Paul Krugman has a new post where he makes the following assertion:

Ezra Klein has written in, asking for a post laying out the difference between the more or less Keynesian model Brad DeLong and I work with and the models others have been using – and how their predictions differ. It’s a good request, although the truth is that the other side in this debate doesn’t necessarily agree on a single model, or even use models at all.  Still, I think it is possible to describe the general views of the other guys “” and to see how off their predictions have been.

So: first of all, the other side in this debate generally adheres, more or less, to something like what Keynes called the “classical theory“ of employment, in which employment and output are basically determined by the supply side.

In the General Theory, John Maynard Keynes created a crude and inaccurate caricature of “classical economics.”  He argued that people like Pigou had models that simply assumed full employment.  In fact, economists like Pigou, Cassel, Hawtrey, Fisher, Hayek and others, believed that wages and prices were sticky in the short run.  They believed that nominal shocks (decreases in the money supply or increases in money demand) would have real effects in the short run, but merely change the price level in the long run.  Indeed this tradition goes all the way back to that most “classical” of classical economists–David Hume.  The standard macro model of the 1920s is in some important respects far closer to the modern new Keynesian model than is the crude model of the General Theory, which lacks a self-correcting mechanism in the long run.  Of course Keynes knew all this, and was being intentionally disingenuous in order to make his own model seem more revolutionary.

In his recent post Krugman has misrepresented the views of those he disagrees with in much the same way that Keynes did.  I’ve read most of the economists that he ridicules (except Fama), and they do not believe that nominal shocks have no short run real effects.  There are debates about whether it is most useful to think about nominal shocks as being essentially monetary, or due to Keynesian expenditure shocks, and there are also disputes about how much of the unemployment in the current recession is due to insufficient AD and how much is due to structural problems. For instance, Cochrane holds NGDP constant when evaluating fiscal stimulus, as he assumes changes in NGDP are a monetary policy issue.

My views are actually much closer to Krugman’s than these other figures on the role of AD in the current business cycle.  But if Klein takes Krugman’s word for it, and argues that economists on the right don’t think a decline in aggregate demand can raise unemployment, he may be in for some embarrassment when people dig up lots of public statements that show Krugman’s caricature of “classical economics” is almost as disingenuous as Keynes’ s.

Mario Rizzo recently commented on a Keynes/Hayek debate from 1932.  Here is the link to the debate (which includes some other notable interwar economists.)

Keynes, et al, give a standard argument for discouraging thrift during depressions, based on the famous “paradox of thrift.”  I find this sort of argument very frustrating, as it is not clear what problem they are actually addressing.  However, if you look at the subsequent development of Keynesian economics, it is pretty clear that Keynes believed that his policy would reduce the problem of deflation by boosting aggregate demand, not aggregate supply.  So far so good.  If we wanted to use the famous MV=PY equation, then Keynes seems to be arguing that more spending would boost V, although it is possible that there are some indirect linkages that would also boost M.  But in either case this raises the question:  If you want more M*V, why not just increase M?  Keynes would probably respond with some sort of liquidity trap argument, which we now know is wrong.

Hayek’s response is just as maddening.  Is he saying that increased thrift would not raise AD?  Or is he saying that it would not raise RGDP?  He does mention the fact that they all agree that deflation is undesirable, but then suggests that this is an argument against cash hoarding, not against saving.  Well yes, but the Keynesian argument can be translated into monetary language as follows:  More saving will lower interest rates and thus encourage people to hoard cash.  That argument may or may not be correct, but nothing Hayek has to say addresses this issue.  Hayek’s letter also contains some arguments based on real factors, such as frictions and misallocation, but those don’t directly address the Keynesian claim that more thrift lowers AD, and hence causes deflation.  And Hayek also misses the opportunity to push for more monetary stimulus (instead he discusses reforms such as trade liberalization), probably because at that time he was opposed to more monetary stimulus.  Trade liberalization is a good policy at any time, but doesn’t do much to address the problem of deflation.

And Mario Rizzo may have been too generous in assuming that Hayek opposed deflation.  Here is Rizzo:

The letter signed by F.A. Hayek and Lionel Robbins (and others) is noteworthy because, first, it makes clear that “everyone” is in agreement that deflation is not desirable and should be avoided.

And here is the Hayek passage he was commenting on:

“It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation in itself is desirable.”

Note that a careful reading of the letter shows that Hayek did not indicate that he opposed deflation, rather he suggested that no one thinks “deflation in itself is desirable.”  In fact, in 1932 Hayek favored deflationary policies as a way of reducing wage and price stickiness.  He thought deflation was bad, but was a price worth paying to eliminate the greater evil of wage and price rigidity.  In the 1970s he changed his views and regretted supporting deflationary policies in the early 1932s.  (Lawrence H. White provides the quotations in this article.)

To get intelligent commentary on the interwar situation, forget about Keynes and Hayek, and instead read Irving Fisher, George Warren, Hawtrey and Cassel.  They made mistakes too.  But at least they understood that monetary policy was the key to the Depression.

Rizzo concludes with the following observation:

It does not take much to see that the issues are basically the same today. The positions of the opposing sides are also the same. As I have said many times before, the great debate is still Keynes versus Hayek. All else is footnote.

I have to admit that a few years ago I would have thought Rizzo was wrong.  I thought we were far past the sort of sterile debates that occurred in the 1930s. I thought we had the models and policy tools necessary to address demand shortfalls.  But as should be obvious from my recent posts, during this recession we have reverted back to the muddled arguments of the 1930s, where concepts are not well-defined and it is almost impossible to figure out what model people are using or what policy goals they have in mind.  And that’s a shame.

PS:  Please don’t write in and say I misunderstood Hayek, and that he was interested in time, capital, disaggregation, blah, blah, blah.  I know that.  And I’m not saying his opposition to fiscal stimulus was wrong, or that all his “real” arguments were wrong.  It is quite likely that building swimming pools is not the best way out of a depression. But his arguments don’t address Keynes’ claim that less thrift would boost AD and stop deflation.  Even worse, I have the feeling that Hayek thinks he did address Keynes’ claim.

HT:  Tyler Cowen

I plan to discuss a very impressive (unpublished) paper from 1991 written by Ronald W. Batchelder and David Glasner.  Then I hope to use this paper as a springboard to re-think the evolution of 20th century macro.  With apologies to Mr. Batchelder, I will refer to “David’s ideas” for simplicity.  (I know David, and he provides some excellent comments to this blog.)  David and I also share similar views on monetary policy, and in many cases he published his views first.  Unfortunately, the paper I refer to is not available on the internet.

The paper focuses on the views of Ralph Hawtrey and Gustav Cassel, two unjustly neglected interwar economists.  Both economists favored an international gold standard, but both were also concerned that the post-WWI system was potentially unstable.  During WWI many countries sold off their gold stocks to help pay for the war.  This big drop in the demand for gold caused the value of gold to plummet, which meant that the price level more than doubled.  Some of that was reversed in the 1920-21 deflation, but Cassel and Hawtrey feared that as countries rebuilt their gold stocks the price level might fall, causing higher unemployment.  They favored policies that would economize on the use of gold, such as replacing gold coins with gold-backed paper money.  Another idea was to supplement gold reserves with some sort of international accepted currency, such as the dollar and/or the pound.  And some of these reforms were implemented.

At first it looked like their fears were overblown.  Throughout most of the 1920s, prices in terms of gold were fairly stable.  After 1929, however, their worst fears came to pass.  Both central bank and private hoarding of gold caused severe deflation throughout most of the world, leading to mass unemployment.  So why didn’t they get credit for their predictions?  Why aren’t they famous today?  It turns out that the answer is surprisingly complicated, and tells us a lot about how macroeconomics evolves over time.
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