Krugman at Cambridge on Keynes
Genevieve Signoret
You can read or watch the Krugman presentation on Keynes at Cambridge. What follows is my summary. It may be hard to follow without opening the pdf so that you can look at the diagrams. The video page provides footage of the Q-A period.
Krugman said nothing not in his blog. In his blog, however, his arguments are scattered; whereas here, they’re laid out compactly.
In Part One of The General Theory, Keynes explains that there is no guarantee that people will spend enough to make use of an economy’s productive capacity: the mere fact that we can produce stuff does not mean that people will necessarily spend amounts equal to the income that would be generated if we were producing all that stuff.
The policy implication is that, under certain circumstances, it is wise for governments to raise spending or induce people to spend more.
Today’s policy debate centers on Part One. Keynes wrote it as if he were arguing with the classicists, who confused accounting identities (e.g., in the end, income must equal spending) with causal relationships (all income must be spent). It is this fallacy which leads people—not just non-professionals but even credentialed economists—to say erroneous things such as “any increase in government spending will necessarily come at the expense of private spending.”
It is necessarily true, as shown in Samuelson’s 45-degree diagram (Figure 1, page 7), that total spending always equals total income. But it is also true, as shown by the same diagram, that a sudden willingness to spend more at any given level of income than before raises income. You need only raise the proportion that everyone is willing to spend out of all income for income to expand. Hence, it is not true that increased government spending can occur only at the expense of private expenditure.
Chapters thirteen and fourteen of The General Theory refute the classical story of interest (figure 2). By this story, if the government borrows, if savings available for private investment falls, interest rates rise, causing income to fall. Its policy implication for today would be that, to ensure economic recovery, we must keep deficits down.
Keynes showed that there is no unique level of interest rate that matches savings to investment (figures 4 and 5); rather, the money market clearing rate varies with the level of income (IS curve, figure 6). (A notion like this one guides all practical monetary policy making today.) Moreover, the rate needed to match savings to investment may not be positive at all. Unfortunately, zero is the lower bound on interest rates. If the market clearing rate is lower but unachievable, then, at the zero rate, the supply of savings will be excessive. This is a liquidity trap.
The USA is in such a situation today. This explains why, although the government has sold $4 trillion in debt since the fall of Lehman Brothers, interest rates remain low (the 10-year yield on Treasuries is below 3%). Investors who have failed to get this have lost millions betting that interest rates would soar.
For the international financial system, this means that the notion that China could hurt the USA by causing interest rates to soar were it to stop buying U.S. debt is a myth. The problem in the USA is excess saving. China does the USA no favor by adding to that pool of saving.
No one (in power) gets this.
Keynes was silent on the question of the banking system and banking crises, although in 1931 he wrote a fine essay on the subject. Perhaps he did not want to muddy his message. Krugman can see why. In the 1990s in Japan, too much focus on the Japanese banking crisis deflected attention from the problem of a liquidity trap and deflation and prevented outside observers from taking warning.
Of course, banking crises occurred in both 1933 and 2008. Today, however, that crisis is largely over. Yet recovery remains elusive. Why? Probably because household balance sheets remain in disrepair (deleveraging continues).
Note that this fact renders absurd the notion that if we could get workers to accept wage cuts, our problems would go away. Perhaps under certain assumptions in normal times that might work. But only by bringing interest rates down, an impossibility when up against the zero bound. Wage deflation would thus only raise the real debt burdens of households, lowering their spending further. Employment would fall, not rise.
See how topsy turvy the world is when we’re trapped like this? Lower wages don’t increase employment, they lower it. More saving leads doesn’t raise business investment, it lowers it.
Keynes did not mention the drag on the economy coming out of a crisis caused by past excessive debt levels. And this drag makes the cases for fiscal stimulus even stronger, not weaker. Fiscal stimulus is required for however much time we must buy to allow households to repair their balance sheets.
How did we get into this mess?
The system after World War II was sensible but unstable. It rested on the consensus Keynesian belief that we need active monetary and sometimes fiscal policy, but outside of that should let markets run free. But this consensus was unstable intellectually. After 60 years, economists who had become so focused on the microeconomic foundations of macro, they had quite forgotten their Keynes. When the crisis caught them, they were living in Dark Ages of Macroeconomics.
It was unstable politically because it clashed with ideology. Some people want no role in the economy at all for government. They see a thin line separating the slightest role from outright communism. Also, business interests resist the notion that in some circumstances government activism may be wise, for it weakens their story, which is that the only way to growth is to boost business confidence. In this story lies their power: it keeps governments under threat never to hurt their interests.
Finally, the consensus was unstable financially, because Hyman Minsky was right: long periods of calm make people careless and lead them to build up too much debt. Crises are inevitable.
Even in the Dark Age of Macroeconomics, there were monasteries. These were the central banks. They kept the old books. They remembered.
Regulation, however, became lax. And now that the thing has blown up so large, we lack the intellectual and political capital to deal with it.
What’s an academic economist to do? Plug away. Over history, sound ideas do eventually prevail.
Well, keep plugging, you academic economist, you!
What about lowering taxes as a way to “induce people to spend more”? Would that tend to make people “suddenly willing to spend more?” Is it really so “wise” for government to spend more in the throes of an economic downturn? Wouldn’t it be wiser for them to spend less, lower taxes, and so “induce” people to spend more, thereby increasing growth and so increasing government revenue, which they could then happily spend, for all I care?
Do academic economists like to tear down straw men like, “Some people want no role in the economy at all for government. They see a thin line separating the slightest role from outright communism. Also, business interests resist the notion that in some circumstances government activism may be wise, for it weakens their story, which is that the only way to growth is to boost business confidence. In this story lies their power: it keeps governments under threat never to hurt their interests,” or is that just you, speaking for academic economists worldwide? I hope not, because I have a lot of respect for academic economists, who keep plugging away, without recourse to such infantile straw men.
It should go without saying, especially for an academic economist,who keeps plugging away in the face of such egregious popular ignorance of “some people” and “business interests”, that nobody sane either wants no government role in the economy or that government does not “fear” business interests. It’s the other way around. Obviously. Government has coercive power; “business interests” do not. And what would stimulate growth in the economy besides confidence in business? Isn’t business the nucleus of the economy in the first place? Or is that the role of government for you “academic economists?” If so, you’re even further out there in left field than I thought.
As for the economy being essentially in the private sphere, well…that’s the root of the word itself: the science of the hearth and home. Otherwise, private property rights trump government in all cases except eminent domain. Otherwise we really do have some kind of communist system, don’t we? If private property rights are subject to the whims of “academic economists” and other bureaucrats, then where does it end, other than in some form of communism? That’s just common sense, not “academic economics.”
Does a “sudden willingness to spend” over one’s income level really raise the general level of income? That has to be magical thinking, not “plugging away” by an “academic economist.
Fulano de Tal:
My article was a summary of a long talk by Krugman presenting Keynes. You’re arguing with Krugman on Keynes, so I’ll try to answer for him. When I’m speaking for myself, I’ll so state.
Your policy proposal works great most of the time. The exception is when you’re in a liquidity trap. In a liquidity trap, marked by excess saving and insufficient demand for consumption and investment, tax cuts lead to more saving, not more spending, which digs the hole deeper, paradoxically. Tax cuts on labor income (income tax cuts) are an incentive to work, so increase the labor supply, when it already exceeds the demand for labor. Tax cuts on saving (e.g., on dividend income), do the same for savings, which exceed the demand for investment. You only worsen the situation and prolong the depression.
In other words, the problem is not how much money is in people’s pockets but people’s behavior. They are putting every penny into paying down debt. When everyone does this at the same time, and the government goes along with the trend instead of leaning against it by spending, the economy spirals down. It’s trapped. Poverty and unemployment deepen. Which is paradoxical.
Keynes argues strongly for fiscal conservatism during normal times. For example, he advocates building up fiscal surpluses during boom times.
Your reference to academic economists is itself a rhetorical reference to straw men. The academic economics profession is sharply divided.
Did you listen to the talk? Krugman directly addresses various academic economists who disagree with him.
All of my words in that post were a synopsis or paraphrase of a talk I had listened to by Krugman. None of the thoughts or words were mine. So I was compressing Krugman.
Was Krugman speaking for all academic economists? I suppose not. Only for those who agree with him and share his frustrations with the other half. He was speaking at a Cambridge-run symposium on Keynes; he had a sympathetic audience.
His theory on business interests is of the type common in the subfield called political economy. It’s of course just a hypothesis. It would be hard to refute so perhaps is not science. It sounds to me like ideology cloaked in economic theory.
Business interests do of course have strong influence over policy. Do you agree? They finance politicians and have ample budgets for lobbying. Politicians who want to stay in power try not to make them mad.
Is business the nucleus of the economy in the first place? In my view? (I will now speak for myself.) Certainly not. I think that people are the nucleus. Entrepreneurs, non-working savers (retirees), workers, non-working dependents (homemakers, students), non-profit workers, government workers. Capitalism is embedded in institutions, including non-official ones (customs, family) and official (coercive) ones. Business is certainly a crucial part of the capitalist system, but no more so than workers or governments.
Likewise, capitalism needs labor. Workers have emotional and economic needs met by informal institutions such as family. And so on. And governments. Competitive markets require massive amounts of information available at low cost, for example. Governments provide this and other services that markets require that are public goods. Governments set up and run central banks. They keep domestic capital and labor safe from would-be violent invaders. They invest in infrastructure needed for public network goods. They immunize children and adults.
So no, I certainly give no more primacy to the role of business over those the remaining actors crucial for capitalism to emerge and be sustained.
The optimal balance of power among the components or sectors is not clear to me. It’s decided in the arena of politics and policy debates. Both you and Krugman have more certainty than I do on this question.
Certainly the Keynesian argument as to how to emerge from a liquidity trap is paradoxical, counter-intuitive. In fact, all studies of Keynes list its various paradoxes (the paradox of thrift, for example).
Common sense? Science often goes against it. Science compensates for its inadequacy.
Note that Keynesian economists do not prescribe the running of massive deficts in normal times (when we’re not in a liquidity trap) and believe that the 30s and now are the only times in recent history that the U.S. economy has fallen into one.
Do you agree that the USA is in a liquidity trap?
Do you agree that it was in one in the 30s?
If so, how do you explain its emergence from the trap? As you know, Keynesians believe that massive deficits to fund World War II caused the emergence from the trap.
What do you think caused the emergence?