In IS-LM models there is always something in the background shifting the IS curve. What is it?
In my view that 'something' is Keynes' animal spirits that we should add to our models as a new fundamental.
Roger Farmer's Economic Window
Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; — though fears of loss may have a basis no more reasonable than hopes of profit had before.
It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.
This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; — it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.
We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.
12 comments:
Farmer seems to have discovered... Milton Friedman and Robert Lucas!
He will, no doubt, arrive at different conclusions.
Right?
If one believes, as I do, that consumption depends on wealth and not on income then fiscal policy may not be the panacea that its proponents claim. Instead, a variant of monetary policy in which the Fed directly stabilizes a stock market index could provide a more effective way of restoring confidence in the markets and moving the economy back towards a full employment equilibrium.
Roger E.A. Farmer, Animal Spirits, Persistent Unemployment and the Belief Functionf, p. 27
consumption depends on wealth and not on income
Tell that to my wonderful cleaning lady. She buys milk and tortillas based on her income, which she fights to get everyday working for people.
Wasn't that Friedman's argument?
Hick repudiated IS-LM just before he died.
Friedman held that a person's consumption is based on "permanent income" as longterm average income rather than current income. This is based on expected income over one's lifetime.
http://en.wikipedia.org/wiki/Permanent_income_hypothesis
Quote A
"If one believes, as I do, that consumption depends on wealth and not on income then fiscal policy may not be the panacea that its proponents claim. Instead, a variant of monetary policy in which the Fed directly stabilizes a stock market index could provide a more effective way of restoring confidence in the markets and moving the economy back towards a full employment equilibrium."
Roger E.A. Farmer, Animal Spirits, Persistent Unemployment and the Belief Function, p. 27
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Quote B
“The rest of the 1960s provided a series of dramatic experiments testifying to the limitations of fiscal policy and to the potency of monetary policy”.
Friedman, Milton. 1972. “Monetary Policy.” Proceedings of the American Philosophical
Society, 116 no.3 (June): 183-196. p. 185.
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Quote C
"Monetary policy is largely ineffective"
Bill Mitchell. April 8, 2015.
http://bilbo.economicoutlook.net/blog/?p=30594
Two of these quotes are strikingly similar, the other one contradicts them.
Which is/are which?
All conventional economists are still monetarists overall, even through they may not subscribe to Friedman's view of QTM, which is no longer so much in fashion.
Even "leftist" Krugman is a monetarist overall and only admits the usefulness of fiscalism in a liquidity trap.
Friedmania has been replaced on the right by Barro's Ricardian equivalence as rationale for why fiscalism can never work.
"If one believes, as I do, that consumption depends on wealth and not on income then fiscal policy may not be the panacea that its proponents claim. Instead, a variant of monetary policy in which the Fed directly stabilizes a stock market index could provide a more effective way of restoring confidence in the markets and moving the economy back towards a full employment equilibrium."
Compare the quote above, with your own statement:
"All conventional economists are still monetarists overall, even through they may not subscribe to Friedman's view of QTM, which is no longer so much in fashion."
What is the conclusion you draw from that comparison?
To me, it sounds like Farmer wants to bring "Friedmania" back to fashion.
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"Friedmania has been replaced on the right by Barro's Ricardian equivalence as rationale for why fiscalism can never work."
"Friedmania" was an attempt at "operationalizing" animal spirits. So was Barro's Ricardian equivalence: it's all about "expectations"
Read John Cochrane, for crying out loud.
I don't see it that way.
Farmer believes that he has come up with a new macro approach that reconciles Keynes and Classical (neoclassical) economics.
Keynes claimed that any unemployment rate could persist as a long-run equilibrium. But he did not explain how long- run unemployment could be consistent with the behavior of rational goal-oriented individuals pursuing their individual self-interests in markets. The postwar Keynesians developed a way of explaining some of Keynes's ideas, but watered them down. In the postwar neoclassical synthesis of Paul Samuelson, unemployment is a temporary phenomenon.
In this chapter, I showed how to integrate Keynes with general equilibrium theory in a new and different way. In my theory, long-run persistent high unemployment is fully consistent with the classical idea of rational behavior in markets. This is important because, as we will see, it suggests a very different policy to cure the problem of high unemployment from the one advocated by Keynesians in the Obama administration in the United States, the Sarkozy government in France, or Gordon Brown's policies in the UK.
If any unemployment rate can persist forever, then what determines which unemployment rate actually occurs? The following chapter answers this question by showing how the labor market is connected to the stock market. I will show that low confidence can result in low asset prices and that a lack of confidence can become a self-fulfilling prophecy that leads to very high unemployment, potentially for a very long period of time.
— R. E. A. Farmer, How the Economy Works, p. 107
That doesn't sound like Friedman's theory of consumption and permanent income to me, or his QTM. Farmer doesn't think he is returning to Friedman. He sees himself as standing on the shoulders of giants and he credits both Keynes and Friedman but finds them lacking.
The following chapter is about reconciling Keynes with rational expectations (Lucas), which Farmer believes to be an innovation.
According to the classical theory, asset prices are deter- mined by rational expectations of future fundamentals. The value of a share in a company is the sum of the values of all of the future dividends that it will pay, weighted by a price that depends on when the dividend will be paid.
According to Keynesian economists, the stock market is driven by confidence. They point to the fact that stock market prices go up and down much more than they should according to classical theory. Dividend payments are much too smooth to justify the movements in stock market prices that we observe.3 Who is right about the way the stock market works, the classical or the Keynesian economists?
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I believe that they are both right and that there is a way of reconciling the fundamentalist and the Keyne- sian view of the stock market. Classical economists insist that fundamentals drive the market. Keynesians insist that confidence matters. Once we recognize that confidence is a separate independent fundamental just like preferences, endowments, and technology, we can reconcile both points of view. This is not just a trick of language; by insisting that confidence should be treated as a fundamental, I am also insisting that as economists, we maintain the rational expec- tations view that market participants are not consistently fooled.
Using the classical definition of fundamentals, classical theory is incomplete. Because there is no unique fundamental labor market equilibrium, there is also no unique fundamental value for the price of a stock. By adding confidence as a separate fundamental, we can retain a theory in which everything is determined by fundamentals, including the value of stock prices. Confidence is an independent fundamental driving force of the business cycle.
Sorry, Tom, but I do see it that way. I don't mean to be snarky, but what makes your view better than mine?
I can argue mine:
Absurd as it may -- at first sight -- appear, Cochrane was reproaching the Keynesians for not taking expectations into account!
Ricardian equivalence is a way of incorporating expectations in an explicit way. It may not a good addition, it may not be the way you and me like, but it's a way.
Now, what Farmer has to offer in concrete? So, far, it doesn't sound too promising.
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Incidentally, sometimes I feel that the label "heterodox" by itself automatically grants "heterodox" people support. It's not what they say, but the label.
Provided one is ready to bash the holy cows, it doesn't much matter what one says.
I find that rather disturbing.
Cochrane was reproaching the Keynesians. You mean the New Keynesians that aren't Keynesians at all?
Farmer is actually dealing with Keynes, and Minsky, and trying to account for what he sees as a failure of Keynes to account for expectations leading to lack of confidence that affects investment by avoiding the behavioral economics approach that assumes irrationality and squares the General Theory with REH.
RF thinks that Keynes's criticism in the GT of previous Classical theory was correct concerning expectations ("animal spirits") leading to lack of confidence resulting in market failure that becomes persistent (elevated UE) but that Keynes left this up in the air and did not model it. RF rejects the New Keynesian explanation of sticky wages and prices as non-Keynesian.
RF notes that Minsky had a conceptual model that elaborates on Keynes's account based on financial reasons rather than economic, But he thinks that conceptual models are too loose for central banks to work with. They want more precise models. RF wants to pin it down so it can be formalized as a theoretical assumption that pushes out the envelope in setting monetary policy, which he believes is the effective way to go.
This would be a big deal if he has it right. BB arguably did take that approach in cutting rates not so much to stimulate investment directly but to support financial markets and address the issue through the wealth effect. BB still thinks he got it essentially right.
Whether RF has been successful is another matter. But that is the task he sets himself. He makes it clear that he thinks he is doing something new and important based on Keynes.
RF sets forth his argument for academics in Expectations, Employment and Prices (2010). I don't have a copy, so I won't comment on it. Anyone familiar with it?
Here is the blurb:
Expectations, Employment and Prices brings Keynesian economics into the 21st century by providing a new paradigm that explains how high unemployment could potentially persist forever without a little help from the government. The book fills in logical gaps that were missing from Keynes' General Theory of Employment Interest and Money by reconciling some of its key ideas with modern economic theory. Central bankers throughout the world are talking now about developing a second instrument of monetary policy in addition to controlling the interest rate. Roger Farmer directly addresses this issue and offers new creative monetary policy proposals and suggestions for the design of new financial institutions for the 21st century.
RF throws general equilibrium and the natural rate overboard.
This is of interest in that he thinks he is doing what MMT proposes to be doing too. That is achieving full employment without inflation. MMT's solution is chiefly fiscal and RF's monetary. Both claim to be true to Keynes rather than either anti-Keynes or "Keynesian" in name only.
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