MR. KEYNES AND THE MODERNS (part 2)

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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.

3. Banks and Debt
Perhaps the most surprising omission in the General Theory – and the one that has so far generated the most soul-searching among those macroeconomists who had not forgotten basic Keynesian concepts – is the book’s failure to discuss banking crises. There’s basically no financial sector in the General Theory; textbook macroeconomics ever since has more or less discussed money and banking off to the side, giving it no central role in business cycle analysis.

I’d be curious to hear what Keynes scholars have to say about this omission. Keynes was certainly aware of the possibility of banking problems; his 1931 essay ―The Consequences to the Banks of the Collapse of Money Values‖ is a razor-sharp analysis of just how deflation could produce a banking crisis, as indeed it did in the United States.
But not in Britain, which may be one reason Keynes left the subject out of the General Theory. Beyond that, Keynes was – or at least that’s how it seems to a Part 1er -- primarily concerned with freeing minds from Say’s Law and the notion that, if there was any demand problem, it could be solved simply by increasing the money supply. A prolonged focus on banking issues could have distracted from that central point. Indeed, I would argue that something very like that kind of distraction occurred in economic discussion of Japan in the 1990s: all too many analyses focused on zombie banks and all that, and too few people realized that Japan’s liquidity trap was both more fundamental and more ominous in its implications for economic policy elsewhere than one would recognize if it was diagnosed solely as a banking problem.
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This time around, of course, there was no mistaking the crucial role of the financial sector in
creating a terrifying economic crisis. You can use any of a number of indicators of financial
stress to track the recent crisis; in Figure 9 I use the spread between Baa-rated corporate debt and
long-term federal debt (―spread1‖‖ is against the long-term rate on federal debt, ―spread2‖
against the 10-year constant maturity Treasury yield), which has the advantage both of being a
measure one can track over a very long history and of being a measure stressed by a fellow
named Ben Bernanke in his analyses of the onset of the Great Depression. As you can see, there
have been two great financial disruptions in modern American history, the first associated with
the banking crisis of 1930-31, the second with the shadow banking crisis of 2008.
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spread1
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Figure 9
Nobody can doubt that these financial crises played a key role in the onset both of the Great
Depression and of our recent travails, which Brad DeLong has taken to calling the Little
Depression. And yet I am increasingly convinced that it’s a mistake to think of our problems as
being entirely or even mainly a financial-sector issue. As you can see from Figure 9, the financial
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disruptions of 2008 and early 2009 have largely gone away. Yet while the economy’s freefall has ended, we’ve hardly had a full recovery. Something else must be holding the economy down.
Like many others, I’ve turned to debt levels as a key part of the story – specifically, the surge in household debt that began in the early 1980s, accelerated drastically after 2002, and finally went into reverse after the financial crisis struck.
In recent work I’ve done with Gauti Eggertsson (Eggertsson and Krugman 2010), we’ve tried to put debt into a New Keynesian framework. The key insight is that while debt does not make the world poorer – one person’s liability is another person’s asset – it can be a source of contractionary pressure if there’s an abrupt tightening of credit standards, if levels of leverage that were considered acceptable in the past are suddenly deemed unacceptable thanks to some kind of shock such as, well, a financial crisis. In that case debtors are faced with the necessity of deleveraging, forcing them to slash spending, while creditors face no comparable need to spend more. Such a situation can push an economy up against the zero lower bound and keep it there for an extended period.
I can’t quite find this story in the General Theory, although the idea of a sudden revision of conventional views about how much debt is safe certainly fits the spirit of Chapter 12. In any case, however, Keynes was definitely aware of the implications of debt and the constraints it puts on debtors for other macroeconomic questions. In the General Theory – and in reality – debt is a crucial reason why the notion expressed by Barro, that it’s just about nominal wages being too high, not only misses the point but even gets the direction of effect wrong.
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In textbook macroeconomics we draw a downward-sloping aggregate demand curve, and in that framework it does look as if a fall in nominal wages, which shifts the aggregate supply curve down, would raise employment. The argument for expansionary policy is then one of practicality: it’s easier to push AD up instead, using monetary policy. Indeed, in simple post-Keynesian models it does all boil down to M/w, the ratio of the money supply to the wage rate.
But this presupposes, first, that a rise in the real quantity of money is actually expansionary, which is normally true, but highly dubious if an economy is up against the zero lower bound. If changes in M/P don’t matter, then the aggregate demand curve becomes vertical – or worse.
For if there are spending-constrained debtors with debts specified in nominal terms – as there are in today’s world! – a fall in wages, leading to a fall in the general price level, worsens the real burden of debt and actually has a contractionary effect on the economy. This is a point of which Keynes was well aware, although it got largely lost even in the relatively Keynesian literature of the 40s and 50s.
There’s something else worth pointing out about an analysis that stresses the role of debtors forced into rapid deleveraging: it helps solve a problem Keynes never addressed, namely, when does the need for deficit spending end?
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The reason this is relevant is concern about rising public debt. I constantly encounter the argument that our crisis was brought on by too much debt – which is largely my view as well – followed by the insistence that the solution can’t possibly involve even more debt.
Once you think about this argument, however, you realize that it implicitly assumes that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.
It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.
Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.
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Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.
The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.
And it seems to me that thinking explicitly about the role of debt, not just with regard to the usefulness or lack thereof of wage flexibility, but as a key causal factor behind slumps, improves Keynes’s argument. In the long run we are, indeed, all dead, but it’s helpful to have a story about why expansionary fiscal policy need not be maintained forever.
4. The Strange Death of Keynesian Policy
So far I’ve argued that Keynesian analysis – or at least what Keynesian analysis looks like now, whatever Keynes may ―really‖ have meant – is an excellent tool for understanding the mess we’re in. Where simple Keynesian models seem to conflict with common sense, with the wisdom of practical men, the Keynesian models are right and the wisdom of the practical men entirely wrong.
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So why are we making so little use of Keynesian insights now that we’re living in an economy that, in many respects, resembles the economy of the 1930s? Why are we having to have the old arguments all over again? For it does seem as if all the old fallacies are new again.
By all means let us condemn famous men. There is no excuse for the timidity of Barack Obama, the wishful thinking of Jean-Claude Trichet, and the determined ignorance of almost everyone in the Republican party. But watching the failure of policy over the past three years, I find myself believing, more and more, that this failure has deep roots – that we were in some sense doomed to go through this. Specifically, I now suspect that the kind of moderate economic policy regime economists in general used to support – a regime that by and large lets markets work, but in which the government is ready both to rein in excesses and fight slumps – is inherently unstable. It’s something that can last for a generation or so, but not much longer.
By ―unstable‖ I don’t just mean Minsky-type financial instability, although that’s part of it. Equally crucial are the regime’s intellectual and political instability.
Let me start with the intellectual instability.
The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasizes the way the economy
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can develop what Keynes called ―magneto trouble‖, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.
It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioral assumptions are essential.
So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish: if you’re driving, a road map suffices, if you’re going hiking, you really need a topographic survey.
But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimization and market-clearing. And if the attempts to provide ―microfoundations‖ fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.
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The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.
To this intellectual instability, add political instability.
It’s possible to be both a conservative and a Keynesian; after all, Keynes himself described his work as ―moderately conservative in its implications.‖ But in practice, conservatives have always tended to view the assertion that government has any useful role in the economy as the thin edge of a socialist wedge. When William Buckley wrote God and Man at Yale, one of his key complaints was that the Yale faculty taught – horrors! – Keynesian economics.
I’ve always considered monetarism to be, in effect, an attempt to assuage conservative political prejudices without denying macroeconomic realities. What Friedman was saying was, in effect, yes, we need policy to stabilize the economy – but we can make that policy technical and largely mechanical, we can cordon it off from everything else. Just tell the central bank to stabilize M2, and aside from that, let freedom ring!
When monetarism failed – fighting words, but you know, it really did — it was replaced by the cult of the independent central bank. Put a bunch of bankerly men in charge of the monetary base, insulate them from political pressure, and let them deal with the business cycle; meanwhile, everything else can be conducted on free-market principles.
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And this worked for a while – roughly speaking from 1985 to 2007, the era of the Great Moderation. It worked in part because the political insulation of central banks also gave them more than a bit of intellectual insulation, too. If we’re living in a Dark Age of macroeconomics, central banks have been its monasteries, hoarding and studying the ancient texts lost to the rest of the world. Even as the real business cycle people took over the professional journals, to the point where it became very hard to publish models in which monetary policy, let alone fiscal policy, matters, the research departments of the Fed system continued to study counter-cyclical policy in a relatively realistic way.
But this, too, was unstable. For one thing, there was bound to be a shock, sooner or later, too big for the central bankers to handle without help from broader fiscal policy. Also, sooner or later the barbarians were going to go after the monasteries too; and as the current furor over quantitative easing shows, the invading hordes have arrived.
Last but not least, there is financial instability. As I see it, the very success of central-bank-led stabilization, combined with financial deregulation – itself a by-product of the revival of free-market fundamentalism – set the stage for a crisis too big for the central bankers to handle. This is Minskyism: the long period of relative stability led to greater risk-taking, greater leverage, and, finally, a huge deleveraging shock. And Milton Friedman was wrong: in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression.
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And by the time that big shock arrived, the descent into an intellectual Dark Age combined with the rejection of policy activism on political grounds had left us unable to agree on a wider response.
So the era of the Samuelsonian synthesis was, I suspect, doomed to come to a nasty end. And the result is the wreckage we see all around us.
5. Dangerous Ideas
The General Theory famously ends with a stirring ode to the power of ideas, which, Keynes asserted, are ―dangerous for good or evil.‖ Generations of economists have taken that ringing conclusion as justification for believing that their work matters, that good ideas will eventually translate into good policy. But how much of that hope can survive now, when both policy makers and many of our colleagues have fallen right back into the fallacies Keynes exposed?
The best answer I can give is that steady upward progress was probably too much to expect, especially in a field where interests and prejudices run as strong as they do in economics. And there may yet be scope for Keynesian ideas even in the current crisis; after all, the crisis shows no sign of ending soon, and the policies of what I call the pain caucus are visibly failing as we speak. There may be another chance to return to the ideas that should have been governing policy all along.
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So since I’m in England, here’s my advice to economists (and policy makers) frustrated – as I am – by the inadequacy of policy responses and the intellectual regression of too much of our profession: Keep calm and carry on. History will vindicate your persistence.
REFERENCES
Barro, Robert (2009), “Government spending is no free lunch”, Wall Street Journal, January 22.
Cochrane, John (2009), “Fiscal stimulus, fiscal inflation, or fiscal fallacies?”, http://faculty.chicagobooth.edu/john.cochrane/research/Papers/fiscal2.htm
Eggertsson and Krugman (2010), “Debt, deleveraging, and the liquidity trap”, mimeo.
Keynes, J.M. (1937), “The general theory of employment”, Quarterly Journal of Economics.
George Soros, Niall Ferguson, Paul Krugman, Robin Wells, and Bill Bradley, et al. (2009), “The crisis and how to deal with it”, New York Review of Books, June 11.