Scott Sumner  

Why are Keynesians so far-sighted?

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I recently did a post pointing out that higher interest rates don't reduce AD.  Indeed even higher interest rates caused by a decrease in the money supply don't reduce AD. Rather the higher rates raise velocity, but that effect is more than offset by the decrease in the money supply.

Of course that's not the way Keynesians typically look at things.  They believe that higher interest rates actually cause AD to decrease.  Except under the gold standard. Back in 1988 Robert Barsky and Larry Summers wrote a paper showing that higher interest rates were expansionary when the dollar was pegged to gold.  Now in fairness, many Keynesians understand that higher interest rates are often associated with higher levels of AD.  But Barsky and Summers showed that the higher rates actually caused AD to increase.  Higher nominal rates increase the opportunity cost of holding gold. This reduces gold demand, and thus lowers its value.  Because the nominal price of gold is fixed under the gold standard, the only way for the value of gold to decrease is for the price level to increase. Thus higher interest rates boost AD and the price level.  This explains the "Gibson Paradox." However I very much doubt whether Summers has applied this model to our current fiat money regime.

Both Keynes and Wicksell thought that monetary policy worked through interest rates, at least in their own country.  Lower interest rates meant easier money. But when they looked at Germany circa 1923, they ignored interest rates and focused on the money supply.  You could probably say the same thing about American Keynesians and Zimbabwe during the hyperinflation.

American Keynesians were contemptuous about the failure of the BOJ to boost AD during the late 1990s and early 2000s, but mostly gave Bernanke's Fed a pass under similar circumstances. Indeed even Bernanke himself went through this change in attitude.

In the late 1930s Keynesians would have laughed at the idea that tight money caused the Great Contraction, but by the 1980s many had bought into the Friedman and Schwartz hypothesis.

Why are Keynesians able to clearly see how monetary policy works in other places and times? Why can't they understand how monetary policy works in the here and now?  Elsewhere I've argued that monetary economics is extremely counterintuitive. Up close it's confusing, as easy money looks like tight money, and vice versa.  From a greater distance the issues become clearer.  You look at outcomes---hyperinflation, deflation, etc.

Barsky and Summers understood that at its most basic level monetary economics is the study of the supply and demand for the medium of account.  That was true during the gold standard, and its equally true today.  Unfortunately market monetarists seem to be the only group that apply this approach to current policy, and we don't have much influence. So society must suffer, until a future generation of smart and influential New Keynesians (Soltas and Wang?) diagnose what the Fed did wrong in 2008.

PS.  Caroline Baum is ahead of the rest of the media on these issues.



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COMMENTS (17 to date)
Nathan Smith writes:

I think I'm getting a clearer idea of how you detach AD from IS-LM, and what the ramifications of that are.

The role of interest rates in the macroeconomy seems to be very confusing and ambiguous. Should monetary policymakers just ignore them, and focus on money supply growth?

Of course, the speed with which interest rates move makes them attractive as a target, no? Immediate feedback?

MikeP writes:

Why are Keynesians so far-sighted?

In the long run, we're all Keynesians now.

Guest2 writes:

What is AD?

But, yes -- we are all Keynesians now.

Scott Sumner writes:

Nathan, No, don't target M, target expected NGDP growth.

Mike and Guest, I'm not.

MikeP writes:

I can't speak for Guest2, but mine was a joke -- a play on two Keynesianisms that fell right in line with the theme of the post.

Eelco Hoogendoorn writes:
Why are Keynesians able to clearly see how monetary policy works in other places and times? Why can't they understand how monetary policy works in the here and now?

Because they are getting paid by their ability to produce rationalizations for politically expedient policies; not by their ability to predict the future.

RPLong writes:
American Keynesians were contemptuous about the failure of the BOJ to boost AD during the late 1990s and early 2000s, but mostly gave Bernanke's Fed a pass under similar circumstances. Indeed even Bernanke himself went through this change in attitude.

In the late 1930s Keynesians would have laughed at the idea that tight money caused the Great Contraction, but by the 1980s many had bought into the Friedman and Schwartz hypothesis.

Why are Keynesians able to clearly see how monetary policy works in other places and times? Why can't they understand how monetary policy works in the here and now?

Prof. Sumner is describing anyone who subscribes to any belief whatsoever. It always makes perfect sense when we're talking about someone else. When we have to question ourselves, it's back to rationalization.

It's a fair criticism, but certainly not unique to Keynesians.

libertarian jerry writes:

Real money is gold and silver. Real money has been around,mostly successfully,for 5000 years. Central bank fiat currencies are money substitutes that in all of history has never retained it's purchasing power eventually becoming worthless. More than that,fiat currency is political money. It allows governments to purchase goods and services in the market to support that government's warfare and welfare states by using legal tender laws and inflation to get around politically unpopular taxes. The Keynesian notion that AG (aggregate demand)is necessary for economic growth is putting the cart before the horse. In essence it is production and the savings that go toward that production that create wealth and raise standards of livings. To spend money substitutes that are backed by debt is the height of economic folly. For,in the end,all that is left are large debts,misspent "money," inflation and a lowering of the standard of livings,in real terms,of the people in the Economic Class (as has occurred over the last 40 plus years since Nixon's closing of the gold window). The only people who have benefited are the members of the Political Class: politicians,government contractors,government employees,crony capitalists and the parasitic welfare class. In the end,it is not spending that creates real economic growth but saving,investing,sound money and the free market. Keynes was wrong.

TESC writes:

"Real money is gold and silver. Real money has been around,mostly successfully,for 5000 years. Central bank fiat currencies are money substitute"

There is no such a thing as real and not real money. Money is any comodity that is use as unit of account and as unit of exchange. As long as people keep quoting prices in dollars and not gold, dollar will still be money.

People percepcions is what matters, not its physical properties. Economics is about subjective valuations.

Andre Mouton writes:

But interest rates have tracked Fed guidance, not OMP. I don't see how Baum can argue that rates respond to "an increased economy-wide demand for credit, which pushes up the price" when it was very clearly taper-talk that drove them higher last year (and simultaneously lower overseas -- was that, too, a response to the demand for credit?). From where I was sitting, it sure looked like a supply event. But either way, are we not "reasoning from a price change"?

TESC writes:

"Why are Keynesians so far-sighted?"

Because it would make government spending irrelevant.

Andrew_FL writes:

From your post at your own blog:

It’s not at all clear that lower interest rates boost investment

This is kind of making me curious as to what effect, if any, you think Fed policy has on the market for loanable funds, and why, if it does have an effect, this should not be connected to investment.

Scott Sumner writes:

Mike, I'm kind of slow, you need to put up a smiley face. :)

RPLong, Very good observation.

Jerry. Gold also has its problems. A rise in the purchasing power of gold can lead to mass unemployment.

Andre, Actually it doesn't look that way at all. Yields rose by about 125 basis points. When the Fed shocked the markets by not tapering in September, yields only fell by about 10 or 20 basis points. Most of the rise in yields was due to a stronger economy, not fear of tapering.

Andrew, Money and credit are very different things. And yet monetary policy can impact the real quantity of credit in the short run, just as it can impact the real quantity of other goods and services in the short run. When the Fed adopts an easy money policy that boosts NGDP growth it will tend to raise the quantity of credit for roughly the same reason that it raises the quantity of steel being produced. But it's not at all clear that the easy money policy will reduce rates, they often rise when NGDP growth accelerates.

Andre Mouton writes:

Scott - that's a pretty simplistic story for a pretty complicated debt market. It also doesn't explain why rates would jump 125 bp over a few days around the world. Russia and India saw rates climb sharply, and they had a weak second half. Perhaps you could argue that credit responds to demand in some places (or times), and something else in other places, but then the devil's in the details.

Ralph Musgrave writes:

The Fed has just produced a study which claims the relationship between interest rates and investment is tenuous:

http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

Ralph Musgrave writes:

Scott asks why Keynsians can’t “understand how monetary policy works in the here and now?”

Where are these Keynsians who don’t understand that QE has an effect? Everyone appreciates that having the Fed buy assets has an effect. The argument is over whether that policy on its own is the best one, or whether it wouldn’t be better to add a bit of fiscal policy.

Keynes himself advocated having government simply print money and spend it in a recession (and/or cut taxes). That’s a mix of monetary and fiscal policy.

Scott Sumner writes:

Andre, I was trying to explain US interest rates.

Ralph, You said;

"Where are these Keynesians who don’t understand that QE has an effect?"

Try goggling "QE has no effect" and see what pops up.

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