In Jacobin: A Demystifying Decade for Economics

(The new issue of Jacobin has a piece by me on the state of economics ten years after the crisis. The published version is here. I’ve posted a slightly expanded version below. Even though Jacobin was generous with the word count and Seth Ackerman’s edits were as always superb, they still cut some material that, as king of the infinite space of this blog, I would rather include.)

 

For Economics, a Demystifying Decade

Has economics changed since the crisis? As usual, the answer is: It depends. If we look at the macroeconomic theory of PhD programs and top journals, the answer is clearly, no. Macroeconomic theory remains the same self-contained, abstract art form that it has been for the past twenty-five years. But despite its hegemony over the peak institutions of academic economics, this mainstream is not the only mainstream. The economics of the mainstream policy world (central bankers, Treasury staffers, Financial Times editorialists), only intermittently attentive to the journals in the best times, has gone its own way; the pieties of a decade ago have much less of a hold today. And within the elite academic world, there’s plenty of empirical work that responds to the developments of the past ten years, even if it doesn’t — yet — add up to any alternative vision.

For a socialist, it’s probably a mistake to see economists primarily as either carriers of valuable technical expertise or systematic expositors of capitalist ideology. They are participants in public debates just like anyone else. The profession as the whole is more often found trailing after political developments than advancing them.

***

The first thing to understand about macroeconomic theory is that it is weirder than you think. The heart of it is the idea that the economy can be thought of as a single infinite-lived individual trading off leisure and consumption over all future time. For an orthodox macroeconomist – anyone who hoped to be hired at a research university in the past 30 years – this approach isn’t just one tool among others. It is macroeconomics. Every question has to be expressed as finding the utility-maximizing path of consumption and production over all eternity, under a precisely defined set of constraints. Otherwise it doesn’t scan.

This approach is formalized in something called the Euler equation, which is a device for summing up an infinite series of discounted future values. Some version of this equation is the basis of most articles on macroeconomic theory published in a mainstream journal in the past 30 years.It might seem like an odd default, given the obvious fact that real economies contain households, businesses, governments and other distinct entities, none of whom can turn income in the far distant future into spending today. But it has the advantage of fitting macroeconomic problems — which at face value involve uncertainty, conflicting interests, coordination failures and so on — into the scarce-means-and-competing-ends Robinson Crusoe vision that has long been economics’ home ground.

There’s a funny history to this technique. It was invented by Frank Ramsey, a young philosopher and mathematician in Keynes’ Cambridge circle in the 1920s, to answer the question: If you were organizing an economy from the top down and had to choose between producing for present needs versus investing to allow more production later, how would you decide the ideal mix? The Euler equation offers a convenient tool for expressing the tradeoff between production in the future versus production today.

This makes sense as a way of describing what a planner should do. But through one of those transmogrifications intellectual history is full of, the same formalism was picked up and popularized after World War II by Solow and Samuelson as a description of how growth actually happens in capitalist economies. The problem of macroeconomics has continued to be framed as how an ideal planner should direct consumption and production to produce the best outcomes for anyone, often with the “ideal planner” language intact. Pick up any modern economics textbook and you’ll find that substantive questions can’t be asked except in terms of how a far sighted agent would choose this path of consumption as the best possible one allowed by the model.

There’s nothing wrong with adopting a simplified formal representation of a fuzzier and more complicated reality. As Marx said, abstraction is the social scientist’s substitute for the microscope or telescope. But these models are not simple by any normal human definition. The models may abstract away from features of the world that non-economists might think are rather fundamental to “the economy” — like the existence of businesses, money, and government — but the part of the world they do represent — the optimal tradeoff between consumption today and consumption tomorrow — is described in the greatest possible detail. This combination of extreme specificity on one dimension and extreme abstraction on the others might seem weird and arbitrary. But in today’s profession, if you don’t at least start from there, you’re not doing economics.

At the same time, many producers of this kind of models do have a quite realistic understanding of the behavior of real economies, often informed by first-hand experience in government. The combination of tight genre constraints and real insight leads to a strange style of theorizing, where the goal is to produce a model that satisfies the the conventions of the discipline while arriving at a conclusion that you’ve already reached by other means. Michael Woodford, perhaps the leading theorist of “New Keynesian” macroeconomics, more or less admits that the purpose of his models is to justify the countercyclical interest rate policy already pursued by central banks in a language acceptable to academic economists. Of course the central bankers themselves don’t learn anything from such an exercise — and you will scan the minutes of Fed meetings in vain for discussion of first-order ARIMA technology shocks — but they  presumably find it reassuring to hear that what they already thought is consistent with the most modern economic theory. It’s the economic equivalent of the college president in Randall Jarrell’s Pictures from an Institution:

About anything, anything at all, Dwight Robbins believed what Reason and Virtue and Tolerance and a Comprehensive Organic Synthesis of Values would have him believe. And about anything, anything at all, he believed what it was expedient for the president of Benton College to believe. You looked at the two beliefs, and lo! the two were one. Do you remember, as a child without much time, turning to the back of the arithmetic book, getting the answer to a problem, and then writing down the summary hypothetical operations by which the answer had been, so to speak, arrived at? It is the only method of problem-solving that always gives correct answers…

The development of theory since the crisis has followed this mold. One prominent example: After the crash of 2008, Paul Krugman immediately began talking about the liquidity trap and the “perverse” Keynesian claims that become true when interest rates were stuck at zero. Fiscal policy was now effective, there was no danger in inflation from increases in the money supply, a trade deficit could cost jobs, and so on. He explicated these ideas with the help of the “IS-LM” models found in undergraduate textbooks — genuinely simple abstractions that haven’t played a role in academic work in decades.

Some years later, he and Gautti Eggertson unveiled a model in the approved New Keynesian style, which showed that, indeed, if interest rates  were fixed at zero then fiscal policy, normally powerless, now became highly effective. This exercise may have been a display of technical skill (I suppose; I’m not a connoisseur) but what do we learn from it? After all, generating that conclusion was the announced  goal from the beginning. The formal model was retrofitted to generate the argument that Krugman and others had been making for years, and lo! the two were one.

It’s a perfect example of Joan Robinson’s line that economic theory is the art of taking a rabbit out of a hat, when you’ve just put it into the hat in full view of the audience. I suppose what someone like Krugman might say in his defense is that he wanted to find out if the rabbit would fit in the hat. But if you do the math right, it always does.

(What’s funnier in this case is that the rabbit actually didn’t fit, but they insisted on pulling it out anyway. As the conservative economist John Cochrane gleefully pointed out, the same model also says that raising taxes on wages should also boost employment in a liquidity trap. But no one believed that before writing down the equations, so they didn’t believe it afterward either. As Krugman’s coauthor Eggerston judiciously put it, “there may be reasons outside the model” to reject the idea that increasing payroll taxes is a good idea in a recession.)

Left critics often imagine economics as an effort to understand reality that’s gotten hopelessly confused, or as a systematic effort to uphold capitalist ideology. But I think both of these claims are, in a way, too kind; they assume that economic theory is “about” the real world in the first place. Better to think of it as a self-constrained art form, whose apparent connections to economic phenomena are results of a confusing overlap in vocabulary. Think about chess and medieval history: The statement that “queens are most effective when supported by strong bishops” might be reasonable in both domains, but its application in the one case will tell you nothing about its application in the other.

Over the past decade, people (such as, famously, Queen Elizabeth) have often asked why economists failed to predict the crisis. As a criticism of economics, this is simultaneously setting the bar too high and too low. Too high, because crises are intrinsically hard to predict. Too low, because modern macroeconomics doesn’t predict anything at all.  As Suresh Naidu puts it, the best way to think about what most economic theorists do is as a kind of constrained-maximization poetry. It makes no more sense to ask “is it true” than of a haiku.

***

While theory buzzes around in its fly-bottle, empirical macroeconomics, more attuned to concrete developments, has made a number of genuinely interesting departures. Several areas have been particularly fertile: the importance of financial conditions and credit constraints; government budgets as a tool to stabilize demand and employment; the links between macroeconomic outcomes and the distribution of income; and the importance of aggregate demand even in the long run.

Not surprisingly, the financial crisis spawned a new body of work trying to assess the importance of credit, and financial conditions more broadly, for macroeconomic outcomes. (Similar bodies of work were produced in the wake of previous financial disruptions; these however don’t get much cited in the current iteration.) A large number of empirical papers tried to assess how important access to credit was for household spending and business investment, and how much of the swing from boom to bust could be explained by the tighter limits on credit. Perhaps the outstanding figures here are Atif Mian and Amir Sufi, who assembled a large body of evidence that the boom in lending in the 2000s reflected mainly an increased willingness to lend on the part of banks, rather than an increased desire to borrow on the part of families; and that the subsequent debt overhang explained a large part of depressed income and employment in the years after 2008.

While Mian and Sufi occupy solidly mainstream positions (at Princeton and Chicago, respectively), their work has been embraced by a number of radical economists who see vindication for long-standing left-Keynesian ideas about the financial roots of economic instability. Markus Brunnermeier (also at Princeton) and his coauthors have also done interesting work trying to untangle the mechanisms of the 2008 financial crisis and to generalize them, with particular attention to the old Keynesian concept of liquidity. That finance is important to the economy is not, in itself, news to anyone other than economists; but this new empirical work is valuable in translating this general awareness into concrete usable form.

A second area of renewed empirical interest is fiscal policy — the use of the government budget to manage aggregate demand. Even more than with finance, economics here has followed rather than led the policy debate. Policymakers were turning to large-scale fiscal stimulus well before academics began producing studies of its effectiveness. Still, it’s striking how many new and sophisticated efforts there have been to estimate the fiscal multiplier — the increase in GDP generated by an additional dollar of government spending.

In the US, there’s been particular interest in using variation in government spending and unemployment across states to estimate the effect of the former on the latter. The outstanding work here is probably that of Gabriel Chodorow-Reich. Like most entries in this literature, Chodorow-Reich’s suggests fiscal multipliers that are higher than almost any mainstream economist would have accepted a decade ago, with each dollar of government spending adding perhaps two dollars to GDP. Similar work has been published by the IMF, which acknowledged that past studies had “significantly underestimated” the positive effects of fiscal policy. This mea culpa was particularly striking coming from the global enforcer of economic orthodoxy.

The IMF has also revisited its previously ironclad opposition to capital controls — restrictions on financial flows across national borders. More broadly, it has begun to offer, at least intermittently, a platform for work challenging the “Washington Consensus” it helped establish in the 1980s, though this shift predates the crisis of 2008. The changed tone coming out of the IMF’s research department has so far been only occasionally matched by a change in its lending policies.

Income distribution is another area where there has been a flowering of more diverse empirical work in the past decade. Here of course the outstanding figure is Thomas Piketty. With his collaborators (Gabriel Zucman, Emmanuel Saez and others) he has practically defined a new field. Income distribution has always been a concern of economists, of course, but it has typically been assumed to reflect differences in “skill.” The large differences in pay that appeared to be unexplained by education, experience, and so on, were often attributed to “unmeasured skill.” (As John Eatwell used to joke: Hegemony means you get to name the residual.)

Piketty made distribution — between labor and capital, not just across individuals — into something that evolves independently, and that belongs to the macro level of the economy as a whole rather than the micro level of individuals. When his book Capital in the 21st Century was published, a great deal of attention was focused on the formula “r > g,” supposedly reflecting a deep-seated tendency for capital accumulation to outpace economic growth. But in recent years there’s been an interesting evolution in the empirical work Piketty and his coauthors have published, focusing on countries like Russia/USSR and China, etc., which didn’t feature in the original survey. Political and institutional factors like labor rights and the legal forms taken by businesses have moved to center stage, while the formal reasoning of “r > g” has receded — sometimes literally to a footnote. While no longer embedded in the grand narrative of Capital in the 21st Century, this body of empirical work is extremely valuable, especially since Piketty and company are so generous in making their data publicly available. It has also created space for younger scholars to make similar long-run studies of the distribution of income and wealth in countries that the Piketty team hasn’t yet reached, like Rishabh Kumar’s superb work on India. It has also been extended by other empirical economists, like Lukas Karabarbounis and coauthors, who have looked at changes in income distribution through the lens of market power and the distribution of surplus within the corporation — not something a University of Chicago economist would have ben likely to study a decade ago.

A final area where mainstream empirical work has wandered well beyond its pre-2008 limits is the question of whether aggregate demand — and money and finance more broadly — can affect long-run economic outcomes. The conventional view, still dominant in textbooks, draws a hard line between the short run and the long run, more or less meaning a period longer than one business cycle. In the short run, demand and money matter. But in the long run, the path of the economy depends strictly on “real” factors — population growth, technology, and so on.

Here again, the challenge to conventional wisdom has been prompted by real-world developments. On the one hand, weak demand — reflected in historically low interest rates — has seemed to be an ongoing rather than a cyclical problem. Lawrence Summers dubbed this phenomenon “secular stagnation,” reviving a phrase used in the 1940s by the early American Keynesian Alvin Hansen.

On the other hand, it has become increasingly clear that the productive capacity of the economy is not something separate from current demand and production levels, but dependent on them in various ways. Unemployed workers stop looking for work; businesses operating below capacity don’t invest in new plant and equipment or develop new technology. This has manifested itself most clearly in the fall in labor force participation over the past decade, which has been considerably greater than can be explained on the basis of the aging population or other demographic factors. The bottom line is that an economy that spends several years producing less than it is capable of, will be capable of producing less in the future. This phenomenon, usually called “hysteresis,” has been explored by economists like Laurence Ball, Summers (again) and Brad DeLong, among others. The existence of hysteresis, among other implications, suggests that the costs of high unemployment may be greater than previously believed, and conversely that public spending in a recession can pay for itself by boosting incomes and taxes in future years.

These empirical lines are hard to fit into the box of orthodox theory — not that people don’t try. But so far they don’t add up to more than an eclectic set of provocative results. The creativity in mainstream empirical work has not yet been matched by any effort to find an alternative framework for thinking of the economy as a whole. For people coming from non-mainstream paradigms — Marxist or Keynesian — there is now plenty of useful material in mainstream empirical macroeconomics to draw on – much more than in the previous decade. But these new lines of empirical work have been forced on the mainstream by developments in the outside world that were too pressing to ignore. For the moment, at least, they don’t imply any systematic rethinking of economic theory.

***

Perhaps the central feature of the policy mainstream a decade ago was a smug and, in retrospect, remarkable complacency that the macroeconomic problem had been solved by independent central banks like the Federal Reserve.  For a sense of the pre-crisis consensus, consider this speech by a prominent economist in September 2007, just as the US was heading into its worst recession since the 1930s:

One of the most striking facts about macropolicy is that we have progressed amazingly. … In my opinion, better policy, particularly on the part of 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.

You might expect the speaker to be a right-wing Chicago type like Robert Lucas, whose claim that “the problem of depression prevention has been solved” was widely mocked after the crisis broke out. But in fact it was Christina Romer, soon headed to Washington as the Obama administration’s top economist. In accounts of the internal debates over fiscal policy that dominated the early days of the administration, Romer often comes across as one of the heroes, arguing for a big program of public spending against more conservative figures like Summers. So it’s especially striking that in the 2007 speech she spoke of a “glorious counterrevolution” against Keynesian ideas. Indeed, she saw the persistence of the idea of using deficit spending to fight unemployment as the one dark spot in an otherwise cloudless sky. There’s more than a little irony in the fact that opponents of the massive stimulus Romer ended up favoring drew their intellectual support from exactly the arguments she had been making just a year earlier. But it’s also a vivid illustration of a consistent pattern: ideas have evolved more rapidly in the world of practical policy than among academic economists.

For further evidence, consider a 2016 paper by Jason Furman, Obama’s final chief economist, on “The New View of Fiscal Policy.” As chair of the White House Council of Economic Advisers, Furman embodied the policy-economics consensus ex officio. Though he didn’t mention his predecessor by name, his paper was almost a point-by-point rebuttal of Romer’s “glorious counterrevolution” speech of a decade earlier. It starts with four propositions shared until recently by almost all respectable economists: that central banks can and should stabilize demand all by themselves, with no role for fiscal policy; that public deficits raise interest rates and crowd out private investment; that budget deficits, even if occasionally called for, need to be strictly controlled with an eye on the public debt; and that any use of fiscal policy must be strictly short-term.

None of this is true, suggests Furman. Central banks cannot reliably stabilize modern economies on their own, increased public spending should be a standard response to a downturn, worries about public debt are overblown, and stimulus may have to be maintained indefinitely. While these arguments obviously remain within a conventional framework in which the role of the public sector is simply to maintain the flow of private spending at a level consistent with full employment, they nonetheless envision much more active management of the economy by the state. It’s a remarkable departure from textbook orthodoxy for someone occupying such a central place in the policy world.

Another example of orthodoxy giving ground under the pressure of practical policymaking is Narayana Kocherlakota. When he was appointed as President of the Federal Reserve Bank of Minneapolis, he was on the right of debates within the Fed, confident that if the central bank simply followed its existing rules the economy would quickly return to full employment, and rejecting the idea of active fiscal policy. But after a few years on the Fed’s governing Federal Open Market Committee (FOMC), he had moved to the far left, “dovish” end of opinion, arguing strongly for a more aggressive approach to bringing unemployment down by any means available, including deficit spending and more aggressive unconventional tools at the Fed. This meant rejecting much of his own earlier work, perhaps the clearest example of a high-profile economist repudiating his views after the crisis; in the process, he got rid of many of the conservative “freshwater” economists in the Minneapolis Fed’s research department.

The reassessment of central banks themselves has run on parallel lines but gone even farther.

For twenty or thirty years before 2008, the orthodox view of central banks offered a two-fold defense against the dangerous idea — inherited from the 1930s — that managing the instability of capitalist economies was a political problem. First, any mismatch between the economy’s productive capabilities (aggregate supply) and the desired purchases of households and businesses (aggregate demand) could be fully resolved by the central bank; the technicians at the Fed and its peers around the world could prevent any recurrence of mass unemployment or runaway inflation. Second, they could do this by following a simple, objective rule, without any need to balance competing goals.

During those decades, Alan Greenspan personified the figure of the omniscient central banker. Venerated by presidents of both parties, Greenspan was literally sanctified in the press — a 1990 cover of The International Economy had him in papal regalia, under the headline, “Alan Greenspan and His College of Cardinals.” A decade later, he would appear on the cover of Time as the central figure in “The Committee to Save the World,” flanked by Robert Rubin and the ubiquitous Summers. And a decade after that he showed up as Bob Woodward’s eponymous Maestro.

In the past decade, this vision of central banks and central bankers has eroded from several sides. The manifest failure to prevent huge falls in output and employment after 2008 is the most obvious problem. The deep recessions in the US, Europe and elsewhere make a mockery of the “virtual disappearance of the business cycle” that people like Romer had held out as the strongest argument for leaving macropolicy to central banks. And while Janet Yellen or Mario Draghi may be widely admired, they command nothing like the authority of a Greenspan.

The pre-2008 consensus is even more profoundly undermined by what central banks did do than what they failed to do. During the crisis itself, the Fed and other central banks decided which financial institutions to rescue and which to allow to fail, which creditors would get paid in full and which would face losses. Both during the crisis and in the period of stagnation that followed, central banks also intervened in a much wider range of markets, on a much larger scale. In the US, perhaps the most dramatic moment came in late summer 2008, when the commercial paper market — the market for short-term loans used by the largest corporations — froze up, and the Fed stepped in with a promise to lend on its own account to anyone who had previously borrowed there. This watershed moment took the Fed from its usual role of regulating and supporting the private financial system, to simply replacing it.

That intervention lasted only a few months, but in other markets the Fed has largely replaced private creditors for a number of years now. Even today, it is the ultimate lender for about 20 percent of new mortgages in the United States. Policies of quantitative easing, in the US and elsewhere, greatly enlarged central banks’ weight in the economy — in the US, the Fed’s assets jumped from 6 percent of GDP to 25 percent, an expansion that is only now beginning to be unwound.  These policies also committed central banks to targeting longer-term interest rates, and in some cases other asset prices as well, rather than merely the overnight interest rate that had been the sole official tool of policy in the decades before 2008.

While critics (mostly on the Right) have objected that these interventions “distort” financial markets, this makes no sense from the perspective of a practical central banker. As central bankers like the Fed’s Ben Bernanke or the Bank of England’s Adam Posen have often said in response to such criticism, there is no such thing as an “undistorted” financial market. Central banks are always trying to change financial conditions to whatever it thinks favors full employment and stable prices. But as long as the interventions were limited to a single overnight interest rate, it was possible to paper over the contradiction between active monetary policy and the idea of a self-regulating economy, and pretend that policymakers were just trying to follow the “natural” interest rate, whatever that is. The much broader interventions of the past decade have brought the contradiction out into the open.

The broad array of interventions central banks have had to carry out over the past decade have also provoked some second thoughts about the functioning of financial markets even in normal times. If financial markets can get things wrong so catastrophically during crises, shouldn’t that affect our confidence in their ability to allocate credit the rest of the time? And if we are not confident, that opens the door for a much broader range of interventions — not only to stabilize markets and maintain demand, but to affirmatively direct society’s resources in better ways than private finance would do on its own.

In the past decade, this subversive thought has shown up in some surprisingly prominent places. Wearing his policy rather than his theory hat, Paul Krugman sees

… a broader rationale for policy activism than most macroeconomists—even self-proclaimed Keynesians—have generally offered in recent decades. Most of them… have seen the role for policy as pretty much limited to stabilizing aggregate demand. … Once we admit that there can be big asset mispricing, however, the case for intervention becomes much stronger… There is more potential for and power in [government] intervention than was dreamed of in efficient-market models.

From another direction, the notion that macroeconomic policy does not involve conflicting interests has become harder to sustain as inflation, employment, output and asset prices have followed diverging paths. A central plank of the pre-2008 consensus was the aptly named “divine coincidence,” in which the same level of demand would fortuitously and simultaneously lead to full employment, low and stable inflation, and production at the economy’s potential. Operationally, this was embodied in the “NAIRU” — the level of unemployment below which, supposedly, inflation would begin to rise without limit.

Over the past decade, as estimates of the NAIRU have fluctuated almost as much as the unemployment rate itself, it’s become clear that the NAIRU is too unstable and hard to measure to serve as a guide for policy, if it exists at all. It is striking to see someone as prominent as IMF chief economist Olivier Blanchard write (in 2016) that “the US economy is far from satisfying the ‘divine coincidence’,” meaning that stabilizing inflation and minimizing unemployment are two distinct goals. But if there’s no clear link between unemployment and inflation, it’s not clear why central banks should worry about low unemployment at all, or how they should trade off the risks of prices rising undesirably fast against the risk of too-high unemployment. With surprising frankness, high officials at the Fed and other central banks have acknowledged that they simply don’t know what the link between unemployment and inflation looks like today.

To make matters worse, a number of prominent figures — most vocally at the Bank for International Settlements — have argued that we should not be concerned only with conventional price inflation, but also with the behavior of asset prices, such as stocks or real estate. This “financial stability” mandate, if it is accepted, gives central banks yet another mission. The more outcomes central banks are responsible for, and the less confident we are that they all go together, the harder it is to treat central banks as somehow apolitical, as not subject to the same interplay of interests as the rest of the state.

Given the strategic role occupied by central banks in both modern capitalist economies and economic theory, this rethinking has the potential to lead in some radical directions. How far it will actually do so, of course, remains to be seen. Accounts of the Fed’s most recent conclave in Jackson Hole, Wyoming suggest a sense of “mission accomplished” and a desire to get back to the comfortable pieties of the past. Meanwhile, in Europe, the collapse of the intellectual rationale for central banks has been accompanied by the development of the most powerful central bank-ocracy the world has yet seen. So far the European Central Bank has not let its lack of democratic mandate stop it from making coercive intrusions into the domestic policies of its member states, or from serving as the enforcement arm of Europe’s creditors against recalcitrant debtors like Greece.

One thing we can say for sure: Any future crisis will bring the contradictions of central banks’ role as capitalism’s central planners into even sharper relief.

***

Many critics were disappointed the crisis of a 2008 did not lead to an intellectual revolution on the scale of the 1930s. It’s true that it didn’t. But the image of stasis you’d get from looking at the top journals and textbooks isn’t the whole picture — the most interesting conversations are happening somewhere else. For a generation, leftists in economics have struggled to change the profession, some by launching attacks (often well aimed, but ignored) from the outside, others by trying to make radical ideas parsable in the orthodox language. One lesson of the past decade is that both groups got it backward.

Keynes famously wrote that “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” It’s a good line. But in recent years the relationship seems to have been more the other way round. If we want to change the economics profession, we need to start changing the world. Economics will follow.

Thanks to Arjun Jayadev, Ethan Kaplan, Mike Konczal and Suresh Naidu for helpful suggestions and comments.

Links for May 25, 2016

Deliberately. The IMF has released its new Debt Sustainability Analysis for Greece. Frances Coppola has the details, and they are something. Per the IMF,

Demographic projections suggest that working age population will decline by about 10 percentage points by 2060. At the same time, Greece will continue to struggle with high unemployment rates for decades to come. Its current unemployment rate is around 25 percent, the highest in the OECD, and after seven years of recession, its structural component is estimated at around 20 percent. Consequently, it will take significant time for unemployment to come down. Staff expects it to reach 18 percent by 2022, 12 percent by 2040, and 6 percent only by 2060.

Frances adds:

For Greece’s young people currently out of work, that is all of their working life. A whole generation will have been consigned to the scrapheap. …

The truth is that seven years of recession has wrecked the Greek economy. It is no longer capable of generating enough jobs to employ its population. The IMF estimates that even in good times, 20 percent of adults would remain unemployed. To generate the jobs that are needed there will have to be large numbers of new businesses, perhaps even whole new industries. Developing such extensive new productive capacity takes time and requires substantial investment – and Greece is not the most attractive of investment prospects. Absent something akin to a Marshall Plan, it will take many, many years to repair the damage deliberately inflicted on Greece by European authorities and the IMF in order to bail out the European banking system.

For some reason, that reminds me of this. Good times.

Also, here’s the Economist, back in 2006:

The core countries of Europe are not ready to make the economic reforms they so desperately need—and that will change, alas, only after a diabolic economic crisis. … The sad truth is that voters are not yet ready to swallow the nasty medicine of change. Reform is always painful. And there are too many cosseted insiders—those with secure jobs, those in the public sector—who see little to gain and much to lose. … One reason for believing that reform can happen … is that other European countries have shown the way. Britain faced economic and social meltdown in 1979; there followed a decade of Thatcherite reform. … The real problem, not just for Italy and France but also for Germany, is that, so far, life has continued to be too good for too many people.

I bet they’re pretty pleased right now.

 

 

Polanyism. At Dissent, Mike Konczal and Patrick Iber have a very nice introduction to Karl Polanyi. One thing I like about this piece is that they present Polanyi as a sort of theoretical back-formation for the Sanders campaign.

The vast majority of Sanders’s supporters … are, probably without knowing it, secret followers of Karl Polanyi. …

One of the divides within the Democratic primary between Bernie Sanders and Hillary Clinton has been between a social-democratic and a “progressive” but market-friendly vision of addressing social problems. Take, for example, health care. Sanders proposes a single-payer system in which the government pays and health care directly, and he frames it explicitly in the language of rights: “healthcare is a human right and should be guaranteed to all Americans regardless of wealth or income.” … Sanders offers a straightforward defense of decommodification—the idea that some things do not belong in the marketplace—that is at odds with the kind of politics that the leadership of the Democratic Party has offered … Polanyi’s particular definition of socialism sounds like one Sanders would share.

 

Obamacare and the insurers. On the subject of health care and decommodification, I liked James Kwak’s piece on Obamacare.

The dirty not-so-secret of Obamacare … is that sometimes the things we don’t like about market outcomes aren’t market failures—they are exactly what markets are supposed to do. …  at the end of the day, Obamacare is based on the idea that competition is good, but tries to prevent insurers from competing on all significant dimensions except the one that the government is better at anyway. We shouldn’t be surprised when insurance policies get worse and health care costs continue to rise.

It’s too bad so many intra-Democratic policy debates are conducted in terms of the radical-incremental binary, it’s not really meaningful. You can do more or less of anything. Would be better to focus on this non-market vs market question.

In this context, I wish there’d been some discussion in the campaign of New York’s new universal pre-kindergarten, which is a great example incremental decommodification in practice. Admittedly I’m a bit biased — I live in New York, and my son will be starting pre-K next year. Still: Here’s an example of a social need being addressed not through vouchers, or tax credits, or with means tests, but through a universal public services, provided — not entirely, but mainly and increasingly — by public employees. Why isn’t this a model?

 

The prehistory of the economics profession. I really liked this long piece by Marshall Steinbaum and Bernard Weisberger on the early history of the American Economics Association. The takeaway is that the AEA’s early history was surprisingly radical, both intellectually and in its self-conception as part of larger political project. (Another good discussion of this is in Michael Perelman’s Railroading Economics.) This is history more people should know, and Steinbaum and Weisberger tell it well. I also agree with their conclusion:

That [the economics profession] abandoned “advocacy” under the banner of “objectivity” only raises the question of what that distinction really means in practice. Perhaps actual objectivity does not require that the scholar noisily disclaim advocacy. It may, in fact, require the opposite.

The more I struggle with this stuff, the more I think this is right. A field or discipline needs its internal standards to distinguish valid or well-supported claims from invalid or poorly supported ones. But evaluation of relevance, importance, correspondence to the relevant features of reality can never be made on the basis of internal criteria. They require the standpoint of some outside commitment, some engagement with the concrete reality you are studying distinct from your formal representations of it. Of course that engagement doesn’t have to be political. Hyman Minsky’s work for the Mark Twain Bank in Missouri, for example, played an equivalent role; and as Perry Mehrling observes in his wonderful essay on Minsky, “It is significant that the fullest statement of his business cycle theory was published by the Joint Economic Committee of the U.S. Congress.” But it has to be something. In economics, I think, even more than in other fields, the best scholarship is not going to come from people who are only scholars.

 

Negative rates, so what. Here’s a sensible look at the modest real-world impact of negative rates from Brian Romanchuk. It’s always interesting to see how these things look from the point of view of market participants. The importance of a negative policy rate has nothing to do with the terms on which present consumption trades off against future consumption, it’s about one component of the return on some assets relative to others.

 

I’m number 55. Someone made a list of the top 100 economics blogs, and put me on it. That was nice.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”

Liquidity Preference on the F Line

Sitting on the subway today, I was struck by the fact that the three ads immediately opposite me were all for what you might call liquidity services. On the left was an ad for “personal asset loans” from something called Borro: “With this necklace … I funded my first business,” says a satisfied customer. Next to it was an MTA ad trumpeting the fact that you can pay your fare with a credit card. And then one from AptDeco.com, which I guess is a clearinghouse for used furniture sales, with the tagline “NYC is now your furniture store.”

the Borro ad was the next one to the left

This was interesting to me because I’ve just been thinking about the neutrality of money, and what an incoherent and contradictory idea it is.

The orthodox view is that the level of “real” economic activity is determined by “real” factors — endowments, tastes, technology — and people simply hold money balances proportionate to this level of activity. In this view, a change in the money supply can’t make anyone better or worse off, at least in the long run, or change anything about the economy except the price level.

Just looking at these ads shows us why that can’t be true. First of all, the question of what constitutes money. All three of these ads are, in effect, inviting you to use something as money that you couldn’t previously. Without the specialized intermediary services being hawked here, you couldn’t pay the startup costs of a business with a necklace (what’s this thing made of, plutonium?), or pay for a subway ride with a promise to pay later, or pay for much of anything with a used couch. And this new liquidity has real benefits — otherwise, no one would be buying it, and it wouldn’t be worth the cost of producing (or advertising) it. The idea — stated explicitly in the Borro ad — is that the liquidity they provide allows transactions to take place that otherwise wouldn’t. The ability to turn a piece of jewelry or a car into cash allows people to use productive capacities that otherwise would go to waste.

And of course this makes sense. The orthodox view is that money is useful — there must be a reason that we don’t live in a barter world, and more than that, that all this huge industry of liquidity provision exists. But money, for some reason, is not subject to the same kind of smoothly diminishing returns that other useful things are. There is a fixed amount you need, you can’t get by with less, and there’s no benefit at all in having more. The problem is worse than that, since the standard view is that money demand is strictly proportionate to the volume of transactions. But, which transactions? Presumably, the amount of economic activity depends on the availability of money — that’s what it means to say that money is useful. And furthermore, as these ads implicitly make clear, some transactions are more liquidity-intensive than others. No one is offering specialized intermediary services to help you buy a hamburger. So both the level and composition of economic activity must depend on money holdings. But in that case, you can’t say that money holdings depend only on the volume of activity — that would be circular. In a world where money is used at all, it can’t be neutral. An increase in the money supply (or better, in liquidity) may raise prices, but it won’t do so proportionately, since it also enables people to benefit from increasing their money holdings (or: shifting toward more liquid balance sheet positions) and to carry out liquidity-intensive transactions that were formerly unable to.

This is a very old issue in economics. The idea that money should be neutral is as old as the discipline, and so is this line of criticism of it. You can find both already in Hume. In “Of Money,” he lays out the argument that money must be neutral in the long run, since it is just an intrinsically meaningless unit of measure; real wealth depends on real resources, not on the units we count them in. Unlike most later writers, he follows this argument to its logical conclusion, that any resources devoted to liquidity provision are wasted:

This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous to every nation. That provisions and labour should become dear by the encrease of trade and money, is, in many respects, an inconvenience; but an inconvenience that is unavoidable, and the effect of that public wealth and prosperity which are the end of all our wishes. … But there appears no reason for encreasing that inconvenience by a counterfeit money, which foreigners will not accept of in any payment, and which any great disorder in the state will reduce to nothing. There are, it is true, many people in every rich state, who having large sums of money, would prefer paper with good security; as being of more easy transport and more safe custody. … And therefore it is better, it may be thought, that a public company should enjoy the benefit of that paper-credit, which always will have place in every opulent kingdom. But to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer. And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.

You can find similar language in “On the Balance of Trade”:

I scarcely know any method of sinking money below its level [i.e. producing inflation], but those institutions of banks, funds, and paper-credit, which are so much practised in this kingdom. These render paper equivalent to money, circulate it throughout the whole state, make it supply the place of gold and silver, raise proportionably the price of labour and commodities, and by that means either banish a great part of those precious metals, or prevent their farther encrease. What can be more shortsighted than our reasonings on this head? We fancy, because an individual would be much richer, were his stock of money doubled, that the same good effect would follow were the money of every one encreased; not considering, that this would raise as much the price of every commodity, and reduce every man, in time, to the same condition as before.

It is indeed evident, that money is nothing but the representation of labour and commodities, and serves only as a method of rating or estimating them. Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself; any more than it would make an alteration on a merchant’s books, if, instead of the Arabian method of notation, which requires few characters, he should make use of the Roman, which requires a great many. 

From this view — which is, again, just taking the neutrality of money to its logical conclusion — services like the ones being advertised on the F train are the exact opposite of what we want. By making more goods usable as money, they are only contributing to inflation. Rather than making it easier for people to use necklaces, furniture, etc. as means of payment, we should rather be discouraging people form using even currency as means of payment, by reducing banks to safe-deposit boxes.

That was where Hume left the matter when he first wrote the essays around 1750. But when he republished “On the Balance of Trade” in 1764, he was no longer so confident. [1] The new edition added a discussion of the development of banking in Scotland with a strikingly different tone:

It must, however, be confessed, that, as all these questions of trade and money are extremely complicated, there are certain lights, in which this subject may be placed, so as to represent the advantages of paper-credit and banks to be superior to their disadvantages. … The encrease of industry and of credit … may be promoted by the right use of paper-money. It is well known of what advantage it is to a merchant to be able to discount his bills upon occasion; and every thing that facilitates this species of traffic is favourable to the general commerce of a state. But private bankers are enabled to give such credit by the credit they receive from the depositing of money in their shops; and the bank of England in the same manner, from the liberty it has to issue its notes in all payments. There was an invention of this kind, which was fallen upon some years ago by the banks of Edinburgh; and which, as it is one of the most ingenious ideas that has been executed in commerce, has also been thought advantageous to Scotland. It is there called a Bank-Credit; and is of this nature. A man goes to the bank and finds surety to the amount, we shall suppose, of a 1000 pounds. This money, or any part of it, he has the liberty of drawing out whenever he pleases, and he pays only the ordinary interest for it, while it is in his hands. … The advantages, resulting from this contrivance, are manifold. As a man may find surety nearly to the amount of his substance, and his bank-credit is equivalent to ready money, a merchant does hereby in a manner coin his houses, his household furniture, the goods in his warehouse, the foreign debts due to him, his ships at sea; and can, upon occasion, employ them in all payments, as if they were the current money of the country.

Hume is describing something like a secured line of credit, not so different from the services being advertised on the F line, which also offer ways to coin your houses and household furniture. The puzzle is why he thinks this is a good thing. The trade credit provided by banks, which is now “favourable to the general commerce of the state,” is precisely what he was trying to prevent when he wrote that the best bank was one that “locked up all the money it received.”Why does he now think that increasing liquidity will stimulate industry, instead of just producing a rise in prices that will “reduce every man, in time, to the same condition as before”?

You can’t really hold it against Hume that he never resolved this contradiction. But what’s striking is how little the debate has advanced in the 250 years since. Indeed, in some ways it’s regressed. Hume at least drew the logical conclusion that in a world of neutral money, liquidity services like the ones advertised on the F train would not exist.

[1] I hadn’t realized this section was a later addition until reading Arie Arnon’s discussion of the essay in Monetary Theory and Policy from Hume and Smith to Wicksell. I hope to be posting more about this superb book in the near future.

Innovation in Higher Ed, 1680 Edition

Does anybody read Bagehot’s Lombard Street any more? You totally should, it’s full of good stuff. It’s baffling to me, as a sometime teacher of History of Economic Thought, that most of the textbooks and anthologies don’t mention him at all. Anyway, here he’s quoting Macaulay:

During the interval between the Restoration and the  Revolution the riches of the nation had been rapidly increasing. Thousands of busy men found every Christmas that, after the expenses of  the year’s housekeeping had been defrayed out of the year’s income, a surplus remained ; and how that surplus was to be employed was a question of some difficulty. In … the seventeenth century, a lawyer, a physician, a retired merchant, who had saved some thousands, and who wished to place them safely and profitably, was often greatly embarrassed. … Many, too, wished to put their money where they could find it at an hour’s notice, and looked about for some species of property which could be more readily transferred than a house or a field. A capitalist might lend … on personal security : but, if he did so, he ran a great risk of losing interest and principal. There were a few joint-stock companies, among which the East India Company held the foremost place : but the demand for the stock of such companies was far greater than the supply. … So great was that difficulty that the practice of hoarding was common. We are told that the father  of Pope, the poet, who retired from business in the City about the time of the Revolution, carried to a retreat in the country a strong-box containing near twenty thousand pounds, and took out from time to time what was required for household expenses… 

The natural effect of this state of things was that a crowd of projectors, ingenious and absurd, honest and knavish, employed themselves in devising new schemes for the employment of redundant capital. It was about the year 1688 that the word stock-jobber was first heard London. In the short space of four years a crowd of companies, every one of which confidently held out to subscribers the hope of immense gains, sprang into existence… There was a Tapestry Company, which would soon furnish pretty hangings for all the parlors of the middle class and for all the bedchambers of the higher. There was a Copper Company, which proposed to explore the mines of England, and held out a hope that they would prove not less valuable than those of Potosi. There was a Diving Company, which undertook to bring up precious effects from shipwrecked vessels, and which announced that it had laid in a stock of wonderful machines resembling complete suits of armor. In front of the helmet was a huge glass eye like that of Polyphemus ; and out of the crest went a pipe through which the air was to be admitted. … There was a society which undertook the office of giving gentlemen a liberal education on low terms, and which assumed the sounding name of the Royal Academies Company. In a pompous advertisement it was announced that the directors of the Royal Academies Company had engaged the best masters in every branch of knowledge, and were about to issue twenty thousand tickets at twenty shillings each. There was to be a lottery : two thousand prizes were to be drawn; and the fortunate holders of the prizes were to be taught, at the charge of the Company, Latin, Greek, Hebrew, French, Spanish, conic sections, trigonometry, heraldry, japanning, fortification, book-keeping, and the art of playing the theorbo.

Many of Macaulay’s examples, which I’ve left out here, are familiar, thanks to Charles Mackay and more recent historians of financial folly. (Including everyone’s favorite, the company that raised funds “for an Undertaking which in due time shall be revealed.”) The line about Pope is also familiar, at least to reader of The General Theory: Keynes cites it as an illustration of the position of the wealth-holder in a world where the rentier had been successfully euthanized. But I, at least, had never realized that the diving suit was a product of the South Sea bubble. And I’d never heard of this spiritual ancestor of Chris Whittle and Michelle Rhee.

It would be interesting to learn more about the claims that were made for this company, and what happened to it. Alas, Google is no help. Although, “Royal Academies Company” turns out to be a weirdly popular phrase among the Markov-chain text generators that populate fake spam blogs. (Seriously, guys, this is poetry.) We can only hope that today’s enterprises that promise to give gentlemen a liberal education on low terms  (or at least an education in japanning and/or ski area management) will vanish as ignominiously.

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.

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.

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.

Where Do Interest Rates Come From?

What determines the level of interest rates? It seems like a simple question, but I don’t think economics — orthodox or heterodox — has an adequate answer.

One problem is that there are many different interest rates. So we have two questions: What determines the overall level of interest rates, and what determines the spreads between different interest rates? The latter in turn we can divide into the question of differences in rates between otherwise similar loans of different lengths (term spreads), differences in rates between otherwise similar loans denominated in different currencies, and all the remaining differences, grouped together under the possibly misleading name risk spreads.

In any case, economic theory offers various answers:

1. The orthodox answer, going back to the 18th century, is that the interest rate is a price that equates the desire to save with the desire to borrow. As reformulated in the later 19th century by Bohm-Bawerk, Cassel, etc., that means: The interest rate is the price of goods today relative to goods tomorrow. The interest rate is the price that balances the gains from deferring consumption with our willingness to do so. People generally prefer consumption today to consumption in the future, and because it will be possible to produce more in the future than today, so the interest rate is (normally) positive. This is a theory of all transactions that exchange spending in one period for spending (or income) in another, not specifically a theory of the interest rate on loans.

The Wicksell variant of this, which is today’s central-bank orthodoxy, is that there is a well-defined natural interest rate in this sense but that for some reason markets get this one price wrong.

2. An equally old idea is that the interest rate is the price of money. In Hume’s writings on money and interest, for instance, he vacillates between this and the previous story. It’s not a popular view in the economics profession but it’s well-represented in the business world and among populists and monetary reformers,. In this view, money is just another input to the production process, and the interest rate is its price. A creditor, in this view, isn’t someone deferring consumption to the future, but someone who — like a landlord — receives an income thanks to control of a necessary component of the production process. A business, let’s say, that needs to maintain a certain amount of working capital in the form of money or similarly liquid assets, may need to finance it with a loan on which it pays interest. Interest payments are in effect the rental price of money, set by supply and demand like anything else. As I say, this has never been a respectable view in economic theory, but you can find it in more empirical work, like this paper by Gabriel Chodorow-Reich, where credit is described in exactly these terms as an input to current production.

3. Keynes’ liquidity-preference story in The General Theory. Here again the interest rate is the price of money. But now instead of asking how much the marginal business borrower will pay for the use of money, we ask how much the marginal wealth owner needs to be compensated to give up the liquidity of money for a less-liquid bond. The other side of the market is given by a fixed stock of bonds; evidently we are dealing with a short enough period that the flow of new borrowing can be ignored, and the bond stock treated as exogenously fixed. With no new borrowing, the link from the interest rate is liked to the real economy because it is used to discount the expected flow of profits from new investment — not by business owners themselves, but by the stock market. It’s an oddly convoluted story.

4. A more general liquidity-preference story. Jorg Bibow, in a couple of his essential articles on the Keynesian theory of liquidity preference, suggests that many of the odd features of the theory are due to Keynes’ decision to drop the sophisticated analysis of the financial system from The Treatise on Money and replace it with an assumption of an exogenously fixed money stock. (It’s striking that banks play no role in in the General Theory.) But I’m not sure how much simpler this “simplification” actually makes the story, or whether it is even logically coherent; and in any case it’s clearly inapplicable to our modern world of bank-created credit money. In principle, it should be possible to tell a more general version of the liquidity preference story, where, instead of wealth holders balancing the income from holding a bond against the liquidity from holding “money,” you have banks balancing net income against incremental illiquidity from simultaneously extending a loan and creating a deposit. I’m afraid to say I haven’t read the Treatise, so I don’t know how much you can find that story there. In any case it doesn’t seem to have been developed systematically in later theories of endogenous money, which typically assume that the supply of credit is infinitely elastic except insofar as it’s limited by regulation.

5. The interest rate is set by the central bank. This is the orthodox story when we turn to the macro textbook. It’s also the story in most heterodox writers. From Wicksell onward, the whole discussion about interest rates in a macroeconomic context is about how the central bank can keep the interest rate at the level that keeps current expenditure at the appropriate level, and what happens if it fails to do so. It is sometimes suggested that the optimal or “natural” interest rate chosen by the central bank should be the the Walrasian intertemporal exchange rate — explicitly by Hayek, Friedman and sometimes by New Keynesians like Michael Woodford, and more cautiously by Wicksell. But the question of how the central bank sets the interest rate tends to drop out of view. Formally, Woodford has the central bank set the interest rate by giving it a monopoly on lending and borrowing. This hardly describes real economies, of course, but Woodford insists that it doesn’t matter since central banks could control the interest rate by standing ready to lend or borrow unlimited amounts at thresholds just above and below their target. The quite different procedures followed by real central banks are irrelevant. [1]

A variation of this (call it 5a) is where reserve requirements bind and the central bank sets the total quantity of bank credit or money. (In a world of bind reserve requirements, these will be equivalent.) In this case, the long rate is set by the demand for credit, given the policy-determined quantity. The interbank rate is then presumably bid up to the minimum spread banks are willing to lend at. In this setting causality runs from long rates to short rates, and short rates don’t really matter.

6. The interest rate is set by convention. This is Keynes’ other theory of the interest rate, also introduced in the General Theory but more fully developed in his 1937 article “Alternative Theories of the Rate of Interest.” The idea here is that changes in interest rates imply inverse changes in the price of outstanding bonds. So from the lenders’ point of view, the expected return on a loan includes not only the yield (as adjusted for default risk), but also the capital gain or loss that will result if interest rates change while the loan is still on their books. The longer the term of the loan, the larger these capital gains or losses will be. I’ve discussed this on the blog before and may come back to it in the future, but the essential point is that if people are very confident about the future value of long rates (or at least that they will not fall below some floor) then the current rate cannot get very far from that future expected rate, no matter what short rates are doing, because as the current long rate moves away from the expected long rate expected capital gains come to dominate the current yield. Take the extreme case of a perpetuity where market participants are sure that the rate will be 5% a year from now. Suppose the short rate is initially 5% also, and falls to 0. Then the rate on the perpetuity will fall to just under 4.8% and no lower, because at that rate the nearly 5% spread over the short rate just compensates market participants for the capital loss they expect when long rates return to their normal level. (Obviously, this is not consistent with rational expectations.) These kinds of self-stabilizing conventional expectations are the reason why, as Bibow puts it, “a liquidity trap … may arise at any level of interest.” A liquidity trap is an anti-bubble, if you like.

What do we think about these different stories?

I’m confident that the first story is wrong. There is no useful sense in which the interest rate on debt contracts — either as set by markets or as target by the central bank — is the price of goods today in terms of goods tomorrow. The attempt to understand interest rates in terms of the allocation across time of scarce means to alternative ends is a dead end. Some other intellectual baggage that should overboard with the “natural” rate of interest are the “real”rate of interest, the idea of consumption loans, and the intertemporal budget constraint.

But negative criticism of orthodoxy is too easy. The real work is to make a positive case for an alternative. I don’t see a satisfactory one here.

The second and third stories depend on the existence of “money” as a distinct asset with a measurable, exogenously fixed quantity. This might be a usable assumption in some historical contexts — or it might not — but it clearly does not describe modern financial systems. Woodford is right about that.

The fifth story is clearly right with respect short rates, or at least it was until recently. But it’s incomplete. As an empirical matter, it is true that interbank rates and similar short market rates closely follow the policy rate. The question is, why? The usual answer is that the central bank is the monopoly supplier of base money, and base money is used for settlement between banks. This may be so, but it doesn’t have to be. Plenty of financial systems have existed without central banks, and banks still managed to make payments to each other somehow. And where central banks exist, they don’t always have a monopoly on interbank settlement. During the 19th century, the primary tool of monetary policy at the Bank of England was the discount rate — the discount off of face value that the bank would pay for eligible securities (usually trade credit). But if the discount rate was too high — if the bank offered too little cash for securities — private banks would stop discounting securities at the central bank, and instead find some other bank that was willing to give them cash on more favorable terms. This was the problem of “making bank rate effective,” and it was a serious concern for 19th century central banks. If they tried to raise interest rates too high, they would “lose contact with the market” as banks simply went elsewhere for liquidity.

Obviously, this isn’t a problem today — when the Fed last raised policy rates in the mid-2000s, short market rates rose right along with it. Or more dramatically, Brazil’s central bank held nominal interest rates around 20 percent for nearly a decade, while inflation averaged around 8 percent. [2] In cases like these, the central bank evidently is able to keep short rates high by limiting the supply of reserves. But why in that case doesn’t the financial system develop private substitutes for reserves? Mervyn King blandly dismisses this question by saying that “it does not matter in principle whether the disequilibrium in the money market is an aggregate net shortage or a net surplus of funds—control of prices or quantities carries across irrespective of whether the central bank is the monopoly supplier or demander of its own liabilities.” [3] Clearly, the central bank cannot be both the monopoly supplier and the monopoly demander of reserves, at least not if it wants to have any effect on the rest of the world. The relevant question — to which King offers no answer — is why there are no private substitutes for central bank reserves. Is it simply a matter of legal restrictions on interbank settlements using any other asset? But then why has this one regulatory barrier remained impassable while banks have tunneled through so many others? Anyway, going forward the question may be moot if reserves remain abundant, as they will if the Fed does not shrink its balance sheet back to pre-crisis levels. In that case, new tools will be required to make the policy rate effective.

The sixth story is the one I’m most certain of. First, because it can be stated precisely in terms of asset market equilibrium. Second, because it is consistent with what we see historically. Long term interest rates are quite stable over very long periods. Third, it’s consistent with what market participants say: It’s easy to find bond market participants saying that some rate is “too low” and won’t continue, regardless of what the Fed might think. Last, but not least from my point of view, this view is clearly articulated by Keynes and by Post Keynesians like Bibow. But while I feel sure this is part of the story, it can’t be the whole story. First, because even if a conventional level of interest rates is self-stabilizing in the long run, there are clearly forces of supply and demand in credit markets that push long rates away from this level in the short run. This is even more true if what convention sets is less a level of interest rates, than a floor. And second, because Keynes also says clearly that conventions can change, and in particular that a central bank that holds short rates outside the range bond markets consider reasonable for long enough, will be able to change the definition of reasonable. So that brings us back to the question of how it is that central banks are able to set short rates.

I think the fundamental answer lies behind door number 4. I think there should be a way of describing interest rates as the price of liquidity, where liquidity refers to the capacity to honor one’s promises, and not just to some particular asset. In this sense, the scarce resource that interest is pricing is trust. And monetary policy then is at root indistinguishable from the lender of last resort function — both are aspects of the central bank’s role of standing in as guarantor for commitments within the financial system.  You can find elements of this view in the Keynesian literature, and in earlier writers going back to Thornton 200-plus years ago. But I haven’t seen it stated systematically in way that I find satisfactory.

UPDATE: For some reason I brought up the idea of the interest rate as the price of money without mentioning the classic statement of this view by Walter Bagehot. Bagehot uses the term “price of money” or “value of money” interchangeably with “discount rate” as synonyms for the interest rate. The discussion in chapter 5 of Lombard Street is worth quoting at length:

Many persons believe that the Bank of England has some peculiar power of fixing the value of money. They see that the Bank of England varies its minimum rate of discount from time to time, and that, more or less, all other banks follow its lead, and charge much as it charges; and they are puzzled why this should be. ‘Money,’ as economists teach, ‘is a commodity, and only a commodity;’ why then, it is asked, is its value fixed in so odd a way, and not the way in which the value of all other commodities is fixed? 

There is at bottom, however, no difficulty in the matter. The value of money is settled, like that of all other commodities, by supply and demand… A very considerable holder of an article may, for a time, vitally affect its value if he lay down the minimum price which he will take, and obstinately adhere to it. This is the way in which the value of money in Lombard Street is settled. The Bank of England used to be a predominant, and is still a most important, dealer in money. It lays down the least price at which alone it will dispose of its stock, and this, for the most part, enables other dealers to obtain that price, or something near it. … 

There is, therefore, no ground for believing, as is so common, that the value of money is settled by different causes than those which affect the value of other commodities, or that the Bank of England has any despotism in that matter. It has the power of a large holder of money, and no more. Even formerly, when its monetary powers were greater and its rivals weaker, it had no absolute control. It was simply a large corporate dealer, making bids and much influencing—though in no sense compelling—other dealers thereby. 

But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value, and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic…. 

If money were all held by the owners of it, or by banks which did not pay an interest for it, the value of money might not fall so fast. … The possessors would be under no necessity to employ it all; they might employ part at a high rate rather than all at a low rate. But in Lombard Street money is very largely held by those who do pay an interest for it, and such persons must employ it all, or almost all, for they have much to pay out with one hand, and unless they receive much with the other they will be ruined. Such persons do not so much care what is the rate of interest at which they employ their money: they can reduce the interest they pay in proportion to that which they can make. The vital point to them is to employ it at some rate… 

The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

The relevant point in this context is the explicit statement that the interest, or discount, rate is set by the supply and demand for money. But there are a couple other noteworthy things. First, the concept of supply and demand is one of monopolistic competition, in which lenders are not price takers, but actively trade off markup against market share. And second, that the demand for money (i.e. credit) is highly inelastic because money is needed not only or mainly to purchase goods and services, but first and foremost to meet contractual money commitments.

[1] See Perry Mehrling’s useful review. Most of the text of Woodford’s textbook can be downloaded for free here. The introduction is nontechnical and is fascinating reading if you’re interested in this stuff.

[2] Which is sort of a problem for Noah Smith’s neo-Fisherite view.

[3] in the same speech, King observes that “During the 19th century, the Bank of England devoted considerable attention to making bank rate ‘effective’.” His implication is that central banks have always been able to control interest rates. But this is somewhat misleading, from my point of view: the Bank devoted so much attention to making its rate “effective” precisely because of the occasions when it failed to do so.