Thursday, October 20, 2011

Another Way to Know That the Keynesians Are Right

-- Posted by Neil H. Buchanan

The annual ritual of granting the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, incorrectly known as "the Nobel Prize in Economics," is always attended by a sub-ritual in which politicians and policy wonks try to claim validation by aligning themselves with the recipients of the prize. Or, if the prize goes to a foe, the standard move is to denigrate the prize. When Krugman won, people on the right screamed. When someone like Buchanan wins (no relation), people on the left dismiss the significance of the award. Given that the prize is awarded on the basis of things that only economics professors really understand, all of that is rather silly.

This year should have been especially non-controversial. The prize, awarded to Christopher Sims and Thomas Sargent, recognized their important work on econometric technique. (I used some of their most important technical innovations as a central part of the empirical analysis in my dissertation.) Even so, Sargent had long been associated with the "rational expectations" school of macroeconomics, which is anti-Keynesian, seeming to give the Wall Street Journal's editorialists and their compatriots reason to cheer. And they did.

In last Sunday's Business Section of the NYT, however, a news analysis article by Jeff Sommer used quotes from the two winners to make it clear that they were "not non-Keynesian." It turns out that Sargent, who had been central in developing rational expectations theory (explanation below), had spent quite a bit of time over the last decade or so moving beyond that theory, due to its limitations. Also, in an interview with Sommer, Sims poured cold water on the idea that he was against Keynesian policies:

"Professor Sims spoke favorably of the Obama administration’s fiscal stimulus programs, which are Keynesian in their countercyclical spending. 'An expansionary fiscal policy is probably what we need right now,' he said. ... He criticized the Republican Congressional leadership for ruling out tax increases, which, he said, most economists know are needed. And he generally approves of the accommodative monetary policies of the Federal Reserve, led by his fellow Princetonian, Ben. S. Bernanke, whom he described as a 'new Keynesian.'"

Sims did criticize Keynesian models "in the temporal dimension," but it was clear that neither Sims nor Sargent believe anything that could validate those who insist on "expansionary austerity" and want to "end the Fed." Again, I find the exercise of looking to faux-Nobelists to weigh in on policy matters a bit silly, but if one was looking to see which side Sims and Sargent are on in the current policy divide, it is clear that they are with people like Krugman (and me).

All of that is on the "top level" of political discussion. That is, we ask the newly-minted super-experts whether they are for the Democrat's basic approach to economic policy, or the Republicans' basic approach, and this year they say the former. What is more interesting to me, however, is Sargent's discussion of rational expectations theory. His defense of that theory is so minimal that it actually says more about the Keynesian/non-Keynesian divide than Sims's endorsement of expansionary fiscal policy ever could.

The major policy divide in economics has long been over the efficacy of government policy. Although post-WWII policy debates centered around the divide over fiscal vs. monetary policy, the profession has long since settled into a camp that denies that government policy can ever help the economy (anti-Keynesians), and another camp that says that it can (Keynesians).

What made Keynesian models Keynesian, therefore, was that they provided a basis for believing that the government's fiscal and/or monetary policies could change the path of the economy (in the short run or long run). Even if one accepted arguendo that the long-run path of the economy is impervious to macro policy changes, the basic Keynesian model showed that government intervention could improve the short-run outcome. In the current environment, that would argue in favor of increased stimulus spending to reduce unemployment and increase economic growth.

The rational expectations theorists purported to show that short run policy interventions could have either no effect, or only the most transitory effect. The idea was that profit-motivated people would respond immediately to any new information, leading the economy back to its "natural" long-run position through the inexorable logic of supply-and-demand equilibrium. Expectations were "rational" in that hyper-rational, maximizing economic actors would exploit all new information as soon as it was available, negating the intended policy effect.

This theoretical prediction was satirized in the famous (among economists) joke about a rational expectations theorist refusing to pick up a $100 bill that was lying on the ground, on the basis that it was not really there at all. Why? "If there were really a $100 bill on the ground, someone would have already picked it up." The serious point was that rational expectations models required people only to be forward-looking, and to process all information as quickly as possible in order to exploit profitable opportunities -- until those opportunities had been competed away.

The Keynesians, meanwhile, used various assumptions about expectations in building their models. The most common was "adaptive expectations," in which people set their expectations based on recent experience, and not only on the basis of what they "rationally" expect everyone else to be "rationally" doing. With anything other than perfectly rational expectations, Keynesian results would follow. That is, government policy could improve the economy in the short-run, to shorten or end a recession.

Now look at Sargent's explanation of what, he says, rational expectations means. He said in 2007 that rational expectations describes "
economic situations in which the outcome depends partly on what people expect to happen." Last week, he added: "The value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future."

Sargent rightly says that this assumption is built into all modern economic models. That assumption, however, is not the rational expectations assumption at all. Rather, it is the assumption that expectations matter in some way. And, as I said, Keynesian models -- which support expansionary fiscal and monetary policies -- can easily incorporate assumptions about how expectations are formed. So long as the expectations are not "rational" in the extremely stylized sense that the anti-Keynesians hypothesized, you get a Keynesian model.

As I said above, Sargent is now a bit of a critic of the rational expectations approach. The quotes immediately above, however, were sincere defenses of the approach -- attempts to say, "Look, all that theory really means to do is make the very reasonable claim that expectations matter somewhat." And they surely do. Once the theory is redefined in that way, however, it is drained of all meaning. It would be like saying, "All Christianity really means, when it comes right down to it, is that people should be good when they can."

When the other side's assumption has to be defended by defining it into oblivion, you know you have won.


Doug said...

"... the profession has long since settled into a camp that denies that government policy can ever help the economy (anti-Keynesians), and another camp that says that it can (Keynesians)."

I think you mean fiscal policy - it can clearly help local economies (i.e. the gov builds a military base in a small down taking it from high unemployment to virtually none) and if the gov wanted to, it could eliminate unemployment by hiring programs (though low wages would be a trade-off). I guess it depends on what you mean by 'help' - if you just mean 'make the pie bigger' then there may be some small room for debate - if you mean provide for jobs, economic security, long-term opportunity, and stability (things normal people value) then there's no debate at all.

Neil H. Buchanan said...

Doug's comment is completely right. My post assumes arguendo that none of what Doug identifies (and a lot of other important things) matters. I agree that they do matter.

The point is that, on its own very narrow terms, rational expectations theory predicted that changes in demand would have no impact on GDP or aggregate employment, even in the short run. Even that very narrow claim is clearly incorrect, and the Keynesians' predictions have been proven correct.

I'll discuss the things that Doug mentions, and more, in tomorrow's post.

egarber said...

How do rational expectation purists address Keynes’ “paradox of thrift”?

When individuals are overexposed, they save – which is perfectly rational. But in the aggregate, that worsens a downturn, because it saps the demand out of the economy. The Keynesian answer is government spending, to avert long-term implosions.

Do purists at least acknowledge that effect, even if they oppose the prescription?

Bob Hockett said...

Thanks much, Neil,

Characteristically thoughtful and informative! One complemetary thought to complement the complimentary observation: I've always thought one of Keynes's greatest contribution to have been his introdcution of recursive ('feedback loop') phenomena into the discussion of monetary and financial phenomena. GT Chapter 12 is probably the most celebrated instance. Sargeant, in turn, is particularly well known for formally incorporating recursion into his models. That always struck me as a very Keynes-reminiscent move - partly because, as mentioned, Keynes himself was conspicuously attentive to such phenomena in a way that more orthodox theorists were not, and partly because recursion introduces indeterminacy (hence lack of 'natural' equilibria) and hence radical uncertainty into economics, themselves very Keynesian contributions. The moment I hear Sargeant named for the prize, then, I found myself involuntarily leaping, for a moment, for joy.

All best and thanks again,

Neil H. Buchanan said...

In response to egarber:

Rational expectations theorists vehemently deny the existence of a paradox of thrift. First, "rational" people are forward looking, so they anticipate and efficiently insure against all probabilities, meaning that they do not become overexposed in the first place. Second, the assumption that people have rational expectations tautologically implies that the economy is always in equilibrium. This means that any changes in saving are immediately processed through the efficient financial markets to become private investment spending by rational businesses, which guarantees that any decreased consumer spending is offset, dollar for dollar, by increased business spending.

I hope that it is clear that I am merely describing this theory, not endorsing it.

Neil H. Buchanan said...

In response to Bob Hockett:

Excellent complementary point, re recursion. I had not thought about that, but you're clearly right that Sargent's work in that area was supportive of Keynes's.

And as you say, it's even more important to note that these insights lead to "radical uncertainty," which means that (per my response to egarber in my comment above) even "rational" people cannot insure against all outcomes. The difference, as you well know, is between "uncertainty" and "risk." The latter can be efficiently handled (under proper assumptions), but the former cannot (under any assumptions).

Sargent's intellectual curiosity and openness are to be commended. I don't know where I read it (or if I heard it second-hand from another economist), but apparently Sargent once said something like this: If you take rational expectations seriously, people at Time 0 will engage in an orgy of efficient contracting to cover all current and future possibilities (aided, of course, by the Walrasian Auctioneer). Once that contracting period is over, then, from Time 1 through infinity, people just let things happen, because they have already insured against every possible outcome (including "surprises"). There are no decisions left to make.

As I understand it, Sargent was simply stating the absurd conclusion that the model (which he had done so much to develop) requires. Once he saw that absurdity, it was time to move on.

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