Wednesday, September 28, 2011

Lucas in context, Keynes out of context


Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):
"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.
What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."
Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

13 comments:

  1. I obvioulsy agree. I would just add the fact that NK and NC/RBC in the end are models of exogenous stochastic shocks, and of the rational impulse responses to them. It is hard to think about any crisis as a mere exogenous shock. The current crisis arose endogenously from the incentives that were built in the financial system (yes, this sentence is very mainstream:) ). That is very different from an oil shock, or the "preference shocks" that most NKs like to put in their utility functions.

    In other words, these models are by construction useless when it comes to serious crashes.

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  2. http://delong.typepad.com/sdj/2011/09/teaching-keynesian-economics-to-your-bulldog.html

    talk about the blind leading the blind...

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  3. Another point: during the time period covered by the post, the canonical General Equilibrium model was becoming the Arrow-Debreu model of intertemporal equilibrium. An increasing emphasis on this very short run model was also a response to the 1960s capital debates.

    I've pointed out before that the employment rate is not well-defined in this model, since an equilibrium is a time path in which employment varies along that path. A spot market exists for immediate supplies of labor services. And forward markets exist for the supplies of labor services a week hence, two weeks hence, etc. On which market is "the natural rate of unemployment" to be found?

    In the Arrow-Debreu model, the initial quantities of capital goods are among the data. Any time to reach equilibrium is too long since those data defining the equilibria would change during any approach to equilibrium. So I don't see how a story about rigidities being slowly overcome can be microfounded.

    And furthermore stories about firms substituting cheaper labor for more expensive capital are not founded in this model either.

    I agree with the post: what logic?

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  4. Thanks for the compliments and complements. Agreed on both counts. As far as I can tell the only consistent models that emphasize endogenous cycles are based on a version of multiplier-accelerator dynamics. In particular, the non-linear version of Kaldor-Goodwin (the 51 not 67 Goodwin) do not need shocks. With the income effect of the accelerator you have cycles, and with the capacity effect you have the super-multiplier. Also, very important to emphasize the change in the notion of equilibrium as a consequence of the capital debates. Also, in the AD model the natural rate of interest would be difficult to find, since it is unclear in what market it would be defined. Hints of Sraffa 1932.

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  5. agreed with Robert. Most economist talk about equilibrium as a centre of gravitation of "actual variables"; For example in the higly praised Dornbusch´s model of overshooting the actual real exchange rate seems to "gravitate" towards it´s equilibrium vale.
    As far as i know, most economist use the old notion of equilibrium, since Arrow-Debreu sheds no light on the issue

    gualra

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  6. I've also found this post fascinating and would like to congratulate the author.

    I wonder if the readers or the author are aware that Keynes' quote above has a remarkable similarity to the underconsumptionist interpretation of Marx's crisis theory?

    Granted, the causal mechanism that Marx envisaged (over-investment and over-production) are left out of the picture; Keynes introduces some nuances that Marx did not consider (the discussion about the transfer from entrepreneurs to rentiers, for instance).

    I also couldn't help but notice these two passages:

    "By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the NEOCLASSICAL THEORY OF VALUE and there are no restrictions the system moves to full employment." [Emphasis added]

    And just below it, the following one:

    [Assuming unemployment and falling real wages] "However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities"

    The first passage establishes two conditions: (1) that "the neoclassical theory of value" holds and (2) "there are no restrictions [so that] the system moves to full employment".

    But we find, according to the above interpretation that even if both assumptions hold true, "is not generally true that there is a tendency for the full utilization of 'factors of production' according to their relative scarcities", because "labor (which is cheaper) is used in the machine sector too their price should fall too".

    I find that this last passage clearly evocative of the labour theory of value: we are speaking of labour costs largely determining the price of commodities used "in the machine sector".

    Am I misreading the passages? I'd appreciate it comments or an outright correction.

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  7. Nope, you are on the right track. Particularly if you think that Sraffa's Production of Commodities is a revival of the labor theory of value. Sraffa suggests in the appendix, that his standard commodity solution should be seen as akin to Smithian labor commanded, in fact.

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  8. Although I certainly like the main drift of your argument, I think there is an amount of ambiguity when discussing Krugman's view. In the article referred to, Krugman is referring to Keynesian economics and NOT Keynes' economics.
    When it comes to the utterly ridiculous NC portraying of Keynes as an economist explaining unemployment as a result of wage rigidites, Chad Jones' Macroeconomics textbook (2nd ed 2011) is the latest example of the perversity
    (http://larspsyll.wordpress.com/2011/07/14/chad-jones-macroeconomics-textbook-utter-nonsense-on-keynes-and-wage-rigidities/)

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  9. Hi NK,

    I've been revisiting this post ever since it was published and I always find new things to think about.

    This time I would like to play the devil's advocate using the first part of Keynes' quote:

    "A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (...)."

    I suppose a mainstream economist would accept the first sentence ("A reduction of money-wages will somewhat reduce prices") as a reasonable assumption. So there is no need to further dwell on it.

    The second sentence ("It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced"), however, would likely be countered on the grounds that lower nominal wages make labour more attractive, relative to "other factors entering into marginal prime cost whose remuneration has not been reduced".

    In that case, there could be some kind of substitution effect, whereby more labour is employed and less of the other factors. If that happened, then depending on the price-elasticity of demand of labour, nominal income could increase. Combined with lower prices, this could bring about higher real wages.

    Is there a theoretical counter-argument against this objection?

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    Replies
    1. HiMagpie:
      Yes indeed that would be the conventional argument, and what Keynes' was suggesting was that the income effect, associated with lower wages, would more than compensate any possible substitution effect. However, more important than that is that the capital debates show that there is no reason for the substitution effect to be operative. If wages fall, the cost of labor falls, but also the costs of say a machine used in production (since labor is also used in its production). It could happen than that with the fall in wages proportinally more of that machine rather than labor is demanded. In that case, both the substitution and income effect imply that as wages fall less labor is demanded. By the way, real wages are pro-cyclical (go down with recessions). Mainstream theory must suggest that a negative technological (real) shock to the demand for labor took place. No such thing is necessary once you dismiss the neolcassical production function and its implicit notion of capital.

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  10. Thanks!

    Yes, I thought so (you suggested that in the text, too).

    I wanted to be really sure on this, because at least some commentators on Marxist crisis theory appear to be using the mainstream framework.

    See here for a recent example (although there are many other, much clearer, ones): http://yanisvaroufakis.eu/2012/04/04/on-keynes-marx-and-the-value-of-models-at-a-time-of-crisis-a-reply-to-david-laibman/

    I suppose the way to settle this dispute is on empirical grounds. What are the main references here?

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