Great Political and Economic Thinkers: Theory and Reality
Lectures by Robert M. Coen Emeritus Professor of Economics Northwestern University
November 11 and 18, 2014 Web site: faculty.wcas.northwestern.edu/~rcoen Email:
[email protected]
November 11
20th Century Revolution in Economic Thinking: John Maynard Keynes November 18 Counterrevolution to Keynes and Critiques of Activist Economic Policies: Hayek, Friedman, Lucas, and Others
What Were Keynes’s Revolutionary Ideas? Old Ideas
Keynesian
Saving is good, it builds nation’s capital
Saving can be too large, depressing demand, production, employment
Tough times call for austerity
May be true for individuals and businesses, but nation needs more spending, not less
Recessions result from too little money supply
Recessions result from too little effective demand
Cut wages to increase employment
Wage cuts reduce incomes and spending, worsening depression
Increase investment by cutting interest rates
Businesses unlikely to respond when they have excess capacity and are pessimistic Businesses might not invest enough even if interest rates are reduced to zero
Government needs to restore confidence by balancing its budget
Balancing budget requires cutting spending and raising taxes, exactly wrong Rx
What Were Keynes’s Revolutionary Ideas? Old Ideas
Keynesian
Government spending crowds out private spending
True at full employment, not when there are large amounts of unemployed resources
The market will eventually adjust to restore full employment
Possibly, but in the long run we are all dead, or a distraught public loses patience with free-market capitalism
Stick to the gold standard to maintain confidence in the currency
Gold standard is antiquated relic, denying nations power to control money supply Paper and bank money allow monetary control
Financial markets are subject to same economic laws as other markets
Financial markets are more like casinos, subject to waves, bubbles
Why was Keynes such an effective revolutionary leader? Member of the cultured British elite, widely admired
Bloomsbury Group
“Art for art’s sake” Leonard and Virginia Woolf
Lady Ottoline Morrell Maria Nye Lytton Strachey Duncan Grant Vanessa Bell
Duncan Grant Keynes
Why was Keynes such an effective revolutionary leader? Member of the cultured British elite, widely admired Leader of the academic economic establishment Best student of the world’s leading economist, Alfred Marshall Editor of the major international professional publication in economics, the Economic Journal A highly successful investor
Keynes the Investor High margin trader in currency and commodities, largely successful Managed King’s College, Cambridge, endowment (Chest Fund)
Made large investments in companies he understood (cf. Warren Buffett)
Why was Keynes such an effective revolutionary leader? Member of the cultured British elite, widely admired Leader of the academic economic establishment Best student of the world’s leading economist, Alfred Marshall Editor of the major international professional publication in economics, the Economic Journal A highly successful investor
Eloquent writer/expositor/debater Man of affairs: Active in government service and as policy critic Analyses of current problems on the mark Foresaw that Treaty of Versailles was a disaster Predicted UK return to gold in 1924 would abort economic recovery Saw that government austerity would worsen depression Wanted to preserve capitalism, not destroy it
Triumph of Keynesianism Massive debt-financed spending in World War II restores full employment Alvin Hansen introduces Keynesian at Harvard in late 1930’s Congress passes Employment Act of 1946 In 1948, Paul Samuelson (Nobel Prize, 1970), one of Hansen’s students, publishes first intro text incorporating Keynesian ideas, a best seller Jan Tinbergen (Nobel Prize, 1969), Lawrence Klein (Nobel Prize, 1980), build first Keynesian-oriented macro-econometric models In 1963, President Kennedy proposes large income tax cuts to promote recovery In 1971, President Nixon takes US completely off gold standard, floats dollar (depreciates), declares, “I am now a Keynesian in economics.”
Time magazine, Dec. 31, 1965
From Time cover story, Dec. 31, 1965 Today, some 20 years after his death, [Keynes’s] theories are a prime influence on the world's free economies, especially on America's … In Washington the men who formulate the nation's economic policies have used Keynesian principles not only to avoid the violent cycles of prewar days but to produce a phenomenal economic growth and to achieve remarkably stable prices. In 1965 they skillfully applied Keynes's ideas … to lift the nation through the fifth, and best, consecutive year of the most sizable, prolonged and widely distributed prosperity in history.
Frederick Hayek, 1899-1992
Austrian London School of Economics, 1931-50 Became British citizen in 1938
University of Chicago, 1950-62 University of Freiburg, 1962-68 University of Salzburg, 1968-retirement
Nobel Prize, 1974 The Road to Serfdom, 1944
The Road to Serfdom, 1944 Warns of attraction of socialist economic planning Economic life too complicated for planning to work Market data needed for good decisions Planners will not take risks Planning failures lead to extended control Planning a slippery slope into authoritarianism, end of liberty Keynes praised the book! “In my opinion it is a grand book … morally and philosophically. I find myself in agreement with virtually the whole of it … in deeply moved agreement.”
Milton Friedman, 1912-2006 Born New York City Rutgers BA, Columbia PhD Taught at UChicago until 1977 retirement President, American Economic Association, 1967
Nobel Prize, 1976 A Theory of the Consumption Function, 1957 Capitalism and Freedom, 1962 Monetary History of the U.S., 1867-1960, 1963 (with Anna Schwartz) Reviver of “Monetarism”
Friedman’s Challenges to Keynesian Macroeconomics A Theory of the Consumption Function, 1957 Keynes:
Consumer spending depends on current income “Multiplier effects” are large Temporary tax cuts have substantial impact
Friedman: Consumer spending depends on “permanent income” “Multiplier effects” are small Tax cuts effective only if they are permanent Monetary History of the U.S., 1867-1960 Keynes:
Great Depression caused by collapse of investment Monetary policy ineffective in depression; need fiscal stimulus Fiscal and monetary policy together can moderate cycles
Friedman: Great Depression caused by excessive money growth Cycles can be smoothed by stabilizing money growth Put Fed on “automatic pilot” – no discretion Fiscal stimulus ineffective, crowds out private spending, except when financed by printing money But allow automatic fiscal stabilizers to operate
Time magazine, Dec. 19, 1969
Friedman’s Presidential Address American Economics Association, 1967 Conventional view: Trade-off between inflation and unemployment Lower unemployment → strengthens bargaining power of labor → higher wages → higher prices Supporting evidence: The Phillips Curve Friedman: Wage demands also depend on expected inflation
Lower unemployment → strengthens bargaining power of labor → higher wages → higher prices → higher wages to compensate for higher prices → higher prices and on and on Lower unemployment leads to accelerating inflation! No stable trade-off (prescient) Stable long-run inflation only at “natural rate of unemployment” Employment policy should seek to reduce the “natural rate”
Phillips Curve: Inflation-Unemployment Tradeoff, 1960-69 10
Inflation Rate (percent)
8
6 1969 1968
4 1966 1967 1962
1965
2
1964 1961
1960 1963
0 2
3
4
5
6
7
Unemployment Rate (percent)
8
9
Friedman’s Presidential Address American Economics Association, 1967 Conventional view: Trade-off between inflation and unemployment Lower unemployment → strengthens bargaining power of labor → higher wages → higher prices Supporting evidence: The Phillips Curve Friedman: Wage demands also depend on expected inflation
Lower unemployment → strengthens bargaining power of labor → higher wages → higher prices → higher wages to compensate for higher prices → higher prices and on and on Lower unemployment leads to accelerating inflation! No stable trade-off (prescient) Stable long-run inflation only at “natural rate of unemployment” Employment policy should seek to reduce the “natural rate”
Phillips Curve: Inflation-Unemployment Tradeoff ???, 1960-75 10 1975 1974
Inflation Rate (percent)
8 1973
6 1971
1970
1972
4
2
0 2
3
4
5
6
7
Unemployment Rate (percent)
8
9
Robert E. Lucas, Jr., 1937-
University of Chicago BA and PhD Carnegie Mellon, 1963-74 University of Chicago, 1974Nobel Prize, 1995 Studies in Business-Cycle Theory, 1981 Extends rational behavior to include expectations
Lucas’s Challenge to Keynesian Macroeconomics Keynes:
Adaptive expectations – extrapolations from past experience Statistical models give accurate measures of consumer responses to change in incomes, interest rates, inflation Example: To reduce inflation, must reduce inflation expectations How? Increase unemployment
Lucas:
Rational expectations – forward-looking Consumers hold beliefs about monetary and fiscal policies Plan their current and future actions accordingly Statistical models unreliable guides to impacts of policy Example: To reduce inflation, must reduce inflation expectations How? Credible monetary authority announces slower growth of money supply
Edward C. Prescott, 1940-
Swarthmore BA, Carnegie Mellon PhD Pennsylvania, 1967-71 Carnegie Mellon, 1971-80 Minnesota, 1980-2003 Arizona State, 2003Nobel Prize, 2004 Supply-side economics “Real Business Cycle” theory Cycles due to shocks to technology and wages Labor supply very sensitive to wages
Supply-Side Challenge to Keynesian Economics Keynes:
Business fluctuations caused by fluctuations in aggregate demand Tax cuts, government spending can increase aggregate demand Tax cuts, government spending increase budget deficits
Supply-siders: Business fluctuations principally due to fluctuations in aggregate supply Aggregate supply depends on labor supply and productivity per worker Great Depression caused by declines in labor supply and productivity “Real” as opposed to “Monetary” causes Tax cuts increase aggregate supply (incentives to work and invest) Reducing tax rates can increase tax revenue and reduce deficits Other prominent supply-siders, influential in 1970s-1980s: Paul Craig Roberts, Norman Ture, Arthur Laffer
Dale T. Mortensen, 1939-2014
Willamette BA, Carnegie Mellon PhD Northwestern, 1965-2013 Nobel Prize, 2010 Search theory of markets
Search Theory and Unemployment
Keynes: Unemployment is an involuntary, disequilibrium state Unemployed are willing to work at existing wage, but can’t find jobs Search Theory: Buyers and sellers must find one another Workers: When to accept a current offer vs. continue looking Employer: When to make an offer vs. waiting for more applicants Frictional unemployment to be expected Unemployment voluntary, an equilibrium state Theory can explain duration of unemployment
Keynesian Revival After 2008 Crisis Misbehaving financial markets central feature – reminder of Keynes’s view
Collapse of investment and slow recovery of investment Monetary policy successful in reducing short-term interest rates, less so long-term Government stimulus (pump priming) worked in US Did not ignite inflation Deficits and debt increased initially, but receding Fiscal austerity retards European recovery But neoclassical view also supported Monetary ease, low interest rates prior to 2008 created housing bubble Monetary policy played vital role in shoring up financial institutions
Gross Private Domestic Investment, 2007Q1-2014Q3 2,800
Billions of 2009 dollars
2,600
2,400
2,200
2,000
1,800
1,600 2007
2008
2009
2010 Year
Source: BEA
2011
2012
2013
2014
Interest Rates on Government Securities, 2007M1-2014M10 6
5
Percent
4
3
2
1
0 2007
2008
2009
2010
2011
Year 1-Year Source: Federal Reserve
30-Year
2012
2013
2014
Government Purchases of Goods and Services, 2007Q1-2014Q3 3,150
Billions of 2009 dollars
3,100
3,050
3,000
2,950
2,900
2,850 2007
2008
2009
2010 Year
Source: BEA
2011
2012
2013
2014
Reflections
Monetary and fiscal policies are powerful, potentially effective tools to achieve stability Hayek correct that complexity of economy makes it difficult to set policy correctly Even if policy could be set correctly, will it be? Will government leaders not use tools to further their own power and reelection? Complexity or politicians’ self-interest leads to misuse – greater instability! Today’s conservatives would limit discretion by imposing rules: Balance (small) budget Set money growth on automatic pilot Is large government not inescapable for national security? Without improved quality of government, market capitalism not likely to survive
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