Vulgar Keynesians
Economics, like all
intellectual enterprises, is subject to the law of diminishing disciples. A
great innovator is entitled to some poetic license. If his ideas are at first
somewhat rough, if he exaggerates the discontinuity between his vision and what
came before, no matter: Polish and perspective can come in due course. But
inevitably there are those who follow the letter of the innovator's ideas but
misunderstand their spirit, who are more dogmatic in their radicalism than the
orthodox were in their orthodoxy. And as ideas spread, they become increasingly
simplistic--until what eventually becomes part of the public consciousness,
part of what "everyone knows," is no more than a crude caricature of the
original.
Such has been the fate of
Keynesian economics. John Maynard Keynes himself was a magnificently subtle and
innovative thinker. Yet one of his unfortunate if unintentional legacies was a
style of thought--call it vulgar Keynesianism--that confuses and befogs
economic debate to this day.
Before the 1936 publication
of Keynes' The General Theory of Employment, Interest, and Money ,
economists had developed a rich and insightful theory of microeconomics ,
of the behavior of individual markets and the allocation of resources among
them. But macroeconomics --the study of economy-wide events like
inflation and deflation, booms and slumps--was in a state of arrested
development that left it utterly incapable of making sense of the Great
Depression.
So-called "classical"
macroeconomics asserted that the economy had a long-run tendency to return to
full employment, and focused only on that long run. Its two main tenets were
the quantity theory of money--the assertion that the overall level of prices
was proportional to the quantity of money in circulation--and the "loanable
funds" theory of interest, which asserted that interest rates would rise or
fall to equate total savings with total investment.
Keynes was willing to
concede that in some sufficiently long run, these theories might indeed be
valid; but, as he memorably pointed out, "In the long run we are all dead." In
the short run, he asserted, interest rates were determined not by the balance
between savings and investment at full employment but by "liquidity
preference"--the public's desire to hold cash unless offered a sufficient
incentive to invest in less safe and convenient assets. Savings and investment
were still necessarily equal; but if desired savings at full employment turned
out to exceed desired investment, what would fall would be not interest rates
but the level of employment and output. In particular, if investment demand
should fall for whatever reason--such as, say, a stock-market crash--the result
would be an economy-wide slump.
It was a brilliant
re-imagining of the way the economy worked, one that received quick acceptance
from the brightest young economists of the time. True, some realized very early
that Keynes' picture was oversimplified; in particular, that the level of
employment and output would normally feed back to interest rates, and that this
might make a lot of difference. Still, for a number of years after the
publication of The General Theory , many economic theorists were
fascinated by the implications of that picture, which seemed to take us into a
looking-glass world in which virtue was punished and self-indulgence
rewarded.
Consider, for example, the
"paradox of thrift." Suppose that for some reason the savings rate--the
fraction of income not spent--goes up. According to the early Keynesian models,
this will actually lead to a decline in total savings and investment.
Why? Because higher desired savings will lead to an economic slump, which will
reduce income and also reduce investment demand; since in the end savings and
investment are always equal, the total volume of savings must actually
fall!
Or
consider the "widow's cruse" theory of wages and employment (named after an old
folk tale). You might think that raising wages would reduce the demand for
labor; but some early Keynesians argued that redistributing income from profits
to wages would raise consumption demand, because workers save less than
capitalists (actually they don't, but that's another story), and therefore
increase output and employment.
Such paradoxes are still fun to contemplate; they still
appear in some freshman textbooks. Nonetheless, few economists take them
seriously these days. There are a number of reasons, but the most important can
be stated in two words: Alan Greenspan.
After all,
the simple Keynesian story is one in which interest rates are independent of
the level of employment and output. But in reality the Federal Reserve Board
actively manages interest rates, pushing them down when it thinks employment is
too low and raising them when it thinks the economy is overheating. You may
quarrel with the Fed chairman's judgment--you may think that he should keep the
economy on a looser rein--but you can hardly dispute his power. Indeed, if you
want a simple model for predicting the unemployment rate in the United States
over the next few years, here it is: It will be what Greenspan wants it to be,
plus or minus a random error reflecting the fact that he is not quite God.
But putting Greenspan (or his successor) into
the picture restores much of the classical vision of the macroeconomy. Instead
of an invisible hand pushing the economy toward full employment in some
unspecified long run, we have the visible hand of the Fed pushing us toward its
estimate of the noninflationary unemployment rate over the course of two or
three years. To accomplish this, the board must raise or lower interest rates
to bring savings and investment at that target unemployment rate in line with
each other. And so all the paradoxes of thrift, widow's cruses, and so on
become irrelevant. In particular, an increase in the savings rate will
translate into higher investment after all, because the Fed will make sure that
it does.
To me, at
least, the idea that changes in demand will normally be offset by Fed
policy--so that they will, on average, have no effect on employment--seems both
simple and entirely reasonable. Yet it is clear that very few people outside
the world of academic economics think about things that way. For example, the
debate over the North American Free Trade Agreement was conducted almost
entirely in terms of supposed job creation or destruction. The obvious (to me)
point that the average unemployment rate over the next 10 years will be what
the Fed wants it to be, regardless of the U.S.-Mexico trade balance, never made
it into the public consciousness. (In fact, when I made that argument at one
panel discussion in 1993, a fellow panelist--a NAFTA advocate, as it
happens--exploded in rage: "It's remarks like that that make people hate
economists!")
What has made it into the public
consciousness--including, alas, that of many policy intellectuals who imagine
themselves well informed--is a sort of caricature Keynesianism, the hallmark of
which is an uncritical acceptance of the idea that reduced consumer spending is
always a bad thing. In the United States, where inflation and the budget
deficit have receded for the time being, vulgar Keynesianism has recently
staged an impressive comeback. The paradox of thrift and the widow's cruse are
both major themes in William Greider's latest book, which I discussed last month.
(Although it is doubtful whether Greider is aware of the source of his
ideas--as Keynes wrote, "Practical men, who believe themselves quite exempt
from any intellectual influence, are usually the slaves of some defunct
economist.") It is perhaps not surprising that the same ideas are echoed by
John B. Judis in the ; but when you see the idea that higher savings will
actually reduce growth treated seriously in ("Looking for Growth in All the
Wrong Places," Feb. 3), you realize that there is a real cultural phenomenon
developing.
To justify
the claim that savings are actually bad for growth (as opposed to the quite
different, more reasonable position that they are not as crucial as some would
claim), you must convincingly argue that the Fed is impotent--that it cannot,
by lowering interest rates, ensure that an increase in desired savings gets
translated into higher investment.
It is not enough to argue that interest
rates are only one of several influences on investment. That is like saying
that my pressure on the gas pedal is only one of many influences on the speed
of my car. So what? I am able to adjust that pressure, and so my car's speed is
normally determined by how fast I think I can safely drive. Similarly,
Greenspan is able to change interest rates freely (the Fed can double the money
supply in a day, if it wants to), and so the level of employment is normally
determined by how high he thinks it can safely go--end of story.
No, to make sense of the
claim that savings are bad you must argue either that interest rates have
no effect on spending (try telling that to the National Association of
Homebuilders) or that potential savings are so high compared with investment
opportunities that the Fed cannot bring the two in line even at a near-zero
interest rate. The latter was a reasonable position during the 1930s, when the
rate on Treasury bills was less than one-tenth of 1 percent; it is an arguable
claim right now for Japan, where interest rates are about 1 percent. (Actually,
I think that the Bank of Japan could still pull that economy out of its funk,
and that its passivity is a case of gross malfeasance. That, however, is a
subject for another column.) But the bank that holds a mortgage on my house
sends me a little notice each month assuring me that the interest rate in
America is still quite positive, thank you.
Anyway,
this is a moot point, because the people who insist that savings are bad do not
think that the Fed is impotent. On the contrary, they are generally the same
people who insist that the disappointing performance of the U.S. economy over
the past generation is all the Fed's fault, and that we could grow our way out
of our troubles if only Greenspan would let us.
Let's quote the Feb. 3 Business
Week
commentary:
Some contrarian
economists argue that forcing up savings is likely to slow the economy,
depressing investment rather than sparking it. "You need to stimulate the
investment decision," says University of Texas economist James K. Galbraith, a
Keynesian. He would rather stimulate growth by cutting interest rates.
So, increasing savings will
slow the economy--presumably because the Fed cannot induce an increase in
investment by cutting interest rates. Instead, the Fed should stimulate growth
by cutting interest rates, which will work because lower interest rates will
induce an increase in investment.
Am I
missing something?
To read the reply of
"Vulgar Keynesian" James K. Galbraith, in which he explains green cheese and
Keynes, click here.
