Tuesday, August 21, 2012

Does Keynes Have a True Cycle Theory?

OK, I'm going to say upfront: I'm am a neophyte in understanding Keynes. I only truly started trying to comprehend what he has to say when I had to teach the history of economic thought and macroeconomics a couple of years ago.* But I am going to offer my understanding of how Keynes has an equally plausible story of how an economy can be driven further and further from equilibrium as do Mises and Hayek. If my understanding of Keynes is primitive, please forgive me!

If we assume, as Keynes does, that the interest rate is moved by liquidity preference, then in response to an increase in liquidity preference, and thus a drop in the price of capital goods, as Jonathan Catalan notes should occur, what will happen? Well, per Keynes, at least as I understand him, this drop in the price of capital goods will further spook the animal spirits of investors, and increase their demand for liquidity yet more. That increased demand for liquidity will drive the price of capital goods yet lower... and you can follow the logic from there yourself.

At some point, in "the long run," this process will drive the price of capital goods so low that investors will again begin to bid up the prices of these assets. What Keynes believes is that this long, painful downward spiral can be reversed if some entity can intervene to boost investment spending. (Typically, Keynesians allot this job to the government, but the theory is compatible with, say, The Bill and Melissa Gates Foundation taking on the same role, so that there is nothing intrinsically "statist" about this Keynesian view.)

The process this Keynesian story describes may or may not occur in reality. But there is nothing "illogical" or "contrary to economic reasoning" about the Keynesian narrative, as some anti-Keynesians sometimes contend. Keynes has put forward a serious theory of how an economy can sink into depression. As Weber would put it, this ideal type has "explanatory adequacy." What we ought to be investigating is its empirical adequacy.

* How dare I teach those courses without already understanding Keynes? Well, having taken similar courses as an undergrad, I understood that my competitors in teaching such courses would tell their students things like, "Inflation is more common than deflation for the same reason refrigerators break down over time: once money is issued, it tends to decay." Yes, a professor at an accredited university once said this in my presence. Thus, I came to understand my stance of "honest and open-minded seeker" was far better than what they were likely to be subjected to if I did not accept these posts.


  1. I have also very little knowledge about the original views of Keynes.

    But the view of modern keynesians is more that the prices change little and slowly in the short and medium term.

    Then, the process is more:

    "an increase in liquidity preference makes everybody trying to sell more than they buy, making that many production remains un-selled; these reduce the corporate profits, reducing even more the demand for capital, then reducing the interest rate, and and increase the demand for liquidity yet more."

    "At some point, in "the long run," this process will reduce the prices of goods to a point that the real value of the money in the hands of economic agents rise, their desire for more liquidity is satisfyed (in real terms), and the general desire to sell mor that to buy disappear and the economy returns to the equilibrium. What Keynes believes is that this long, painful downward..."

    1. @Miguel: In particular, contemporary Keynesians seem to focus on downward nominal wage rigidity.

    2. Yes, but I don't see how this is very different than my tale.

  2. Gene, do you think it's fair to say that RBC also depends on "animal spirits?" It seems to me that it does, on the boom side. How else does all that mal-investment occur, but by an excess of optimism? Even if you want to ascribe boom and bust cycles to government "debasing the coinage" through excess currency creation, you still need Austrian/Randian heroic entrepreneurs to be taken in by this. Otherwise they would not make mal-investments, for their clear-sighted and rational minds would tell them all the money floating around is illusory.

    Now if I'm right, these are still not equivalent theories, and RBC suffers in comparison. Because Keynes also applies his animal-spirits principle to booms, right? Optimism makes liquidity preference drop, leverage rises, and - mal-investments occur! Keynesianism's thesis of animal spirits has explanatory adequacy across the entire business cycle.

    But RBC theorists switch assumptions on us! They characterize recessions as the same heroic entrepreneurs and clairvoyant financiers who were excessively optimistic during the boom as becoming suddenly rational and essentially error-less. Per Hangover Theory, they are correctly and judiciously squeezing out "the excess." And it's somehow the right excess. We are not to worry that they're compounding their previous errors of optimism with new errors of pessimism. We are to understand that they are never more clear-eyed and far-seeing than during a bust.

    That seems implausible! And it seems to me that if RBC doesn't grapple with the possibility of genuine bipolarity - depression and mania - it's done at most half of its work.

    1. Jim, I think the Royal Bank of Canada relies more on a Prisoner's Dilemma situation than it does on animal spirits, although we can certainly add animal spirits in there with no loss.

    2. Jim writes,

      "How else does all that mal-investment occur, but by an excess of optimism?"

      The Austrian theory is not about pessimism or optimism, it's about changing prices, and thus changing profits.

  3. Oh wow. Everywhere I referred to RBC in the previous post, please substitute "Austrian." RBC is the technology-shocks people.

  4. I do not understand the fridge comment at all.

  5. I do not understand the fridge comment at all.

  6. Nick Rowe once had a good formulation of Keynesianism: qty adjusts rather than prices. So producers, seeing falling sales, cut production rather than lower prices.

    Also, why is there no Keynesian support for speeding up the spiral? It seems that would also be a good way to get the Gates foundation to show up.

  7. My view:

    Keynes believed that high interest rates caused by liquidity preference would lower investment (simply because they are a higher cost) and also push people into more speculative activity as they sought higher returns. This was the main cause of business cycles.

    Obviously he also believed in fiscal stimulus should a recession/.depression occur, as well as the inherent instability of financial markets. He doubted that a low interest rate would be sustainable and so advocated the state eventually taking care of investment.