Keynes stole my musical chairs model

[Fourth city in 5 nights.  Tired.  I wrote this a few weeks ago to post while traveling. I hope to respond to comments for this post and earlier posts on Sunday.]

So I started rereading the General Theory, just for the heck of it, and noticed something very interesting.  Early in the book Keynes lays out the musical chairs model of the business cycle.

The General Theory begins with an appalling caricature of “classical economics”. Keynes says that the classical economists believed that unemployment was caused by sticky wages.  This is true.  Then Keynes suggests that the classical economists believed all unemployment was “voluntary”.  The idea was (according to Keynes) that the classical economists believed that full employment could be reached at a sufficiently low wage level, and hence if there were unemployment then it must be voluntary—workers refused to take the pay cuts that would restore full employment.

This makes no sense to me, as it seems to confuse collective action and suffering at the individual level.  No single automobile factory worker can regain a job by cutting his or her wages, and thus their unemployment is every bit as involuntary as if the sticky wages were caused by an Act of God. But that’s not how Keynes looked at it.  Then we come to a sentence that reminds me of the style of a certain famous NYT columnist:

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment—if there be such a thing (and who will deny it?).

Who will deny it?  Keynes has just told us that the classical economists deny the existence of involuntary unemployment. Then why say, “Who will deny it?”  Keynes wants the readers to nod their heads, and note that there’s clearly lots of involuntary unemployment 1936, it’s just that the classical economists are too dense to see the obvious.

But what is so obvious about involuntary unemployment, as defined by Keynes? We all agree that there were lots of people without jobs. We all agree that lots of them wanted to be working.  We all agree that lots of them were miserable.  I call that “involuntary unemployment.”  But I think they were unemployed because of sticky wages, and that if workers collectively accepted lower wages then we would have had full employment in 1936.  And Keynes tells us that if we hold the belief that I hold, and that many interwar economists also held, then we are not entitled to say we think there is such a thing as involuntary unemployment.

OK, so what is Keynes’s theory of unemployment?  Brace yourself.

Sticky wages!

The only difference is that Keynes also believes that if workers did accept wage cuts, it would not solve the problem.  Prices would also fall in response, and hence real wages would not fall.  I don’t think he’s right, but the key point is that he thinks that assumption somehow magically turns “voluntary unemployment” into “involuntary unemployment.”  I can’t imagine that the unemployed workers even understand that distinction, or care.  Nor do I understand how the reader is supposed to think it’s “obvious” that there is one type of unemployment and not the other.  Does a miserable unemployed worker look different if his plight is “voluntary” at a level that he has no control over?

It might seem I’m nitpicking, but Keynes’s entire critique of the “classical model” of unemployment falls apart once you allow for the fact that sticky wages can cause involuntary unemployment.  The interwar economists had perfectly fine theories of the business cycle, and Keynes doesn’t lay a glove on them.  So much for chapter 2.

In chapter 3 he argues that demand shocks cause changes in employment, and says that the “classical” economists did not realize this.  The classical economists (supposedly) assumed Say’s Law held true.  And yet during the interwar years the standard model of business cycles was essentially a demand shock model, although economists used different terminology in those days. Fisher did early Phillips Curve models.  Pigou, Hawtrey, Cassel, and the others certainly understood that demand shocks (monetary shocks) affected employment.

I must say that Chapter 3 is beautifully written, especially section 3.  But that must have infuriated the interwar economists all the more.  I can’t even imagine what it would be like to be unfairly attacked by a brilliant economist with a devastating wit. Oh wait . . .

In book II things get much better.  Recall that I often argue that inflation is a vague and undefined concept, which makes real GDP also hard to pin down.  On the other hand I do grudgingly concede that the CPI provides a ballpark estimate of inflation.  I certainly don’t think the actual rate is 8%, as some claim.  Inflation estimates are accurate enough so that we know China has grown faster than Zimbabwe, despite the higher NGDP growth in the latter country.  On the other hand I’ve also suggested that macroeconomists should discard inflation and real GDP, and focus on more easily measured concepts, such as NGDP, wages, and employment.  Now let’s look at Keynes:

But the proper place for such things as net real output and the general level of prices lies within the field of historical and statistical description, and their purpose should be to satisfy historical or social curiosity, a purpose for which perfect precision “” such as our causal analysis requires, whether or not our knowledge of the actual values of the relevant quantities is complete or exact “” is neither usual nor necessary. To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth “” a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis.

.  .  .

In dealing with the theory of employment I propose, therefore, to make use of only two fundamental units of quantity, namely, quantities of money-value and quantities of employment. . . .

We shall call the unit in which the quantity of employment is measured the labour-unit; and the money-wage of the labour-unit we shall call the wage-unit.

.  .  .

It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole; reserving the use of units of particular outputs and equipments to the occasions when we are analysing the output of individual firms or industries in isolation; and the use of vague concepts, such as the quantity of output as a whole, the quantity of capital equipment as a whole and the general level of prices, to the occasions when we are attempting some historical comparison which is within certain (perhaps fairly wide) limits avowedly unprecise and approximate.

Right on!!  That’s exactly my view. (I did a similar post on this a year ago, with a much longer section of quotations, in case you want more context. Here I’ll explore different implications.)

So Keynes basically has a model with three components:

1.  Aggregate demand shocks (NGDP shocks)

2.  Sticky wage-units  (sticky nominal wages)

3.  Labour unit fluctuations  (employment fluctuations)

Wait, that’s my musical chairs model!

This is all explained by the end of chapter 4, on page 45 of a nearly 400 page book. If I were writing the General Theory, I would have merely added that NGDP is determined by monetary policymakers, and then called it a day after 50 pages.

I probably won’t read any more, because I know what’s coming next.  There will be hundreds of pages explaining what causes demand shortfalls, and monetary policy plays only a modest role in the model.  Why did Keynes and I reach such different conclusions?  Because I am living in a fiat money world where central banks really do determine NGDP.  Indeed if they didn’t then the entire concept of inflation targeting would be nonsensical.  The 2% inflation rate since 1990 would be an amazing coincidence, almost a miracle.

In contrast, Keynes lived in a gold standard world or at least in a world where countries were expected to soon return to a gold peg.  In that sort of world monetary policy was much more constrained.  If you go to the extreme and assume M was fixed, then explaining NGDP is all about explaining velocity.  And what explains velocity?  Things like interest rates and uncertainty.  Here are some things that would lower V when M is fixed:

1.  The public decides to save more–lowering interest rates, which lowers V.

2.  Less animal spirits among businessmen, which leads to less investment, less demand for credit, lower interest rates and lower V.

3.  Fiscal austerity, which lowers government borrowing, lowering interest rates and V.

4.  A big inflow of foreign saving from surplus countries like Germany and China, which depressed interest rates and lowered V.

5.  Wage cuts would transfer income to capitalists, which would boost saving, reduce interest rates, and reduce V.

But Keynes did not build the General Theory around the Equation of Exchange—that would not have been revolutionary.  Instead he created the Keynesian cross and hinted at IS-LM.  Instead of pointing out that shocks to V affect NGDP and hence (because of sticky wages) also employment, he made it seem like thrift, and bearish expectations, and austerity, and beggar-thy neighbor trade policies directly caused unemployment.  He appealed to the prejudices of what he calls the “uninstructed.”  These are, after all, the common sense views of most people, even politically conservative people who are not well versed in economics.  Here’s Keynes:

That it [classical theory] reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige.

The General Theory screams out that the uninstructed people were correct, and then whispers that they were correct for the wrong reason, and not at all when monetary offset applies.  The problem here is that he was too successful.  We now have several generations of reporters and politicians who think this these bearish factors are always contractionary, even when not at the zero bound.

Of course Keynes did talk about the possibility of monetary stimulus, and was pessimistic that it would be sufficient in a deep depression, for standard liquidity trap reasons (actually its more complicated, but the liquidity trap is still a necessary condition for complete monetary policy ineffectiveness.)  And even if there was not a complete liquidity trap, under a gold standard the ability to print money was limited.

To summarize, Keynes started with the same basic business cycle model as I use—the musical chairs model.  Combine deficient nominal spending with sticky wages and you end up with high unemployment.  But he did not become a market monetarist, for two reasons:

1.  He did not think that wage cuts would help, they would merely lead to further cuts in AD.

I think that’s wrong, but I also think it’s a pretty minor dispute.  As a practical matter I don’t think wage cuts are a very effective solution to a collapse in NGDP. The big difference is the second distinction:

2.  He did not think the monetary authority could provide adequate levels of AD (NGDP) during a depression.

There’s an interesting similarity between these two points.  Keynes was very clear that excessively high real wages were a root cause on unemployment, but didn’t think nominal wage cuts would help.  Keynes was very clear that inadequate spending in money terms was the root cause of labor markets being out of equilibrium, but didn’t think printing more money would (necessarily) solve the problem.  So in both cases he correctly diagnosed the problem, but drew back from the obvious solution.

However I do think we need to cut him some slack here.  Things looked very different in a gold standard world, and most other economists were just as confused as he was.  A few such as Fisher, Hawtrey and Cassel saw the true nature of the (monetary) problem more clearly than Keynes did, but they were the exception.

I’m a bit skeptical about the utility of the Keynesian model, even in a world of constrained monetary policy.  But here I need to admit that an awfully lot of very smart people see things differently than I do, so it’s at least plausible that the Keynesian model has merit as a sort of backdoor way of explaining movements in V when M is fixed, and hence as a theory of demand side business cycles under certain types of monetary regimes.

But I don’t think I’ll read anymore.  I can’t bear to work though 100s of pages of convoluted (implicit) explanations for why certain shocks might impact V.  If only Keynes had stopped at page 45 and said:

“So the central bank should create a NGDP futures market and target the futures price along a track rising at 4%/year.  That makes the world safe for classical economics.

The end.”


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46 Responses to “Keynes stole my musical chairs model”

  1. Gravatar of Ray Lopez Ray Lopez
    13. November 2015 at 21:21

    Keynes is like Nostradamus, you can read whatever you wish from his prescriptions. In fact, Keynes apparently was neo-conservative, more so than Schumpeter, see: This is from an essay by Peter Drucker on Keynes vs Schumpeter –
    – See more at: http://marginalrevolution.com/marginalrevolution/2010/10/the-mortensen-and-pissarides-employment-model.html#sthash.Zdi9MccM.dpuf

    A quick read of your massive missive shows some confused and feverish prose:

    1) you attack Keynes on semantics. Apparently both you and him believe in sticky wages (which is very weak say the data), so there should not be so much antagonism re Chap. 2

    2) A fallacious sleight of hand: “Pigou, Hawtrey, Cassel, and the others certainly understood that demand shocks (monetary shocks)[!!!] affected employment.” (Sumner). Yes, but “monetary shocks” is NOT the same as a “demand shock”. Wrap your tiny head around this please.

    3) You correctly state that the Equation of Exchange is not revolutionary, then you criticize Keynes because he introduced revolutionary ideas! Sumner: “But Keynes did not build the General Theory around the Equation of Exchange—that would not have been revolutionary. Instead he created the Keynesian cross and hinted at IS-LM. Instead of pointing out that shocks to V affect NGDP and hence (because of sticky wages) also employment, he made it seem like thrift, and bearish expectations, and austerity, and beggar-thy neighbor trade policies directly caused unemployment. He appealed to the prejudices of what he calls the “uninstructed.” ”

    So Keynes is not following your model and you wish to say he’s wrong? Absurd. Trying to ride on the Great Man’s coat tails are we? Your last paragraph tries to put words into his mouth. If Keynes assumptions were based on unproven hypotheses, how much more is yours?

    You should get some rest. And tell us more about ‘musical chairs’ when you’re sober.

  2. Gravatar of Brian Donohue Brian Donohue
    13. November 2015 at 22:54

    This is great, Scott.

  3. Gravatar of Jerry Brown Jerry Brown
    14. November 2015 at 00:30

    I did not reach the same conclusions as you in my reading of the General Theory. In respect for you, I am going to re-read it with your criticisms in mind. I am not looking forward to this- its a horribly written long difficult to understand book- and I will blame you for wasting my time if I don’t see the points you are making here.
    In the meantime, you do know that there are economists who still say that there is no such thing as ‘involuntary unemployed’ right?

  4. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    14. November 2015 at 04:39

    Prof. Sumner, Great post, a comment:
    I am not a researcher of that period, so I have missed the idea that the fact that countries under a gold standard, or trying to go back to gold standard, effectively restricted monetary policy. If you accept that, one understand why practitioners of the time (let’s not forget that Keynes was a government official) tended the focus on interest rates and fiscal policy, because those tools they could effectively use. Never heard this explanation before, that is, if I understood this post correctly …

  5. Gravatar of Benjamin Cole Benjamin Cole
    14. November 2015 at 04:42

    Fun post. I find Keynes writing perfectly awful, though the ideas interesting.

    Fun fact: At FRED St. Louis the data on CPI all urban consumers new vehicles says auto prices are up 1.8%…from 20 years ago. Yes, nominally.

    Measuring general inflation, as Keynes noted, is tricky. But here on an identifiable product we see no inflation in 20 years. Housing, which is scarce due to local zoning, has become more expensive in the last 20 years. But what can the Fed do about that?

  6. Gravatar of Major.Freedom Major.Freedom
    14. November 2015 at 06:27

    Sumner inadvertantly and rather amusingly stumbles upon the obvious fact that he was a Keynesian all along.

    ————-

    Keynes, by the way, believed unemployment would rise even with perfectly flexible wage rates that fell. He believed not even lower wage rates could cure unemployment. Sticky wages are not the centrality of his theory.

  7. Gravatar of W. Peden W. Peden
    14. November 2015 at 06:27

    Tim Congdon on Piketty, inequality and macroeconomic crises-

    https://www.youtube.com/watch?v=E5JxU4Womcg

    The point at the end makes me wonder whether or not you can find a (spurious) correlation between increasing inequality and macro stability. At the very least, there’s no good relationship the other way around.

  8. Gravatar of Ray Lopez Ray Lopez
    14. November 2015 at 07:15

    @ W. Peden- (Off-topic) – Peden: “The point at the end makes me wonder whether or not you can find a (spurious) correlation between increasing inequality and macro stability.” – you need to read Piketty. He explicitly says inequality decreases during times of war and upheaval, which directly addresses your point. And chances are, it’s not ‘spurious’ but the direct result of war as a great leveler.

    On-topic: why is Sumner so in love with weak tools like monetary policy, which Ben S. Bernanke’s FAVAR paper says accounts for merely 3.2% to 13.2% change in economic variables like GDP? Why not advocate fiscal policy like Krugman and Ryan Avent (http://www.economist.com/blogs/freeexchange/2015/11/macroeconomics)? Maybe his Chicago School ideology? BTW, I don’t think fiscal policy is good long-term either, but it does “work”, short-term, to put people to ‘work’ and increases demand (artificially); monetarism by contrast doesn’t work ever.

  9. Gravatar of Market Fiscalist Market Fiscalist
    14. November 2015 at 07:30

    “The only difference is that Keynes also believes that if workers did accept wage cuts, it would not solve the problem. Prices would also fall in response, and hence real wages would not fall.”

    If Keynes thinks that “if workers did accept wage cuts, it would not solve the problem.” then doesn’t that means he actually didn’t think that sticky wages were the problem ?

  10. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    14. November 2015 at 07:36

    ‘I can’t even imagine what it would be like to be unfairly attacked by a brilliant economist with a devastating wit. Oh wait . . .’

    Blogging well is the best revenge.

  11. Gravatar of Market Fiscalist Market Fiscalist
    14. November 2015 at 07:38

    BTW: On “I can’t even imagine what it would be like to be unfairly attacked by a brilliant economist with a devastating wit. Oh wait . . .”

    I bet Bob Murphy thinks that is about him :)

  12. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    14. November 2015 at 09:13

    Speaking of the dish best served cold;

    http://www.nytimes.com/2015/10/16/opinion/democrats-republicans-and-wall-street-tycoons.html?_r=2

    ———–quote—————
    Mr. Sanders has been focused on restoring Glass-Steagall, the rule that separated deposit-taking banks from riskier wheeling and dealing. And repealing Glass-Steagall was indeed a mistake. But it’s not what caused the financial crisis, which arose instead from “shadow banks” like Lehman Brothers, which don’t take deposits but can nonetheless wreak havoc when they fail. ….

    But is Mrs. Clinton’s promise to take a tough line on the financial industry credible? Or would she, once in the White House, return to the finance-friendly, deregulatory policies of the 1990s?

    …. Robert Rubin of Goldman Sachs became Bill Clinton’s most influential economic official; big banks had plenty of political access; and the industry by and large got what it wanted, including repeal of Glass-Steagall.
    ————–endquote—————-

    So, the witty NY Times columnist appears to be unaware of what Scott recently posted of at EconLog; that Glass-Steagall was not repealed (only 2 of its ‘affiliations provisions’, not the 2 which separate investment and commercial banking). As well as the supreme irony that Gramm, Leach, Bliley, while not repealing Glass-Steagall, DID contain a provision that, had it been implemented, would have spared the country the worst of the recent financial crisis.

    What an ignoramus!

  13. Gravatar of Major.Freedom Major.Freedom
    14. November 2015 at 09:14

    Market Fiscalist gets it.

  14. Gravatar of Major.Freedom Major.Freedom
    14. November 2015 at 09:15

    …about Keynes’ beliefs of the futility of wage cuts that is.

  15. Gravatar of Major.Freedom Major.Freedom
    14. November 2015 at 09:23

    Keynes by the way totally contradicted the context of lower wage rates and prices as a cure for depressions, when he argued against that cure.

    His response to whether lower wage rates and prices can cure depressions was that it would result in higher prices(!).

    This is perhaps the best takedown of Keynesianism ever written:

    https://mises.org/library/standing-keynesianism-its-head

  16. Gravatar of Major.Freedom Major.Freedom
    14. November 2015 at 09:25

    FTA:

    “Keynesianism has been a refuge for masses of economists badly deficient in understanding of economics and equally lacking in essential aspects of moral character, namely, in abhorrence of the use of physical force for any purpose but that of self-defense, and in an equal abhorrence of blatant irrationalism, such as manifested in Keynes’s claims about the economic value of wars and earthquakes. Content with the unchecked growing use of physical force by government in all aspect of the life of the individual, and often taking delight in the ability to confuse the minds of students by convincing them that the absurd is true, they are completely at home in Keynesianism.”

  17. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    14. November 2015 at 09:49

    To me, “wage stickiness” = no involuntary unemployment, since nominal wages don’t go down precisely because individuals refuse (a voluntary act) to reduce nominal wages. In my view, it is inconsistent to believe in nominal wages rigidity and involuntary unemployment.

  18. Gravatar of Jerry Brown Jerry Brown
    14. November 2015 at 14:00

    Well, I am reading the General Theory again, thank you very much Professor Sumner. I thought I might provide frequent updates about my progress and select quotes for interested readers.

    I am currently engrossed in chapter 2. (Chapter 1 is a half page of reasonably intelligible prose, so I really am not all that impressed with my progress to date.) Be that as it may, here is a gem of a quote from Lord Keynes from chapter 2-

    “The utility of the wage when a given volume of labor is employed is equal to the marginal disutility of that amount of employment”

    While this may be a little difficult for casual readers like me to understand, fear not- there is an immediate explanatory statement-

    “That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of the employed persons themselves) to induce the volume of labour actually employed to be forthcoming; subject to the qualification that the equality for each individual unit of labour may be disturbed by combination between employable units analogous to the imperfections of competition which qualify the first postulate.”

    Why did I quote these (Two !!) sentences? Misery loves company is why. There’s 380 more pages of this and I blame Sumner for making me say I would read it.

  19. Gravatar of Jerry Brown Jerry Brown
    14. November 2015 at 15:43

    On page 7 now but had to stop because I thought the phone might ring. It didn’t.

  20. Gravatar of ssumner ssumner
    14. November 2015 at 16:30

    Ray, You said:

    “In fact, Keynes apparently was neo-conservative”

    Love the “apparently”, as if we needed confirmation that you are a parrot.

    Jerry, You said:

    “In the meantime, you do know that there are economists who still say that there is no such thing as ‘involuntary unemployed’ right?”

    Yes, and it’s perhaps the most boring and stupid debate in all of economics. Whether there is involuntary unemployment depends on how you define the term. We all know why people are unemployed, we simply don’t agree what to call it.

    Jose, I published an article on the role of gold in Keynesian economic theory, about 15 years ago.

    Ben, You said:

    “I find Keynes writing perfectly awful, though the ideas interesting.”

    That’s the opposite of my view.

    Ray, You said:

    “BTW, I don’t think fiscal policy is good long-term either, but it does “work”, short-term, to put people to ‘work’ and increases demand”

    I guess you don’t understand that this violates your claim that wages are flexible and money is neutral. Here’s your problem Ray. If you automatically disagree with everything I say, you will end up contradicting yourself and looking like a fool. But maybe that’s a position you enjoy.

    Market, It would seem so.

    And maybe I did mean Bob.

    Jose, You are missing the point, it is collective stickiness that matters, not individual stickiness. Workers have no control over the decision of the other 150 million workers.

  21. Gravatar of Don Geddis Don Geddis
    14. November 2015 at 16:46

    @Jose Romeu Robazzi: I think you’re missing how wage stickiness causes unemployment. It is not the laid-off workers who (“voluntarily”) refuse to lower their wage demands. The “problem” is the still employed workers, who continue to receive real wages above their market-clearing free-market value. Those workers who still have jobs, absorb the excess of wage income. The unemployed workers can’t find jobs … even if their wage demand was zero!

    Do you still have a problem with calling the unemployed “involuntary”?

    (Another example to consider: a school district employing 100 teachers, in a union with collective bargaining. The economy crashes, property tax declines, the district discovers it has less incoming revenue than expected. Wage expenses must be cut. In collective bargaining, do you think the teacher’s union votes in favor of an across-the-board equal pay cut for every teacher? How might that compare to a proposal where, because of seniority, the teachers know the individual identity of the 10 (new) teachers who will get laid off, if they decide instead not to accept lower pay for themselves. In practice, the remaining 90 teachers vote not to lower their own pay, they win by “majority rules”, and the 10 newest teachers get laid off. Are those teachers, now without jobs, “involuntarily unemployed”? What possible individual choice could they make, to get a teaching job? The entire wage revenue that the district has available, is now being spent on the remaining 90 teachers. The district wouldn’t hire back one of the laid off teachers, even for zero salary!)

  22. Gravatar of Market Fiscalist Market Fiscalist
    14. November 2015 at 18:07

    I was thinking about this some more….

    Your musical chairs model (MCM) is elegant, simple and quite likely correct.

    But I am not seeing how you can claim it was supported by Keynes.

    – In the MCM full employment can be maintained via adjustments to either NGDP (easy) or wages (hard). Keynes explicitly rejects changes in wages as effective in controlling employment and I think he would reject changes in NGDP as well for the same reason. He believes there is a fixed relationship between income (RGDP) and employment level (driven by Investment and the MPC). Therefore implicitly just as a fall in nominal wages leaves real wages , prices and RGDP (and employment) the same – I think, for Keynes ,a rise in NGDP will cause nominal wages and prices to increase proportionally together with no change in RGDP.

    – He did think that the increase in the money supply needed to increase NGDP would have an effect but it would be due to lower interest rates boosting investment, and he explains the lower interest rates via his LP theory.

    – This effect would be limited to the point where interest rates reach the lower bound, after which increased G would be needed to affect employment levels

    In other words Keynes has much more in common with modern New Keynesian (not much of a surprise there!) than with Market Monetarists, and he would reject the Musical Chair model.

  23. Gravatar of Market Fiscalist Market Fiscalist
    14. November 2015 at 19:36

    Which is perhaps in line with your views that:

    “Keynes was very clear that inadequate spending in money terms was the root cause of labor markets being out of equilibrium, but didn’t think printing more money would (necessarily) solve the problem. So in both cases he correctly diagnosed the problem, but drew back from the obvious solution.’

  24. Gravatar of Ray Lopez Ray Lopez
    14. November 2015 at 20:30

    @Don Gheddis – Robazzi has it right, though he wrote ‘wage stickiness = involuntary unemployment’ when clearly he mean ‘voluntary’.

    @MF – you’re right as rain

    @Sumner – I am not saying that money neutrality implies there’s never any recession, or that Say’s law applies (i.e., involuntary unemployment does not exist)…do you think the opposite?

    Sumner: “(Ray):BTW, I don’t think fiscal policy is good long-term either, but it does “work”, short-term, to put people to ‘work’ and increases demand”

    I guess you don’t understand that this violates your claim that wages are flexible and money is neutral.

    An example: due to overproduction of goods (e.g., financial services, housing–sorry Kevin Erdman) there is a glut in one sector, causing people to be laid off, and money to become more desirable, that leads to a general glut in the economy (positive feedback). With me so far? Good. Money is largely neutral in this model (printing more of it won’t change things much). However, the government can step in and ‘make work’ so these unemployed carpenters and bankers can get paid, thereby increasing the flow of money as per Keynes hydraulic model. Still with me? Try harder. This will increase government debt, which has to be paid later, but short term it does reduce unemployment a bit, and increase demand a bit.

    Bonus question for the reader: explain how the increase in Fed assets since 2008, nearly 4x, is not the same as an increase in government debt, given money is neutral. Hint (data is old but point is good): “Deirdre McCloskey pointed out in 2000 that the Fed’s open market operations constitute a very small part of the world’s capital markets. McCloskey highlighted that, in a capital market of approximately $300 trillion, the Greenspan Fed typically increased or decreased its bond holdings in the neighborhood of $40 billion per year.” (and keep in mind the US Fed government spends about 3T *a year*, which is about the same as the *entire* Fed Reserve balance sheet of 4.1T).

    Shorter answer: money is neutral, Fed doesn’t influence the economy that much ($4T entire balance sheet vs $3T a year US government expenditures, not including transfers like Social Security)

    Even shorter answer: Krugman, Keynes more right that Sumner, monetarists.

  25. Gravatar of Ray Lopez Ray Lopez
    14. November 2015 at 20:48

    @myself – even if you include just Fed budget deficits rather than Fed spending, my point is still valid: since 2008 the Fed deficit is about $6T more, while Fed balance sheet is only about $3T more. Fed gov’t has (at least) twice the power of the Fed.

  26. Gravatar of Ben J Ben J
    14. November 2015 at 22:35

    Ray,

    In your mind, is money “always neutral” as you have often said, or “largely neutral” as you have also often said? Do you not care about this distinction? Do you worry that holding contradictory positions means that you are demonstrating your own lack of understanding?

  27. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    15. November 2015 at 06:26

    @Prof. Sumner
    You said “I published an article on the role of gold in Keynesian economic theory, about 15 years ago”. That is why I read your blog, to get a good summary of nice stuff that has been written and I don’t have time to research myself!

    @Don Geddis, Prof. Sumner
    I certainly don’t ignore that what is important is”collective stickiness”. I also don’t ignore that most workers that were laid off didn’t do so voluntarily (although one could argue that an individual firm could offer voluntary packages to induce voluntary resignation). But that is a static view. Under a negative aggregate supply shock, if the economy could adjust real wages by creating instantaneous inflation, all would be well. Also, if all nominal wages could be adjusted down instantaneously, all would be well to, but there would be no inflation in this case. Unfortunately neither of this extreme scenarios reflect correctly how the underlying economic events unfold.

    Let’s assume a certain (important) sector suffers a negative supply shock. Suddenly it can’t provide the same amount of jobs that it did earlier. Since it is an important sector, the aggregate statistics will start to show the negative aggregate supply shock. On the margin, some of the workers on that sector that were laid off will have to either accept lower paid jobs int he same industry (but in other companies), or look for other jobs on other industries, putting downward pressure on wages everywhere. I know, this process take time. What I meant with my first commnent was that laid off workers that refuse either to search for jobs in other industries or refuse lower paid jobs in the same industry are doing so voluntarily. If they refuse, they will probably remain unemployed. What sensible policies can do is to smooth the rearranging of labor process, and in that sense trying to keep nominal spending constant will happen a lot, because firms in other sectors will not see downward pressure in revenues, even if real sales are down somewhat, what will make it easier for managers to keep hiring.

  28. Gravatar of Ray Lopez Ray Lopez
    15. November 2015 at 07:32

    @Robazzi – “Under a negative aggregate supply shock, if the economy could adjust real wages by creating instantaneous inflation, all would be well.” – not true at all. What are your priors? Do you think a structural imbalance like overbuilding in houses, or asset inflation / balance sheet recession, can be cured by inflation? Do you think one can ‘inflate away’ debt? In this age of TIPS and inflation savvy consumers? Recall Brazil, and how they coped with high teens inflation for forty years. Why not Americans? Sumner’s NGDPLT will either fail miserably (most likely), or, if we adopt his absurd suggestion we keep printing money if we don’t hit some sort of ‘target’ then possibly the people will panic and will have Zimflation. Either way, we lose.

    @Ben J- “In your mind, is money “always neutral” as you have often said, or “largely neutral” as you have also often said? Do you not care about this distinction?” – No I don’t care. 3.2% to 13.2% of 100% is close enough to zero for me. If non-monetary, non-Fed factors explain 96.7% to 86.8% of something, that’s close enough to 100% for me.

  29. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. November 2015 at 08:11

    James Hamilton manages to write about real interest rates, and make sense (rare!);

    http://www.voxeu.org/article/estimating-equilibrium-real-interest-rate

    ‘There is much uncertainty about the steady state, or equilibrium, real rate. This rate varies considerably over time. Its determinants are manifold and time-varying, with the effects of trend output growth generally dominated by those of other factors. Looking forward, a plausible range for the equilibrium rate is wide, perhaps ranging from a little above zero up to 2%. The lower end is consistent with a view that the rate is trendy, or unit root like. The upper end is consistent with the view that the rate will mean revert to its traditional level.’

  30. Gravatar of Major.Freedom Major.Freedom
    15. November 2015 at 10:56

    Ray, you said:

    “No I don’t care. 3.2% to 13.2% of 100% is close enough to zero for me. If non-monetary, non-Fed factors explain 96.7% to 86.8% of something, that’s close enough to 100% for me.”

    That is because “for you” you put ideology above not only basic logic, but basic arithmetic.

    Ray, your math stinks. A number between 3.2% and 13.2% is greater than the historical rate of price inflation (CPI). By your irrational philosophy, which is bordering on religion, we would be compelled to conclude that there has been zero consumer price inflation since 1913, as the historical rate (2%) is even closer to zero than the minimum percent from Bernanke’s paper.

    But since that is absurd even to a 5th grader, we know for an absolute fact that your beliefs are absurd.

    Close to zero is not equal to zero. 0 + [0.032,0.132] is NOT equal to zero.

    Money neutrality requires the percent to be statistically not different from zero, which means zero has to fall in the range estimate.

    You are only denying it is non-zero in order to peddle your very false superstitious belief that money is neutral. Since the facts don’t gel with your ideology, instead of readjusting your beliefs to fit the facts, you are digging an even deeper hole by making the ridiculously absurd claim that he standard is not a rational one, but rather your arbitrary whims. “To me” is not a rational standard. That is precisely the kind of irrationalism that leads ultimately to genocide and war.

    Oh what’s that? This madman’s actions are resulting in the murders of 10% of the world’s population? Don’t worry folks, the madman has reassured us that Ray said 10% is “pretty much zero.”

    Ray, I try really really hard to refrain from calling people names, because typically it doesn’t help much. But after all thes years of basic logic falling on your deaf ears, I must say that you are a stupid idiot, at least in this particular area of economics. A stupid idiot because you actually want people to take YOUR own personal whims as the ultimate standard.

    Apologies to other readers who see the above.

  31. Gravatar of art andreassen art andreassen
    15. November 2015 at 11:38

    Benjamin Cole;

    The inflation index for autos highlights a seldom mentioned anomaly in the BLS construction of these indexes. For years the BLS has has estimated the dollar value of quality increases embedded in the price not only of autos but of many other items priced. Quality increases are considered real dollar increases in the deflated value of the product and are subtracted from the nominal cost thus lowering the rate of inflation and increasing the real value of the good.

    This has been going on for many decades and has never been explicitly enumerated by the BLS. Until the explosion of high tech this has had only a minor impact on the National Accounts. However with the growth of high tech products the quality changes that the BLS incorporate into prices has resulted in discrepencies in the Accounts that should really be taken into consideration. The BLS procedure only specifically impacts total Gross Domestic Product and its components while there is no compensating impact for Gross Product Originating and its components, I assume the necessary balancing is carried out with an indiscriminate scaling.

    Needles to say one only has to see what the BLS procedure does to integrated circuits industry. Moore’s Law has resulted in the number of transistors doubling every two years. The BLS has increased the real value of the output of circuits however the actual cost of inputs into production the circuits has not doubled destroying the inherent balancing of the National Accounts.

    Ironically, the Bureau of Economies Analysis has been handling a similar problem in the National Accounts for many decades. In the case of inventories it has been realized that changes in the price of inventories held will impact the value of both GDP and the inventory sector but there is no commensurate increase in GPO, i.e., output changes but there is no balancing increase in measured inputs. An adjustment is accomplished by the creation of a dummy industry, the Inventory Valuation Adjustment industry. This industry consists only of a dollar estimate of the change in the price of inventories which is then added specifically to GDP and to GPO to maintain the accounting balance.

    The BLS and the BEA should handle industry quality changes the same way they handle IVA. They should explicitly show how much and in what industries these adjustment take place. The BLS in its construction of the industry indexes calculates a nominal dollar value of the quality change. They should create a dummy industry, the Industry Output Quality Adjustment industry, and add it explicitly to both GDP and GPO.

    At present no one knows by how much the BLS on its own has increased the value of real GDP and how much real GPO has been violated by the balancing proceedure. Further, not knowing how much real industry output has been changed wrecks havoc with real inputs in the creation of real input output tables and in any economic comparisons that rely on real GPO data.

  32. Gravatar of Blair Blair
    15. November 2015 at 15:52

    I thought the chapter on mercantilism, Chapter 23 I think, was very interesting.

  33. Gravatar of Ray Lopez Ray Lopez
    15. November 2015 at 19:14

    @MF – it is you who makes a basic math error when you say “Ray, your math stinks. A number between 3.2% and 13.2% is greater than the historical rate of price inflation (CPI).” I read the Bernanke FAVAR paper of 2003, and what it says is the effect of the Fed is 3.2% to 13.2% on a range of variables INCREASE, meaning, if inflation is what is under consideration, then, if inflation is say 5%, the Fed’s actions were responsible for 5%*.0032 = 0.16% to 5%*.132 = 0.66% inflation. Do you think 0.16% to 0.66% inflation is significant when inflation is 5%/year? Nobody does except you and maybe Sumner. Face it MF, Austrians are barking up the wrong tree (as are monetarists and Keynesians, though Keynesians by advocating direct government spending have a more potent argument). Money is *largely* neutral, says the data.

    Put another way: I used to believe in the power of the Fed, until I saw the data. What will it take to change your mind, if not data? What about logic? What about Sumner? He’ll not even read the FAVAR paper for fear of discovering the truth. Carnival of ideology, as the famous mural in Guadalajara says.

    People are not stupid in this day and age of internet data, TIPS, inflation adjustment clauses in wages and contracts. There is no money illusion (or it’s very small). The data shows there’s also very little price stickiness and not that much wage stickiness (contracts are typically adjusted ever year, sometimes downwards by cutting benefits). Accept these facts, and, Mr. Sumner, tear down this blog!

  34. Gravatar of Ray Lopez Ray Lopez
    15. November 2015 at 19:31

    The below recent paper says there’s no correlation between GDP and real interest rates. Since nominal = real + inflation, and inflation is also not predictable nor controllable (see the JP central bank, see the US Fed) is stands to reason you cannot ‘control’ either nominal GDP nor real GDP says the evidence.

    The Fed has no power. When the evidence changes, I change my mind. What do you do sir?

    RL

    HT: Tyler Cowen’s blog of Sunday.

    http://www.voxeu.org/article/estimating-equilibrium-real-interest-rate

    It is manifest that the link between steady state output growth and the steady state real rate is noisy. Clearly peak-to-peak GDP growth of approximately 3% can be associated with a wide range of peak-to-peak average values of the ex ante real rate – 0.7 % (1980:1), 2.9 % (2001:1) and 5.0% (1990:3). Clearly the correlation is negative (at -0.4, it so happens), rather than positive as suggested by theory.

  35. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    16. November 2015 at 02:53

    @Ray
    There is a context in the comment. “all is well” = real wages instantaneously adjusting to supply shock. But I think I made clear that I don’t think that’s how the real world works. Also, there is a type at the end of my comment, where it prints “keep nominal spending constant will happen a lot” please read “will help a lot”. Im my view, relatively stable nominal spending will smooth out changes in relative prices.

  36. Gravatar of ssumner ssumner
    16. November 2015 at 07:11

    Market, Most of what you say is simply repeating points I made in the post, differences between my version of the MCM and Keynes’s version.

    You said:

    “I think, for Keynes ,a rise in NGDP will cause nominal wages and prices to increase proportionally together with no change in RGDP.”

    Only at full employment.

    Ray, Here’s a hint. If the money is neutral then the SRAS curve is vertical. Get it?

    You said:

    “The below recent paper says there’s no correlation between GDP and real interest rates.”

    Keep it up and eventually you might figure out “never reason from a price change.”

    Art, Good comment.

  37. Gravatar of Maurizio Maurizio
    16. November 2015 at 08:12

    Keynes also believes that if workers did accept wage cuts, it would not solve the problem. Prices would also fall in response, and hence real wages would not fall. I don’t think he’s right

    Could you explain why you don’t think he’s right? Sounds interesting to me.

  38. Gravatar of Bill Reeves Bill Reeves
    16. November 2015 at 08:45

    Well, ummmm yeeeeees. You’ve established that 1. Keynes was not a fool and 2. Keynes was producing content for western politicians who in a collectivist age believed in the God of the State. And in the end as is true of most academics (though they will deny it loudly) power over others is what they want more than anything else in the world. And Keynesian economics is nothing but a primer on how to justify never ending intervention and manipulation of any societal attribute that can remotely be tied to Aggregate Demand. And unlike Marxism which is simple and stark and uninterested in governing process, Keynesianism is sold directly to the Apparatchik as his Operating Manual for expanding his power and influence.

    Economists operate in a free market of ideas. They generate theory to justify their customer’s desired actions. Those in power want theories to justify their desire to do as they please. In this respect Keynes was a Great Economist.

  39. Gravatar of Travis Allison Travis Allison
    16. November 2015 at 09:15

    Scott, could you explain why you think wage cuts wouldn’t hurt AD?

    “1. He did not think that wage cuts would help, they would merely lead to further cuts in AD.

    I think that’s wrong, but I also think it’s a pretty minor dispute. As a practical matter I don’t think wage cuts are a very effective solution to a collapse in NGDP. ”

    Krugman has a post that is on the face of it, persuasive.

    http://krugman.blogs.nytimes.com/2012/07/22/sticky-wages-and-the-macro-story/

    I know that the actual results from FDR’s attempt to raise wages was the reverse of PK predicts at the zero bound. I still would like to know what the logical flaw is in PK’s thinking about wage cuts.

    Thanks.

  40. Gravatar of Jared Jared
    16. November 2015 at 10:34

    Scott, you seem to ignore the presence of private debt. If wages are cut, real debt burdens increase, defaults rise, and consumer spending decreases, putting downward pressure on other prices, including asset prices. Hence, AD falls with wage cuts, a la Keynes.

  41. Gravatar of Jason Jason
    16. November 2015 at 10:58

    Jared – I think that was Fisher’s theory from the 1933 Debt-Deflation paper.

  42. Gravatar of Jared Jared
    16. November 2015 at 13:50

    Jason, ah, yes, looks like I conflated Fisher’s theory with Keynes’. I guess that makes me a Post-Keynesian, huh? Was Keynes’ reasoning simply that a fall in wages would equate to a fall in the general price level? Wasn’t there some overlap between the two?

    Anyway, I’d like to know how Scott would see a reduction in nominal wages but fixed nominal debt play out.

  43. Gravatar of Ray Lopez Ray Lopez
    16. November 2015 at 18:11

    Sumner: “Ray, Here’s a hint. If the money is neutral then the SRAS curve is vertical. Get it?”

    Ray: I got it professor. And here is a teaching moment, check out Wikipedia on the AD-AS model:

    https://en.wikipedia.org/wiki/AD%E2%80%93AS_model

    And the graph for SRAS. Looks very vertical to me. Get it now?

    I did learn something however, that Say’s Law proposes the AS curve is always vertical. Say’s Law, as Brad Delong says, is wrong in theory but people try to make it true in practice…

  44. Gravatar of Ray Lopez Ray Lopez
    16. November 2015 at 18:21

    @anybody- has anybody (you, or somebody else) tried to reconcile the various schools of economic thought (Keynesian, Monetarist, Austrian) by what the slopes of the AD-AS model are? Seems you can. If so, has anybody tried to measure the slopes? Things like stickiness of prices (small), wages (a bit larger but small), flexibility of output (machines are hard to ‘turn on’ when idle, since they are mothballed)? Seems using data we can prove Monetarism does not work, once and for all…oh wait, Bernanke in his 2003 FAVAR paper did just that.

  45. Gravatar of Don Geddis Don Geddis
    16. November 2015 at 21:38

    @Ray Lopez: “here is a teaching moment … And the graph for SRAS. Looks very vertical to me. Get it now?

    What’s awesome is how you don’t even understand what your own links are saying. No graph on that page shows a vertical SRAS curve.

  46. Gravatar of ssumner ssumner
    17. November 2015 at 18:11

    Maurizio and Travis, I believe the Fed controls NGDP (or inflation), and wouldn’t reduce it just because workers took a pay cut.

    Travis, Krugman assumes that deflation is contractionary. But it isn’t as long as NGDP is rising.

    Jared, What matters for debts is total nominal income, not nominal hourly wages. A cut in hourly wages does not reduce total income.

    Ray, You said:

    “And the graph for SRAS. Looks very vertical to me. Get it now?

    I did learn something however, that Say’s Law proposes the AS curve is always vertical. Say’s Law, as Brad Delong says, is wrong in theory but people try to make it true in practice…”

    You are like that D student, just putting something down on the essay question, hoping to get 2 points out of 10.

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