Why It's So Hard to Kill Keynesianism
We all know how stimulus works, right? The government spends money, and then the people who get that money spend it again, which increases gross domestic product and makes us all richer.
The interesting thing about this model is that economists abandoned it more than 30 years ago, as John Cochrane points out:
How many Nobel prizes have they given for demolishing the old-Keynesian model? At least Friedman, Lucas, Prescott, Kydland, Sargent and Sims. Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.
But people love the story. Policy makers love the story. Most of Washington loves the story. Most of Washington policy analysis uses Keynesian models or Keynesian thinking. This is really curious. Our whole policy establishment uses a model that cannot be published in a peer-reviewed journal. Imagine if the climate scientists were telling us to spend a trillion dollars on carbon dioxide mitigation -- but they had not been able to publish any of their models in peer-reviewed journals for 35 years.
New Keynesian models do predict stimulative effects from government spending. But they do so through a completely different channel from the old Keynesian models that are still popular with most of the public intellectuals who support stimulus.
What to do? Part of the fashion is to say that all of academic economics is nuts and just abandoned the eternal verities of Keynes 35 years ago, even if nobody ever really did get the foundations right. But they know that such anti-intellectualism is not totally convincing, so it's also fashionable to use new-Keynesian models as holy water. Something like "well, I didn't read all the equations, but Woodford's book sprinkles all the right Lucas-Sargent-Prescott holy water on it and makes this all respectable again." Cognitive dissonance allows one to make these contradictory arguments simultaneously.
Except new-Keynesian economics does no such thing, as I think this example makes clear. If you want to use new-Keynesian models to defend stimulus, do it forthrightly: "The government should spend money, even if on totally wasted projects, because that will cause inflation, inflation will lower real interest rates, lower real interest rates will induce people to consume today rather than tomorrow, we believe tomorrow's consumption will revert to trend anyway, so this step will increase demand. We disclaim any income-based "multiplier," sorry, our new models have no such effect, and we'll stand up in public and tell any politician who uses this argument that it's wrong."
I find it interesting that an economic model with zero percent mindshare among professional macroeconomists has nearly 100 percent mindshare among public intellectuals and politicians. Even the conservatives who oppose stimulus are unlikely to resort to the Lucas critique; at best they generally argue from distortion, and at worst they wave their hands and declare that it's obviously ridiculous to think that government spending could make you richer.
It's tempting to say that this is true of big economic fights in the media: The ideas that capture mindshare are not necessarily the ones most likely to be true, but rather the ones that are easiest to describe. Take supply-side conservatives who believe that tax cuts raise revenue in the immediate future. Their mental model is easy to describe: If you take less of the fruits of people's labor, they will work more. But it is too naive to be a good description of the real world. I explained why a few years back:
Consider the supply-siders. The thing is intuitively appealing; when we get more money from working, we ought to be willing to work more hours. And it is a mathematical truism that revenue must maximize at some point. Why couldn't we be on the right-hand side of the Laffer Curve?
It was entirely possible that we were; unfortunately, it wasn't true. And one of the reasons that supply-siders failed was that they were captivated by that one appealing intuition. In economics, it's known as the "substitution effect" -- as your wages go up, leisure becomes relatively more expensive relative to work, so you tend to do less of the former, more of the latter.
Unfortunately, the supply-siders missed another important effect, known as the "income effect". Which is to say that as you get richer, you demand more of some goods, and less of others. And one of the goods you demand more of as you get richer -- a class of goods known as "superior goods" -- is leisure.
Of course, some people are so driven that they will simply work until they drop in the traces. But most people like leisure. So say you raise the average wage by 10%. Suddenly people are bringing home 10% more income every hour. Now, maybe this makes them all excited so they decide to work more. On the other hand, maybe they decide they were happy at their old income, and now they can enjoy their old income while working 9% fewer hours. Cutting taxes could actually reduce total output.
(We will not go into the question of how much most people can control their hours -- on the one hand, most people can't, very well, but on the other hand, those who can tend to be the high-earning types who pay most of your taxes.)
Which happens depends on which effect is stronger. In practice, apparently neither was strong enough to thoroughly dominate, at least not when combined with employers who still demanded 40 hour weeks. You do probably get a modest boost to GDP from tax cuts. But you also get falling tax revenue.
At this point, no conservative economist endorses the "ultra-strong supply-side hypothesis"; even most conservative policy wonks with economics training will not be caught endorsing it, because it's not true. Not only do we know that the model is incomplete, but we also have data on things like the Bush tax cuts, and they do not show revenue rising. You can make an argument about how, over time, a 0.1 percent increase in the growth rate will compound into enough money to more than pay for the tax cut, but no one thinks that you can cut taxes and have those tax cuts pay for themselves within the 10-year budget window.
Nonetheless, among politicians, and a lot of less economically focused wonks and pundits, the ultra-strong supply-side argument remains very popular.
Or take efficient markets. On both sides of the aisle, the ultra-strong version of the efficient markets hypothesis -- that markets not only incorporate all known information into the price of assets, but also actually closely approximate the true platonic ideal value that we would see if prices were being set by the Archangel Gabriel -- is very popular. Depending on the issue, both sides mock the idea while also embracing it; you see conservatives argue that some government program must be no good because if people wanted the service, the market would be providing it ... and you see progressives argue that some corporate practice must be a boil on the body politic, because if it wasn't insanely, extortionately profitable, companies wouldn't be doing it. If I had a dollar for every time I've heard or read someone arguing that food advertising must be the next best thing to a secret mind control ray, and offering as "proof" the big sums of money companies spend on it, I would be writing this blog post from my fabulous retirement villa on the Riviera.
Yet among economists, the argument is not over whether asset prices reflect the "true" value of the security, because economists don't think there's any such thing. When economists debate the efficient markets hypothesis, they're mostly arguing about the extent to which nonpublic information is incorporated in the price of assets.
But those sorts of arguments are tedious and abstruse -- I considered taking a few paragraphs to explain the differences between the weak, strong and semi-strong versions of the efficient markets hypothesis, and then realized that I wanted you to stay with me to the end of this article, not open a new tab and go hunting for videos of cats flushing toilets. This same calculation, performed by economics journalists throughout the world, has prevented literally millions of readers from being exposed to the first two sentences of an explanation of the efficient markets hypothesis.
On the other hand, debating whether prices are a good reflection of an asset's "true value" is fun. It doesn't require any particular economics education, and it provides lots of vivid examples for debate -- you won't believe how much the family across the street from me paid for a two-bedroom ranch that backs up to the highway! And so 95 percent of the public discussion involves an efficient markets hypothesis that doesn't exist, at least as far as economists are concerned.
The lesson from this, of course, is to beware of choosing your economic models on their sound. Something that can be explained in a couple of short, declarative English sentences is not more likely to be right; in fact, it might be less likely to be right. But it will seem more right than something that requires you to spend hours reading before you can intelligently have an opinion. Plus, you can explain the easy ones to your friends on Facebook!
The more complicated theories are often better. But they have one drawback, which is -- hey, have you seen those videos of cats flushing the toilet?
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To contact the author on this story:
Megan McArdle at firstname.lastname@example.org