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Keynesian Economics

February 19, 2010 7 comments

Once I was at an end-of-year barbeque for the econ department when I was an undergraduate and I was talking to one of my favorite professors about reading the classics (which nobody seems to do anymore).  I had read the Wealth of Nations and I wanted to read Marshall but didn’t know what the different volumes were all about.  At some point he said to me “…and of course eventually you will have to read Keynes as well.”  And I said “I don’t think I want to read Keynes” because I didn’t. 

The reason I had no interest in reading Keynes was that I didn’t feel like I had ever learned anything from Keynesian economics.  The models I had seen in class never made me feel like I knew more about how the world works.  At that time I had a feeling in the back of my mind that I just didn’t get the logic behind them.  Eventually, though, as I learned more and more about economics and these models kept coming up, I became more and more confident that the reason I didn’t get it was that they didn’t make sense.  That is not to say that the math is incorrect or something as superficial as that but that the logic behind this entire view of economics is flawed on a fundamental level.  Since this feeling didn’t go away (and neither did these models…) I eventually resolved to read the General Theory.  I just finished it and I have some things to point out. 

Before I begin, let me say that I realize there is a vast literature criticizing Keynes and I have read almost none of it.  It is not my intention to survey that literature here nor am I claiming to say things that have never been said before.  I’m just a wanna-be economist who just read Keynes and has some thoughts.  Here they are:

1. This entire theory is politically motivated.  And I don’t mean just in the sense of trying to affect policy to fix the economy I mean trying to affect policy to bring about a different social order.  I always felt like Keynes had a political motive behind his work but I would consider it irresponsible to make a claim like that (at least in writing) without some evidence and I never really had any…. until I read the book.  The following language all comes from the final chapter of the General Theory.  The reader may click this link and start reading on page 235 to get the full context.

He starts out with fairly standard leftist notions of the inherent unfairness of income inequality.

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.”

“Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation.”

 “[This theory]…does dispose of the most important of the reasons why hitherto we have thought it prudent to move carefully [with regard to redistributive taxes].”

“For my own part, I believe that there is social and psychological justification for significant inequalities of incomes and wealth, but not for such large disparities as exist to-day.”

“Thus we might aim in practice….at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, to be harnessed to the service of the community on reasonable terms of reward” (italics added by me).

Then his rhetoric takes on a subdued Marxist quality.

“Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. 

But adds the typical progressive twist.

“I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work.  And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change.  It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.”

“…the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society.”

“It would need a volume of a different character from this one to indicate even in outline the practical measures in which [the fulfillment of these ideas] might be gradually clothed.”

Then, my favorite part, in a George W. Bush “I’m a free market guy” moment, he declares his position “moderately conservative,” devotes a paragraph to praising the virtues of individualism and then claims that his reforms are the only way to protect liberty.

“Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.”

He also claims that his system will bring world peace…

On this subject I don’t have much to add.  I think the man’s words speak for themselves but nobody ever puts this work in the progressive context to which It belongs.

2.  He is profoundly confused in a way which should be obvious but is cloaked in a complicated and confusing system in order to obscure the defect.  There is a common confusion which comes up in introductory economics classes.  Students will often say things like “when price increases quantity increases.”  The problem with this is that in a supply and demand model, both price and quantity are endogenous.  This means that they are determined simultaneously by supply and demand.  So a correct statement is that when demand increases, price and quantity increase.  But if supply increases, price increases and quantity decreases.  So you can get any combination of price change and quantity change depending on which curve moves and in which direction.  Price doesn’t cause the change in quantity.  They are both caused by a change in supply or demand.  Similarly if price is arbitrarily increased (say by a government mandated price-floor) then you don’t say quantity increases or decreases, you have to say that quantity demanded decreases and quantity supplied increases.  The change in the actual quantity depends on which curve you assume determines the actual quantity.  Now consider the following quote.

“The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.”

Now he didn’t so much “show” that the extent of effective saving is necessarily determined by the scale of investment as say it.  In other words, the price of investment is the interest rate and he says that if you lower it you get more investment because there will be more demand whereas his predecessors (he claims) said that lowering the rate of interest decreases investment because it decreases the quantity supplied.  These are just different assumptions about what determines quantity when the market is out of equilibrium.  It is worth noting that the previous assumption is, I think, more reasonable.  However, the more important issue is that these views both miss the point.  In a free market, it is nonsensical to say that the rate of interest increases or decreases investment.  Keynes takes for granted the notion that the state sets the interest rate and also seems to assume that there is no efficient positive price determined in a market for investment.

“Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant.”

“Sufficiently abundant” here apparently means that level which makes the interest rate equal to zero.  He says this even though the interest rate has been positive almost everywhere and every time in history.  So “the long run” apparently means whenever we eventually achieve utopia.  But he is ignoring the fact that capital is scarce for a reason.  Some consumption today must be given up to produce capital which produces output tomorrow.  This “genuine sacrifice” is what leads to a positive interest rate.  It is not surprising that after assuming the rate of interest is always above its market-clearing level (0 in this case) that lowering it is beneficial, but Keynes gives no convincing reason why the interest rate would be too high in a free market and ignores the obvious reason for a market rate greater than zero.

The underlying theme of Keynesianism seems to be that supply is an unnecessary obstacle to demand.  That if the quantity of investment demanded increases, the investment is necessarily produced.  If more consumption is demanded more is produced.  Nothing is given up, it just appears because people demand it.  It is worth noting that in the IS-LM model which eventually resulted from this literature, the only source of scarcity was people’s marginal propensity to save.  If they just don’t save they have infinite wealth!  They talk about “aggregate demand” and then assume that (in the long run) equilibrium supply must be equal to demand so whenever demand goes up we get more stuff.  The concept of aggregate demand is ridiculous in itself.  In order to demand something one must be willing and able to give something up.  The Keynesian “aggregate demand” allows for no tradeoff.  One cannot trade one good for another because it is aggregate consumption which is being demanded.  If economics is the study of tradeoffs in the face of scarcity can someone explain to me how this qualifies as such? 

I am just a little confused about how this stuff is well regarded by the economics community.  I know everyone says that they don’t believe in Keynes anymore but most of our current macro models are “new Keynesian models” which suffer from many of the same fundamental flaws (though they are admittedly somewhat more reasonable), and our policy makers seem to still be using a vaguely defined version of IS-LM.  Krugman has even recently more or less suggested that we should go back to Keynes and start over.  This should be buried next to alchemy and a geocentric universe and economists should be embarrassed for letting it survive this long.

For my part, I am working on an alternative.  More on that to come.

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