Thursday, March 19, 2015

Levine on the Keynesian Illusion

David Levine has a very nice post on the Keynesian Illusion.

David Levine's analogy for Stimulus
Some big themes: Standard Keynesian economics violates budget constraints. He explains it well, but it is sure to occasion the usual venom from with the "Say's law fallacy" brigade that has a lot of trouble understanding the difference between budget constraints and equilibrium conditions.

David does a lot without equations. That broadens the appeal, but equations can be useful. For example equations clarify that crucial difference between budget constraints and equilibrium conditions. Equations can put to rest silly controversies. We might not still be writing papers, books, and blog posts about what "Keynes really meant," 80 years after the fact, or using "Say's law" as rotten tomatoes, if Keynes had written some equations.  Cynically, maybe the lesson is that lack of equations -- or even an equations appendix or citation -- keeps debate going and your name in the papers.

I also fear that his lovely anecdote about people each of whom wants what others produce will lead readers a bit astray. Keynesian economics is about lack of "demand," sticky prices not absent prices. It's not about absence of money, double coincidence of wants, and so forth.

David goes beyond the usual IS/LM formalism, to explain some of the "coordination failure" interpretations of Keynes. He also references Axel  Leijonhufvud's "great and famous work" describing a mismatch between saving, a desire for generic future consumption, and the demand for specific goods that firms need to invest.

He has a nice personal story of his Keynesian upbringing, which reminds me of my own. And
Knowledge of Keynesianism and Keynesian models is even deeper for the great Nobel Prize winners who pioneered modern macroeconomics - a macroeconomics with people who buy and sell things, who save and invest - Robert Lucas, Edward Prescott, and Thomas Sargent among others. They also grew up with Keynesian theory as orthodoxy - more so than I. And we rejected Keynesianism because it doesn't work not because of some aesthetic sense that the theory is insufficiently elegant.
The constant refrain that critics "don't know" Keynesian economics is an ingorant (I mean that not an insult, but in its literal meaning, ignoring the facts) calumny. Sargent's first book "Macroeconomic Theory" is a great example of a modern economists wrestling hard with Keynes.

The last paragraph is a gem:
Keynes own work consists of amusing anecdotes and misleading stories. Keynesianism as argued by people such as Paul Krugman and Brad DeLong is a theory without people either rational or irrational, a theory of graphs pulled largely out of thin air, a series of predictions that are hopelessly wrong - together with the vain hope that they can be put right if only the curves in the graphs can be twisted in the right direction. As it happens we have developed much better theories - theories that do explain many facts, theories that provide sensible policy guidance, theories that work reasonably well, theories that are not an illusion. The current versions of these theories are very unlike caricature theories of hopelessly rational people who are all identical. Current theories are not perfect - but unlike the Keynesian theory of perpetual motion machines they explain a great deal and have a great deal of truth to them. A working macroeconomist reading Krugman and DeLong feels as a doctor would if the Surgeon General got up and said that the way to cure cancer was to draw blood using leeches. 


  1. There’s a glaring flaw in Levine’s argument, namely his assumption that Keynsianism depends on the multiplier. The reality is that even if there is no multiplier, Keynsian stimulus still works.

    E.g. if government simply prints and spends enough to employ X people, then about X extra people will be employed (assuming the economy is not at capacity / full employment and assuming no multiplier). Alternatively government could cut taxes by the same amount, though the effect on employment there is not quite so certain.

    Keynes said that stimulus could be funded by borrowed or printed money. In the case of borrowed money, the effect is less clear because borrowing obviously has an anti-stimulatory effect: or to use the jargon, that borrowing will to some extent “crowd out” other borrowing.

    But in the case of printing, it’s desperately simple: print and spend enough to employ X people and X extra people will be employed. And if there is a multiplier, it’ll be more than X people.

    1. ...Sure Ralph! And perhaps we could add some crowding in too there. How about, for each X additional employees in the public sector, the private sector responds by hiring some workers too? We could end up with an employment over population ratio of 150% in no time...

  2. John, either you are unaware of the other blogs pointing out the flaws in Levine's argument. I find this unlikely, since you seem to read in the blogosphere (after all, you also found Levine's post).

    Or you're aware of them, read them, and thought they didn't make sense, so Levine's argument still stands in your eyes. But then I'd expect you to engage with the critics, rather than just ignore them.

    Or you thought the critics were right, Levine's argument doesn't make sense, but you still approvingly link to it because it fits with you own ideology.

    Either case is a bad sign...

    1. I just read Levine, thought it was interesting and worth passing on, with my own reservations. If you want to post links to critics, perhaps with a sentence or two about their main cirticism, we could have a good discussion. I suspect we'll find the advantages of writing some equations if we get in to blog posts criticizing blog posts. In the end, there is a useful distinction between idea generation and refinement and exposition for nontechnical audiences.

    2. 1- Safe assets glut:

      2- Levine does not understand what money is:

      Regarding old Keynesian/Hickians models, it's true they are not the best but at least they match the data fair enough without recurring to very implausible calibrations: e.g. see here:

    3. Any article blog post or tweet that starts with "x does not understand y", "x does not know y" etc is unworthy of even being read.

    4. Ok, John do what you prefer but this is not very professional.

    5. I agree. Ad-hominem attacks, insults, allegations of corruption, and writing about what people do and do not know are completely unprofessional and unethical. And the best response is silence. If people want their arguments considered and responded to, they need to learn to talk about ideas. If you respond, you incentivize such behavior.

    6. Any article blog post or tweet that starts with "x does not understand y", "x does not know y" etc is unworthy of even being read.

      Actually, Nick Rowe's post begins:

      I confess this is a bit of a "Gotcha!". But it's a bit more than that as well. It illustrates the difficulty that people (even economists) have in "seeing" money.

      That's hardly offensive.

    7. Levine claims to understand modern Keynesianism, but then makes the bizarre claim that "Keynes is so popular with those that do not do math" and tries to refute Keynesianism with a simplistic example that doesn't appear to be relevant to Keynesianism.

      Really, are people supposed to believe that Greg Mankiw is disproved by that essay? That's absolutely ridiculous.

      So I agree that more clarification is in order if we're supposed to take this seriously, and not assume that it's just a few grumpy conservatives desperately looking for excuses to rag on liberals.

  3. John, the "x does not understand y" bit was added by anonymous. As I'm sure you're aware Nick Rowe is very polite and I think his argument is worth addressing.

  4. "Standard Keynesian economics violates budget constraints."

    I'm intrigued by this comment. Can you elaborate.

    My overall impression of Levine's post was that it was quite interesting but didn't really relate to the sort of problems Keynesian polices are intended to address. It was like reading an elegant explanation of why a hammer is no good at cutting wood.

  5. Levine claims that there is no model representing Keynesian theory, but this is false. At a minimum, there is the Old Keynesian model, and there is the New Keynesian models. He probably doesn't like the former, but the latter has budget constraints, rational expectations, and so on.

    Instead of addressing these models, he builds his own model of "Keynesian economics" in order to critique it. But what he produces is quite unlike the models that Keynesian actually work with, and so it's not clear that he's critiquing Keynesian economics at all, rather than just a strawman.

    This isn't even getting at the Rowe/Delong criticism of his model (i.e. that the phones are serving as a medium exchange, and hence are money, and that he neglects the possibility of a monetary economy).

  6. John,

    As pointed out above, the New Keynesian model has ratex, budget constraints *and* aggregate demand. Maybe price setting isn't perfectly well microfounded, but then as Simon Wren-Lewis has pointed out, neither is the Walrassian auctioneer.

    Bottom line: if prices are sticky *at all* (whatever the mechanism), then liquidity preference effects dictate that the monetary authority controls the real rate by setting the nominal rate. And inflation *cannot* be determined by the Fisher equation alone. If the CB sets the real rate, you can't avoid AD.

    Neoclassicals need an intertemporally consistent model of the real rate that respects the fact that the CB sets real rate in the short run.


  7. I'm not sure I understand this: "A working macroeconomist reading Krugman and DeLong feels as a doctor would if the Surgeon General got up and said that the way to cure cancer was to draw blood using leeches."

    Presumably, results from New Keynesian models are not analogous to drawing blood using leeches. Krugman, DeLong, and some others use ISLM sometimes to tell a story, but in the background (and sometimes explicitly too) they use modern New Keynesian models. Why is this so horrible? In graduate school, we first study the simplest RBC models because, even though they are missing a lot, they provide some intuition to keep in mind in more complex models. The same is true in finance, labor, and other fields. Why is the line between acceptable and unacceptable drawn at contains optimizing agents vs. does not contain optimizing agents? Lots of models are useful for telling stories and a smaller class are useful for calibrating and making concrete policy decisions. Is it necessarily the case that Krugman and DeLong don't understand this?

  8. John: Let me put it this way: I think that David missed seeing another interpretation of his parable: that "phones" are money, and that the "phone guy" who produces phones is the central bank that produces money.

    (I would also say, and have said several times, that many Keynesians, and New Keynesians in particular, miss "seeing" the money that is implicitly in their models. David is not alone.)

    1. Nick Rowe,

      I saw your comment before, and I'm perplexed. How can phones be money in this example, since only the tattoo artist is willing to accept a phone as payment? To be money, wouldn't the item need to be more universal? Not necessarily acceptable to all, but to at least more than 25% of the population? If not, then aren't there four types of money here?

    2. Prof J,

      As I read Levine's piece, it seems that everyone accepts the phone as payment:

      "What happens is clear enough: the phone guy produces a phone, trades it to the tattoo artist in exchange for a tattoo, who trades the phone to the hairdresser in exchange for a haircut, who trades it to burger flipper in exchange for a burger. All are employed, all get what they want - everyone is happy."

    3. Prof J: think about a $20 bill. Each person accepts it in payment, and passes it on to the next person, who also accepts it in payment, and passes it on, and so on forever. Nobody wants to hold it without planning to pass it on to someone else. What percentage of the population would accept a $20 bill in payment, if they did not plan to pass it on to someone else? Only people who collect rare currency. That's a lot less than 1% of the population.

      It's exactly the same with the phone in David's example. Most people accept the phone in payment, but only because they plan to pass it on to someone else.

    4. Nick, the phones are money, but money is not the problem in the story. The problem is that each person has only one unique buyer and seller. Consider a case where any of them decide they don't want to buy anything. You'll get the same depression.

      Check out the addendum from Levine. Same link as original.

    5. I went back to read Levine's addendum. That clears up my problem, but also makes the point that money isn't the issue creating the problems.

    6. I'm pretty sure that Levine meant phones to be money in his model.

  9. Let me try to see if I get this.

    Round 1 (Levine): Everyone produces because they want to consume. If someone decides they no longer want to produce, it all falls apart. Same thing happens if someone decides they no longer want to consume, because the person who produces whatever they consumed now has no market, and stops producing, and it all falls apart.

    Round 2 (Um... Smith?): In reality it doesn't "all fall apart" because for each thing there's more than one producer, and more than one consumer, and people can substitute on both ends. So it's more of a gradual failure. Now, instead of "it all falls apart" we have more of an equilibrium, that re-adjusts for disruptions like "someone decides not to produce/consume".

    Round 3 (deLong): None of this is relevant to the recent downturn, because the economy also includes money and financial assets, which are claims against future output. What happened here was that people's financial assets evaporated simultaneously, and they wanted to restore their assets, so they all stopped consuming at once, and the system couldn't adjust to a disruption that large - so it all fell apart, but there's a simple fix. Put money into the system, restoring people's financial assets to their former value, and they resume consuming and producing.

    Round 4 (Friedman?): Financial assets are claims on future output. They fall in value because people are afraid that the output will not actually be there. But money is just another claim on output. When you add money, you dilute the value of the financial assets-plus-money by adding MORE claims on future output. When people realize that, they realize the value of their financial assets-plus-money has declined again. They then redouble their efforts to save, further reducing consumption.

    Round 5 (Modern Keynesians?): Round 4 is called inflation, and it's too simplistic. If you add a measured quantity of money, and do it in the right way by giving the money to the right people (with a "high propensity to consume"), their consumption increases production, which increases future output faster than you're adding money to the system, and all will be well - no inflation.

    Round 6 (Modern Austrians?): Round 5 sounds great, but the people with high propensity to consume will not be the ones generating the extra production - in fact, they will produce less. The extra production will come from either holders of financial assets or from producers, through wealth and income taxes being cycled back to the consume-but-not-produce-or-invest-ers. So the returns to investment and the returns to production will be lower, causing those people to cut back, slowing the rate of economic growth - and economic growth is what fixes all problems, and its lack is what ultimately causes all problems.

    Round 7 (Progressives?): Round 6 isn't so bad. Sure, the investors will cut back, and producers will cut back, but when they do, what will they do with their money instead? They'll consume! That will help to restore the returns to investing and producing. Maybe the growth rate will end up lower, but there will be more social justice, and that's worth something.

    Round 8 (Austrians again, I think): Round 7 is wrong! The investors and producers won't spend their money instead - they'll just have less money! The marginal value of producing will be lower, so they'll adjust by producing less and making less effort. They won't consume more, and they'll produce less, which will be spread more thinly, and everyone will collectively be worse off.

    Round 9 (Progressives, again): Okay, maybe - just maybe - everyone will collectively be worse off. But, the poorest will be less poor, and the richest will be less rich, and social justice is worth something.

    Round 10 (Cochrane): We're going to need some equations, here.

    Do I have that about right?

  10. Levine: "Now suppose that the phone guy suddenly decides he doesn't like tattoos enough to be bothered building a phone."

    It's called the demand shock. Government buys the tattoos for a while whereas a tattoo artist is getting a new profession.

  11. An interesting article that attempts to evaluate Keynesian views from the ground up. It presents an invitation to think more deeply about the fundamental of Keynesianism, but most of the commenters appear interested only in denying Levine's conclusion. I need to read and reread it a few times to take it all in (including also the contra views).

  12. Stephen Williamson had a response to all of this for anyone who is interested. And I think this quote from the comments section kind of sums up why these arguments never seem to go anywhere:

    "What "Keynesians have in mind" are many things. And for every person with a "Keynesian" idea, there is another who claims the idea is "not Keynesian."

    Kind of reminds me of all of the back and forth bickering after your Alan Blinder post from a couple months ago about Keynesians, New Keynesians, etc.


    Well, according to Simon Wren-Lewis, New Keynesians are doing much better than RBC people in 80's because RBC price taking isn't microfounded.

  14. "Cynically, maybe the lesson is that lack of equations -- or even an equations appendix or citation -- keeps debate going and your name in the papers."

    Regardless of whether I agree with this post (or Levine), I have to admit that this statment got me thinking for quite a bit. I think you are definitely onto something here.

  15. Levine certainly has a mastered the verbosity of Keynes.
    Shorter version:
    In a closed economy in which everyone is a producer and consumer of one good, all transactions stop.

    Keynes - There is a demand problem
    Friedman - There is a supply problem
    Mulligan - Everyone went on vacation, what's the problem?


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