Am I a heterodox Keynesian?
By Arnold Kling
Probably. Politically, I’m in a different place, obviously, and I’m not heavily invested in macro as a subject. But how else would you label someone who believes the following:
1. Textbook macro is misguided.
2. The most useful insights in macro are not well expressed in terms of equations.
3. A big part of the story is financial market psychology.
4. Another big part of the story is the slow process by which information diffuses in markets. Yes, that means that wages and prices are slow to adjust. But no, that does not mean that equations with fixed W and P are a good way to describe this phenomenon.
5. The money supply is not a very useful concept in today’s economy.Tyler wrote,
More generally, the currency vs. interest-bearing assets decision doesn’t have many implications for foreign exchange markets, if any.
Nowadays, I don’t think that traditional monetary theory has much relevance. The last time ordinary monetary policy made a difference was in 1980-82, when Paul Volcker broke the 1970’s inflation. But even then, I think that the key was the interaction of his policies of raising interest rates with the regulatory environment for banks and savings and loans. The whole S&L industry basically went under, and we had a whale of a recession.
But just as an oil price shock is easier to deal with now that we do not have price controls, I think that without deposit interest ceilings a rise in short-term interest rates would not be nearly as devastating as it was in 1980-82.
I see the conventional money supply as a relatively small fish in a big pond of financial markets. The Fed affects one teeny-tiny interest rate, the Federal Funds rate. Meanwhile, what matters for the economy are all sorts of other financial rates, including mortgage rates, the P/E ratio for stocks, and so on. The Fed does not control those. See Can Greenspan Steer?
I think that risk premiums matter a lot, and they change as the confidence of investors in financial intermediaries ebbs and flows. The recent cycle in subprime mortgage lending is a good illustration, as I explained in The Risk Disclosure Problem.
Some financial market prices can vary widely. Even Fischer Black once said that markets are only efficient up to a factor of 2. Today, no one knows the right long-term price for oil. If speculators woke up tomorrow convinced that in three years that price will be $30, then we would have $30 oil, at least for a while.
No one knows the right long-term value for the exchange rate between the dollar and other currencies. When investors change their outlook, the exchange rate can move dramatically.
A large change in the exchange rate sends an important signal to people who buy and sell tradable goods and services. However, it takes a really long time for this signal to affect prices and quantities. The reaction is quicker in some markets than in others. Because the signal is not processed immediately and fully in all markets, trade patterns are affected. Typically, a depreciation will cause a rise in exports and a fall in imports.
I think of cyclical unemployment as resulting from the slow diffusion of signals in the labor market. Basically, unemployment is a signal that average wages need to fall. But average wages are the outcome of local decisions made by individual firms in particular markets and by individual workers in particular occupations. It could take years for the signal to work its way through the entire economy, by which point conditions will have changed, anyway.
This description of macro may seem vague and imprecise. But I think it’s better than textbook macro, which promises greater precision but is precisely incorrect.