Why Keynes wouldn’t have too rosy a view of our economic future

September 7, 2013

The economy is currently sick, as yet another month of weak job growth shows. But is it sick in a "walk it off" kind of way, where, even though it looks like a commercial for flu medication, it’ll eventually get better on its own, or is it sick in a pneumonia kind of way and will just permanently stay that way?

The technical term for this sickness is the output gap, or the gap between what we could be producing and what we are producing. It’s been remarkably constant through the "recovery." As Neil Irwin wrote earlier this year, professional projections from the Federal Reserve have argued for several years now that a recovery -- in which the economy closes this output gap and job growth soars -- is just around the corner. And as of this year, they’re still insisting a turnaround is imminent. Once again they are saying that economy is weak right now, but it’ll close the gap in a year or two.

But what if the gap never closes? What if it could stay on this parallel track forever? The answer matters. It matters for how, or whether, the Great Recession will end. Thus it matters for government policy. But it also matters because this question has historically been one of the most contentious in economic theory. It is what separates John Maynard Keynes from his predecessors, and it is what separates "Old Keynesians" from "New Keynesians."

Let’s start with the latter group, which is dominant in the academy. According to New Keynesians, everyone knows their lifetime income and what the economy will look like across the future. As such, they pick a path for their spending. A recession is when some failure (often called a "friction" or "imperfection") prevents people from taking that path. However, since this problem causes less spending now, it must cause more spending later. So efforts to pull that future spending toward the present can make everyone better off.

These economists are particularly certain that the economy must recover to its potential, given enough time. As Dave Altig, executive vice president and research director of the Atlanta Fed, argued, "Forecasters, no matter where they think that potential GDP line might be, all believe actual GDP will eventually move back to it …given an output gap — forecasts will include a bounce back in GDP growth above its long-run average, at least for a while. That's just the way it works."

That is not what Keynes thought. To understand how Old Keynesians would view this, it might be worthwhile to look at what they said at the beginning and the end of their reign over the economic establishment. Let’s start at the beginning, with Keynes’s 1935 essay in The New Republic, "A Self-Adjusting Economic System."(also here).

In it, Keynes distinguishes between two camps of economists. The first were those who thought the economy must eventually return to full employment on its own following a recession. They were "those who believed that the existing economic system is in the long run self-adjusting, though with creaks and groans and jerks, and interrupted by time-lags, outside inference and mistakes," he wrote. Although there are frictions, this camp argued, they will eventually be overcome by the economy.

The "other side of the gulf," where Keynes placed himself, "rejected the idea that the existing economic system is, in any significant sense, self-adjusting." He acknowledges, in 1935, before he has written the General Theory, that believing this places him among an "isolated group of cranks."

Harvard economist Stephen Marglin defines this as the crucial difference between Keynes and both what came before him and what exists now. "Keynes himself thought that there was no automatic tendency towards full employment. Even with flexible prices and wages, even if competition reigned, the economy could get stuck. High unemployment can last for an indefinite period of time." The labor force would then do the adjusting, with people simply giving up looking for work.


Harvard professor Greg Mankiw (left) and UC - Berkeley's Christina Romer (right), both former Council of Economic Advisers chairs, are among the more prominent New Keynesians. (Dominick Reuter for MIT)

You can see this debate when we jump forward to watch the surrender of the Old Keynesians to the forces of the New. In a 1992 symposium talk titled "Price Flexibility and Output Stability: An Old Keynesian View" the Nobel laureate James Tobin addressed several recent New Keynesian papers that were declaring victory over the old order. (Tobin’s speech reads like the final defense of someone who has just been convicted of a war crime by a group who ran a coup d'etat.)

Tobin wanted it to be clear that the Old Keynesians he represented thought the "economy’s natural market adjustments in restoring full employment …were weak, possibly non-existent or perverse, and needed help from government policy." Interestingly, Tobin argues that those who think the interest rates can simply take care of monetary policy shouldn’t get too cocky, because "the zero floor on nominal interest rates is still there."

So why might an economy get stuck? As Roosevelt University economist J.W. Mason notes, "in the old Keynesian vision people can’t know the future, so they go by the present." As such, there’s a relationship between current income and current expenditures. Instead of frictions holding us back, we’ve just settled at a lower rate of economic activity given our resources. "If you think, like Keynes did, that aggregate spending mainly depends on current income, there is no puzzle. Consumption is just as high relative to disposable income as it was before the recession."

This divide can help explain the boldness of more conservative, non-Keynesian economists who argue that we are just permanently poorer, or that President Obama’s policies are responsible for the country’s problems. Because if you see the economy as a person who knows his or her entire future, and you play down frictions but still observe that people are spending less, it must be because the economic downturn and government policies just made them permanently poorer.

It also explains the crucial concept of hysteresis — the idea that short-run recessions can lead to long-run damage to the economy — which is an area where the Old and New Keynesian overlap. As University of Massachusetts at Amherst economist Peter Skott argues, "after a period of high unemployment, you’ll have workers leave the market and firms reduce their investment. So the output gap will collapse because we can produce less, and it will become that much harder to break out of our current cycle." Some New Keynesians have also flagged the hysteresis issue as well.

This is important to understand in light of the declining percentage of people involved in the labor force. Friday’s job numbers showed yet another drop in the labor force participation rate. Many people keep asking what the normal rate of participation should be. But hysteresis crucially implies that there is no "natural" labor force participation rate -- it depends on the historical evolution of unemployment.

Now, there may be little to explain. We’ve been through European chaos, austerity in state and local government spending, a close call with defaulting on our debt, federal austerity in tax hikes and spending cuts, and more upcoming GOP threats, all while monetary policy has tried to gain traction at the zero lower bound. For every step forward there’s been a step back, which could explain the economy’s slowness in returning to full employment.

But while that analysis tells us it will eventually recover, another perspective suggests this is just hope. A renewed focus on unemployment and actual, sustained expansionary policies wouldn’t just help -- it may also be necessary.

Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.

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