Tag: John Maynard Keynes

A note on Niall Ferguson: Why did Keynes write “In the long run we are all dead”?

Posted on by Brad DeLong

Niall Ferguson (2013): An Open Letter to the Harvard Community: “Last week I said something stupid about John Maynard Keynes…

…Asked to comment on Keynes’ famous observation “In the long run we are all dead,” I suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay. This was doubly stupid. First, it is obvious that people who do not have children also care about future generations. Second, I had forgotten that Keynes’ wife Lydia miscarried…

Niall, I think, misses the entire point. There is much, much more here than he recognizes… And what he recognizes is not, in fact, here at all…

Niall speaks of Keynes’s “In the long run we are all dead” as if it is a carpe diem argument–a “seize the day” argument, analogous to Marvell’s “To His Coy Mistress” or Herrick’s “To the Virgins”. Ferguson sees his task as that of explaining why Keynes adopted this be-a-grasshopper-not-an-ant “party like we’re gonna die young!” form of economics, or perhaps form of morality.

But that is not what is going on.

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Go to Keynes’s Tract on Monetary Reform. Read pages 80-82, so you see the “in the long run we are all dead” quote in context. It is not part of any carpe diem argument. Two sentences earlier we find:

If, after the American Civil War, that American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k’ would be entirely unaffected…

Six sentences earlier we find:

[T]he [Quantity] Theory [of Money] has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k’,–that is to say, in mathematical parlance, that n is an independent variable in relation to these quantities…

Two sentences later we find:

In actual experience, a change in n is liable to have a reaction both on k and k’ and on r…

And six sentences later we find:

There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way…

Keynes is discussing not how to “seize the day” for pleasure.

Keynes is discussing how to use the quantity theory of money as an analytical tool.

What he is saying is that you cannot assume that you can analyze the consequences of an altered time path of the quantity of cash in the economy–n, in Keynes’s notation–without considering whether the public’s demand for real cash balances k, the public’s demand for real checking-account balances k’, and banks’ desired reserves-to-deposits ratio r will also change. This is a principle that today’s economists call the “Lucas Critique”. (No, it is not clear to me why they do not call it the “Keynes Critique”.) And this critique is correct: assume that those three other variables are not themselves altered when you consider an altered path for the money stock is, as Keynes says in the sentence after “in the long run…”, for economists to set themselves too easy a task–it sweeps all the problems of analysis under the rug–and too useless a task–it generates predictions that are simply wrong.

In this extended discussion of how to use the quantity theory of money, the sentence “In the long run we are all dead” performs an important rhetorical role. It wakes up the reader, and gets him or her to reset an attention that may well be flagging. But it has nothing to do with attitudes toward the future, or with rates of time discount, or with a heedless pursuit of present pleasure.

So why do people think it does?

Note that we are speaking not just of Ferguson here, but of Mankiw and Hayek and Schumpeter and Himmelfarb and Peter Drucker and McCraw and even Heilbronner–along with many others.

I blame it on Hayek and Schumpeter. They appear to be the wellsprings.

Hayek is simply a bad actor–knowingly dishonest. In what Nicholas Wapshott delicately calls “misappropriation”, Hayek does not just quote “In the long run we are all dead” out of context but gives it a false context he makes up:

Are we not even told that, since ‘in the long run we are all dead’, policy should be guided entirely by short run considerations? I fear that these believers in the principle of apres nous le déluge may get what they have bargained for sooner than they wish.

And Hayek’s bad-faith writing yielded a lot of fruit: cf. Himmelfarb:

[S]omething of the “soul” of Bloomsbury penetrated even into Keynes’s economic theories. There is a discernible affinity between the Bloomsbury ethos, which put a premium on immediate and present satisfactions, and Keynesian economics, which is based entirely on the short run and precludes any long-term judgments. (Keynes’s famous remark. “In the long run we are all dead,” also has an obvious connection with his homosexuality – what Schumpeter delicately referred to as his “childless vision.”) The same ethos is reflected in the Keynesian doctrine that consumption rather than saving is the source of economic growth – indeed, that thrift is economically and socially harmful. In The Economic Consequences of the Peace, written long before The General Theory, Keynes ridiculed the “virtue” of saving. The capitalists, he said, deluded the working classes into thinking that their interests were best served by saving rather than consuming. This delusion was part of the age-old Puritan fallacy:

The duty of “saving” became nine-tenths of virtue and the growth of the cake the object of true religion. There grew round the non-consumption of the cake all those instincts of puritanism which in other ages has withdrawn itself from the world and has neglected the arts of production as well as those of enjoyment. And so the cake increased; but to what end was not clearly contemplated. Individuals would be exhorted not so much to abstain as to defer, and to cultivate the pleasures of security and anticipation. Saving was for old age or for your children; but this was only in theory – the virtue of the cake was that it was never to be consumed, neither by you nor by your children after you.

Never mind that Himmelfarb cuts off her quote from Keynes just before Keynes writes that he approves of this Puritan fallacy–that he is not, as Himmelfarb claims, ridiculing it, but rather praising it:

In the unconscious recesses of its being Society knew what it was about. The cake was really very small in proportion to the appetites of consumption, and no one, if it were shared all round, would be much the better off by the cutting of it. Society was working not for the small pleasures of today but for the future security and improvement of the race,—in fact for “progress.” If only the cake were not cut but was allowed to grow in the geometrical proportion predicted by Malthus of population, but not less true of compound interest, perhaps a day might come when there would at last be enough to go round, and when posterity could enter into the enjoyment of our labors…

So if you do read Himmelfarb, do so with great caution: this is a strange woman indeed[1].

As for Schumpeter, in Schumpeter’s Keynes obituary Schumpeter is working as hard as he can to try to minimize Keynes’s global influence:

[England’s] social fabric had been weakened and had become rigid. Her taxes and wage rates were incompatible with vigorous development, yet there was nothing that could be done about it. Keynes was not… in the habit of bemoaning what could not be changed… not the sort of man who would bend the full force of his mind to the individual problems of coal, textiles, steel, shipbuilding…. He was the English intellectual, a little deracine and beholding a most uncomfortable situation. He was childless and his philosophy of life was essentially a short-run philosophy. So he turned resolutely to the only “parameter of action” that seemed left… monetary management. Perhaps he thought that it might heal. He knew for certain that it would sooth–and that return to a gold system at pre-war parity was more than his England could stand. If only people could be made to understand this, they would also understand that practical Keynesianism is a seedling which cannot be transplanted into foreign soil: it dies there and becomes poisonous be- fore it dies.

[“Childless”] is a truly classless move given Keynes’s wife Lydia Lopokova’s two miscarriages–the best we can hope for Schumpeter is that his self-absorption in the 1920s, 1930s, and 1940s had kept him from ever learning about them. There was when I was an undergraduate an oral tradition that Schumpeter’s “childless” was a sotto voce synonym for “homosexual”–I presume Himmelfarb picked that up from similar sources to those I heard it from.

But Schumpeter, at least, does not cite “In the long run we are all dead” as evidence for the proposition that Keynes’s “philosophy of life was essentially a short-run philosophy”. Instead, he simply asserts that Keynes’s “philosophy of life was essentially a short-run philosophy”.

Is there any evidence that Keynes’s “philosophy of life was essentially a short-run philosophy” that unjustly neglected the long run? Keynes would have denied it: Keynes would have said that he gave proper balance to the short run and the long run. But, he would have added, it is also the case–as Skidelsky quotes him in The Economist as Saviour–that:

Burke ever held, and held rightly, that it can seldom be right… to sacrifice a present benefit for a doubtful advantage in the future…. It is not wise to look too far ahead; our powers of prediction are slight, our command over results infinitesimal. It is therefore the happiness of our own contemporaries that is our main concern; we should be very chary of sacrificing large numbers of people for the sake of a contingent end, however advantageous that may appear…. We can never know enough to make the chance worth taking…

So here we have it: not Herrick or Marvell or decadent Bloomsbury. Instead, Edmund Burke. Not a heedless disregard for the future, but a sober acknowledgement of the limited power of the brains of jumped-up East African Plains Apes like us to even see the long-run, and a plea not to sacrifice those currently alive to the Dreadful Moloch of Utopian Fantasies of the Future.

Schumpeter has, I think, considerable explaining to do.

As does Hayek.

As does Himmelfarb.

The rest–the Fergusons and the McCraws and the Druckers and the Heilbronners and company? At the very least, they need to explain why they didn’t check their “In the long run we are all dead” quotes against the context, and why doing so did not then lead them to have an Inigo Montoya moment as they said: “wait a minute–this doesn’t mean what I thought it meant”.

[1] Himmelfarb, writing in 1960:

The familiar racist sentiments of Buchan, Kipling, even Conrad, were a reflection of a common attitude. They were descriptive, not prescriptive; not an incitement to novel political action, but an attempt to express differences of culture and colour in terms that had been unquestioned for generations. To-day, when differences of race have attained the status of problems–and tragic problems–writers with the best of motives and finest of sensibilities must often take refuge in evasion and subterfuge. Neutral, scientific words replace the old charged ones, and then, because even the neutral ones–“Negro” in place of “nigger”–give offense, in testifying to differences that men of goodwill would prefer forgotten, disingenuous euphemisms are invented–“non-white” in place of “Negro”. It is at this stage that one may find a virtue of sorts in Buchan: the virtue of candor, which has both an aesthetic and an ethical appeal…

That somebody could–in 1960–write of how “to-day… differences of race have attained the status of problems–and tragic problems” as opposed to 1920, when presumably differences of race were not problems? Feh!

Must-read: John Maynard Keynes: “The General Theory of Employment, Interest and Money”

Posted on by Brad DeLong

Must-Read: John Maynard Keynes (1936): The General Theory of Employment, Interest and Money: “Is the fulfilment of these ideas a visionary hope?…

…Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?

I do not attempt an answer in this place…. But if the ideas are correct… it would be a mistake, I predict, to dispute their potency over a period of time…. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas….

There are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

Must-read: John Maynard Keynes: “A somewhat comprehensive socialization of investment…

Posted on by Brad DeLong

Must-Read: John Maynard Keynes (1936): The General Theory of Employment, Interest and Money: “It seems unlikely that the influence of banking policy on the rate of interest…

…will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary…

Must-read: Martin Sandbu: “Free Lunch: On Models and Making Policy”

Posted on by Brad DeLong

Must-Read: Superb from the extremely sharp Martin Sandbu! Only three quibbles:

  1. There are indeed “three great economists” in the mix here, but their names are Summers, Krugman, and Blanchard…
  2. This isn’t really a conversation that would have taken place even in an academic setting. If I have ever been in the same room at the same time with Larry, Paul, and Olivier–let alone all of Olivier’s coauthors, Michael Woodford, Danny Vinit, and Lukasz Rachel and Thomas Smith–I cannot remember it. And discussions and exchanges in scholarly journal articles are formal and rigid in an unhelpful way.
  3. Do note that Keynes was on Summers’s side with respect to the importance of maintaining business confidence: cf.: General Theory, ch. 12, “The State of Long-Term Expectation”

Martin Sandbu: Free Lunch: On Models and Making Policy: “The internet has… open[ed] up to the public…

…discussions… that previously took place mostly in face-to-face gatherings or scholarly journal articles. Neither medium was particularly accessible….

Summers posted a characteristically succinct statement on why he disagreed with the Federal Reserve’s decision to begin tightening… His analysis is well worth reading in full, but the trigger of the ensuing debate was his explanation for why the Fed thinks differently: ‘I suspect it is because of an excessive commitment to existing models and modes of thought. Usually it takes disaster to shatter orthodoxy.’… DeLong expressed doubts that the Fed’s analysis was indeed compatible with existing models; Krugman asserted that conventional models straightforwardly showed the Fed to be in the wrong, and that… policy was driven… by… ‘a conviction that you and your colleagues know more than is in the textbooks’….

Summers then responded… showed a fascinating divergence…. DeLong and Krugman think the Fed erred by ignoring… models…. Summers thinks the Fed erred by ignoring things that such models do not capture…. Summers is also much more comfortable with the notion that policymakers should aim to underpin market confidence. That notion has often been derided by Krugman…. Two quotes rather nicely capture the methodological disagreement here. Summers writes: ‘I think maintaining confidence is an important part of the art of policy…. Paul is certainly correct in his model but I doubt that he is in fact.’ DeLong responds: ‘Larry, however, says: We know things that are not in the model. Those things make Paul’s claim wrong. My problem with Larry is that I am not sure what those things are.’…

What is a policymaker to do if she thinks this is the case in reality, even if no extant model captures it? Surely not wait for 30 years in the hope that new mathematical techniques enable economists to model that reality. In his willingness to listen to those who may have an untheoretical ‘feel’ for the market, and in his intellectual respect for the limits of his own knowledge, Summers comes across as the most Keynesian of these three…

MOAR musings on whether we consciously know more or less than what is in our models…

Posted on by Brad DeLong

Larry Summers presents as an example of his contention that we know more than is in our models–that our models are more a filing system, and more a way of efficiently conveying part of what we know, than they are an idea-generating mechanism–Paul Krugman’s Mundell-Fleming lecture, and its contention that floating exchange-rate countries that can borrow in their own currency should not fear capital flight in a utility trap. He points to Olivier Blanchard et al.’s empirical finding that capital outflows do indeed appear to be not expansionary but contractionary:

Olivier Blanchard et al.: Macro Effects of Capital Inflows: Capital Type Matters: “Some scholars view capital inflows as contractionary…

…but many policymakers view them as expansionary. Evidence supports the policymakers…. Bond inflows lead to currency appreciation and are contractionary, while non-bond inflows lead to an appreciation but also to a decrease in the cost of borrowing, and thus may be expansionary…. How can we reconcile the models and reality? … Capital inflows may… reduce the cost of financial intermediation… be expansionary even for a given policy rate. In emerging markets, with a relatively underdeveloped financial system, the effect of a reduction in the cost of financial intermediation may dominate, leading to a credit boom and an output increase despite the appreciation….

The appropriate policies vis-à-vis capital inflows depend very much on the nature of the inflows. Sterilised foreign exchange (FX) market intervention… used in response to non-bond inflows… increases capital inflows, and thus increases the effects of inflows on credit and the financial system…. If the central bank is worried about both appreciation and unhealthy or excessive credit growth, FX intervention or capital controls are preferable to the use of the policy rate in response to an increase in bond inflows…. In response to non-bond inflows, our framework suggests that if the goal is to maintain exchange rate stability with minimum impact on the return to non-bonds, capital controls do the job best, followed by FX intervention, followed by a move in the policy rate…

If you asked me for a precis of what is going on in Blanchard et al., I would start drawing a graph in which we had:

  1. An IS (“Investment-Savings”) curve, for which the level of production (a) increases when government purchases increase; (b) falls when the long-term risky real interest rate rises, discouraging investment and consumption directly and discouraging exports indirectly by raising the value of the currency; and (c) falls when desired capital inflows rise and thus raise the value of the currency.
  2. An LM (“Liquidity-Money) curve, relating demand for money and thus the short-term safe nominal interest rate as a function of the level of output given the money stock.
  3. A CC (“Credit-Channel) wedge between the two, consisting of (a) the term premium on interest rates, that is how much long-term rates exceed short-term rates; (b) the risk premium on investments; and (c) the expected inflation rate:

Untitled 2

I would point out that, in Blanchard et al.‘s setup, what they call “bond inflows” move the IS curve to the left by raising the value of the currency for any given short-term safe nominal policy interest rate. Thus they are contractionary–for a constant policy interest rate on the LM curve, and a constant double-arrow CC credit-channel wedge.

I would point out that what they call “nonbond inflows” both move the IS curve to the left and shrink the double-arrow CC credit-channel wedge. So–for a constant policy rate–are contractionary if the first and expansionary if the second effect dominates.

And I would point out that Krugman’s Mundell-Fleming lecture deals with this case under the heading of “banking crisis”:

Banking crisis: Several commentators – for example, Rogoff (2013) — have suggested that a sudden stop of capital inflows provoked by concerns over sovereign debt would inevitably lead to a banking crisis, and that this crisis would dominate any positive effects from currency depreciation. If correct, this would certainly undermine the optimism I have expressed about how such a scenario would play out. The question we need to ask here is why, exactly, we should believe that a sudden stop leads to a banking crisis. The argument seems to be that banks would take large losses on their holdings of government bonds. But why, exactly? A country that borrows in its own currency can’t be forced into default, and we’ve just seen that it can’t even be forced to raise interest rates. So there is no reason the domestic-currency value of the country’s bonds should plunge. The foreign-currency value of those bonds may indeed fall sharply thanks to currency depreciation, but this is only a problem for the banks if they have large liabilities denominated in foreign currency…

Krugman is working in a framework in which the risk-premium part of the credit channel–the risk-premium part of the double-headed orange CC arrow–is small in normal times but can discontinuously shift to large in the event of a “banking crisis”. For Blanchard et al. and Summers, the size of the risk-premium part of the CC arrow is not discontinuously 0-1, but rather moves gradually with “confidence”: low when confidence is high and desired capital inflows are large, high when confidence is low and there is a sudden stop. Krugman says that since, in the absence of large foreign currency-denominated debt, there is no reason for there to be fears of a banking crisis in the event of a sudden stop.

Blanchard et al. appear to think that Krugman is largely right about developed economies. In them risk premiums are, they think, relatively small: financial markets work relatively well, and are not all that sensitive to amounts of new investment money flowing in. But, they say, they believe that in developing economies things are different. There, they believe, the risk premium component of the credit channel wedge is sensitive to international market conditions and thus the size the desired capital inflow.

In brief, Blanchard et al appear to think that only developing economies are “Minskyite” in the sense of a strong vulnerability of the CC risk premium to “confidence” even in the absence of fundamental shocks. Summers’s judgment appears to be that all economies are “Minskyite”. If I understand Paul’s thinking, it is more that “confidence” is only likely to matter as an equilibrium-selection device in a model with multiple equilibria like that of Krugman’s (1999b) third-generation financial-crisis model in “Balance Sheets, the Transfer Problem, and Financial Crises”. No multiple equilibrium, no possibility of suddenly jumping to a bad equilibrium, and so little possibility of any sort of pure “confidence” shock causing large amounts of trouble.

Paul here is more on the “financial markets work like they ought to” side of the argument. Olivier and company are more on the side of “developing economies have financial-market vulnerabilities North Atlantic economies do not” side. And Summers is more on the side of Keynes here:

Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus…. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die…. This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;–it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends…

Must-Read: Jeffry Frieden: ‘The Money Makers,’ by Eric Rauchway

Posted on by Brad DeLong

Must-Read: Few people today realize the extent to which the New Deal was not ideological or theoretical but rather their opposites: pragmatic. And where the New Deal was ideological or theoretical, it tended to be the least successful–witness Thurman Arnold and utilities, or Roosevelt’s austerian turn in 1937-1938:

Jeffry Frieden: ‘The Money Makers,’ by Eric Rauchway: “In 2008, the international economy came within weeks of catastrophic collapse…

…Concerted action by the world’s monetary authorities staved off disaster. Although stagnation continues to plague much of the globe, especially Europe, a major depression was avoided. The world was not so lucky in 1929…. The policies of the world’s major governments helped turn the recession that began in 1929 into a full-fledged depression…. [But[ the sooner countries left the gold standard in the 1930s, the more quickly their economies rebounded. Britain went off gold in September 1931, followed by most of the rest of the world. America’s path out of the Depression was slowed by the Hoover administration’s gold-standard orthodoxy. When Roosevelt took office in 1933, he almost immediately took the United States off gold and devalued the dollar. The result, as Rauchway shows, was a robust recovery. By 1936, the world had left gold behind. For the next 10 years, even as war clouds gathered and then as war raged, American and British policy makers, led by John Maynard Keynes and the United States Treasury official Harry Dexter White, planned a new international monetary order…. Rauchway tells this important story with passion, intelligence and style….

The major players come alive in ‘The Money Makers.’ Rauchway’s archival research gives depth to Roosevelt and Treasury Secretary Henry Morgenthau Jr., showing that both men understood the economic and political implications of their monetary policies, even if they were uninterested in the theoretical foundations for them that Keynes and others were building. The book also gives great detail about the practical involvement of the two principal economists involved, Keynes and White. Rauchway places the political context front and center, especially in addressing the issue of White’s contacts with Soviet agents…. Perhaps today’s policy makers — especially contemporary advocates of orthodox austerity sitting in Berlin — can learn something from the story Eric Rauchway tells so well.”

History: John Maynard Keynes Getting One Very Wrong

Posted on by Brad DeLong

Here it is plain to me that Keynes has simply not understood John Hicks–call this Keynes “Keynes the Pre-Hicksian”:

John Maynard Keynes (1937): The General Theory of Employment: “There are passages which suggest that Professor Viner is thinking too much…

…in the more familiar terms of the quantity of money actually hoarded,and that he overlooks the emphasis I seek to place on the rate of interest as being the inducement not to hoard. It is precisely because the facilities for hoarding are strictly limited that liquidity preference mainly operates by increasing the rate of interest. I cannot agree that “in modern monetary theory the propensity to hoard is generally dealt with, with results which in kind are substantially identical with Keynes’, as a factor operating to reduce the ‘velocity’ of money.” On the contrary, I am convinced that the monetary theorists who try to deal with it in this way are altogether on the wrong track.

Again, when Professor Viner points out that most people invest their savings at the best rate of interest they can get and asks for statistics to justify the importance I attach to liquidity-preference, he is over- looking the point that it is the marginal potential hoarder who has to be satisfied by the rate of interest, so as to bring the desire for actual hoards within the narrow limits of the cash available for hoarding. When, as happens in a crisis, liquidity-preferences are sharply raised, this shows itself not so much in increased hoards–for there is little, if any, more cash which is hoardable than there was before–as in a sharp rise in the rate of interest, i.e. securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms. A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity-preference.

Nor is my argument affected by the admitted fact that different types of assets satisfy the desire for liquidity in different degrees. The mischief is done when the rate of interest corresponding to the degree of liquidity of a given asset leads to a market-capitalization of that asset which is less than its cost of production…

It seems very clear that this Keynes has not yet read–or has not understood–John Hicks (1937), “Mr. Keynes and the ‘Classics’: A Suggested Interpretation”.

Keynes thinks that money demand consists of three terms:

  • kPY, the amount of money needed to grease the amount PY of total nominal spending,
  • S, the liquidity-preference speculative demand for money, and
  • -jr, a term that depends on increases in the interest rate r curbing the speculative demand for money, and also inducing people to economize on their transactions balances.

For a given money supply, M, this gives us a money demand-money supply equation:

M = kPY + S – jr

Jacob Viner wants to take this equation and rewrite it in quantity-theory terms as an LM-curve relation:

kPY = M – S + jr

Y = [M – S + jr]/Pk

Y = (M/P)V, with V = [1-(S/M)-(jr/M)]/k

An increase in Keynes’s liquidity preference S is thus a reduction in the velocity of money V associated with any interest rate r. This is what Viner means when he writes that:

In modern monetary theory the propensity to hoard is generally dealt with, with results which in kind are substantially identical with Keynes’, as a factor operating to reduce the ‘velocity’ of money.

And he is correct.

Keynes says he disagrees. He claims that the key effect of a rise in liquidity preference is not to reduce the velocity of money–to produce “increased hoards”–but rather to raise the interest rate r. And working through the IS-curve relation:

Y = C + I
C = co + (cy)Y
I = io – (ir)r
Y = [co + io]/(1-cy) – [ir/((1-cy)]r

This rise in r reduces real spending Y.

Keynes is right when he says that an increase in liquidity preference S reduces Y working through the IS-curve relationship. But Keynes is wrong when he says that implies that Viner is wrong. Viner is right too. The LM-curve and the IS-curve relations jointly determine Y and r. You can use either. In fact, you have to use both in order to get an answer, even if you are not aware that you are using both. That is what Hicks made clear. But Keynes does not know it. And I see no signs that Viner knows it either.

History: John Maynard Keynes Getting One Very Right: There Is No Medium-Run Full-Employment Sheet-Anchor for the Economy

Posted on by Brad DeLong

Here we see Keynes getting one, I think, very right: denying that the full-employment equilibrium serves as a medium-run sheet anchor sharply damping short-run fluctuations:

John Maynard Keynes (1937): The General Theory of Employment: “Money, it is well known, serves two principal purposes…

…By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence.

In the second place,it is a store of wealth. So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit.

Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even though this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded; and importance has been attached to this because it has been supposed to have a direct proportionate effect on the price-level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money-income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard. And changes in the propensity to hoard, or in the state of liquidity-preference as I have called it, primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest.

This, expressed in a very general way, is my theory of the rate of interest. The rate of interest obviously measures–just as the books on arithmetic say it does–the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money. The quantity of money and the amount of it required in the active circulation for the transaction of current business (mainly depending on the level of money-income) determine how much is available for inactive balances, i.e. for hoards. The rate of interest is the factor which adjusts at the margin the demand for hoards to the supply of hoards.

Now let us proceed to the next stage of the argument. The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest, or he can purchase some kind of capital-asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money-prices of capital-assets relative to the prices of money-loans. The prices of capital-assets move until, having regard to their prospective yields and account being taken of all those elements of doubt and uncertainty, interested and disinterested advice, fashion, convention and what else you will which affect the mind of the investor, they offer an equal apparent advantage to the marginal investor who is wavering between one kind of investment and another.

This, then, is the first repercussion of the rate of interest, as fixed by the quantity of money and the propensity to hoard, namely, on the prices of capital-assets. This does not mean, of course,that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for the reason already given, namely, the flimsiness of the basis of knowledge on which they depend. It is these opinions taken in conjunction with the rate of interest which fix their price.

Now for stage three. Capital-assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the prices of capital-assets, the volume of current investment (meaning by this the value of the output of newly produced capital-assets) will be increased; while if, on the other hand, these influences reduce the prices of capital-assets, the volume of current investment will be diminished.

It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation–on the propensity to hoard, and on opinions of the future yield of capital-assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard.

The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital-assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.

This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production which have usually been supposed hitherto to be the chief influence governing the marginal efficiency of capital.
If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiableto assume that the liquidity-preference curve was both stable and very inelastic. In this case a small decline in money-income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed;and the conditions required by the orthodox theory wouldbe satisfied.

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of the demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described,have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought; the theory of effective demand,that is the demand for output as a whole, having been entirely neglected for more than a hundred years.

My own answer to this question involves fresh considerations. I say that effective demand is made up of two items–investment-expenditure determined in the manner just explained, and consumption-expenditure. Now what governs the amount of consumption-expenditure? It depends mainly on the level of income. People’s propensity to spend (as I call it) is influenced by many factors, such as the distribution of income, their normal attitude to the future and-though probably in a minor degree–by the rate of interest. But in the main the prevailing psychological law seems to be that when aggregate income increases, consumption-expenditure will also increase, but to a somewhat lesser extent. This is a very obvious conclusion…

John Maynard Keynes in His High Wicksellian Mode in 1937: Today’s History of Economic Thought

Posted on by Brad DeLong

Today’s History of Economic Thought: Here we have John Maynard Keynes in his High Wicksellian mode:

  • The natural rate of interest depends on unstable and flutuating opinions about the future yield of capital-assets.
  • The market rate of interest depends on the supply of money and the unstable and fluctuating propensity to hoard–liquidity preference.
  • Thus we have large-scale fluctuations in investment (unless a central bank can neutralize fluctuations in liquidity preference and also make the market rate dance in time with the fluctuating natural rate)
  • Add in the multiplier, and we have unemployment business cycles.

This was, I think, the article that made the Swedes whimper: “Why are the citations to Knut Wicksell missing?”

John Maynard Keynes (1937): The General Theory of Employment: “Money, it is well known, serves two principal purposes…

…By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place,it is a store of wealth.

So we are told, without a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognized characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit.

Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Because, partly on reasonable and partly on instinctive grounds, our desire to hold Money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. Even though this feeling about Money is itself conventional or instinctive, it operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.

The significance of this characteristic of money has usually been overlooked; and in so far as it has been noticed, the essential nature of the phenomenon has been misdescribed. For what has attracted attention has been the quantity of money which has been hoarded; and importance has been attached to this because it has been supposed to have a direct proportionate effect on the price-level through affecting the velocity of circulation. But the quantity of hoards can only be altered either if the total quantity of money is changed or if the quantity of current money-income (I speak broadly) is changed; whereas fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard. And changes in the propensity to hoard, or in the state of liquidity-preference as I have called it, primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest.

This, expressed in a very general way, is my theory of the rate of interest. The rate of interest obviously measures–just as the books on arithmetic say it does–the premium which has to be offered to induce people to hold their wealth in some form other than hoarded money. The quantity of money and the amount of it required in the active circulation for the transaction of current business (mainly depending on the level of money-income) determine how much is available for inactive balances, i.e. for hoards. The rate of interest is the factor which adjusts at the margin the demand for hoards to the supply of hoards.

Now let us proceed to the next stage of the argument. The owner of wealth, who has been induced not to hold his wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest, or he can purchase some kind of capital-asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money-prices of capital-assets relative to the prices of money-loans. The prices of capital-assets move until, having regard to their prospective yields and account being taken of all those elements of doubt and uncertainty, interested and disinterested advice, fashion, convention and what else you will which affect the mind of the investor, they offer an equal apparent advantage to the marginal investor who is wavering between one kind of investment and another.

This, then, is the first repercussion of the rate of interest, as fixed by the quantity of money and the propensity to hoard, namely, on the prices of capital-assets. This does not mean, of course,that the rate of interest is the only fluctuating influence on these prices. Opinions as to their prospective yield are themselves subject to sharp fluctuations, precisely for the reason already given, namely, the flimsiness of the basis of knowledge on which they depend. It is these opinions taken in conjunction with the rate of interest which fix their price.

Now for stage three. Capital-assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the prices of capital-assets, the volume of current investment (meaning by this the value of the output of newly produced capital-assets) will be increased; while if, on the other hand, these influences reduce the prices of capital-assets, the volume of current investment will be diminished.

It is not surprising that the volume of investment, thus determined, should fluctuate widely from time to time. For it depends on two sets of judgments about the future, neither of which rests on an adequate or secure foundation–on the propensity to hoard, and on opinions of the future yield of capital-assets. Nor is there any reason to suppose that the fluctuations in one of these factors will tend to offset the fluctuations in the other. When a more pessimistic view is taken about future yields, that is no reason why there should be a diminished propensity to hoard. Indeed, the conditions which aggravate the one factor tend, as a rule, to aggravate the other. For the same circumstances which lead to pessimistic views about future yields are apt to increase the propensity to hoard.

The only element of self-righting in the system arises at a much later stage and in an uncertain degree. If a decline in investment leads to a decline in output as a whole, this may result (for more reasons than one) in a reduction of the amount of money required for the active circulation, which will release a larger quantity of money for the inactive circulation, which will satisfy the propensity to hoard at a lower level of the rate of interest, which will raise the prices of capital-assets, which will increase the scale of investment, which will restore in some measure the level of output as a whole.

This completes the first chapter of the argument, namely, the liability of the scale of investment to fluctuate for reasons quite distinct (a) from those which determine the propensity of the individual to save out of a given income and (b) from those physical conditions of technical capacity to aid production which have usually been supposed hitherto to be the chief influence governing the marginal efficiency of capital.

If, on the other hand, our knowledge of the future was calculable and not subject to sudden changes, it might be justifiable to assume that the liquidity-preference curve was both stable and very inelastic. In this case a small decline in money-income would lead to a large fall in the rate of interest, probably sufficient to raise output and employment to the full. In these conditions we might reasonably suppose that the whole of the available resources would normally be employed;and the conditions required by the orthodox theory wouldbe satisfied.

My next difference from the traditional theory concerns its apparent conviction that there is no necessity to work out a theory of the demand and supply of output as a whole. Will a fluctuation in investment, arising for the reasons just described,have any effect on the demand for output as a whole, and consequently on the scale of output and employment? What answer can the traditional theory make to this question? I believe that it makes no answer at all, never having given the matter a single thought; the theory of effective demand,that is the demand for output as a whole, having been entirely neglected for more than a hundred years.

My own answer to this question involves fresh considerations. I say that effective demand is made up of two items–investment-expenditure determined in the manner just explained, and consumption-expenditure. Now what governs the amount of consumption-expenditure? It depends mainly on the level of income. People’s propensity to spend (as I call it) is influenced by many factors, such as the distribution of income, their normal attitude to the future and-though probably in a minor degree–by the rate of interest. But in the main the prevailing psychological law seems to be that when aggregate income increases, consumption-expenditure will also increase, but to a somewhat lesser extent. This is a very obvious conclusion…

John Maynard Keynes (1937), “The General Theory of Employment”, Quarterly Journal of Economics 51:2 (February), pp. 209-223 http://www.jstor.org/stable/1882087

Cracking the Hard Shell of the Macroeconomic Knut: “Keynesian”, “Friedmanite”, and “Wicksellian” Epistemes in Macroeconomics

Posted on by Brad DeLong

The very-sharp Tyler Cowen gets one, I think, more wrong than right. He writes:

Tyler Cowen: What’s the Natural Rate of Interest?: “I… find all this talk of natural rates of interest…

…historically strange. A few points: (1) David Davidson and Knut Wicksell debated the… concept very early in the twentieth century, in Swedish…. Most people believe Davidson won…. (2) Keynes devoted a great deal of effort to knocking down the natural rate of interest…. There could be multiple natural rates… [or] no rate of interest whatsoever…. (3) In postwar economics, the Keynesians worked to keep natural rates of interest concepts out….

(4) The older natural rate of interest used to truly be about price stability… [not] “two percent inflation a year.”… (5) Milton Friedman warned (pdf) not to assign too much importance to interest rates…. (6) When Sraffa debated Hayek and argued the natural rate of interest was not such a meaningful concept, it seems Sraffa won…. (7) I sometimes read these days that the “natural [real] rate of interest” consistent with full employment is negative. To me that makes no sense in a world with positive economic growth and a positive marginal productivity of capital….

Of course economic theory can change, and if the idea of a natural rate of interest makes a deserved comeback we should not oppose that development per se. But I don’t see that these earlier conceptual objections have been rebutted, rather there is simply now a Kalman filter procedure for coming up with a number…. In any case, this is an interesting case study of how weak or previously rebutted ideas can work their way back into economics. I don’t object to what most of the people working on this right now actually are trying to say. Yet I see the use of the term acquiring a life of its own, and as it is morphing into common usage some appropriately modest claims are taking on an awful lot of baggage from the historical connotations of the term…

In my view, all (7) of these are more than debatable. For example, (7): “[That] the ‘natural [real] rate of interest’ consistent with full employment is negative… makes no sense in a world with positive economic growth and a positive marginal productivity of capital…” misses the wedge–the wedge between the (positive) expected real rate of return from risky investments in capital and the (positive) temporal slope to the expected inverse marginal utility of consumption, on the one hand; and the (negative) equilibrium real low-risk interest rate, on the other hand.

In a world that is all of a global savings-glut world with large actors seeking portfolios that provide them with various kinds of political risk insurance, risk-tolerance gravely impaired by the financial crisis and the resulting deleveraging debt supercycle, moral hazard that makes the remobilization of societal risk-bearing capacity difficult and lengthly, and reduced demographic and technological supports for economic growth, it seems to me highly plausible that this wedge can be large enough to make the low-risk ‘natural [real] rate of interest’ consistent with full employment negative alongside positive economic growth and a positive marginal productivity of capital.

And the bond market agrees with me in email:

Graph Long Term Government Bond Yields 10 year Main Including Benchmark for Germany© FRED St Louis Fed

Graph 10 Year Treasury Inflation Indexed Security Constant Maturity FRED St Louis Fed

And (2): “Keynes devoted a great deal of effort to knocking down the natural rate of interest…” Indeed he did Keynes saw the natural rate of interest as part of a wrong loanable-funds theory of interest rates: that, given the level of spending Y, supply-and-demand for bonds determined the interest rate. Keynes thought that people must reject that wrong theory before they could adopt what he saw as the right, liquidity-preference, theory of interest rates: that, given the level of spending Y and the speculative demand for money S, supply-and-demand for money determined the interest rate.

I think Keynes was wrong. I think Keynes made an analytical mistake.

Hicks (1937) established that Keynes was wrong when he believed that you had to choose. You don’t. Because spending Y is not given but is rather jointly determined with the interest rate, you can do both. Indeed, you have to do both. Liquidity-preference without loanable-funds is just one blade of the scissors: it cannot tell you what the interest rate is. And loanable-funds without liquidity-preference is just the other blade of the scissors: it, too, cannot tell you what the interest rate is. You need both.

More important, however, in thinking about our present concern with the natural (“neutral”) (“equilibrium”) real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation. Alan Greenspan did it. On July 20, 1994, Alan Greenspan announced that the Federal Reserve was not a “Keynesian” institution, focused on getting the volume of the categories of aggregate demand–C, I, G, NX–right. He announced that the Federal Reserve was not a “Friedmanite” institution, focused on getting the quantity of money right. He announced that the Federal Reserve was now a “Wicksellian” institution, focused on getting the configuration of asset prices right:

Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20: “The FOMC, as required by the Humphrey-Hawkins Act…

…set[s] ranges for the growth of money and debt…. M2 has been downgraded as a reliable indicator…. [The] relationship between M2 and prices that could anchor policy over extended periods of time… [has] broken down…. M2 and P-star may reemerge as reliable indicators of income and prices….

In the meantime… in assessing real rates [of interest], the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction. Maintaining the real rate around its equilibrium level should have a stabilizing effect…. The level of the equilibrium real rate… [can] be estimated… [well] enough to be useful for monetary policy…. While the guides we have for policy may have changed recently, our goals have not…

Greenspan thus shifted the focus of America’s macroeconomic discussion away from the level of spending and the quantity of money to the configuration of asset prices. In some ways this is no big deal: “Keynesian”, “Friedmanite”, and “Wicksellian” frameworks are all perfectly-fine ways to think about macroeconomic policy. They are different–some ideas and some factors are much easier to express and focus on and are much more intuitive in one of the frameworks than in the others. But they are not untranslateable–I have not found any point that you can express in one framework that cannot be more-or-less adequately translated into the others.

The point, after all, is to find a macroeconomic policy that will make Say’s Law, false in theory, true enough in practice for government work. You can start this task by focusing your analysis first on either spending, or liquidity, or the slope of the intertemporal price structure. You will almost surely have to dig deeper into the guts of the economy in order to understand why the current emergent macro properties of the system are what they are. But any one of the languages will do as a place to start. Greenspan in the mid-1990s judged that the Wicksellian language provided the best way to communicate. And, looking back over the past 25 years, I cannot really disagree.

But at the time, back in 1994, the shift to a Wicksellian episteme led to substantial confusion. As I remember it, I spent my lunchtime on July 20, 1994, seated at my computer in my office on the third floor of the U.S. Treasury, frantically writing up just what Alan Greenspan was talking about when he said (1) pay no attention to Federal Reserve policy forecasts of M2; instead, (2) pay attention to our assessments of the relationship of interest rates to an equilibrium interest rate. Greenspan announced that the Fed was no longer asking in a Friedmanite mode “do we have the right quantity of money?”, but rather was asking in a Wicksellian mode “do we have the right configuration of interest rates”. And that still does not seem to me to be a bad place to be.