Wednesday, October 26, 2011

Do We Need a New Keynes?

John Cassidy, a journalist who writes for the New Yorker, wonders where the New Keynes is lurking. Cassidy states:
At the end of the [radio] show, Leonard asked me an interesting question: Has the financial crisis and Great Recession produced any big new economic ideas? My immediate response was that it hasn’t, or, if it has, I wasn’t aware of them.
I seems that what excites journalists is the personal, and the large. A nice, readable story is one that focuses on an individual with a "big" idea, that can be stated crisply in a few lines.

Unfortunately for Cassidy, but fortunately for the rest of us as it turns out, modern economics is not set up to give journalists tasty sound bites. In my generation, and in younger ones, it's hard to identify the "big" people with the "big" ideas, as economic research is a collective effort - much more so than in the days of Keynes, or even in the generation of Lucas, Prescott, Sargent, and Sims. The big idea that is helpful in understanding the financial crisis, its causes, and what should have been done or should be done about it, is the idea that was developed by the information theorists of the 1970s - Akerlof, Stiglitz, Townsend, Rothschild, Holmstrom; by the mechanism designers - Hurwicz, Maskin, Myerson; by the monetary theorists - Wallace, Townsend (again), Kiyotaki, Wright; by the financial intermediation theorists - Diamond, Dybvig, Townsend (again), Prescott, Boyd; by the dynamic contracting theorists - Green, Abreu-Pearce-Stacchetti, Atkeson-Lucas; by general-equilibrium financial-frictions people - Gertler, Bernanke, Smith, Kiyotaki-Moore. That idea is much much bigger, and immensely more solid science than Keynes.


  1. How about Farmer ? He seems to be consciously trying to put Keynesian ideas on a micro founded setting.

  2. Steve,

    Perhaps you're being modest, but you belong on that list for your work on financial intermediation. You are, after all, cited by BGG, Carlstrom and Fuerst, and others you mention.

  3. Sometimes this blog is an exercise in shameless marketing, but Canadians are trained to be modest, so sometimes I revert to that.

  4. If someone talks about big ideas that are helpful in understanding the financial crisis and doesn't mention Hyman Minsky I can only conclude: this person is either befuddled or doesn't know what he's talking about.

  5. I have never found Minsky useful. There's not much economics there - I think of it as descriptive.

  6. You don't think the psychology Minsky describes is a significant driver in the financial markets and the economy as a whole?

  7. wonks anonymous,

    I think he means Bernanke-Gertler-Gilchrist (financial accelerator).


    People use the words "market psychology" all the time. What do you think it means?

  8. How about "Market psychology" = risk premium. Which is a defined concept in financial econ.

  9. How can that be? The standard ways of thinking about risk premia have nothing to do with psychology. Decision theorists and behavioral theorists of course get into alternatives to expected utility theory that aim to explain anomalies in asset pricing theory, and some of that brings in ideas from psychology. I doubt if that's what Minsky had in mind.

  10. Minsky exemplifies the worst features of both The General Theory and Austrian bullshit -- lots of reduced-form nonsense combined with endless prating.

    Minsky was in the dustbin of history once, and he should have remained there.

  11. I thought "dustbin of history" comments were supposed to be applied to things that were once outside the bin, and my understanding is that Minsky was always a marginal figure.

  12. Stephen,

    You conclude with the claim that “this big idea” (technique?) “is much bigger, and immensely more solid science than Keynes.”
    Of course, Keynes wasn’t a scientist in your sense of term. His approach was closer to Marshall’s: write the narrative, try to express it mathematically, check for logical consistency, and revise the narrative as necessary.  But the right narrative was the ultimate objective.

    Robert Lucas, one of the economists you associate with “the big idea,” actually gave a narrative explanation of the Great Recession in my hometown of Seattle (at the University of Washington) in May of this year.  You can see his slide show here:

    Lucas argues that the Great Depression was precipitated when people tried to rebuild their cash balances “to restore a comfortable ratio of cash/bank deposits to spending flows.”  This is the old Cambridge k to which Keynes added the “speculative motive.”  It’s not easy to model this motive (and Tobin’s “Liquidity Preference as Behavior Towards Risk” doesn’t capture it), but it remains a very big idea. 

    Professor Lucas goes on to explain that the desired cash/spending ratio was “restored,” but then asks, “at what cost?”  And he goes on to say that this pursuit of increased liquidity “played out as deflation and [a] reduction in production and employment.”  In the spirit of controversy, I’m inclined to say, “if you can’t find this line of reasoning in the General Theory, then you haven’t read it.”

    Regarding the slow pace of recovery, Lucas says the “most important, in my view, but hardest to measure, were [the] effects of demonization of business.”  Did this “demonization” recede between 1934-1937, when the economy started to recover, and then gain traction again between 1937-1939, as the economy faltered, before finally receding with the onset of World War II (when price controls and an “excess profits tax” were adopted to counteract business profiteers)?

    Turning to the Great Recession, Lucas says that the economics of the “2008 ‘credit freeze’ following the Lehman Brothers failure were identical to the economics of the 1930s bank runs.”  More specifically, he adds, “A part of the effective supply of liquidity supply had vanished . . .  A flight to currency? Not exactly. But a flight to government promises of currency, current or future.”

    Compare this to Keynes’s, "Unemployment develops . . . because people want the moon;--men cannot be employed when the object of desire (i.e. money) is something which cannot be produced . . . There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control."

    Looking ahead, Lucas asks, “Where do we go from here?” We’re not moving.  “Is this because government is not spending enough?”  “[I]t is more accurate to say that the problem is that government is doing too much.”  And, finally, the coup de grace, “Is it possible that by imitating European policies on labor markets, welfare, and taxes [the] U.S. has chosen a new, lower GDP trend?”

    Consider this: if you exclude the income gains of the top 1% in the U.S. and in France, average real income has actually grown faster in France than in the U.S. over the past 25 years.  For “the 99%,” arguments built on the claim that highly taxed and over-regulated Europe underperforms the unfettered U.S. economy aren’t very compelling.

  13. Place not too much faith in the technical marvel of a modern-day model. Models work until they don't. Most are fragile, resting upon premises that may change. (BTW, guys have been constructing models on Wall Street for years. LTCM was a model-based investment fund.)

    As for influence, I suspect in the future the Market Monetarists will be much remembered. Scott Sumner may become an iconic figure, not only for reviving a insightful, meaningful and valuable monetary perspective, but for doing so sans the institution support that so many others have. If economists could be folk heroes, Sumner would qualify. If they made movies about economists, Sumner could be a star.

    No one will remember the modelers.

  14. BTW, Matt Rognlie has a terrific post on models right now. Worth reading.

  15. "If they made movies about economists..."
    There's at least one, "A beautiful mind".

    "Models work until they don't". We know. In the 1960s, conventional wisdom was that you could buy lower unemployment with higher inflation.
    Milton Friedman and Ed Phelps reasoned by using the most basic economic theory that this was wrong. They were proved correct by subsequent events. And they used a model.
    Who'd have thought ?

  16. "Models work until they don't". Funny, there's a model of that. Its called the efficient markets theory. It's a super model - a model of models!

    Models rule!

    As Keynes roughly said: "the models of economists are ultra powerful. Everyone is the slave of the theory of some defunct economist."

  17. The movie "A Beautiful Mind" was about a troubled math guy, who developed game theory, and won a Nobel Price in Economics---another example of what a feeble branch of thought economics is, at least as practiced.

    Keynes was right in the sense there are economics professionals, hired as lackeys by either political party, as their models produce what people want to hear.

    Keynes was wrong in this sense---usually the partisan despot has decided his view, and hires sychophantic economists to echo his biases. (Think Heritage Foundation). As an upper-class Englishman, Keynes was unable to conceive he might be a mere dupe.

    I like the efficient markets theory. I think it is roughly right.
    I like the nominal GDP targeting theory. I think it is roughly right.

    In economics, theories are only roughly right. It is the rough-and-tumble and always evolving real world. Extremely complicated and fragile models are like using delicate ballerinas to play football. On paper, the ballerinas might dance around the defenders and win the game. In real life....

  18. Greg: if Lucas is correct, then we should have observe a huge demand for cash and very low demand for bond. So the price of bond should be low and the nominal interest rate should be high. Is it happening right now?

  19. Anonymous,

    Can you spell it out a bit more, e.g., "if Lucas is correct . . . " regarding what exactly?

  20. Anonymous: Did you mean to say, "if Keynes (not Lucas) is correct . . . "?

  21. I mean the specific market psychology that Minsky was talking about -- when prices rise fast for a few years, people start thinking that stocks are a great investment and will keep rising fast, so they invest more, and prices rise more as a result, so they think they're even better, so people buy even more, and so on until the bubble pops (and the same thing can happen in reverse with reverse bubbles, where you can get some startlingly low PEs).

  22. Greg and unknown: oh yes that was a typo :) just to point out that, some old keynesian refer the current liquidity trap as a result of sharp increase in liquidity demand (so people hold more money and do less spending), that is not the case right now, as we should have seen the nominal interest rate jumps like crazy.

  23. Richard,

    That's what I meant about Minsky not being very useful.


    I wrote about Lucas's talk here:

    and here:

  24. You don't think this Minsky psychology exists? You don't think it's a strong factor in the financial markets and thus the economy?

  25. Does anybody else think it unfair to compare Keynes's General Theory with Lucas's PowerPoint presentation?

  26. Anonymous,

    It's important to bear in mind Stephen's original post, which concluded that the "idea" developed by Lucas among several others "is much much bigger, and immensely more solid science than Keynes."

    In response, I wanted to make two points. First, Keynes was ultimately interested in a verbal model of the economy because he was skeptical of mathematical models.

    Keynes complained that mathematical models "assume strict independence between the factors involved and lose their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating and know all the time what we are doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves and qualifications."

    I think Keynes goes a bit overboard here, but that's another story.

    The second point I was trying to make is that *some* of this "immensely more solid science than Keynes" seems wanting when applied to the Great Recession. Did Lucas not draw on this science when he prepared his talk? Did Prescott not draw on it in attributing the Great Recession to forthcoming tax increases (which implicitly assumes an implausible labor supply elasticity)?

    In retrospect, I had a third aim, which was to encourage people reading this blog to think about the 99% rather per capita GDP, which gives a very misleading view of how we're doing in comparison to both our past and to parts of Europe.

  27. "people should look beyond per capita GDP"....
    Williamson blogged about this a few months ago with the Klenow and Jones paper

  28. Greg Hill is worried we're not adequately transferring wealth to the people who thought English degrees would make them rich. I doubt he even knows the Klenow-Jones paper.

  29. Benjamin, as always, remains a persistent crackpot.

  30. First, Keynes was ultimately interested in a verbal model of the economy because he was skeptical of mathematical models."

    No, I think if he knew the mathematics, he would have applied it. However, why should we care whether Keynes liked math or not?

    I agree with anonymous 11:23 above. There are a lot of younger macroeconomists doing research to help us understand what went on in the financial crisis and what is going on now. More weight is being attached to a couple of suggestions in Lucas's slides and some offhand remarks made by Prescott at a conference than should be.

    Regarding the 99% vs. the 1%, read this:

  31. Anonymous at 6:45 above writes, "Greg Hill is worried we're not adequately transferring wealth to the people who thought English degrees would make them rich," which, while it misses the point, is nevertheless a revealing illustration of the vulgar worldview which holds that everyone wants to get "rich."

    The Klenow-Jones paper is illuminating, but, as the authors themselves allow, incomplete. One thing that's missing is a careful consideration of positional goods. If everyone spends more on housing in order to get their kids into a good school district, then some of this extra spending contributes nothing to social welfare.

    Stephen, I didn't say, or even suggest, that Keynes wouldn't have taken advantage of new mathematical techniques. I said that Keynes was *ultimately* interested in a verbal account, or model, of economic relationships, which might well be informed by these techniques.

    And regarding Lucas's slide show, is it not more or less consistent with what he has written in his journal articles?

  32. you claim to be the holder of "immensely more solid science than Keynes."

    respectfully, as the Queen, a better thinker than you observed, science predicts and you did not predict the Lesser Depression

    I have read through your blog at length. I must say I am glad I don't know you. You never, ever, say anything positive, about anything. You just attack anyone and everyone, most using meaningless word games, quoting out of context, or, your favorite---attributing to people what they have not said.

    You are incapable of any meaninful idea. You refuse to confront obvious questions. (With interest rates so low, why does no one thing about borrowing money? Maybe it is because they don't see any orders coming in because income distribution is so bad and aggregate demand isn't there or both? Is Friedman right that low interest rates are evidence of a lack of money in the real economy? If such, we may have reached the point where it is best to print money and give it away?) In sum, it is very easy to see what you are about, personally.

    I feel sorry for your students, especially the ones who leave your classes with massive debts, which because of your "ideas" they may never be able to repay