Let's All Be Keynesians Now

Konstantin Platonov and I have updated our working paper on reinventing the IS-LM model. You can download it from the NBER here, or from an open link on this website. If you haven't read our paper, or our summary on VOX, here are a few highlights.

The Hicks-Hansen representation of The General Theory is summarized by the  IS-LM diagram, a tool that was designed to represent temporary equilibrium in the sense that Hicks used that term in his book, Value and Capital. The price level is  pre-determined in Hicks version of Keynesian economics and it wasn't until Samuelson introduced the idea of the neo-classical synthesis in the third edition of his undergraduate textbook that the current view of sticky-price Keynesian economics was born. Samuelson was the original 'bastard Keynesian' (in the immortal words of Joan Robinson.) 

In our working paper, we reinvent the IS-LM model and add a new curve, the NAC condition, which integrates the value of the stock market into the  model and explains, not just the interest rate and GDP, but also how the price level is determined. In our IS-LM-NAC model, high involuntary unemployment is not just a temporary phenomenon; it is a potentially permanent feature of a market economy. Larry Summers has resuscitated Alvin Hansen's idea of secular stagnation. Our work provides a coherent theory of what that might mean. Building on earlier work  that integrates The General Theory with general equilibrium theory in a new way, our paper offers fresh insights about the role of the asset markets on economic activity that cannot be understood using a more conventional approach.

A second feature of our paper is the introduction of animal spirits as an independent driver of economic activity. We formalize that idea  with a belief function, an idea that was first introduced in my 1993 graduate text, the Macroeconomics of Self-Fulfilling Prophecies. And as in my previous use of that concept, the idea that beliefs are fundamental is completely consistent with rational expectations. Our IS-LM-NAC model provides a coherent way for policy makers to think about the effects of monetary and fiscal policy on output, employment and inflation and we propose that our model be adopted as a viable and superior alternative to the current textbook approach.



Post Keynesian Dynamic Stochastic General Equilibrium Theory

Last year, I was invited to present a keynote address to the 20th annual conference of the FMM Research Network on Macroeconomics and Macroeconomic Policies, “Towards Pluralism in Macroeconomics”, held in Berlin on October 20th – 22nd 2016. Due to unforeseen circumstances, I was  unable to attend in person but the organizer, Torsten Niechoj, kindly invited me to submit a paper for the conference volume. That paper is now available as an NBER working paper here, and as a CEPR discussion paper here. In it, I make the case that Post-Keynesians and New-Keynesians have much to learn from each other and I invite the next generation of macroeconomists to help develop a fresh approach to our subject: Post-Keynesian Dynamic Stochastic General Equilibrium Theory.

Image from: The Rocky Horror Picture Show

Image from: The Rocky Horror Picture Show

Here is an extract from the paper, that reports a conversation overheard between Janet, a North American economist from the Great Lakes region, and Brad, a Post Keynesian graduate student who has read my book, Prosperity for AllJanet seems a bit confused over Gene Fama's use of the word 'efficiency' in the efficient markets hypothesis. Brad explains that Fama is talking about informational efficiency and that this is distinct from Pareto Efficiency. Janet thinks that these are the same thing. Brad disagrees.

Janet:      The distinction between informational efficiency and Pareto efficiency is a distraction. If people trading in the financial markets cannot make money, nor can the government. There is no such thing as a free lunch. 

Brad:    I disagree. The fact that a market is in equilibrium does not mean that it is efficient.

Janet:    Well OK, I know that you Post-Keynesian types are willing to make all sorts of assumptions about market frictions. Those assumptions don’t seem credible to me. As a first approximation, I am willing to assume that prices are perfectly flexible.

Brad:    You seem to be confusing me with a New-Keynesian. I’m happy with the flexible price assumption.  I’ll give you that one.

Janet:    Well perhaps you think that there are missing financial markets. I know that Kenneth Arrow has argued that transactions costs preclude the existence of all the financial instruments necessary to generate market efficiency. But I don’t buy that. If there are big potential gains from trade, there are big incentives for private agents to create new markets. Just look at all the derivatives that were created over the last few decades. They came about because of lower transactions costs. I’m willing to assume, to a first approximation, that there is a complete set of financial markets.

Brad:    While that seems like a stretch; I’ll give you that one too. Let’s assume that there is a complete set of financial markets and that everyone participating in the financial markets can make any conceivable trade in the futures markets at zero cost.

Janet:    Is it the assumption of perfect knowledge you’re uncomfortable with? I know that Frank Knight  drew a distinction between risk and uncertainty and that you Post Keynesian types keep harping on about radical uncertainty. Although you may have a point there, I just don’t see how we can make any progress if we assume that nobody knows anything about the future. I’m willing to go with the assumption that we live in a stationary world because it’s the best chance we have of saying something about the behavior of short-run macroeconomic variables. And that means that we should also assume that people have rational expectations.

Brad:    Well I’m not entirely on board with that. But, for the sake of argument, let’s agree to model the way that human beings would act if they did live in a world where all uncertainty is generated by a known stationary probability distribution and where the people in our model have rational expectations. If we can agree on the answer to what an equilibrium would look like in that world, then perhaps we can extend our equilibrium concept to a more complicated world where the future is characterized by radical uncertainty.

Janet:    Hmmm… If you accept all of these assumptions, I’m having trouble understanding why you don’t understand, that if private agents can’t make money in markets, then, neither can the government. Maybe you’re one of those Marxist types who thinks that product markets are characterized by monopolists and we need unions to defend workers’ rights. In my view, that’s a load of poppycock. Product markets are contestable and, to the extent they’re not, the solution is limited regulation. I don’t see what that has to do with the distinction between informational efficiency and Pareto efficiency. 

Brad:    Wow: you really have drunk the Kool-Aid. But no; that’s not my point either. Let’s suppose you’re right that the labor market and the product markets are well approximated by the assumption of perfect competition. I’m willing to give you flexible prices, complete markets, rational expectations, and perfect competition. But there’s one little fact you can’t get around.

Janet:    What’s that Brad?

Brad:    The Grim Reaper. People die and new people are born. Even if everyone present today could make trades with each other contingent on every conceivable future event, the unborn cannot participate in markets that open before they are born. Government, on the other hand, is present in every period and it can intervene on behalf of our children and our grandchildren.

Janet:    Nonsense. We don’t need government for that; we need the family. Robert Barro showed that all we need to correct the inefficiency in an overlapping generations model is for parents to love their children. The representative household is a useful fiction because each of us is connected by a chain of operative bequests. 

Brad:    You’re wrong Janet. Overlapping generations models have not one, but two kinds of inefficiencies. Robert Barro’s argument applies to dynamic inefficiency, which is the fact that, in overlapping generations models, interest rates can be too low. There is a second kind of inefficiency that was pointed out by David Cass and Karl Shell . And Costas Azariadis (Azariadis, 1981) showed that overlapping generations models can lead to volatile fluctuations in asset markets that have nothing to do with fundamentals. In his book, Prosperity for All Farmer argues that a large fraction of the fluctuations we see in stock markets are caused by this second kind of inefficiency. And this second kind of inefficiency cannot be eliminated by the family because it would require that our parents leave positive bequests in some states of nature and negative bequests in other states of nature.

My imagined conversation between Janet and Brad is meant to illustrate the idea that we can accept the tenets of a version of general equilibrium theory while rejecting the first welfare theorem.

It is my hope that the shock of the Great Recession will catalyze interbreeding between new-Keynesian and heterodox economists. If I am right, more of my neo-classical contemporaries will need to listen to the drum beat that post-Keynesians have been sounding for sixty years. And Post-Keynesians will need to explain to neo-classical and new-Keynesian economists, in their own language, what they are doing wrong. General equilibrium theory, broadly interpreted, like mathematics, is a language.

If you are young enough to have not yet been corrupted by establishment elites of either subspecies, I urge you to think hard about joining me in establishing Post-Keynesian DSGE theory as the future of macroeconomics. 

Keynesian Economics Without the Consumption Function

In Prosperity for All,  (PFA) I describe a theory of Keynesian economics, developed in my recent body of work,  in which the transmission mechanism from demand to employment is through wealth, not through income. I call this, a theory of Keynesian economics without the consumption function.

I reject the Keynesian theory of aggregate demand, and I reject the theory of the multiplier that goes along with it. My reason is that the empirical evidence does not support a theory in which government expenditure  multipliers work by increasing consumption, as they must if the Keynesian consumption theory is correct. As Valerie Ramey has shown, when government expenditure goes up; consumption goes down.

Here is how I describe my reluctance to embrace the traditional Keynesian approach to aggregate demand in Chapter 10 of PFA,

Keynesian economics has two parts: a theory of aggregate supply and a theory of aggregate demand. Traditionally, Keynesians have focused on the theory of aggregate demand. The central part of that theory is the consumption function, and an implication of the theory of the consumption function is that an increase in government expenditure will cause GDP to increase by a multiple of the initial increase in spending. That theory is wrong. Consumption depends on wealth, not on income. PFA, pages 177-178

If consumption depends on wealth, and not on income, we should be concerned that movements in wealth may lead to socially inefficient fluctuations in the unemployment rate. Those movements are not simply temporary movements away from a social planing optimum, they are permanent movements in the unemployment rate that can lead to decades of misery for those without jobs.

Figure 1: Roger E. A. Farmer. (c) Oxford University Press.

Figure 1: Roger E. A. Farmer. (c) Oxford University Press.

Quoting again from PFA,

Figure 1 illustrates the implications of a theory of Keynesian economics without the consumption function. The aggregate demand curve does not slope upward with income; it is a horizontal straight line. The position of this line depends on the beliefs of market participants about the value of their financial assets. As the value of financial assets fluctuate, driven by self-fulfilling beliefs, so the aggregate demand curve moves up and down between the solid horizontal line and the dashed horizontal line. As people feel more or less wealthy, they buy more or fewer goods. Firms hire more or fewer workers and real GDP fluctuates between point YA* and YB*.  (PFA, page 178.)

But although, I reject the simple Keynesian version of Aggregate Demand, I do not reject Keynesian economics. The key idea in the General Theory is that high involuntary unemployment may persist as an equilibrium of a market economy. How can that be? In Prosperity for All,

I provide a foundation—Keynesian search theory—to the Keynesian theory of aggregate supply. This new theory is rooted firmly in the microeconomic theory of behavior. According to Keynesian search theory, everything demanded will be supplied and any unemployment rate can be an equilibrium unemployment rate.  (PFA pages 178-9.)  

The implications of these ideas, taken as a package, are profound. If demand works through wealth, the right policy to maintain full employment is an intervention in the asset markets, not in the goods markets. 

Reinventing the Keynesian Cross

In, Aggregate Demand and Supply, a paper I wrote in 2006 that was published in the International Journal of Economic Theory, I developed my own version, and interpretation, of the Keynesian Cross. The Keynesian Cross is a diagram that, in times gone by, was taught to every student of macroeconomics.  

The Keynesian Cross, a formulation of the central ideas in The General Theory, appeared as a central component of macroeconomic theory as it was taught by Samuelson in his textbook, Economics: An Introductory Analysis.  The Keynesian Cross plots income on the horizontal axis and expenditure on the vertical axis.
Figure 1: The Keynesian Cross (my interpretation using employment and output in wage units) 

Figure 1: The Keynesian Cross (my interpretation using employment and output in wage units) 

In Figure 1, I have graphed a version of the Keynesian Cross that is closer in spirit to the General Theory than the version developed by Samuelson. In contrast to Samuelson’s version, my version plots employment on the horizontal axis and output, measured relative to the money wage, on the vertical axis
Following Keynes, I am measuring employment in units of ordinary labor and I am measuring output in wage units. I explain this diagram in my published paper Aggregate Demand and Supply The use of employment and output on the axes reflects the definitions in Chapter 4 of The General Theory.  In his exposition of Keynesian Economics, Samuelson amended this diagram by plotting income on the horizontal axis and expenditure on the vertical axis.
The student who truly understands [the Keynesian Cross] is well on the way to mastering the most important ideas in macroeconomics. It illustrates the two most important concepts in The General Theory, concepts that have formed the basis for everything I have drawn attention to in my work.
The first is the idea of beliefs as an independent driver of business cycles. ... The second is ... that any unemployment rate can persist as a steady state equilibrium. 
An important research question for macroeconomics is: what are the determinants of the aggregate demand curve and why does it shift around in sometimes unpredictable ways over time? In my view, Keynes’ theory of the consumption function is inadequate to answer this question.  We should instead explicitly model the connections between consumption and wealth.

I have included my version of the Keynesian cross in a new paper I have just completed that explains the connection between ideas developed in my books and papers and those of economists who self-identify as Post-Keynesians. Look out for my new paper, Post-Keynesian Dynamic Stochastic General Equilibrium Theory, coming next week. A discussion of the Keynesian cross can also be found in my new book Prosperity for All, pages 156--158 and pages 174--175. 

Keynes Betrayed

" To complete the reconciliation of Keynesian economics with general equilibrium theory, Paul Samuelson introduced the neoclassical synthesis in 1955...

... 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....

... Although Samuelson’s neoclassical synthesis was tidy, it did not have much to do with the vision of the General Theory...

... 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. "

Prosperity for All: Pages 25-26