The General Theory at 90: The reconstruction of macroeconomics

On February 4, 1936, Maynard Keynes published The General Theory of Employment, Interest and Money (GT). I'm off by a few days. ROKE did notice it, but I had no time to post. I recently presented on the social policies discussed in the last chapter of the book at the ASSA Meetings in Philly (photo below; paper soon, hopefully).

Ninety years later, the book remains perhaps the single most important book in twentieth-century economics. The work that most decisively changed the direction of the discipline. And yet, much of what people think about the book is wrong.

The first thing to understand is that the GT is not a book about economic policy. Keynes says so explicitly at the outset. It is a theoretical work, written for fellow economists. It is not a blueprint for government spending programs. It is not a political manifesto. It is not a defense of deficit finance in simple terms. It is a theoretical reconstruction of how a monetary economy actually works.

The popular image of Keynes as the prophet of fiscal stimulus obscures this. Ironically, the book itself says very little about fiscal policy. There are some vague remarks about what Keynes calls the “socialization of investment,” but there is no systematic discussion of fiscal policy, for how to pursue expansionary fiscal policy or the construction of the welfare state, which is also often associated with Keynes. The policies we associate with Keynesianism, deficit spending, expansionary fiscal policy, tolerance for deficits and debt, at least in times of crisis, are not the core contribution of the book.

Another important historical irony, the GT arrived relatively late, both politically for the New Deal, but also in Keynes' own trajectory as a policy wonk. By 1936, Franklin Delano Roosevelt and the New Deal had already reshaped American politics. The Wagner Act had strengthened unions. The CIO was organizing industrial labor. Sit-down strikes in Detroit had forced General Motors to negotiate with the United Auto Workers. Figures like Frances Perkins, the first woman to hold a cabinet position, were central to labor reforms. Obviously Marriner Eccles (see my paper on him here), and his advisor Lauchlin (not Laughlin) Currie (and on him here) had not yet won the battle for fiscal activism, but they were entrenched in the New Deal environment. The shift toward a more interventionist state was already underway.

In that sense, Keynes’ theoretical revolution did not initiate policy change. It provided a new framework for understanding an economic world that was already politically transforming. So what was truly new in the GT, you may ask? After all, many still claim that the Treatise on Money, his previous work, with endogenous money, and more institutional discussion was a better book (Schumpeter, for example; Friedman preferred his Tract on Monetary Reform, more aligned with the Quantity Theory of Money). The revolutionary core of the GT is the principle of effective demand.

Neoclassical economics rested on Say’s Law (and so did classical economics, properly defined, but in a different way; without full utilization of labor), the idea that supply creates its own demand. Production generates income, and income automatically generates sufficient demand to purchase output. Persistent unemployment, therefore, could only be temporary. Keynes turned that logic upside down in the GT. Demand generates income. Output and employment are determined by the level of effective demand. There is no automatic mechanism guaranteeing full employment.

This idea was not fully developed until 1932, during intense discussions in Cambridge among the group known as “the Circus,” which included: Joan and Austin Robinson, Richard Kahn, James Meade and Piero Sraffa. Their critiques of Keynes’ earlier Treatise helped push him toward the insight that defines the book. That theoretical shift, not fiscal activism, is the true intellectual rupture.

Another misconception is to assume that Keynes needed the GT to defend fiscal activism. Theory and policy would be tied up together. In fact, he had already been advocating public works and expansionary measures since the mid-1920s, especially after Britain’s return to the gold standard created severe deflationary pressures. The 1926 General Strike and the electoral victories of the Labour Party in 1924 and 1929 occurred in this context of economic stagnation (see my paper on this here). Keynes’ policy activism predated his theoretical breakthrough. In other words, the policy ideas were not new. The theory that justified them, and explained why unemployment could persist, was.

It is also worth dispelling another myth. Keynes was not a socialist bent on expanding the state at all costs. He remained, throughout his life, a liberal in the classical sense, though one deeply critical of laissez-faire orthodoxy. His goal was to save capitalism from its own instability, not to replace it.

The “socialization of investment” he envisioned was pragmatic, not revolutionary. It reflected a recognition that private investment decisions were volatile and insufficient to guarantee full employment, not a desire to abolish markets or even for economic planning.

Ninety years on, The General Theory still matters, but his views have been in retreat since the 1930s, and only succeeded, during the so-called Golden Age of Capitalism, because they could be incorporated within the mainstream of the profession. The irony is that the book most associated with fiscal stimulus is fundamentally about something deeper: a reconstruction of macroeconomic theory. That task is still ahead.

A late note on the Economic Report of the President

This is a bit old. The Economic Report of the President was published a while ago. I just was looking recently, essentially because it has a chapter on the 70th anniversary of the Council of Economic Advisers (CEA). The report discusses the role of Leon Keyserling, the second chair of the CEA, but the most relevant one in the early period, who, like Eccles at the Fed, tends to be a relatively underestimated and forgotten influence on the rise of Keynesian economics (that's in this chapter). That is enough to make this Report worth reading.

But the first chapter (on inclusive growth) tackles the issue of inequality, and not just income, but wealth too. Below the shares in wealth distribution for the top 0.1%, 1% and the bottom 90%.

It's very clear that while the New Deal compressed the shares of the top groups, the Reagan Revolution has completely reversed the earlier achievements. And it is also clear that inequality is important also at the top, since the 0.1% do so much better than the 1%. And the early Keynesians like Keyserling and Eccles were partially responsible for the improvement in wealth and income equality back then.

On Eccles and QE in the 1930s

So last weekend I was at the Eastern Economic Association meetings, and I presented with Steve Bannister (on and off contributor to NK) a paper on Quantitative Easing in the 1930s. It's been a while since we looked at this work, which started long ago (4 years at least). One point worth noticing is that while most accounts of Eccles performance at the Fed suggest that he didn't do much (see Meltzer in his A History of the Federal Reserve), we suggest that he was crucial in pushing qualitative easing (the term first used by Buiter here), that is a shift in the composition of the Fed's balance sheet.

The figure shows that when Eccles assumed at the Fed, in 1934, QE, the increase of the balance sheet had already started, but the shift from short term government bills (blue ones) to long term bonds (green) had not. The dark line shows Eccles' policy, which had the objective of keeping long term interest rates at 2.5 percent, in order to allow for fiscal stimulus and sustainable expansion of public debt.

Lord Eatwell in the Financial Times

A short Letter to the Editor, but worth reading. He clearly explains the policy failure since the global crisis and the reasons for the current problems in financial markets in developed and developing countries. He says:

The adage that, in the absence of the prospect of growing demand, cheap money amounts to “pushing on a string” has been once again confirmed in advanced economies by the slowest recovery from any modern recession. Instead of funding real investment, monetary expansion has resulted in a boom in asset prices — not just in real estate and equity markets, but in the flow of funds into emerging market corporate bonds in the search for higher return. All these asset markets are extremely unstable, as is now all too evident. And, as has been once again demonstrated in the last 7 years, financial instability leads to substantial real economic loss.

Yet in the face of evident policy failure, and of severe asset market distortions that can only lead to further financial instability, the response seems to be “more of the same”, or even, in the case of negative interest rates, “very much more of the same”. There was a significant fiscal expansion in the US in 2009 that had a clear positive impact. But the federal government lost its nerve and reined back on the expansion just as it was gathering pace. The quiet abandonment of severe austerity by the UK government in 2012 at least enabled something of a recovery, albeit fuelled by growing household debt. Fiscal policy works. 

Given that the cost of funds to most governments is today negative in real terms (and sometimes in money terms too) it is difficult to understand the failure to initiate a major expansion of investment in infrastructure and the other major components of “supply-side” strength. This failure is resulting not just in a loss of output today, but a long-term loss of competitive productive capacity (a particularly severe problem for the UK). Fiscal policy can provide the pull on the string required to validate the monetary push.

Read the full letter here (subscription required). Pushing on a string as an explanation for the inefficiency of monetary policy in a crisis was a term popularized by Marriner Eccles, by the way.

Lauchlin Currie's review of Keynes' General Theory

Curried Keynesianism in action

 

The review with an intro can be read here (or here). Currie is often considered the first Keynesian in the Roosevelt administration (I suggested here that, while not a professional economist, that merit goes to Eccles), and was also the first to work in the White House, before the Employment Act and the creation of the Council of Economic Advisers (CEA). He was also later unjustly attacked as a Soviet spy, and Roger Sandilands has dealt with this here (subscription required). His biography of Currie is a must read.

Clarida on Fed policy: or how does the Fed affect inflation

Richard Clarida gave an interview (right at the beginning of the podcast) on why the Fed should increase the rate of interest. He also said that the Fed can affect inflation, which, he correctly points out, is denied by several economists. However, the degree of confusion on this subject is significant, and modern monetary theory, and its implications for central banking behavior, is, in part, responsible for that.

The conventional wisdom on what central banks can do (and one can think of Clarida's contribution with Galí and Gentler as a good summary of the dominant position) suggests that central banks can only target inflation efficiently in the absence of cost-push inflation or if they do not care about deviations from the natural rate of unemployment (or output, depending on whether the unemployment gap or the output gap is used for the central bank's policy rule). And some authors believe that inflation is in the long run really always caused by excess demand, and that the system gets back to its natural level, so that there should be no concern other than inflation.

Under these circumstances the Fed has an effect on inflation through two mechanisms.The Fed could maintain the rate of interest low even in the face of an economy close or in extremis at the natural rate, supposedly stimulating spending, and it could also affect inflationary expectations. The later is the basis for Blanchard's proposal to increase the inflation target to 4%, for example. The same solution was suggested by Krugman (my comments here).

On the first issue, besides the problem that most mainstream economists do not know what is the precise level of the natural rate of unemployment (and I'm not even going to get into the logical problems which the rate), there is the issue that the natural rate is not constant, and it might be affected by the actual level of unemployment. So as the Fed keeps the rate low, and again this would arguably lead to more spending, higher output and lower unemployment, the natural rate would fall, and inflation might not pick up.* In addition, there is the fact that lower rates might not translate into higher private spending after all. Eccles famous 'pushing on a string' story. In that case, it seems that the Fed has actually limited capacity to affect inflation.

The second point emphasis the role of expectations. The notion is that the Fed affects what agents think and has real effects through this channel. This is a variation of the inflation expectations fairy according to which higher expected inflation would lead to more investment. Here again Eccles is relevant. Eccles was very explicitly against confidence fairy type arguments (see here and here). Here the argument is that if the Fed announces its willingness to allow for higher inflation, then agents would assume that inflation would indeed be higher (economic agents don't seem to care what the mechanism by which inflation will end up being actually higher), and would spend more (holding to cash would hurt them).

So if the Fed says inflation could go up to 4%, even though oil prices are low, and wages are stagnant, economic agents ignore facts, and hold to the expectations of inflation. In this case, by spending, with the economy being at the natural level, economic agents cause the inflation that the Fed stimulated in a self-fulfilling prophesy. Again, inflation occurs because of excess spending when the economy is at the natural rate. The key to understand how (what mechanism) the Fed can (or can't) affect prices is crucially linked to that very problematic concept of the natural rate.

Don't get me wrong. I think the Fed can affect prices, but is way less effective than what the conventional wisdom suggests, and its powers are asymmetric, meaning it can reduce inflation more than it can increase it. First, hiking the rate of interest, from a cost perspective, increases financial burden of firms and that might lead to higher prices (something that was known as the Gibson Paradox, the positive relation between the interest rate and the price level; later has been also known as the Cavallo-Patman effect). But higher rates, more importantly, increase the burden of debt, leading consumers and firms to possibly default, and reduce the level of activity. It is the lower level of activity, and its impact on workers bargaining power, and, hence, the absence of wage pressures, that matters for stabilization.

On the other hand, reducing rates as noted above might have little impact on spending and the level of activity. Traditionally low rates were instrumental in making fiscal expansion easier, since the government could borrow at low rates. But in the absence of government spending, and any other additional increase in autonomous spending, lower rates per se are unlikely to lead to a booming economy, particularly one that is beyond full capacity and that would display demand-pull inflation (inflation more often than not is cost-push anyway).

* Laurence Ball now says the natural rate of unemployment is around 4.3%, for example.

Did the New Deal help in the recovery?

I have posted on this before (e.g. here and here, but there is more). Here a short excerpt from Joshua Hausman dissertation, supervised by Barry Eichengreen and Brad DeLong. He suggests in this particular paper that the 1936 Veteran Bonus was essential for the expansion of consumption and growth in 1936. Table below show aggregate data. Note that most of the accelerated expansion is explained by consumption (one might add, investment is derived demand and follows the accelerator, but that's another discussion).

He says: "All this is not easily explained by factors other than the bonus. Monetary factors were if anything contractionary in 1936. Broad money supply growth slowed from 14 percent in 1935 to 11 percent in 1936. And in August 1936, the Federal Reserve raised reserve requirements."

Hausman correctly notices that monetary policy had little effect on the boom in 1936, which fits what Eccles thought about that, and also about the role of monetary policy in the 1937-8 recession. The recession was for Eccles caused by a fiscal contraction largely due to two factors, the new Social Security Law that went into effect, increasing taxes, without initially disbursing payments, and the end of soldier’s bonus payments, which would add support to Hausman's story. Yep, multipliers (effective demand) work.

Kirsten Ford, a young Old Institutionalist

Kirsten Ford (1976-2014)

I first met Kirsten in the mathematics leveling class for the incoming PhD students. I think it was in 2007, but it might have been the year before. She felt she needed to take more math courses, and did so at Westminster College, where she had obtained her Bachelor's degree. She had come to economics out of a concern with social justice, and her early views were shaped in Dick Chapman's classes on Keynes' General Theory and Chace Stiehl's discussion of classical political economy authors, both PhDs from Utah's graduate program, which influenced her choice for her graduate studies.

At that time I taught two regular courses in the graduate program, the second required macro class, which basically reviewed heterodox approaches and growth theory (both conventional and heterodox views), and the second history of economic thought course, which went from the Marginalist Revolution to the post-capital debates developments (the change in the notion of equilibrium, and what I referred to as the return of vulgar economics; the first part of the course on classical political economy and Marx was taught by E.K. Hunt). She and her classmates, which were among the best cohorts of students in the PhD program I can remember, took also two other elective courses with me. A seminar on Sraffian topics, and a course in international economic history.

That course was not chronologically organized. The topics covered emphasized unresolved controversial issues in international economic history, e.g. whether there was an Industrial Revolution, the critique of Eurocentric interpretations of History, and the revival of cultural and geographical explanations for relative backwarderness. One of the most fun courses I ever taught, not just because I basically taught what I wanted, but more importantly because I never learnt as much from my students as I did in that opportunity.

Kirsten's interests were broad, but she had a particular concern with the institutional aspects of economic development, approached from a historical perspective, and that would include the history of ideas. That was very much in line with the institutional/Marxist traditions that already existed in Utah's economics department, and fit with my own work in what might be called the Classical-Keynesian tradition (classical meaning the old classical political economists, including Marx, as interpreted by Sraffa, while Keynesian puts an emphasis on the radical followers of Keynes and Kalecki).

She published early on a paper (in a Brazilian journal called Versus, which I suggested as a venue; accessible version here) that was based on a previous one done in a development course with Nilüfer Çağatay. It was a critique of the New Institutionalism of Douglas North, and a discussion of the Veblenian, or Old Institutionalist roots in the radical development economics of Ha-Joon Chang. She also published, with Bill McColloch, one of her colleagues in the graduate program, a paper on the Journal of Economic Issues on the methodological compatibility between Marx and Veblen (working paper version available here), influenced by Hunt's views on the topic, to some extent.

Kirsten also collaborated with me, and Nathaniel Cline, another graduate student at the U, on a paper on the persistence of mainstream policy advice, even after the crisis of the marginalist paradigm in the 1970s, in which we hinted that a real world economic crisis, like the Global Recession of 2008, was an unlikely cause for significant changes in the direction of research, which was published in the Journal of Philosophical Economics (see here). Kirsten was particularly interested in the role of the IMF as a the institutional instrument by which conservative policies were maintained in developing countries. Further research on the lack of change in the IMF policy positions that she conducted will be published later this year in Development and Change.

She was also interested in the role of institutionalist authors during the New Deal, and helped me to do research on Marriner Eccles papers at Marriott Library. We had a project of publishing some of Eccles speeches as the chairperson of the Fed.

Kirsten was extremely generous in her intellectual exchanges, unwilling to take her contributions as exclusively her own, and sharing them as part of the knowledge of the group. Surprisingly that's not common among the heterodox tribe, in which pride and the desire for prominence often lead to fratricidal disputes. She was also generous with her time, dedicating immense amounts of it to organize the Heterodox Economics Student Association (HESA), and making the economics department better for other graduate students, and to her classes and her students. Economics as a profession is a little bit better because of her work.

David Warsh on Marriner Eccles

David Warsh from Economic Principals has written a nice post on Marriner Eccles. I particularly think he hits the nail when he argues that:

"Eccles embodied a peculiarly Mormon ethic of public service, full of frontier practicality (as Boston often has represented Puritan ideals and Philadelphia Quakerly ways). His was a role reprised by Willard “Mitt” Romney, who, as governor of Massachusetts, put a mandatory health insurance reform in place, presumably as the model for a national plan. (Romney eventually buckled under Tea Party pressure and disavowed the aim.)"

Although it is not well-known early Mormon doctrine was closer to Socialism that one might think, with an emphasis in redistribution and cooperative work (see for example this paper on "Communism among Mormons"; subscription required).

For more on Eccles go here and here. For a discussion of the LDS social ethic of cooperation the classic book by Leonard Arrington, Building the City of God, is a must read.

Currie and the 1937-38 recession

Lauchlin Currie, the first economist to work in the White House (in 1939, that is, before the creation of the Council of Economic Advisers, CEA, in 1946) and main advisor to Marriner Eccles at the Fed, said this in a memo to Eccles in October 1937:

“When the Government disburses more to the community than it collects in taxes, it adds to national buying power and the demand for the products of industry. The excess of spending over tax receipts in the years 1935-36 was the primary factor in increasing national income, in increasing Federal revenues, in increasing national demand for goods and, hence, in finally making it profitable to make additions to plant capacity in 1936.
…
At a time when the national income is shrinking the Government is seeking to raise revenues and cut expenditures this merely intensifies the deflationary trend. We are in danger of starting again the hopeless attempt to increase Federal revenues when the national revenue is shrinking. The attempt failed in 1929-32. It will fall again. The only condition under which the Federal budget can be technically balanced in 1939 is a reversal of the present deflationary trend.”

I hope a memo like this has been sent to Bernanke. Hope springs eternal.

Heterodox central bankers again

A new version of the paper Heterodox Central Bankers: Eccles, Prebisch and Financial Reform co-authored by Esteban Pérez Caldentey has been published in the Network Ideas Working Paper Series. Again from the abstract: The Great Depression led to a need to rethink the principles of central banking, as much as it had led to the rethinking of economics in general, with the Keynesian Revolution at the forefront of the theoretical changes. This paper suggests that the role of the monetary authority as a fiscal agent of government and the abandonment of the view of the economy as self-regulated were the central changes in central banking in the center. In the periphery, the change in central banking was related to insulating the worst effects of balance of payments crises, while the use of capital controls became more common. The experiences of Marriner S. Eccles in the United States following the Great Depression, and Raúl Prebisch in Argentina in the 1930s and in Latin America in the 1940s are paradigmatic examples of those new tendencies in central banking at the time.