On Keynesian economics and the economics of Keynes.

Clower and Leijonjufjud reconstructed Keynes against the Keynesians - dynamic Keynesianism against static formal modelling - real time versus model time. They pointed to real-world experiences of changes in real time of prices and quantities produced by people acting on their disparate expectations. If incomes adjust rapidly - more rapidly than prices - an "income-constrained" process is possible. Production and employment may fall as a result of pessimistic expectations (loss of confidence, uncertainty) however produced.

My interpretation of real-world history suggests that this is not only logically coherent, it is also possible, and has happened from time to time. One may wonder whether the bounce-back of Keynesianism in the wake of the dot.com bust and the financial crisis, can be defended on the basis of this dynamic Keynesianism. On this I say the following.

1. Though one may see, if one looks hard enough, echoes of the Leijonhufjued-Clower reconstruction in the current climate of Keynesian opinion, it seems to me most of it is simply of the old ISLM, AS-AD variety, either explicitly, or else by implication inside the more sophisticated macro-models (stochastic or otherwise).

2. One may see in recent events evidence of income-constrained processes.

3. But this alone does not a Keynesian policy make. It is one thing to suggest that under some circumstances, the unsupported macro-economy may experience downturns. It is quite another to claim that, therefore, activist macro-policy is called for. There is no 'therefore' about it. Activist policy to be successful requires solutions to formidable knowledge and incentive problems. Failure to overcome these problems makes such policy destabilizing. And there is absolutely no attempt by the reborn Keynesians to grapple with this.

4. The conditions that produce significant income-constrained processes are worthy of examination, and, I would suggest are usually characterized by an accumulation of bad macro intervention policies - like artificially low interest rates, regulatory distortions on a macro scale (housing), etc.

5. Though income-constrained processes occur in the absence of policy distortions, they are likely to be relatively short-lived - quickly self-correcting. This is the empirical counterpart to recognizing the cogency of the argument while arguing against its significance in supporting activist, discretionary policy.

6. Non-Keynesians, Austrians and others, have not denied the possibility of income-constrained processes, like the 'secondary depression' that Hayek refers to. To claim that the unfettered market is basically stable, is not to claim that it is perfect, that it is free of all errors, or that adjustments to change are painless.

Keynes's beauty contest and the stock market.

Keynes was dismissive of stock markets in the determination of asset prices likening them to a beauty contest. I have some thoughts on this.

In Keynes’s beauty contest the voters form expectations about the judgement of others about the beauty of the contestants. And if everybody behaves like this no one may pay any attention to their opinion about the actual beauty of the contestants. The result is an emergent reflection of the opinion of other people’s opinion. There is no feedback from the ‘fundamental’ beauty of the contestants. There actually is no such thing, since beauty is in the eyes of the beholder anyway. And when the contest is over it is over. Nobody cared about ‘true beauty’.

On the stock market, people form expectations about other people’s expectations of the future price of the stock. And if everyone behaves this way, then the price of the stock depends simply on everyone’s expectations of everyone’s expectations of the future price of the stock. And no one may actually have any expectations about the future price of stock apart from these expectations of expectations (of expectations, …, ?). And the emergent outcome is thus a reflection of these optimistic or pessimistic expectations about expectations. A process without an anchor, says Keynes.

Except that is not the whole story. Unlike the beauty contest, things happen in the world outside of the stock market that affect the price of the stock. Most importantly the company, whose stock is in question, either does or does not have a cash flow from profits. Negative or zero profits means borrowing. This can go on for a while, but “at some point” the absence of profits must impinge upon those expectations because ‘everyone’ knows that the future price of the stock depends ‘fundamentally’ on future net earnings. The palpable uncertainty associated with these asset prices is a result of the ambiguity of the concepts “future”, “at some point”, etc. How long could Amazon actually have gone on without showing any real profits? It went on much longer than many thought possible, and many dot.com companies failed for want of earnings, even while Amazon endured. What determines the strength of investor forbearance in some cases and not in others? For that one needs a valid theory of expectation determination, probably an impossibility.

The stock market, for that reason, however, is not a beauty contest. Earnings, in a sense an ‘objective’ measure of performance depend upon revealed consumer preferences – whether *consumers* not *investors* think the product is beautiful. There is an *outside* judge who is not concerned about the asset price or even the future earnings of the company, but, rather, only about the value to him of the product being produced. That lends the crucial anchor to the process that is absent in the beauty contest. (Again we see the importance of capital accounting).

They're baaack.

It is hard for some of us to believe this, but the Neo-Ricardians (NCs) are still with us. In fact there seems to be something of a resurgence. They are still claiming that the phenomenon of reswitching renders the very concept of 'capital' as a factor of produciton meaningless and, that this, therefore, shatters the *entire* foundation of neoclassical economics. How frustrating it is! Not that these ridiculous ideas will not die, but that a whole new generation has now to be taught how wrong and dangerous they are.

The NCs are wrong in a number of ways. 1. they erect a metaphysics of a world in equilibrium and engage in comparative statics - never addressing the question of how actual economies actually work and move from one 'equilibrium' to another. 2. they confuse the price of capital services with the price of borrowing (any kind of service) and call it the rate of interest instead of the rental rate on capital. 3. they never address the fact that billions of people use capital accounting every day and seem to think that capital is a real thing. I could go on.

But perhaps the 'largest' of their errors is to claim that, while the factor of production capital is non-existent, labor is real - in fact what we think is capital is actually (HT Karl Marx) indirect labor. In fact, it is the other way round. It's all capital. All productive services - from human bodies or from machines or buildings or land - are valuable only because they are 'knowledgeable' - they 'know how' to do things that we value - they are 'embodied knowledge' (HT Howard Baetjer Jr.). The simplest and most plausible way to think of factors of production is to think of them as different types of capital - human and physical.

Thoughts upon trying to fall asleep - famous economists in my life (in case it may be of interest).

My limited dealings with Milton Friedman (as a student at U of C and various chance meetings) did not endear him to me. I found him a rather unsympathetic personality. But, as a scholar, from his writing, I learned a great deal. I refer to his writing on policy and political economy. He was always clear and logical and tried to anticipate all possible counterarguments. He did not engage in hyperbole or gratuitous denigration. He was perhaps the most effective popularizer of the ideas of classical liberalism of the twentieth century. There was a lot he did behind the scenes that may emerge over time. He advised many governments, including those of Israel, India, Chile, China and the U.S. Who knows how many millions of people benefited from his advice in the journey from poverty to middle class.

I found his scholarly work frustrating in his concessions to the prevailing methodology. He was a strategic writer. He adopted the medium best suited to get the attention of those who disagreed with him most. As a result, for example, he adopted the Keynesian macro-model and much of his work on money comes to us through that. Its hard to know how much he actually approved of the models he used. But he was a master in dressing up appropriately. His Theory of the Consumption Function is more than that though. In that work he went to the center of the conventional wisdom in econometrics and exposed it for a fraud - there were fatal conceptual errors in the main variables. I believe it is hard to overstate the influence of this work on the economics profession and on Friedman's career. After this they absolutely had to take him seriously. He played the game better than they did.

Friedman was forever a "pragmatist" looking for the practical rule to live by. Perhaps the most valuable simple rule for policy that he offered was that the composition of government spending matters much less than the sheer size of government. To do something simple to advance the cause of freedom and prosperity downsize the government dramatically.

In terms of his relationship to the Austrians, I don't know much from my own personal experience. I speculate that the story about the first Mont Pelerin meeting in which Friedman, Stigler and other American 'liberals' found themselves together with Mises, Hayek and a bunch of old-world gentleman, was typical of cultural dynamics that characterized the relationships more generally (just speculation). Maybe Friedman saw in Mises a stuffy, dogmatic old foreigner without much practical relevance. He represented the past and could not speak to the future in an effective way. Mises probably saw Friedman and company as brash, superficial, compromisers who were part of the problem rather than the solution.

Concerning Hayek, who later spent considerable time at Chicago, Friedman clearly owed him a great debt and was much influenced by him in his political economic writings. Friedman acknowledges this debt but is sadly dismissive of Hayek's work as an economist. I wonder still whether Friedman was really so narrowly superficial in his understanding of scientific inquiry or if this was just a strategic decision. (He shared with Hayek a fundamental distrust of convoluted mathematical and/or statistical modelling devoid of economics). Either way - not good.

I met Hayek on very few occasions and got to ask him only one question. I was a budding U of C PhD and was young and an idiot. I asked him what he thought of Friedman's monetary rule. He seemed irritated. He gave the now-familiar answer about how such a rule would never be adhered to in a real crisis (something Friedman seems to have to believe himself in the end), but then he said that, in any case, Friedman had misunderstood the role of statistics in economics and social science. I did not have the faintest idea what he meant. Now I know. At the time Hayek was in the middle of his turn to the examination of complex phenomena and he would have seen Friedman's pedestrian data-crunching as rather pathetically naive. Perhaps he was also bothered by Friedman's appropriation of the ideas of Hayek's friend and colleague Karl Popper to characterize what he (Friedman) was doing - "hypothesis refutation."

Friedman's position toward Hayek pretty much mirrored that of the rest of the mainstream profession - condescending dismissal. And the rest is history.