'Keynes' Only Useful Insight' Is Liquidity

[Niklas Blanchard]

First off, I would like to thank Megan McArdle for the opportunity to guest blog. It is quite an honor! My name is Niklas Blanchard, and for the past year I've been blogging at ModeledBehavior with Karl Smith and Adam Ozimek. I'm an econo-nerd through-and-through, and have a particular interest in monetary economics (including alternative currency systems). I am currently rather sick, so please forgive me if my posts seem to wander.

This week, Cambridge University is hosting a conference commemorating the 75th anniversary of Keynes' General Theory. As one might expect, the "godfather" of New Keynesian (NK) monetary economics is scheduled to speak, and papers are being presented that do fairly well at representing the state of NK empirical research. Of course the highlight is none other than Keynes Krugman, himself. I view Krugman as being about as close to a modern-day Keynes as anyone could ask for, and read his writings accordingly, and crucially, I think that this is an important way to read Krugman (at least his economics).

Krugman is giving the plenary lecture, which can be viewed here, and is aptly entitled "Mr. Keynes and the Moderns". Krugman, in his lecture, resurrects old Keynesianism. Everything from Keynes himself, to Samuelson, and Hicks. But is Keynes really that important to our modern economy? Is not studying Keynes, and paying homage to his magnum opus really that much of a sin? I don't think so.

One reason is that I view Keynes' only useful insight as extreme liquidity preference. In more plain speak, Keynes envisioned a world where money was a special good, which was traded in all markets, and that an excess demand for money would lead to a general glut in every other market that trades in money. This useful piece of the General Theory is a refutation of Say's law, in the short-run.

In his presentation, Krugman points to Japan as an example of the classic Keynesian liquidity trap in action, and follows up with a blog post which introduces expectations (missing in old Keynesianism), to completely demolish the idea that Japan has been experiencing a liquidity trap for the past two decades:

Note both that Japan reversed much of the initial expansion in the monetary base, confirming the expectations of those who might have regarded that expansion as temporary -- and Japan did this even though deflation continued! Note also that nominal GDP never moved at all despite the huge amount of money "printed".

In a world (or even a model) with expectations, whether rational or not, a classical liquidity trap can't exist. As you will note in the Krugman quote, the Bank of Japan did not credibly commit to higher inflation. What did the bank of Japan do? They increased the monetary base in a way that was consistent with demand to allow mild deflation in prices. It's hard to say that Japan has been in a trap, when the BoJ has ostensibly targeted price stability, and quite successfully gotten just that.

Now what about fiscal vs. monetary policy. Krugman has been the grand champion of expansionary fiscal policy in the current downturn...but why argue for fiscal expansion when monetary policy is not impotent at the zero lower bound? Krugman invokes Mike Woodford's reasoning, which follows:

1. A fiscal response to a severe slump doesn't require committing yourself to changes once the storm has passed; it "only requires unusual action while the situation remains grave."

2. Fiscal policy is "not wholly dependent on expectations changing for its effect (more robust to alternative models of expectations)"

I think that Woodford believes molding expectations to be a very hard task, which is exacerbated by the fact that Woodford also believes that monetary policy is interest rate targeting, and raising inflation expectations is a shot-in-the-dark, hail-mary play.

There may be a few advantages to fiscal stimulus, including the fact that funds can be targeted more specifically, but I believe that Woodford is wrong on number 1. Fiscal stimulus must work to raise expectations of future NGDP growth, or else it will fall flat. And that is exactly what happened with the ARRA:

Above is a chart showing actual NGDP, and extrapolating expectations of NGDP through 2013 from Fed forecasts. And it shows the problem. If your monetary authority sees it fit to let NGDP fall 8% below trend, and then simply pick up growth from the new lower level, your economy is going to be mired in weakness for a long time, as prices and wages stagnate in order to equilibriate ant the lower level.

The answer to this is to set an NGDP level target, and credibly commit to (in Krugman's words) "be irresponsible" for a time in order to catch back up to the previous trend. Political road blocks do not a liquidity trap make...and the liquidity trap (in my mind) was the only useful contribution of the General Theory. If the liquidity trap has never really been a binding constraint, then what should we make of the General Theory?