New Keynesian Orthdoxy and Hysteresis
The debate between Gerald Friedman and the economics profession seems to be settled — Friedman agrees that he may have made a mistake. It is really unfair to him that preliminary unpublished analysis received so much attention (mostly from the Sanders campaign). Oh and it is unfair to them to expect them to ignore favorable forecasts made by a Clinton supporter of the effects of Sanders’s proposals.
The discussion did lead to an interesting discussion. Uh on twitter.
The idea that temporary bursts of govt spending will raise output forever and ever is well beyond the bounds of Keynesian thinking.
@robertwaldmann 22h22 hours ago
@Noahpinion hysteresis is outside the bounds of new Keynesian thinking by assumption not evidence or even argument.
Sam G @fl0pson 6h6 hours ago
@robertwaldmann @Noahpinion didn’t Blanchard and Summers write the famous hysteresis paper? and wrote a new one months ago?
@fl0pson Summers is not a new Keynesian. Blanchard assumed no hysteresis soon after arguing there is hsyteresis (sic and link — I think this is the most influential paper with the name “Blanchard” on it)
@robertwaldmann @Noahpinion i hate NK models (mostly bc solving them sucks) but i figured you could kludge hysteresis in there somehow
@Noahpinion 6h6 hours ago
@fl0pson @robertwaldmann sure
@robertwaldmann 6h6 hours ago
@fl0pson @Noahpinion economic orthodoxy is odd — too complicated for twitter
hence this post.
A large number of prominent progressive economists argued that it is generally agreed and probably true that demand stimulus has only temporary effects and in particular that the level of GDP depends on the level of stimulus. I note in passing that this is already a big step from New-Keynesian back to paleo Keynesian. In 2008 the mainstream new Keynesian view was that expansionary monetary and fiscal policy both cause higher output (so new Keynesian not new classical) but a permanent shift towards policy which causes higher output in the short run would have no effect on output in the long run.
Yet leading new Keynesian Olivier Blanchard and Larry Summers recently argued that depressed demand can have permanent a effects on output and quite possibly the rate of growth of output (exactly Friedman’s derided assumption). What is going on here ?
I think there is a common pattern (not entirely fitting this particular case). There is a standard model in which demand stimulus has only a temporary effect on output and certainly no long term effect on the rate of growth of output. The model does not fit the data. In the academic discussion, macro economists note this and discuss alternative models. But if an outsiders (the Sanders campaign) or other than top status academics say something inconsistent with the standard model, economists say they are wrong and appeal to the standard model.
This can make the orthodoxy invulnerable to data. It can be noted that it is rejected by data and alternatives discussed when confronting the problematic data, but this discussion isn’t shared with non-economists.
So far I have been unfair to the orthodox progressive economists. Their actual position is that the long run effect of temporary stimulus is smaller than the short run effect. Friedman assumed they were equal. The CEA chairs’ critique of Friedman is consistent with Summers’s view expressed here, here and here (all pdfs).
When discussing the discussion Krugman asserted
“Finally, there’s hysteresis: the proposition that demand-side weakness now breeds supply-side weakness later, so that there are big payoffs to boosting the economy through public spending. There’s now a lot of evidence for that proposition,”
But there are still odd things going on.
One is the appeal to models which are known to be inadequate when explaining economics to non-economists. This is very odd. It makes sense to teach simple models before moving on to realistic models (Newtonian physics is still taught). But it makes no sense to discuss policy using old models which don’t fit the data — that would be like assuming no relativity when discussion public spending on particle accelerators (why spend so much on colliding beams when according to the simple model the energy released by the collision is only twice as high as with a beam hitting a stationary target ?) or assuming no tunneling when designing transistors.
The other is the use of failed models to make forecasts. It is known that the standard New Keynesian model (Smets-Wouters) doesn’t fit the data post 2008 well at all. But similar models are still used by central banks and such. The problem as Sam G (and Paul K and many others note) is that it is hard to program up DSGE models so the choice is sticking to the old one or working without a DSGE model. I think the actual practice is to have a DSGE model, ignore it when its implications are silly but treat it as authoritative when this is useful.
The recent G. Friedman vs Keynesian consensus debate has been civil and intellectually honest.
Salim Furth @salimfurth Feb 27
@Noahpinion Worth noting that @gfriedma has behaved like a gentleman throughout.
(if only one could say the same about @mfriedma’s conduct during his debate vs the Keynesian consensus).
Also the progressive orthodoxy generally avoided appeals to standard models which they don’t respect (there are slips here and there).
However, I think the concern Sam G @fl0pson expressed is very valid. I think the high level of the recent debate is unusual when economics and politics mix.
Hysteresis seems to have magical properties. It seems one can invoke it as one wishes without regard to symmetry, data or mathematics. When scientists talk about hysteresis, they are talking about something in the underlying system changing state, for example, the magnetic domains of a material aligning or its phase energetics of its atoms and molecules changing. Surprisingly, economists are more mystical, despite working with a more observable system.
When economists talk about a stimulus, they seem to be talking in a vacuum. Surely it matters how the stimulus is spent and distributed. I still buy dirt cheap hydroelectric power because of stimulus spending 80 years ago. This is an obvious example of hysteresis. Amazon and Google buy some of that cheap power too. I seriously doubt that I will ever see any benefits from our stimulus spending prosecuting a war in Iraq. As all non-economists know, not all spending is the same. Somehow, for economists, parts is parts.
Personally, I think Romer & Romer’s critique of Friedman’s estimates is lacking. They seem to feel that our economy is running flat out and could not bear the slightest increase in demand. They say this more than twice. I sure haven’t seen any of the obvious signs of an economy running at the edge of its productive capacity. If nothing else, there haven’t been enough inflationary signals driving changes in the supply system. More ominously, productivity growth seems to have slowed recently. After over 30 years with income and output decoupled, this indicates that the system is seriously starved of demand. We have an industrial scale carrot grater capable of supplying half the nation churning out a quart or two of carrot slaw a month.
Just as a hypothetical , what if , over a period of decades , the shares of both the income stream and the stock of accumulated wealth is slowly but surely redistributed upward , to a tiny fraction of the population at the top. This redistribution impacts both individuals and firms similarly , i.e. you get an ever-enriched elite class developing in both.
These elites fail to consume in proportion to their increased income and wealth. Additionally , due to their access to top tax lawyers and to legislators , they game the system over time so that more and more of their yearly gains accrues as capital gains rather than as income , and more and more is diverted into offshore tax havens and such.
It seems to me that this might show up in the economic data as a declining rate of GDP growth along with an increased ratio of wealth to gdp. To counteract the declining rate of growth – due entirely to flagging demand – someone comes up with the idea of substituting rising debt for the stagnant incomes of the non-elites. Voila ! This works , but it works less well as leverage levels climb , and , finally , stops working altogether. Now GDP growth really slows.
This process could be mistaken for many things – declining innovation / productivity , failing educational system , welfare and disability slackers , etc. – when in reality it’s just been a prolonged erosion in the demand side of the circular flow economy , and a prolonged plumping of the – largely ignored – wealth side. Graphs like this one might have a very simple explanation , but one the mainstream models can’t pick up ( by design ? ) :
If one can imagine that this explanation describing this ( hypothetical ) scenario is plausible , then one should be able to imagine the plausibility of running the above process precisely in reverse , with the reverse impact on the economic aggregates.
Indeed , Sanders and Friedman can so imagine , it seems.
Mainstream econs , not so much.
What is the out rage of the Sanders people was the coordination of the Krugman paper with the new TV add by Hillary. Both seem to be saying that Sanders’ goal were unrealistic; only small incremental goals would work, and that large growth was unrealistic.
Too repeat what was in Kalebergs’ post; there is productive debt and unproductive debt.
Iraq war stimulus aided al Qaeda more than it will ever benefit you.
Stimulus (militarist Keynesian) for the Iraq war, Afghanistan face saving, regime change in Syria, new B-2, Pacific anti access/area denial tilting with China, a trillion to upgrade the H bomb stock pile etc. is for pentagon troughers, welfare queens selling their franchised goods and services to the monopsony they own.
Huge amounts of cash are in the reserves, the music is playing on wall st. It is not doing anything for main st.
The two parties are not so in to main st.
“Hysteresis” is flat earth theory used to put Galileo under house arrest.
Kind of agree with the Justin Wolfers’ NYT article and your post. If the stimulus proposed was in the form of helicopters money to citizens, it most certainly would be a temporary stimulus. I would think though and the same as my rearranging the layout of a facility, if the stimulus took the form of infrastructural improvements there would be a much longer impact of the stimulus. This “may” be seen in reduced costs as opposed to the older methodology or in increased efficiencies.
I do not view this to be out of the ordinary as much as an application of the investment. Friedman appears to stumble in the 2nd to the last paragraph, “To me, when the government spends money, stimulates the economy, hires people who spend, that stimulates more private investment. That remains, and at the next year, you’re starting at the higher level.” rather than explain what he meant. I guess the question might be; how non-standard is this belief of infrastructure stimulus investment rather than temporary tax cuts and helicoptering money?
The movement of materials in a plant may be longer and more arduous due to the flow of manufacturing operations to complete the component/product. Change the layout and you change the flow and reduce transit time. This is not temporary and continues. Along the way in the process you my go from one CNC to a finishing operation. Change it to a cell with one operator or with robotics and the transit time is reduced even more and we have also increased throughput with the addition of newer equipment or equipment + robotics. The only issue with the stimulus is the flow of productivity gains to Labor or Capital. I believe the view by economics is limited in how the stimulus can be applied and Wolfers keeps it at such.
“In the usual telling, changes in government spending lead to changes in output. In Mr. Friedman’s spreadsheets, changes in government spending permanently raise the level of output. Mr. Friedman confirmed to me that this was how he had made his calculations.”
I would contend, how the stimulus was applied would determine whether the stimulus is temporary or having a lasting impact. The impact of which would deteriorate over time and not disappear completely after the stimulus was applied. If the economist’s “standard approach (Romer and Romer)” is to say the impact disappears once the money is applied, then I would question as to how it was applied and look for the resulting impact over a ten year period. Some investments have a greater impact than others.
New Keynesians appear of the opinion that because an economy will of its own accord tend to return to full employment equilibrium, a stimulus must necessarily be only of value in accelerating this process. One would therefore assume as implicit in the models that delayed technological investments do not exist and employment preferences are inalterable.
I think the Romers’ letter indicates they understand Friedman’s heterodox work less than he understands theirs.
Simply grateful to AngryB for writing such a clear, succinct explanation/account of a seriously complicated topic.
Laura Tyson – ” Closing the Investment Gap ”
“…The weakness of private investment in the United States and other advanced economies …….according to the International Monetary Fund, through 2014, private investment declined by an average of 25% compared to pre-crisis trends. ”
“…extensive empirical research confirms that at the macro level, business investment depends primarily on expected future demand and output growth, not on current returns or retained earnings. According to the IMF, this “accelerator” theory of investment explains most of the weakness of business investment in the developed economies since the 2008 crisis. ”
“…Businesses have marked down their pre-crisis investment plans to reflect a post-crisis “new normal” of slower and more uncertain growth in demand for their output….
…Under conditions of weak aggregate demand, stronger public investment encourages more private business investment. ”
“….at the macro level, expected growth in demand and associated innovation opportunities will remain the primary drivers of business investment. ”
Tyson may not realize it , but she just provided a ringing endorsement of the Sanders economic plan as well as Friedman’s analysis of same.