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Saturday, June 16, 2012

Bait and Switch attacks on Keynesian Economics

Keynesian Economics is still under attack by the right. And I have to confess that for a time I bought some of the arguments. One of the opening arguments was that somehow the STAGFLATION of the late 70's and early 80's was the fault of officials applying Keynes ideas and that Keynesian economics had no theoretical model for dealing with STAGFLATION, and that what they did apply was counter productive. According to the straw argument Keynesians didn't think that inflation could be fought by raising unemployment -- and that that failed. It was a straw argument. I remember the contrary, since I was in one of the last cohorts who studied Keynesian economics. It turns out that Keynesian economics had prescriptions, but that they weren't being followed in the 70's and eighties anymore than they are followed now.

Paul Krugman's most recent piece pretty much dredges up the truth -- Keynesian was discredited with lies.

Paul writes:

"I’ve been writing about how macroeconomic reality under Ronald Reagan didn’t actually match the myth, and many people are inevitably upset. And one of the things they tend to bring up is the hoary old myth that the 80s success in taming inflation was somehow a terrible shock and surprise to Keynesians, who had no explanation.
"This is, as it happens, completely wrong: what actually happened in the 80s was, quite literally, a confirmation of the validity of textbook Keynesian economics."

Paul says:

The two leading undergrad macro textbooks at the time were Dornbusch-Fischer and Gordon, both with first editions published in 1978. (Gordon has a retrospective (pdf) on all this, which tells me something I didn’t know: in both cases the analysis drew on a handout presented by Rudi in 1975). Both books presented an adaptive-expectations Phillips curve, in which inflation depended both on the unemployment rate and on lagged inflation, which was supposed to determine expectations:
Inflation rate = -α(u – NAIRU) + Lagged inflation rate
where u was the unemployment rate and the NAIRU was the non-accelerating-inflation rate of unemployment.

Krugman writes:

And what did this approach predict about disinflation? It said that if policy makers were willing to impose a period of very high unemployment, they could bring inflation down — and that even if unemployment then fell back to the NAIRU, inflation would stay down.

Dornbusch-Fischer, which declares on p. 421,

We should not be surprised if the level of output and the inflation rate move in opposite directions at some stages of the adjustment process.

And of course Paul is preaching to the choir when he writes;

That is, we should not be surprised by the very thing that supposedly shocked, surprised, and refuted Keynesian economics.

Keynesian theory never had the holes in it that it was accused of.

The truth, which Gordon has been trying to get out, is that 1978-vintage macro has actually done very well these past three decades. Unfortunately, a couple of generations of economists have never seen that stuff.

I've been feeling a lot of "I told you so" after years of "I'm warning you." But my warnings, and those of others like Krugman who actually have integrity have been falling on deaf ears. Those studying the subject have followed alternative realities manufactured because they validated the extractive and gambling approaches that big business and big banks prefer to follow.

The paper he cites offers this summary:

"The paper resurrects “1978‐era” macroeconomics that combines non‐market‐clearing aggregate demand based on incomplete price adjustment, together with a supply‐side invented in the mid‐1970s that recognizes the co‐existence of flexible auction‐market prices for commodities like oil and sticky prices for the remaining non‐oil economy. As combined in 1978‐era theories, empirical work, and pioneering intermediate macro textbooks, this merger of demand and supply resulted in a well‐articulated dynamic aggregate demand‐supply model that has stood the test of time in explaining both the multiplicity of links between the financial and real economies, as well as why inflation and unemployment can be both negatively and positively correlated." (page 1

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