In a recent WSJ opinion piece, Jeffrey Liebman, a professor of public policy at Harvard’s Kennedy School of Government, articulated the current establishment understanding of the economic situation and the policies needed to deal with it. It is unabashed, one might say, simplistic, Keynesianism. Yet it represents a large and powerful consensus position. All the bad things that have happened to the economy are the spontaneous result of malfunctions in the market system – a system that has been insufficiently regulated and supported. The President proposed a reasonable and necessary jobs program and the Congress blocked it. Sensible people, Republicans and Democrats, know in their hearts this is true and need to get behind the president and support his spending-stimulus programs. (This is a very liberal interpretation – you can read the original for details).
The interesting thing for me is not so much the extent of the buy-in to this nonsense, as it is how they get there. I have always maintained that there is a sophisticated Keynesian story to be told, but it doesn’t get you Keynesian policy prescriptions unless you make some very unreasonable assumptions.
The essential element on which this turns is behavior in disequilibrium. There is no good theory of this. Yet all real behavior occurs in disequilibrium, in a situation in which different people have different expectations (including expectations about what things are worth), a situation in which their actions are bound to be inconsistent. Errors are inevitable. Do they on balance tend to get eliminated by feedback in the form of price (and other) signals? What does “tend to get eliminated” even mean? What does this mean for the employment of resources?
To be more specifically Keynesian, imagine a situation in which, because of irrational exuberance, there is overinvestment in some sector that goes bad. The result is a precipitous fall in consumer spending as people reassess their wealth situations – revalue their assets and their net worth. There is contagion. The decline in spending precipitates quantity adjustments. Instead of prices falling rapidly to counteract the decline in spending (which would mean people made swift decisions to reduce prices), producers cut back on production and employment and so it goes. As John Hicks put it, this is a fix-price rather than a flex-price world.
I have no doubt that there are elements of truth in this. The world is neither completely fix-price nor flex-price, but is a bit of both, and sometimes more of one than the other depending on the circumstances. So what? So, what does this mean for economic stability? Does it mean that the market system is, therefore, habitually unstable, poised on a cliff’s edge in danger of being tipped over by the barest of bad speculative bubbles? Or is it rather a robust system, embedded in a set of multiple complex institutional networks that can deal with, and profit from, the inevitable errors that are made? Theoretical models can be created to support both stories, and, therefore, the matter is at bottom not a theoretical (logical) one. It is fundamentally empirical. I believe that we “know” from experience that the market system is robust and stable. But if people behaved differently, more erratically and if institutions did not provide the anchors that they do, the market system would be more unstable than it is. So what, again?
That the market economy is inherently prone to cyclical swings is, at best, a necessary condition for policy-intervention to stabilize it. It is not sufficient, not nearly. For sufficiency one needs to show that somehow macroeconomic policy-makers know enough to mitigate the cycles, rather than exacerbating them; and further that they can be trusted to do so. That is to say, pretty much all of the Keynesian policy prescriptions fail to come to grips with the familiar knowledge and incentive problems – with the central ideas of modern Austrian and Public Choice approaches. While the Post-Keynesians and Austrians may share the conviction that economic agents face unavoidable uncertainty, the latter see no reason to exempt policy-makers from that uncertainty. Why should policy-makers know any more about the future than the agents in the field? And why should we trust them to want to mitigate the cycle, rather than exacerbate it to their advantage?