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MR. KEYNES AND THE MODERNS
Paul Krugman
June 18, 2011
Prepared for the Cambridge conference commemorating the 75th anniversary of the publication of The General Theory of Employment, Interest, and Money.
Paul Krugman
June 18, 2011
Prepared for the Cambridge conference commemorating the 75th anniversary of the publication of The General Theory of Employment, Interest, and Money.
1
It’s a great honor to be asked to give this talk, especially because I’m arguably not qualified to do so. I am, after all, not a Keynes scholar, nor any kind of serious intellectual historian. Nor have I spent most of my career doing macroeconomics. Until the late 1990s my contributions to that field were limited to international issues; although I kept up with macro research, I avoided getting into the frontline theoretical and empirical disputes. So what am I doing here?
The answer, I suspect, lies in two things. First, in 1998 I was, I think, among the first prominent economists to give voice to the notion that Japan’s experience – deflation that stubbornly refused to go away, despite what looked like very loose monetary policy – was a warning signal. The kind of economic trap Keynes wrote about in 1936 was not, it turned out, a myth or a historical curiosity, it was something that could and did happen in the modern world. And now, of course, we have all turned Japanese; if we are not literally experiencing deflation, we are nonetheless facing the same apparent impotence of monetary policy that Japan was already facing in 1998. And the thought that the United States, the UK, and the eurozone may be facing lost decades due to persistently inadequate demand now seems all too real.
The other reason I’m here, I’d guess, is that these days I’m a very noisy, annoying public intellectual, which means among other things that I probably have a better sense than most technically competent economists of the arguments that actually drive political discourse and policy. And not only do these disputes currently involve many of the same issues Keynes grappled with 75 years ago, we are – frustratingly – retracing much of the same ground covered in the 1930s. The Treasury view is back; liquidationism is once again in full flower; we’re
2
having to relearn the seeming paradox of liquidity preference versus loanable funds models of interest rates.
What I want to do in this lecture is talk first, briefly, about how to read Keynes – or rather about how I like to read him. I’ll talk next about what Keynes accomplished in The General Theory, and how some current disputes recapitulate old arguments that Keynes actually settled. I’ll follow with a discussion of some crucial aspects of our situation now – and arguably our situation 75 years ago – that are not in the General Theory, or at least barely mentioned. And finally, I’ll reflect on the troubled path that has led us to forget so much of what Keynes taught us.
1. On Reading Keynes
What did Keynes really intend to be the key message of the General Theory? My answer is, that’s a question for the biographers and the intellectual historians; I won’t quite say I don’t care, but it’s surely not the most important thing. There’s an old story about a museum visitor who examined a portrait of George Washington and asked a guard whether he really looked like that. The guard answered, ―That’s the way he looks now.‖ That’s more or less how I feel about Keynes. What matters is what we make of Keynes, not what he ―really‖ meant.
I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment
3
decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, that all those who have invoked the great man’s name on behalf of quasi-equilibrium models that push this insight into the background, from John Hicks to Paul Samuelson to Mike Woodford, have violated his true legacy.
Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed, while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: ―The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand‖.
So who’s right about how to read the General Theory? Keynes himself weighed in, in his 1937 QJE article, and in effect declared himself a Chapter12er. But so what? Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can.
For what it’s worth, I’m basically a Part 1er, with a lot of Chapters 13 and 14 in there too, of which more shortly. Chapter 12 is a wonderful read, and a very useful check on the common
4
tendency of economists to assume that markets are sensible and rational. But what I’m always looking for in economics is intuition pumps – ways to think about an economic situation that let you get beyond wordplay and prejudice, that seem to grant some deeper insight. And quasi-equilibrium stories are powerful intuition pumps, in a way that deep thoughts about fundamental uncertainty are not. The trick, always, is not to take your equilibrium stories too seriously, to understand that they’re aids to insight, not Truths; given that, I don’t believe that there’s anything wrong with using equilibrium analysis.
And as it turns out, Keynes-as-equilibrium-theorist – whether or not that’s the ―real‖ Keynes – has a lot to teach us to this day. The struggle to liberate ourselves from Say’s Law, to refute the ―Treasury view‖ and all that, may have seemed like ancient history not long ago, but now that we’re faced with an economic scene reminiscent of the 1930s, it turns out that we’re having to fight those intellectual battles all over again. And the distinction between loanable funds and liquidity preference theories of the rate of interest – or, rather, the ability to see how both can be true at once, and the implications of that insight – seem to have been utterly forgotten by a large fraction of economists and those commenting on economics.
2. Old Fallacies in New Battles
When you read dismissals of Keynes by economists who don’t get what he was all about – which means many of our colleagues – you fairly often hear his contribution minimized as amounting to no more than the notion that wages are sticky, so that fluctuations in nominal demand affect real output. Here’s Robert Barro (2009): ―John Maynard Keynes thought that the problem lay
5
with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.‖And if that’s all that it was about, the General Theory would have been no big deal.
But of course, it wasn’t just about that. Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained. They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested. And they had a theory of interest that thought solely in terms of the supply and demand for funds, failing to realize that savings in particular depend on the level of income, and that once you take this into account you need something else – liquidity preference – to complete the story.
I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way. But I’m inclined to believe that he was right. Why? Because you can see modern economists and economic commentators who don’t know their Keynes falling into the very same fallacies.
There’s no way for me to make this point without citing specific examples, which means naming names. So, on the first point, here’s Chicago’s John Cochrane (2009):
―First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a
6
company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about ―crowding out.‖‖
That’s precisely the position Keynes attributed to classical economists – ―the notion that if people do not spend their money in one way they will spend it in another.‖ And as Keynes said, this misguided notion derives its plausibility from its superficial resemblance to the accounting identity which says that total spending must equal total income.
All it takes to dispel this fallacy is the hoary old Samuelson cross (Figure 1), in which the schedules E1 and E2 represent desired spending as a function of income. Equilibrium – or, if you like, quasi-equilibrium – is at the point where the spending schedule crosses the 45-degree line, so spending does equal income. But this accounting identity by no means implies that an increase in desired spending, whether by the government or a private actor, cannot affect actual spending. (Yes, a private actor. As some of us have pointed out, the argument that deficit spending by the government cannot raise income also implies that a decision by a private business to spend more must crowd out an equal amount of spending elsewhere in the economy. Needless to say, in the political debate this point isn’t appreciated; conservatives tend to insist both that fiscal policy can’t work and that improving business confidence is crucial. But that’s politics.)
7
On the contrary, as the Samuelson cross shows, a rise in desired spending will normally translate
into a rise in income.
Income
Expenditure
E1
E2
Y=E
Figure 1
But you can see right away part of our problem: who teaches the Samuelson cross these days? In
particular, who teaches it in graduate school? It’s regarded as too crude, too old-fashioned to be
even worth mentioning. Yet it conveys a basic point that is more sophisticated than what a lot of
reputable economists are saying – in fact, if they had ever learned this crude construct it would
have saved them from falling into a naïve fallacy. And while it’s possible to convey the same
point in terms of more elaborate New Keynesian models, such models, by their very complexity,
fail to make the point as forcefully as the good old 45-degree diagram.
What about interest rates?
8
Keynes’s discussion of interest rate determination in Chapter 13 and 14 of the General Theory is
much more profound than, I think, most readers realize (perhaps because it’s also rather badly
written). The proof of its profundity is the way so many people – including highly reputable
economists – keep falling into the fallacies Keynes laid out, both in discussions of fiscal policy
and in discussions of international capital flows.
Figure 2
The natural inclination of practical men – who are not necessarily slaves of defunct economists,
since there are plenty of live and kicking economists ready to aid and abet their misconceptions –
is to think of the interest rate as being determined by the supply and demand for loanable funds,
as in Figure 2. When you think in those terms, it’s only natural to suppose that any increase in
9
the demand for or fall in the supply of loanable funds must drive up interest rates; and it’s easy to imagine that this, in turn, would hurt prospects for economic recovery.
Again, I need to name names to assure you that I’m not inventing straw men. So here’s Niall Ferguson (in Soros et al 2009):
―Now we’re in the therapy phase. And what therapy are we using? Well, it’s very interesting because we’re using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman—Milton Friedman, that is —which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I’m fine with that. That’s the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes—John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.
―There is a clear contradiction between these two policies, and we’re trying to have it both ways. You can’t be a monetarist and a Keynesian simultaneously—at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.
―After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them. It’s certainly not going
10
to be the Chinese. That worked fine in the good times, but what I call ―Chimerica,‖ the marriage
between China and America, is coming to an end. Maybe it’s going to end in a messy divorce.‖
What’s wrong with this line of reasoning? It’s exactly the logical hole Keynes pointed out,
namely that the schedules showing the supply and demand for funds can only be drawn on the
assumption of a given level of income. Allow for the possibility of a rise in income, and you get
Figure 3 – which is Keynes’s own figure, and a horrible drawing it is:
Figure 3
Figure 4 is my own version, very much along Hicks’s lines: we imagine that a rise in GDP shifts
the savings schedule out from S1 to S2, also shifts the investment schedule, and, as drawn,
reduces the equilibrium interest rate in the market for loanable funds:
11
Figure 4
As Hicks told us – and as Keynes himself says in Chapter 14 – what the supply and demand for
funds really give us is a schedule telling us what the level of income will be given the rate of
interest. That is, it gives us the IS curve of Figure 5, which tells us where the central bank must
set the interest rate so as to achieve a given level of output and employment. Of course, as the
figure indicates, it’s possible that the interest rate required to achieve full employment is
negative, in which case monetary policy is up against the zero lower bound, that is, we’re in a
liquidity trap. That’s where America and Britain were in the 1930s – and we’re back there again.
12
Figure 5
One way to think about this situation is to draw the supply and demand for loanable funds that
would prevail if we were at full employment, as in Figure 6. The point then is that there’s an
excess supply of desired savings at the zero interest rate that’s the lowest achievable. A zerolower-
bound economy is, fundamentally, an economy suffering from an excess of desired saving
over desired investment.
Which brings me back to the argument that government borrowing under current conditions will
drive up interest rates and impede recovery. What anyone who understood Keynes should realize
is that as long as output is depressed, there is no reason increased government borrowing need
drive rates up; it’s just making use of some of those excess potential savings – and it therefore
helps the economy recover. To be sure, sufficiently large government borrowing could use up all
13
the excess savings, and push rates up – but to do that the government borrowing would have to
be large enough to restore full employment!
Figure 6
But what of those who cling to the view that government borrowing must drive up rates, never
mind all this hocus-pocus? Well, we’ve has as close to a controlled experiment as you ever get in
macroeconomics. Figure 7 shows U.S. federal debt held by the public, which has risen around $4
trillion since the economy entered liquidity-trap conditions. And Figure 8 shows 10-year interest
rates, which have actually declined. (Long rates aren’t zero because the market expects the Fed
funds rate to rise at some point, although that date keeps being pushed further into the future.)
14
Figure 7
So those who were absolutely certain that large borrowing would push up interest rates even in
the face of a depressed economy fell into the very fallacy Keynes went to great lengths to refute.
And once again, I’ve made that point using very old-fashioned analysis – the kind of analysis
many economist no longer learn. New Keynesian models, properly understood, could with
greater difficulty get you to the same result. But how many people properly understand these
models?
I’m not quite done here. If much of our public debate over fiscal policy has involved reinventing
the same fallacies Keynes refuted in 1936, the same can be said of debates over international
financial policy. Consider the claim, made by almost everyone, that given its large budget
deficits the United States desperately needs continuing inflows of capital from China and other
emerging markets. Even very good economists fall into this trap. Just last week Ken Rogoff
15
Figure 8
declared that ―loans from emerging economies are keeping the debt-challenged United States
economy on life support.‖
Um, no: inflows of capital from other nations simply add to the already excessive supply of U.S.
savings relative to investment demand. These inflows of capital have as their counterpart a trade
deficit that makes America worse off, not better off; if the Chinese, in a huff, stopped buying
Treasuries they would be doing us a favor. And the fact that top officials and highly regarded
economists don’t get this, 75 years after the General Theory, represents a sad case of intellectual
regression.
I’ll have more to say about that intellectual regression later. But first let’s talk about key features
of our current situation that aren’t in Keynes.
16
It’s a great honor to be asked to give this talk, especially because I’m arguably not qualified to do so. I am, after all, not a Keynes scholar, nor any kind of serious intellectual historian. Nor have I spent most of my career doing macroeconomics. Until the late 1990s my contributions to that field were limited to international issues; although I kept up with macro research, I avoided getting into the frontline theoretical and empirical disputes. So what am I doing here?
The answer, I suspect, lies in two things. First, in 1998 I was, I think, among the first prominent economists to give voice to the notion that Japan’s experience – deflation that stubbornly refused to go away, despite what looked like very loose monetary policy – was a warning signal. The kind of economic trap Keynes wrote about in 1936 was not, it turned out, a myth or a historical curiosity, it was something that could and did happen in the modern world. And now, of course, we have all turned Japanese; if we are not literally experiencing deflation, we are nonetheless facing the same apparent impotence of monetary policy that Japan was already facing in 1998. And the thought that the United States, the UK, and the eurozone may be facing lost decades due to persistently inadequate demand now seems all too real.
The other reason I’m here, I’d guess, is that these days I’m a very noisy, annoying public intellectual, which means among other things that I probably have a better sense than most technically competent economists of the arguments that actually drive political discourse and policy. And not only do these disputes currently involve many of the same issues Keynes grappled with 75 years ago, we are – frustratingly – retracing much of the same ground covered in the 1930s. The Treasury view is back; liquidationism is once again in full flower; we’re
2
having to relearn the seeming paradox of liquidity preference versus loanable funds models of interest rates.
What I want to do in this lecture is talk first, briefly, about how to read Keynes – or rather about how I like to read him. I’ll talk next about what Keynes accomplished in The General Theory, and how some current disputes recapitulate old arguments that Keynes actually settled. I’ll follow with a discussion of some crucial aspects of our situation now – and arguably our situation 75 years ago – that are not in the General Theory, or at least barely mentioned. And finally, I’ll reflect on the troubled path that has led us to forget so much of what Keynes taught us.
1. On Reading Keynes
What did Keynes really intend to be the key message of the General Theory? My answer is, that’s a question for the biographers and the intellectual historians; I won’t quite say I don’t care, but it’s surely not the most important thing. There’s an old story about a museum visitor who examined a portrait of George Washington and asked a guard whether he really looked like that. The guard answered, ―That’s the way he looks now.‖ That’s more or less how I feel about Keynes. What matters is what we make of Keynes, not what he ―really‖ meant.
I’d divide Keynes readers into two types: Chapter 12ers and Book 1ers. Chapter 12 is, of course, the wonderful, brilliant chapter on long-term expectations, with its acute observations on investor psychology, its analogies to beauty contests, and more. Its essential message is that investment
3
decisions must be made in the face of radical uncertainty to which there is no rational answer, and that the conventions men use to pretend that they know what they are doing are subject to occasional drastic revisions, giving rise to economic instability. What Chapter 12ers insist is that this is the real message of Keynes, that all those who have invoked the great man’s name on behalf of quasi-equilibrium models that push this insight into the background, from John Hicks to Paul Samuelson to Mike Woodford, have violated his true legacy.
Part 1ers, by contrast, see Keynesian economics as being essentially about the refutation of Say’s Law, about the possibility of a general shortfall in demand. And they generally find it easiest to think about demand failures in terms of quasi-equilibrium models in which some things, including wages and the state of long-term expectations in Keynes’s sense, are held fixed, while others adjust toward a conditional equilibrium of sorts. They draw inspiration from Keynes’s exposition of the principle of effective demand in Chapter 3, which is, indeed, stated as a quasi-equilibrium concept: ―The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand‖.
So who’s right about how to read the General Theory? Keynes himself weighed in, in his 1937 QJE article, and in effect declared himself a Chapter12er. But so what? Keynes was a great man, but only a man, and our goal now is not to be faithful to his original intentions, but rather to enlist his help in dealing with the world as best we can.
For what it’s worth, I’m basically a Part 1er, with a lot of Chapters 13 and 14 in there too, of which more shortly. Chapter 12 is a wonderful read, and a very useful check on the common
4
tendency of economists to assume that markets are sensible and rational. But what I’m always looking for in economics is intuition pumps – ways to think about an economic situation that let you get beyond wordplay and prejudice, that seem to grant some deeper insight. And quasi-equilibrium stories are powerful intuition pumps, in a way that deep thoughts about fundamental uncertainty are not. The trick, always, is not to take your equilibrium stories too seriously, to understand that they’re aids to insight, not Truths; given that, I don’t believe that there’s anything wrong with using equilibrium analysis.
And as it turns out, Keynes-as-equilibrium-theorist – whether or not that’s the ―real‖ Keynes – has a lot to teach us to this day. The struggle to liberate ourselves from Say’s Law, to refute the ―Treasury view‖ and all that, may have seemed like ancient history not long ago, but now that we’re faced with an economic scene reminiscent of the 1930s, it turns out that we’re having to fight those intellectual battles all over again. And the distinction between loanable funds and liquidity preference theories of the rate of interest – or, rather, the ability to see how both can be true at once, and the implications of that insight – seem to have been utterly forgotten by a large fraction of economists and those commenting on economics.
2. Old Fallacies in New Battles
When you read dismissals of Keynes by economists who don’t get what he was all about – which means many of our colleagues – you fairly often hear his contribution minimized as amounting to no more than the notion that wages are sticky, so that fluctuations in nominal demand affect real output. Here’s Robert Barro (2009): ―John Maynard Keynes thought that the problem lay
5
with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.‖And if that’s all that it was about, the General Theory would have been no big deal.
But of course, it wasn’t just about that. Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained. They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested. And they had a theory of interest that thought solely in terms of the supply and demand for funds, failing to realize that savings in particular depend on the level of income, and that once you take this into account you need something else – liquidity preference – to complete the story.
I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way. But I’m inclined to believe that he was right. Why? Because you can see modern economists and economic commentators who don’t know their Keynes falling into the very same fallacies.
There’s no way for me to make this point without citing specific examples, which means naming names. So, on the first point, here’s Chicago’s John Cochrane (2009):
―First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a
6
company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about ―crowding out.‖‖
That’s precisely the position Keynes attributed to classical economists – ―the notion that if people do not spend their money in one way they will spend it in another.‖ And as Keynes said, this misguided notion derives its plausibility from its superficial resemblance to the accounting identity which says that total spending must equal total income.
All it takes to dispel this fallacy is the hoary old Samuelson cross (Figure 1), in which the schedules E1 and E2 represent desired spending as a function of income. Equilibrium – or, if you like, quasi-equilibrium – is at the point where the spending schedule crosses the 45-degree line, so spending does equal income. But this accounting identity by no means implies that an increase in desired spending, whether by the government or a private actor, cannot affect actual spending. (Yes, a private actor. As some of us have pointed out, the argument that deficit spending by the government cannot raise income also implies that a decision by a private business to spend more must crowd out an equal amount of spending elsewhere in the economy. Needless to say, in the political debate this point isn’t appreciated; conservatives tend to insist both that fiscal policy can’t work and that improving business confidence is crucial. But that’s politics.)
7
On the contrary, as the Samuelson cross shows, a rise in desired spending will normally translate
into a rise in income.
Income
Expenditure
E1
E2
Y=E
Figure 1
But you can see right away part of our problem: who teaches the Samuelson cross these days? In
particular, who teaches it in graduate school? It’s regarded as too crude, too old-fashioned to be
even worth mentioning. Yet it conveys a basic point that is more sophisticated than what a lot of
reputable economists are saying – in fact, if they had ever learned this crude construct it would
have saved them from falling into a naïve fallacy. And while it’s possible to convey the same
point in terms of more elaborate New Keynesian models, such models, by their very complexity,
fail to make the point as forcefully as the good old 45-degree diagram.
What about interest rates?
8
Keynes’s discussion of interest rate determination in Chapter 13 and 14 of the General Theory is
much more profound than, I think, most readers realize (perhaps because it’s also rather badly
written). The proof of its profundity is the way so many people – including highly reputable
economists – keep falling into the fallacies Keynes laid out, both in discussions of fiscal policy
and in discussions of international capital flows.
Figure 2
The natural inclination of practical men – who are not necessarily slaves of defunct economists,
since there are plenty of live and kicking economists ready to aid and abet their misconceptions –
is to think of the interest rate as being determined by the supply and demand for loanable funds,
as in Figure 2. When you think in those terms, it’s only natural to suppose that any increase in
9
the demand for or fall in the supply of loanable funds must drive up interest rates; and it’s easy to imagine that this, in turn, would hurt prospects for economic recovery.
Again, I need to name names to assure you that I’m not inventing straw men. So here’s Niall Ferguson (in Soros et al 2009):
―Now we’re in the therapy phase. And what therapy are we using? Well, it’s very interesting because we’re using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman—Milton Friedman, that is —which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I’m fine with that. That’s the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes—John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.
―There is a clear contradiction between these two policies, and we’re trying to have it both ways. You can’t be a monetarist and a Keynesian simultaneously—at least I can’t see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.
―After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them. It’s certainly not going
10
to be the Chinese. That worked fine in the good times, but what I call ―Chimerica,‖ the marriage
between China and America, is coming to an end. Maybe it’s going to end in a messy divorce.‖
What’s wrong with this line of reasoning? It’s exactly the logical hole Keynes pointed out,
namely that the schedules showing the supply and demand for funds can only be drawn on the
assumption of a given level of income. Allow for the possibility of a rise in income, and you get
Figure 3 – which is Keynes’s own figure, and a horrible drawing it is:
Figure 3
Figure 4 is my own version, very much along Hicks’s lines: we imagine that a rise in GDP shifts
the savings schedule out from S1 to S2, also shifts the investment schedule, and, as drawn,
reduces the equilibrium interest rate in the market for loanable funds:
11
Figure 4
As Hicks told us – and as Keynes himself says in Chapter 14 – what the supply and demand for
funds really give us is a schedule telling us what the level of income will be given the rate of
interest. That is, it gives us the IS curve of Figure 5, which tells us where the central bank must
set the interest rate so as to achieve a given level of output and employment. Of course, as the
figure indicates, it’s possible that the interest rate required to achieve full employment is
negative, in which case monetary policy is up against the zero lower bound, that is, we’re in a
liquidity trap. That’s where America and Britain were in the 1930s – and we’re back there again.
12
Figure 5
One way to think about this situation is to draw the supply and demand for loanable funds that
would prevail if we were at full employment, as in Figure 6. The point then is that there’s an
excess supply of desired savings at the zero interest rate that’s the lowest achievable. A zerolower-
bound economy is, fundamentally, an economy suffering from an excess of desired saving
over desired investment.
Which brings me back to the argument that government borrowing under current conditions will
drive up interest rates and impede recovery. What anyone who understood Keynes should realize
is that as long as output is depressed, there is no reason increased government borrowing need
drive rates up; it’s just making use of some of those excess potential savings – and it therefore
helps the economy recover. To be sure, sufficiently large government borrowing could use up all
13
the excess savings, and push rates up – but to do that the government borrowing would have to
be large enough to restore full employment!
Figure 6
But what of those who cling to the view that government borrowing must drive up rates, never
mind all this hocus-pocus? Well, we’ve has as close to a controlled experiment as you ever get in
macroeconomics. Figure 7 shows U.S. federal debt held by the public, which has risen around $4
trillion since the economy entered liquidity-trap conditions. And Figure 8 shows 10-year interest
rates, which have actually declined. (Long rates aren’t zero because the market expects the Fed
funds rate to rise at some point, although that date keeps being pushed further into the future.)
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Figure 7
So those who were absolutely certain that large borrowing would push up interest rates even in
the face of a depressed economy fell into the very fallacy Keynes went to great lengths to refute.
And once again, I’ve made that point using very old-fashioned analysis – the kind of analysis
many economist no longer learn. New Keynesian models, properly understood, could with
greater difficulty get you to the same result. But how many people properly understand these
models?
I’m not quite done here. If much of our public debate over fiscal policy has involved reinventing
the same fallacies Keynes refuted in 1936, the same can be said of debates over international
financial policy. Consider the claim, made by almost everyone, that given its large budget
deficits the United States desperately needs continuing inflows of capital from China and other
emerging markets. Even very good economists fall into this trap. Just last week Ken Rogoff
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Figure 8
declared that ―loans from emerging economies are keeping the debt-challenged United States
economy on life support.‖
Um, no: inflows of capital from other nations simply add to the already excessive supply of U.S.
savings relative to investment demand. These inflows of capital have as their counterpart a trade
deficit that makes America worse off, not better off; if the Chinese, in a huff, stopped buying
Treasuries they would be doing us a favor. And the fact that top officials and highly regarded
economists don’t get this, 75 years after the General Theory, represents a sad case of intellectual
regression.
I’ll have more to say about that intellectual regression later. But first let’s talk about key features
of our current situation that aren’t in Keynes.
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