As we enter of Year 4 of OSBATRJLD – Our Seemingly Bull-Headed Attempt to Replicate Japan’s Lost Decade – the name John Maynard Keynes has been bandied about quite a bit. I think conventional wisdom among today’s economists about Keynes is the following: Samuelson rigorously translated Keynes’ ideas, Lucas and Phelps fixed the wrongheaded idea that fooling people over and over could be a basis for policy, Myerson and others taught us the importance of agency, and many figures in the neoclassical synthesis rectified the excesses of Lucas while exploring more and more interesting frictions. That is, Keynes is seen by most economists as brilliant for his time, a fantastic rhetorician, and certainly much more useful than the dominant American Institutionalist school of the early 20th century; nonetheless, he is also seen as not terribly useful in and of his own work, primarily because of his strange bias against mathematical social science, but also because, like anyone writing in 1930, he has missed the last 80 years of ideas which build on his work.
But we have the OSBATRJLD. Keynes is back! As Keynes’ long-time biographer Robert Skidelsky puts it in the title of the present book, now we see “the return of the master”! Does Keynes have something interesting to tell us about the present crisis which is being neglected by mainstream macroeconomists?
Skidelsky takes an interesting tack in the book, a mini-biography of Keynes grafted onto some guesses about what Keynes would think about today’s crisis. Essentially he argues that counter-cyclical fiscal policy and the important of cash as a store of value – the great Keynesian ideas which Samuelson famously said really just come down to classical economics plus downward sticky wages – are not the critical Keynesian ideas to remember. Rather, it is Keynes’ emphasis on the difference between risk, where probabilities are known, and Knightian uncertainty, where they are not. A lot of what has gone on in the financial world since the 1970s has involved greater and greater levels of diversification and risk-pooling, but Keynes would argue that beyond the very short run, no one really knows anything, so any attempt to model such risks is foolish. You may be thinking that Keynes sure doesn’t sound Bayesian, and indeed he wasn’t; His first finished book developed a number of interesting (though not particularly influential) ideas about interval probabilities. I would have liked a much tighter focus on this idea, but what is in the book certainly makes it worth reading. What follows are minor points of interest and quibbles.
Concerning RBC: Though Skidelsky’s book is in general entirely fair to modern schools of economic thought, I continue to be amazed by the hatred out there for RBC style recession explanations. All RBC is saying, really, is that technological shocks to productivity can cause people to move in and out of the labor force. How is this even controversial? When the internet boom is in full swing and secretaries can make $100,000 in a year, many people choose to work. When the dominant sectors in California are not particularly productive, they choose to retire early, or stay home with their kids, or whatever. Accepting this point doesn’t mean you need to accept that all recessions fit the basic RBC framework; indeed, the “basic” model has little to say about financial intermediation at all, so surely isn’t a good explanation for the 2000 and 2007 recessions. In any case, making a joke about neoclassicals thinking the Great Depression is a Great Vacation and then moving on strikes me as a failure to take on the RBC literature fairly.
Many quotes in the book prove again that Keynes’ is an incredible writer. Of that, there is no doubt. Perhaps he disliked math-heavy economics simply because he knew he had a comparative advantage in words! (A brief aside: Keynes certainly was no fool when it came to math. He has a first class in math from Cambridge and was originally brought on to the faculty for his work in probability theory.) A few examples: the economist “must understand symbols and speak in words” (the legendary Marshall biography). And “economics is a science of thinking in terms of models joined to the art of choosing models that are relevant to the contemporary world” (here the second clause is the most important).
Some quibbles: A few of the supposed Keynesian insights to today’s situation seem somewhat stretched. Keynes basically never talks about financial intermediation, and doesn’t talk about agency at all. The liquidity preference of consumers cannot automatically be applied to liquidity preference in terms of bank behavior. I also don’t buy the argument, on page 112, that contemporary economists are monetarists. Where are these central banks targeting the money supply? Who even knows what the “money supply” is, anyway? The chapter on the success or failure of Keynesian Economics is brutally tough to read. Among other things, there is a heavily cherry-picked argument about volatility in the economy being higher in the post-82 era than in the 50s and 60s. You don’t have to believe the Great Moderation was permanent to accept, at the very least, that from 1982 to 2007 volatility of a huge number of important economic aggregates was historically tiny. The final chapter, about where we should go now, also is odd to me. Skidelsky suggests that microeconomists should be left to do the mathematical modeling of individual behavior, but that macroeconomists should stop worry about microfoundations and worry more about politics and ethics and much else. What’s strange here is the most useful ways of understanding the present macro crisis seem to me to be perfectly standard microfounded explanations: Diamond-Dybvig and followups on bank runs, Epstein-Zin and followup finance papers on ambiguity aversion, Everybody on the importance of the principal-agent problem. If anything, I think many macroeconomists need to know more of what the micro guys can tell us about the interactions of individuals.
Finally, a few particularly interesting tidbits aside from the uncertainty argument. Keynes argued that wage contracts are good because, rather than just making economies adjust more slowly to shocks, they are also a sensible way for society to deal with Knightian uncertainty; substituting risk aversion for uncertainty, this argument looks a lot like the modern agency theory results concerning when to pay bonuses and when to pay fixed wages. Bloomsbury Group member he may have been, but Keynes was much more of a traditional Victorian than I’d realized. You can see in “Economic Possibilities for our Grandchildren” (and in the General Theory, to some extent) that Keynes basically expects society to get “rich enough” then slowly work fewer and fewer hours while spending time pondering knowledge, nature and the arts. Even more Victorian, he explicitly accepts the Burkean idea that property rights are essential because giving land to the poor will do nothing (there are so many poor and each will get so little land) but that the landed gentry and rentiers produce great social goods as thinkers, artists and the like! In a further echo of Burke, and perhaps contrary to common conceptions of “what Keynesians are”, Keynes was explicitly against big attempts at social engineering and utopian-style projects; Skidelsky suggests that this position is linked to his ideas about the importance of Knightian uncertainty. Last, Keynes late in life, and perhaps not surprisingly given the events of the 1930s, was not much of a free trader. Intellectually, the argument was that modern factory-style production means that Ricardian advantage wasn’t too important anymore since anyone could learn to make anything. I imagine he would not have held such views had he lived longer: the differences between Proton and Toyota, or between German and French automakers, remain quite stark.
http://www.amazon.com/Keynes-Return-Master-Robert-Skidelsky/dp/B005EP1SEI/ref=tmm_hrd_title_0 (No online pdf is available aside from excerpts, but the hardcover is only ten bucks on Amazon and indeed free at your local library. It’s worth a read. And if you haven’t had enough Keynes afterward, know that Skidelsky won’t talk in this book about Keynes’ legendary sex journals!)