Yes, Keynes was a smart guy

I’ve mentioned before that I’ve attempted The General Theory on several occasions but have never really “got” it. Knowing Keynes was a smart guy and he basically founded the field I research in, I assume the problem is me not him. Really.

Judge Posner wrote a “Nixon in China” summary of the book which is quite good. Posner says the fundamental tenants of Keynes’ thought are ((Also, he mentions the book’s most important historical context was the persistent unemployment in the UK, not the Great Depression. Embarrassingly, this is the first I’ve heard of that.)):

  • Consumption spending is more important than investment spending
  • Hording leads to the paradox of thrift
  • Animal spirits and Knightian uncertainty

Consumption is more important than investment spending, except, of course, investment spending IS consumption spending only in the future. I’m not sure what to make of this concern in the context of modern dynamic models where a trade-off is made between consuming today and consuming tomorrow. And the idea that consumption drives growth is alien to me in light of all the research in growth that’s happened since Keynes. I guess we can thank him for being the first to tell us to keep our eyes on the ball. Thanks dude!

The paradox of thrift is interesting for two reasons. First, its a case were micro-based thinking gives you wrong answers when you aggregate up. Saving is good unless everyone does it, then its bad and counter-productive. Learning this paradox gives one good instincts about the macroeconomy: the sum doesn’t look like its parts. Second, the paradox is only an issue when prices can’t adjust and monetary policy is ineffective. Thanks again Lord Keynes!

Now for some good ‘ol psychology. Posner says Keynes says investors have “animal spirits” and he, apparently, goes on to commit a fallacy of composition of his own. Its true that investors are frightenable creatures, manic depressive and dumb. I kid. But even if we take this investor psychology as given, its not obvious that it matters in aggregate. Unless these mood swings are highly correlated, crazy investor A’s zig will be matched by crazy investor B’s zag. Just to repeat myself: it is not enough to identify systematic individual psychological biases. You have to show those biases change over the business cycle and those changes are heavily correlated.

Also, I wonder what is meant by animal spirits exactly. Did Keynes mean investors respond to interest rates? That’s uncontroversial. Does he mean risk preferences are volatile? In which case, how important is this effect? This is an empirical question; one needs to model “animal spirits” and quantify their importance.

This leads to my final point. Keynes had tons of insight into the macroeconomy. For that, thanks dude! Its not clear, though, how these insights fit together and its doubly uncertain how they interact with his policy prescriptions. For example, Russ Roberts wonders how animal spirits are impacted by large deficit spending. The only way to answer this question would be to model these effects and see if that model generates data that looks like data generated by the actual economy.

To me the difference between old style, Keynes-influenced macroeconomics and modern macro is this empirical discipline ((This is a nice way of saying THE SALT/FRESH WATER “DEBATE” IS MOOT!!!)). As I’ve said before, its not enough to come up with plausible mechanisms, you have to show how those mechanisms generate the data. Almost every mechanism that the critics of modern macro have come up with, at least the ones I’m aware of, has been tested and has been found to be quantitatively irrelevant.

Posner, and most everyone else, doesn’t like the stories modern macro tells (i.e. exogenous technology and monetary shocks drive business cycles). He likes the stories Keynes told. For what ever reason, quantitative relevance isn’t an important criterion for folks to like a story.

14 Responses to “Yes, Keynes was a smart guy”

  • Kevin Dick says:

    Nice post. No comments but wanted to let you know I appreciate a good synthesis when I read one.

  • gabemathy says:

    “Its true that investors are frightenable creatures, manic depressive and dumb. I kid. But even if we take this investor psychology as given, its not obvious that it matters in aggregate.”

    Well, just look at the bankrupcy of Lehman Brothers. In terms of the overall US economy, it is quite small, and so its direct effect was quite small. The large effect the bankrupcy of Lehman Brothers had was through the panic it created among the financial system. This clearly falls within animal spirits for me, but maybe you prefer a different explanation? Economists like Cochrane or Mulligan who don’t like Keynes also underestimated the effect problems in the financial sector could have on the real economy. You can call it credit channels or something else, but you need some swing in ivestor sentiment for things to go south so violently so suddenly. (exogeneous productivity shocks or money supply shocks won’t do it).

    “Second, the paradox is only an issue when prices can’t adjust and monetary policy is ineffective.” This is the case that Keynes is addressing.

    “To me the difference between old style, Keynes-influenced macroeconomics and modern macro is this empirical discipline”

    You might be curious to look at the klein-Goldberger models, or some of Tinbergen’s work. These are vulnerable to the Lucas critique, but I think they did a decent job at modelling the economy (70s expected).

    I think it’s odd that Posner mentions Keynes and growth in the same sentence. I haven’t read the whole General Theory, but I don’t see it as addressing growth at it. It’s just about the short run (obvious quote about being dead suppressed)

  • pushmedia1 says:

    The school yard fight of the day on the econ blogosphere is how “insane” Ed Prescott and Joe Stiglitz are for thinking government actors can coordinate investor fears.

    I’m more interested in how these fears drive business cycles in general.

  • gabemathy says:

    Yes, it is definitely time for the profession to focus more on moving forward instead of more navel-gazing about the crisis.

  • Pithlord says:

    I guess the “animal spirits” claim is that investor mania and investor depression *are* correlated, at least enough of the time to get psychology-driven booms and busts. Are you saying that’s been empirically disproven? How and when?

  • pushmedia1 says:

    No. These things have never been spelled out and tested.

  • Pithlord says:

    Somebody should totally get on that.

  • pushmedia1 says:

    Great idea. I wonder why no one has thought of that…

  • Gabriel says:

    Why? It’s not promising. There’s an amorphous, undefined, unqualified, unquantified source of volatility that can explain everything and therefore nothing.

  • Gabriel says:

    P.S. Now that I see your footnote 2 I have to protest vehemently!!! — Reread CKM’s critique of NK models. The temptation to add dubious shocks and dubious atheoretical features is too much for some, since they think (1) raw fit*; and (2) policy “relevance” are the final goals.

    NK models might, *might*, capture local dynamics in “normal times”, the dynamics of a stable environment (when the incentives to change prices are relatively constant and therefore the Calvo abomination is not “binding” in some sense) but those environments are boring and better forecasted w/ VARs anyways.

    If you want to study a change in a structural feature then a smaller, simpler model with better identified shocks and minimal parametrization should be better than having all the frills and gratuitous noise fudged into every spot in the model… imho.

    [felt like ranting]

    (*) i.e. sample-wide fit, as opposed to what we really care about, which is fitting particular changes in policy or regime changes or whatever you want to call them.

  • pushmedia1 says:

    “There’s an amorphous, undefined, unqualified, unquantified source of volatility that can explain everything and therefore nothing.”

    Oh. I see. I thought macro researchers were idiots and they couldn’t pick low hanging fruit if it landed in their hand.

    Also, adding “dubious” shocks never hurt nobody. CKM’s critique is about parsimony. To me having an ugly theory is better than no theory. Would we have had a Copernicus without Ptolemy’s epicycles and whatnot?

  • Gabriel says:

    Well, that’s the attitude that gave us the ’70s :-(

    The whole point of the RE literature was that all adjustment speeds (yes, including price resets) are endogenous and very much policy variant. So yeah, I guess it’s better to have the wrong answer than no answer at all? — Calvo might be fine for getting “fit” and forecasting in normal time, but if you’re hoping to say something meaningful about large deviation from normal times (hello today) then no one should be comfortable with it, I think.

    Neoclassicists agree that price setting behavior is very important. They just disagree about how much they want to compromise the Lucas vision of having only policy invariant stuff in your models. In their case, none. — But again, this is about model for policy analysis, not forecasting.

  • pushmedia1 says:

    I don’t think “can this model be used for policy analysis?” has a binary answer.