Why Fear Keynes?

Time Magazine quoted its Man of the Year, Chairman Bernanke, regarding his boyhood interest in the Great Depression. He had heard his family discuss a town full of shoe factories that closed during the depression leaving the community so poor that its children went barefoot. He said he kept asking why they didn’t just open the factories and make kids shoes. Good question.

A depression does seem paradoxical. People can’t spend because they don’t have the income. They don’t have the income because they aren’t spending. Around and around it goes with the gears not engaging. Looking ahead, there is no supply because there is no demand and no demand because there is no supply.

Which is it? Does supply create its own demand? Or, does demand create its own supply? Apparently, we must choose the one, and only one, correct answer. Who was right: Say (supply creates its own demand) or Keynes (demand creates its own supply)? Are you a Methodist, or a Baptist? We are discussing religion, you know.

On the first day of my Money and Banking class, circa 1961 or 1962, Professor Waller asked us if we knew the way to Kennedy’s New Frontier? We didn’t. He said, well you go to Harvard and turn left. Harvard was left; Chicago was right. Harvard, you see, was under the influence of the Great Satan, John Maynard Keynes. (Jean Baptiste Say was an early Classical economist who was influenced by Adam Smith and who, in turn, was a great influence on Frederick Bastiat, among others.)

Although I never quite learned why, I did learn early on that Keynesianism was a corrupting influence to be avoided, or, better yet, refuted. That wasn’t all that easy since the national income accounts had adopted Keynes’s spending categories and the elementary economics textbooks–by the late Paul Samuelson and his imitators–had laid out “the Keynesian System” with simple graphs and formulas that were easy to remember and easy to teach. Who can forget that the multiplier is the reciprocal of the marginal propensity to save?

Relevant to today, much attention was paid to showing that Classical economics had a logical answer to the Keynesian “Liquidity Trap,” a condition whereby the demand to hold cash balances becomes perfectly elastic (horizontal) so that increases in the money supply no longer reduce interest rates. Such a condition seemed highly unlikely at the time, and the search for a non-Keynesian way out struck me as the proverbial search for the number of angels that could dance on a pin. The root-canal solution at the time was that deflation would raise the value of cash balances to the point that spending would resume. A kinder-gentler reaction would be not to wait for deflation to prime the spending pump, but to increase the money supply anyway (called quantitive easing nowadays) until the marginal value or utility of additional money units held fell below the marginal utility of what could be bought with extra money and spending resumed.

If more money is only hoarded and does not lead to more spending, the solution is still more money until spending finally resumes. The metaphor in the modern era became dropping money from helicopters, which Chairman Bernanke caught so much flack for using mostly from people who had no idea he was using a well-known (among economists) metaphor. The root-canal version, which waits for deflation to become self-correcting after a while was dubbed the Pigou effect or Pigou-Patinkin effect.

I wondered why there was such satisfaction at finding (or creating) this escape from the Keynesian liquidity trap when the Keynesian prescription of fiscal stimulus financed with newly created money was so much less painful and could actually be used in the real world. I suppose the answer was, and still is among some, that the Keynesian solution involved government action. Any solution that involves government action is to be avoided at all costs. Keynes. I agree with the “avoiding” part; just not the “at all costs” part.

To me it seemed obvious that while Keynes’ General Theory may not be a guide for all times, it was a practical blueprint for fighting recessions caused by a lack of sufficient “aggregate demand.” In normal times, the supply side is the constraint and deserves our attention; in depressed times, insufficient demand must be remedied first. The gears have to be engaged for the supply side to work.

I don’t get why we can’t be supply-siders in normal times and yet accept that Keynes is relevant for depressions and   deep recessions. Both supply and demand are important. Why must each side ridicule the other? Why must it be a religious issue?

I have much sympathy with the supply-siders who prefer private sector solutions to our problems. I are one, as they say. However, denying the relevance of demand–the relevance of Keynes during a deep recession–erodes our credibility unnecessarily. Why fear Keynes? He’s into his long run and can’t bite us. Why leave it to others to state the obvious?

Comments (6)

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  1. W.C. Varones says:

    Because Keynes prescribed running surpluses in the good years, and Congress never does that.

    We have no stored grain in the winter.

  2. W.C. Varones says:

    Keynes never advocated running deficits of 13% of GDP. Nor did he advocate running large structural deficits throughout the business cycle.

    I don’t think he ever advocated debasing the currency so that the dollar loses 95%+ of its value every few generations, either.

    In a fantasy world of balanced budgets and a sound dollar, sure, running a small, temporary deficit and/or printing a little money to smooth the cycle might be a good idea. But we are so far from that world that the discussion is nonsensical.

  3. I bow to the astute wisdom on my cohort WCV above. He is absolutely correct – and even if Keynes’ arguments were valid in some long gone age, times change, politicians get drunk on power (or, in some cases, those who claim to be “politically neutral” get drunk on the power they are not supposed to know they have – Chairman Greenspan, anyone?) and voila, you have the mess we find ourselves in today.

    We are a year beyond ZIRP. It does not appear as though any member of 2010′s FOMC would dare to suggest hiking up interest rates, so deathly afraid it will send “recovery” sputtering… pull off the bandaid already!

    If we’ve learned anything from this, it is that we need new terms and new heroes in economics. The word “capitalism” needs to be redefined or at least taken back by the capitalists. Whatever version of capitalism we believe we have going now is most certainly not capitalism and should be defined as such.

    If we are going to apply Keynes’ principles to our situation, it’s only reasonable to adopt them to the times. But no, it’s easier to take the good parts and chuck the rest. Who cares about “consequences”?

    Keynes’ principles, in this day and age, are much like the CPA Exam (I teach it so I would know)… in the CPA Exam World, there are scenarios that CPAs will never encounter in the wild. In the Real World, there’s a convenient button to do variance analysis and complicated computer programs to gauge risk and materiality. But in the CPA Exam world, the good little accountants do all of this by hand and always, ALWAYS calculate an overinflated AMT.

    We train our CPAs to operate in a world that does not exist using “ideal conditions” that they do not encounter. Does that make sense? We train our economists the same way.

    In a perfect world…

  4. Joe Calhoun says:

    Why incur the debt involved with deficit financed fiscal spending when monetary policy is more efficient and avoids the debt?

  5. Joe,

    I hope Bob will forgive me for hijacking his blog but I believe the answer to that, at least for now, is that monetary policy has its limits. Were it an effective tool at this point, surely they’d have utilized it.

    Or you could look at Greenspan’s 18 years and get your answer.

  6. Sergei says:

    Hi Bob,

    Merry Christmas and a Happy New Year to you and your family. Just want to use this opportunity to thank you for all the posts you have written in the past couple of years. I started reading this blog in mid-2008, and have learned a great deal about monetary policy, macroeconomics, banking, as well as other more eccentric subjects. As a Hong Kong-based bank analyst in a rating agency, knowledge and insights gleaned from this blog have and will help me a great deal at work in the past and well into the future.

    Kind regards,