Great Political and Economic Thinkers:
Theory and Reality
Lectures by Robert M. Coen
Emeritus Professor of Economics
Northwestern University
November 11 and 18, 2014
Web site: faculty.wcas.northwestern.edu/~rcoen
Email: rcoen@northwestern.edu
November 11
20th Century Revolution in Economic Thinking:
John Maynard Keynes
November 18
Counterrevolution to Keynes
and Critiques of Activist Economic Policies:
Hayek, Friedman, Lucas, and Others
What Were Keynes’s Revolutionary Ideas?
Old Ideas
Keynesian
Saving is good, it builds nation’s capital
Saving can be too large, depressing demand,
production, employment
Tough times call for austerity
May be true for individuals and businesses, but
nation needs more spending, not less
Recessions result from too little money supply
Recessions result from too little effective demand
Cut wages to increase employment
Wage cuts reduce incomes and spending,
worsening depression
Increase investment by cutting interest rates
Businesses unlikely to respond when they have
excess capacity and are pessimistic
Businesses might not invest enough even if
interest rates are reduced to zero
Government needs to restore confidence by
balancing its budget
Balancing budget requires cutting spending
and raising taxes, exactly wrong Rx
What Were Keynes’s Revolutionary Ideas?
Old Ideas
Keynesian
Government spending crowds out private
spending
True at full employment, not when there are
large amounts of unemployed resources
The market will eventually adjust to restore full
employment
Possibly, but in the long run we are all dead,
or a distraught public loses patience
with free-market capitalism
Stick to the gold standard to maintain confidence
in the currency
Gold standard is antiquated relic, denying
nations power to control money supply
Paper and bank money allow monetary control
Financial markets are subject to same economic
laws as other markets
Financial markets are more like casinos, subject
to waves, bubbles
Why was Keynes such an effective revolutionary leader?
Member of the cultured British elite, widely admired
Bloomsbury Group
“Art for art’s sake”
Leonard and
Virginia Woolf
Lady Ottoline Morrell
Maria Nye
Lytton Strachey
Duncan Grant
Vanessa Bell
Duncan Grant
Keynes
Why was Keynes such an effective revolutionary leader?
Member of the cultured British elite, widely admired
Leader of the academic economic establishment
Best student of the world’s leading economist, Alfred Marshall
Editor of the major international professional publication in
economics, the Economic Journal
A highly successful investor
Keynes the Investor
High margin trader in currency and commodities, largely successful
Managed King’s College, Cambridge, endowment (Chest Fund)
Made large investments in companies he understood (cf. Warren Buffett)
Why was Keynes such an effective revolutionary leader?
Member of the cultured British elite, widely admired
Leader of the academic economic establishment
Best student of the world’s leading economist, Alfred Marshall
Editor of the major international professional publication in
economics, the Economic Journal
A highly successful investor
Eloquent writer/expositor/debater
Man of affairs: Active in government service and as policy critic
Analyses of current problems on the mark
Foresaw that Treaty of Versailles was a disaster
Predicted UK return to gold in 1924 would abort economic recovery
Saw that government austerity would worsen depression
Wanted to preserve capitalism, not destroy it
Triumph of Keynesianism
Massive debt-financed spending in World War II restores full employment
Alvin Hansen introduces Keynesian at Harvard in late 1930’s
Congress passes Employment Act of 1946
In 1948, Paul Samuelson (Nobel Prize, 1970), one of Hansen’s students,
publishes first intro text incorporating Keynesian ideas, a best seller
Jan Tinbergen (Nobel Prize, 1969), Lawrence Klein (Nobel Prize, 1980), build
first Keynesian-oriented macro-econometric models
In 1963, President Kennedy proposes large income tax cuts to promote recovery
In 1971, President Nixon takes US completely off gold standard, floats dollar
(depreciates), declares, “I am now a Keynesian in economics.”
Time magazine, Dec. 31, 1965
From Time cover story, Dec. 31, 1965
Today, some 20 years after his death,
[Keynes’s] theories are a prime influence
on the world's free economies, especially
on America's … In Washington the men
who formulate the nation's economic
policies have used Keynesian principles
not only to avoid the violent cycles of
prewar days but to produce a phenomenal
economic growth and to achieve
remarkably stable prices. In 1965 they
skillfully applied Keynes's ideas … to lift
the nation through the fifth, and best,
consecutive year of the most sizable,
prolonged and widely distributed prosperity
in history.
Frederick Hayek, 1899-1992
Austrian
London School of Economics, 1931-50
Became British citizen in 1938
University of Chicago, 1950-62
University of Freiburg, 1962-68
University of Salzburg, 1968-retirement
Nobel Prize, 1974
The Road to Serfdom, 1944
The Road to Serfdom, 1944
Warns of attraction of socialist economic planning
Economic life too complicated for planning to work
Market data needed for good decisions
Planners will not take risks
Planning failures lead to extended control
Planning a slippery slope into authoritarianism, end of liberty
Keynes praised the book! “In my opinion it is a grand book … morally
and philosophically. I find myself in agreement with virtually the whole
of it … in deeply moved agreement.”
Milton Friedman, 1912-2006
Born New York City
Rutgers BA, Columbia PhD
Taught at UChicago until 1977 retirement
President, American Economic Association, 1967
Nobel Prize, 1976
A Theory of the Consumption Function, 1957
Capitalism and Freedom, 1962
Monetary History of the U.S., 1867-1960, 1963
(with Anna Schwartz)
Reviver of “Monetarism”
Friedman’s Challenges to Keynesian Macroeconomics
A Theory of the Consumption Function, 1957
Keynes:
Consumer spending depends on current income
“Multiplier effects” are large
Temporary tax cuts have substantial impact
Friedman: Consumer spending depends on “permanent income”
“Multiplier effects” are small
Tax cuts effective only if they are permanent
Monetary History of the U.S., 1867-1960
Keynes:
Great Depression caused by collapse of investment
Monetary policy ineffective in depression; need fiscal stimulus
Fiscal and monetary policy together can moderate cycles
Friedman: Great Depression caused by excessive money growth
Cycles can be smoothed by stabilizing money growth
Put Fed on “automatic pilot” – no discretion
Fiscal stimulus ineffective, crowds out private spending,
except when financed by printing money
But allow automatic fiscal stabilizers to operate
Time magazine, Dec. 19, 1969
Friedman’s Presidential Address
American Economics Association, 1967
Conventional view: Trade-off between inflation and unemployment
Lower unemployment → strengthens bargaining power of labor
→ higher wages → higher prices
Supporting evidence: The Phillips Curve
Friedman: Wage demands also depend on expected inflation
Lower unemployment → strengthens bargaining power of labor
→ higher wages → higher prices
→ higher wages to compensate for higher prices → higher prices
and on and on
Lower unemployment leads to accelerating inflation!
No stable trade-off (prescient)
Stable long-run inflation only at “natural rate of unemployment”
Employment policy should seek to reduce the “natural rate”
Phillips Curve: Inflation-Unemployment Tradeoff, 1960-69
10
Inflation Rate (percent)
8
6
1969
1968
4
1966
1967
1962
1965
2
1964
1961
1960
1963
0
2
3
4
5
6
7
Unemployment Rate (percent)
8
9
Friedman’s Presidential Address
American Economics Association, 1967
Conventional view: Trade-off between inflation and unemployment
Lower unemployment → strengthens bargaining power of labor
→ higher wages → higher prices
Supporting evidence: The Phillips Curve
Friedman: Wage demands also depend on expected inflation
Lower unemployment → strengthens bargaining power of labor
→ higher wages → higher prices
→ higher wages to compensate for higher prices → higher prices
and on and on
Lower unemployment leads to accelerating inflation!
No stable trade-off (prescient)
Stable long-run inflation only at “natural rate of unemployment”
Employment policy should seek to reduce the “natural rate”
Phillips Curve: Inflation-Unemployment Tradeoff ???, 1960-75
10
1975
1974
Inflation Rate (percent)
8
1973
6
1971
1970
1972
4
2
0
2
3
4
5
6
7
Unemployment Rate (percent)
8
9
Robert E. Lucas, Jr., 1937-
University of Chicago BA and PhD
Carnegie Mellon, 1963-74
University of Chicago, 1974Nobel Prize, 1995
Studies in Business-Cycle Theory, 1981
Extends rational behavior to include
expectations
Lucas’s Challenge to Keynesian Macroeconomics
Keynes:
Adaptive expectations – extrapolations from past experience
Statistical models give accurate measures of consumer
responses to change in incomes, interest rates, inflation
Example: To reduce inflation, must reduce inflation expectations
How? Increase unemployment
Lucas:
Rational expectations – forward-looking
Consumers hold beliefs about monetary and fiscal policies
Plan their current and future actions accordingly
Statistical models unreliable guides to impacts of policy
Example: To reduce inflation, must reduce inflation expectations
How? Credible monetary authority announces slower growth of
money supply
Edward C. Prescott, 1940-
Swarthmore BA, Carnegie Mellon PhD
Pennsylvania, 1967-71
Carnegie Mellon, 1971-80
Minnesota, 1980-2003
Arizona State, 2003Nobel Prize, 2004
Supply-side economics
“Real Business Cycle” theory
Cycles due to shocks to technology and wages
Labor supply very sensitive to wages
Supply-Side Challenge to Keynesian Economics
Keynes:
Business fluctuations caused by fluctuations in aggregate demand
Tax cuts, government spending can increase aggregate demand
Tax cuts, government spending increase budget deficits
Supply-siders:
Business fluctuations principally due to fluctuations in aggregate supply
Aggregate supply depends on labor supply and productivity per worker
Great Depression caused by declines in labor supply and productivity
“Real” as opposed to “Monetary” causes
Tax cuts increase aggregate supply (incentives to work and invest)
Reducing tax rates can increase tax revenue and reduce deficits
Other prominent supply-siders, influential in 1970s-1980s:
Paul Craig Roberts, Norman Ture, Arthur Laffer
Dale T. Mortensen, 1939-2014
Willamette BA, Carnegie Mellon
PhD
Northwestern, 1965-2013
Nobel Prize, 2010
Search theory of markets
Search Theory and Unemployment
Keynes:
Unemployment is an involuntary, disequilibrium state
Unemployed are willing to work at existing wage, but can’t find jobs
Search Theory:
Buyers and sellers must find one another
Workers: When to accept a current offer vs. continue looking
Employer: When to make an offer vs. waiting for more applicants
Frictional unemployment to be expected
Unemployment voluntary, an equilibrium state
Theory can explain duration of unemployment
Keynesian Revival After 2008 Crisis
Misbehaving financial markets central feature – reminder of Keynes’s view
Collapse of investment and slow recovery of investment
Monetary policy successful in reducing short-term interest rates, less so long-term
Government stimulus (pump priming) worked in US
Did not ignite inflation
Deficits and debt increased initially, but receding
Fiscal austerity retards European recovery
But neoclassical view also supported
Monetary ease, low interest rates prior to 2008 created housing bubble
Monetary policy played vital role in shoring up financial institutions
Gross Private Domestic Investment, 2007Q1-2014Q3
2,800
Billions of 2009 dollars
2,600
2,400
2,200
2,000
1,800
1,600
2007
2008
2009
2010
Year
Source: BEA
2011
2012
2013
2014
Interest Rates on Government Securities, 2007M1-2014M10
6
5
Percent
4
3
2
1
0
2007
2008
2009
2010
2011
Year
1-Year
Source: Federal Reserve
30-Year
2012
2013
2014
Government Purchases of Goods and Services, 2007Q1-2014Q3
3,150
Billions of 2009 dollars
3,100
3,050
3,000
2,950
2,900
2,850
2007
2008
2009
2010
Year
Source: BEA
2011
2012
2013
2014
Reflections
Monetary and fiscal policies are powerful, potentially effective tools to achieve
stability
Hayek correct that complexity of economy makes it difficult to set policy correctly
Even if policy could be set correctly, will it be? Will government leaders not use
tools to further their own power and reelection?
Complexity or politicians’ self-interest leads to misuse – greater instability!
Today’s conservatives would limit discretion by imposing rules:
Balance (small) budget
Set money growth on automatic pilot
Is large government not inescapable for national security?
Without improved quality of government, market capitalism not likely to survive
END