Jeffrey Sachs and the Keynesian Conundrum

June 17, 2010

by Mario Rizzo  

In a very interesting Financial Times opinion piece (June 8th) Jeffrey Sachs of Columbia University explains his problems with Keynesian calls for more stimulus. He says we should now focus on longer-run policy considerations, including reducing the fiscal deficit. While I have difficulties with some of Sachs’s prescriptions (like higher taxes for the “rich”), I believe his article is a welcome breath of fresh air.  

Nevertheless, it raises some problems on which Keynesians need to focus.  

When does the Keynesian moment end — and the ordinary laws of economics retake the stage?  

An important, and I should say, absolutely critical aspect of Keynesian policy is that there exists a period of time in which:  

1. The opportunity cost of unemployed labor resources in approximately zero;

2. Spending in general, rather than a specific allocation of spending, is the primary concern.  

As the reader can easily see, the Keynesian moment abstracts from the usual economic concern with optimal resource allocation. We should just spend, cure the macroeconomic problem, and then worry about allocation of scare resources among differently-valued and competing ends.  

One answer to the question about when the Keynesian moment ends is to say: It ends when the economy has reached “full employment.” But what is “full employment”? Is it defined relative to only labor resources or other resources as well (capital goods, for example)?  Are resources less than fully employed when they are looking for more profitable uses? How do we distinguish looking, or perhaps waiting for better uses to emerge, from pointless idleness?  

As confusing as the concept of “full employment” is, its measurement is fraught with many difficulties as well. The continual extension of unemployment insurance, for example, tends to lengthen the period of idleness or search or waiting. So what is “natural” and what is induced by policy?  

Yet this is not the most basic problem.  

Keynes himself worried about animal spirits and the “news.” In other words, at any point in time, something could happen – some shock, some irrational wave of influence — that could knock (investment) spending down and cause a slump.  

This is why Keynes’s solution was not functional finance or counter-cyclical spending. Often, according to Keynes, that spending would come too late to prevent a recession. So he advocated the stabilization of total investment by ensuring permanent investment spending of relatively large sums by the government or quasi-independent agencies of the state (like universities, the Port of London Authority, etc). 

Thus, Keynes did not have the problem many of his less sophisticated followers have. When do we stop worrying about falling back into a slump? The macroeconomic equilibrium, absent permanent stabilization of investment, is very fragile. Thus he did not advocate the stop-go approach of functional finance.  

Either Keynesians must come up with a better theory of when the Keynesian moment is over or they must follow Keynes himself and advocate the permanent state or quasi-state stabilization of investment.  

Of course, we need not accept the basic Keynesian framework. That would be best.

17 Responses to “Jeffrey Sachs and the Keynesian Conundrum”

  1. Daniel Kuehn Says:

    I’ve agreed with you in the past on this point that Keynes is best understood as a theory of output, rather than a theory of cycles. I don’t think, though, that that fact invalidates fiscal finance.

    I think this question is a lot simpler than you’re making it. When bond rates pick up we ease off. When inflation picks up we ease off. When private sector job growth picks up we ease off. And we err on the side of caution. Keynes regularly made the point that economic policy is not one-size fits all. You have to always tailor the response to the situation. So I’m not sure why you’re looking for a grand theory of the right moment. This is a practical question. Practically speaking we have indicators and we proceed cautiously, and we don’t abandon the entire enterprise because there’s a real possibility that we might stop a little too early or a little too late. That’s like not getting surgery for a serious problem because the doctor may mess up. Human error and miscalculation is always a part of our world. It’s never a justification for abandoning a potentially sub-optimal policy in favor of a definitively sub-optimal policy.

  2. Daniel Kuehn Says:

    I also agree on unemployment insurance, and I’ve agreed with you on this in the past too. Keynes personally thought the idea of unemployment insurance was ridiculous, and he mocked politicians who supported it in the General Theory.

    I think it serves an important purpose – but collecting it for over two years inevitably makes it part of the problem.


  3. If “prosperity” is the product of monetary and fiscal stimulus, policymakers can never let up. If they even slow the rate of growth of stimulus, then the bubble will burst.

    If one brings in expectations, then the problem confronting policymakers becomes more complicated. It will take an ever-increasing rate of growth of stimulus to sustain the artificial propsperity.

    The Fed is now wondering what to do if the recovery falters. Short-term nominal interest rates are near zero and real rates are negative. The Fed has purchased almost every financial asset available without much regard to toxicity.

    Perhaps we will actually a helicopter moment. We can all look to skies for our future prosperity. Truly, then, the sky will be the limit.

  4. Daniel Kuehn Says:

    Jerry –
    RE: “If one brings in expectations, then the problem confronting policymakers becomes more complicated. It will take an ever-increasing rate of growth of stimulus to sustain the artificial propsperity.”

    If you include expectations, it should lower the burden on fiscal stimulus. If you put in an initial stimulus, expectations for future periods improve and private demand responds to the expectation. It’s when you don’t take expectations into account that you may need longer stimulus.

    RE: “If “prosperity” is the product of monetary and fiscal stimulus, policymakers can never let up.”

    But that “if” is conditional in the real world.

  5. Daniel Kuehn Says:

    Jerry, I’ve had these sorts of interactions with you before. I really like what Mario has to say and want to respond to it, and yes – I do take issue with some of what he has to say.

    If you can’t handle someone disagreeing with a point you make in a comment, then please just don’t respond to me – don’t post things like “troll alert”. Every comment up until that one has been constructive. I’m not berating or browbeating anyone here – I’m thinking through the issues just like you.

  6. Daniel Kuehn Says:

    btw Mario – I linked you on my blog: http://factsandotherstubbornthings.blogspot.com/2010/06/rizzo-on-keynesian-policy.html

    Not really the behavior of a troll, Jerry.

  7. RickC Says:

    DK,

    Sorry but I’ve got ask. Can this assertion of yours be proven?

    “If you put in an initial stimulus, expectations for future periods improve and private demand responds to the expectation.”

    We’ve just seen a massive initial stimulus and I’m not seeing improved expectations in my neck of the woods. Anyone out there seeing any? Or any positive demand in the private sector?

  8. Mario Rizzo Says:

    Daniel,

    Thanks for the link.

    My initial analysis did include expectations in the sense that firms may not expect a certain pattern of demand to continue. But if this pattern in industries that are interest sensitive *is* to continue the interest rate will have to remain artificially low for an extended period.

    This was the problem in the first place.

  9. Troy Camplin Says:

    It seems to me easy enough to disprove Keynes’ theory of economic slowdown being connected to “animal spirits” responding to what’s in the “news.” Simply track economic conditions and see if they correlate with various “shocks”. Pick what you would expect to be shocks to the economy, then see if they match downturns.

    Here’s my guess: you won’t find anything more than a statistically insignificant correlation between an economic downturn and these “shocks.”

    It seems to me that if he’s wrong about the causes of recessions, he may not know much about how to fix them, either. If you have someone with congested lungs, a runny nose, and general achiness, do you give them an antibiotic? If you guess the cause is a bacteria and it’s really a virus, you are wasting your time and antibiotics. So you do have to know what is causing a problem to consistently fix it.

  10. Daniel Kuehn Says:

    RickC –
    I have to push back a little on your assertion that we’ve had an initial stimulus. We have had a federal stimulus that’s largely been neutralized by state and local government cuts. We live in a federal republic, and the macroeconomy doesn’t know the difference between a federal dollar, a state dollar, and a local dollar. The federal stimulus has prevented a decline in total government spending, but there hasn’t really been much net stimulus to speak of.

    As for that comment of mine – of course it’s entirely predicated on what you believe about fiscal policy. My point is simply that Jerry’s understanding of the role of expectations is entirely contingent on the assumptions he brings about fiscal policy (and of coruse, so is my understanding).

  11. Daniil Gorbatenko Says:

    Daniel, for me the main problem with Keynesianism is that it postulates the existence of Keynesian world instead of explaining how it can be possible.

    In other words, instead of maintaining that the US is in a liquidity trap, Keynesians should prove that such a situation is even possible.

    The presence of low rates on government bonds does not prove this. To prove that a liquidity trap may be a reality you should explain why people may have an unlimited liquidity preference.

    So far, I have not seen a satisfactory explanation. The low interest rates on bonds argument does not do the job for me. Because it is not clear at all that the interest rate on bonds is the opportunity cost of holding money. I would say it is improbable that it is so.

    I think the real interest rate is better suited for that role. Real interest rates are of course low now (and thus you may claim that there is still a liquidity trap), but they were sky high during the Great Depression, and then you can’t claim that the Great Depression was a liquidity-trap case.

  12. Daniel Kuehn Says:

    Daniil –
    You don’t think the General Theory explains the basis of its postulates?

    I don’t know – this gets into murky territory. My problem with non-Keynesianism is that it postulates a non-Keynesian world without justifying it. There’s a point where we’re all convinced by different arguments and there’s not much you can say in response to things like that.

    RE: “In other words, instead of maintaining that the US is in a liquidity trap, Keynesians should prove that such a situation is even possible.”

    I think the liquidity trap is an interesting idea, but largely a distraction. I’m not sure about your standards of proof. If I remember, Keynes describes a liquidity trap simply as an indifference between cash and bonds. That doesn’t necessitate a zero interest rate (a small positive interest rate is the compensation for parting with liquidity), but a very low interest rate seems proof enough that that is in effect, right? As for “unlimited demand”, I think I’d phrase it “demand that is insensitive to price changes”. That’s more of a Hicksian definition of the liquidity trap, and I have no idea if we’re there or not because like I said – it’s more of a curiosity for me than a foundational problem.

    RE: “Because it is not clear at all that the interest rate on bonds is the opportunity cost of holding money. I would say it is improbable that it is so.”

    Again – it’s a question of indifference between cash and bonds. It seems to me that a low or zero interest rate makes a pretty good case for that indifference.

    I think you’re making far too much of the liquidity trap. I think the liquidity trap only really tells us about the relative efficacy of fiscal and monetary policy. The argument that some make is that monetary policy isn’t effective at all in a liquidity trap. But even if you’re not in a liquidity trap, monetary policy can still be LESS effective by the same logic. It’s a neat little idea, but I think people make too much of it. It makes up one little paragraph of the General Theory and people act like it is the foundation of Keynesian economics.

  13. chidemkurdas Says:

    Re Mario– “So he advocated the stabilization of total investment by ensuring permanent investment spending of relatively large sums by the government or quasi-independent agencies of the state (like universities, the Port of London Authority, etc).” This has in fact happened with the secular rise in spending by the government & its agencies. Think Fannie Mae & Freddie Ma, which have grown over several decades.

    There is the argument that this is a stabilizer in the down part of the cycle. In any case, much of this spending becomes entrenched, regardless of how it originated, so there is a tendency for government activity to expand long term. The cyclical issues interact with this secular trend.

  14. Richard Ebeling Says:

    Mario:

    Let me suggest that Keynesian policy ends before it begins.

    Precisely by focusing on “aggregates” — total output, general employment, etc., — it misses the fact that it is not sufficient to “merely” get people back to work and then worry about “allocation” issues later.

    The way these unemployed are brought back into employment influences whether or not those jobs and productions are likely to be stable and sustainable in the long run.

    That is, by ignoring the “microeconomic” aspects of government monetary and fiscal “stimulus,” the Keynesians completely miss one of Hayek’s central points in his monetary and business cycle analysis:

    How, where and for what resources are brought back into employment determines whether or not this is restoring coordination or setting the stage for a future needed “correction.”

    This is the reason that, traditionally, most Austrian economists have considered that sustainable “rebalancing” of the economy requires the necessary adjustments on the supply-side of the market, including in the relative structure of prices and wages, in the face of the distortions and resource misallocations that may have occurred in the upturn that preceded the downturn being experienced.

    “Demand-side” Keynesian policies tend to delay or retard these supply-side adjustments and overlay new distortions that will require readjustment at some point in the future, as well.

    Richard Ebeling

  15. Current Says:

    Daniel,

    Do you think that functional-finance provides anything more than a means of reducing the demand for money?

    Do you think that a normal situation would ever arise when a central bank’s attempts to inflate would fail? Or do you think that the problems are tied up with particular circumstances (like paying interest on excess reserves).

    I’m not happy about the state of the subject of studying Keynesianism (by Keynesians and others). I read some of the recent enormous discussion between Krugman, Sumner, Woolsey and Thoma about fiscal policy expectations vs monetary policy expectations. I really don’t agree with any of them, and the discussion is a real mess.

  16. B Keeffe Says:

    Unemployment pay.
    What would Keynes say to public employees, in the UK, civil servants (central govt)and public servants (local councils), receiving higher wages for shorter hours(35) than those in private employment? Is this not in fact a form of unemployment pay? Isn’t it a distortion of market equilibrium? Or is it a form of financial stimulus? Permanent or temporary?


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