Archive for the Category Keynesianism


Cowen and Smith on monopoly and stimulus

In a recent Bloomberg debate, there was an interesting exchange.  First, Tyler Cowen:

But Noah, I have a question for you. You’ve written several columns about how the American economy is becoming more monopolistic. If true (and it is not exactly my view), that implies output could be much higher with current resources, even at full employment. A boost in demand could spur firms to produce more, rather than restricting output so much. So are you now a fan of these Trumpian deficits? They may not be your preferred form of deficit spending, but do you see them still as a net positive?

Then Noah Smith:

As you say, monopoly power could potentially increase the case for stimulus in bad times.

Actually, that’s not what Tyler said, nor is what Tyler said true.  (Now everyone will be annoyed at me.)

One of the fundamental principles of modern macro is that demand-side stimulus cannot solve real problems.  It can overcome problems such as high unemployment caused by sticky wages and prices combined with inadequate spending, but that’s all it can do.  Inefficiencies associated with monopoly are a real problem, and cannot be solved by printing money.  There are actually a number of issues here that need to be disentangled, some of which are quite subtle.

1.   Monopoly is a microeconomic problem, not a macroeconomic problem.  Thus it’s quite possible to have low unemployment rates and high levels of monopolization.  Indeed, I’d argue that’s true in America right now.  Employment in the monopolistic sector is indeed lower than we’d like, but the result of this is not unemployment, it’s workers being employed in the less efficient competitive sector of the economy.  This is important, because the mechanism by which demand stimulus creates growth is by encouraging more employment (not moving workers between sectors).  But we are already at full employment.

2.  Suppose I’m wrong, and monopolization causes the natural rate of unemployment to be higher than otherwise. Say America’s natural unemployment rate rises to French levels, due to monopolization.  Is Tyler correct in that case?  No, demand stimulus is still not called for even if monopolization causes the natural rate of unemployment to be higher than otherwise.  That’s because when you are at the natural rate, demand stimulus basically tricks workers and firms into producing more output than they’d like, by pushing up nominal spending in the face of sticky wages and prices.

So doesn’t that make us better off?  In the short run yes, but only at the cost of being worse off in the long run.  When prices are sticky, demand stimulus can reduce a monopoly’s real price, which is its price relative to NGDP.  But once the monopoly catches on to the higher NGDP, it will raise the real price again.  That might not sound so bad, but it leads to cyclical instability.  Ditto for wage stickiness.  Demand stimulus will give monopolies an incentive to hire more workers, as long as nominal wages are sticky.  That will indeed make the economy more efficient for a short time (this may have been Tyler’s intuition), but at a cost of future instability.

This is why we have independent central banks.  Because our economy is riddled with inefficient policies such as minimum wage laws and taxes on labor, our natural rate of output is suboptimal.  Demand stimulus tricks us into producing more, and we move closer to the optimal position for the economy.  But it’s not sustainable. It’s a sugar rush.  Minimum wages eventually get increased with NGDP, and workers renegotiate contracts.  In the short run, the stimulus really does make us better off as a country (with or without monopoly), but it overheats the economy and leads to a painful recession in future years.  Once mainstream monetarist and New Keynesian economists understood this problem, they decided the best we could do was to keep the economy close to the natural rate of unemployment, and then advocated setting up independent central banks that would be immune from pressure by a corrupt future president that might have a big ego and a short attention span.  (Hmmm . . . . )

Unless I’m mistaken, there is nothing particularly controversial about this post.  Think about a standard NK model, which produces an optimal policy of 2% inflation.  How would the existence of monopoly change the optimal policy?  Make it more expansionary?  But what does that even mean?  In the standard model, money is neutral in the long run.  Going to 3% inflation doesn’t have any long run benefit.  I suppose you could advocate steadily rising inflation, ending up in hyperinflation, but that won’t work if there are any welfare costs of inflation.  In fact, the optimal policy under a NK model is no more expansionary with monopoly than without.

Now I suppose there might be models where the optimal policy is more countercyclical if there is monopoly, and this seems to be what Noah is hinting at.  But that doesn’t help Tyler’s argument, as in that case policy should actually be more contractionary when unemployment is 4.1%.  And I’m not even sure that claim is true; do NK models imply that more weight should be put on output, and lesson inflation, when the economy is more monopolistic? Are there any models that do so?

PS.  Tyler might argue that the monopoly argument was not his view, just the implication of Keynesian models with which he does not agree.  But I’m saying even that’s not true.  The argument he makes is not even an implication of any sound Keynesian model that I’m aware of.

PPS.  I have a new post criticizing proposals to “experiment” with a hot economy, over at Econlog.


Keynes was wrong; animal spirits do not drive growth

Here is Neil Irwin:

After Donald J. Trump won the presidential election, Americans’ optimism about the economic future soared. But midway through the year, that optimism has not translated into concrete economic gains.

This seeming contradiction exposes a reality about the role of psychology in economics — or more specifically, how psychology is connected only loosely to actual growth. It will take more than feelings to fix the sluggishness that has been evident in the United States and other major economies for years. Confidence isn’t some magic elixir for the economy: Businesses will hire and invest only when they see concrete evidence of demand for their products, and consumers intensify their spending only when their incomes justify it.

Long run growth is driven by fundamentals: free markets, property rights, sensible taxes, low corruption, human capital, technology, peace, etc. Short run growth is driven by aggregate demand, i.e. monetary policy.

That’s why I prefer monetarism to Keynesianism, despite all its faults.  At least monetarists understand that monetary policy drives AD.

PS.  Off topic, I found this NYT story to be of interest:

Jason Kenney, then a Conservative member of Parliament, convinced Prime Minister Stephen Harper that the party should court immigrants, who — thanks to Mr. Trudeau’s efforts — had long backed the Liberal Party.

“I said the only way we’d ever build a governing coalition was with the support of new Canadians, given changing demography,” Mr. Kenney said.

He succeeded. In the 2011 and 2015 elections, the Conservatives won a higher share of the vote among immigrants than it did among native-born citizens.

The result is a broad political consensus around immigrants’ place in Canada’s national identity.

That creates a virtuous cycle. All parties rely on and compete for minority voters, so none has an incentive to cater to anti-immigrant backlash. That, in turn, keeps anti-immigrant sentiment from becoming a point of political conflict, which makes it less important to voters.

In Britain, among white voters who say they want less immigration, about 40 percent also say that limiting immigration is the most important issue to them. In the United States, that figure is about 20 percent. In Canada, according to a 2011 study, it was only 0.34 percent.


Keynesianism as religion

If there is any intellectual framework that should have been discredited over the past decade it is old-style Keynesianism.  Unfortunately, just the opposite has happened.  Marcus Nunes directed me to a Noah Smith post that discusses the revival of old Keynesian ideas:

Another way of putting this is that Paul Krugman was right. Krugman has long advocated that macroeconomists learn to once again think in terms of simple simple Keynesian theory. And when more fully developed, complex models are needed, Krugman uses the kind of models that Christiano endorses.

As Christiano mentioned, the New Keynesian revolution isn’t so new. Even in the 1990s, economists like Greg Mankiw and Olivier Blanchard were arguing that monetary policy had real effects on demand. And at the same time, international macroeconomists were realizing that Japan’s post-bubble experience of slow growth, low interest rates and low inflation implied that demand shortages could last for a very long time unless the government rode to the rescue. Krugman, Adam Posen, Lars Svensson, and others were already referring to a Japan-type stagnation as a liquidity trap in the late 1990s, and warning that standard monetary policy of cutting interest rates wouldn’t work in that sort of situation. .  .  .

If economists gravitated toward anti-Keynesian theories, it was at least in part because evidence wasn’t strong enough to push them in the right direction. It’s just very hard to assess the impacts of fiscal stimulus. For example, Japan’s tremendous government spending binge in the 1990s looks to a casual observer like it had no effect, since the economy didn’t recover until years later — but government spending might have been the only thing saving the country from a deeper recession.

I certainly agree that Japan tells us a lot about the validity of old Keynesian thinking.  Here are some things it tells us:

1.  Depreciating the yen is a foolproof way of creating inflation.  Thus Keynes was wrong about monetary policy being ineffective at the zero bound.

2.  From 1993 to 2013 Japan ran up by far the largest peacetime fiscal deficits ever seen by a major economy.  And all that “stimulus” led to by far the worst growth in AD over 20 years ever seen by a major economy.  Roughly zero growth in NGDP over two decades.  And the Keynesian takeaway is that this was a great success, as it prevented an even more record-breaking fall in NGDP.  This is like a religious person who believes in the efficacy of prayer, prays for peace in 1939, and then later argues that his prayers prevented an even bigger war and Holocaust. Okaaaay . . .

3.  Then in 2013 Abe takes office and raises consumption taxes.  This fiscal tightening causes the debt to GDP ratio to level off at 250%.  Instead Abe relies on monetary stimulus, raising the inflation target.  And both inflation and NGDP growth actually increase, the opposite of the prediction of the old Keynesian model.

Of course I could go on and on.  There’s the letter signed by 350 Keynesians warning that the fiscal austerity of 2013 risked recession (growth actually sped up.) Or the fact that Keynesians don’t even know how to estimate the multiplier (as documented recently by Ryan Murphy.)

Smith points out that Paul Krugman realized in the late 1990s that the standard policy of cutting interest rates would no longer work at zero.  But he doesn’t tell you that everyone already knew that, even Milton Friedman.  AFAIK, not one economist in the entire world in the late 1990s thought that cutting interest rates when they were already zero would work. Perhaps you think I’m being too picky; what Smith really meant is that Krugman discovered that monetary stimulus no longer worked in Japan, and that fiscal stimulus was needed. Except that’s not true, in the late 1990s and early 2000s Krugman ridiculed the idea of using fiscal stimulus in Japan, and suggested that monetary stimulus was the obvious solution. Whatever “new facts” caused Krugman to revert to old Keynesianism more recently; it certainly wasn’t his famous 1998 study of Japan’s liquidity trap.  So what caused Krugman to change?  I’m not sure, but Smith hints at one possibility:

When evidence is sparse or inconclusive, things like sociology and politics often fill the gap.

Why macroeconomists need to study history

One of the ways that macro differs from micro is that macro is essentially a branch of history.  Micro is not.  And yet today’s macroeconomists often have not studied monetary history.  Marcus Nunes and Ramesh Ponnuru directed me to a paper by White House economics advisor Jason Furman:

A decade ago, the prevalent view about fiscal policy among academic economists could be summarized in four admittedly stylized principles:

1. Discretionary fiscal policy is dominated by monetary policy as a stabilization tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.

2. Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).

3. Moreover, fiscal stabilization needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.

4. Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimizing harmful side effects and long-run fiscal harm.

Today, the tide of expert opinion is shifting the other way from this “Old View,” to almost the opposite view on all four points.

I think this is right, but where Furman and I differ is on the desirability of this shift.

Furman refers to the view “a decade ago” but he might just as well have said 90 years ago.  The New Keynesian consensus is actually not all that far from the views of progressive economists back in the 1920s, which favored a price level target and were skeptical about fiscal policy.  After the 1930s, opinions moved in the old Keynesian direction.  It wasn’t until the 1960s that the tide started swinging away from the “vulgar Keynesian” view that fiscal policy was more important than monetary policy.  Friedman and Schwartz started he counterrevolution, and by the 1990s it was pretty much complete.  Stabilization policy should rely on monetary policy.

And now we have still another swing of the pendulum, back toward the old Keynesian views of the post-1936 period. Here’s Furman:

The New View of fiscal policy largely reverses the four principles of the Old View—and adds a bonus one. In stylized form, the five principles of this view are:

1. Fiscal policy is often beneficial for effective countercyclical policy as a complement to monetary policy.

2. Discretionary fiscal stimulus can be very effective and in some circumstances can even crowd in private investment. To the degree that it leads to higher interest rates, that may be a plus, not a minus.

3. Fiscal space is larger than generally appreciated because stimulus may pay for itself or may have a lower cost than headline estimates would suggest; countries have more space today than in the past; and stimulus can be combined with longer-term consolidation. 

4. More sustained stimulus, especially if it is in the form of effectively targeted investments that expand aggregate supply, may be desirable in many contexts.

5. There may be larger benefits to undertaking coordinated fiscal action across countries.

Those old Keynesian views of the late 1930s were rejected for lots of good reasons.

I’m not quite sure what is more humiliating for the profession of macroeconomics:

1.  That we keep making the same mistakes, over and over again.

2.  That we change our views of macro on “new information”, which in fact is not new to anyone with an even passing interest in macro history.  (I.e., who know that the temporary QE of 1932 had little impact, just as the more recent temporary QE had little effect.)

3.  That we don’t pay attention to the empirical studies that refute old Keynesianism.

4.  That many macroeconomists are not even aware of the cyclical nature of their field.

It’s not unusual to find this sort of cyclicality in the arts.  For instance, in the arts there are swings back and forth between a more “classic” style and a more “romantic” style.  But it’s kind of embarrassing to see this in a science.

(And don’t embarrass yourself by arguing macroeconomics is not a science.  Of course it’s a science.  It’s failed science, but then so are some of the other sciences, at least based on what I’ve read about the crisis in replication.  The term ‘science’ is not a compliment, it’s not some sort of award given to a field, like a Nobel Prize.  It’s simply a descriptive term for a field that builds models that try to explain how the world works.  Saying that science must be successful to be viewed as science is as silly as saying that a work of art must be good to be considered art.)

We need a “timeless” macro.  That is, theories should not be developed to meet the specific conditions in the economy, at that moment.  And yet that’s exactly what old Keynesianism is, which is why it goes in and out of style.  Instead, theories should be developed to explain the entire history of macroeconomics—the full data set.  If your model is not good at explaining hyperinflation, stagflation, liquidity traps and the Great Moderation, then it’s not a good theory.

Old Keynesianism is not a good theory.

PS. I’d like to congratulate Ben Klutsey for winning the Great Communicators Tournament in Washington DC on Wednesday night. Some of you may know that David Beckworth and I both participate in the Mercatus Center’s Program on Monetary Policy. Unfortunately we both live some distance from the headquarters in Arlington, VA. Ben is the program’s manager, and does a lot of the behind the scenes work that readers might not be aware of. I feel lucky to work with someone who is both a very nice guy and a highly talented manager.

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Also congratulations to runner-up Charles Blatz, another Mercatus employee.


Over at Econlog I did a post discussing the austerity of 1946.  The Federal deficit swung from over 20% of GDP during fiscal 1945 (mid-1944 to mid-1945) to an outright surplus in fiscal 1947.  Policy doesn’t get much more austere than that! Even worse, the austerity was a reduction in government output, which Keynesians view as the most potent part of the fiscal mix.  I pointed out that employment did fine, with the unemployment rate fluctuating between 3% and 5% during 1946, 1947 and 1948, even as Keynesian economists had predicted a rise in unemployment to 25% or even 35%—i.e. worse than the low point of the Great Depression.  That’s a pretty big miss in your forecast, and made me wonder about the validity of the model they used.

One commenter pointed out that RGDP fell by over 12% between 1945 and 1946, and that lots of women left the labor force after WWII.  So does a shrinking labor force explain the disconnect between unemployment and GDP?  As far as I can tell it does not, which surprised even me.  But the data is patchy, so please offer suggestions as to how I could do better.

Let’s start with hours worked per week, the data that is most supportive of the Keynesian view:


Weekly hours worked dropped about 5% between 1945 and 1946. Does that help explain the huge drop in GDP?  Not as much as you’d think. Here’s the civilian labor force:


So the labor force grew by close to 9%, indicating that the labor force in terms of numbers of worker hours probably grew.  Indeed if you add in the 3% jump in the unemployment rate, it appears as if the total number of hours worked was little changed between 1945 and 1946 (9% – 5% – 3%).  Which is really weird given that RGDP fell by 22% from the 1945Q1 peak to the 1947Q1 trough–a decline closer to the 36% decline during the Great Contraction, than the 3% fall during the Great Recession.

That’s all accounting, which is interesting, but it doesn’t really tell us what caused the employment miracle.  I’d like to point to NGDP, which did grow very rapidly between 1946 and 1948, but even that doesn’t quite help, as it fell by about 10% between early 1945 and early 1946.

Here’s why I think that the NGDP (musical chairs) model did not work this time. Let’s go back to the hours worked, and think about why they were roughly unchanged.  You had two big factors pushing hard, but in opposite directions. Hours worked were pushed up by 10 million soldiers suddenly entering the workforce.  In the offsetting direction were three factors.  A smaller number of (mostly women) workers leaving the workforce, unemployment rising from 1% to 4%, and average weekly hours falling by about 5%.  All that netted out to roughly zero change in hours worked.

So why did RGDP fall so sharply?  Keep in mind that while those soldiers were fighting WWII, their pay was a part of GDP. They helped make the “G” part of GDP rise to extraordinary levels in the early 1940s.  But when the war ended, that military pay stopped.  Many then got jobs in the civilian economy.  Now they were counted as part of hours worked. (Soldiers aren’t counted as workers.)  That artificially depressed productivity.

It’s also worth noting that real hourly wages fell by nearly 10% between February 1945 and November 1946:


This data only applies to manufacturing workers. But keep in mind that the 1940s was the peak period of unionism, so I’d guess service workers did even worse.  So my theory is that the sudden drop in NGDP in 1946 was an artifact of the end of massive military spending, and the strong growth in NGDP during 1946-48, which reflected high inflation, helped to stabilize the labor market.  When the inflation ended in 1949, real wages rose and we had a brief recession.  By 1950, the economy was recovering, even before the Korean War broke out in late June.

Obviously 1946 was an unusual year, and it’s hard to draw any policy lessons.  At Econlog, I pointed out that the high inflation occurred without any “concrete steppes” by the Fed; T-bill yields stayed at 0.38% during 1945-47 and the monetary base was pretty flat.  Some of the inflation represented the removal of price controls, but I suspect some of it was purely (demand-side) monetary—a rise in velocity as fears of a post-war recession faded.

This era shows that you can have a lot of “reallocation” and a lot of austerity, without necessarily seeing a big rise in unemployment.  And if you are going to make excuses for the Keynesian model, you also have to recognize that most Keynesians got it spectacularly wrong at the time.  Keynesians often make of big deal of Milton Friedman’s false prediction that inflation would rise sharply after 1982, but tend to ignore another monetarist (William Barnett, pp. 22-23) who correctly forecast that it would not rise.  OK, then the same standards should apply to the flawed Keynesian predictions of 1946.

Tyler Cowen used to argue that 2009 showed that we weren’t as rich as we thought we were.  I think 1946 and 2013 (another failed Keynesian prediction) show that we aren’t as smart as we thought we were.

Update:  David Henderson has some more observations on this period.