Lucas, Keynes, Animal Spirits, Co-ordination and the Recent Crisis

Abstract

This paper begins by examining Robert E. Lucas’s views on the relationship of macro-economics to real world economic phenomena, and on Keynes’s place in its history, suggesting that these stem from a particular and debatable understanding of how the sub-discipline has evolved. It then considers some implications for today’s awkward economic facts of aspects of Keynes’ General Theory, its speculations about the role of psychology and social conventions in the economic decisions of individual agents recently highlighted by Akerlof and Shiller (Animal Spirits. Princeton, N.J.: Princeton University Press, 2009) under the label “animal spirits”, as well as its insights into the influence of the monetary system on the coordination of these decisions, along lines later extended by Clower (The Keynesian counter-revolution – A theoretical appraisal. In F. H. Hahn, F. R. P Brechling (Eds.), The Theory of Interest Rates. London: Macmillan, 1965) and Leijonhufvud (On Keynesian economics and the economics of Keynes, Oxford: Oxford University Press, 1968). It concludes that the questions about co-ordination that Keynes addressed, not to mention some of his answers, are well worth revisiting.

JEL Classifications, B22, B31, E12, E13, E32

Fellow in Residence, C.D. Howe Institute, Toronto, Canada, and Professor Emeritus, University of Western Ontario (laidler@uwo.ca) This is a revised version of a paper originally presented to the History of Economics Society in Denver Colorado on June 28th, 2009, and published in the March 2010 issue of the Journal of the History of Economic Thought under the title “Lucas, Keynes and the Crisis”. I am grateful for comments to Roger Backhouse, Bradley Bateman, David Colander, Michel De Vroey, Robert Dimand, Harald Hagemann, Susan Howson, Peter Howitt , Ephraim Kleiman, Perry Mehrling, Donald Moggridge, Michael Parkin, Greg Ransom and Sandra Peart on various earlier drafts. Of course I alone remain responsible for the current version.

Appendices

Comments on David Laidler’s Paper

I welcome this opportunity to comment on the work of David Laidler, who has contributed so much to the development of both monetary theory and the history of economics. Although I did not comment on the paper at the meeting where it was presented in its original version, or on the revised version presented at this symposium, I think that the issues he raises are worth careful consideration.

I will comment on the paper as one who still considers himself to be a “hagiographer”, as Frank Hahn called me over 2 decades ago, albeit, now one of documents pertaining to the development of post-1960 economic thought for the most part. In this context let me first turn to the theme of Laidler’s interpretation of the treatment of Keynes at the hands of Robert Lucas and then to its variations. I start at the end of Laidler’s paper for it is there that he states, what is in my view, its central message, as Don Patinkin would have put it.

Laidler maintains that there is a possibility of what Klug, among others, (Klug, 2006, ed. Young and Bordo) called “recurrence” in the application of “theoretical ideas” in economics, and goes on in his conclusion to stress the need “for a reconsideration of Keynes’ insights into the mechanics of inter-temporal coordination in a monetary economy and their proneness to occasional failure”, proceeding even further to assert that the “basic question” that Lucas and others “he has influenced” should address is: “what is it about a monetary economy that sometimes causes its coordination mechanism to break down ?”.

In my view, however, this is not necessarily the task, or should it be, of New Classical or “Equilibrium Business Cycle” economists, whose economic weltanschuung – based upon the competitive market equilibrium approach – simply cannot co-exist with coordination failure, as is recognized by Laidler himself in the paper. Rather, I think Laidler should have also addressed his critique at the protagonists of the other school of new mainstream macroeconomics that is to say, the venue of New Keynesian economists. There he would find confirmation of “recurrence” in the form of imperfect competition and their belief in wage and price stickiness, and their efforts to reconcile these elements with, as Laidler puts it, a “rational maximizing behavior and in particular on the formulation and use of rational expectations to guide it”.

What then of the New Keynesian Macroeconomics approach to coordination failure; is it simply the result of market imperfections or stickiness, and not, as Laidler would have it, “the occasional failure” of “inter-temporal co-ordination in a monetary [my emphasis] economy”?. Whether or not they have – to borrow Joan Robinson’s term – bastardized Keynes’s General Theory message regarding the possibility of this type of coordination failure cannot be discussed in detail here; however, in my view, it as an issue worth consideration by Laidler and others. Moreover, is the existence of widely utilized New Keynesian DSGE models such as those, for example, of Christiano et al (2005), Blanchard and Gali (2007) and Smets and Wouters (2007) simply “coincidence”, or a manifestation of the “progress” New Keynesian macroeconomics has made away from Laidler’s interpretation of Keynes’s General Theory approach to coordination failure?

I now turn to Laidler’s discussion of Lucas as a critic of Keynes’s role in the history of economic doctrines, especially regarding the role of the General Theory and Keynes’s “economics of depression”. Simply put, as Laidler knows well, having written the masterpiece entitled Fabricating the Keynesian Revolution (1999), Lucas was not the first to question the universal or general relevance Keynes’s General Theory or its focus on the “economics of depression”. Indeed, what is, in fact Hicks’s 1937 critique of Keynes’s General Theory approach, among others, surpasses, in my view, the intensity of Lucas’s critique. Moreover, as Laidler also knows well, Hicks liked Keynes’s Treastise, but not his General Theory, because he thought the latter to be “static”, whereas the former, in Hicks’s view, was “dynamic” in nature. Given the emphasis placed by Lucas and those he influenced on the development of, as Laidler puts it, “dynamic general equilibrium modeling in macroeconomics”, it should not surprise us that Lucas sees General Theory, given its static nature, not as the theoretical breakthrough Keynes thought it was; and, given its focus on the economics of depression, as a polemical tome, rather than a “general” theory per-se, parallel to the views of Hicks.

My final comment deals with Laidler’s assertion that Luca’s statement regarding real business cycle theory that has been “augmented” by “monetary variations” is, as Laidler puts it, “the approach that doesn’t let us think about…financial crises and the depression”. I would refer the reader of Laidler’s most interesting paper to consult, among other things, the volume entitled Great Depressions of the 20th Century (2002), edited by Tim Kehoe and Ed Prescott , to ascertain how far the augmented real business cycle approach has actually evolved (on this see Young, forthcoming).

A Response to Warren Young

David Laidler

I am grateful to Warren Young for his constructive comments, which pay me the considerable compliment of carrying the discussion to which my own paper sought to contribute a step or two further forward. Rather than devote the small space available here to disagreeing with him explicitly about anything, let me rather clarify my own position on two of the issues he raises, and permit readers to make up their own minds about where to take matters next.

In some contexts, it is indeed important to distinguish between the New Classical and New Keynesian strands in modern macroeconomics. (How much I dislike both labels, though, because they have so little to do with the historical antecedents that their creators claim for themselves!). I have no doubt, moreover, that there have been areas in which the latter has proved extremely useful. It is hard to imagine successful inflation targeting without the type of model that Woodford (2003) codifies, sticky wages and all, and it is worth recalling that a number of successful inflation targeting countries – Canada, Israel and Australia, for example – largely managed to avoid the excesses that led up to the recent crisis while basing much of their policy thinking on this kind of apparatus.

But, as I argued in Laidler (2007), which in some respects is complementary to my discussion of these particular questions in the current paper, there are a number policy problems with which this kind of model is not much help: – e.g. the role of fiscal deficits in prompting seigniorage-raising monetary expansions, the choices that face some countries between maintaining monetary autonomy or joining a wider monetary union, and, of course, the design of policies to avoid the onset of asset-market crises and to respond to them when they occur. These deficiencies, I persist in believing, arise because the models in question provide inadequate room for the analysis of monetary and financial systems. This weakness in turn stems, or so it seems to me, from their starting with the assumption of a fully coordinated economic system. Money and finance are not “frictions” that change the behaviour of an otherwise well coordinated economy and therefore need to be introduced as elaborations of some more basic model. They are the socio-economic institutions through which coordination is, or sometimes is not, achieved in the first place, and they need to be there from the very beginning of the analytic story. Keynes showed us one coherent way of doing this, which is why his work remains theoretically interesting and important. To re-iterate this hardly original theme in today’s context was the main point of my paper.

Real business cycle theory, to which Young also alludes in his comment, is a type of modern equilibrium modeling, but it also provides an example of macroeconomics’ tendency to double back on itself with fruitful results. As Charles Goodhart (1992) pointed out quite some time ago, its central idea of cyclical fluctuations as equilibrium responses to productivity shocks looks a lot like Dennis Robertson’s (1926) story about the “appropriate fluctuations” in output that follow technical innovations and ought to be encouraged rather than ironed out by policy. Furthermore, as I noted towards the end the current paper, and as I have elaborated at much greater length in Laidler (2003), there is much to be said for Robertson’s account of the roots of economic crises, including the one we have recently encountered, as lying in shocks to technology.

If asked to identify the crucial innovations this time around, I think I would locate them in the technology of the financial system – e.g. in innovations in the securitization of household debt and the invention of the credit-default swap. Thus it was probably the market rate of interest that took the shock, rather than the natural rate, which would have responded to an innovation to the technology of production, and I don’t think that modern real business cycle theory in its current state of development has room for this possibility, though I’m open to correction on this point. Nor, so long as it confines itself to the clearing-markets assumption, will it be able to come to grips with the financial-sector-driven “inappropriate” fluctuations that Robertson believed to be all too often superimposed upon an “appropriate” base, and to be capable of causing much mischief.

All this being said, however, New Keynesian macroeconomics and real business cycle theory are both works in progress, and who knows where they might end up. If my paper, and this brief exchange with Young, nudge them further in the direction of helping us address our post-2007 problems, no-one will be more pleased than me.