Rules-based Keynesian Policy?

John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The Economist.  He writes:

In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view. 

"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects.  This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences.  In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model.  In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy.  The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version.  Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others).   His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion."  He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view.  Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules. 

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy.  Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian."  Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian."  I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy.  The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us.  In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks.  It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate).   To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place. 

Practical Lessons in Keynesian Economic Policy

Ezra Klein writes:

Keynes — and others who later elaborated on his work, like Hyman Minsky — taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.

In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.

The first problem was conceptual. What Keynes told us to do simply feels wrong to people. “The central irony of financial crises is that they’re caused by too much borrowing, too much confidence and too much spending, and they’re solved by more confidence, more borrowing and more spending,” Summers says.

The second problem was practical. “What I didn’t appreciate was the extent to which we only got one shot on stimulus,” Romer says. “In my mind, we got $800 billion, and surely, if the recession turned out to be worse than we were predicting, we could go back and ask for more. What I failed to anticipate was that in the scenario that we found we needed more, people would be saying that what was happening showed that stimulus, in general, didn’t work.”

Many of us economists believe Keynesian policies have been successful, and that more would have been better, but politics doesn't judge outcomes relative to a counter-factual scenario.  That is, the argument that things would have been far worse in the absence of a policy isn't a winner, even if it is correct.  Unfortunately, that means future policy makers are likely to draw exactly the wrong lessons, and do even worse next time (at least on the fiscal side; central bank independence gives monetary policy some space to follow academic rather than political views).

Furthermore, as Paul Krugman explains, the economics profession (or at least some parts of it) isn't playing an entirely helpful role.

Cavallo on Greece

Some have likened Greece's situation today to Argentina's in 2001, when, after repeated austerity "cures" failed, it ultimately was forced off its peg to the dollar and suffered a severe crisis, but a floating currency ultimately facilitated a recovery.   In a Vox column, former Argentine finance minister Domingo Cavallo offers some reflections on Argentina's experience and what it suggests for Greece.  Unfortunately for them, he says "Greece’s crisis is much more difficult to manage than the 2001 Argentinean crisis." (Yikes!!).   He offers some suggestions on how the debt restructuring should be done (and I think everyone who isn't a European government official sees that it needs to be done), but doesn't think Greece should leave the Euro.

June Employment: Bad Economy!

A really bad employment report - according to the BLS, the economy only gained 18,000 jobs in June and the unemployment rate ticked up to 9.2% (from 9.1%).

The government continues to be a drag - private sector payrolls increased by 57,000, but government employment shrank by 39,000.  The employment numbers are calculated from a survey of businesses; the numbers from the BLS' survey of households (from which the unemployment rate is calculated) are even worse - the number of employed persons dropped by 445,000 and labor force participation decreased to 64.1%.

On a non-seasonally adjusted basis, the unemployment rate rose from 8.7% to 9.3% because of a large increase in the labor force (1.089 million, presumably due to the end of the school year) outstripped a small increase in employment (101,000).  Non-seasonally adjusted payrolls rose by 376,000.  The comparison between seasonally-adjusted and unadjusted numbers shows that June is a month that normally sees a big increase in labor force participation and employment, and this June's increase in employment is disappointing compared to what we would expect for this part of the year (and what is needed to keep pace with changes in the labor force).

The discussion in Washington seems increasingly detached from reality...

See also: Tim Duy, Menzie Chinn, Calculated Risk, Greg Ip.

Orzag for State-Contingent Stimulus

In a column for Bloomberg, former CBO chief and White House budget director Peter Orszag writes:

...[P]olicy makers should provide additional macroeconomic support in 2012 by extending the existing payroll tax holiday. But more than that, Congress should link the payroll tax to the unemployment rate. This would allow the tax holiday to automatically calibrate itself to existing conditions, providing support only when the economy is weak. If necessary, the underlying payroll tax rate could be raised to make this mechanism budget-neutral. 

As I said back in April, one of the main lessons I've drawn from recent experience is that the recovery act would have been much better if the support for the economy had been made state-contingent like this.  This is a way of overcoming two problems: (i) uncertainty about the speed of recovery (or lack thereof) and (ii) the political system's utter inability to deal with timing issues (nicely explained in Orszag's piece), as evidenced by the absurdity that it appears that we are heading for significant fiscal tightening even as nearly 14 million people remain unemployed.

Krugman on Keynes

Vox has published Paul Krugman's speech at a conference commemorating the 75th anniversary of The General Theory.  The speech brings together a number of themes Krugman has addressed at his blog.  Among other things, Krugman says:

The brand of economics I use in my daily work – the brand that I still consider by far the most reasonable approach out there – was largely established by Paul Samuelson back in 1948, when he published the first edition of his classic textbook. It’s an approach that combines the grand tradition of microeconomics, with its emphasis on how the invisible hand leads to generally desirable outcomes, with Keynesian macroeconomics, which emphasises the way the economy can develop what Keynes called “magneto trouble”, requiring policy intervention. In the Samuelsonian synthesis, one must count on the government to ensure more or less full employment; only once that can be taken as given do the usual virtues of free markets come to the fore.

It’s a deeply reasonable approach – but it’s also intellectually unstable. For it requires some strategic inconsistency in how you think about the economy. When you’re doing micro, you assume rational individuals and rapidly clearing markets; when you’re doing macro, frictions and ad hoc behavioural assumptions are essential.

So what? Inconsistency in the pursuit of useful guidance is no vice. The map is not the territory, and it’s OK to use different kinds of maps depending on what you’re trying to accomplish. If you’re driving, a road map suffices. If you’re going hiking, you really need a topographic survey.

But economists were bound to push at the dividing line between micro and macro – which in practice has meant trying to make macro more like micro, basing more and more of it on optimisation and market-clearing. And if the attempts to provide “microfoundations” fell short? Well, given human propensities, plus the law of diminishing disciples, it was probably inevitable that a substantial part of the economics profession would simply assume away the realities of the business cycle, because they didn’t fit the models.

The result was what I’ve called the Dark Age of macroeconomics, in which large numbers of economists literally knew nothing of the hard-won insights of the 30s and 40s – and, of course, went into spasms of rage when their ignorance was pointed out.

I share Krugman's view that the "textbook" Keynesian apparatus remains a useful apparatus for thinking about the economy.  However, I think his portrayal of the turn macroeconomics has taken over the past forty or so years is a bit unfair.  As Krugman notes, contemporary macroeconomic models are grounded in microeconomic optimization.  Although a foolish desire for consistency can be the hobgoblin of our little economist minds, there is more to the story - the shift in methodology was also motivated by real deficiencies in the Keynesian framework identified by Friedman and Lucas, as well as the "stagflation" of the 1970's, which appeared to contradict Keynesian theory.

Toles on Austerity

I've been thinking I should say something about the contradiction between Washington's new obsession with budget cutting and the still-struggling economy, but this cartoon from Tom Toles nails it better than anything I could have said:

May Employment: Where are the Flowers

looks like no "green shoots" this spring....

The May employment situation report from the BLS confirms the impression from other bits of data (see Gavyn Davies and David Leonhardt from last week) that the already sluggish recovery is wobbling.  Payroll employment (from the BLS survey of firms) rose by 54,000, which is quite a bit less than the 130,000 or so needed to keep unemployment steady as the labor force grows and productivity increases.  The unemployment rate (from the survey of households), ticked up to 9.1% (from 9% in April). 

 The underlying numbers in the household survey (which gets second billing because it has a smaller sample) are slightly less unpleasant.  The number of people employed increased by 105,000, while the number of unemployed increased by 167,000.  This partly reflects re-entry into the labor force, 105,000 fewer people reported not being in the labor force, and the labor force participation rate ticked up from 64.15 to 64.22.

Mark Thoma has collected links to commentary on the report from around the econo-blogosphere.

Antidumping in Action

Today's Washington Post provides another example of our dysfunctional "Antidumping" rules in action.  This case is about antidumping tariffs imposed on furniture imports from China:

But do tariffs work? In the case of bedroom furniture, they’ve clearly helped slow China’s export machine. In 2004, before tariffs went into force, China exported $1.2 billion worth of beds and such to the United States. The figure last year was just $691 million.

Over the same period, however, imports of the same goods from Vietnam — where wages and other costs are even lower than in China — have surged, rising from $151 million to $931 million. The loss of jobs in America, meanwhile, only accelerated. 

This may be a case where the differential tariff treatment between Chinese and Vietnamese furniture which resulted from the antidumping case induced "trade diversion" - i.e., an efficiency loss because the trade preferences result in imports coming from someplace other than the low cost producer.  However, in this example, it could also be the case that comparative advantage shifted to Vietnam as China's labor costs have risen. 

Furthermore:

The only Americans getting more work as a result of the tariffs are Washington lawyers, who have been hired by both U.S. and Chinese companies. Their work includes haggling each year over private “settlement” payments that Chinese manufacturers denounce as a “protection racket.”

Fearful of having their tariff rates jacked up, many Chinese furniture makers pay cash to their American competitors, who have the right to ask the Commerce Department to review the duties of individual companies. Those who cough up get dropped from the review list.

It is clear from the article that workers in the US industry have suffered from a disruptive wave of furniture imports.  While it may indeed be the case that the US no longer has a comparative advantage in furniture production, standard comparative static trade theory fails to account for the adjustment costs associated with reallocating resources.  That is, trade theory assumes full employment and that workers will be shifted to another sector, ignoring the fact that this process involves losing their jobs in one industry and, usually, a period of unemployment before finding a job in another.

Although it is also less than perfect, a more appropriate remedy in this case would be the application of "safeguard tariffs" which the President can impose (following the recommendation of the International Trade Commission) in cases where industries are disrupted by import surges.  Relative to antidumping tariffs, safeguards have the advantages of being (i) time limited, (ii) at the discretion of the president (who presumably can consider the interest of the nation as a whole, rather than just an affected industry or region), and (iii) not requiring any allegation of "unfair" trade practices on the part of the exporters (which are usually somewhat bogus).

Resetting European Bonds

When I saw this headline on the Washington Post's website

I thought the president was going over there to work out a debt restructuring, but that's not the kind of bonds they mean.

It would be kind of weird if a US president to be directly involved in a European sovereign debt crisis (though it has global repercussions so the US is not disinterested), but Europe sure seems in need of some kind of intervention.  It is easy to understand why politicians prefer to hope they can get through the next election before things blow up rather than confronting a debt crisis.  Unfortunately the two institutions best placed to push Europe's politicians into a restructuring of Greek (and maybe Irish) debt that everyone knows is necessary - the ECB and IMF - are not being helpful, according to Steven Pearlstein:

At the time of his arrest, Strauss-Kahn was headed to a meeting with German Chancellor Angela Merkel, reportedly to talk her out of a debt restructuring plan for Greece. The official IMF view, like that of the European Central Bank, is that allowing any euro-zone country to restructure its debt will trigger another global financial crisis as investors rush to indiscriminately dump all their European bonds, forcing European banks, which hold large piles of them, into insolvency. In this scary scenario, a debt default or restructuring in any euro-zone country would cause the collapse of the euro. 

Pearlstein goes on to explain why this logic is flawed.  Indeed, Kash Mansouri argues that the ECB is, in effect, pushing Greece out of the Euro (though he seems to interpret this as an unintended consequence...).

Its not really President Obama's job to tell Europe how to sort out their debt problems - indeed, he's got his hands full with a Congress that seems to want to set off a much bigger crisis by not raising the debt ceiling - but hopefully he can give them a friendly nudge in the right direction while he's over there.  And the US should be using its influence over the IMF to get them to play a more constructive role.