Keynes 101 for failing Treasurer Josh Recessionberg

Via FTAlphaville:

The skill of the good economist, like the good writer, lies not just in what they include in their work, but what they choose to leave out.

The real world is hideously complex. So too are people. If economists are going to tell us anything about either, then they must resort to abstraction.

The trouble is what happens when what you choose to leave out one of the things that ends up mattering the most?

In a new paper (hat-tip to the University of Washington’s Fabio Ghironi for drawing our attention to it), Nobel Prize winning economist George Akerlof does a brilliant job of explaining how and why, in the decades before the financial crash, macroeconomists failed to include any meaningful role of the financial system in their economic models.

The paper takes us back to his graduate studies at the Massachusetts Institute of Technology in 1962, “when a particular version of Keynesian economics was ascendant”.

This “particular version” did not, Akerlof notes, pay much heed to John Maynard Keynes’ “beauty contest” theory of market behaviour, which helps explain why asset prices become unmoored from economic fundamentals due to people allocating their wealth partly based on what they think others will value, rather than what they themselves do. From the General Theory:

…the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole: so that each competitor has to pick, not those faces that he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view . . . We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth, and higher degrees.

As Akerlof notes, this theory was left out as it was largely incompatible with the version of Keynesian economics that was ascendant during the 1960s. That version — dubbed the Keynesian neo-classical synthesis — has one equilibrium position, where demand is equal to supply. Whereas Keynes’ “beauty contest” theory has multiple equilibria, with each face a possible winner. And we all lost as a result.

What we like about Akerlof’s paper is not only the degree of examination he applies to himself and his profession, but also the (not all that common) acceptance of the broader social and political forces that influence its findings.

In so doing, he manages to show why, when the world and people change, economists’ models have a habit of staying the same.

What we have to understand, he says, is that in the run-up to Akerlof’s graduate studies, the Keynesians had a fight on their hands.

The fight was to convince a sceptical US audience who had long dismissed Keynes as a socialist that the British economist’s teachings were compatible with the idea of free enterprise. Hence the synthesis of Keynes with a neo-classical theory a lot more attuned to the idea of free enterprise. From Akerlof:

The primary public policy lesson of Keynesian economics — that we now know how to respond to economic downturns — had been a hard-won fight. It had been fought for decades, with high stakes: nothing less than the maintenance of full employment, rather than lapses into Great Depression.

By the mid sixties Keynes was on the cover of Time Magazine.

© http://content.time.com/time/covers/0,16641,19651231,00.html

How this played out in the teaching of economics was in the choice of the dominant textbook. In the early 1960s, that was Paul Samuelson’s, based around the “Keynesian cross”, implicit within which was that fiscal policy could be used to create full employment in a society where savings rates were too high. Another textbook, this one by Garner Ackley, took the Keynesian IS-LM equilibrium for aggregate demand and coupled it with an upward sloping curve for aggregate supply.

The model soon became “accepted wisdom” on how to stabilise economies without having to sacrifice jobs.

In the 1960s, their models would be applied to the task of “getting America moving again” after the high unemployment of the late 1950s. Samuelson and friends would be advisors to the new Kennedy administration.

Meanwhile gifted students such as himself were dissuaded from going into business cycle economics and instead flocked into growth theory pushed in part “by the presumed end of straight macro as researchable”.

A hard and important problem… was now solved… Questioning the model then would be dangerous: it might divert the public, already misguided by their misunderstandings of economics, away from the expansionary fiscal policy needed to hold unemployment at bay.

And so it remained. The paradigm held to the degree that we recall, as rather less gifted students, struggling to master the workings of the IS-LM curve in our undergraduate economics course almost 40 years later.

By that point, however, we had the feeling that retaining the spoils of battles hard won had given way to hubris.

Hubris indeed for our L-plate Treasurere Josh Recessionerg. The “beauty contest” theory of asset prices goes beyond which will rise and fall. It extends to spending behaviour based upon these notions at any given point in time.

Sometimes, private sector individuals get it in their heads to priortises saving regardless of the outcome of the beauty contest. When enough people do this we reach what Keyenes called the “paradox of thrift”, that what is good for one has negative consequences when it’s adopted by all.

It is then than the prublic sector balance sheet should step in with expansion, to short-circuit any kind of feedback from the private saving activity into employment and, before long, expectations of falling asset prices as the beauty contest turns bad.

In short, equilibium is not reached by allowing saving or liquidation. Sometimes it is reached by counter-cyclical policy internvetion.

Now, tell me how Australian households are behaving today with regard to their attitudes towards the asset price beaty contest. via Damien Boey at Credit Suisse:

It is already very late for Josh Recessionberg to short-circuit Australia’s burgeoning paradox of thrift.

Leave is much longer and it may even be too late.

David Llewellyn-Smith
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