provided that the increased output materialised in due course.

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Those timorous souls who doubt the Keynesian argument might care to look instead at practical experience. Franklin Delano Roosevelt used exactly this technique to increase investment in American industry in the year or two before the US entered the Second World War. It was that substantial boost to American industrial capacity that was the decisive factor in allowing the Allies to win the war.

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And the great Japanese (and Keynesian) economist, Osamu Shimomura, (almost unknown in the West), took the same approach in advising the post-war Japanese government on how to re-build Japanese industry in a country devastated by defeat and nuclear bombs.

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The current Japanese Prime Minister, Shinzo Abe, is a follower of Shimomura. His policies, reapplied today, have Japan growing, after years of stagnation, at 4% per annum and with minimal inflation.

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Our leaders, however, including luminaries of both right and left, some with experience of senior roles in managing our economy – and in case it is thought impolite to name them I leave it to you to guess who they are – prefer to remain in their fearful self-imposed shackles, ignoring not only the views of experts and the experience of braver leaders in other countries and earlier times, but – surprisingly enough – denying even our own home-grown New Zealand experience.

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Many of today’s generation will have forgotten or be unaware of the brave and successful initiative taken by our Prime Minister in the 1930s – the great Michael Joseph Savage. He created new money with which he built thousands of state houses, thereby bringing an end to the Great Depression in New Zealand and providing decent houses for young families (my own included) who needed them.

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Who among our current leaders would disown that hugely valuable legacy?

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Bryan Gould, 2 October 2017

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BryanGould.com

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How to Use Fiscal and Monetary Policy to Make Us Rich Again – Tom Streithorst. 

The easiest way to return to Golden Age tranquility and equality is to empower fiscal policy.

During the post war Golden Age, from 1950 to 1973, US median real wages more than doubled. Today, they are lower than they were when Jimmy Carter was president. If you want an explanation why Americans are pessimistic about their future, that is as good a reason as any. In a recent article, Noah Smith examines the various causes of the slide in labor’s share of national income and finds most explanations wanting. With a blind spot common amongst economists he doesn’t even investigate the most obvious: politics.

Take a look at this chart. From the end of World War II, productivity rose steadily. Until the 1972 recession wages went up alongside it. Both dipped, both recovered and then, right around the time Ronald Reagan became President, productivity continued its upward trajectory but wages stopped following. If wages had continued to track productivity increases, the average American would earn twice as much as he does today and America would undoubtedly be a calmer and happier nation.

Collectively we are richer than we were 40 years ago, as we should be, considering the incredible advances in technology since them, but today the benefits of productivity increases no longer go to workers but rather to owners of stocks, bonds, and real estate. Wages don’t go up, but asset prices do. Rising productivity, that is to say the ability to make more goods and services with fewer inputs of labor and capital should make us all more prosperous. That it hasn’t can only be a distributional issue.

The timing suggests Ronald Reagan had something to do stagnating wages. That makes sense. Reagan cut taxes on the rich, deregulated the economy, eviscerated the labor unions and created the neoliberal order that still rules today. But perhaps an even more significant change is the tiny, technical and tedious shift from fiscal to monetary policy.

Government has two ways of affecting the economy: monetary and fiscal policy. The first involves the setting of interest rates, the other government tax and spending policy. Both fiscal and monetary policy work by putting money in people’s pockets so they will spend and thereby stimulate the economy but fiscal focuses on workers while monetary mostly benefits the already rich. Since Ronald Reagan, even under Democratic presidents, monetary has been the policy of choice. No wonder wages stopped going up but real estate, stock and bond prices have gone through the roof. During the Golden Age we shared the benefits of technological progress through wages gains. Since Reagan, we have allocated them through asset price inflation.

Fiscal policy, by increasing government spending, creates jobs and so raises wages even in the private sector. Monetary policy works mostly through the wealth effect. Lower interest rates almost automatically raise the value of stocks, bonds, and other real assets. Fiscal policy makes workers richer, monetary policy makes rich people richer. This, I suspect, explains better than anything else why monetary policy, even extreme monetary policy remains more respectable than even conventional monetary policy.

During the Golden Age, fiscal was king. Wages rose steadily and everybody was richer than their parents. Recessions were short and shallow. Economic policy makers’ primary task was insuring full unemployment. Anytime unemployment rose over a certain level, a government spending boost or tax cut would get the economy going again. And since firms were confident the government would never allow a steep downturn, they were ready and willing to invest in new technology and increased productive capacity. The economy grew faster (and more equitably) than it ever has before or since.

During the 1960s, Keynesian economists thought they could “fine tune” the economy, using Philips curve trade offs between inflation and unemployment. Stagflation in the 1970s shattered that optimism. Inflation went up but so did unemployment. New Classical economists decided in the long run, Keynesian stimulus couldn’t increase GDP, it could only accelerate inflation. Keynesianism stopped being cool. According to Robert Lucas, graduate students, would “snicker” whenever Keynesian concepts were mentioned.

In policy circles, Keynesians were replaced by monetarists, acolytes of Milton “Inflation is always and everywhere a monetary phenomenon” Friedman. Volcker in America and Thatcher in Britain decided the only way to stomp out inflationary expectations was to cut the money supply. This, despite their best efforts, they were unable to do. Controlling the money supply proved almost impossible but monetarism gave Volcker and Thatcher the cover to manufacture the deepest recession since the Great Depression.

By raising interest rates until the economy screamed Volcker and Thatcher crushed investment and allowed unemployment to rise to levels unthinkable just a few years before. Businessmen, union leaders, and politicians pleaded for a rate cut but the central bankers were implacable. Ending inflationary expectations was worth the cost, they insisted. Volcker and Thatcher succeed in crushing inflation, not by cutting the money supply, but rather with an old fashioned Phillips curve trade off. Workers who fear for their jobs don’t ask for cost of living increases. Inflation was history.

The Federal Funds Rate hit 20% in 1980. Now even after a few hikes, it is barely over 1%. The story of the past 30 years is of the most stimulative monetary policy in history. Anytime the economy stumbled, interest rate cuts were the automatic response. Other than military Keynesianism and tax cuts, fiscal policy was relegated to the ash heap of history. Reagan of course combined tax cuts with increased military spending but traditional peacetime infrastructure stimulus was tainted by the 1970s stagflation and for policymakers remained beyond the pale.

Fiscal stimulus came back, momentarily, at the peak of the financial crisis. China’s investment binge combined with Obama’s stimulus package probably stopped the Great Recession from being as catastrophic as the Great Depression but by 2010, fiscal stimulus was replaced by its opposite, austerity. According to elementary macroeconomics, when the private sector is cutting back its spending, as it was still doing in the wake of the financial crisis, government should increase its spending to take up the slack. But Obama in America, Cameron in Britain and Merkel in the EU insisted that government cut spending, even as the private sector continued to retrench.

It is rather shocking, for anyone who has taken Econ 101 that in 2010, when the global economy had barely recovered from the worst recession since the Great Depression, politicians and pundits were calling for lower deficits, higher taxes and less government spending even as monetary policy was maxed out. Rates were already close to zero so central banks had no more room to cut.

So, instead of going to the tool box and taking out their tried and tested fiscal kit, which would have created jobs and had the added benefit of improving infrastructure, policymakers instead invented Quantitative Easing, which in essence is monetary policy on steroids. Central Banks promised to buy bonds from the private sector, increasing their price, thereby shoveling money towards bond owners. The idea was that by buying safe assets they would push the private sector to buy riskier assets and by increasing bank reserves they would stimulate lending but the consequence of all the Quantitative Easings is that all of the benefits of growth since the financial crisis have gone to the top 5% and most of that to the top 0.1%.

A feature or a bug? The men who rule the planet are happy that most of us think economics is boring, that we would much rather read about R Kelly’s sexual predilections than about the difference between fiscal and monetary policy but were we to remember that spending money on infrastructure or health care or education would create jobs, raise wages, and create demand which the economy craves, we would have a much more equitable world.

One cogent objection to stimulative fiscal policy is that it has the potential to be inflationary. Indeed the fundamental goal of macroeconomic policy is to match the economy’s demand to its ability to supply. If fiscal policy gets out of hand (as arguably it did in the 1960s when Lyndon Johnson tried to fund both his Great Society and the Vietnam war without raising taxes), demand could outstrip supply, creating inflation. But should that happen, we have the monetary tools to cure any inflationary pressure. Rates today are still barely above zero. Should inflation threaten, central banks can raise interest rates and nip it in the bud.

Fiscal and monetary policy both have a place in policymakers’ toolkits. Perhaps the ideal combination would be to use fiscal to stimulate the economy and monetary to cool it down. Both Brexit and Trump should have told elites that unless they share the benefits of growth, a populist onslaught could threaten all our prosperity. The easiest way to return to Golden Age tranquility and equality is to empower fiscal policy to invest in our future and create jobs today.

2017 August 6

Evonomics.com

A Keynesian Opportunity Missed. Did We Take Low Interest Rates for Granted? – NY Times. 

The era of superlow interest rates, which began in 2008, will draw to a close this year if, as expected, the Federal Reserve lifts rates to fend off inflation from tax cuts and spending increases under a Trump administration.

The end of rock-bottom rates represents a huge missed opportunity for generations of Americans. Congress could have — and should have — used those near-zero rates to borrow money to rebuild the country’s decrepit infrastructure, which would have sped up the recovery by creating jobs and set the stage for growth long into the future.

That chance was squandered. After Republicans won control of the House in 2010, they managed to shift the debate from economic-recovery spending to deficit reduction. They did this despite evidence that the still-weak economy required more, not less, federal aid, and even threatened to default on the national debt unless federal spending was slashed. In 2013 and 2014, the budget was cut so deeply that the government sector subtracted from economic growth. In 2015, the government added nothing to growth. In 2016, it added a smidgen.

New York Times

Keynes Reborn – Koichi Hamasaki. 

Large public debts are not always bad for an economy, just as efforts to rein them in are not always beneficial.

The focus on a balanced budget in the United States, for example, has led some elements of the Republican Party to block normal functions of state and even federal authorities, supposedly in the name of fiscal discipline. Likewise, the eurozone’s recovery from the 2008 financial crisis has been held back by strict fiscal rules that limit member countries’ fiscal deficits to 3% of GDP.

Contrary to popular belief, aggregate demand and the price level (inflation) are not dictated only – or even primarily – by monetary policy. Instead, they are determined by the country’s net wealth and the liabilities of the central bank and the government.

When government deficits are lower, investing in government debt becomes more attractive. As the private sector purchases more of that debt, demand for goods and services falls, creating deflationary pressure. If the central bank attempts to spur inflation by expanding its own balance sheet through monetary expansion and by lowering interest rates, it will cause the budget deficit to fall further, reinforcing the cycle. In such a context monetary policy alone would not be adequate to raise inflation; fiscal policy that increases the budget deficit would also be necessary.

John Maynard Keynes’ The General Theory of Employment, Interest, and Moneywhich argued for active fiscal policies, was published in 1936. Forty years later, a counterrevolution took hold, reflecting sharp criticism of fiscal activism. After another 40 years, Keynes’ key idea is back, in the form of the FTPL (fiscal theory of the price level). This may be old wine in a new bottle, but old wine often rewards those who are willing to taste it.

Project Syndicate 

How New Keynesian Economics Betrays Keynes – Roger E. A. Farmer. 

Classicals, Keynesians, and Bastard Keynesians. 

Macroeconomics is a child of the Great Depression. Before the publication of Keynes’ book, The General Theory of Employment, Interest and Money, macroeconomics consisted primarily of mon­etary theory.

Economists were preoccupied with price stability, as we are today, but the idea that government should control ag­gregate economic activity through active fiscal and monetary policy was absent.

There is no self-correcting market mechanism to return the boat to a safe harbor. We must rely on political interventions to maintain full employment. That is the essential insight of Keynes’ General Theory.

Hicks embraced the Keynesian idea that mass unemployment is caused by insufficient aggregate demand, and he formal­ized that idea in the IS- LM model.

The program that Hicks initiated was to understand the connection between Keynesian economics and general equi­librium theory. But, it was not a complete theory of the macro­economy because the IS- LM model does not explain how the price level is set. The IS- LM model determines the unemploy­ment rate, the interest rate, and the real value of GDP, but it has nothing to say about the general level of prices or the rate of inflation of prices from one week to the next.

To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical synthesis in 1955. According to this theory, if un­employment is too high, the money wage will fall as workers compete with each other for existing jobs. Falling wages will be passed through to falling prices as firms compete with each other to sell the goods they produce. In this view of the world, high unemployment is a temporary phenomenon caused by the slow adjustment of money wages and money prices. In Samuelson’s vision, the economy is Keynesian in the short run, when some wages and prices are sticky. It is classical in the long run when all wages and prices have had time to adjust.

In Keynes’ vision, there is no tendency for the economy to self- correct. Left to itself, a market economy may never recover from a depression and the unemployment rate may remain too high forever. In contrast, in Samuelson’s neoclassical synthe­sis, unemployment causes money wages and prices to fall. As the money wage and the money price fall, aggregate demand rises and full employment is restored, even if government takes no corrective action. By slipping wage and price adjust­ment into his theory, Samuelson reintroduced classical ideas by the back door— a sleight of hand that did not go unnoticed by Keynes’ contemporaries in Cambridge, England. Famously, Joan Robinson referred to Samuelson’s approach as “bastard Keynesianism.”

The New Keynesian agenda is the child of the neoclassical synthesis and, like the IS- LM model before it, New Keynesian economics inherits the mistakes of the bastard Keynesians. It misses two key Keynesian concepts: (1) there are multiple equilibrium unemployment rates and (2) beliefs are funda­mental. My work brings these concepts back to center stage and integrates the Keynes of the General Theory with the mi­croeconomics of general equilibrium theory in a new way.

Evonomics.com

THE ECONOMIC CONSEQUENCES OF THE PEACE by JOHN MAYNARD KEYNES, C.B. Fellow of King’s College, Cambridge – Introduction. 

A warning for our times. 

The writer of this book was temporarily attached to the British Treasury during the Great War and was their official representative at the Paris Peace Conference up to June 7, 1919; he also sat as deputy for the Chancellor of the Exchequer on the Supreme Economic Council.

He resigned from these positions when it became evident that hope could no longer be entertained of substantial modification in the draft Terms of Peace.

The grounds of his objection to the Treaty, or rather to the whole policy of the Conference towards the economic problems of Europe, will appear in the following chapters.

They are entirely of a public character, and are based on facts known to the whole world.

J.M. Keynes. King’s College, Cambridge, November, 1919.

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Introduction


The power to become habituated to his surroundings is a marked characteristic of mankind. Very few of us realize with conviction the intensely unusual, unstable, complicated, unreliable, temporary nature of the economic organization by which Western Europe has lived for the last half century.
On this sandy and false foundation we scheme for social improvement and dress our political platforms, pursue our animosities and particular ambitions, and feel ourselves with enough margin in hand to foster, not assuage, civil conflict in the European family.

Moved by insane delusion and reckless self-regard, the German people overturned the foundations on which we all lived and built. But the spokesmen of the French and British peoples have run the risk of completing the ruin, which Germany began, by a Peace which, if it is carried into effect, must impair yet further, when it might have restored, the delicate, complicated organization, already shaken and broken by war, through which alone the European peoples can employ themselves and live.
Perhaps it is only in England and America that it is possible to be so unconscious.
In continental Europe the earth heaves and no one but is aware of the rumblings. There it is not just a matter of extravagance or “labor troubles”; but of life and death, of starvation and existence, and of the fearful convulsions of a dying civilization.

In this lies the destructive significance of the Peace of Paris.
If the European Civil War is to end with France and Italy abusing their momentary victorious power to destroy Germany and Austria-Hungary now prostrate, they invite their own destruction also, being so deeply and inextricably intertwined with their victims by hidden psychic and economic bonds.

The British people received the Treaty without reading it. But it is under the influence of Paris, not London, that this book has been written by one who, though an Englishman, feels himself a European also, and, because of too vivid recent experience, cannot disinterest himself from the further unfolding of the great historic drama of these days which will destroy great institutions, but may also create a new world.

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1919 – Keynes predicts economic chaos

At the Palace of Versailles outside Paris, Germany signs the Treaty of Versailles with the Allies, officially ending World War I. The English economist John Maynard Keynes, who had attended the peace conference but then left in protest of the treaty, was one of the most outspoken critics of the punitive agreement. In his The Economic Consequences of the Peace, published in December 1919, Keynes predicted that the stiff war reparations and other harsh terms imposed on Germany by the treaty would lead to the financial collapse of the country, which in turn would have serious economic and political repercussions on Europe and the world.

In January 1919, John Maynard Keynes traveled to the Paris Peace Conference as the chief representative of the British Treasury. The brilliant 35-year-old economist had previously won acclaim for his work with the Indian currency and his management of British finances during the war. In Paris, he sat on an economic council and advised British Prime Minister David Lloyd George, but the important peacemaking decisions were out of his hands, and President Wilson, Prime Minister Lloyd George, and French Prime Minister Georges Clemenceau wielded the real authority. Germany had no role in the negotiations deciding its fate, and lesser Allied powers had little responsibility in the drafting of the final treaty.

The treaty that began to emerge was a thinly veiled Carthaginian Peace, an agreement that accomplished Clemenceau’s hope to crush France’s old rival. According to its terms, Germany was to relinquish 10 percent of its territory. It was to be disarmed, and its overseas empire taken over by the Allies. Most detrimental to Germany’s immediate future, however, was the confiscation of its foreign financial holdings and its merchant carrier fleet. The German economy, already devastated by the war, was thus further crippled, and the stiff war reparations demanded ensured that it would not soon return to its feet. A final reparations figure was not agreed upon in the treaty, but estimates placed the amount in excess of $30 billion, far beyond Germany’s capacity to pay. Germany would be subject to invasion if it fell behind on payments.

Keynes, horrified by the terms of the emerging treaty, presented a plan to the Allied leaders in which the German government be given a substantial loan, thus allowing it to buy food and materials while beginning reparations payments immediately. Lloyd George approved the “Keynes Plan,” but President Wilson turned it down because he feared it would not receive congressional approval. In a private letter to a friend, Keynes called the idealistic American president “the greatest fraud on earth.” On June 5, 1919, Keynes wrote a note to Lloyd George informing the prime minister that he was resigning his post in protest of the impending “devastation of Europe.”

“If we aim at the impoverishment of Central Europe, vengeance, I dare say, will not limp. Nothing can then delay for very long the forces of Reaction and the despairing convulsions of Revolution, before which the horrors of the later German war will fade into nothing, and which will destroy, whoever is victor, the civilisation and the progress of our generation.”

This Day In History 

Keynesian economics: is it time for the theory to rise from the dead? – Larry Eliot. 

Lessons were learned from the 1930s. Governments committed themselves to maintaining demand at a high enough level to secure full employment. They recycled the tax revenues that accrued from robust growth into higher spending on public infrastructure. They took steps to ensure that there was a narrowing of the gap between rich and poor.

The period between FDR’s second win and Donald Trump’s arrival in the White House can be divided into two halves: the 40 years up until 1976 and the 40 years since.

Keyne’s lessons were forgotten. (Hans: after the assault on western economies by the offspring of Saudi Arabia’s oil embargo of 1973: Hyper Inflation and the mistaken conviction that Keynesian economics was to blame.) Instead of running budget surpluses in the good times and deficits in the bad times, UK governments ran deficits all the time. They failed to draw the proper distinction between day-to-day spending and investment. In Britain, December 1976 was the pivotal moment. Matters came to a head in early December when a divided and fractious cabinet agreed that austerity was a price that had to be paid for a loan from the International Monetary Fund, which was needed to prop up the crashing pound.

Subsequently there was a paradigm shift. Labour had been reluctant converts to monetarism; the Thatcherites who followed were true believers. Controls on capital were lifted, full employment was abandoned as the prime policy goal, trade union power was curbed, taxes for the better off were cut, inequality was allowed to widen, finance waxed as manufacturing waned.

The Guardian