The Keynes That Can Be Diagrammed

is not the true Keynes...

When I teach the IS-LM / AS-AD apparatus to my intermediate macro students, I preface it with the caveat that some believe that the "textbook" Keynesian model is not a correct representation of the General Theory. Roger E.A. Farmer is among them. He writes:

In the FT’s Economists’ Forum, Benn Steil wrote a stimulating piece in which he argued that Keynes was wrong. His argument is that interpretations of Keynesian economics are all based on the assumption that wages and prices are sticky. But wages and prices are not sticky. Ergo - Keynes was wrong. Mr. Steil and I are in complete agreement that the Keynesians, interpreted in this way are, to use a technical term, out to lunch. But that does not imply that Keynes was wrong. At least not entirely wrong. Far from it.

My emeritus colleague, Axel Leijonhufvud, made a distinction in his 1966 book, on Keynesian Economics and the Economics of Keynes, between Keynes and the Keynesians. He meant that orthodox Keynesian interpretations of the General Theory, that began with influential papers by John Hicks in England and Alvin Hansen in the US, got it all wrong.

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment.

He was right on all three counts. But he was wrong about something else. Keynes thought that consumption depends on income. Two decades of research on the consumption function, following world war two, led to a different conclusion. Consumption, and this is two thirds of the economy, depends not on income but on wealth. This is no small matter: the theory of the multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point.

Whether the "Keynesians" got Keynes right and whether Keynes was right are separable issues. On the former, I am a little more sympathetic to the textbook version - it seems to me a correct, but highly incomplete, representation of what Keynes said in the General Theory. On the latter point, Farmer goes on to argue that because (in his view) consumption is dependent on wealth, not income, fiscal policies intended to raise demand through an increase in disposable income will not be effective. Instead, policy needs to focus on asset prices:

Where does this leave us? Keynes was right about three key points. 1) High unemployment can persist forever because the market is not self-correcting. 2) Confidence matters. 3) Government can and should intervene to fix things. But the orthodox Keynesians are wrong: fiscal policy cannot provide a permanent fix to the problem of high unemployment. We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention.

Offhand, it seems to me that using monetary policy to prop up the stock market is not so radically different from increasing "M" in the textbook model. The transmission mechanism is different: Farmer would have the central bank buy stocks, instead of bonds, as it does in conventional open market operations (or instead of dropping money from helicopters, or burying it in bottles...), but the end result would still be an increase in nominal demand.

I suspect I may be missing something - Farmer had limited space to make his argument and the "textbook" Keynesian framework is pretty engrained in my thinking, so it is hard for me to think of these issues outside of it. I'll look forward to the longer version in his forthcoming books.