Monday, October 19, 2009

Posner: How I became a Keynesian

Somehow I missed this! Thanks to a reader for pointing it out to me.

Posner was as captured by Chicago School nonsense as anyone else, but at least we learn that he can perform a Bayesian update (i.e., learn from reality) -- posteriors need not be wholly determined by priors :-)

Strangely, I don't see any discussion of this article on the Becker-Posner blog. How do Gary Becker and Robert Lucas feel about the recent apostasy of their colleague?

How I Became a Keynesian, by Richard Posner

... I had never thought to read The General Theory of Employment, Interest, and Money, despite my interest in economics.

... We have learned since September that the present generation of economists has not figured out how the economy works. The vast majority of them were blindsided by the housing bubble and the ensuing banking crisis; and misjudged the gravity of the economic downturn that resulted; and were perplexed by the inability of orthodox monetary policy administered by the Federal Reserve to prevent such a steep downturn; and could not agree on what, if anything, the government should do to halt it and put the economy on the road to recovery. By now a majority of economists are in general agreement with the Obama administration's exceedingly Keynesian strategy for digging the economy out of its deep hole.

... The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

... It is an especially difficult read for present-day academic economists, because it is based on a conception of economics remote from theirs. This is what made the book seem "outdated" to Mankiw--and has made it, indeed, a largely unread classic. (Another very distinguished macroeconomist, Robert Lucas, writing a few years after Mankiw, dismissed The General Theory as "an ideological event.") The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

The General Theory is full of interesting psychological observations--the word "psychological" is ubiquitous--as when Keynes notes that "during a boom the popular estimation of [risk] is apt to become unusually and imprudently low," while during a bust the "animal spirits" of entrepreneurs droop. He uses such insights without trying to fit them into a model of rational decision-making.

An eclectic approach to economic behavior came naturally to Keynes, because he was not an academic economist in the modern sense. He had no degree in economics, and wrote extensively in other fields (such as probability theory--on which he wrote a treatise that does not mention economics). He combined a fellowship at Cambridge with extensive government service as an adviser and high-level civil servant, and was an active speculator, polemicist, and journalist. He lived in the company of writers and was an ardent balletomane.

... The third claim that I am calling foundational for Keynes's theory--that the business environment is marked by uncertainty in the sense of risk that cannot be calculated--now enters the picture. Savers do not direct how their savings will be used by entrepreneurs; entrepreneurs do, guided by the hope of making profits. But when an investment project will take years to complete before it begins to generate a profit, its prospects for success will be shadowed by all sorts of unpredictable contingencies, having to do with costs, consumer preferences, actions by competitors, government policy, and economic conditions generally. Skidelsky puts this well in his new book: "An unmanaged capitalist economy is inherently unstable. Neither profit expectations nor the rate of interest are solidly anchored in the underlying forces of productivity and thrift. They are driven by uncertain and fluctuating expectations about the future." Only what Keynes called "animal spirits," or the "urge to action," will persuade businessmen to embark on such a sea of uncertainty. "If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation."

But however high-spirited a businessman may be, often the uncertainty of the business environment will make him reluctant to invest. His reluctance will be all the greater if savers are hesitant to part with their money because of their own uncertainties about future interest rates, default risks, and possible emergency needs for cash to pay off debts or to meet unexpected expenses. The greater the propensity to hoard, the higher the interest rate that a businessman will have to pay for the capital that he requires for investment. And since interest expense is greater the longer a loan is outstanding, a high interest rate will have an especially dampening effect on projects that, being intended to meet consumption needs beyond the immediate future, take a long time to complete.

... An ambitious public-works program can be a confidence builder. It shows that government means (to help) business. "The return of confidence," Keynes explains, "is the aspect of the slump which bankers and businessmen have been right in emphasizing, and which the economists who have put their faith in a ‘purely monetary' remedy have underestimated." In a possible gesture toward Roosevelt's first inaugural ("we have nothing to fear but fear itself"), Keynes remarks upon "the uncontrollable and disobedient psychology of the business world."

See also my talk (for physicists) on the financial crisis. Some related posts on Keynes. Even more on Keynes (12th Wrangler) here.

3 comments:

anon said...

What does "truncated and informal" mean really?

Given limited understanding and information rational choices and irrational choices can be indistinguishable.

Ultimately Posner, like most lawyers, thinks there is a real, operational distinction where in fact there are only words.

David said...

On a side note, I had to occasion to visit the Supreme Court's opinion in Gonzales v. Raich yesterday. I love [no, hate] this quote from in [apparently] technologically naive bench:

In assessing the scope of Congress’ Commerce Clause authority, the Court need not determine whether respondents’ activities, taken in the aggregate, substantially affect interstate commerce in fact, but only whether a “rational basis” exists for so concluding.

Makes me wonder who is left to define 'rational'. Lawyers [ptooey].

DaveinHackensack said...

Steve,

See Bruce Bartlett's recent thoughts on Keynes. Bartlett seems to have remained more grounded during the current crisis than Posner. Here's an excerpt:

"As I thought about the cycle that SSE had gone through from a response to the failure of Keynesian economics in the 1970s to triumph in the 1980s to caricature in the 2000s, it occurred to me that SSE and Keynesian economics had a lot in common. Each had been developed in response to serious economic problems that the existing orthodoxy was incapable of dealing with, both struggled for acceptance but were ultimately implemented to great success, both were then misapplied in inappropriate circumstances, thus leading to them becoming discredited.

So basically the book is about the rise and fall of Keynesian economics followed by the rise and fall of SSE. Although the Keynesian part of the book was originally intended to flesh out my model of the rise and fall of economic theories, it turned out to have very valuable lessons for today. Indeed, the circle appears to have come around to where Keynesian theories are now the best ones we have for dealing with today's economic crisis.

One thing I did in the Keynesian section that helped me a lot in my thinking was to largely ignore John Maynard Keynes' technical writings. What was much more useful in understanding his thinking were his popular writings. For example, Keynes had what today we would call an op-ed article in the New York Times on New Year's Eve 1933 that may be the single best thing written during the Great Depression on its cause and what to do about it. It's certainly more accessible than The General Theory of Employment, Interest and Money, much of which is incomprehensible even today.

The General Theory, I think, was really just Keynes' way of making some relatively simple ideas look scientific in order to make them more acceptable to policymakers."

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