Farmer 09 Two Visions of the Economy

8/18/2019 Farmer 09 Two Visions of the Economy

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Chapter 2

Two Visions of the Economy

What was diff erent about Keynesian economics from everything that wentbefore? Consider the two following physical analogs of a modern economy.In the first; think of the economy as a fruit bowl (see Figure 2.1). The fruitbowl represents the economic infrastructure. In it is a ball; this representsgdp - the value of all goods and services produced in the United States ina given year. The bowl is continually rocked by random economic events- the Gulf war, the invention of the personal computer, Hurricane Katrina.These events move the bowl and gdp goes up (to the right) or down (tothe left). But whatever happens to the infrastructure, the system itself isself-correcting in the sense that the ball always moves towards the bottom

of the bowl. The unemployment rate, when the ball is at its rest point, iswhat economists now call the natural rate of unemployment. This is howeconomists before the Great Depression thought of the economy.

Keynes saw things diff erently - he was much less inclined to view theeconomy as a self-correcting mechanism. Instead of the fruit bowl modelhe proposed what I call the windy boat model. In this view of the worldthe economic infrastructure is like an ocean. The boat is gdp, and randomevents, the Gulf war, the invention of the personal computer and HurricaneKatrina are like the wind. The wind could blow from the east; it could blowfrom the west. When the wind stops - the boat is becalmed wherever events

leave it.Keynes went further than this. In the fruit bowl view of the world,

the shocks that rock the bowl are predominantly fundamental; these areshocks that will have a lasting eff ect on the ability of the economy to producecommodities and satisfy human wants. The invention of the automobile. The

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6 CHAPTER 2. TWO VISIONS OF THE ECONOMY

As the bowlrocks, the ball

moves back andforth

The ball alwaysreturns to the

same point

Shocks rock

the bowl

Figure 2.1: The Fruit Bowl Model of the Economy

discovery of oil in Alaska. The personal computer. In the windy boat viewthey might also include what Keynes called the ‘animal spirits of investors’

and Alan Greenspan referred to as ‘irrational exuberance’. In other words- the wind might blow for no sound economic reason and it might leave theeconomic boat stranded in calm waters with high unemployment for a verylong time. When writing about his view of the long run and the short run in1924 when the debate was about the speed that prices would adjust Keynesfamously asserted that; “In the long run we are all dead!”1.

2.1 The Depression and Economic Theory

Keynes was a very clever man - but he was a polemicist and pragmatist first

and a social scientist second. He was a student of Alfred Marshall, one of thefounders of modern economics. Keynes studied under Marshall in CambridgeEngland in the early part of the twentieth century. During the 1920s Keynes

1 A Tract on Monetary Reform (1924, Chapter 3).


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2.1. THE DEPRESSION AND ECONOMIC THEORY 7

The wind canblow in any

direction

The wind

blows the boat

The boat is blownaround and can

end up anywhere

Figure 2.2: The Windy Boat Model of the Economy

wrote a number of books on economics including a Treatise on Money anda major work on the theory of probability that was not well received by the

critics.2

He worked as a bureaucrat, an academic and a journalist but hedid not come to prominence in the public eye until the publication of a bestselling book in 1920, the Economic Consequences of the Peace (1920). In it,he argued that the Treaty of Versailles, which sliced up German assets afterWorld War I, was unworkable and would have disastrous consequences forinternational relations and world peace.

In the late 1920s Keynes was a conventional fruit bowl economist. Itwas his interpretation of the Great Depression that caused him to change hisviews and to develop an alternative theory that would justify policies thathe believed were the right way to cure the Great Depression. Fruit bowleconomists argued that in hard times everyone needed to tighten their belts.

Just as a family would need to save more if its income fell so the consen-sus opinion amongst mainstream fruit-bowl economists was that government

2A Treatise on Probability, Keynes (1921). For a discussion of the reception of theTreatise see Robert Skidelsky (1992), pages 67—73


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must do the same. Keynes argued for exactly the opposite. His remedy for

the Great Depression was a massive public works programme paid for byborrowing or by printing money.It was one thing to be sure of oneself and another to explain why state of

the art economic theory was wrong. As Keynes put it in the opening chapterof the General Theory;

The classical theorists resemble Euclidian geometers in a non-Euclidian world who, discovering that straight lines apparentlyparallel often meet, rebuke the lines for not keeping straight—asthe only remedy for the unfortunate collisions which are occur-ring. Yet, in truth, there is no remedy except to throw over the

axiom of parallels and to work out a non-Euclidian geometry.To convince his fellow economists that they were wrong - Keynes made

two major changes to the fruit bowl model of the economy. First, he insistedon overturning the paradigm of demand and supply as applied to the labormarket. Second, he introduced ‘animal spirits’ as a separate fundamentalfactor that determines unemployment.

Supply and demand is a building block of modern economic theory. Ac-cording to this model, one that had persisted for over a hundred years whenKeynes was writing, the price of a good and the quantity sold are determinedby the intersection of a downward sloping demand curve and an upward slop-

ing supply curve. When applied to the labor market, the model implied thatthere could be no unemployment in the sense that Keynes defined it sincethe price of labor (the money wage) would either rise or fall until demandwas equal to supply. How could this model be a good description of a worldwhere unemployment of over twenty percent could persist for more than fiveyears? Keynes proposed instead to throw out the labor supply curve andreplace it with the idea that employment is determined only by demand.This bold proposal was successful because the policies that were suggestedby Keynes were successful. But it was also a major weakness that wouldreturn to haunt Keynesian economists in the two decades following WWII.

2.2 Macroeconomics before Keynes

The state of the art in understanding business cycles in the 1920s was summa-rized in an influential book, Industrial Fluctuations , by the British economist


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2.2. MACROECONOMICS BEFORE KEYNES 9

0

5

10

15

20

25

30

90 00 10 20 30 40 50 60 70 80 90 00

Unemployment

P e r c e n t o f t h e

l a b o r f o r c e

Figure 2.3: The Unemployment Rate Since 1890

Arthur Pigou.3 In it, he listed at least six diff erent causes of business cyclesincluding errors of optimism and pessimism, agricultural fluctuations causedby the weather, shocks to productivity as a consequence of new inventions,

monetary fl

uctuations, industrial disputes and changes in tastes. These wereall possible causes of disturbances to the fruit bowl. Nobody at this timedisputed the fact that, left to itself, the fruit bowl will tend to return toits unique rest point. The Great Depression of the 1930s changed this viewforever.

Figure 2.3 plots the percentage of unemployed persons in the UnitedStates from 1890 through 2007. The ups and downs that occur at irregularintervals are a manifestation of business cycles and it is these ups and downsthat Pigou attributed to a laundry list of possible causes from optimism andpessimism to changes in tastes. There are two features of the graph worthnoting. First, the upward spike that began in 1929 and ended in 1941 is

much larger than any spike in unemployment that has occurred before orsince. The closest episode is the recession that occurred in the last decade of the nineteenth century in which unemployment reached 18% and exceeded

3Pigou (1929).


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10% for six years in a row. Second, fluctuations in the unemployment rate

since 1941

have been less volatile than fl

uctuations before world war two. Iwill return to this latter fact when I discuss the success of Keynesian policies.A recession is a time in which families tighten their belts and reduce

expenditure. Since there is less money coming into the household - lessmust necessarily go out. According to the fruit bowl view of economics -the same applies to government. Because tax revenues are reduced duringa recession the government should cut back on its expenditure. This fruitbowl view was overturned by Keynes who provided a theory that explainedwhy governments should instead spend more during recessions.

2.3 Macroeconomics after Keynes

The Great Depression was significant because it put a dent in the notion of the unregulated capitalist economy as a self-correcting system. According tothe theory laid out by Pigou in Industrial Fluctuations the Depression musthave been caused by one of the six fundamental factors listed above. The firstproblem with Pigou’s theory is that it is difficult to identify a fundamentalshock of significant importance that could have triggered a depression of themagnitude that was experienced in the 1930s. The second problem is thatwhatever this shock might have been, a self-correcting economy should havereturned quickly to a state of full employment.

As an alternative to the classical model of demand and supply Keynesthrew away the labor supply curve, one of the equations that economistsused to describe a rest point of the classical economic system. He replacedthis equation with what he called the ‘animal spirits’ of investors. In onestroke this solved both problems of the Pigouvian system. The impulse thatcaused the Great Depression was a spontaneous fall in expectations aboutthe future - a kind of mass hysteria aff ecting all stock market participantssimultaneously. In this interpretation of events the stock market crash wasthe impulse that triggered the Great Depression. The failure of the system toreturn to full employment followed from the fact that the economy does not

possess any self-correcting mechanism of the kind envisaged by Pigou andhis contemporaries. In Keynes’ view, any level of optimism or pessimismwould be consistent with a rest point of the system since the forces that tendto restore equilibrium are either non existent or so weak that we would notexpect to see them operating in finite time.


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2.3. MACROECONOMICS AFTER KEYNES 11

In contrast to the fruit bowl view that government should reduce expendi-

ture in a recession; Keynes argued instead that the government should borrowmoney and use it to stimulate aggregate demand. He explained why this wasappropriate with his alternative windy boat theory of the economy. In thefruit bowl economy - every dollar spent by government is one less dollar spentby households since the size of the pie is fixed. In windy boat economics,an extra dollar spent by government increases the size of the pie and causesan increase in the amount available to both government and households.Keynes argued for ‘deficit spending’, that is, during recessions the govern-ment should borrow and use the borrowed money to purchase goods andservices from private firms. He explained how this increase in governmentexpenditure would cause a change in the equilibrium of the economy that

would stimulate employment and cause an expansion in economic activitythat would make everyone better off .

Keynes’ ideas were tried in a half-hearted way during the Great Depres-sion by Franklin Delaware Roosevelt who initiated relatively modest publicworks programs.4 These were too small to have much eff ect. Deficit spendingon a large scale wasn’t tried until the United States entered WWII and atthis time Keynesian policies were dramatically successful. The U.S. economyrebounded and in the early 1940s unemployment fell to historically low levels,gdp growth accelerated and output per person finally caught up with whereit would have been if the depression had not occurred.

During the fi

rst three years of the depression stocks lost 84%

of their peakvalue and investment expenditure fell to zero. At the same time unemploy-ment went up from 4% in 1929 to 25% in 1933. According to Keynes - thedrop in the value of the stock market caused the increase in unemploymentand he constructed a theory that was taught to several generations of post-war students which explained why. His explanation involved a spontaneousloss in confidence (animal spirits) that caused a drop in purchases of newinvestment goods; nobody wanted to invest in capital if the existing capital,embodied in firms, was worthless. The drop in investment caused businessesto fire workers because they could not sell everything they were producing.These workers, in turn, bought less consumption goods and the net result

was a new equilibrium of the economy with higher unemployment and a lowervalue of gdp.

To correct the situation Keynes argued for a massive public works pro-

4Robert Skidelsky (1992, Chapter 14).


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gramme. In 1940 government expenditure was equal to 12% of gdp, a number

that is roughly equal to investment expenditure in the same year. By 1945

government expenditure had increased to 50% of gdp, and unemployment fellfrom 15% to 2%. This is exactly the result that was predicted by Keynes whoargued that if private investment expenditure is too low it must be replacedby government expenditure to increase aggregate demand. The success of theKeynesian explanation of these events led the Nobel prize winning economistMilton Friedman to assert in a 1965 interview with Time Magazine that “Weare all Keynesians Now”.5

2.4 How to Fix Keynesian Economics

Although there is much in Keynesian economics that has merit; it is a statictheory that fails to account for the way that forward looking householdsplan for the future. In my book Expectations Employment and Prices Iretain the basic idea of Keynesian economics, that the macroeconomy is nota self-correcting system, but I make two changes that put the theory on asounder theoretical footing. First, I provide a foundation to Keynes’ theoryof aggregate supply in which I explain why flexible prices are not sufficientto maintain full employment. In other words, I explain why the economy isnot a self correcting mechanism. Second, I provide a dynamic foundation to

Keynes’ theory of aggregate demand that replaces his static theory of themultiplier.

According to the Keynesian theory of the multiplier, a one dollar increasein government expenditure causes a more than one dollar increase in expen-diture on goods and services. Every dollar spent by government increasesemployment. The newly employed workers, in turn, spend some fraction of their increased income on goods and services and these increases generateadditional employment. The additional employment generates further ex-penditure and a cascade of additional expenditures that converges to a final

5 There appears to be a long history of misattributions of this quote. In private corre-

spondence, Riccardo DiCecio pointed out to me that the phrase “We are all Keynesiansnow”, often attributed to President Nixon is from Milton Friedman and incomplete. Nixonsaid “I’m now a Keynesian in economics” according to journalist Howard K. Smith of ABCnews. Friedman in an interview with Time said “in one sense, we are all Keynesians now;in another, no one is a Keynesian any longer”. However, Time magazine only quoted “Weare all Keynesians now”.


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2.4. HOW TO FIX KEYNESIAN ECONOMICS 13

increase in aggregate demand that is larger than the initial increase in govern-

ment purchases by a multiple that depends on the propensity of householdsto save. In Keynesian theory, a recession is caused by a lack of demand byfirms and it must be replaced by the demand of government. It is the successof this theory in influencing politicians that accounts for a vastly increasedrole of government in the post-war economy.

In the theory I develop in my 2009 book, in contrast to the standardKeynesian approach, consumption depends on wealth as well as income. Iargue there that the Great Depression was caused by a fall in stock marketwealth that triggered a fall in consumption. The drop in consumption andthe drop in investment were both secondary events caused by the change inbusiness confidence. This diff ers from the Keynesian account where there is

a causal chain from business confidence to investment to consumption. Thediff erence is significant since the Keynesian theory suggests that investmentmust be replaced by government purchases to restore aggregate demand. Iwill explain this diff erence and the policy proposal that it leads to in Chapter10.

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Farmer 09 Two Visions of the Economy