Lectures on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture( shorlink: bit.do/azifa)
3100 word summary of lecture:
Lectures on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture( shorlink: bit.do/azifa)
3100 word summary of lecture:
This 1000 word article is the third in a series of posts on Re-Reading Keynes. It traces the impact of Keynesian theories on the 20th century, as necessary background knowledge for a contextual and historically situated study of Keynes. It was published in Express Tribune on 4 Nov 2016.
The Global Financial Crisis (GFC) has created awareness of the great gap between academic models and reality. IMF Chief Economist Olivier Blanchard said that modern DSGE macroeconomic models currently used for policy decisions are based on assumptions which are profoundly at odds with what we know about consumers and firms. More than seven different schools of macroeconomic thought contend with each other, without coming to agreement on any fundamental issue. This bears a striking resemblance to the post-Depression era when Keynes set out to resolve the “deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”
Likewise, today, the inability of mainstream economists to predict, understand, explain, or find remedies for the Global Financial Crisis, has deeply damaged the reputation of economists and economic theories. Recently, World Bank Chief Economist Paul Romer stated that for more than three decades, macroeconomics has gone backwards. Since modern macroeconomics bears a strong resemblance to pre-Keynesian theories, Keynesian theories have fresh relevance, as described below.
In the aftermath of the Great Depression, economic misery was a major factor which led to the Russian Revolution and the rise of Hitler in Germany. Conventional economic theory held that market forces would automatically and quickly correct the temporary disequilibrium of high unemployment and low production in Europe and USA. Keynes argued that high unemployment could persist, and government interventions in the form of active monetary and fiscal policy were required to correct the economic problems. Many have suggested that Keynes rescued Capitalism by providing governments with rationale to intervene on behalf of the workers, thereby preventing socialist or communist revolutions. There is no doubt that strong and powerful labor movements in Europe and USA derived strength from the economic misery of the masses, and also took inspiration from the pro-labor and anti-capitalist theories of Marx. While it is hard to be sure whether Keynes saved capitalism, we can be very sure that Keynes and Keynesian theories were extremely influential in shaping the economic landscapes of the 20th Century.
Keynes actually met Roosevelt (FDR) to try to persuade him of the necessity of an aggressive fiscal policy and of running budget deficits, in order to lift the US economy out of recession. He was only partially successful. FDR, like nearly all political leaders as well as economists of the time, was convinced of the necessity of balancing budgets: this is the same ‘austerity’ being touted today as the cure for economic problems. Leading economists like Lionel Robinson and Friedrich Hayek argued in favor of austerity, and said that Keynesian remedies were dangerously wrong. They held the view that the Great Depression had been caused by excessively easy monetary policies in the pre-Depression period, and Keynesian interventions in the form of further easy monetary and fiscal policies would only prolong the agony.
FDR was not quite convinced by Keynes, but was politically savvy enough to announce that he would not balance the budget on the backs of the American people. Accordingly, he did go against his personal convictions, as well as his campaign promises of balancing the budget, which he believed to be a sound and necessary economic policy. Keynes felt that the economic policies of FDR were timid and hesitant, and prolonged the recession un-necessarily. In light of contemporary experience of the tremendously aggressive expansionary monetary policy in the post-GFC era, we can see that bolder steps by FDR would not have caused the harms that he was afraid of. In fact, after the economy recovered somewhat, FDR went back to conventional wisdom and started reducing budget deficits in 1936. This created a mini-recession which has been labelled the “Roosevelt Recession of 1937”. Duly chastened, FDR embraced Keynesian policies with greater conviction, and increased deficit spending right up to the second World War. It was the effectiveness of Keynesian policies that led even arch-enemy Friedman to state that “We are all Keynesians now,” though he later recanted. Indeed, he master-minded the Monetarist counter-revolution in the 1970’s which eventually led to a rejection of Keynesian insights, and a return to the pre-Keynesian ideas of austerity as a cure for recessions. Forgetting the hard-learned lessons of Keynes led to a recurrence of problems very similar to those faced by Keynes in the form of GFC 2007.
Following the GFC, there has been a resurgence of interest in Keynes and Keynesian Theories. In the “Return of Depression Economics”, Krugman argued for the continuing relevance of Keynes, and stated that we could end the Great Recession immediately by implementing Keynesian policies. China implemented Keynesian policies, and used a fiscal stimulus of $586 billion spread over two years, to successfully combat the global recession created by the GFC. Unlike countries forced to implement austerity, which further wrecked their economies, the Chinese economy was able to perform well in the aftermath of the GFC. The Shanghai index had been falling sharply since the September 2008 bankruptcy of Lehman Brothers, but the decline was halted when news of the planned stimulus leaked in late October. The day after the stimulus was officially announced, the Shanghai index immediately rose by 7.3%, followed by sustained growth. Speaking at the 2010 Summer Davos, Premier Wen Jiabao also credited the Keynesian fiscal stimulus for good performance of the Chinese economy over the two years following the GFC.
Meanwhile, even IMF acknowledged the failure of austerity, the anti-thesis of the Keynesian policy. Massive damage was caused to Greece, Ireland, Portugal and other economies which were forced to tighten budgets in response to the recession. In the see-saw battle between Keynesians and Monetarists, after three decades of darkness, the Keynesian star seems to be rising. Strange as it may seem, many fundamental insights of Keynes were never actually absorbed by conventional economists. Keynes himself said that he had the greatest difficulty in escaping the habits of thought created by an economics education. Mainstream economists never made this escape. As a result, Keynesian theories remain an undiscovered treasure offering deep insights into current economic conditions.
The website page has many links to related materials on L3: Impact of Keynes
I am planning a sequence of posts on re-reading Keynes, where I will try to go through the General Theory. This first post explains my motivations for re-reading Keynes. As always, my primary motive is self-education; this will force me to go through the book again — I first read it in my first year graduate course on Macroeconomics at Stanford in 1975, when our teacher Duncan Foley was having doubts about modern macro theories, and decided to go back to the original sources. At the time, I could not understand it at all, and resorted to secondary sources, mainly Leijonhufvud, to make sense of it. Secondarily, i hope to be able to summarize Keynes’ insights to make them relevant and useful to a contemporary audience. Thirdly, there are many experts, especially Paul Davidson, on this blog, who will be able to prevent me from making serious mistakes in interpretation.
Reasons for Studying Keynes
“The heart has its reasons of which reason knows nothing.” Blaise Pascal
In line with the objectives of the WEA Pedagogy Blog, I am initiating a study group with the aim of [re-]reading Keynes’ classic The General Theory of Employment, Interest and Money. There are many reasons why I think this is a worthwhile enterprise. I hope to make weekly posts summarizing various aspects of the book, as we slog through the work, which can be difficult going in some parts. At the very least, this will force me to re-read Keynes, something I have been meaning to do for a long time. In this first post, I would like to explain my motivation in doing this exercise. Read More
The Global Financial Crisis of 2007 has led to a renewed interest in Keynesian theories. In particular, Krugman in “The Return of Depression Economics” argued that Keynesian ideas remain relevant to understanding contemporary recessions. To motivate this, he has used a real world example of the Capitol Hill Baby-Sitting Cooperative (BSC). According to an analysis by economists who were members of the Cooperative, the BSC suffered from a recession due to a shortage of “scrip”, the currency used to exchange baby-sitting services.
Krugman’s analysis is based on an intuitive and heuristic analysis by Sweeney and Sweeney (1977). However, the BSC is a very simple single good economy, where the sole function of money is to allow for inter-temporal trade. This simplicity allows for a rigorous analytic treatment. Our research was motivated by the idea of analytically validating the intuitive insights of the Sweeneys and Krugman. Is the BSC a Keynesian economy? Can a shortfall of money create a recession in this economy? A simple model which displays Keynesian effects should be useful in building understanding of these phenomenon in more complex situations.
A few authors who have analyzed the BSC economy have found Keynesian effects under the assumption of fixed prices. But in presence of fixed prices, the existence of an optimal quantity of money, and recession for low money is a triviality. The Keynesian rejection of neutrality of money is not based solely on sticky prices. In this paper, we create a simple model of the BSC economy to investigate the presence of Keynesian phenomena. The model leads to strange and paradoxical results, not available in earlier analyses. We list these results below.
We are used to thinking that there is progress in knowledge. As we gain experience, the collective wisdom of mankind increases. The story of economics in the twentieth century provides the most amazing example of the opposite: How precious knowledge of vital importance for the welfare of humanity was gained and then lost. Many studies show that a meaningful job is the most important determinant of life satisfaction, and among the thing most desired by the general public. Economists learned how to create full employment, leading to a period of tremendous prosperity. How and why these lessons were forgotten provides a perfect illustration of the thesis that knowledge is shaped to protect the interests of the powerful.
Before the Great Depression of 1929, dominant economic theories stated that the free market automatically eliminates unemployment. Obviously, a theory which does not recognize the existence of a problem cannot provide solutions. Before the Great Depression, the economy was booming, with jobs for all and high levels of production. After 1929, factories lay idle, there was massive and persistent unemployment, and correspondingly high level of general misery. Why did unemployment persist, and how could we get the economy back to full employment of all the resources now lying idle? The revolutionary accomplishment of Keynes was to recognize the source of the problem, and provide an effective remedy.
Keynes argued that the key to the problem was depressed investor expectations about the future. Investors were afraid to produce goods because they did not foresee any demand. If they did take a risk and start producing, the demand would be created, because they would provide jobs to people in the process of production. People with jobs would have income and demand goods. Thus a favorable future forecast would create a self-fulfilling prophecy. People were not demanding goods because they did not have jobs. Producers were not providing jobs because they did not see any demand. This deadlock could be broken by the government in several ways. Lowering interest rates and making money cheaply available would reduce the costs of production, and might induce producers to take a risk on starting investments and production. Indeed, just printing a lot of money and throwing it from helicopters would be enough – people with money would demand goods, and producers would start hiring people to fulfill the demand for goods. The “Helicopter Money” scheme could fail for a number of reasons. The alternative was for government to step into the gap, and start hiring people itself. Even meaningless jobs like digging ditches and filling them up again would be enough to start off a chain reaction which would lead to full employment. Using the secrets of Keynesian demand management, Western governments managed to achieve near full employment, and widespread prosperity for fifty years.
Unfortunately, general prosperity of the 99% does not suit the interests of the 1%. Full employment leads to an unruly labor class, who can walk out of unsatisfactory jobs to find a better one. Secondly, direct government investment can interfere with business profits. Thirdly, before the Keynesian era, politicians understood that business confidence was essential to economic prosperity and votes. Keynes freed the government from this dependence, much to the annoyance of business leaders.
The story of how Keynesian theories were ridiculed and discredited, and completely fallacious pre-Keynesian theories were re-furbished to take their place is long and complex, and cannot be detailed here. The punchline is that the remedies to today’s economic ills are known, but they are not being implemented because they go against the interests of the powerful. There has been a huge increase in debt globally; Debt forgiveness would remove the heavy weight dragging down aggregate demand which is weighing down the economy. Helicopter money is being dropped but into the vaults of the banks instead of the pockets of the public, and Keynes is being blamed for the lack of effectiveness of this ridiculous policy. Zero interest loans to producers are not working, so negative interest rates are being talked about. Meanwhile, everyone ignores the elephant in the room, a fully effective Keynesian theory which explains exactly how we can stimulate aggregated demand to revive the global economy.
Above 700 Words published in Express Tribune on Tuesday 30th For short posts on diverse Topics see my author page on LinkedIn. Other works: Index . More material on Keynesian Economics. Some additional materials for readers of WEA Blogs:
Some of ideas are taken from Kalecki’s insightful note on why captains of industry resist full employment, even though it bring benefits to them as well. There is very strong evidence from multiple sources that their is a finance mafia in operation globally, which thrives on poor economic performance. This enables them to make multi-billion dollar loans and reap in interest payments. Enforcement of austerity is a crucial element in this scheme, since creation of Sovereign money — which is also done indirectly by deficit financing – by states would deprive them of their most valuable weapon — they have money while others don’t. Keeping an economy starved of the money lubricant required for smooth functioning helps the 1% at tremendous cost to the 99%
Many leading economists have come to agree with Nobel Laureate Stiglitz that modern economic theory represents the triumph of ideology over science. One of the core victories of ideology is the famous Quantity Theory of Money (QTM). The QTM teaches us that money is veil – it only affects prices, and has no real effect on the economy. One must look through this veil to understand the working of the real economy. Nothing could be further from the truth.
In fact, the QTM itself is a veil which hides the real and important functions of money in an economy. The Great Depression of 1929 opened the eyes of everyone to the crucial role money plays in the real economy. For a brief period afterwards, Keynesian theories emerged to illuminate real role of money, and to counteract errors of orthodox economics. Economists believed in the QTM, that money doesn’t matter, and also that the free market automatically eliminates unemployment. Keynes started his celebrated book “The General Theory of Employment, Interest and Money” by asserting that both of these orthodox ideas were wrong. He explained why free markets cannot remove unemployment, and also how money plays a crucial role in creating full employment. He argued that in response to the Depression, the government should expand the money supply, create programs for employment, undertake expansionary fiscal policy, and run large budget deficits if necessary.
Free market economists believe that markets work best when left alone, and any type of government intervention to help the economy can only have harmful effects. Even after the Great Depression, they continued to argue that the government intervention would only cause further harm, and the free market would automatically resolve the problems. However, it was obvious to all that the massive amount of misery called for urgent action. QTM was discredited and mainstream economists accepted Keynesian ideas, rejecting free market ideologies. US President Franklin Delano Roosevelt (FDR) started his campaign with orthodox promises to balance the budget but converted to Keynesianism when faced with the severe hardships imposed by the Great Depression. He later said that “to balance our budget in 1933 or 1934 or 1935 would have been a crime against the American people.” In the 1960’s, the aphorism that “We are all Keynesians now” became widely accepted.
Free market ideologues like Friedman and Hayek patiently bided their time, while preparing the grounds for a counter-attack. Their opportunity came when stagflation – high unemployment together with high inflation – occurred in the 1970’s as a result of the Arab oil embargo. They skillfully manipulated public opinion to create the impression that economic problems were due to Keynesian economic theories, and could be resolved by switching to free market policies. The rising influence of free market ideology was reflected in the election of Reagan and Thatcher, who rejected Keynesian doctrines. Milton Friedman re-packaged old wine in new bottles, and the QTM went from being a discredited eccentric view to the dominant orthodoxy. Throughout the world, including Pakistan, monetary policy had been based on the Keynesian idea the money supply should be large enough to create full employment, but not so large as to create inflation. However, monetarists succeeded in persuading many academics and policy makers of the pre-Keynesian ideas that money only affects prices, and has no long run effects on the real economy. Central Bankers were persuaded to abandon the Keynesian idea of using expansionary monetary policy to fight unemployment. Instead, they started to focus on inflation targets. Forgetting the hard learned lessons of the Great Depression led to The Global Financial Crisis. Excess money creation for speculation led to a boom in housing and stock markets, followed by a crash very much like that of the Great Depression. Chastened Central Bankers remembered Keynes and took some actions necessary to prevent a collapse of the banking system. A deeper understanding of money could have prevented the Great Recession which followed. The truth is exactly opposite of the QTM idea that money does not affect the real economy. In fact, money plays a central role in the real economy. The mystery of why, even after repeated rejections, such an obviously wrong theory continues to dominate will be addressed in later articles.
PS: For more material on this issue, see: The Vital Importance of Understanding International Financial Architecture — shortlink: bit.do/azifa
See also, 90m video on: Quantity Theory of Money: Five Flaws
While money and banking plays an extremely important role in the economy, economics textbooks teach the opposite. According to the quantity theory of money (QTM), money plays no role in the economy at all; it is a veil which covers the workings of the real economy. An increase or decrease in the money supply will cause an increase or decrease in the prices, and will have no long run real effects on the economy. According to QTM money is neutral: we must look beyond the veil of money to understand how the economy functions.
The truth is that the standard theories of money and banking are themselves a veil which covers the reality of how the system works. This veil was penetrated briefly following the Great Depression of 1929, which was completely incomprehensible according to standard economic theories of the time. To explain the Great Depression, Keynes invented a new economics, in which money was not neutral. He argued that shortages of money would lead to unemployment and recessions, while excess would lead to inflation. At the same time, leading economists such as Irving Fisher, Frank Knight, Simon Schultz and many others realized the crucial role played by excessive credit creation by banks in precipitating the Great Depression. In 1933, they came up with the Chicago Plan which takes away the power to create money from the banks and gives it back to the government. The Banking Act of 1935 created deposit insurance and many other regulatory measures to control banking, but did not implement the Chicago Plan. Keynesian insights about money and Chicago insights about banking were gradually forgotten. The eerie resemblance of the Global Financial Crisis of 2007 to the Great Depression led two IMF economists to dust off the bookshelves of history and re-visit the Chicago Plan. Since then, it has been gathering momentum in terms of public awareness, but has been mostly invisible in the dominant media and politics which are controlled by big finance. However, the Iceland Government recently published a report which proposed a variant of the Chicago Plan. Most recently, on 1st December 2015, the Swiss public created a successful petition with 112,000 signatures to ensure parliamentary hearing on the proposal for Sovereign Money, which is a core element of the revised Chicago Plan. Since powerful interests have been blocking and opposing the Chicago Plan, it is up to the public to learn about the issues and create a movement for change. In this connection, interested readers may look up “Corrupt Banking System explained by twelve year old” on internet for an entertaining and informative detailed video of explanation. We provide a very brief explanation of the central issues below.
In the fractional reserve banking system, banks are only required to keep a small fraction of cash against the demand deposits outstanding against them. For example, in order to create grant a loan of 10,000,000 to Mr X, Mozoon bank only needs 5% of the amount, only 500,000 in the form of cash deposits. The bank grants the loan simply by creating an electronic entry in its accounts. In advanced economies, money travels electronically between financial institutions, and cash reserves are little needed. When necessary, they can be borrowed from many sources; especially the Central Bank is under obligation to cover cash shortfalls of banks. At 10% interest on the loan, Mozoon Bank will make a cool profit of 1,000,000 based on its meagre cash reserves of only 500,000. Where did this profit come from? It came from the money created out of thin air by Mozoon Bank and then lent out to the borrower at 10% interest. Because Pakistan is financially primitive, banks keep larger reserves (nearly 30%) and cannot leverage their cash deposits to the extent possible in more advanced economies.
The conventional wisdom, taught in textbooks of monetary economics, is that the government creates money, not banks. Furthermore, banks are financial intermediaries: they lend money which they gather as deposits. The reality is that the banks invent the money that they lend. This means that the banks, and not the government, are in control of the money supply in the economy. Bank creation of money acts in ways that are opposite to Keynesian prescriptions, and de-stabilize the economy. According to Keynes, when the economy is in a recession, the government should expand the money supply. In a booming economy with full employment, the government should cut back on money supply to prevent inflation. However, banks lend less in recessions, reducing the money supply. They lend more in a booming economy, adding to inflationary forces. Following the Global Financial Crisis, theories of Hyman Minsky called the Financial Fragility Hypothesis have become very popular. Minsky adds details to this crude picture, and show that banks systematically de-stabilize economies, leading to crises and crashes. The empirical record showing more than 200 banking crises over the past thirty years bears out the theories of Minsky. The Global Financial Crisis, like most others, was caused by excess money creation by banks, which fueled the fires of speculation, leading to a crash.
The solution to this problem is the proposal for Sovereign Money which has been detailed in the Iceland Plan, and will now be up for discussion in the Swiss Parliament. Instead of fractional reserve, banks must keep 100% reserves, preventing them from creating money. Instead the Central Banks will create money in the right quantity designed to stabilize the economy according to the Keynesian prescriptions. IMF economists Benes and Kumhoff have shown that this radical reform of money and banking will bring multiple benefits. It will eliminate banking crises, increase growth, eliminate debt, and create more fiscal space for development projects. It will also decrease the massive inequality which allows a tiny minority to control the political and economic system. The present system enslaves the majority in chains of debt only because a large number of deceptive claims about its benefits are widely believed. If we learn the truth, it can set us free.