Posts Tagged ‘Keynes’

Japan’s debt and money illusion

Friday, October 1st, 2010

Harvard economist Martin Feldstein worries that a shift from 1% deflation to 1% inflation in Japan will produce soaring deficits and increased debt, even if real interest rates do not change:

[D]espite the large government deficit and the enormous government debt – now close to 200% of GDP – the interest rate on 10-year Japanese government bonds is just 1%, the lowest such rate in the world.

But what of the future? While the current situation could continue for a number of years, there is a risk that rising interest rates and reductions in net business saving will bring Japan’s current-account surplus to an end.

One reason for a rise in the interest rate would be a shift from low deflation to low inflation. Prices in Japan have been falling at about 1% a year. If that swung by two percentage points – as the government and the central bank want – to a positive 1% inflation rate, the interest rate would also increase by about two percentage points. With a debt-to-GDP ratio of 200%, the higher interest rate would eventually raise the government’s interest bill by about 4% of GDP. And that would push a 7%-of-GDP fiscal deficit to 11%.

Higher deficits, moreover, would cause the ratio of debt to GDP to rise from its already high level, which implies greater debt-service costs and, therefore, even larger deficits.

Martin Feldstein, “Japan’s Savings Crisis”, Project Syndicate, 24 September 2010.

Professor Feldstein is wrong. He suffers from “money illusion”, a tendency to think of debt and interest rates in nominal, rather than real, terms. Economists regard money illusion as a sign of irrationality. In fact, money illusion separates the Keynesians (who believe that people suffer from it) from the New Classical economists (who assume that everyone is rational). Professor Feldstein has an extraordinary cv. He was Chairman of President Ronald Reagan’s Council of Economic Advisors, and is former President of the prestigious National Bureau for Economic Research. It is thus remarkable that he suffers from money illusion.

A rise of two percentage points in inflation and nominal interest rates would increase nominal interest payments on Japan’s public debt, but not real (inflation adjusted) interest payments. If the government actually paid the higher nominal costs of debt service, the real value of its debt would fall. Debt service costs in real terms would also fall.

Yale economist Irving Fisher (1867-1947), along with John Maynard Keynes (1883-1946), believed that people are afflicted in varying degrees by “money illusion”. In 1928 Fisher wrote an important book on the subject, appropriately titled Money Illusion. Years ago I read the book, which was then out-of-print and difficult to locate. The book has since been reprinted as an inexpensive paperback. It is a short book – 236 pages plus index – an easy read. I recommend it highly.  Fisher was the first economist to distinguish clearly between real and nominal interest rates. The resulting equation is known as the Fisher equation in his honour.

A digitized edition of Fisher’s longer and more difficult work, The Theory of Interest (1930) is available online (ungated). A scan of the first chapter can be viewed here. Although Fisher was a mathematical economist, he wrote clearly, expressing ideas with words rather than symbols.

Update: I posted a short comment at Project Syndicate, with a link to this post. The comment was accepted, but has since been removed. Very strange. Fortunately, I have my own blog and can voice my concerns here.

Keynes vs Hayek

Sunday, July 11th, 2010

In October of 1932, in the midst of the Great Depression, John Maynard Keynes, A.C. Pigou, and other Cambridge and Oxford economists published an invited letter in The Times, in which they advocated public spending on all manner of projects in order to put people to work.

[I]in present conditions, private economy does not transfer from consumption to investment part of an unchanged national real income. On the contrary, it cuts down the national income by nearly as much as it cuts down consumption. Instead of enabling labour-power, machine-power and shipping-power, to be turned to a different and more important use, it throws them into idleness.

Moreover, what is true of individuals acting singly is equally true of groups of individuals acting through local authorities. If the citizens of a town wish, to build a swimming-bath or a library, or a museum, they will not, by refraining from doing this, promote a wider national interest. They will be “martyrs by mistake,” and, in their martyrdom, will be injuring others as well as themselves. Through their misdirected good will the mounting wave of unemployment will be lifted still higher.”

J.M. Keynes, A.C. Pigou and others,“Private Spending”, The Times (London), 17 October 1932, p. 13.

Two days later, Friedrich Hayek and his colleagues at the London School of Economics responded, urging fiscal restraint.

We are of the opinion that many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities.  We do not desire to see a renewal of such practices.  At best they mortgage the Budgets of the future, and they tend to drive up the rate of interest — a process which is surely particularly undesirable at this juncture, when the revival of the supply of capital to private industry is an admitted urgent necessity.  The depression has abundantly shown that the existence of public debt on a large scale imposes frictions and obstacles to readjustment very much greater than the frictions and obstacles imposed by the existence of private debt.  Hence we cannot agree with the signatories of the letter that this is a time for new municipal swimming baths, etc., merely because people “feel they want” such amenities.

F.A. Hayek, Lionel Robbins and others, “Spending and Saving”, letter to the editor, The Times (London), 19 October 1932, p. 10.

The letter from Hayek and friends could have been written today, by a deficit hawk. As NYU economist Mario Rizzo puts it, “the great debate is still Keynes versus Hayek. All else is footnote.”

HT: Mario Rizzo, via P. Krugman

Max Corden on fiscal stimulus

Tuesday, March 2nd, 2010

Max Corden has given considerable thought to the world economy’s recent heart attack, an economy’s “heart and arteries being the financial sector”. He has written a concise essay about fiscal stimulus – “about the ambulance that has been called upon all over the world, from China and Japan, to the US and Germany, and about all those hostile arguments that have been thrown at it as it hurtled past”. Here is a short excerpt from the essay:

In this crisis we have seen a major case of worldwide market failure. That can hardly be questioned. But can governments be trusted? It is too early to judge and compare government reactions. Here is important scope for research. But on the broad issue, let me refer to The Master.

Keynes was certainly critical of governments. He was definitely not naïve. In his view governments did the wrong thing after the First World War, at the Versailles Treaty negotiations – so he wrote The Economic Consequences of the Peace. The British government did the wrong thing in 1925 when it returned sterling to the gold standard at an overvalued parity – so that he wrote The Economic Consequences of Mr Churchill. And the American, British and other governments failed, of course, during the Great Depression, especially by adhering too long to the gold standard, and by being preoccupied with budget balancing. But he did believe that governments can get it right, and he believed in his ability, and indeed duty, to persuade.

The other underlying issue is the relative weight one places on the danger of another Great Depression relative to a revival of inflation. I think that older people (like myself), are likely to weigh heavily the danger of another depression. There is also the issue of how much one knows about the Great Depression – a matter of knowing history. I find the concern about inflation in present circumstances surprising, though one has to accept that it is reasonable to focus on the ‘exit’ from the crisis, so as not to lay the foundation for another inflationary or bubble period.

W. Max Corden, “Ambulance economics: The pros and cons of fiscal stimuli”, CEPR Policy Insight No. 43 (January 2010), p. 6.

University of Melbourne economist Warner Max Corden (1927-) emigrated from Nazi Germany to Australia in 1939. His numerous publications include The Theory of Protection (Oxford University Press, 1971) and Too Sensational: On the Choice of Exchange Rate Regimes (MIT Press, 2002). I purchased the first book and read it from cover to cover when I was in graduate school in the early 1970s. Professor Corden’s writing is as lucid and didactic today as it was four decades ago. We are very fortunate to have him with us during the current financial crisis.

Edmund Phelps on macroeconomics

Tuesday, November 3rd, 2009

Columbia University macroeconomist Edmund Phelps thinks that economic fallacies abound because spokesmen on each side of the “theory wars” ignore past economic thought. “The ‘Keynesians’ seem not to have studied Keynes and the neoclassicals misread or do not read Hayek.”

These fallacies lull analysts into the false sense that, one way or another, a full recovery lies ahead – thanks to government spending or to self-correcting market forces. As I see it, the poor state of balance sheets in households, banks and many companies augurs a “structural slump” of long duration. Employment will recover, quickly or slowly, only as far as investment demand will carry it. It is highly uncertain whether government spending on infrastructure would help, after taking into account the employment effects of the higher tax rates to pay for it. ….

The lesson the [financial] crisis teaches, though it is not yet grasped, is that there is no magic in the market: the expectations underlying asset prices cannot be “rational” relative to some known and agreed model since there is no such model.

Edmund Phelps, “A fruitless clash of economic opposites”, Financial Times, 3 November 2009.

Professor Phelps has long been concerned with workers who suffer in economic recessions yet do not participate fully in periods of economic growth. To address this concern, he proposes – most elaborately in Rewarding Work: How to Restore Participation and Self-Support to Free Enterprise (Harvard University Press, 1997) – a system of public subsidies to increase the wages of low-skilled workers. In 2006 he received the Nobel Prize in Economics, concluding his Nobel Prize Lecture with the words “a morally acceptable economy must have enough dynamism to make work amply engaging and rewarding; and have enough justice, if dynamism alone cannot do the job, to secure ample inclusion.”

Richard Posner becomes a Keynesian

Friday, September 25th, 2009

Judge Posner, the prolific conservative writer who co-blogs with Chicago economist Gary Becker, read Keynes and saw the light. This surprising transformation speaks volumes about Posner’s intellectual honesty.

Until last September, when the banking industry came crashing down and depression loomed for the first time in my lifetime, I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics. ….  I had heard that it was a very difficult book, which I assumed meant it was heavily mathematical; and that Keynes was an old-fashioned liberal, who believed in controlling business ups and downs through heavy-handed fiscal policy (taxing, borrowing, spending); and that the book had been refuted by Milton Friedman, though he admired Keynes’s earlier work on monetarism. ….

We have learned since September that the present generation of economists has not figured out how the economy works. The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery. ….

Baffled by the profession’s disarray, I decided I had better read The General Theory. Having done so, I have concluded that, despite its antiquity, it is the best guide we have to the crisis.  ….

Keynes’s masterpiece is many things, but “outdated” it is not. So I will let a contrite Gregory Mankiw, writing in November 2008 in The New York Times, amid a collapsing economy, have the last word: “If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront. . . . Keynes wrote, ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.’ In 2008, no defunct economist is more prominent than Keynes himself.”

Richard Posner, “How I Became a Keynesian: Second Thoughts in the Middle of a Crisis”, The New Republic, 23 September 2009.

Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School. Gregory Mankiw is a professor at Harvard and author of a best-selling economics textbook.

HT to Greg Mankiw.

Krugman on Keynes

Thursday, September 24th, 2009

“At research seminars, people don’t take Keynesian theorising seriously anymore; the audience starts to whisper and giggle to one another.” So declared Robert Lucas of the University of Chicago, writing in 1980. At the time, Lucas was arguably the world’s most influential macroeconomist; the influence of John Maynard Keynes, the British economist whose theory of recessions dominated economic policy for a generation after the Second World War, seemed to be virtually at an end.

But Keynes, it turns out, is having the last giggle. Lucas’s “rational expectations” theory of booms and slumps has shown itself to be completely useless in the current world crisis. Not only does it offer no guide for action, but it more or less asserts that market economies cannot possibly experience the kind of problems they are, in fact, experiencing. Keynesian economics, on the other hand, which was created precisely to make sense of times like these, looks better than ever.

Paul Krugman, “Keynes: The Return of the Master by Robert Skidelsky”, The Observer, 30 August 2009.

Paul Krugman is reviewing Robert Skidelsky’s latest book.

Robert Gordon on macroeconomics

Monday, September 14th, 2009

Via David Warsh we are treated to yet another critique of modern macroeconomics, this time by Northwestern University economist Robert J. Gordon. Professor Gordon does not think much of the developments of the past 30 years, which produced sophisticated “Dynamic Stochastic General Equilibrium (DSGE) models that combined new-classical market clearing with the new-Keynesian contribution of sticky prices.” He concludes:

To understand the domestic macroeconomic environment of the 2007-09 worldwide crisis, we are best served by … re-learning 1978-era macroeconomics and dropping the adjective “Keynesian” due to its perjorative connotations. …. Empirical success and common sense have triumphed over the endless search for deep micro foundations in a world in which macroeconomic interactions triumph over individual choice. Modern macro needs to go back to the drawing board and recognize that the integrated world view of 1978-era macro has been established and tested for more than 30 years and can no longer remain ignored.

Robert J. Gordon, “Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis?“, 12 September 2009.

This is the revised version of a paper first presented to an International Colloquium in Sao Paulo, Brazil, on 3 August 2009. In it, Gordon is asking us to forget all macroeconomic theory developed since 1978 and accept that unemployment can be involuntary. The 35-page paper is very academic, with five pages of references and two diagrams. Its message is strikingly similar to that of Paul Krugman’s recent essay, with an important difference in style: Gordon’s intended audience is professional economists whereas Krugman was writing for the New York Times. Krugman also is more ‘reactionary’ than Gordon, and would like to turn the clock back further, to 1936 rather than 1978. Krugman proudly deploys the adjective “Keynesian” and praises “1936-era Keynesian thought” (Gordon’s words) that Gordon explicitly rejects.