Keynes vs. the Classics, circa 2010

The debates between John Maynard Keynes and those who do not accept his views are just as fresh today as they were in the 1920s and 30s. That is both a testament to the power of Keynes' ideas and a damning indictment of Economics' claim to be a science. Two cases in point:

(1) Recent fears that inflation is just around the corner, coupled with skepticism about the effectiveness of last year's fiscal stimulus. From Keynes' "A Programme of Expansion," May 1929:

"The suggestion that a policy of capital expenditure, if it does not take capital away from ordinary industry, will spell Inflation, would be true enough if we were dealing with boom conditions... But we are far, indeed, from such a position at the present time. A large amount of deflationary slack has first to be taken up before there can be the smallest danger of a development policy leading to Inflation. To bring up the bogy of Inflation as an objection to capital expenditure at the present time is like warning a patient who is wasting away from emaciation of the dangers of excessive corpulence."

"The whole of the labour of the unemployed is available to increase the national wealth. It is crazy to believe that we shall ruin ourselves financially by trying to find means for using it and that "Safety First" lies in continuing to maintain men in idleness. It is precisely with our unemployed productive resources that we shall make the new investments."

"Negation, Restriction, Inactivity - these are the Government's watchwords. Under their leadership we hav been forced to button up our waistcoats and compress our lungs. Fears and doubts and hypochondriac precautions are keeping us muffled up indoors. But we are not tottering to our graves. We are healthy children. We need the breath of life. There is nothing to be afraid of. On the contrary, the future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered."

(2) The infamous Lew Rockwell links to the David Gordon reviewing Hunter Lewis' book on Keynesian economics:

Defenders of Keynes, such as the recent convert Bruce Bartlett, often claim that he supported capitalism... His interventionist measures had as their aim not the replacement of capitalism by socialism or fascism. Rather, it is alleged, Keynes aimed to save the existing order. The unhampered market cannot by itself recover from a severe depression or at best can do so after long years of privation and unemployment. Keynes discovered a way by which the government, through an increase in spending, can restore the economy to prosperity... Hunter Lewis convincingly shows the error of this often heard line of thought. Keynes, far from being the savior of capitalism, aimed to replace free enterprise with a state-controlled economy run by "experts" like him. His prescriptions for recovery from depression do not save capitalism: they derail the price system by which it functions...

Further, Keynes ignored the significance of a fundamental fact. The rate of interest is also a price. It reflects the preferences of consumers for present over future goods: the greater the time preference, the higher the rate of interest. Keynes principal aim in economic policy, not only to combat depressions but more generally, was to keep the rate of interest low: ideally, it should be done away with entirely. To do so flies in the face of consumer preferences. If the rate of interest is forced below what it would have been on the unhampered market, then people are being compelled to invest more than they wish. The point holds altogether apart from the Austrian theory of the business cycle, which Lewis fully accepts. That theory tells us that forcing the rate of interest below the natural rate may lead to an unsustainable boom. But even if this theory were mistaken, interference with interest rates would still distort the economic system. "Businesses depend on prices to give then the information with which to run the economy. If the price system for interest rates is broken, no part of the price system is unaffected. "

Of course a careful reading of the General Theory and Keynes' other works makes it clear that he was not in favor of government control of the economy. Government should manage the aggregate amount of spending through fiscal and monetary policy, but leave the allocation of investment spending to the private sector. When Keynes argues for the "socialization of investment" in the General Theory he is talking about the creation or expansion of semi-public institutions like "Universities, the Bank of England, the Port of London Authority, even perhaps the Railway Companies" and even throws in corporations whose management is insulated from the short-sighted demands of shareholders and are therefore free to take up social responsibilities (see "The End of Laissez-Faire," 1926). He approved not the free-wheeling capitalism we now have, nor something like the "commanding heights" program of the post-war Labor governments in the UK, but a system in which a critical mass of private enterprises were structurally insulated from the vagaries of the market.

It's entertaining to imagine how Keynes would have responded to each of Gordon's (and by implication Lewis') critiques of Keynes' theory. I'll take just one, the meaning of the interest rate. Keynes argued that

"It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period." (GT, chapter 13)

Capital, Keynes argued, earns a rate of return (equal to the rate of interest) not because it is productive, but because it is scarce. Thus the solution to our problems in the long-term is to lower the rate of interest and flood the world with capital. It's an interesting, provocative argument that I'm not sure I agree with, but it's ludicrous to claim that Keynes policy prescriptions are based on his having "ignored" the "fact" of the true determinants of the rate of interest.

Old school, indeed

Apparently the "Shadow Open Market Committee" is pushing for the Fed to start raising interest rates but soon. The WSJ reports:

The guys on the shadow open market committee are old school.

Rutgers University professor Michael Bordo said 0% interest rates, if continued for much longer, are going to cause a “run up in inflation expectations.” Noting history shows the Fed often ends up “exiting too late,” he said the central bank should be raising rates by summer, lest it engineer an unpleasant inflation situation.

Gregory Hess, of Claremont McKenna College, offered the most aggressive prescription.

“At this point it’s time for the Fed to make an announcement that it’s time to get out of the business” of owning mortgages, he said. The central bank needs to offer a timeline, saying the securities would be sold over the course of one to two years, as the Fed moves back to an all-Treasury balance sheet.

Meanwhile, Marvin Goodfriend, of Carnegie Mellon University’s Tepper School of Business, said the risk for the Fed right now was that market perceptions “are in flux” — Treasury yields spiked this week in a worrisome development — and officials should create the impression they will act to keep inflation under control, lest investor confidence be lost.

This is just a wee bit crazy. The spike in the 10-year note rate amounts to less than 20 basis points. Most of that is an increase in expected real interest rates. Expected inflation, as measured by the difference between yields on nominal and inflation-indexed 10-year Treasuries have risen by 5 basis points and is considerably lower than it was at the beginning of the year. The unemployment rate is still 9.7 percent, in case the SOMC has forgotten. So how about we wait a bit until we actually see a net job created before panicking about inflation?

Stagflation

Recent increases in food, energy and now steel prices have raised concerns about a burst of inflation around the world, including the US. Is this evidence that the Fed has gone too far in its efforts to generate a recovery by increasing bank reserves? In my judgment the answer is definitely, no. What's happening with input prices is clearly a relative price phenomenon: flooding in Australia and crop failures elsewhere have made food scarce (and, interestingly, the flooding has also hit the steel market), and the boom in China and other emerging economies has increased demand for energy. This requires an increase in prices of those products (and goods and services that use them intensively as inputs) relative to other products. The easiest way to accomplish this is for the Fed to allow a one-time jump in the US price level, which means several months or a couple of years of somewhat higher inflation than usual. A monetary contraction would not solve anything. The increase in food, energy and steel prices is a result of events in the economy outside the US, so slower growth in the US would have very little effect. A major contraction in the US might put downward pressure on inflation (presumably if the US economy shut down entirely that would diminish demand for food and oil), but the costs of another recession would seem to me to be far too great to pay.

There may be some regulatory changes that could provide temporary relief. First thing I would do would be to suspend or repeal requirements that gasoline require a certain amount of ethanol and eliminating ethanol subsidies. Ethanol seems to be a dead end anyway, and this would free up corn supplies for use as food.

The cruelest tax

One often hears inflation referred to as "the cruelest tax," as in this piece by Len Oppenheim:

Inflation is the cruelest tax of all because it does the most damage to the middle class, retirees, and anyone living on a fixed income possibly supplemented by hard-earned savings.

Inflation, when it occurs, is certainly a macroeconomic problem. The argument that inflation hurts the poor most of all is an effective one, and there's a chance that it's true. Inflation is a tax on money holdings (you can insulate yourself from inflation by holding your wealth in nonmoney form such as bonds, stock, or real estate, whose rate of return tends to rise along with inflation). People with low incomes are likely to hold a larger fraction of their wealth in the form of money than people with high incomes, and so it's possible that inflation is a regressive tax.

But I'm interested in the origins of this expression, "the cruelest tax." We hear it everywhere - a Google search for "inflation" and "cruelest tax" comes up with over 10,000 hits. So who came up with this gem?

Back in 1982, in his letter to Congress introducing the Economic Report of the President, Ronald Reagan trumpeted the success of his economic policies of the past year:

The most significant result was the contribution these policies made to a substantial reduction in inflation, bringing badly needed relief from inflationary pressures to every American... This moderation in the rate of price increases meant that inflation, "the cruelest tax," was taking less away from individual savings and taking less out of every working American's paycheck.

But the quotes suggest that this isn't the first time the phrase was used. Blinder and Esaki (Review of Economics and Statistics, May 1994) quote Tobin (American Economic Review, March 1972):

Facile generalizations about the progressivity or equity of inflationary transfers are hazardous; certainly inflation does not merit the cliche that it is 'the cruelest tax'.

The quotes again: where is Tobin getting the phrase? Well, I can take it back to the 1964 Republican Party platform:

In furtherance of our faith in the individual, we also pledge prudent, responsible management of the government's fiscal affairs to protect the individual against the evils of spendthrift government—protecting most of all the needy and fixed-income families against the cruelest tax, inflation—and protecting every citizen against the high taxes forced by excessive spending, in order that each individual may keep more of his earnings for his own and his family's use.

And can go no further. Incidentally, there's a long tradition in economics beginning at least from Keynes' Economic Consequences of the Peace that inflation has a progressive effect on the income distribution, because it redistributes wealth from the passive accumulators of wealth to entrepreneurs, thereby stimulating economic activity. This is most likely to be true when inflation is unanticipated in advance (because then the interest rate on bonds that the wealthy have accumulated would not have risen in advance to compensate them for the loss). In fact, Blinder and Esaki found that inflation probably has a small progressive effect on the income distribution once macroeconomic effects are accounted for. Their results were confirmed by Markus Jantti (Review of Economics and Statistics, May 1994). He concludes that

The notion that inflation is the "cruellest tax" on the disadvantaged is not supported by empirical research on the distribution of income. The present evidence indicates that unemployment, not inflation, is the crueller tax.

Next up: when did we start spelling "cruellest" with two L's instead of one?