Shinzo Abe: Monetarist or Keynesian Hero?

A couple weeks back, Tim Duy argued that many economists were missing the big story in Japan:

Ultimately, it is the story of the end game of the permanent zero interest rate policy.

In a follow up post, Duy noted that:

a thread is making the rounds claiming that Japanese Prime Minister Shinzo Abe is all bark, no bite. Joshua Wojnilower argues that Abe is a closet austerian, thus ultimately the actual stimulus enacted will be of the short-term, low-power variety. Noah Smith is less diplomatic, pointing out that Abe's first time at the helm was something of a disaster because Abe fundamentally has a narrow focus:

"I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second."

I highlighted the following chart in my previous post:

Abe’s previous leadership entailed the smallest budget deficit during the past 12 years, by a wide margin (Source: IMF): 

Although Abe may be willing to accept short-term fiscal expansion this time around, his medium and long term views still seem focused on reducing public debt.

Now Abe’s government is following through with a $116bn stimulus package that sent the Nikkei shooting higher and pushed the Yen even lower. Supposedly:

the stimulus will boost Japan’s economy by 2% and create 600,000 jobs.

Has the Monetarist hero suddenly become a New Keynesian icon? For the time being, maybe so, but I maintain my reservations about the mid-to-long term stimulative plans of this government. Fortunately, for me, Noah Smith also remains pessimistic given Abe’s and the LDP party’s history of waste and favoritism accompanying stimulus measures:

Anyway, the tweaked electoral system, lower "clientelist" pork spending, and the disastrous unpopularity of Abe's first tenure as prime minister helped ushed the DPJ into power, breaking the LDP's 55-year run. But now the LDP is back, and they need to re-establish their base of support. This means re-establishing the back-scratching relationship with those construction firms (and, by extension, rural Japan, right-wing Tea Party type groups, and the mafia). The LDP needs to say "Hey, guys, things are back to the way they were." This, I suspect, is the main reason for the "emergency stimulus".

…

To sum up: Once again, I think that Abe's appearance as a bold Keynesian experimenter is a cover for a program of traditional mercantilism and corporatism. I guess we'll see how well that program works.

Despite Hicks' Denouncing His IS-LM Creation, The Classroom Gadget Lives On

Within my PhD program, the first unit/half of the Macroeconomics course was devoted to growth theory. Although the different models within this category (Solow, Ramsey-Cass-Koopmans, Diamond, etc.) are still widely used today, with various modifications, I think it’s fair to say that the empirical results of forecasts stemming from these models leave much to be desired. That view, however, is not one I wish to delve further into today.

The second half of the course has begun and will revolve largely around variations of the Keynesian IS-LM model. The Keynesian title associated with IS-LM models is a bit of a misnomer since the original model was expounded by John Hicks in a paper, “Mr. Keynes and the Classics” (1937). Considering the title of Hicks’ paper, it should come as no surprise that many (most) economists over the years have assumed the IS-LM framework was an interpretation of John Maynard Keynes’ The General Theory of Employment, Interest and Money.

Should we accept the mainstream view? Well, according to Hicks himself, the answer is no. More than 40 years after bringing the IS-LM model to economics, Hicks returned to the topic in a paper within the Journal of Post-Keynesian Economics titled “ “IS-LM”: An Explanation” (1980). He wrote (my emphasis):

“Mr. Keynes and the Classics” was actually the fourth of the relevant papers which I wrote during those years. The third was the review of The General Theory that I wrote for the Economic Journal, a first impression which had to be written under the pressure of time, almost at once on first reading of the book. But there were two others that I had written before I saw The General Theory. One is well known, my “Suggestion for Simplifying the Theory of Money” (1935a), which was written before the end of 1934. The other, much less well known, is even more relevant. “Wages and Interest: the Dynamic Problem” was a first sketch of what was to become the “dynamic” model of Value and Capital (1939). It is important here, because it shows (I think quite conclusively) that that model was already in my mind before I wrote even the first of my papers on Keynes.

The notion that IS-LM was a Hicksian, not Keynesian, construction should not dampen its value in any meaningful way. However, one may be interested to learn that Hicks later admitted to the broad uselessness of IS-LM analysis in the same paper quoted above (my emphasis):

I accordingly conclude that the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected-if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached …

I have paid no attention, in this article, to another weakness of IS-LM analysis, of which I am fully aware; for it is a weakness which it shares with General Theory itself. It is well known that in later developments of Keynesian theory, the long-term rate of interest (which does figure, excessively, in Keynes’ own presentation and is presumably represented by the r of the diagram) has been taken down a peg from the position it appeared to occupy in Keynes. We now know that it is not enough to think of the rate of interest as the single link between the financial and industrial sectors of the economy; for that really implies that a borrower can borrow as much as he likes at the rate of interest charged, no attention being paid to the security offered. As soon as one attends to questions of security, and to the financial intermediation that arises out of them, it becomes apparent that the dichotomy between the two curves of the IS-LM diagram must not be pressed too hard.

Unfortunately IS-LM analysis still dominates the policy field today, which is why it remains a core component of introductory Macroeconomics courses at the graduate level. As Lars P Syll points out:

Back in 1937 John Hicks said that he was building a model of John Maynard Keynes’ General Theory. He wasn’t.

What Hicks acknowledges in 1980 is basically that his original review totally ignored the very core of Keynes’ theory – uncertainty. In doing this he actually turned the train of macroeconomics on the wrong tracks for decades. It’s about time that neoclassical economists – as Krugman, Mankiw, or what have you – set the record straight and stop promoting something that the creator himself admits was a total failure. Why not study the real thing itself – General Theory – in full and without looking the other way when it comes to non-ergodicity and uncertainty?

Why not study models that incorporate endogenous money and heterogeneous capital? I recognize that time is limited, but if not now, when? Most of my fellow classmates will likely only take one more semester of Macroeconomics before earning their PhD. If historical awareness and other models are not presented now, the task of changing the mainstream approach going forward becomes that much harder. Hopefully I can play a role in changing that trend going forward.

Krugman Reveals New, Flawed Definition of Austerity

For the fact is that you can’t just look at spending levels to ask what is happening to spending programs. Here in the United States spending on unemployment insurance and food stamps has risen sharply, not because the welfare state has expanded, but because a lot more people are unemployed and poor. Similar effects are at work in European countries, which have stronger safety nets than we do. Also, some spending represents banking bailouts, not exactly what people have in mind when they talk about big government.

Read it at The Conscience of a Liberal
Austerity, Safety Nets, and Spending
By Paul Krugman

Krugman continues to argue against austerity but this time makes his distinction of the term a bit clearer. Basically, in his perspective, government spending that counts is limited to funds used for consumption and investment. All that government spending on “capital transfers” (bank bailouts) and “social transfers” (e.g. unemployment benefits and food stamps) doesn’t count as an expansion of government. While I certainly don’t oppose some “social transfers”, this separation of government spending strikes me as odd.

As I understand the situation, the purpose of governments increasing spending (or the deficit) is to add income to the private sector, alleviating the deflationary effects of private sector deleveraging. Whether spending money on bank bailouts or investment, both sources add income in the current period to the private sector. This is not to suggest that the longer-term effects of the two policies is the same or that I don’t prefer the latter to the former. The point is that either form of spending is the choice of (generally) elected political leaders. If the Spanish government decides tomorrow to spend a few hundred billion euros to recapitalise its banks, then in my mind it is electing not to pursue austerity.

The real issue here seems to be that government spending is not being directed to the types of uses that are favored by proponents of Keynesian stimulus (presumably because those uses have a larger multiplier). This may very well be true (bank bailouts, as structured, were an awful idea) but that is an argument against the current political institutional framework by which those decisions are made. Arguing simply for more government spending in no way guarantees, or even implies, that governments will choose to direct funds towards consumption or investment and away from “capital transfers” or “social transfers”.

The discussion is moving in a positive direction, away from abstract claims of general spending and towards specific policy measures. This distinction of austerity, however, simply dismisses some aspects of government for the sake of trying to prove a point. In my view that is no better than the comments from the other side Krugman rails against. Yes there were spending cuts in some areas. Yes there were spending increases in others. Neither argument explicitly proves or disproves austerity (especially when we all mean different things.) Let’s focus on where the spending is going and then, if we decide it’s not ideal, figure out how to make politicians alter the composition.

(Note:  I definitely have in mind bank bailouts when I talk about “big government”.)

Chris Edwards - A Contradiction in Keynesian Fiscal Policy

Yet how can a Keynesian administration or Keynesians in Congress ever make a “credible” medium- or long-term commitment to deficit reduction? As soon as the next recession hits, they will demand ripping up any previous deficit-reduction deal so that they can stimulate aggregate demand some more.

Read it at Cato @ Liberty
A Contradiction in Keynesian Fiscal Policy
By Chris Edwards
(h/t David Henderson at EconLog)

While I don’t disagree with the Keynesian cohort that more fiscal stimulus now could improve GDP growth in the short-term, I don’t think either political party can make a “credible” claim to reign in spending in the future. Both parties during the past 12 years have overseen massive spending increases with relatively little to show for their efforts. It’s hard to envision either side willingly choosing to reduce their power (level of spending) once in office.  

Peterc - Reform or Revolution, MMT or Marx

The Keynesian, like the Marxist, recognizes that capitalism is inherently flawed and that left to its own devices it cannot stand. It is only by overriding its internal logic, whenever necessary, through the implementation of deficit spending not dictated by the profit motive that the system can be preserved for the benefit of capitalists, and most Keynesians apparently choose to support policies to prop up the system in this way.

Read it at heteconomist
Reform or Revolution, MMT or Marx
By peterc

Harvard Students Walkout on Modern Economics

From the Harvard Political Review online, An Open Letter to Greg Mankiw:

The following letter was sent to Greg Mankiw by the organizers of today’s Economics 10 walkout. 

Wednesday November 2, 2011 

Dear Professor Mankiw— 

Today, we are walking out of your class, Economics 10, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society. 

As Harvard undergraduates, we enrolled in Economics 10 hoping to gain a broad and introductory foundation of economic theory that would assist us in our various intellectual pursuits and diverse disciplines, which range from Economics, to Government, to Environmental Sciences and Public Policy, and beyond. Instead, we found a course that espouses a specific—and limited—view of economics that we believe perpetuates problematic and inefficient systems of economic inequality in our society today. 

A legitimate academic study of economics must include a critical discussion of both the benefits and flaws of different economic simplifying models. As your class does not include primary sources and rarely features articles from academic journals, we have very little access to alternative approaches to economics. There is no justification for presenting Adam Smith’s economic theories as more fundamental or basic than, for example, Keynesian theory. 

Care in presenting an unbiased perspective on economics is particularly important for an introductory course of 700 students that nominally provides a sound foundation for further study in economics. Many Harvard students do not have the ability to opt out of Economics 10. This class is required for Economics and Environmental Science and Public Policy concentrators, while Social Studies concentrators must take an introductory economics course—and the only other eligible class, Professor Steven Margolin’s class Critical Perspectives on Economics, is only offered every other year (and not this year).  Many other students simply desire an analytic understanding of economics as part of a quality liberal arts education. Furthermore, Economics 10 makes it difficult for subsequent economics courses to teach effectively as it offers only one heavily skewed perspective rather than a solid grounding on which other courses can expand. Students should not be expected to avoid this class—or the whole discipline of economics—as a method of expressing discontent. 

Harvard graduates play major roles in the financial institutions and in shaping public policy around the world. If Harvard fails to equip its students with a broad and critical understanding of economics, their actions are likely to harm the global financial system. The last five years of economic turmoil have been proof enough of this. 

We are walking out today to join a Boston-wide march protesting the corporatization of higher education as part of the global Occupy movement. Since the biased nature of Economics 10 contributes to and symbolizes the increasing economic inequality in America, we are walking out of your class today both to protest your inadequate discussion of basic economic theory and to lend our support to a movement that is changing American discourse on economic injustice. Professor Mankiw, we ask that you take our concerns and our walk-out seriously. 

Sincerely,
Concerned students of Economics 10

Roberts: The Microeconomics of the Broken Window Fallacy

As a DC resident, last week I experienced both an earthquake and a hurricane. Thankfully neither resulted in significant injuries within the impacted areas and property damage was also less than some might have expected. These experiences have provided opportunity for several economists to once again discuss the economic effects of natural disasters. Earlier this year, when Japan was hit by a terrible earthquake and tsunami, numerous economists and market "experts" noted that the destruction would be positive for economic growth due to rebuilding efforts. Similar comments sprung up following Hurricane Irene's treacherous path across the eastern seaboard.

These discussions are precisely when better definitions of economic growth are needed apart from GDP. Based on my understanding, if someone's car was destroyed and they choose to replace the vehicle by purchasing another, that purchase adds to GDP, while the lost vehicle subtracts nothing. From a real world perspective, the person whose car was demolished is now worse off, since they still own only one car but are now out a significant sum of money. Meanwhile, the car salesman is only better off by the amount the other individual spent. On the whole the economy is not better off since the amount of goods remains the same. GDP therefore fails to account for the depreciation or destruction of asset value, which plays a significant role in establishing wealth and economic well-being.

Russ Roberts of Cafe Hayek, who helped create the "Fight of the Century" videos (linked below), provides a wonderful example of what's known as the broken window fallacy. His counterpart on the website, Don Boudreaux, also had a humorous retort to Peter Morici (Professor at University of Maryland) regarding this fallacy and his willingness to destroy property for payment in order to benefit others (http://cafehayek.com/2011/08/open-letter-to-peter-morici.html). I urge those not familiar with the argument to read the articles and determine which theory is more compelling.

The Microeconomics of the Broken Window Fallacy:
The Keynesian defense of breaking windows or the economic virtues of hurricanes would go something like this:

Yes, breaking windows is destructive. Yes, it reduces wealth. But when there are large amounts of unemployed resources, say in the glass business, then breaking windows is close to a free lunch. In a world of unemployed glaziers, breaking windows can jump-start the economy by putting the unemployed back to work. They will spend the money they receive for repairing the broken windows.

When confronted with the claim by those of us who like Bastiat, that the money to repair the windows will now be unavailable to spend on something else, the Keynesian responds like this:

But people are sitting on money that is doing nothing. The insurance company that will now pay back the homeowner whose house was damaged by the hurricane was sitting on piles of cash. That cash was sitting in the bank where the bank has excess reserves not being lent out, not being invested. So yes, breaking windows can improve the incomes of glaziers and start a process of recovery.

What do we respond, those of us who are enamored with Bastiat and who think he’s right?
I would re-state the Bastiat story and tell it a little differently than it is usually told. The usual point is that the money has to come from somewhere–we see the repaired window but ignore the things that don’t get built or bought. But I think a better way to tell the story is to point out that the RESOURCES have to come from somewhere. The hurricane increases the demand for glaziers and that is good for glaziers. But that is good for all glaziers, employed and unemployed. It pushes up the price of glass repair. That discourages some folks from having glass work done who otherwise would have done it. So there is some offset of the hurricane’s impact on glazier employment. And as the Hayek character says in “Fight of the Century“:
You see slack in some sectors as a “general glut”
But some sectors are healthy, only some in a rut
So spending’s not free – that’s the heart of the matter
Too much is wasted as cronies get fatter.
So while glaziers (and carpenters) may be unemployed, other sectors (such as the wood market) may not be having such problems. The hurricane has a big impact on the price of wood, discouraging a bunch of would-be demanders of wood from buying as much as they did before. Again, there’s an offset. The point is that “aggregate demand” doesn’t tell the whole story.
But the real problem with breaking windows is that it’s not productive. I know. That’s obvious. But think about what the words mean. Right now, there are a lot of unemployed construction workers. What does a hurricane do? A hurricane IS good for carpenters and glaziers and roofers. But it’s unproductive work. It gets the home owner back to the status quo. It doesn’t create anything new or valuable. I’m not saying the production is wasted. I’m saying it’s a repair. Why is that important?
Imagine a world where there hasn’t been a hurricane and I want to help the unemployed carpenter. Here are two ways to do so. One is to burn my house down and then call the carpenter and give him $100,000 to rebuild my house. Here is the second way. I call the carpenter and say, I feel bad that politicians artificially increased the demand for housing at the end of the 20th century, pulling you into an industry that cannot be sustained at its current leve. I feel bad that you’ve been unemployed for three years. So I’m going to give you $100,000.
Which of those two policies would have the bigger stimulative effect? The charity should have a bigger effect. No offsets from pushing up the price of lumber and so on. But giving people money doesn’t change the underlying problem that there are more carpenters than work available for them. Creating temporary work either by burning down houses deliberatively or accidentally through a hurricane doesn’t change the fact that there are too many carpenters and glaziers relative to demand.
So the hurricane will put carpenters back to work. But it would be even better if there had been no hurricane and people had just given them a check. Charity is more productive than destroying stuff and paying people to get back to square one.
But the charity approach is what we’ve been doing for the last few years. It’s called unemployment insurance. I know, it’s supposed to be stimulative but there’s no sign that it is. Why would it be? It doesn’t solve the problem that there are too many carpenters.
This is related what Arnold Kling calls “Patterns of Sustainable Specialization and Trade.” Repairing houses damaged by a hurricane isn’t sustainable. And if I just give carpenters money because I feel sorry for them, that isn’t trade. That’s charity. Both have the same stimulative effect–very little, because they don’t get at the underlying problem. Prosperity is the way we specialize and serve each other, creating products and services that we each value. Destruction cannot be the source of prosperity.