Posts Tagged ‘John Maynard Keynes’
In his 1936 book that would give theoretical support to Franklin D. Roosevelt’s New Deal, the British economist John Maynard Keynes wrote the following: “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.”
There is little doubt that the ideas of economists – their models or theories or ideologies – have had a profound influence on our daily lives. To give just one example: when South Africa’s Monetary Policy Committee decides whether to lower or raise the interest rate, they do so based on a model that predicts the likely effects of the policy change.
But there is not one universal model. Macroeconomists, depending on their school of thought, have different beliefs about how the real world works. Some, like those that propound Real Business Cycle (RBC) theory, argue that business cycle fluctuations are the result of exogenous changes to an economy, and because wages and prices are flexible, there is little that governments can do through fiscal and monetary policy in a downswing. Others, like New Keynesians, see a greater role for government intervention because of things like sticky wages and prices.
Though these ideological disagreements in macroeconomics are nothing new, one would expect that the competition between these ideas would ultimately lead to a better way to explain what is happening in the world. This is, however, not the case, and one of the main reasons the World Bank’s new chief economist, Paul Romer, formerly professor at Stanford and New York University, recently wrote a stinging critique of macroeconomics. “I have observed more than three decades of intellectual regress”, he begins, explaining that macroeconomics has gone down a wrong path and have now reached a dead-end.
The basic premise is this: macroeconomists’ increasingly sophisticated models have ignored real-world evidence. Simon Wren-Lewis of Oxford University explains: “If we look at the rise of Real Business Cycle (RBC) research a few decades ago, that was only made possible because economists chose to ignore evidence about the nature of unemployment in recessions.”
Why would scholars willingly choose to ignore real-world evidence? “The obvious explanation is ideological” says Wren-Lewis. “I cannot prove it was ideological, but it is difficult to understand why – in an area which … suffers from a lack of data – you would choose to develop theories that ignore some of the evidence you have.” Ironically, this shift came at a time when the rest of the profession, fields like labour economics, development economics and international trade, shifted the other way: from theory to empirics.
To be fair, RBC models have become less popular, replaced by ‘New Keynesian’ models. These ones make more realistic assumptions of the real world, like adding sticky wages, but still share many of the same concerns. Because these new generation models, known as Dynamic Stochastic General Equilibrium models, are ‘built from the ground up’ (in other words, built on microeconomic foundations) they are far more appealing theoretically (and technically more difficult to construct) than the structural models of the previous generation, models which only considered the interlinkages of different macroeconomic variables. But in practice they turned out to be less than satisfactory: DSGE models require the modeller to make many assumptions about how individual agents behave, and it turns out that this behaviour is difficult to measure, making the assumptions rather subjective. The result is that, though theoretically plausible, the outcome is often far removed from the real-world evidence. And, most importantly, forecasts – that thing that most people think is an economist’s only job – are often far less accurate with DSGE models than with multiple-equation structural models. That is why most reserve banks, including our own, still mostly rely on structural models to help predict the future outcomes of their policy decisions.
So why continue with DSGE models? This is a consequence of the way scholarship works. In a blog post in response to Romer, Narayana Kocherlakota of the University of Rochester writes: “We tend to view research as being the process of posing a question and delivering a pretty precise answer to that question. In this process, machines that can be used by many scholars to generate answers to wide ranges of questions are highly prized. The King-Plosser-Rebelo real business cycle model was one such machine. The New Keynesian three-equation model is another. And people who have the mathematical and computational skills to make machines even more powerful, so that they can answer even more questions, are naturally highly valued.”
Yet if these ‘answers’ increasingly abstract away from reality, we are not much better off than before. Keynes, who developed a new theory when the existing paradigm could not explain the real world anymore, knew this all too well: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
For academic macroeconomics to regain its influence, it needs to be, as Kocherlakota writes, “a lot more flexible in our thinking about models and theory, so that they can be firmly grounded in an improved empirical understanding”. This won’t be easy. As Locherlakota says, it will be “hugely messy work”. Will this generation’s John Maynard Keynes please stand up?
*An edited version of this first appeared in Finweek magazine of 9 February.
I find holidays paradoxical. The thought of sitting on a beach, staring over the ocean and watching the sun set seems like a great way to spend a Friday evening after a productive week of work, but to do so for a week or two – or even a month – seems, to me at least, a frightening prospect. And do what? Listen to the waves. Oh okay, I’m listening. And then? No, listen. Switch off. Think of nothing but the waves. Hmm, okay. Tik tok. And now? As soon as I’m on holiday, there’s an urge to want to be productive.
I’m being unfair to beach holidays, of course. Every December I spend at least a few days on the beach, soaking in the southern sun, and reading my too long list of books. It is paradise. But I do sometimes wonder about the idea of leisure: what is its purpose and how to best use ‘free’ time, i.e. time not spent working? I’m not only thinking about it because I’ve just been on holiday (which made me think about the value of leisure time) but because I’m reading a book in which a couple of leading economists predict the future. Their predictions are fascinating and not all positive, but one of them, the idea of more leisure time, had me thinking: do we really want a 3-day work-week? What would we do with all our free time? Richard Branson, founder of Virgin, suggested the same thing in a post yesterday:
New innovations will drive industries forward, but they will also reduce our reliance on people power. Ideas such as driverless cars and drones are becoming a reality, and machines will be used for more and more jobs in the future. Who knows, maybe even pilot-less planes, could become reality one day! On the face of it, this sounds like bad news for people. However, if governments and businesses are clever, the advance of technology could actually be really positive for people all over the world. It could help accelerate the marketplace to much smarter working practices. The idea of working five days a week with two day weekends and a few weeks of annual holiday is just something people accept. For some reason, it is considered set in stone by most companies. There is no reason this can’t change. In fact, it would benefit everyone if it did.
The trade-off seems straightforward: More work means higher incomes, which in turn means a greater ability to consume. Better technologies would mean that we can do the same work faster, so instead of working five days a week, we can get the same work done in three days. More time for leisure, right? Well, not exactly. What if ‘work’ provides some utility? What if you have a job that you actually enjoy: not always, of course, but a job which brings success and a sense of self-worth. (Just consider someone that is unemployed. It is not only the fact that they do not have an income that matters; it is that their skills are unwanted by anyone else.) In addition, leisure – let’s think of travelling, for example – is costly. So having a long weekend every weekend may not sound so appetising if you think about what it might do to your wallet. More importantly, what if what we do is not about maximising our absolute utility – i.e. obtaining a certain level of income that would satisfy our basic needs – but instead maximising our relative utility, in other words, keeping up with the Joneses (or the Kardashians). In this case we would be forced to spend more hours working harder to reach the top of the status ladder.
It is for this reason that John Maynard Keynes’s prediction, made a century ago, has not been realised. While he correctly predicted that living standards would vastly improve, he believed that we would spend a considerable larger amount of our time on leisure. (In technical terms, he overestimated the backward-bending labour supply curve.)
Thus for the first time since his creation man will be faced with his real, his permanent problem – how to use his freedom from pressing economic cares, how to occupy the leisure, which science and compound interest will have won for him, to live wisely and agreeably and well.
The strenuous purposeful money-makers may carry all of us along with them into the lap of economic abundance. But it will be those peoples, who can keep alive, and cultivate into a fuller perfection, the art of life itself and do not sell themselves for the means of life, who will be able to enjoy the abundance when it comes.
Yet there is no country and no people, I think, who can look forward to the age of leisure and of abundance without a dread. For we have been trained too long to strive and not to enjoy. It is a fearful problem for the ordinary person, with no special talents, to occupy himself, especially if he no longer has roots in the soil or in custom or in the beloved conventions of a traditional society. To judge from the behaviour and the achievements of the wealthy classes today in any quarter of the world, the outlook is very depressing! For these are, so to speak, our advance guard-those who are spying out the promised land for the rest of us and pitching their camp there. For they have most of them failed disastrously, so it seems to me – those who have an independent income but no associations or duties or ties – to solve the problem which has been set them.
I feel sure that with a little more experience we shall use the new-found bounty of nature quite differently from the way in which the rich use it today, and will map out for ourselves a plan of life quite otherwise than theirs.
For many ages to come the old Adam will be so strong in us that everybody will need to do some work if he is to be contented. We shall do more things for ourselves than is usual with the rich today, only too glad to have small duties and tasks and routines. But beyond this, we shall endeavour to spread the bread thin on the butter – to make what work there is still to be done to be as widely shared as possible. Three-hour shifts or a fifteen-hour week may put off the problem for a great while. For three hours a day is quite enough to satisfy the old Adam in most of us!
The decision to switch to a more leisure-filled life would presumably have important consequences for society too. Richer individuals would substitute income for leisure, meaning that inequality would fall. The poorer part of society will work harder until they attain a certain level of wealth, and then also begin to substitute income for leisure. But I just don’t see this happening. Perhaps we’ll leave the dull, mind-numbing tasks for computers and robots, but we’ll certainly continue to work. Look at the richest individuals: do they work any less than us normal folk? Not really. Yes, they certainly enjoy a higher standard of living, with access to better medical services and larger houses and more travel and better education for their kids. But they don’t actually work less. The backward-bending supply curve only really kicks in once people reach retirement age.
The paradox of leisure is that we want to have the freedom to afford it, but when we do we choose more work instead. Even if we can ensure a minimum income to all citizens, either through something like a basic income grant or because a lot of things are now free as Michael Jordaan has argued, the truth is that ‘the old Adam in most of us’ (or is that Eve whispering in our ear?) will want us to work harder so that we can move up the social ladder (or at least avoid moving down). While we all need a holiday once in a while (or something besides doing what we normally do), I don’t see us working three hours a day and spending the rest sipping cocktails and watching the sunset over the horizon. Not even Richard Branson, who owns his own beach on his own island, does that.