Reply #118: How I Became a Keynesian: Second Thoughts in the Middle of a Crisis Richard Posner

[Demeter]

http://www.tnr.com/article/how-i-became-keynesian?page=0,2

Keynes's analysis provides an explanation--though there is debate among economists whether it is the correct one--for England's persistent high unemployment in the interwar period, or more precisely for the component that represented involuntary unemployment, the plight of unemployed workers who would have preferred to work at a wage below the prevailing rate than to be on the dole. One might think that wages would have fallen to a level at which anyone who wanted a job could have found one. But Keynes pointed out that since workers are a high proportion of all consumers, a fall in the wage level will reduce incomes, and therefore reduce consumption and investment, unless prices fall proportionately. They would be likely to fall somewhat, because producers' labor costs will be lower.

But a general fall in the price level--deflation--imperils economic stability, and actually cutting workers' wages to make room for the unemployed is a surefire formula for industrial strife.

And workers are not fungible. A factory that employs 100 highly skilled workers may have a lower average cost of production than one that employs 120 less-skilled workers at a lower wage. Only if demand for goods is high may the market have room for a firm that, because it employs those less skilled workers, has higher costs of production than the existing firm.

Thus a high level of involuntary unemployment could be, as Keynes showed, an equilibrium, rather than a temporary result of the business cycle. His analysis casts a particularly bright light on the cyclical downturns that we call recessions, or in extreme cases depressions. For when the demand for goods and services falls, as in the present downturn, the economic environment becomes unsettled and even the near future becomes unpredictable. This dampens businessmen's animal spirits and causes consumers to hoard--and businessmen as well. For when the urge to action deserts them, they build up their cash balances, in lieu of active investment, in order to hedge against uncertainty. Owing to uncertainty, businessmen even in the best of times lack "strong roots of conviction" in their estimate of what the future holds, and so a sudden change in economic conditions can paralyze them. If so, a downward spiral will develop, as falling demand and falling investment reinforce each other, causing layoffs that reduce incomes and therefore consumption and production, and so induce more layoffs.

But the government may be able to arrest the decline--another of Keynes's central ideas, and one strongly resisted by the conservative economists of his time, as of today. It can reduce interest rates (by buying government bonds or other debt for cash, which increases the amount of money that banks are permitted to lend) in an effort to reduce the costs of active investment and thus encourage employment. Keynes urged this approach. But he also pointed out that it might not work well--as we have learned in the current downturn. The banks may lack confidence in "those who seek to borrow from them," so that "while the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition." In fact, banks in America today are hoarding, rather than lending, most of the cash that they have received from the government's bailouts. The hoard may make the banks a little freer with lending, but the effect on economic activity, at least in the short run, may be tepid.

Fortunately, there is more that government can do to arrest a downward economic spiral besides pushing down interest rates. It can offset the decline in private consumption and investment in a recession or a depression by increasing public investment. When we say that the government builds highways, we mean it buys highways from private contractors. And the more it buys, the more that investment--and because of the multiplier effect, the more that income, output, and employment--are stimulated. And because private decisions to invest and to consume are influenced by confidence in the future, or the lack thereof, the government must do everything it can to convince businessmen and consumers that it is resolute and competent in working for economic recovery. An ambitious public-works program can be a confidence builder. It shows that government means (to help) business. "The return of confidence," Keynes explains, "is the aspect of the slump which bankers and businessmen have been right in emphasizing, and which the economists who have put their faith in a ‘purely monetary' remedy have underestimated." In a possible gesture toward Roosevelt's first inaugural ("we have nothing to fear but fear itself"), Keynes remarks upon "the uncontrollable and disobedient psychology of the business world."

But for a confidence-building public-works program to be effective in arresting an economic collapse, the government must be able to finance its increased spending by means that do not reduce private spending commensurately. If it finances the program by taxation, it will be draining cash from the economy at the same time that it is injecting cash into it. But if it borrows to finance the program (deficit spending), or finances it with new money created by the Federal Reserve, the costs may be deferred until the economy is well on the way to recovery and can afford to pay them without endangering economic stability. When investors passively save rather than actively invest, government can borrow their savings (as by selling them government bonds) and use the money for active investment. That is the essential Keynesian prescription for fighting depressions.

Keynes's emphasis on consumption as the driver of active investment and hence of economic growth may seem to give his theory a hedonistic flavor. He was indeed hostile to thrift, which is another name for hoarding. We have seen the damaging effects of thrift in the current downturn, in which rich people's forswearing luxury purchases in the name of thrift has reduced employment in the retail sector, thus deepening the downturn. This is an example of the "paradox of thrift." "Prodigality is a vice that is prejudicial to the Man, but not to trade," in the words of the seventeenth-century economist Nicholas Barbon, quoted by Keynes. (The full paradox of thrift is that, if incomes fall far enough because people are saving rather than consuming, savings will actually decline.)

Keynes commends FDR for having destroyed agricultural stocks during the Great Depression, since sales from existing inventories do not stimulate active investment, but are actually a form of disinvestment. He even discusses sympathetically, though ultimately he rejects, the curious proposal of "stamped money," whereby people would be required to have their currency stamped periodically at a government office in order to remain legal tender, because the bother of having to get one's money stamped would have the effect of a tax on hoarding.

All this may seem like an incitement to profligacy, consistent with Keynes's rather bohemian private life as a charter member of the Cambridge Apostles and the Bloomsbury group. But nothing in his theory limits consumption to the purchase of frivolous private goods, or indeed to private goods of any kind. I gave the example of a public highway; other examples are the purchase of military equipment for national defense and the public subvention of education and art. And while he famously (or notoriously) argued the value of unproductive projects--or so they would seem to us--such as the building of the Egyptian pyramids, on the ground that they provided employment, which increased consumption (the workers, even if they were slaves, had to be fed and clothed and housed), he preferred that governments undertake productive projects.

Correctly anticipating the rapid growth of living standards, moreover, Keynes predicted that within a century people's material wants would be satiated, and so per capita consumption would stop growing. People would work less, but only because their need for income, and more important their desire for it, was less. And then the challenge to society would be the management of unprecedented voluntary leisure. This was a popular 1930s theme--think of Huxley's Brave New World--but it underestimated the ability of business to create new wants, and new goods and services to fulfill them.

That was merely a mistake, an oddity in Keynes's belief in the possibility of perpetual boom. He has wise words, which Alan Greenspan and Ben Bernanke could with profit have heeded earlier in this decade, about the need to raise interest rates to prick an asset-price bubble before it gets too large. Yet just a few pages earlier he remarked that "the remedy for a boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last." (That may have been what Greenspan thought!) The statements can be reconciled by observing that as long as there is involuntary unemployment, low interest rates, by stimulating active investment and therefore production without raising labor costs, should not produce inflation. But we have just seen, in the United States of the 2000s, how even if labor costs are steady, low interest rates can produce an asset-price inflation (the housing and credit bubbles) that can precipitate an economic collapse. Keynes had earlier in his career written prophetically about the potentially disastrous effects of inflation. There is almost no mention of inflation in The General Theory, but he does say what many of his successors forgot--that when an economy no longer has any involuntary unemployment, further efforts to stimulate demand will merely cause inflation.

Perpetual-boom thinking illustrates the left-leaning utopian strain in The General Theory. This was what made Keynes a bête noire for conservatives, but it charms Skidelsky, who devotes the last chapters of his book to celebrating Keynes as a "green," a philosopher of limits to growth, of "the good life" lived simply, even of the end of economics. Recall Keynes's erroneous prediction that within a century people's material wants would be satiated. When that happened, the demand for capital (to finance consumption) would plummet and rentiers (people who live on income from passive investments, such as stocks or bonds, and thus are hoarders) would be wiped out--a prospect that delighted Keynes, who looked forward to "the euthanasia of the rentier," though fortunately he did not mean this literally. He questioned free trade--that holy of holies of conventional economists--by pointing out that a country whose people had a low propensity to consume could stimulate investment by depreciating its currency so that its exports were attractive, because that would encourage its industries to invest in producing for foreign consumption and therefore to employ more workers. The country would accumulate foreign currency that it could use to invest abroad--the policy that China has been following lately, with pretty good results. He even had kind words for usury laws, arguing that they had reduced interest rates and thus discouraged hoarding. He favored a heavy estate tax, reasoning that it would increase consumption by reducing accumulation for bequests. (The standard economic argument against the estate tax is identical--it encourages "wasteful" consumption!)

Although there are other heresies in The General Theory, along with puzzles, opacities, loose ends, confusions, errors, exaggerations, and anachronisms galore, they do not detract from the book's relevance to our present troubles. Economists may have forgotten The General Theory and moved on, but economics has not outgrown it, or the informal mode of argument that it exemplifies, which can illuminate nooks and crannies that are closed to mathematics. Keynes's masterpiece is many things, but "outdated" it is not. So I will let a contrite Gregory Mankiw, writing in November 2008 in The New York Times, amid a collapsing economy, have the last word: "If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront. . . . Keynes wrote, ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.' In 2008, no defunct economist is more prominent than Keynes himself."



Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School.