After the crisis: Are we all Keynesians?

1. After the crisis:Are we all Keynesians? Marc Lavoie

2. But first what is Keynesian economics? • New Keynesians • Nominal rigidities • Real rigidities • Coordination problems, multiple equilibria • New Consensus Keynesians (New neoclassical synthesis: endogenous money, real business cycles, rigidities) • Post-Keynesians • Fundamentalist Keynesians • Kaleckians/Kaldorians • Neo-Ricardian Keynesians Conférence AFEP Paris 2012

3. What defines Keynesians? Is it a belief …. • In the existence of involuntary unemployment • In the principle of effective demand and the paradox of thrift • In the existence of an independent investment function • That capitalism is the best system but that it needs to be tamed • That markets, especially financial markets, are inherently unstable • The need for capital movement impediments, managed exchange rates • The need for fiscal counter-cyclical policies • In animal spirits and fundamental uncertainty • In path dependence, multiple equilibria, and hysteresis • In the non-neutrality of money, the significance of liquidity • The dangers of wage and price deflation • In the existence of imperfections that thwart price adjustments Conférence AFEP Paris 2012

4. The question in the title seems to imply that Keynesianism is making a comeback.Was Keynesianism ever set aside? • The answer is yes and no. • Clearly, in academia, Keynesianism was a dirty word in the late 1970s and early 1980s, and it is only in the late 1980s and early 1990s that the New Keynesians made it respectable again. • In academia, macroeconomics was built on three concepts: the natural rate of unemployment hypothesis, supply-side economics, and the exclusive reliance on monetary policy. • Any attempt at using fiscal policy as an expansionary measure had to be thwarted by a compensatory action of the monetary authorities, through an increase in interest rates. Conférence AFEP Paris 2012

5. Was Keynesianism ever set aside? • However, at the policy level, at least in several of the rich industrialized countries, “the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy” (Mankiw 2006). • Policy makers and international organizations still opt either for the simple Keynesian counter-cyclical policies or for simple pre-Keynesian policies (cf. James Galbraith 1994-5). • Central bankers have reverted to interest-rate targeting, as argued in the days of the Radcliffe committee 50 years ago, which was influenced by Cambridge Keynesians. Conférence AFEP Paris 2012

6. The financial crisis has brought about mistrust in free markets G20 leaders have moved away from unfettered markets and uncontrolled capitalism; financial regulation is back. According to Gordon Brown (UK), author of the ‘golden rule’: “The Washington consensus is out”; Financial Times: “The credit crunch has destroyed faith in the free market ideology”. Conférence AFEP Paris 2012

7. The financial crisis has brought about a second Keynesian pragmatic revolution • In 2009, there was a “Keynes moment” when nearly all governments implemented fiscal stimulus packages. • These were based on Keynesian demand-side ideas regarding the merits of running budget deficits in times of recession. • These ideas, defended by policy makers, were in strong conflict with the views of most academic economists who had been trained for decades to believe that budget deficits are destabilizing because they would ultimately lead to higher interest rates and higher rates of inflation, thus requiring deflationary monetary policies. Conférence AFEP Paris 2012

8. The pragmatic revolution is not yet over • In contrast to previous financial crises, the IMF has advocated low interest rates and government stimulus packages with budget deficits for industrialized countries. • G20 press releases, often based on IMF advice, keep calling for stimulus packages in countries that can afford it. • Still today (this week), the IMF is begging the USA not to hit the « fiscal wall » and to act upon its « debt ceiling ». • However, as early as the Fall of 2009, G20 press releases were asking governments to prepare medium-term fiscal consolidation plans, so as to retain credibility and provide sustainable sovereign debt ratios. Conférence AFEP Paris 2012

9. The financial crisis has brought about a hybrid view, the “new fiscalism” • The concern with debt sustainability does not necessarily mean a return to « sound finance », and does not imply that the expansionary fiscal policies were misguided. • Most policy makers would still argue that these Keynesian policies were necessary in the midst of the financial crisis. • What we have is a form of new fiscalism (Mario Seccareccia), which is neither traditional sound finance nor Keynesian functional finance (of the Abba Lerner type). Conférence AFEP Paris 2012

10. Is there also a second Keynesian academic revolution? A rather negative answer: “These changes in ideology among world politicians create a different environment for economists. But as yet there are no strong shifts of opinion or practice among academic leaders of our profession. We search in vain for similar conversions or recantations. The signs are business as usual” (Hodgson, CJE 2009) Conférence AFEP Paris 2012

11. But there are indeed some academic leaders that reject current mainstream macro theory Richard Posner, University of Chicago Law school, 2009: « Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some appromimation of cost-benefit analysis ». Akerlof and Shiller, 2009, p. 168: « It is necessary to incorporate animal spirits into macroeconomic theory in order to know how the economy really works. In this respect the macroeconomics of the past thirty years has gone in the wrong direction. In their attempt to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed a research structure and discipline by focusing on how the economy would behave if people had only economic motives and they were also fully rational ». Brazilian Keynesian Association, Porto Alegre, September 2009 Conférence AFEP Paris 2012

12. And others have even a harsher diagnostic • Willem H. Buiter 2009, LSE professor, former member of the Monetary Policy Committee of the Bank of England: • « The typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so [Lucas,Prescott, Sargent, Barro, Woodford], may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. » • « Most of the profession continued to swallow the EMH [efficient market hypothesis] hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. » Conférence AFEP Paris 2012

13. This is unlikely to change mainstream scholarly activity in macroeconomics however • While there is a certain amount of tolerance in microeconomics, with experimental economics and behavioural economics at the vanguard, game theory and multi-agent modelling, things are very much different in macroeconomics. • David Colander, who claims that mainstream theory has changed, gives many examples of tolerance in microeconomics, but few or none in macroeconomics. • Indeed, the accepted framework for macroeconomics has become more orthodox and stringent (Dutt 2003, King 2008). • Experience as a recent writer for the Canadian version of the Baumol and Blinder principles of economics textbook has shown that it is much easier to introduce heterodox themes and critiques in microeconomics than it is to do so in macroeconomics. Conférence AFEP Paris 2012

14. There is a very strong counter-revolution against the revival of Keynesian economics • It is claimed by defenders of the market faith that government intervention and bad regulation were the causes of the crisis. Free-market capitalism is essentially perfect and stable. • The US government would have forced banks to grant subprime loans. • The Fed set short-term rates at too low a level (from 2002 to 2004). • The Chinese rigged the exchange rate and flooded long-term bond markets, also leading to overly low long-term rates. Conférence AFEP Paris 2012

15. The counter-revolution against the revival of Keynesian economics • There would be no crises if government was small and interest rates were always set at their natural levels. • Stimulus packages have and have had no impact on aggregate output (J.B. Taylor). • Expansionary fiscal policy and low interest rates will prolong the crisis, as it did in the 1930s. • Measured unemployment is of a structural nature, not of a cyclical nature, therefore we need more structural reforms, that is, more flexible labour markets, and less protection for the workers. Conférence AFEP Paris 2012

16. There is a very powerful counter-revolution in European policy circles • Pragmatism is lacking in European policy circles. • The ECB still does not want to purchase large amounts of government securities, thus acting as the purchaser of last resort, and thus insuring sustainable interest rates for all eurozone sovereign debt. • Eurozone politicians, including UK ones, still believe TINA; that austerity policies are the only possible solution; that more restrictions on fiscal deficits will do the trick; that more « Maastricht-type » rules will solve their economic problems. • They believe that deficit reduction will increase confidence and hence will stimulate the economy (a possible effect noted by Keynes himself). Conférence AFEP Paris 2012

17. What will be the impact of the financial crisis on economics at large? • In the short run, many more students should take economics, trying to understand what has happened. • It is unlikely that economics students will be provided with any convincing answer. As a result, in the medium run, there should be even less students than before in (orthodox) economics department as students will be disillusioned. • Government employers are themselves disillusioned with economics, as the financial crisis has demonstrated the futility of economic advice and theories. • In the long run, economics departments may become like departments of philosophy, theology, or ancient greek. • They might be supplanted by fields such as public policy, public affairs, international affairs, public administration, or others (C. Goodwin 2000). Conférence AFEP Paris 2012

18. What will be the final impact of the crisis on academia? Three possibilities • Mainstream macroeconomics will become ever more entrenched in its models and assumptions : the New consensus model, which is a variant of the real business cycle model with some rigidities, will be slightly amended, banks and behavioural economics will be added, and all other approaches will still be dismissed. • A second possibility, least likely, is that there will be more tolerance with respect to other theories, even if it does not incorporate the intertemporal utility maximizing representative agent with rational expectations, but only as long as the theories are formalized in some way. • A third possibility is that macroeconomics will be split into two parts: one presumed to be valid in normal times, which will correspond to mainstream macro, and another one, which will be valid in depression times. Conférence AFEP Paris 2012

19. A dual macroeconomics • Richard C. Koo wrote a book, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, 2007. • His argument is that mainstream theory (profit-maximization) is valid in normal times, but that it is not in depression times (debt-minimization): the yin and the yan. • A similar dual macroeconomics is proposed by DeLong and Summers (2012), and also by Paul Krugman (Depression Economics) Conférence AFEP Paris 2012

20. Koo’s dichotomy Conférence AFEP Paris 2012

21. DeLong and Summers’ dichotomy • In depression times or severe downturns: • Absence of supply constraints; • Monetary policy is constrained by the zero lower bound; • The fiscal multiplier is positive, possibly as high as 1.5; • There are hysteresis effects: higher actual output will raise potential output or even the growth rate of potential output (cf. Leon-Ledesma and Thirwall 2002 CJE): high rates of utilization generate high rates of investment. • Fiscal expansion will be self-financing under very weak conditions, i.e., the debt ratio will not rise in the future (cf. Abba Lerner’s functional finance). • But in normal times, the fiscal multiplier is zero! Conférence AFEP Paris 2012

22. Any other change in macroeconomics? • Change of the benchmark economy (supply-side growth model); • Focus on credit rather than on money; • Rejection of the money multiplier story; • Rejection of the HPM-Money-Prices relationship; • Revision of the principal-agent approach; • Revision of « rational » behaviour and « efficient markets »: Minsky’s euphoria; • Revision of the negative effects of moderate inflation; • Reconsideration of leverage, risk premia. • Positively-sloped AD curve, negatively-sloped MP curve Conférence AFEP Paris 2012

23. Falling wages with an upward-sloping AD curve Conférence AFEP Paris 2012

24. Fiscal expansion with a downward-sloping MP curve BBB r IS N D E MP Y Conférence AFEP Paris 2012

25. Conclusion: Are we all Keynesians? • The financial crisis will provide more room for dissenters in macroeconomics. • But it is unlikely to improve the fate of heterodox dissenters, including post-Keynesians or Marxists, within departments of economics • However the standing of heterodox dissenters may improve in departments other than economics (social sciences, public administration, etc.) Conférence AFEP Paris 2012