Strange Defeat

Following up on the previous post, below the fold is an article Arjun and I wrote last year for the Indian publication Economic and Political Weekly, on how liberal New Keynesian economists planted the seeds of their own defeat in the policy arena. 

I should add that Krugman is very far from the worst in this respect. If I criticize my soon-to-be colleague so much, it’s only because of his visibility, and because the clarity of his writing and his genuinely admirable political commitments make it easier to see the constraints imposed by his theoretical commitments. You might say that his distinct virtues bring the common vices into sharper focus.

Strange Defeat: How Austerity Economics Lost All the Intellectual Battles but Won the War
J. W. Mason[1] and Arjun Jayadev[2]
In 2010, policy makers in the advanced industrialized world pivoted sharply away from the Keynesian policies they had briefly espoused in the wake of the financial crisis of 2008-2009. A confluence of economic and political events meant that the fragile consensus in favor of expanding government expenditure broke apart.  Contributing factors included the sharp rise in public debt in much of Europe, largely due to government assumption of the liabilities of failing banks; the rise of “Tea Party” conservatives in the US following the November 2010 congressional elections; and the lack of a convincing political narrative about government expenditure. The Keynesian position was replaced, at least among elite policy makers, with a commitment towards fiscal consolidation and ‘austerity’.
With the hindsight of three years it is clear that this historical recapitulation of the Keynesian versus “Treasury view” debate, 80 years after the original, and the consequent implementation of orthodox policies, was both tragic and farcical. Tragic, because fiscal retrenchment and rectitude prolonged depression conditions in the advanced economies and sentenced millions to the misery of unemployment. Farcical, because the empirical and theoretical foundations of wholesale austerity policies were almost comically weak. A few implausible and empirically questionable papers were used to provide the intellectual cover for the pivot, despite the fact that each in turn was quickly discredited both on their own terms and by real life events. As Mark Blyth (Blyth 2013) put it “Austerity didn’t just fail – it helped blow up the world.”
In the first part of this paper, we review some of the most influential academic arguments for austerity, and describe how they collapsed under scrutiny. In the second, we broaden the focus, and consider the “new consensus” in macroeconomics, shared by most pro-stimulus economists as well as the “austerians.” We argue that this consensus – with its methodological commitment to optimization by rational agents, its uncritical faith in central banks, and its support for the norms of “sound finance” – has offered a favorable environment for arguments for austerity. Even the resounding defeat of particular arguments for austerity is unlikely to have much lasting effect, as long as the economics profession remains committed to a view of the world in which in which lower government debt is always desirable, booms and downturns are just temporary deviations from a stable long-term growth path, and in which – in “normal times” at least — central banks can and do correct all short-run deviations from that optimal path. Many liberal, New Keynesian, and “saltwater” economists have tenaciously opposed austerity in the intellectual and policy arenas.[3] But they are fighting a monster of their own creation.
INTRODUCTION
In April 2013, an influential paper (“Growth in a Time of Debt”) by Carmen Reinhart and Kenneth Rogoff (Reinhart and Rogoff 2010) that purported to show hard limits to government debt before causing sharp decreases in growth was the subject of an enormous amount of attention for the second time.  Whereas in its first airing, the paper became a touchstone paper for the austerity movement across the advanced industrialized world, this time it was for less august reasons. Papers by Herndon, Ash and Pollin (2013) and by Dube (2013) showed the paper to have had serious mistakes in both construction and interpretation. This was not the first time that the academic case for austerity had been shown to be invalid or overstated. Two years earlier the major source of intellectual, support for immediate fiscal retrenchment was provided by another paper (“Large Changes in Fiscal Policy: Taxes Versus Spending”), again by two Harvard economists-Alberto Alesina and Silvia Ardagna (Alesina and Ardagna 2009). This too was shown almost immediately to be deeply flawed, misapplying lessons from boom periods to periods of recession, wrongly attributing fiscal consolidation to countries undergoing fiscal expansion, wrongly applying the special conditions of small open economies to the world at large, and other egregious errors (IMF, 2010, Jayadev and Konczal 2010).
Below, we examine the claims of these key papers and their logical and empirical failings. But the weakness of these papers invites a broader question: How could the wholesale shift to austerity have been built on such shaky foundations? While some of the blame must go to opportunism by policy makers and confirmation bias by politically motivated researchers, a large share of the blame rests with what is often called the “new consensus” in macroeconomic theory, a consensus shared as much by austerity’s ostensible opponents as by its declared supporters. It is a matter of some amazement that the most effective theoretical counterpoint to the austerity position is provided not by cutting edge scholarship, but by a straightforward application of models that college students learn in their second year. Paul Krugman, for instance, most often makes his claims that “economic theory” has well-established answers to the problem of deep recessions, by referring t the IS-LM model. This was first written down by John Hicks in 1936, and has not appeared in graduate economics textbooks in 50years .That it is being trotted out now as the public face of a professional economics to which it bears no resemblance, is remarkable. But it’s perhaps less of a surprise when one recalls that the essential insights of Keynesian economics have long been  banished from mainstream economics, to linger on only in “the Hades of undergraduate instruction.” (Leijonhufvud, 1981)
Modern macroeconomic theory is organized around inter-temporal optimization and rational expectations, while policy discussions are dominated by a commitment to the doctrines of “sound finance” and a preference for ‘technocratic’ monetary policy conducted by ‘independent’ central banks. The historical processes that led to these commitments are complex.  For present purposes, what is important to note is that they severely limit the scope of economic debate.The need for “structural reform” and for long-term budget balance is agreed across the admissible political spectrum, from pro-austerity European conservatives to American liberals who savor the memory of Clinton era debt reduction. Even someone like Paul Krugman, who has been the foremost critic of austerity policies, treats the idea that governments do not face financing constraints, and that macroeconomic policy cannot be fully trusted to central banks, as special features of the current period of “depression economics,” which must sooner or later come to an end. Mainstream Keynesians then become modern day Augustines: “Give me chastity and continence, but not yet”.
THE RISE AND FALL OF AUSTERITY ECONOMICS
In 2010 Alberto Alesina from Harvard University was celebrated by Business Week for his series of papers on fiscal consolidation. This was ‘his hour,’ the article proclaimed (Coy, 2010). His surprising argument that the best way forward for  countries facing high unemplyment was to undertake “Large, credible and decisive spending cuts” was, for a while, on everyone’s lips. Such cuts, he reasoned, would change the expectations of market participants and bring forward investment that was held back by the uncertainty surrounding policy in the recession. Specifically, Alesina and Ardagna purported to show that across a large sample of countries, governments had successfully cut deficits, reduced debts and seen higher growth as a result. The mechanism by which this occurs  enhancing the confidence of investors in countries with “credible” governments, thereby raising investment —  has been derisively labeled ‘the confidence fairy’ by Paul Krugman.
This idea of ‘expansionary austerity’– the notion that cutting spending would increase growth–is both an attack on traditional notions of demand management, and also extraordinarily convenient for conservative macroeconomic policy makers. Not only would reducing the deficit and debt burdens of countries advancetheir  long term goal of reducing  the size of the state, it would riase spending even in the short term, since the confidence effects of fiscal surpluses on private expenditure would more than offset any drag from the public sector contraction. Even better, consolidation was better according to Alesina and Ardagna (2009) if it was weighted towards spending cuts, rather than tax increases. As Coy (2010) notes “The bottom line: Alesina has provided the theoretical ammunition fiscal conservatives want..”
As Blyth (2013) documents, this idea obtained immediate traction among policy-making elites and by mid 2010 the idea of deficit reduction in a period of weak demand (which might otherwise have been deemed nonsensical), was receiving support from high-level policy makers who spoke knowingly about the immediate need to restore ‘confidence’ in the markets.  Thus, for example Jean Claude Trichet, the president of the European Central Bank, observed that
“It is an error to think that fiscal austerity is a threat to growth and job creation. At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable”.[4]
As Blyth notes, while the argument for expansionary austerity was enthusiastically endorsed by policymakers (especially but not only in Europe), the intellectual case collapsed almost immediately. The paper was .. “dissected, augmented, tested, refuted and generally hauled over the coals” (Blyth 2013). First, Jayadev and Konczal (2010) noted that none of the alleged cases of expansionary austerity occurred during recessions. They also noted that in some cases Alesina -Ardagna had misclassified periods of fiscal expansion as periods of fiscal consolidation. Immediately following this, the IMF  (IMF, 2010) noted that the way in which Alesina -Ardagna had classified fiscal policy as being expansionary or contractionary seemed to have very little connection with actual fiscal policy changes. In terms of both effects and causes, the empirical work turned out to be valueless for policy.
Faced with mounting challenges to his work, Alesina appeared undeterred and defended his ideas while prognosticating on the future of Europe: “In addition, what is unfolding currently in Europe directly contradicts Jayadev and Konczal. Several European countries have started drastic plans of fiscal adjustment in the middle of a fragile recovery. At the time of this writing, it appears that European speed of recovery is sustained, faster than that of the U.S., and the ECB has recently significantly raised growth forecasts for the Euro area.” (Alesina 2010).
Three years on, this confident prognostication is an embarassment. The Washington Post,  taking stock of the argument, concluded “No advanced economy has proved Alesina correct in the wake of the Great Recession” (Tankersley, 2013). Not only did austerity not deliver higher growth: in the countries that tried it, output contracted more or less exactly in line with the degree of austerity they managed to impose. (Degrauwe and Ji 2013)
But just as the case for short-term fiscal consolidation was disintegrating in the eyes of all but a few diehard believers, a new set of arguments became the intellectual bulwark of the austerity movement. As the Greek debt crisis spun out of control and interest rates on sovereign debt rose   elsewhere in the European periphery, concern with public debt rose even in countries like the US, where  bond markets were untroubled and yields on government debt remained at record lows. For respectable opinion, the question was when, and not if, government debt needed to be cut, if we do’t want to “turn into Greece.”[5]
It was at this point that the paper by Reinhart and Rogoff struck its mark. Using a panel of data on growth and government debt over many decades, Reinhart and Rogoff came up with a magic number – a 90% government debt to GDP ratio — beyond which economies faced a sharp drop-off in growth rates.
As with expansionary austerity, this argument caught on very quickly with policy makers it was cited by David Cameron, Olli Rehn and Paul Ryan, among others,  to justify a push for deep, immediate debt reduction. Unlike the Alesina-Ardagna paper, this one was not easily refuted.  For one thing, the construction of the paper made it difficult for other researchers to try to replicate the results. But despite some early warnings about interpretations of the data (Bivens and Irons 2010. Ferguson and Johnson 2010), this difficulty was generally  interpreted as a reason to defer to its findings rather than as a basis for skepticism. Second, and more insidiously, there is a widespread agreement among mainstream economists that high government debt must eventually reduce growth, and so Reinhart and Rogoff’s work was received without much critical scrutiny. The 90% threshold seemed to simply confirm a widely accepted principle.
It is not surprising therefore that the errors in Reinhart and Rogoff’s work was discovered by researchers decidedly out of the mainstream. Thomas Herndon, Michael Ash and Robert Pollin, all from the University of Massachusetts Amherst—a department that has been called the ‘single most important heterodox department in the country’ — published a paper in April 2013 which showed that the Reinhart-Rogoff results were the consequence of coding errors and omissions and nonstandard weighting of data. The 90% drop-off in growth disappeared when these errors were corrected.
Even more devastatingly, Arindrajit Dube (also from the University of Massachusetts) showed that if at all there was a correlation between debt and growth, it was more likely that episodes of low growth led to higher levels of debt rather than the other way around. ( Dube, 2013) Again, this counter argument had been made by opponents of austerity, and could easily have been verified by supporters of austerity or Reinhart and Rogoff themselves, but simply hadn’t been taken seriously.
With the key intellectual arguments for the austerity consensus falling apart before their eyes, the commentariat went into overdrive, speculating on the reasons why such policies could be adopted with such little vetting.
The media proposed various  relatively benign reasons: confirmation bias, opportunism by politicians, etc.. But while these were surely factors, they surely do not explain the catastrophic failure of the economics profession to offer a rational basis for policy discussion.
James Crotty has provided a larger political economy framing of the austerity wars (Crotty, 2012). He suggests  that austerian policies should  be seen as class conflict—protecting the interests of the wealthy and attacking those of the poor, and that these battles should be seen as the latest skirmish in a longer war of ideas and priorities. Austerity, fro this viewpoint, is less an intellectual failure than a deliberate choice reflecting the political dominance of finance capital and capital in general[6].
Our purpose in this paper is to more deeply explore the battle of ideas and the extent to which the “macroeconomic consensus”, shared by mainstream economists across the political spectrum, must take a large part of the blame. Many liberal “New Keynesian” economists have done yeoman work in making the political case for stimulus and against austerity. But they have not yet come to terms with the role their own theoretical and policy frameworks played in the turn to austerity – and continue to impede realistic discussion of the crisis and effective responses to it.
THE HEGEMONY OF CONSENSUS MACROECONOMICS
While there is much to admire in the doggedness of the UMass-Amherst team (and the alacrity with which a network of left-leaning bloggers and media figures publicized their results) the truth is that knocking down Alesina and Ardagna and Reinhart and Rogoff’s results wasn’t difficult. The real question is, how was such crude work so successful in the first place?
The easy answer is that it was telling policymakers what they wanted to hear. But that lets the economics profession off too easily. For the past thirty years the dominant macroeconomic models that have been in used by central banks and by leading macroeconomists have had very little time and space for discussions of fiscal policy. In particular, the spectrum of models really ranged only from what have been termed real business cycle theory approaches on the one end to New Keynesian approaches on the other: perspectives that are considerably closer in flavor and methodological commitments to each other than to the ‘old Keynesian’ approaches embodied in such models as the IS-LM framework of undergraduate economics. In particular, while demand matters in the short run in New Keynesian models, it can have no effect in the long run; no matter what, the economy always eventually returns to its full-employment growth path.
And while conventional economic theory saw the economy as self-equilibrating, , economic policy discussion was dominated by faith in the stabilizing powers of central banks and in the conventional wisdom of “sound finance.” Perhaps the major reason Reinhart and Rogoff’s work went unscrutinized for so long is that it was only putting numbers on the prevailing consensus.
This is clearly seen when one observes that some of the same economists who today are leading the charge against austerity, were arguing just as forcefully a few years ago that the most important macroeconomic challenge was reducing the size of public debt. More broadly, work like Alesina -Ardagna and Reinhart – Rogoff has been so influential because the new Keynesians in the economics profession do not provide a compelling argument in favor of stimulus. New Keynesians follow Keynes in name only; they’ve certainly given better policy advice than the austerians in recent years, but such advice does not always flow naturally from their models.
There are two distinct failures here, one in economic theory and the other in discussions of economic policy.
The limited support for fiscal expansion in ‘frontier’ theory
On a theoretical level, professional economists today are committed to thinking of the economy in terms of intertemporal optimization by rational agents. In effect, the first question to ask about any economic outcome is, why does this leave people better off than any alternative? In such framework, agents know their endowments and tastes (and everyone else’s,) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously (“on the 8th day of creation”) the optimal path of labor, output and consumption (Leijonhufvud 1981)).
Given a framework in which explanation in terms of optimization is always the default, it’s natural to think that unemployment is just workers making an optimal choice to take their leisure now, in the knowledge that they will be more productive in the future. In this view — mockingly termed the ‘Great Vacation’ theory of recessions – stimulus is not only ineffective but unneeded, since the “problem” of high unemployment is actually what’s best for everyone. Most economists wouldn’t accept this claim in its bald form. Yet they continue to teach their graduate students that the best way to explain changes in investment and employment is in terms of the optimal allocation of consumption and leisure over time. . New Keynesians have spent a generation trying to show why the economy can move (temporarily) off the optimal path. The solution to these deviations is almost always found in monetary policy and only in very special circumstances can fiscal policy play a (limited)  role.
Degrauwe (2010) distinguishes ‘Old Keynesian’, ‘New Keynesian’ and Real Business cycle (Ricardian) models. He notes that the latter two ‘state of the art’ frameworks are similar in their framing and methodological commitments. As he puts it:

In the (Old) Keynesian model there is no automatic return to the long run output equilibrium. As a result, policy can have a permanent effect on output. The New Keynesian model, like the Ricardian model, contains a very different view of the economy. In this model fiscal policy shocks lead to adjustments in interest rate, prices and wages that tend to crowd out private investment and consumption. As a result, output is brought back to its initial level. In the Ricardian model this occurs very rapidly; in the New Keynesian models this adjustment takes time because of rigidities in wages and prices. But fundamentally, the structure of these two models is the same.

Moreover, in most cases, the ‘rigidities in wages and prices’ in New Keynesian models are best handled by monetary policy.  While these class of models are extremely large and varied, for the most part, in the New Keynesian approach, the key problem arises because periodically the interest rate generated by imperfect competition and pricing rigidities lead to a ‘wrong’ real interest rate.  As Simon Wren-Lewis (2012) argues:

Once we have the ‘wrong’ real interest rate, then (using imperfect competition as a justification) New Keynesian analysis determines output and perhaps employment only from the demand side, and the determination of effective demand becomes critical to the model. Perhaps a better way of saying this is that if real interest rates are at their natural level, we do not need to think about demand when calculating output. In most cases, it is the job of monetary policy to try and get the economy back to this natural real interest rate. This gives you the key insight into why, ZLB problems apart, it is monetary rather than fiscal policy that is the primary stabilizing policy.

Indeed, the New Keynesian models that provide any support for fiscal policy only do so at the zero lower bound, where monetary policy has stopped being effective. And even here, the models can provide some tremendously counterintuitive predictions that militate against common-sense. For example, in the canonical model of policy at the ZLB, a payroll tax cuts are contractionary, by the same logic that  government expenditure is expansionary. Since nobody actually believes this odd result – liberal economists universally supported payroll tax cuts as part of the Obama stimulus package in 2009, and bemoaned the demand-reducing effects of the cuts’ expiration at the beginning of this year – it appears that even New Keynesians don’t really believe their own models are useful guides to questions of stimulus and austerity.
Even if one does believe them, the truth is that New Keynesian models provide very little support for stimulus. With Ricardian equivalence built in, this is always going to be case-but as Cogan et al (2010) show, the majority of these models provide very little empirical support for fiscal policy. Instead, the estimates of effectiveness of fiscal expansion coming from the wide array of these models were very small indeed.
Taken as a whole then, neither the New Classical nor New Keynesian theoretical approaches—those that dominate modern macroeconomics– afford a robust case for fiscal expansion. It is not surprising therefore that Keynesians seeking support for stimulus have ‘retreated’ to older Keynesian frameworks like IS-LM. But this embrace of IS-LM is only for purposes of advocacy; in the journals and the graduate classrooms, New Keynesian models are as dominant as ever.[7]
On the specific question of government finances and the sustainability of debt, the analysis in any modern macroeconomics textbook is in terms of the intertemporal budget constraint. The core idea is that the present value of government spending across all future time must be less than or equal to the present value of taxation across all future time, minus the current value of government debt. This assumes that government must balance budget eventually: After infinite time (this is how economists think), debt must go to zero. And it assumes that interest rates and growth rates are can’t be changed by policy, and that inflation makes no difference — any change in inflation is fully anticipated by financial markets and passed through one for one to interest rates. At the same time, the budget constraint assumes that governments face no limit on borrowing in any given period. This is the starting point for all discussions of government budgets in economics teaching and research. In many graduate macroeconomics courses, the entire discussion of government budgets is just the working-out of that one equation.
But this kind of budget constraint has nothing to do with the kind of financial constraint the austerity debates are about.  The textbook constraint is based on the idea that government is setting tax and spending levels for all periods once and for all. There’s no difference between past and future — the equation is unchanged if you reverse the direction of time and simultaneously reverse the sign of the interest rate. This approach isn’t specific to government budgetconstraints, it’s the way most matters are approached in contemporary macroeconomics. The starting point for most macro textbooks is a model of a “representative agent” allocating known production and consumption possibilities across an infinite time horizon.[8] Economic growth simply means that the parameters are such that the household, or planner, chooses a path of output with higher values in later periods than in earlier ones. Financial markets and aggregate demand aren’t completely ignored, of course, but they are treated as details to be added later, not part of the main structure.
One important feature of these models is that the interest rate is not the cost of credit or finance; rather, it’s the rate of substitution, set by tastes and technology, of spending or taxing between different periods. The idea that interest is the cost of money, not the cost of substitution between the future and the present, was arguably the most important single innovation in Keynes’ General Theory. But it has disappeared from contemporary textbooks, and without it there isn’t even the possibility of bond markets limiting government budget options. As soon as we begin talking about the state of confidence in the bond market, we are talking about a financial constraint, not a budget constraint. But the whole logic of contemporary macroeconomics excludes the possibility of government financial constraints. At no point in either of the two most widely-used macro textbook in the US — Paul Romer’s Advanced Macroeconomics and Blanchard and Fischer’s Lectures on Macroeconomics — are they seriously discussed.
This framework at once overstates and understates the limits on government finances. On the one hand, it ignores the positive possibilities of financial repression to hold down interest rate, and of growing or inflating out of debt,[9] and also the possibility — in fact certainty — that government debt can be held by the public permanently rather than being eventually paid off. But on the other hand, it also ignores reasons why governments might not be able to borrow unlimited amounts in any given period. (This goes for private budget constraints too.) The theory simply doesn’t have any place for the questions about government borrowing
A faulty excel spreadsheet was able to carry the field on stimulus and austerity because the economics profession had already limited itself to conceiving of the main problems of fluctuations as either desirable or easily solved by monetary policy. But the limits of modern macroeconomic theory are only half the problem. The other half is the policy implications promoted by consensus macroeconomics — specifically, the consensus that all the hard policy questions can be delegated to the central bank.
The preference for technical monetary policy
In the view of consensus macroeconomics, Keynes was right that markets alone can’t ensure the full use of society’s resources. But that’s only because a single wrong price, the interest rate. Let a wise planner set that correctly, and everything else will fall into place. Historically, this view owes more to Wicksell than to Keynes. [See Axel Leijonhufvud, “The Wicksellian Heritage.” 1987] But Wicksell was deeply worried by the idea that the market rate of interest, determined by the financial system, could depart from the “natural” rate of interest required to balance demands for present versus future goods. For him, this was a grave source of instability in any fully developed system of credit money. For modern economists, there’s no need to worry; the problem is solved by the central bank, which ensures that the rate of interest is always at the natural rate. Lost in this updating of Wicksell is his focus on the specific features of the banking system that allow the market rate to diverge from the natural rate in the first place. But without any discussion of the specific failures that can cause the banking system to set the interest rate at the “wrong” level, it’s not clear why we should have faith that the central bank can overcome those failures.
Nonetheless, faith in monetary-policy ‘Maestros’, became nearly universal in the 1990s as the cult of Greenspan reached full flower in the US, the European Central Bank came into being as the commanding institution of the European Union, and central banks replaced government ministries as the main locus of economic policy in many countries.  Respectable mainstream economists flirted with fatuity in their paeans to the wisdom of central bankers. In a somewhat ill-timed issue of the Journal of Economic Perspectives, Goodfriend (2007) argued that

The worldwide progress in monetary policy is a great achievement that, especially when viewed from the perspective of 30 years ago, is a remarkable success story. Today, academics, central bank economists, and policymakers around the world work together on monetary policy as never before … The worldwide working consensus provides a foundation for future work because it was forged out of hard practical lessons from diverse national experiences over decades, and because it provides common ground upon which academics and central bankers can work to improve monetary policy in the future.

Christina Romer, a leading American New Keynesian who was soon to lead Barack Obama’s Council of Economic Advisors, was even more obsequious in her praise for the wisdom of central bankers:

The most striking fact about macropolicy is that we have progressed amazingly. … The Federal Reserve is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. … The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards… Real short-run macroeconomic performance has been splendid. … We have seen a glorious counterrevolution in the ideas and conduct of short-run stabilization policy. (Romer 2007)

This was, to put it mildly, an overstatement.
As far as the capabilities of central banks go, there’s reason to doubt that they have the decisive influence on real economic outcomes that the conventional wisdom of the 2000s attributed to them. Short-term interest rates appear to have ceased having much effect on longer rates and on economic activity well before they reached zero.  And if central banks could always guarantee full employment assuming positive interest rates, there would undoubtedly be ways to work around the problem of zero — committing to more expansionary policy in the future, intervening at longer maturities through quantitative easing, and so on. But while the Fed and other central banks – such as the Bank of Japan — have tried many of these unconventional approaches, they have had little impact. This failure should raise serious questions about whether the effectiveness of conventional policy was also exaggerated. The relative stability of output and employment prior to 2008 may not have been, as widely believed, due to the skillful hand of central bankers on the economy’s tiller, but to favorable conditions that were largely outside their control. And in any case, that stability is easy to exaggerate. In the US and Europe, the so-called “Great Moderation” featured asset bubbles and long “jobless recoveries,” while in much of the developing world it witnessed a series of devastating financial crises and repeated collapses in employment and output.
For economists who received their training under the monetarist consensus that has dominated policy discussions since the 1980s, the terms “effective demand failure” and “monetary policy error” were practically synonyms.  This notion that the central bank can achieve any level of money expenditure that it wishes, has always been a matter of faith rather than reason or evidence. But it was a very convenient faith, since it allowed the consensus to remove the most contentious questions of macroeconomic policy from the democratic process, and vest them in a committee of “apolitical” experts.
And that is the other problem with the cult of the central bankers: They have never really been apolitical. Mainstream economists have made the disinterestedness of central banks into an axiom — in standard macro models, the  “reaction function” of monetary policy has the same status as an objective fact about the world as, say, the relationship between unemployment and inflation. It’s taken for granted that while elected officials may be corrupt or captured by particular interests, central bankers are disinterested technicians who only want what’s best for everyone, or at least always follow their stated rules. For prominent liberal economists like Alan Blinder (who served on the Fed board under President Clinton), the performance of “apolitical” central banks is so exemplary that it becomes an argument against political democracy in general:

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. … the argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. … Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? … The justification for central bank independence is valid. Perhaps the model should be extended to other arenas. … The tax system would surely be simpler, fairer, and more efficient if … left to an independent technical body like the Federal Reserve rather than to congressional committees. (Blinder 1987)

The idea of leaving hard questions to “independent technical bodies” is seductive. But in practice, “independent” often means independent from democratic accountability, not from the interests of finance. Private banks have always had an outsize influence on monetary policy. In the early 1930s, according to to economic historians Gerald Epstein and Thomas Ferguson, expansionary monetary policy was blocked by pressure from private banks, whose interests the Fed put ahead of stabilizing the economy as a whole (Epstein and Ferguson, 1984). More recently, in the 1970s and ’80s, for the Fed of this era, holding down wages was job number one, and they were quite aware that this meant taking the of side of business against labor in acute political conflicts. And when a few high-profile union victories, like 1997’s successful strike of UPS drivers, briefly made it appear that organized labor might be reviving, Fed officials made no effort to hide their displeasure:

I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.” (Quoted in “Not Yet Dead at the Fed: Unions, Worker Bargaining, and Economy-Wide Wage Determination” (2005) by  Daniel J.B. Mitchell and Christopher L. Erickson.)

Europe today offers the clearest case of “independent” central banks taking on an overtly political role. The ECB has repeatedly refused to support the markets for European sovereign debt, not because such intervention might fail, but precisely because it might work. As Deutsches Bundesbank president Jens Weidman put it last year, “Relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act.” (“Monetary policy is no panacea for Europe,” Financial Times, May 7 2012.) In a letter to the Financial Times, one European bank executive made the same point even more bluntly: “In addition to price stability, [the ECB] has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.” In other words, it is the job of the ECB not simply to maintain price stability or keep Europe’s financial system from collapsing, but to inflict “pain” on democratically elected governments in order to compel them to adopt “reforms” of its own choosing.
What the ECB means by “reforms” was made very clear in a 2011 memo to the Italian government, setting out the conditions under which it would support the market in Italian debt.  The ECB’s demands included “full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; “reform [of] the collective wage bargaining system … to tailor wages and working conditions to firms’ specific needs…”;  “thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, “making more stringent the eligibility criteria for seniority pensions” and raising the retirement age of women in the private sector. (Quoted in: “Trichet e Draghi: un’azione pressante per ristabilire la fiducia degli investitori,” Corriere della Serra, September 29, 2011.[10]) Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This goes well beyond the textbook remit of a central bank. But it makes perfect sense if one thinks that central banks are not the disinterested experts but representatives of a specific political interest, one that stands to gain from privatization of public goods and weakened protections for workers.
Certainly many economists don’t support the kind of slash-and-burn “reform” being promoted by the ECB. But for the most part, consensus macroeconomics endorsed the delegation of all macroeconomic policymaking to central banks, insisted that monetary policy was a matter for technical expertise and not democratic accountability, and downplayed the real conflicting interests involved. This opened the way to a power grab by the central banks, on behalf of the owners of financial wealth who are their natural constituents.
The theoretical commitment to an economy where markets optimally arrange work, consumption and investment across all time, and the practical commitment to central banks as sole custodians of macroeconomic policy: These were undoubtedly the two most important ways in which the New Keynesian mainstream of economics prepared the way for the success of the austerian Right. A third contribution, less fundamental but more direct, was the commitment of economists to the tenets of “sound finance.”


Commitment to ‘Sound Finance’
The term “sound finance” was adopted in the 1940s by the pioneering American Keynesian Abba Lerner, to describe the view that governments are subject to the same kind of budget constraints as businesses and households, and should therefore guide their fiscal choices by the dangers of excessive debt. He contrasted this view with his own preferred approach, “functional finance,” which held that government budget decisions should be taken with an eye only on the state of the macroeconomy. High unemployment means higher spending and lower taxes are needed, high inflation the opposite; the government’s financial position is irrelevant.
Consensus macroeconomics has a strong commitment to the idea of sound finance. But this commitment is more reflexive, emotional or psychological than based on any coherent vision of the economy. As a result, liberal, “saltwater” economists waver between incompatible views depending on the rhetorical needs of the moment. . On the one hand, when stimulus is  required, they dismiss the idea of financial constraints, and reject the idea of some threshold above which the costs of pubic debt rise precipitously. This was the heart of the Reinhart and Rogoff dispute, and the 90% threshold was the (disproven) cliff. But on the other hand, they invoke the very same cliffs when arguing for surpluses in good times, that they dismiss when arguing for stimulus in bad ones.
This idea that the inflationary constraint to government spending is logically the primary constraint to government spending is rarely promoted. Instead appeals to unobservable ‘cliffs’, nonlinearities and future collapses in confidence dominate the conversation about government spending. Then ECB President Jean-Claude Trichet was roundly attacked by the pro-stimulus economists for arguing, in 2010, in the depths of Europe’s recession, that it was time to cut deficits and raise interest rates, on the grounds that:

The economy may be close to non-linear phenomena such as a rapid deterioration of confidence among broad constituencies of households, enterprises, savers and investors. My understanding is that an overwhelming majority of industrial countries are now in those uncharted waters, where confidence is potentially at stake. Consolidation is a must in such circumstances. (Trichet:”Stimulate no more: Now is the time for all to tighten.” Financial Times, July 22, 2010.)

As the critics rightly pointed out, there is no evidence or systematic argument for these “nonlinear responses.” The Reinhart – Rogoff paper was intended to provide exactly such evidence; its usefulness to conservative policymakers like Trichet was undoubtedly part of the reason for its success. The problem is, the collapse of Reinhart-Rogoff has hardly touched the larger vision of even the richest countries governments as perpetually teetering on the edge of a financial cliff. And one reason for the persistence of this vision is that it is shared by many of Reinhart-Rogoff’s liberal critics.

Here again is Christina Romer — one of the country’s leading “Keynesian” economists—arguing in 2007 that the biggest macroeconomic problem facing the country is that policymakers are not sufficiently worried about holding down government debt. True, she admits, there is no direct evidence high public debt has caused any problems so far. But:

It is possible that the effects of persistent deficits are highly nonlinear. Perhaps over a wide range, deficits and the cumulative public debt really do have little impact on the economy. But, at some point, the debt burden reaches a level that threatens the confidence of investors. Such a meltdown and a sudden stop of lending would unquestionably have enormous real consequences.  (Romer 2007)

Soon after giving this speech, Romer would be one of the leading advocates within the Obama administration for a larger stimulus bill. Lined up against her were economists such as Larry Summers and Peter Orszag. The conservatives’ arguments in that debate recapitulated the language Romer herself had been using less than two years before. Summers, in a contemporary account, “believed that filling the output gap through deficit spending was important, but that a package that was too large could potentially shift fears from the current crisis to the long-term budget deficit, which would have an unwelcome effect on the bond market.”  (Lizza 2009)
Mainstream New Keynesian economists want to argue that lack of fiscal space is never a constraint on stimulus in bad times, but that gaining fiscal space is a reason to run surpluses in good times. Logically, these two views are contradictory. After all, “With low debt, fiscal policy is less costly” and “With high debt, fiscal policy is more costly” are just two ways of saying the same thing. But the mainstream of economists has so far failed to face up to this contradiction. Liberal American economists seem unable to accept that if they give up the idea of a threshold past which the costs of public debt rise steeply, they must also give up the main macroeconomic argument in favor of the Clinton surpluses of the 1990s. Most critics of austerity are reluctant to admit that if high debt is not a constraint on stimulus in bad times, then it is not sensible to talk about “paying for” stimulus with surpluses in good times. Instead, they remain committed to the idea that government surpluses are definitely, absolutely needed – not now, but at some point in the future, they say. But that only cedes the moral high ground to the principled austerians who insist that surpluses are needed today.
In the stimulus vs. austerity wars of the past four years, the New Keynesians who make up the left wing of the mainstream consensus have undoubtedly been on the right side of many big policy questions. Case by case, they certainly have the better arguments. But they have no  vision. And so their victories  overAlesina -Ardagna or  Reinhart- Rogoff, count for much less than you might expect, since in the end, the vision of the economy, of the economics profession, and of economic policy hardly differs between the two camps. Alternative views of the macroeconomy exist, but they are simply ignored.
In this light, it’s interesting to compare Krugman’s 2009 New York Times magazine piece with his recent New York Review of Books piece. In the earlier article, while he has plenty of criticism for politicians, he makes it clear that the  insidious problem is in economics profession. Even the best economists, he writes, prefer mathematical elegance to historical realism, make a fetish of optimization and rational expectations, and ignore the main sources of instability in real economies. In 2009, Krugman was scathing about “the profession’s blindness to the very possibility of catastrophic failures in a market economy,” and made it clear that better policy would require better economics. He was unsparing — and insightful — about his own school as well as his opponents. The New Keynesian models used by “saltwater” economists like himself, he wrote, still “assume that people are perfectly rational and financial markets are perfectly efficient.” He was scornful of the all-purpose excuse that “no one could have predicted,” insisting that the world faced “disasters that could have been predicted, should have been predicted.”[11]
In the 2013 piece,  this self-critical tone is gone. Now, the economics profession as a whole is almost completely exonerated. Their “failure to anticipate the crisis,” he writes, “was a relatively minor sin. Economies are complicated, ever-changing entities; it was understandable that few economists realized” the fragility of the system before the crisis. Instead, his fire is all aimed at politicians, who “turned their back on practically everything economists had learned.”[12]the economists who have given intellectual support for austerity are reduced in this telling to a few outliers, a marginal clique. As a whole, he now says, the profession understands the problem properly; the lack of a proper solution is a sign of “just how little good comes from understanding.” Building a better economics seemed both urgent and promising in 2009; four years later, that project has been abandoned.
CONCLUSION
It is too easy to dismiss the idea of the pivot to austerity as being the failure of flawed papers or as political opportunism alone. Such an analysis misses the fact that, for the majority of the economics profession, , the ideas of stimulus and especially fiscal policy have always been intellectually uncomfortable, while the arguments for austerity and sound finance come naturally. A conception of macroeconomic dynamics in which the economy was by its nature unstable, and central banks could not be relied on to stabilize it, was difficult even to describe in the language of the mainstream. This state of affairs is what Gramsci would identify as hegemony.
The 2008 financial crisis and the multiple subsequent crises it engendered did seem to shake that hegemony. For a brief period, it became obvious that writers such as Keynes, Bagehot, Minsky and even Marx had much more to provide in terms of explanation and solutions than were available from the kind of macroeconomic taught in graduate classes and published in the top journals. But as time has gone on and memories of the crisis have faded, the consensus has reasserted itself. Nowhere, perhaps, has this been more evident, and more consequential, than in the austerity wars.
If Krugman got it right the first time and macroeconomists have no answers today’s urgent questions, and not just that politicians won’t listen to them – the question, then, is what is to be done? There are those who argue that there is nothing intrinsically wrong with the ways in which macroeconomics is studied, that it is just a matter of adding a few more frictions. But this is simply the traditional cherished belief of intellectual endeavors that the discipline always improves on itself. As any historian of ideas might suggest, this narrative of continuously closer approximation to the truth is often a myth, and intellectual “progress” is often down a blind alley or wrong turn.
In Axel Leijonhufvud’s eloquent essay on the value of studying the history of economic thought (Leijonhufvud 2002), he offers the metaphor of a traveller who finds himself at a dead end in the road. If he is very bold, he might try to scale the walls (or bushwhack through the forest) blocking the path. But often, it’s better to backtrack, to see if there was a turnoff somewhere earlier on the road that looked less promising at the time but in retrospect might have been a better choice. This, he suggests, is the situation of economics today. In this case, further progress means, first of all, looking back to earlier points in the discipline’s evolution to see what of value might have been overlooked.
How far back we need to go — how long ago did economics take the wrong turn that led us to the current impasse? Was it 40 years ago, when the rational expectations revolution overturned Gordon’s  “Economics of 1978,” which had less faith in central banks and was perhaps better suited to describing economies as systems evolving in time? Or was it 75 years ago, when Keynes’ radical insights abut fundamental uncertainty and the inherent instability of the capitalist investment process were domesticated by writers like Hicks and Samuelson in the neoclassical synthesis? Or was it 150 years ago, when the classical tradition of Ricardo and Marx – with its attention to dynamics, and central concern with distributional conflict  — was displaced by the marginalist approach that made economics primarily about the static problem of efficient allocation? We do not here suggest that there is nothing worth keeping in the current macroeconomic canon, but we think these earlier traditions suggest important routes forward that have been abandoned. Indeed, those economists who worked in alternative traditions (Minskyan, Post-Keynesian, Marxist, and even Austrian) had a much more robust vocabulary for making sense of the crisis and the responses to it.
The industrialized world has gone through a prolonged period of stagnation and misery and may have worse ahead of it. Probably no policy can completely tame the booms and busts that capitalist economies are subject to. And even those steps that can be taken, will not be taken without the pressure of strong popular movements challenging governments from the outside. The ability of economists to shape the world, for good or for ill, is strictly circumscribed. Still, it is undeniable that the case for austerity – so weak on purely intellectual grounds – would never have conquered the commanding heights of policy so easily, if the way had not been prepared for it by the past thirty years of consensus macroeconomics.  Where the possibility and political will for stimulus did exist, modern economics – the stuff of current scholarship and graduate education –  tended to hinder rather than help. While when the turn to austerity came, even shoddy work could have an outsize impact, because it had the whole weight of conventional opinion behind it. For this the mainstream of the economics profession – the liberals as much as the conservatives — must take some share of the blame.
References
Alesina, Alberto (2010) ‘Fiscal Adjustments:  What do We Know and What are We doing?’ Mercatus Center Working Paper September 2010
Alesina, Alberto and Ardagna, Silvia (2009) ‘Large Changes in Fiscal Policy: Taxes Versus Spending’, National Bureau of Economic Research (NBER), Working Paper No. 15438.
Ball, Laurence, Davide Furceri, Daniel Leigh, and  Prakash Loungani
(2013) The Distributional Effects of Fiscal  Consolidation. IMF working paper

Bivens, Josh and John Irons (2010)’ Government Debt and Economic Growth’
 
Blinder, Alan S (1987) Is Government Too Political? Foreign Affairs Vol. 76, No. 6 (Nov. – Dec., 1997), pp. 115-126
 
De Grauwe Paul  (2010) Fiscal policies in “normal” and “abnormal” recessions. VoxEU, 30th March 2010
De Grauwe Paul and Yuemei Ji (2013) Panic-driven austerity in the Eurozone and its implications.  VoxEu 21st Feb 2013.
Kotlikoff, Laurence (2011).America’s debt woe is worse than Greece’s http://www.cnn.com/2011/09/19/opinion/kotlikoff-us-debt-crisis
Leijonhufvud, Axel (1981) Information and Coordination : Essays in Macroeconomic Theory by Axel Leijonhufvud (1981, Paperback)
Lizza, Ryan (2009)  “Inside the Crisis:Larry Summers and the White House economic team”, New Yorker October 2009.
 
Tankersley, James (2013).Sequester, to some economists, is no sweat, Washington Post, April 2013
Taylor, Lance (2004) Reconstructing Macroeconomics: Structuralist Proposals and Critiques of the Mainstream. Harvard University Pres.

  Economic Policy Institute, #271
Blyth, Mark (2013). Austerity: The History of a Dangerous Idea, OUP USA,
Cogan, John F. & Cwik, Tobias & Taylor, John B. & Wieland, Volker, 2010. “New Keynesian versus old Keynesian government spending multipliers,” Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 281-295, March
Coy, Peter (2010) ‘Keynes vs Alesina. Alesina Who?’ Bloomberg Business Week, June 3, 2010
Crotty, James (2012) The great austerity war: what caused the US deficit crisis and who should pay to fix it?Camb. J. Econ. (2012) 36 (1): 79-10
Dube, Arindrajit (2013) ‘Growth in a Time Before Debt: A Note Assessing Causal Interpretations of Reinhart and Rogoff (2010)’. Mimeo
Eggertsson, Gauti B., What Fiscal Policy is Effective at Zero Interest Rates? (November 1, 2009). FRB of New York Staff Report No. 402. Available at SSRN: http://ssrn.com/abstract=1504828 or http://dx.doi.org/10.2139/ssrn.1504828
Epstein, Gerald, and Thomas Ferguson (1984). “Monetary Policy,Loan Liquidation, and Industrial Conflict: The Federal Reserve and the Open Market Operations of 1932’ Journalof Economic History (December 1984), pp. 957-83.
Ferguson, Thomas and Robert Johnson (2010) “A World Upside Down? Deficit Fantasies in the Great Recession”. Roosevelt Institute
Goodfriend, Marvin. 2007. “How the World Achieved Consensus on Monetary Policy.” Journal of Economic Perspectives, 21(4): 47-68.
Gordon, Robert (2009). “Is Modern Macro or 1978‐era Macro More Relevant to the Understanding of the Current Economic Crisis?”. Mimeo
Herndon, Thomas Michael Ash and Robert Pollin, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute,  Working Paper 322. April 2013;
IMF (2010). “From stimulus to consolidation: revenue and expenditure policies in advanced and emerging economies” Mimeo
Jayadev, Arjun and Michael Konczal (2010) ‘The Boom Not the Slump: The Right Time For Austerity’, August 23, Roosevelt Institute
Leijonhufvud, Axel, (1997), The Wicksellian Heritage, No 9705, Department of Economics Working Papers, Department of Economics, University of Trento, Italia.
Leijonhufvud, Axel, (2002), The Uses of History. Department of Economics, University of Trento, Italia.
Reinhart, Carmen M and Kenneth S. Rogoff (2010), “Growth in a Time of Debt,” American Economic Review: Papers & Proceedings 100 (May 2010): 573–578

Romer, Christina (2007), “Macroeconomic  Policy in the 1960s: The Causes and Consequences of a Misguided Revolution” Speech delivered at the Economic History Association Annual Meeting
Wren-Lewis, Simon (2012).  What is New Keynesian economics really about? http://mainlymacro.blogspot.com/2012/07/what-is-new-keynesian-economics-really.html
[1]          University of Massachusetts Amherst and Roosevelt University
[2]          University of Massachusetts Boston and Azim Premji University
            We would like to thank, without implicating, Suresh Naidu, Jim Crotty, Mark Blyth, Peter Spiegler and an anonymous referee for very helpful comments.
[3]   There is a challenge of terminology here, since economists, perhaps even more than most academics, are committed to the idea of a professional consensus. For the purposes of this article, “liberal”  refers to the left side of mainstream U.S. politics, as opposed to conservative. “New Keynesian” refers to a particular methodology in macroeconomics, which combines the Walrasian general-equilibrium framework of neoclassical economics with a specific set of “frictions” that allow for superficially Keynesian results in the short run, including some form of aggregate demand. (This is opposed by “New Classical” economists, who believe that the long-run models they and the New Keynesians share should be used for the short run as well.) “Saltwater” refers to one side of a sociological divide within the economics profession, with saltwater economists more eclectic, more willing to modify their models as needed to describe particular events or support particular policies, while “freshwater” economists are more committed to logically consistent reasoning from first principles. While these three divisions are distinct in principle, in practice there is much overlap between them. The important point for our purposes is that a strong set of assumptions is shared across all these divides, especially with respect to methodology but also with respect to policy. There is a much wider field of economic beyond this consensus, from the postwar economics of Samuelson, Solow and Tobin; to the radical (or “heterodox”) Keynesian economics kept alive at places like UMass-Amherst, The New School, and the University of Missouri-Kansas City; to the various traditions of Marxism. But since these schools currently have little or no influence on policy in the US or in Europe, they are outside the scope of this article.
[4]          See European Central Bank, Interview with Jean-Claude Trichet, President of the ECB, and Liberation, July 8 2010
[5]          For example, Laurence Kotlikoff (2011) – a respected financial economist —  argued  “The financial sharks are circling Greece because Greece is small and defenseless, but they’ll soon be swimming our way.”
[6]          It is interesting in this regard that a recent paper by the IMF addresses the distributional effects of austerity (Ball et al. 2013) . The abstract alone confirms the Crotty viewpoint: “This paper examines the distributional effects of fiscal consolidation. Using episodes of fiscal consolidation for a sample of 17 OECD countries over the period 1978–2009, we find that fiscal consolidation has typically had significant distributional effects by raising inequality, decreasing wage income shares and increasing long-term unemployment. The evidence also suggests that spending-based adjustments have had, on average, larger distributional effects than tax-based adjustments
[7]   For a sense of what a serious academic development of “IS-LM-style” models could look like, the best starting point is probably the work of Lance Taylor, particularly Reconstructing Macroeconomics. Taylor (2004)
[8]   It is somewhat ironic that the specific growth model that is most often used is the version developed by Robert Solow, since Solow himself is quite critical of the turn toward intertemporal optimization as the core methodology of macroeconomics. http://www.nobelprize.org/nobel_prizes/economics/laureates/1987/solow-lecture.html
[9]          This is also ironic because Carmen Reinhart and Kenneth Rogoff have both argued (albeit unenthusiastically) for financial repression or inflation.
[10]        See also the discussion on the Triple Crisis blog: http://triplecrisis.com/from-technocrats-to-autocrats/
[11]        “How Did Economists Get It So Wrong,” New York Times Magazine, September 2, 2009.
[12] “How the Case for Austerity Has Crumbled,” New York Review of Books, June 6, 2013.

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly — if that class used Krugman’s textbook.

Here’s what Krugman’s International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it’s pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that’s irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn’t people listen to him, and ignore Paul Krugman the blogger?

[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different … and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the “self-correcting economy,” even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through “price flexibility.” In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That’s what “a return to full employment via price flexibility” means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run — in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a “surprising big” part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that’s what happens once you accept that your job as an educator is to produce ideological fables.

Ancient Economists: Two Views

John Cochrane, reporting from the NBER Summer Institute:

The use of ancient quotations came up several times. I  complained a bit about Eggertsson and Mehrotra’s long efforts to tie their work to quotes from verbal speculations of Keynes, Alvin Hansen, Paul Krugman and Larry Summers. Their rhetorical device is, “aha, these equations finally explain what some sage of 80 years ago or Important Person today really meant.”  Ivan Werning really complained about this in Paul Beaudry’s presentation. What does this complex piece of well worked out “21st century economics” have to do with long ago muddy debates between Keynes and Hayek? It stands on its own, or it doesn’t. (In his view, it did, so why belittle it?) 

Physics does not write papers about “the Newton-Aristotle debate.” Our papers should stand on their own too. They are right or wrong if they are logically coherent and describe the data, not if they fulfill the vague speculations of some sage, dead or alive. It’s especially unhelpful to try to make this connection, I think, because the models differ quite sharply from the speculations of the sage. Alvin Hansen certainly did not think that a Taylor interest rate rule with a phi parameter greater than one was a central culprit in “secular stagnation.” I haven’t checked against the speech, but I doubt he thought that inflation would completely cure the problem in the first place. 

Sure, history of thought is important; tying ideas to their historical predecessors is important; recognizing the centuries of thinking on money and business cycles is important. But let’s stand up for our own generation; we do not exist simply to finally put equations in the mouths of ancient economists. 

But, tying it all up, perhaps I’m just being an old fogey. Adam Smith wrote mostly words. Marx like Keynes wrote big complicated books that people spent a century writing about “this is what they really meant.” Maybe models are at best quantitative parables. Maybe economics is destined to return to this kind of literary philosophy, not quantified science.

(via Suresh, who was also there.)

For the case in favor of ancient economists, here is Axel Leijonhufvud:

According to Sir Peter Medawar

A scientist’s present thoughts and actions are of necessity shaped by what others have done and thought before him: they are the wave-front of a continuous secular process in which The Past does not have a dignified independent existence of its own. Scientific understanding is the integral of a curve of learning; science therefore in some sense comprehends its history within itself.

… Not every field of learning can claim to “comprehend its history within itself.” For the current state of the art to be the “integral of past learning” in Medawar’s sense, the collective learning process must be one that remembers everything of value and forgets only the errors and the false leads. But this requires the recognized capability to decide what is correct or true and what is in error or false. These decisions, moreover, must compel general assent. Once an answer is arrived at, it must be generally agreed to be the answer. The field must be one in which answers kill questions so definitively that the sense of alternative possibilities disappears. … 

A science, or a subfield within it, may come to approximate these conditions because of its positive successes. But two other mechanisms that are not so nice will also be at work. First, the people in the field agree that certain questions, which they would have a hard time deciding, are somebody else’s responsibility. So economics among the social sciences, like physics among the natural sciences, had first pick of problems and left the really hard ones, on which their methods did not give them a firm grip, for the younger sister disciplines to deal with as best they might. Second, the insiders to the field will agree to exclude some people who refuse to assent to the manner in which certain important questions have been settled. Both the exclusion of undecidable questions from the field of inquiry and the exclusion of undecided people from the professional group help to achieve collective concentration and intensive interaction within the group. … 

These reflections … offer some suggestions about when scientists might find the history of their field relevant and useful to current inquiry. One suggestion is to look for situations when a research program has bogged down, when anomalies have cropped up that cannot be reduced to or converted into ordinary puzzles within the paradigm. Another is to look for cases in which three conditions seem to be met:
a) certain central questions cannot be decided in a way that commands assent,
b) the (for the time being) undecidable questions cannot very well be left for somebody else to worry about, and
c) the people who withhold their assent from some popular suggested answer cannot be ignored or excommunicated.

… Economists are wont to reduce everything to choices. Economics itself develops through the choices that economists make. To use the past for present purposes, we should see the history of the field as sequences of decisions, of choices, leading up to the present. Imagine a huge decision tree, with its roots back in the time of Aristotle, and with the present generation of economists — not all of them birds of a feather! — twittering away at each other from the topmost twigs and branches. 

The branching occurs at points where economists have parted company, where problematic decisions had to be made but could not be made so as to command universal assent. The two branches need not be of equal strength at all; in many cases, universal agreement is eventually reached ex post so that one branch eventually dies and falls away. The oldest part of the tree is, perhaps, just the naked trunk; but the sap still runs in some surprising places. 

If you want to translate Medawar’s image of science into my decision tree metaphor, you will have to imagine his sciences as fir trees — with physics, surely, as the redwood – majestic things with tall, straight trunks and with live branches only at the very top. Economics, in contrast, would come out as a rather tangled, ill-pruned shrub … 

As long as “normal” progress continues to be made in these established directions, there is no need to reexamine the past … Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the “frontier of the field” ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we do get stuck occasionally. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might often be content to accommodate themselves to it, spend their time tidying up the place, putting in a few modern conveniences, and generally improving the neighborhood. Braver souls will want out and see a tremendous leap of the creative imagination as the only way out — a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time. At this point, a mental map of the road network behind the frontier becomes essential.

The Rentier Would Prefer Not to Be Euthanized

Here’s another one for the “John Bull can stand many things, but he cannot stand two percent” files. As Krugman says, there’s an endless series of these arguments that interest rates must rise. The premises are adjusted as needed to reach the conclusion. (Here’s another.) But what are the politics behind it?

I think it may be as simple as this: The rentiers would prefer not to be euthanized. Under capitalism, the elite are those who own (or control) money. Their function is, in a broad sense, to provide liquidity. To the extent that pure money-holders facilitate production, it is because money serves as a coordination mechanism, bridging gaps — over time and especially with unknown or untrusted counterparties — that would otherwise prevent cooperation from taking place. [1] In a world where liquidity is abundant, this coordination function is evidently obsolete and can no longer be a source of authority or material rewards.

More concretely: It may well be true that markets for, say, mortgage-backed securities are more likely to behave erratically when interest rates are very low. But in a world of low interest rates, what function do those markets serve? Their supposed purpose is to make it easier for people to get home loans. But in a world of very low interest rates, loans are, by definition, easy to get. Again, with abundant liquidity, stocks may get bubbly. But in a world of abundant liquidity, what problem is the existence of stock markets solving? If anyone with a calling to run a business can readily start one with a loan, why support a special group of business owners? Yes, in a world where bearing risk is cheap, specialist risk-bearers are likely to go a bit nuts. But if risk is already cheap, why are we employing all these specialists?

The problem is, the liquidity specialists don’t want to go away. From finance’s point of view, permanently low interest rates are removing their economic reason for being — which they know eventually is likely to remove their power and privileges too. So we get all these arguments that boil down to: Money must be kept scarce so that the private money-sellers can stay in business.

It’s a bit like Dr. Benway in Naked Lunch:

“Now, boys, you won’t see this operation performed very often and there’s a reason for that…. You see it has absolutely no medical value. No one knows what the purpose of it originally was or if it had a purpose at all. Personally I think it was a pure artistic creation from the beginning. 

“Just as a bull fighter with his skill and knowledge extricates himself from danger he has himself invoked, so in this operation the surgeon deliberately endangers his patient, and then, with incredible speed and celerity, rescues him from death at the last possible split second….

Interestingly, Dr. Benway was worried about technological obsolescence too. “Soon we’ll be operating by remote control on patients we never see…. We’ll be nothing but button pushers,” etc. The Dr. Benways of finance like to fret about how robots will replace human labor. I wonder how much of that is a way of hiding from the knowledge that what cheap and abundant capital renders obsolete, is the capitalist?

EDIT: I’m really liking the idea of Larry Summers as Dr. Benway. It fits the way all the talk when he was being pushed for Fed chair was about how great he would be in a financial crisis. How would everyone known how smart he was — how essential — if he hadn’t done so much to create a crisis to solve?

[1] Capital’s historic role as a facilitator of cooperation is clearly described in chapter 13 of Capital.

Boulding on Interest

Kenneth Boulding, reviewing Maurice Allais’s  Économie et intérêt in 1951:

Much work on the theory of interest is hampered at the start by its unquestioned assumption that “the” rate of interest, or even some complex of rates, is a suitable parameter for use in the construction of systems of economic relationships, whether static or dynamic. This is an assumption which is almost universally accepted and yet which seems to me to be very much open to question. My reason for questioning it is that the rate of interest is not an objective magnitude… The rate of interest is not a “price”; its dimensions are those of a rate of growth, not of a ratio of exchange, even though it is sometimes carelessly spoken of as a “price of loanable funds.” What is determined in the market is not strictly the rate of interest but the price of certain “property rights.” These may be securities, either stocks or bonds, or they may be items or collections of physical property. Each of these property rights represents to an individual an expected series of future values, which may be both positive and negative. If this expected series of values can be given some “certainty equivalent” … then the market price of the property determines a rate of interest on the investment. This rate of interest, however, is essentially subjective and depends on the expectations of the individual; the objective phenomenon is the present market price 

It is only the fact that the fulfilment of some expectations seems practically certain that gives us the illusion that there is an objective rate of interest determined in the market. But in strict theory there is no such certainty, even for gilt-edged bonds; and when the uncertainties of life, inflation, and government are taken into consideration, it is evident that this theoretical uncertainty is also a matter of practice. What is more, we cannot assume either that there are any “certain equivalents” of uncertain series for it is the very uncertainty of the future which constitutes its special quality. What this means is that it is quite illegitimate even to begin an interest theory by abstracting from uncertainty or by assuming that this can be taken care of by some “risk premium”; still less is it legitimate to construct a whole theory on these assumptions … without any discussion of the problems which uncertainty creates. What principally governs the desired structure of assets on the part of the individual is the perpetual necessity to hedge — against inflation, against deflation, against the uncertainty in the future of all assets, money included. It is these uncertainties, therefore, which are the principal governors of the demand and supply of all assets without exception, and no theory which abstracts from these uncertainties can claim much significance for economics. Hence, Allais is attempting to do something which simply cannot be done, because it is meaningless to construct a theory of “pure” interest devoid of premiums for risk, liquidity, convenience, amortization, prestige, etc. There is simply no such animal. 

In other words: There are contexts when it is reasonable to abstract from uncertainty, and proceed on the basis that people know what will happen in the future, or at least its probability distribution. But interest rates are not such a context, you can’t abstract away from uncertainty there. Because compensation for uncertainty is precisely why interest is paid.

The point that what is set in the market, and what we observe, is never an interest rate as such, but the price of some asset today in terms of money today, is also important.

Boulding continues:

The observed facts are the prices of assets of all kinds. From these prices we may deduce the existence of purely private rates of return. The concept of a historical “yield” also has some validity. But none of these things is a “rate of interest” in the sense of something determined in a market mechanism.  

This search for a black cat that isn’t there leads Allais into several extended discussions of almost meaningless and self-constructed questions… Thus he is much worried about the “fact” that a zero rate of interest means an infinite value for land, land representing a perpetual income, which capitalized at a zero rate of interest yields an infinite value… This is a delightful example of the way in which mathematics can lead to an almost total blindness to economic reality. In fact, the income from land is no more perpetual than that from anything else and no more certain. … We might draw a conclusion from this that a really effective zero rate of interest in a world of perfect foresight would lead to an infinite inflation; but, then, perfect foresight would reduce the period of money turnover to zero anyway and would give us an infinite price level willy-nilly! This conclusion is interesting for the light it throws on the complete uselessness of the “perfect foresight” model but for little else. In fact, of course, the element which prevents both prices from rising to infinity and (private) money rates of interest from falling to zero is uncertainty – precisely the factor which Allais has abstracted from. Another of these quite unreal problems which worries him a great deal is why there is always a positive real rate of interest, the answer being of course that there isn’t! … 

Allais reflects also another weakness of “pure”interest theory, which is a failure to appreciate the true significance and function of financial institutions and of “interest” as opposed to “profit” – interest in this sense being the rate of growth of value in “securities,” especially bonds, and “profit” being the rate of growth of value of items or combinations of real capital. Even if there were no financial institutions or financial instruments … there would be subjective expected rates of profit and historical yields on past, completed investments. In such a society, however, given the institution of private property, everyone would have to administer his own property. The main purpose of the financial system is to separate “ownership” (i.e., equity) from “control,” or administration, that is, to enable some people to own assets which they do not control, and others to control assets which they do not own. This arrangement is necessitated because there is very little, in the processes by which ownership was historically determined through inheritance and saving, to insure that those who own the resources of society are … capable of administering them. Interest, in the sense of an income received by the owners of securities, is the price which society pays for correcting a defect in the otherwise fruitful institution of private property. It is, of course, desirable that the price should be as small as possible – that is, that there should be as little economic surplus as possible paid to nonadministering owners. It is quite possible, however, that this “service” has a positive supply price in the long run, and thus that, even in the stationary state, interest, as distinct from profit, is necessary to persuade the nonadministering owners to yield up the administration of their capital.

This last point is important, too. Property, we must always remember, is not a relationship between people and things. it is a relationship between people and people. Ownership of an asset means the authority to forbid other people from engaging in a certain set of productive activities. The “product” of the asset is how much other people will pay you not to exercise that right. Historically, of course, the sets of activities associated with a given asset have often been defined in relation to some particular means of production. But this need not be the case. In a sense, the patent or copyright isn’t an extension of the idea of property, but property in its pure form. And even where the rights of an asset owner are defined as those connected with some tangible object, the nature of the connection still has to be specified by convention and law.

According to Wikipedia, Économie et intérêt,  published in 1947, introduced a number of major ideas in macroeconomics a decade or more before the American economists they’re usually associated with, including the overlapping generations model and the golden rule for growth. Boulding apparently did not find these contributions worth mentioning. He does, though, have something to say about Allais’s “economic philosophy” which “is a curious combination of Geseel, Henry George and Hayek,” involving “free markets, with plenty of trust- and union-busting, depreciating currency, and 100 per cent reserves in the banking system, plus the appropriation of all scarcity rents and the nationalization of land.” Boulding describes this as “weird enough to hit the jackpot.” It doesn’t seem that weird to me. It sounds like a typical example of a political vision you can trace back to Proudhon and forward through the “Chicago plan” of the 1930s and its contemporary admirers to the various market socialisms and more or less crankish monetary reform plans. (Even Hyman Minsky was drawn to this strain of politics, according to Perry Mehrling’s superb biographical essay.)What all these have in common is that they see the obvious inconsistency between capitalism as we observe it around us and the fairy tales of ideal market exchange, but they don’t reject the ideal. Instead, they propose a program of intrusive regulations to compel people to behave as they are supposed to in an unregulated market. They want to make the fairy tales true by legislation. Allais’ proposal for currency depreciation is not normally part of this package; it’s presumably a response to late-1940s conditions in France. But other than that these market utopias are fairly consistent. In particular, it’s always essential to reestablish the objectivity of money.

Finally, in a review full of good lines, I particularly like this one:

Allais’s work is another demonstration that mathematics and economics, though good complements, are very imperfect substitutes. Mathematics can manipulate parameters once formulated and draw conclusions out which were already implicit in the assumptions. But skills of the mathematician are no substitute for the proper skill of the economist, which is that of selecting the most significant parameters to go into the system.

Varieties of Keynesianism

Here’s something interesting from Axel Leijonhufvud. It’s a response to Luigi Pasinetti’s book on Keynes, but really it’s an assessment of the Keynesian revolution in general.

There really was a revolution, according to Pasinetti, and it can be dated precisely, to 1932. Leijonhufvud:

By the Spring of that year, Keynes had concluded that the Treatise could not be salvaged by a revised edition. He still gave his “Pure Theory of Money” lecture series which was largely based on it but members of his ‘Circus’ attended and gave him trouble. The summer of that year appears to have been a critical period. In the Fall, Keynes announced a new series of lectures with the title “The Monetary Theory of Production”. The new title signaled a break with his previous work and a break with tradition. From this point onward, Keynes felt himself to be doing work that was revolutionary in nature. 

What was revolutionary about these lectures was that they weren’t about extending or modifying the established framework of economics, but about adopting a new starting point. A paradigm in economics can be thought of as defined by the minimal model — the model that (in Pasinetti’s words) “contains those analytical features, and only those features, which the theory cannot do without.” Or as I’ve suggested here, the minimal model is the benchmark of simplicity in terms of which Occam’s razor is applied.

For the orthodox economics of Keynes’s day (and ours), the minimal model was one of “real exchange” in which a given endowment of goods and a given set of preferences yielded a vector of relative prices. Money, production, time, etc. can then be introduced as extensions of this minimal model. In Keynes’ “monetary production” model, on the other hand, the “analytical features which the theory cannot do without” are a set of income flows generated in production, and a set of expenditure flows out of income. The minimal model does not include any prices or quantities. Nor does it necessarily include exchange — it’s natural to think of the income flows as consisting of profits and wages and the expenditure flows as consumption and investment, but they can just as naturally include taxes, interest payments, asset sales, and so on.

I don’t want to suggest that the monetary production paradigm has ever been as well-defined as the real exchange paradigm. One of Leijonhufvud’s main points is that there has never been a consensus on the content of the Keynesian revolution. There are many smart people who will tell you what “Keynes really meant.” With due respect (and I mean it) I’m not convinced by any of them. I don’t think anyone knows what Keynes really meant —including Keynes himself. The truth is, the Hicks-Patinkin-Samuelson version of Keynes is no bastard; its legitimate paternity is amply documented in the General Theory. Pasinetti quotes Joan Robinson: “There were moments when we had some trouble in getting Maynard to see what the point of his revolution really was.” Which doesn’t, of course, means that Hicks-Patinkin-Samuelson is the only legitimate Keynes — here even more than  in most questions of theory, we have to tolerate ambiguity and cultivate the ability to hold more than one reading in mind at once.

One basic ambiguity is in that term, “monetary production.” Which of those words is the important one?

For Pasinetti, the critical divide is between Keynes’ theory of production and the orthodox theory of exchange. Pasinetti’s production-based Keynesianism

starts from the technological imperatives stemming from the division and specialization of labor. In this context, exchange is derivative, stemming from specialization in production. How it is institutionalized and organized is a matter that the minimal production paradigm leaves open (whereas the exchange paradigm necessarily starts by assuming at least private property and often also organized markets). Prices in the production paradigm are indices of technologically determined resource costs and, as such, leave open the question whether the system does or does not have a tendency towards the full utilization of scarce resources and, in particular, of labor. …

The exchange paradigm relies on individual self-interest, on consumer’s sovereignty, and on markets and private property as the principal institutions needed to bring about a socially desirable and harmonious outcome. In putting the division of labor and specialization at center stage, the pure production model, in contrast, highlights the “necessarily cooperative aspects of any organized society…

To an unsympathetic audience, I admit, this could come across as a bunch of commencement-speech pieties. For a rigorous statement of the pure production paradigm we need to turn to Sraffa. In Production of Commodities by Means of Commodities he starts from the pure engineering facts — the input-output matrices governing production at current levels using current technology. There’s nothing about prices, demand, distribution. His system “does not explain anything about the allocation of resources. Instead, the focus is altogether on finding a logical basis for objective measurement. It is a system for coherent, internally coherent macroeconomic accounting.”

In other words: We cannot reduce the heterogeneous material of productive activity to a single objective quantity of need-satisfaction. There is no such thing. Mengers, Jevons, Walras and their successors set off after the will-o-the-wisp of utility and, to coin a phrase, vanished into a swamp, never to be heard from by positive social science again.

The question then is, how can we consistently describe economic activity using only objective, observable data? (This was also the classical question.) Sraffa answers in terms of a “snapshot” of production at a given moment. Or as Sen puts it, in a perceptive essay, he is showing how one can do economics without the use of counterfactuals.

For Pasinetti, Keynes’ revolution and Sraffa’s anti-subjectivist revival of classical economics — his effort to ground economics in engineering data — were part of the same project, of throwing out subjectivism in favor of engineering. Leijonhufvud is not convinced. “Keynes was above all a monetary economist,” he notes, “and there are good reasons to believe” that it was monetary and not production that was the key term in the “theory of monetary production.” Keynes made no use of the theory of imperfect competition, despite its development by members of his inner circle (Richard Kahn and Joan Robinson). Or consider his famous reversal on wages — in the General Theory, he assumed they were equal to the marginal product of labor, which declined with the level of output. But after this claim was challenged Dunlop, Tarshis and others, he admitted there was no real evidence for it and good reason to think it was not true. [1] The fact that JMK didn’t think anything important in his theory hinged on how wages were set, at least suggests that production side of economy was not central to his project.

The important point for us is that there is one strand of Cambridge that rejects orthodoxy on the grounds that it misrepresents a system of production based on objective relationships between inputs and outputs, as a system of exchange based on subjective preferences. But this is not the only vantage point from which one can criticize the Walrasian system and it’s not clear it’s the one occupied by Keynes or by Keynesianism — whatever that may be.

The alternative standpoint is still monetary production, but with the stress on the first word rather than the second. Leijonhufvud doesn’t talk much about this here, since this is an essay about Pasinetti. But it’s evidently something along the lines of Mehrling’s “money view” or “finance view.” [2] It seems to me this view has three overlapping elements: 1. The atomic units of the economy are money flows (and commitments to future money flows), as opposed to prices and quantities. 2. Quantities are quantities of money; productive activity is not measurable except insofar as it involves money payments. 3. The active agents of the economy are seeking to maximize money income or wealth, not to end up with some preferred consumption basket. Beside Mehrling, I would include Minsky, Paul Davidson and Wynne Godley here, among others.

I’m not going to try to summarize this work here. Let me just say how I’m coming at this.

As I wrote in comments to an earlier post, what I want is to think more systematically about the relationship between the network of financial assets and liabilities recorded on balance sheets, on the one hand, and the concrete social activities of production and consumption, on the other. What we have now, it seems to me, is either a “real” view that collapses these two domains into one, with changes in ownership and debt commitments treated as if they were decisions about production and consumption; or else a “finance” view that treats balance-sheet transactions as a closed system. I think the finance view is more correct, in the sense that at least it sees half of the problem clearly. The “real” view is a hopeless muddle because it tries to treat the concrete social activity of production and consumption as if it were a set of fungible quantities like money, and to treat money commitments as if they were decisions about production and consumption. The strength of the finance view is that it recognizes the system of contingent money payments recorded on balance sheets as a distinct social activity, and not simply a reflection of the allocation of goods and services. To be clear: The purpose of recognizing finance as a distinct thing isn’t to study it in isolation, but rather to explore the specific ways in which it interacts with other kinds of social activity. This is the agenda that Fisher dynamics, disgorge the cash, functional finance and the other projects I’m working on are intended to contribute to.

[1] It’s a bit embarrassing that this “First Classical Postulate,” which Keynes himself said “is the portion of my book which most needs to be revised,” is the first positive claim in the book.

[2] Mehrling prefers to trace his intellectual lineage to the independent tradition of American monetary economics of Young, Hansen and Shaw.  But I think the essential content is similar.