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The coming of macroeconomics

Pekka SutelaAalto University30 March 2015a

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The emphasis today is on

• The great debate between Keynes and the Austrian School (Friedrich Hayek) on the Great Depression

• Three excellent recent secondary sources– Nasar, Sylvia: Grand Pursuit: The story of economic

genius. Simon & Schuster, New York 2010– Wapshott, Nicholas: Keynes Hayek: The clash that

defined modern economics. WW Norton, New York 2011– White, Lawrence H: The Clash of Economic Ideas: The

great policy debates and experiments of the last hundred years. Cambridge University Press, Cambridge 2012

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Three theoretical schools

• By early 1900s theoretical economics was divided into three distinct schools– Cambridge

• Partial equilibrium• Practical concerns• ”No nonsense”• Jevons -> Marshall -> Pigou -> Keynes

– General equilibrium• Perfect competition• Theoretical concerns• Mathematics• Wide research program since 1950s

– Austrian

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• Little communication across schools– Language barriers: Knowledge of both English and German rare– Basic differences in philosophies, including conceptions of

science• In addition different heterodox approaches

– With little contact and impact on the major schools• And importantly for the Nordics, the Stockholm School

– Knut Wicksell, “the missing link between the Austrians and later Keynesians”?

– Foundations of the Nordic welfare state– Theoretical economics came to Finland via Stockholm, but only

in the 1940s (!)

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Joseph Schumpeter and Max Weber, Cafe

Landtmann, Vienna, 1918 • ”The conversation turned to the Russian revolution, and Schumpeter

expressed his satisfaction that socialism is no longer a paper discussion but had to demonstrate its viability. Weber grew rather excited and declared that communism at Russia’s stage of development was quite simply a crime...; the road would pass through untold human suffering and end in a terrible catastrophe. ’That may be so’, Schumpeter said, ’but it will be a nice little experiment for us.’ ’A laboratory with heaps of human corpses’, Weber specified. ’All anatomy is like that’, Scumpeter came back.... Weber flared up and and spoke more loadly, Schumpeter more softly and sarcastically, while all around them the coffee-house customers interrupted their card game and listened to them with curiosity, until Weber jumped up and hurried out to the Ringstrasse with the words: ’That’s more than anyone can take...’ – Felix Somary, cited in Radkau: Max Weber, A Biography. Polity Press, London

2009

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The Austrian School: background

• Background– Karl Menger

• Subjective value theory– Concept of marginal utility– No mathematics

• Methodenstreit– Justification of abstract theory or prevalence of detailed historical studies

– Vienna• Traditionalist, bureaucratized and multicultural Habsburg empire• The Social Democratic challange• Collapse and dissolution in first world war• Vienna as the leading European cultural centre until 1918• Economists as Ministers of Finance!• Hyperinflation

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The Austrian School: people• Friedrich von Wieser (1851-1926)

– Marginal utility– Relation between commodity prices and prices for factors of production– Systems debate

• Eugen von Böhm-Bawerk (1851-1914)– Interest rate

• Why is interest rate positive?: (1) Positive growth rate; (2) Underestimation of future needs; (3) More ”roundabout” methods of production

– Capital theory• Value of a good increases with longer periods of production. Equilibrium at some

positive interest rate– Knut Wicksell, Irving Fisher and even JM Keynes (A Treatise on Money,

1931) had similar ideas– Against Karl Marx; three times Finance Minister of Habsburg Empire

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More Austrians...• Ludwig von Mises (1881-1973)

– New York University 1945-1969– Dislike of formalized models of the economy

• Also deep scepticism of measuring economic processes• Still the Austrians were involved in establishing business cycle studies

– Role of prices in market economy• Impossibility of socialist calculation• Free markets as key to both efficiency and freedom

• Friedrich (von) Hayek (1899-1992)– Brought Austrian school to Britain (1931) and the USA (1950 – affiliated (!) with

University of Chicago)• In the USA, mostly engaged in philosophy and psychology: economics as a human science

– Against Keynes and active state role in the economy• The Road to Serfdom (1944)• Fascism, Communism and (almost) welfare state the same• Great impact on Thatcher, Reagan and others

• Joseph Schumpeter (1883-1950)

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Hayek on information• ”The peculiar character of the problem of a rational economic

order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate ”given” resources – if ”given” is taken to mean given to a single mind which deliberately solves the problem set by these ”data”. It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.”

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Implications• Equilibrium is a misleading concept, as the economy is in continuous

unpredictable flux. There is no simple predictable economic behaviour• Equilibrium is a dangerous concept, as it leads to the impression that

the economy can be completely known• State interference in markets means losing information otherwise

embedded in prices– Citizens will find ways around distorted prices– Inflation as a way of denying the citizen’s will

• Thinking that the economy can be completely known is extremely dangerous as it leads to social engineering with its totalitarian temptation

• Thus the Road to Serfdom – There is no third way between free market economy and totalitarianism

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Austrian view on the Great Depression

• Menger – Böhm-Bawerk – Mises – Hayek• Background: length (roundaboutness) of production process

– Average time between inputs and outputs– The lower the interest rate, the more capital invested in

production; share of investment goods in all production increases• Boom of the 1920s…

– Federal Reserve (active only since 1914) increased money supply and pushed interest rates low

– In spite of no need to compensate for war damage in the USA• So why? To stabilize price level as feared deflation?; to support Bank of

England in returning to gold standard?

– Stock prices grew by 50% in 1928, further 27% in 1929M1-M10

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• …goes bust– Fed hiked interest rate from early 1928– Industrial production declined by 47% in 1929-1933,

GDP by 26.5%– Private domestic investment almost stopped– Huge underutilization of capital goods, labour– Depression goes international through different channels– ”Beggar thy neighbour” exchange rate policies

• Thus post-WWII cooperation agenda

– Depressed levels only corrected by preparing for war

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• The Austrian view on boom…– Loose monetary policy had depressed interest rates below (Wicksell’s) natural

level and created an unsustainably top-heavy industrial structure (Böhm-Bawerk – Mises roundaboutness)

– Note: if lower interest rates had been natural (caused by higher voluntary savings), the boom would have been sustainable.

– Thus the monetary policy mistake is to drive a wedge between savings and investment

• …and bust– either (central and commercial) banks push the breaks…– …or the currency collapses– Either way much previous investment is found to be unprofitable -> collapse of

new investment– Over time new equilibrium is found by markets– Meantime much unemployment and loss of production

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• This view proposed by Hayek stands in contrast with Keynes and (later) Friedman– Keynes: Fed monetary policy in the 1920s OK; Depression caused by

investor panic– Friedman: Fed monetary policy in the 1920s OK; Depression caused by

Fed allowing the moneý stock to half since 1929• Hayek’s monetary policy rule in terms of MV = PY (Quantity

equation – remember David Hume)– Money stock should only change to offset changes in velocity– Price level should be allowed to decrease to offset production growth– While Mises proposed either gold standard or free banking, Hayek

more cautiously noted that they would only approximate the quantity theory equation as a rule

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Hayek and Keynes• Hayek was brought (by Lionel Robbins) to LSE to counter the ever-

growing policy and theoretical impact of John Maynard Keynes and his Cambridge circle (The Circus).

• After Keynes published the General Theory (1936), Hayek’s influence and credibility collapsed– JMK argued up to bottom, FH bottom up– With the huge unemployment of the Great Depression activism was called for,

not theorizing why it was impossible– History had made Keynes an optimist, Hayek a pessimist– Hayek’s long-produced great work on capital theory (1940) was intended as

the anti-Keynes argument but failed. Hayek did not really challenge Keynes head-on.

– Most pupils abandoned FH for JMK (including, importantly, J.R. Hicks)– FAH and JMK remained in good personal relations (like Malthus and Ricardo)

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Did Hayek deepen the Depression?

• … By arguing for spontaneous adjustment?• Keynes surely thought so (1931):

– ”The book, as it stands, seems to me to be one of the most frightful muddles I have ever read, with scarcely a sound proposition in it … It is an extraordinary example of how, starting with a mistake, a remorseless logician can end up in Bedlam.”

• So did Milton Friedman (1999):– ”In think the Austrian business-cycle theory has done a great

deal of harm… you have the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world… You can’t do anything about it.”

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Milton Friedman and Hayek• ”I am an enormous admirer of Hayek, but not for his economics. I think

Prices and Production (1931) was a very flawed book. I think his capital theory book is unreadable.”

• In contrast with Friedman later, Hayek (1940) continued to largely deny the possibility of rational monetary policy (just watch the language!)– ”We are certainly entitled to conclude ... that the extent to which we can

hope to shape events at will by controlling money are much more limited, that the scope of monetary policy is much more restricted, than is widely believed. We cannot, as some writers seem to think, do more or less what we please with the economic system by playing on the monetary instrument.”

– In 1975 he however did regret that had proposed deflation as a means of breaking wage rigidities. His monetary policy rule would actually have called for increase in money supply!

– However unclear if Hayek’s views had much actual policy impact

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Blame the Fed!• Austrians were divided whether Fed had caused (Mises) or amplified

(Hayek) the 1920s boom by expanding the supply of loanable funds.– Credit was increased to prevent interest rate from increasing

• Fed policy was influenced by early 19th century Real Bills Doctrine:– Extending credit to finance purchase of assets backed by real production

(ie real bills) is never inflationary– Extending credit to finance other transactions (eg financial deals) is always

inflationary– But how could this distinction be practically implemented?– Again the view that some activities are ”productive”, others not

• Further, as demand for Real Bills declined in Depression following slump in production, allowing money supply to decrease was in this view OK!

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The Road to Serfdom (1944)

• Fascism and Communism are two variants of Totalitarianism, the opposite of freedom– The potential road to serfdom begins when prices are interfered with.

But even with activist state Totalitarianism is a danger, not something inevitable

• Prolonged widespread unemployment is ”one of the gravest and most pressing problems of our time”, but the solution ”does not – or at least need not – require that special kind of planning that according to its advocates is to replace the market.”

• Keynesian remedy comes with too high price: creeping inflation. Inflation destroys information, incentives and freedom and is therefore worse than unemployment.

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Keynes on Road to Serfdom• ”In my opinion it is a great book. ... You will not expect me to accept

quite all the economic dicta in it. But morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement, but in deeply moved agreement.”

• But• - more planning is needed• - ”Moderate planning will be safe if those carrying it out are rightly

oriented in their own minds and hearts to the moral issue.” For FH the relation was between government intervention and tyranny, for JMK tendency towards totalitarianism came from individual moral choices – and perhaps from national traditions.– Keynes: Scandinavia can afford more state involvement than Britain

• In practice both agreed that it was a matter of drawing the line

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Afterlife

• The book was and remains a major best-seller• Churchill in 1945: after a Labour victory in elections the party

”would have to fall back on some form of Gestapo”• Most critics accused Hayek of being inconsistent: there is a

road to serfdom but still it is a matter on drawing a line• US libertarian Ayn Rand in the margins of her copy: Hayek is

”compromiser”, a ”God damn fool”, an ”abysmal fool”, an ”ass” and a ”total, complete, vicious bastard.”

• Later Hayek gained fame and respect, exerting great influence on Ronald Reagan and Margaret Thatcher– And many of their advisors

• Nobel prize jointly with Gunnar Myrdal (!!)

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Macroeconomics entering

• Neoclassical and Austrian theory were both bottom-up (microeconomic) views– But in their views of equilibrium and rationality very different

ones• The existence of what we would regard as macroeconomic

issues was not denied– Cycles perhaps exogenous (Jevons and sunspots!)– Or policy-induced (Fisher and others on the Great Depression:

role of monetary policy)– Say’s Law generally adhered to

• Terminology micro- and macroeconomics only emerged by 1950s

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But did the Fed cause the Great Contraction (1929-1933)?: The debate continues

• Milton Friedman and Anna Schwartz (1963): – The Fed did cause 1929-1933 by not offsetting the effects of four

banking panics 1930-1933• Interest rates were increased as Britain left the gold standard

– Also, doubling reserve requirements in 1936-1937 lengthened and worsened the Great Depression

– But more than monetary policy was involved– The argument was a narrative, not an explicit model

• Which left the policy transmission mechanism unclear• But was very good for purposes of persuation

– Also discussed other episodes than 1929-1933• Few would now argue that monetary policy is unimportant

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Keynes• John Maynard Keynes (1883-1946)• Cambridge, Bloomsbury, policy activism, practical investor• Economic Consequences of the Peace (1919)

– Excessive German war preparations will cause another war (in ten years!)– Actually the problem was not size but financial form of reparations (the transit problem)

• Economic Consequences of Mr. Churchill (1925)– Return to gold standard on pre-war parity will create a lengthy deflationary depression– Unemployment is the big issue, inflation secondary

• A Treatise on Money (1930)– Attempt at theoretical work, immediately abandoned by JMK

• Strongly criticised by Hayek

• By 1931 a practical consensus on expansionary fiscal policy in Britain– For persuing colleagues a theoretical basis was needed– The General Theory of Employment, Interest and Money (1936)

• Bretton Woods– Exchange rate system– IMF, World Bank– Bancor -> Special Drawing Rights (SDR)

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The General Theory• Sounding board: ”The Circus”

– Richard Kahn (the multiplier), Joan Robinson (imperfect competition), Austin Robinson, James Meade, Piero Sraffa (neo-Ricardianism)

• The priority of persuation:– ”The book is chiefly addressed to my fellow economists. I hope that it will be

intelligible to others. But its main purpose is to deal with difficult questions of theory, and only in the second place with the applications of this theory to practice.”

– The book is less than coherent and the arguments often incomplete. Writing is partially provocative.

– Exceptionally wide ”What X actually meant” –literature, but then JMK was not a doctrinarian• What actually was Keynes’ view on uncertainty?• Was the market economy inherently unstable or not?• Why does rational action by economic agents produce undesired outcomes?• What really is the proper role of the state?

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Codifying Keynes• The multiplier model

– Y = C + I (national income identity)– C = cY (consumption function: c < 1)– I = I* (exogenous investment determined by ”animal spirits”)– Assume a change in I (dI). Then dY = dC + dI. Solving for dY: dY = (1/(1 – c))dI. If for instance c = 0.8

then (1/1 – c) (the multiplier) equals 5!!– Actually JMK believed that the multiplier is perhaps 1.5. Anyway fluctuations in investment cause

changes greater than themselves in aggregate demand and thus national income.– If nominal wages are rigid, changes in national income lead to changes in employment: labour

markets do not balance– The state can even out fluctuations by adjusting fiscal policy (budget expenditure and taxation) to

countervail change in (private) investment• IS/LM model (Hicks)

– J.R. Hicks vs Sir John Hicks• The 45 degree diagram (Samuelson)• The Phillips Curve (Phillips)• Any number of econometric models for policy analysis and forecasting• And the textbooks, starting with Samuelson

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Keynes and neoclassical analysis• To distinguish himself, JMK used ”the classics” as a generalized term of reproach• On a friendly interpretation basic difference philosophical. ”The classics” regarded

unemployment as a temporary lapse from equilibrium due to policy failures or other exogenous factors, JMK (perhaps) as a normal state

• For both JMK and ”the classics” downward rigid nominal wages cause labour markets to adjust through quantities, not prices (wages). – ”The Classics”: rigidity due to unions, a correctable institutional fact– JMK: price expectations and importance of relative wages

• JMK: (neo)classical analysis relevant in full employment• Samuelson (1947 – written in about 1938-40): Foundations of Economic Analysis:

bifurcation of economics into micro- and macroeconomics.• Samuelson (1948): Economics – the 3rd iconic textbook • Later literature on microfoundations:

– Market frictions, missing markets, imperfect contracts, imperfect and asymmetrical information... cause unemployment

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Circular flow of income

• Say’s law: why would supply in the aggegate not create its own demand?– Keynes: Speculative demand for money– Fisher: deflation and credit

• System of National Accounts– Richard Stone, UN

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The multiplier• Investment

– Animal spirits: but is investment really that volatile?• In extreme case monetary policy has no impact on investment: liquidity trap

(Robertson). Are we there now?

– ”In the long run we are all dead”: concentrating on the short run implies that any investment is equally good• JMK: building pyramids; digging and fulfilling holes• Did the Great Depression only end with war preparations?• If long run taken into account, different investment has different growth impact

– Alternative view in Wicksell and Fisher• Investment equilibrium when marginal productivity of capital equals the interest

rate• Fluctuations when the market interest rate differs from the natural one due to

monetary policy mistakes or financial system peculiarities

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• In very simple models multiplier looks huge, in more realistical ones much smaller– Keynes believed in ~1.5, hoped for 2– Today’s estimates generally around 1– In open economies small multipliers

• Should one adjust fiscal expenditure or revenue? – Possible dividing line between left- and right-wing Keynesianism– Structure of demand will differ, but will the size of multiplier?

• Does multiplier vary over time?– Psychology may well differ in depression and boom

• Ricardian equivalence– R. Lucas 1978: when government has budget deficit, consumption will decrease due

to anticipated tax increases. Same holds for deficits financed by borrowing as repayment is anticipated

– Thus no multiplier!

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Keynes and Hayek: differences revisited

Hayek• Looks at an economy at or

near full resource use: consumption and investment are substitutes

• Interest rate equilibrates savings and investment of loanable funds

• Over business cycle, change in structure of production is crucial

Keynes• Looks at a depression

economy: consumption and investment are complements

• Interest rate is at best secondary in determining savings and investment

• Over business cycle, change in labour markets is crucial

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Why was Keynes so persuasive?

• Offered reason for optimism: Depression can be fought!– And this can be done without losing freedom and liberal

values• Offered another path of thought in contrast with

received wisdom, which had been tainted by the Great Depression

• The theory could be put in a simple form– Which then formed the base of econometric models

• The theory seemed to be consistent with empirical facts

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”The Keynesian revolution”

• ”The ideas which are here expressed so laboriously are entremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

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• Until the 1970s the triumph of Keynes seemed complete– The Phillips curve prevailed in thinking: unemployment is

due to too little aggregate demand, inflation due to too much aggregate demand

– Government must smooth out fluctuations in aggregate demand, thus balancing the budget over the business cycle

– Compare EU stability policies!• Does one size fit all?• Can one distinguish cycle and trend?• Balances can be defined in different ways!

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Uncomfortable facts of life

• Does a long-run Phillips exist?• Co-existence of inflation and stagnation (stagflation)• Collapse of Bretton Woods exchange rate mechanism

– With floating exchange rates a different policy regime, different transmission of business cycles

– Fast growth of international capital flows– Who makes economic policy for a globalizing world?

• ”Bastard Keynesianism”: using permanent budget deficits to boost long-term growth– Excess debt and financial crises in Latin America, and not only

there

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Theoretical challenges• Monetarism

– Money is important– Empirically Great Depression was caused by central bank mistakes (Friedman

and Schwartz 1963)– As discrete (Keynesian) policy is hampered by ignorance and lags, policy

should be based on rules• Balanced budget• Money supply rule

• Public choice– Politicians and bureaucrats do not aim at common good but private interests

(Buchanan and Tullock 1962). Policy should aim at rules constraining them.– Market failures and policy failures.

• Real business cycles– If economic agents utilize all relevant information, business cycles are

exogenous

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Keynes is also famous for having said: In the long term we are all dead

• Yes, he argued for short-term activism, but then he was a liberal and a strong believer in capitalism

• See “Economic possibilities for our grandchildren” (1930)• “What can we reasonably expect the level of our economic life to be

a hundred years hence? What are the economic possibilities for our grandchildren?

• Technological unemployment … is only a temporary phase of maladjustment. I would predict that the standard of life in progressive countries one hundred years hence will be between four and eight times as high as it is to-day. … assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years.”

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A more pessimistic view: Alvin Hansen and secular stagnation

• Alvin Hansen (1887-1975)– Professor at Harvard with students like Paul Samuelson and James Tobin

• Future leading Keynesians – Originally believed in exogenous business cycle explanations, but was convinced

Keynesian by 1938– More importantly claimed that the USA had entered “secular stagnation”, ie a

long period of slow if any growth• Why? Slow population growth• And slower technological change• And other factors

– Therefore government needed to maintain permanent fiscal deficits• This is what became known as Bastard Keynesianism

– But return of high growth after 1940 discredited Hansen• However return of stagnation was widely feared after WWII, as there were large

reconstruction needs only in a few countries

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• The return of secular stagnation economics– Lawrence Summers: “the profound macroeconomic challenge of

the next 20 years in the industrial world”• Potential growth estimates of 1-2% annually for Europe and the USA• Very low interest rates following increase in private savings and decline

in investment– But is this normal (Barry Eichengreen) or abnormal?– How does a world of negative real interest rates function?

• Why: mainly slow growth or decline in labour force, but also financial strains, dysfunctional policies and ineffective decision-making

– Robert Gordon: there is no reason to suppose that technological progress in future would be as huge as in 1870-1910