A theory of economic policy and the role of institutions

Nicola Acocella published a paper in the Journal of Economic Surveys (a free, preliminary version is available here) on the development of the theory of economic policy. Acocella is clearly fully aware of the differences between classical political economics and marginalism (neoclassical economics).* And he dismisses the pre-margnialist views on economic policy as being unsystematic and devoid of general principles.
In his words:

Most classical writers and the marginalists had suggested cases where public intervention was in order. This had been so for Smith (1776), Ricardo (1817), Mill (1848), Marshall (1890), Walras (1874-1877, 1898). But these cases were mainly what Walras called ‘examples of empirical policy’ rather than consistent policy. They were certainly dictated on the basis of an analytical evaluation of the circumstances suggesting them, but were not part of a systematic and consistent assessment of the foundations and the articulation of public policy.

In his view, economic policy as an autonomous discipline, meaning one based on theoretical principles, only started with Sidgwick,  Marshall and Pigou, that is, with Welfare Economics or Social Choice Theory, which apparently now is referred to as Implementation Theory (I didn't know that, I might confess). So it is in the debate of the 1930s, with Robbins and his followers and critics, and more fundamentally with Arrow's Impossibility Theorem that he sees the development of the main themes of a theory of economic policy.

He also suggests that before the development of a the theory of economic policy proper "the ‘night-watchman’ position became an exception as most classical and marginalist economists tended to state a number of specific or general cases where government intervention was in order." I'm not fully convinced about that. Sure there were some views about government intervention, but for the most part the Victorian consensus, among economists (not necessarily in practice, meaning actual economic policy) was for free trade, adherence to the rules of the Gold Standard, and sound finance. The idea of the minimal state was probably dominant, and the exceptions, particularly among marginalists that dominated in the UK at least, were associated to market failures.

The two major obstacles to this dominant view that government action was possible, in Acoccela's view were due to Arrow and Lucas. In his words, these 'vital failures' were: "the impossibility of taking people’s preferences as a reference for public action, underlined by Arrow (1951) and ‘radical’ objections to effectiveness of public action of the kind raised by Lucas (1976)." I should note that it seems that, in his view, the major critiques have been successfully dealt with, by Sen and his followers in one field and New Keynesians in the other, and the current consensus would be that government action is possible and desirable.

In this view, then, the history of the development of of the field is one in which the profession goes from being in favor of government action up to the development of the theory (essentially the from the beginning of marginalism to the 40s), broadly speaking, to being critical from the 50s to the 80s, with a slow return to a more interventionist consensus ever since. And maybe this describes well the field of Implementation Theory. But it strikes me as being at odds with conventional views of what the profession thinks about the role of government over time.

I mean, normally you would think of the profession as being essentially for laissez-faire, the reason why sometimes there is a conflation of classical and marginalist authors, and then after the Great Depression and the Keynesian Revolution (even if not complete, and dominated by an imperfectionist view) there would be an interventionist turn, which starts to be contested in the 1970s, with the Conservative Revolution and the Great Inflation. The apotheosis of the return of the market would come with the fall of the Soviet Union, shock therapy and the so-called Washington Consensus. The question would be to what extent this neoliberal dominance has been undermined by the last Global Financial Crisis (I would say less than what people think).

I also think that the dismissal of the classical political economy approach to economic policy, which was based on historical understanding of the specific conditions of a particular situation, is a mistake, and that there is a lot be learned from that tradition. Note that for classical political economy authors history and institutions, and, hence, policy analysis, were at a different level of abstraction, and had a different relation with the core of the theory (value and distribution). At any rate, this is an interesting paper worth reading.

* For example, he is careful to note that the meaning of the invisible hand in Adam Smith is often out of context. However, he argues that: "we use the term ‘invisible hand’ as a metaphor of the Smithian position as well as of later theories, in particular neo-classical thinking, which has then prevailed, even if the latter are deprived of some social aspects of the working of the market that certainly were in Adam Smith." This reading of Smith leaves room for intervention in the case of imperfections, and seems to follow the ideas of Acoccela's mentor, the famous Italian economist Federico Caffè.

How Keynesianism became a dirty word: not Hayek, the New Deal is the real cause

Noah Smith, now writing regularly for Bloomberg, had a piece on this subject. There are a few good points on how New Keynesians are really followers of Friedman, something Mankiw admitted long ago, and how everybody including conservative economists (meaning GOP economists like John Taylor and Ben Bernanke) are New Keynesians (these would be the potty trained GOP economists, not your supply-side fringe economists like Arthur Laffer). Note that this is essentially correct as pointed out here before, since New Keynesians accept fully Friedman's notion of a natural rate of unemployment, while Keynes explicitly said he wanted to reject the twin concept of a natural rate of interest.

Noah also suggests that Keynes only wanted stabilization policies, and no redistributive policies, which is more open to debate. Keynes was certainly a moderate reformer trying to save capitalism from itself, and was no fan of the Soviet experiment. On the other hand, he was an Asquith liberal, meaning concerned with the expansion of the welfare system, and knew that laissez-faire, if it had advantages in the past, was essentially dead.

In the General Theory (GT) he famously starts chapter 24, on his social philosophy, with the idea that: "the outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes." That is, income distribution is squarely in the middle of his preoccupations, and the socialization of investment at the center of his solution (let alone the euthanasia of the rentier). Using public investment, and one would imagine taxes, to deal with employment and income distribution, plus compressing the remuneration of rentiers, and keeping low rates of interest to expand the safety net, are not simply stabilization policies.

On the main topic of his piece, however, Noah is simply wrong. He argues that the reason why: "people think Keynesianism is socialism-lite [is] the fault of Keynes’s main intellectual opponent, Friedrich Hayek." First, while it's true that Keynes and Hayek had a few debates in the 1930s (but the key Keynesian author in these debates was actually Sraffa, not Keynes), prompted by Lionel Robbins plan to make the London School of Economics (LSE) an alternative to Cambridge, it is preposterous to say that Hayek was the main intellectual opponent of Keynes. In the GT, it was his own teacher Pigou, and the Marshallian tradition in Cambridge that Keynes was battling. In his personal debates Robertson was certainly more relevant than almost any other conventional (Marshallian) economist. Hayek was irrelevant.

Second, Hayek basically vanished, literally, after the 1940s only to reaper in the 1970s as a result of his dubious "Nobel"/Bank of Sweden's prize (see Sissela Bok's, Myrdal's daughter, story on that topic). By that time Keynes and Keynesianism were already dirty words. Early on Keynesian ideas were associated, fairly or not, with Roosevelt and the New Deal in the US, and then to the war coalition government in the UK, the Beveridge Report and the post-war Labour reforms. Keynesian economists were in many cases persecuted, like Lauchlin Currie, the first economist to work inside the White House, and one of the early Keynesians. But by the 1950s and 1960s (particularly after the Kennedy administration) one kind of Keynesianism was dominant anyway (the Kennedy tax cut and the economists working for his administration are the symbol of the dominance of Keynesian ideas).

So you ask why indeed did Keynesianism become a dirty word? Simply because even if Keynes had differences with Roosevelt (FDR was actually a sound finance guy) and with Labour, his ideas did provide the intellectual basis for New Deal policies, particularly after the 1937-38 recession, and for the expansion of the Welfare State in general. The economists that where against these policies by the 1940s were in the minority. Mont Pelerin is, if anything, prove of their sheer irrelevance. Friedman years later would complain about how ostracized he was (but less than Hayek, since he accepted the ISLM/Phillips curve apparatus of the Neoclassical Synthesis Keynesians; and that's why New Keynesians, who are really followers of Friedman, can say they are Keynesian, by the way). Liberalism, in the US sense of the word, was at its height. But the rise of conservatism (Goldwater was a joke back then) eventually transformed liberalism into a dirty word (that's why we use progressive now rather than liberal).

Hayek was resuscitated very much like conservative ideas. By the big bucks of business leaders and their think tanks that were against the New Deal. The rise of Hayek or of his renewed respectability results from the same forces that explain why Keynesianism and the New Deal kind of welfare policies fell in disrepute, to the point that Niall Ferguson could say that Keynesianism was flawed because Keynes was childless and gay. Oh well.

PS: In fact, the title of this blog is related to the view that Keynesianism is a dirty word, and that some people (Galbraith) unashamedly teach naked Keynesianism to innocent college kids. For more see here.

Lawrence Klein author of The Keynesian Revolution has passed away

Lawrence R. Klein (1920-2013)

Lawrence Klein, of Klein-Goldberger US econometric model fame, and author of The Keynesian Revolution (here the Google Books link), and winner of the Sveriges Riksbank Prize in Memory of Alfred Nobel in 1980, has passed away. Klein was a Neoclassical Synthesis Keynesian (often referred to as Old Keynesian now, to distinguish him from the New Keynesians) that made his contribution by developing the empirical applications of the Keynesian model for the US economy.

The seminal work was done in the late 1940s and early 1950s in the context of the Cowles Commission. His book An Econometric Model of the United States, 1929–1952 was further developed in 1955 with his co-author (Arthur Goldberger), published as An Econometric Model of the United States 1929–1952, introduced the celebrated Klein-Goldberger model. The Cowles Commission Model still lives in Ray Fair's macro-econometric model, that maintains essentially the same methodology, resisting to the Lucas critique and the Dynamic Stochastic General Equilibrium (DSGE) models of the Real Business Cycle School (RBC) and their New Keynesian alternatives.

It must be noted that in Klein's original model, expectations did not play a role, since it was complicated to incorporate those, interest rates did not have an impact on investment (basically adopting an accelerator) and that wealth effects (which allow for the Pigou effect, and the return to full employment) on consumption were also absent. So in a sense his model did differ, because of the need to adapt to economic data, from the theoretical versions of the Neoclassical Synthesis, and was closer to heterodox interpretations of Keynes.

Robert Skidelsky on Hayek, Keynes and Common Sense

Robert Skidelsky at a Liberty Fund event, not too long ago. Note that in the opening remarks he says: "I'm going to talk about the conditions of liberty, which seems a good topic of conversation for a Liberty Fund event. Owing to the hazards of the weather, I find myself the sole representative of common sense this afternoon." Not sure what the weather conditions had to do with it, but I must agree, given the venue.

The whole thing here. My only major disagreement is that I really do not think that Hayek is the great rival of Keynes, or even one of the major economists of the 20th century, given his contributions. On the neoclassical front, Hicks, Modigliani, by bringing neoclassical results in the long run, but opening space for Keynesian policies in the short run, associated to rigidities an imperfections, and even Friedman, with the return of the concept of the natural rate, were more relevant than Hayek.

Who was Keynes great rival? While he was alive his debates were with his Cambridge peers, Pigou and Robertson, more than with Robbins, Hayek and the LSE economists. In fact, a good chunk of the younger LSE economists became, in different degrees, Keynesian (e.g. Hicks, Kaldor, Lerner, and even Shackle). But if I had to say, his great rival was himself, which would probably fit his very elevated sense of self-worth. In particular, his inability of getting rid of marginalist (neoclassical) elements of his theory is what ultimately opened the door for the Neoclassical Synthesis.

In the long run we are NOT all dead

Niall Ferguson has apologized for his offensive suggestion that Keynes' phrase on being dead in the long run was somehow related to his sexuality or the fact that he was childless (more here and here). Good for him. Note, however, that in that famous phrase from the Tract on Monetary Reform, from 1923, Keynes was still very much a conventional Marshallian author who thought that full employment would reassert itself, and that the Quantity Theory of Money (QTM) worked pretty well. In fact, it is often said that the Tract was Milton Friedman's favorite among all of Keynes' books.

The full quote says:

"But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

The point of the quote is that in the long run everything would be fine, since markets do get to full employment, and so, even without intervention, deflation and inflation do its magic, but the process is too long and painful, so it would be more reasonable to act in the short run. This was typical of the Cambridge version of Marginalism, which was very much in favor of government intervention to deal with market imperfections in the short run. This is true of Marshal and Pigou, as well as Robertson, and certainly Keynes, before the General Theory. Note that this does not mean, as most people think, that one should only be concerned with the short run. The point is that action in the short run facilitates the road towards the fully adjusted equilibrium in the long run.

This was still essentially Keynes' view by 1930, when he published the Treatise on Money, a book that is at heart Wicksellian [so at least he got rid of the QTM in this book], and that suggests that unemployment results from a monetary rate of interest that is too high with respect to the natural rate, in practice as a result from the Gold Standard rules, which Keynes wanted to abandon. [This precedes the modern views that the Gold Standard caused the Depression, by the way, as say defended by Barry Eichengreen]. This was a cyclical crisis that could be solved by reducing the monetary rate of interest, and in the short run employment programs, something Keynes defended in Can Lloyd George Do It?

The point of the General Theory (GT) is that there is no natural rate of interest, meaning that reducing the rate of interest would not bring investment to the full employment level of savings, and that the crisis was caused by lack of demand. The equilibrium between investment and savings was determined by variations in the level of output, and in the long run we are not self adjusted to full employment. Hence, the very logic of the phrase above is debunked by Keynes, when he became Keynesian, so to speak, and got rid of the old modes of thinking. Intervention is not needed because in the long run we are dead, but because the long run depends on the short run, and we tend to fluctuate around a sub-optimal position.

So in the long run we are NOT dead in the GT, in the absence of counter-cyclical policies we are all in deep trouble. Keynes was very much concerned about the possibility of capitalism to promote well being for all in the long run. In other words, not only is Ferguson wrong about the effects of Keynes' sexuality and lack of children on his economic reasoning, but he does not even get the point of the phrase.

PS: The best book to understand the theoretical changes in Keynes' views is still Edward Amadeo's  Keynes' Principle of Effective Demand, his PhD dissertation, supervised by Murray Milgate, and co-supervised by Lance Taylor, published with an intro by Vicky Chick.