Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Monday, February 2, 2009

On Krugman, Barro, Boneheads, and Keynes

How can one not love or hate Paul Krugman? (There appears to be no middle ground with this guy). He must have been an imp as a child; no doubt a terror to his parents and his petrified teachers. One cannot help but admire his academic contributions (primarily in international trade, for which he recently won a Nobel prize). He is courageous and opinionated; he is fun to read.

His impishness appears to have persisted well beyond middle age. On his personal webpage, he writes "With any luck, you will find many of these pieces extremely annoying." I think that he underestimates his own abilities in this regard; I am sure that luck has nothing to do with it at all.

Speaking of imps, I found it amusing to see that Robert Barro is a recent addition Krugman's Bonehead List. I am not in a position to evaluate Barro's government multiplier analysis or Krugman's critique of it. But I would like to comment on Krugman's update concerning Barro's interpretation of Keynes' economics. The quote from Barro is this:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.
In reply to this, Krugman writes:

Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes—at least enough to know that he devoted a whole chapter to explaining why a fall in wages would not expand employment?
I can hardly believe what I am about to say here, but...Krugman is absolutely correct; and Barro is being a bonehead on this matter. In support of Krugman, let me cite a relevant passage from Keynes' General Theory.

In this summary, we shall assume that the money-wage and other factor costs are constant per unit of labour employed. But this simplification, which we shall dispense later, is introduced solely to facilitate the exposition. The essential character of the argument is precisely the same whether or not money wages are liable to change. (Chapter 3, Part II)

Indeed, Keynes goes on to suggest in a later chapter that sticky wages were likely a good thing; and that flexible wages would serve to reinforce his general theory. The basic idea (as far as I understand it) is that falling wages would serve primarily to lower "effective demand;" leading to a further contraction in output and employment. It seems clear enough that Keynes had in mind some notion of "coordination failure;" i.e.,

Indeed it (the economy) seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. (Chapter 8, Part III).

Contrary to what some may believe, this type of outcome can be shown to be a theoretical possibility in suitably modified (and non-crazy) versions of otherwise standard neoclassical macro models (with fully flexible wages).

And so, Barro did indeed make a boneheaded remark. But to what might we attribute his error to? There is little doubt that this common boo-boo is the product of Hicks' interpretation of Keynes' theory; which relied heavily on the simplification of sticky wages alluded to above. Generations of economists were subsequently trained to believe that sticky wages were essential to Keynes' theory. The legacy of this "bastard Keynesianism" (Joan Robinson's colorful adjective) lives on today in the form of "New Keynesian" economics.

To see how this misperception lives on today, consider the following quotes from a graduate level macro course taught not too long ago at one of the world's best economics departments.

To make the transition (from neoclassical to Keynesian theory) we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline...
Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.

The lecture notes in question are available here. Who was the bonehead who made these remarks? Hint: His initials are not RB.

4 comments:

  1. Is there a contradiction here?

    You: The basic idea (as far as I understand it) is that falling wages would serve primarily to lower "effective demand;" leading to a further contraction in output and employment.

    Krugman: To make the transition (from neoclassical to Keynesian theory) we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline...

    Does output fall with sticky prices or without sticky prices? Or perhaps both, so the point is moot.

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  2. Pointbite:

    While output may fall whether prices are sticky or not, the point is not moot.

    The reason is as follows. The mechanism that leads to a drop in output is very different across the "true" Keynesian view and the "Hicks" Keynesian view. These two views lead to very different policy prescriptions.

    If the "problem" is simply one of sticky prices, the "solution" is legislate nominal contracts that are indexed to the price-level (indeed, we frequently see this in the form of COLA clauses in high inflation environments). Alternatively, the solution might be to inject huge quantities of money in the economy to push up prices (and reduce real wages).

    If the problem is expectations that are coordinated on some pessimistic state, then there is no reason to believe that simple COLA clauses or monetary injections alone might serve to cure this coordination failure. Indeed, either policy will serve to reduce real wages and (according to Keynes) contribute to lower effective demand and simply serve to reinforce the pessimistic expectations.

    So, it appears to matter how one views which mechanism is truly at work. What I find strange is that Krugman (intelligent as he is) appears to berate Barro for failing to understand basic "Keynesian" principles. The irony here is that Krugman never did any serious macro research (his expertise is in trade); while Barro began his career as a serious Keynesian scholar (see his early work on effective demand with Gordon).

    Thanks for your comment.
    David

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  3. "Who was the bonehead who made these remarks? Hint: His initials are not RB."

    But in that essay, Krugman was describing not so much what Keynes wrote, but rather what Hicks wrote:

    PK: "Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argument that may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinks he said. But how did Hicks come up with that concise statement? To answer that question we need only look at the book he himself was writing at the time, Value and Capital ...."

    Remember the question here is what *Keynes* actually wrote. If Barro was a "serious Keynesian scholar", it might have been in a vein of theory where sticky prices ("fixprices" in Hicks' terms) were considered "crucial" (as PK puts it). If you want to tell students about a theoretical tradition, you have teach them about that tradition -- with its flaws as well.

    PK wrote that essay back in, what, 1999, it looks like? "Not so long ago"? If you want to dredge it up now, you should at least parse it correctly.

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  4. If leftists think sticky wages are a market problem that needs a government solution then why are they for unions and minimum wage laws?

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