Keynesian Reflections.
Effective Demand, Money, Finance and Policies in the Crisis
edited by Toshiaki Hirai, Maria Cristina Marcuzzo and Perry Mehrling,
Oxford University Press, 2013
TABLE OF CONTENTS
Introduction: Keynesian Reflections
Toshiaki Hirai, Maria Cristina Marcuzzo and Perry Mehrling
I. Effective Demand in the Crisis
1. Re-embracing Keynes: Scholars, Admirers and Sceptics in the Aftermath of the Crisis
Maria Cristina Marcuzzo
2. The Dog Called Investment
Roger E. Backhouse and Bradley W. Bateman
3. Keynes, Kalecki and the Real World
Julio López Gallardo
II. Economic Theory and the World Recession
4. The State of Macroeconomics in View of Global Economic Crisis
Asahi Noguchi
5. Keynes and Capitalism: the Case of Japan
Colin Rogers
6. Keynes and the Case for Europe
Toshiaki Hirai
III. Money and International Liquidity
7. Was Keynes’s Monetary Policy, à outrance in the Treatise, the Model for ZIRP and QE?
Jan A. Kregel
8. Liquidity Preference of Banks and Crises
Fernando J. Cardim de Carvalho
9. Why Not Bancor? Keynes’s Currency Plan as a Solution to Global Imbalances
Luca Fantacci
10. In a Keynesian Mood? Why Exchange Rate Systems Collapse
Peter H. Spahn
IV. Finance and International Economic Disorder
11. Uncertainty and Speculation in the Keynesian Tradition: Relevance in Commodity Futures
Sunanda Sen
12. Financial Keynesianism and Market Instability
L. Randall Wray
13. Financial Globalization and the Future of the Fed
Perry Mehrling
14. Some Foreseeable Disasters of the Global Economy: The High Cost of Neglecting Keynes’s Approach
Anna M. Carabelli and Mario A. Cedrini
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Introduction
Toshiaki Hirai, Maria Cristina Marcuzzo and Perry Mehrling
Keynes was, throughout his life, engaged with the problems of his time, always starting from the economics that he knew, but never afraid to invent new economics as the situation might require. It is this Keynesian spirit, above all, that provides the linking theme for the papers in this volume, papers written originally for conferences held in Tokyo (2010, 2011) and in Florence (2012).
The present volume was initially conceived as a follow-on companion to The Return to Keynes (Bateman, Marcuzzo, and Hirai 2010), a volume inspired by the aggressive world-wide policy response, both fiscal and monetary, to the global financial crisis that started in 2007. The more sober tone of the present volume reflects the mood of the present moment, when retrenchment and austerity are the themes of policy in most of the western economies. Instead of celebrating the return to Keynesian policy, we find ourselves engaging with the more structural problems of our own time, starting from the economics that Keynes invented but then adapting and going beyond Keynes himself, as modern conditions require.
But what exactly is ‘the economics of Keynes’ and how, if at all, does it differ from the Keynesian economics presented in macroeconomic textbooks and described in the media? There is no easy answer to this question, since many varieties of Keynesianism have made their way into the profession, competing for the ‘best’ interpretation of Keynes. Opposition to Keynesian policies has also been argued on multiple grounds, ranging from the purported superiority of market mechanisms to fear of government deficit and the ensuing size of the public debt. This book situates itself in the very middle of this maze of argument, and seeks to provide a modern key for those seeking to engage the modern debate over whether to support or to oppose Keynes and Keynesian theories and policy.
Keynesian economics is usually associated with an emphasis on changes in the level of income (rather than the interest rate) as the central mechanism that brings saving and investment into line with one another. A further idea is that it is mainly saving that adjusts to investment, rather than the other way around, since investment is determined by the independent fluctuation of the marginal efficiency of capital. A central question is why the adjustment mechanism does not guarantee that the level of income/output will come to a rest in a position corresponding to full employment/capacity.
There are two views on the matter: one explanation is rigidity in prices, wages, and the interest rate (via liquidity trap); the other explanation is found in the role of money and expectations. The rigidity view, which goes back to the formulation of the ‘old’ neoclassical synthesis developed between the 1950s and the 1970s (Arena 2010), has always been rejected by those who claim to be closer to the spirit of Keynes. Price flexibility, far from facilitating adjustment to full employment, may actually aggravate the downward trend in output and employment. Lower prices and nominal wages increase the interest payment burden of debtors, causing them to cut back on spending so that effective demand is likely to fall rather than to rise. Rather than engaging argument with fellow Keynesians, the New Keynesians in the 1980s preferred to focus their efforts on justifying the assumption of rigid prices or wages by the use of optimizing models—such as the efficiency-wage hypothesis, insider-outsider bargaining theory, and menu costs. In effect, they preferred to respond to the anti-Keynesian critics, who urged the superiority of optimizing models, and the necessity of building a bridge between microeconomics and macroeconomics.
Another dividing line among the varieties of Keynesianism is whether Keynesian economics applies only to macroeconomic questions, such as deviation from full employment, or whether microeconomics is also at stake. For those who argue the latter, the emphasis is on deficiency of the standard model of the rational economic agent who makes choices under constraint in an environment in which radical uncertainty does not exist and risk is calculable. As against this caricature of human behaviour, Keynes himself presented a theory of individual decision making which rejected the use of mathematical expectation as a criterion for making decisions, and instead built on his own theory of probability. Keynes’s interpretation of probability, different from chance or frequency, treats it as a property of the way individuals think about the world. This way of thinking then leads to an explanation of human conduct whereby decision rules under uncertainty incorporate a measure of the degree of confidence in probability assessment. Since for Keynes the degree of confidence in the available evidence is as important as the amount of information, the weight of argument has a central role (Basili and Zappia 2010).
This way of thinking about human behaviour under uncertainty has far-reaching implications for how we think about markets and the economy as a whole. If risk cannot always be effectively tamed and priced, it follows that markets cannot always properly assess risk and shift it to those best able to bear it. Even more, the demand for liquidity as a kind of safe haven in a world of incalculable risk means that money and expectations are inextricably involved in determining macroeconomic outcomes. Until recently, this ‘fundamental Keynesian’ critique of standard finance and macroeconomics was a distinctly minority view. But the events which started in 2007 have made it manifest that financial and macroeconomic instabilities arises cannot be explained with the standard macro models, and the profession is beginning to shift.
De Grauwe provides a compelling description of the status quo ante:
A graduate student in a typical American or European university studying the subject of macroeconomics would be taught that the macroeconomy can be represented by representative consumers and firms who continuously optimize a multi-period plan, and in order to do so, use all available information including the one embedded in the model. These consumers and firms not only perfectly understand the complex intricacies of the workings of the economy, they also know the statistical distributions of all the shocks that can hit the economy. As a result, they can make scientifically founded probabilistic statements about all future shocks. In this world of God-like creatures, there is no uncertainty, there is only risk. Coordination failures do not occur because representative agents internalize all possible externalities. Bankruptcies of firms and consumers are impossible. Bubbles and crashes cannot occur because rational agents using all available information would never allow these to happen. Prolonged unemployment is impossible except when consumers choose to take more leisure.
Having mastered the intricacies of Dynamic Stochastic General Equilibrium models (DSGE models), our brilliant new PhD graduate would then start a career teaching this model to the next cohort of PhD students (De Grauwe 2010, pp. 157–8).
The essays in this volume represent explorations toward a new more satisfactory macroeconomics, on both analytical and empirical grounds, building on Keynes’s legacy but also reaching out in new directions.
Effective Demand in the Crisis
In Part I, three papers consider the present crisis and policy response from the perspective of Keynes’s own teaching rather than textbook Keynesianism or stereotyped Keynes. All three share a common concern that Keynes’s arguments have not been fully engaged in the ‘Return to Keynes’ euphoria. As a consequence, there is real danger that the return may be short-lived, and that many other promising future developments will be halted prematurely. Keynes’s vision of economics as a realm of possibility to promote social values should inform our research agenda; behind the current crisis lies a ‘failure of ideas’ (De Grauwe 2010, p. 159) quite as much as a failure of markets.
The Keynesian resurgence has so far largely been a change in the political mood and the attention of the media, rather than a change in academia; no academic breakthroughs appear yet associated with the resurgence. The boost to aggregate demand through government expenditure and the injection of liquidity into the system to fight depressions and offset credit crunches are merely policy recipes, invoked often by people of non-Keynesian persuasion whose search for alternatives to mainstream economics look in different directions. The fear expressed in the first paper is that ‘Scholars and admirers of Keynes may fail to persuade sceptics and opponents, and there is no telling whether a new generation of economists will take today’s lesson to heart’ (Marcuzzo).
Let it not be misunderstood. The lesson of today is all about the issue of aggregate demand, not the issue of debt and deficits that occupies so much of current policy debate. As Keynes taught in his 1936 General Theory of Employment, Interest and Money, the economy fluctuates mainly because of variations in the marginal efficiency of capital, which cause fluctuations in investment spending. Fluctuations can therefore be damped if the level of investment is sustained directly by public intervention, or indirectly by structural reforms that reduce uncertainty and improve profitability.
In a crisis, the primary concern must be to forestall the vicious circle whereby an initial decrease in income is followed by a fall in demand which then induces a further fall in income. The aim of policy should be to raise the level of effective demand closer to full employment. Ideally this is done not by stimulating consumption (private or public), but rather by targeting investment. Against the argument that we cannot afford to undertake stabilization policy because government deficits are creating a burden that will rest on future generations, Keynes’s original insights still hold, as neatly summarized in the second paper of the collection: ‘investment creates assets that can compensate for, if not outweigh, the costs of any debt created in the process of building it up’ (Backhouse and Bateman).
Granted the role of aggregate demand in generating income and employment, there are two issues still debated between the pro- and anti- Keynesian camps, namely the effects of changes in income distribution on the level of output and employment, and the ability of economic policies to exert a lasting influence on those variables. These issues are addressed by the third paper of the section. In all the countries under his investigation (US, Japan, France, Germany, Italy, Spain, UK) López Gallardo concludes that the evidence is on the Keynesian side:
First, we find that a higher share of wages encourages demand and output in the short and in the long run.
Second, higher government expenditure also stimulates demand and output. Let us note here that this positive effect takes place even when such expenditure is financed with higher taxes.…
Third, monetary conditions also influence demand and output, not only in the short but also in the long run. When credit conditions are relaxed and broad money grows, or when the interest rate declines, growth is stimulated. (López Gallardo)
In conclusion, the principle of effective demand remains the defining feature of a type of macroeconomics that does not rely on price and wage flexibility to bring about full employment. Since aggregate demand is likely to remain insufficient for significant periods, public intervention to sustain it is the only way to prevent serious recessions.
Economic Theory and the World Recession
Noguchi argues that Keynes went too far, as also do those of us who would start from Keynes today. In his view, the macroeconomics which has evolved since the 1970s—that is, monetarism, rational expectations, and the real business cycle approaches—provides better policy guidance that the previous so-called Keynesian models. It should be noted that Noguchi’s criticism is directed not so much against Keynes himself, but rather against the naive ‘hydraulic Keynesianism’ that Joan Robinson famously dismissed as an illegitimate American interpretation of Keynes. His criticism therefore opens the door to other potentially more productive ways of building on Keynes, which is the theme of the last section of the book.
The continued relevance of the classic Keynesian point of view is demonstrated in practice by two papers that use it as a frame to understand Japan’s bubble performance and the European crisis, respectively.
Rogers argues that Japan, which has suffered from a long period (18 years) of below par growth, finds itself in a predicament not unlike that of post-WWI Britain after its loss of export markets and return to gold at an overvalued parity which depressed the marginal efficiency of capital. There is, however, an important differences between the two, he argues:
…Japan finds itself ‘trapped’ on the US dollar standard in much the same way that Britain was trapped on the gold standard in the 1920s and 1930s—committed by the power of convention to stay on the US dollar standard even though that commitment puts it at a strategic disadvantage because it depresses the structural marginal efficiency of capital and the domestic point of effective demand. In Japan’s case, not because it forces domestic interest rates up as was the case with Britain on the gold standard, but because the post Bretton Woods non-system has allowed the US to induce an ever appreciating yen, and also allowed some countries to hold exchange rates for sustained periods of time at undervalued rates. (Rogers)
While the case of Japan represents a cautionary tale of the difficulties of emerging from a prolonged recession, the situation in Europe can be seen as a premonition of a similar scenario looming in the near future. The Euro crisis started with the fiscal crisis in Greece in the Fall of 2009—one year after the collapse in the US banking system following the subprime crisis and the Lehman shock. The policy response was a massive bailout implemented by the European Commission, the European Central Bank and the International Monetary Fund, but accompanied by the condition that the countries concerned should pledge to carry out austerity measures. The point made in Hirai’s paper, drawing on Keynes’s analysis of similar circumstances occurring after the First and the Second World Wars, is that these austerity measures are sharply deflationary and far from offering a fundamental solution to the crisis.
In both cases, we are faced with a situation in which a recession has turned out to be broader and deeper than ordinary downturns, and in which standard policies that may have worked in ordinary downturns prove inadequate to the larger task. A combination of monetary and fiscal expansionary measures, combined with a new set of rules (structural reforms) for the international financial market and monetary system, are seen as the only adequate response to the present recession. Some in the economics profession have warned of ‘need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound’ (De Long and Summers 2012, p. 1). We feel that more should be conceded to Keynes’s argument that concern about long-term debt levels should never be a priority over the level of unemployment and income.
Money and International Liquidity
In Part III, four papers focus attention on what is perhaps the most distinctive feature of Keynes’s vision of the working of capitalist economy, that is, its monetary nature. For Keynes, the role of money, both in private hands (household and banks) and in the public sector (central banks and supra-national monetary institutions) is not in any sense ‘neutral’ with respect to the ‘real’ variables in the economy and the working of the market mechanism. Kregel sets the scene by showing how present ideas and prescriptions are in fact recycling ideas already present in Keynes’s 1930 Treatise on Money, where recipes such as zero interest rate policy (ZIRP) and quantitative easing (QE) were spelt out with Keynes’s typical clarity of language and thought, explaining why central banks might be forced to step ‘into shoes which the feet of the entrepreneurs are too cold to occupy’ (Keynes 1930, p. 335). Today, the same desperate measures are being adopted as central banks substitute for the cold feet of fiscal authorities and political leaders.
Keynes’s attempt to understand how these monetary interventions worked, and why ultimately they did not work well enough, led him to invent new economics, in particular his conception of liquidity preference. Unfortunately, however, this key invention has survived in the economics literature only in a simplified and therefore distorted version. Cardim de Carvalho argues convincingly that liquidity preference is more than Keynes’s preferred word for the demand for money; it is the central core of his distinctive theory of asset pricing. Asset markets have of course changed much since Keynes’s day, but if we extend the application of Keynes’s theory to banks, we find a clue to much of what we have observed in the financial markets during the current crisis, in which commercial banks borrowed from central banks but then refused to roll over broker’s debts or to extend them new loans.
This issue of liquidity preference is further elaborated in the next paper (Fantacci) which argues that what has occurred, since the summer of 2007, is not so much a cancellation or restructuring of non-performing loans, but rather a substitution of one kind of non-payable debt for another kind of non-payable debt: from private debts, to public debts, to foreign debts. In current policy discussion, the emphasis is on what to do about the sovereign debts of potentially insolvent states, but Fantacci maintains that the problem is not solvency but sustainability, which requires the possibility of selling domestic debts on liquid international markets. From this point of view, the focus of policy discussion should be on the sources of international liquidity, including the state of the international reserve currency, the strength of issuing institutions, and the size of global imbalances. For developing this alternative frame, Keynes’s intuitions and proposals, such as ‘Bancor’ and the Clearing Union, provide a fruitful place to start.
For modern conditions, however, Keynes’s vision of a world central bank empowered to impose ceilings for account balances, and to distribute reserves according to political priorities, is arguably impossibly utopian (Spahn). What seems to be emerging instead is a system with two or even three key currencies, accompanied by regulations on the scope and structure of reserve holding. Our challenge today is to imagine how this emerging new system will work, and how it can be made to work better.
Finance and International Economic Disorder
In the final Part IV, four papers engage with what is arguably the central issue of the present moment: speculation, finance, and global markets. The opening piece (Sen) offers an explanation of the recent pattern of rising commodity prices in the global economy, viewed through Keynes’s writings on uncertainty and risk, and revolving around his notion of probability. This Keynesian perspective is contrasted with explanations based on conventional economic thinking, in which price volatility and trends are attributed mainly to fundamental supply and demand factors. Building on the foundations laid by Keynes, the author emphasizes the dominance of speculation which is made possible by the increased ‘financialization’ of commodity markets. Unlike the mainstream literature on derivative trading, speculation is viewed here as a de-stabilizing factor.
Next, and more generally, Wray focuses attention on the ‘financial instability hypothesis’ put forward by Hyman Minsky as an alternative way of developing the ideas of Keynes for the modern world. Wray’s focus is on the emergence of money market capitalism, and the role of pension funds and money managers in fuelling the asset price boom and subsequent bust. The point made here is that the financial superstructure of managed money has become too large to support by the nation’s ability to produce output and income. In the absence of growth (and of policies for it), the ‘financialization’ of the economy—layering and leveraging existing levels of production and income—poses a continuing structural challenge, quite apart from the immediate problem of crisis.
The next piece is an excursion into the intricacies of the sophisticated money market as it has developed in the recent years, and into the changed role of the Fed, from lender of last resort to dealer of last resort (Mehrling). To appreciate fully why this has happened, the author brings us back to the beginning of the subprime mortgage story, showing us how the assets were funded in global money markets through cross-border banking and explaining in detail how this worked. This new capital market-based credit system—sometimes called the ‘shadow banking system’—is seen as nothing less than the latest institutional form taken by financial globalization, as it has grown up in the last 30 years. Bringing together the discussions on the international dollar funding system, the emerging institutions of the derivative clearing system, and the Fed’s role during the crisis, Mehrling suggests a new line of departure for thinking about how to regulate the emerging new system.
In the closing piece of this collection Carabelli and Cedrini make a plea that the global order should be reformed so as to use international discipline as a tool to enhance, rather than repress, national policy space. By contrast, the evolution of the international economic system since the 1980s has been in exactly the opposite direction. The Washington Consensus paradigm as applied by the international financial institutions in the 1990s was an attempt to construct a global order based on a highly unbalanced relationship between international discipline and national policy space. ‘Private licence’ has been mistaken for ‘public liberty’, and shared responsibility has been cast aside. As a consequence, international economic disorder has emerged. The road forward, following Keynes, is to recognize the complexity of international economic relations, a sphere involving analyses of the fallacy of composition between particular and general interests, and of the policy dilemmas which face both debtor and creditor countries.
Keynesian Reflections has been chosen as a title of this collection of essays to indicate the connecting theme, that Keynes remains a relevant and vital starting point for understanding modern problems, as well as inspiration for the hard work of inventing the new economics that modern problems demand. The word ‘reflections’ has been chosen to denote both Keynes’s original insights which we are now seeing more clearly, and also the process of deliberately and reflectively building something new on those foundations. We have been witness to Keynes’s ideas being reflected in varieties of Keynesianism and distorted in the stereotyped image of a defender of ‘big government’ and ‘less market’; several essays in this volume bring back to life those aspects of Keynes’s thinking which have been neglected in the recent revival of interest in his work.
The distinguishing feature of the Keynesian approach is a conception of economics as extension of human possibilities, proposing remedies to safeguard the general interest as condition for prosperity and social harmony. The concept of reasonableness, as opposed to rationality, captures what in general separates the economics of Keynes from the conventional approach. The tenets of economic rationality lie behind current demands to bring debtors to book, imposing indiscriminate sacrifices, ignoring the pleas of the weakest, invoking rigorous laws, and threatening social protection and security. In the name of rationality, we are urged to implement policies which may threaten confidence in democracy, fuelling various forms of political radicalism as a response to social disruption and distress. By contrast, Keynes’s reasonableness urges judgment on the basis of specific circumstances, and exercise of the imagination and creativity in seeking solutions characterized by analysis of the consequences from the overall point of view. His approach appeals to the principles of shared responsibility between debtors and creditors, collective action in place of individual self-interest, and the pursuit of individual liberties within a context of norms and rules. Keynes’s middle way between extreme liberalism on the one hand and pervasive government intervention on the other still seems to us a viable path towards equitable growth.
Just so, for Keynes and for economists of Keynesian persuasion today, the question of income distribution revolves crucially around institutional factors and arrangements, such as the existence of trade unions, laws governing minimum wages, employee rights at work, and systems of social protection such as unemployment insurance. The dismantling of these institutions in pursuit of higher flexibility and efficiency of free markets has proven to favour rather than to prevent the onset of the crisis. Increased vulnerability on the real side of the economy has exacerbated fragility on the financial side of the economy, since the loss of safeguards against low wages and unemployment made private debts the only viable option for sustaining consumption during downturns.
Conflicts of economic interest are not the only obstacle to the acceptance of the philosophy of shared responsibility. The inability to foresee all the consequences of a given policy, and lack of openness to consider unconventional thinking, also stand in the way of reforms and change. The challenge of applying Keynes’s approach thus requires us to enlarge the basis of consensus to include the general public and the media, as well as academia. Each of these has its own source of knowledge about the questions involved, which leads each to respond differently to different issues.
In his activities as policy adviser, Keynes was in constant contact with ministers, civil servants, officers, politicians, bankers, and opinion makers. The extraordinary number of his correspondents testifies to the compelling need he felt to keep in touch with opinions and points of view coming from different quarters. In this respect, The General Theory is better portrayed as a study in persuasion rather than in policy making. It offers not a set of recipes or rules to be followed in all circumstances, but rather a brilliant example of the power of argument for guiding human decision making in a time of grave uncertainty. Similarly though more modestly, the present book should be understood primarily as a study in persuasion for our own time of grave uncertainty. We offer the reflections in this book not as the end of the matter, but rather as the beginning of a new discussion. Our aim is to provoke and inspire others to do better in developing the new economic thinking that is needed for the world of today.
May 2012
References
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Basili M., and C. Zappia. 2010. ‘Keynes and the financial crisis’, mimeo, paper presented at the Annual Conference of the European Society for the History of Economic Thought (ESHET), Amsterdam, 25–27 March.
Bateman B. W., T. Hirai, and M. C. Marcuzzo. 2010. The Return to Keynes. Cambridge: Harvard University Press.
De Grauwe P. 2010. ‘The Return of Keynes’, International Finance, 13 (1): 157–63.
DeLong B., and L. Summers. 2012. ‘Fiscal Policy in a Depressed Economy’, Spring 2012 Brookings Panel on Economic Activity, Brookings Institution, Washington, DC, 22–23 March, available online: http://www.brookings.edu/about/projects/bpea/editions/~/media/projects/bpea/spring%202012/2012_spring_bpea_delongsummers.pdf (accessed 7 May 2012).
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