Lorenzo Bini Smaghi: Slaves of defunct economists
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Master Programme in International Business and Economics, University of
Pavia, Pavia, 24 February 2010.
* * *
Introduction1
economist John Maynard Keynes is back in
"The fashion", writes Robert Skidelsky in the
preface of his most recent book "Keynes, the Return of the Master", published less than one
year ago. The reason, says Skidelsky, is not so much that the world is facing the worst crisis
since the Great Depression and that governments all over the world have embarked on
stimulative packages to support the economy, as the author of the General Theory had
advocated, but because Keynes "provides the right kind of theory", a theory which is "an
indispensable guide for the future".
A question that comes to mind in reading these words is why Keynes had to make a
comeback in the first place, why the General Theory was forgotten and its prescriptions
abandoned. If the Theory was indeed general, it should apply in all circumstances and not
only when the world is on the verge of collapse.
There are two possible answers to the question. The first is that the Theory is not general,
and thus cannot apply to all economic states of the world. The second is that Keynes'
famous admonition in the last page of his General Theory - according to which "Practical
men, who believe themselves to be quite exempt from any intellectual influences, are usually
the slaves of some defunct economist " - has been turned upside down. In other words,
defunct economists - and their theories - are usually enslaved by practical men who do not
fully understand them.
I side with the second interpretation and will use this lecture today to explain why. In my
view, the most important contribution that Keynes has made throughout his life is to warn
practical men, including policy-makers, not to remain trapped in pre-conceived ideas when
addressing new issues. In "The Economic Consequences of the Peace" (1919) he warned
against adopting the traditional practice of peace treaties - namely, extracting huge
reparations from the defeated countries, without taking into account the general economic
situation and the burden that this would also impose on the victorious countries. In "A Tract
on Monetary Reform" (1923), he warned against a precipitous return to the Gold Standard
which prevailed before the war as a way to reinstate monetary discipline and fight against
inflation. In "The General Theory of Employment, Interest and Money" (1936) he warned
against the predictions of the classical theory, in particular when the underlying assumptions
of such a theory are not fulfilled, as was the case during the Great Depression.
Throughout his life Keynes questioned mental constructions based on very restrictive
assumptions. He shows the limitations of such approaches in "The General Theory" by
putting at the centre of his analysis the role played by uncertainty in shaping economic
outcomes. As he pointed out: "The state of confidence, as they term it, is a matter to which
practical men always pay the closest attention. But economists have not analysed it
carefully."2 In his view, the pervasive role played by uncertainty in the economy explains a
number of otherwise puzzling departures of the real world from the idealised system
described by classical general equilibrium theory. In particular, it explains why a state of
depressed expectations can persist, and can lead to a protracted recession, or even to a
depression. According to Keynes, the "state of confidence" is constantly in flux. When it is
high, business thrives; when it is depressed, on the other hand, the economy contracts, and
can even end up in a permanent state of under-utilisation of resources.
government intervention
Keynes' analysis of the need for and role of is predicated on the
state of uncertainty prevailing in the economy. The main contribution that economic policies
can make is to reduce uncertainty. Policies are not intrinsically "good" or "bad", but rather,
their effectiveness depends, first, on the extent to which they decrease or increase
macroeconomic uncertainty, and second, on their ability to coordinate agents' expectations
towards a better equilibrium. Keynes was not in favour of systematic government intervention
in the economy under all circumstances and all states of the world. In his view government
should abstain from interfering with the normal functioning of the economy and should only
step in under exceptional circumstances, in particular in the presence of a heightened state
of uncertainty. This point was unfortunately lost on many of his followers after the Second
World War, who advocated government intervention under all circumstances and all states of
uncertainty, thus leading to policy mistakes such as the Great Inflation of the 1970s.
To make sure that Keynes is back for good, and will not be returned to the shelves when the
crisis is over, we need to fully understand the breadth of his analysis, in particular the role
played by uncertainty in shaping economic outcomes. I would like to make a contribution
here by reviewing a few key aspects of his analytical work regarding the importance of
uncertainty, the role of government intervention and the effectiveness of stabilisation policies.
1. The importance of uncertainty
In his Treatise on Probability,3 Keynes discussed three types of uncertainty. The first, and
easiest to characterise and handle within macroeconomic models, is cardinal uncertainty. Its
key feature is that it can be measured, and that a specific number can be attached to it. For
example, we can say that, based on data from the last (say) thirty years, there is an X%
probability that next year the euro area economy will grow by Y%. An important assumption
is that the structure of the economy must remain sufficiently stable over time, or, in case it
experiences time-variation, both the type of variation, and its pace (or velocity) must be
known with a reasonable degree of accuracy.
The second type is ordinal uncertainty. In such a situation, although no specific number can
be attached to the probability of a specific event, we are still in a position to state that event A
is more likely than event B. According to Keynes this was by far the single most important
probability class.4 It's important to stress that this second type of uncertainty lies outside the
dominant macroeconomic framework. Indeed, according to the rational expectations
hypothesis, agents use the structure of the model in order to compute objective, numerical
probabilities of alternative events occurring. Even in models where expectations are not fully
rational, but rather computed on the basis of learning schemes, probabilities are computed
econometrically.
Finally, there is the so-called "irreducible uncertainty" - a concept originally introduced by
Frank Knight5 - which is simply based on the fact that agents have no rational basis for
making any probabilistic statement of any kind about a specific event occurring or not
occurring.
It is obviously very difficult to identify which type of uncertainty prevails at a specific point in
time, especially with respect to this third one.
There is ample evidence to suggest that the 1930s was a period in which the third type of
zeitgeist of,
uncertainty dominated. Paul Valéry, writing in 1931, captured the well:6 "Instead
as in the past, playing an honest card game with fate, knowing the rules, knowing the
number of cards and face cards, we are now in the position of a player who is astonished to
discover that his adversary's hand contains face cards never seen before, and that the rules
of the game change with each hand." As The Magazine of Wall Street put it a month after
Black Thursday:7 "Uncertainty is worse than knowing the truth, no matter how bad ". This was
the psychological climate and state of mind Franklin Roosevelt was referring to when, in his
inaugural address as President of the United States in 1933, he stated that "the only thing we
have to fear is fear itself ".
The economic literature confirms the uncertainty prevailing during those days. In their classic
Monetary History of the United States,8 Friedman and Schwartz pointed out that: "The
contraction after 1929 clearly shattered beliefs in a "new era", in the likelihood of
longcontinued stability [...]. The contraction instilled instead an exaggerated fear of continued
economic instability, of the danger of stagnation, of the possibility of recurrent
unemployment". Events such as the 1929 stock market crash, or the September 2008
collapse of Lehman Brothers, create a vast amount of "irreducible uncertainty", which exerts
paralysing effects on spending decisions and may cause the economy to slide into a
depression.
During the months immediately following the 1929 crash, indeed, both consumer purchases
of durable goods and business investment dropped sharply, while spending on perishable
goods rose slightly. Christina Romer (1990) argues that the most likely explanation for this
phenomenon is that the uncertainty generated by the financial crisis induced both consumers
and firms to put off purchases of durable and investment goods, respectively, thus causing
the economy to stall and contract. The mechanism underlying this "wait and see" attitude
during periods of heightened uncertainty has been well known since the work of Bernanke
(1983), and it has been extensively explored by Dixit and Pindyck (1994). The key point is
that when a specific purchase is irreversible, as is the case with either investment or durable
goods purchases, agents must make a trade-off between the benefit deriving from an early
commitment and those deriving from waiting for better information. Within such an
environment, an increase in uncertainty can therefore naturally lead to a postponement of
expenditure decisions in order to get better information, thus causing a fall in demand.
The effects of irreducible uncertainty tend to have a long-lasting economic impact. For
instance, one of the leading explanations for Mehra and Prescott's (1985) "equity premium
puzzle" - i.e. the large excess return of stocks over the risk-free rate which has characterised
the last several decades - has to do with the trauma of the Great Depression, and with the
public's gradual and slow realisation of the aberrant nature of those years, which led the
equity premium to gradually decrease from the peaks reached during the 1930s.9
2. The role of government intervention
Classical theory maintains that government should not interfere with the interaction between
economic agents, because this would lead to a sub-optimal allocation of resources. This
approach may apply also to situations of heightened uncertainty, to the extent that sooner or
later the economy is expected to get back to normal. By not intervening, the policy-maker
avoids introducing distortions into the economy which may cause further and graver
problems later on.
The notion that the excesses and imbalances that lead to a crisis should be allowed to play
out and unwind without government intervention was the intellectual rationale behind the
position of Herbert Hoover's Secretary of the Treasury, Andrew Mellon, during the early
years of the Depression, when he famously stated: "Liquidate labor, liquidate stocks,
liquidate the farmers, liquidate real estate[...]. Purge the rottenness out of the
system."
Expressed less dramatically, Mellon's idea was that the crisis originated in a series of
distortions which had been building up in the American economy during the "Roaring
Twenties", first and foremost a highly overvalued stock market, and, to a slightly lesser
extent, a housing boom. Given that the problem resulted from massive distortions and
imbalances that developed over the years, the only way to solve the problem was to wait
patiently until the imbalances unwound. Once the storm had passed, the economy would
return to equilibrium, an equilibrium, it is important to note, free from the previous distortions.
There are (at least) three reasons why this approach, although at first sight intellectually
attractive, might be flawed. The first reason is the theoretical possibility that the economy
possesses multiple equilibria, so that an especially large negative shock may push it into a
permanent underemployment equilibrium. Over the last three decades a branch of
macroeconomic research has further explored the idea, proposed by Keynes in "The General
Theory", that the economy may possess a continuum of equilibria, so that autonomous
fluctuations in the degree of "optimism" or "pessimism" can move it from one equilibrium to
the other, thus generating booms and recessions. Diamond (1982),10 for instance, develops
a model characterised by trading externalities. The key intuition is that a firm's optimal level
of production crucially depends on the probability of finding buyers, which in turn depends on
the level of aggregate demand. So if the firm thinks that the probability of selling its output is
low, it will produce less. But since this holds for all firms, this attitude will generate a low level
of aggregate demand, so that the initial pessimistic belief will be validated. Such an economy
exhibits multiple equilibria, and, in principle, there is no reason why one of them should be
"preferred", or should be regarded as "more likely" than any other, so that the economy, once
dislocated from a high-employment equilibrium by (say) a large bout of pessimism, can
potentially remain in the low equilibrium. In recent years, this position has been mainly
associated with the work of Roger Farmer, who has produced several examples of
economies characterised by a continuum of equilibria. Keynesian "animal spirits" may select
one of these as "the" equilibrium which will ultimately prevail.11
The possible existence of multiple equilibria, with a significant fraction of them characterised
by extensive unemployment and under-utilisation of productive resources, provides a
conceptual rationale for government intervention in the economy. In this kind of environment,
coordinate
government's fundamental role is to help the private sector's expectations in
respect of one of the high-employment equilibria. The second reason why government
intervention is justified in the face of uncertainty is the possibility of deflation. On this I will be
brief, because the argument is well known, and it has been well understood at least since the
work of Irving Fisher.12 The key point is that, because of the zero lower bound on nominal
interest rates, once the economy has fallen into a deflationary trap, traditional monetary
policy tools, and in particular, changes in the short-term policy rate, are ineffective at lifting it
not
out of the doldrums. To be sure, this does imply that monetary policy, as more generally
conceived, is ineffective under these circumstances.13
The third reason has to do with the fact that the severity of the economic contraction may
change the economy's equilibrium level - or potential output - bringing it down together with
actual output. This is routinely ignored by standard macroeconomic models, which are
"loglinearised" (in plain English, approximated) around a fixed equilibrium, and for which
macroeconomic fluctuations are, by construction, temporary. Although the assumption that
the economy's equilibrium is independent of past business fluctuations represents a useful
simplification when dealing with comparatively small fluctuations, this is not the case when
we are dealing with collapses on the scale of the Great Depression, for the simple reason
that they may trigger chains of events that can lower potential output permanently.
There are several mechanisms through which a comparatively large economic downturn may
lead to a permanent decrease in potential output. One mechanism involves the impact of
long periods of unemployment on workers' skill sets, their productivity and their very
attachment to the labour force. To put it simply, the longer a worker is unemployed, the more
his or her skill set deteriorates because of lack of use, and the more tenuous his or her
attachment to the labour force becomes, with the result that, as time passes, the less
employable the worker becomes. In the end, some workers even drop out of the labour force
altogether. This phenomenon used to characterise Europe, whereas the US labour market,
significantly more flexible and dynamic, was essentially immune to it, with a comparatively
low fraction of long-term unemployed. It is a measure of the depth of the recession in the
United States that, in October of last year, nearly 40% of the unemployed had been out of a
job for at least six months, whereas 20% had been jobless for at least a year.14 In both cases
these were significantly higher figures than the corresponding ones for the recession of the
early 1980s.
3. The effectiveness of stabilisation policies
laissez-faire
Given the previously mentioned problems associated with a classical, approach
in the presence of a heightened state of uncertainty, government has the responsibility under
such circumstances to intervene in order to counteract the potentially devastating effects on
the economy. Since - as previously mentioned with reference to the period following the
stock market collapse of 1929 - situations characterised by a heightened state of uncertainty
are also typically associated with a collapse in aggregate demand, the effectiveness of
stabilisation policies under these circumstances crucially depends on their ability to stimulate
aggregate expenditure.
A substantial body of literature has developed in recent decades showing how monetary and
fiscal policies can contribute to stabilising income. The literature is based on several
alternative approaches, from the so-called "narrative approach" originally introduced by
Milton Friedman and Anna Schwartz in their historical analysis of US monetary policy,15 to
the technically clearest evidence coming from structural vector autoregressions16 and
estimated general equilibrium macroeconomic models.17
Macroeconomic policies can contribute to decrease heightened uncertainty by supporting
aggregate demand but also by improving the functioning of markets. As we have seen
recently, a key characteristic of such periods is that financial markets' normal trading activity
tends to become severely impaired, to the point that a significant fraction of operators may
even stop trading with one another, thus leading to a credit crunch, and to a further
contraction in aggregate demand. Under these circumstances, central banks can intervene,
for example, by accommodating banks' liquidity demand at a pre-specified interest rate,
lengthening the maturities of long-term refinancing operations, or expanding the list of assets
which banks can use as collateral. All these measures support the functioning of financial
markets, thus countering the effects of the credit crunch and ultimately decreasing irreducible
uncertainty and supporting aggregate demand. This prevents the economy from entering a
recessionary loop, in which the freezing-up of financial markets leads to a contraction of
credit, which, in turn, leads to an economic contraction, additional uncertainty, and further
financial market immobility, in a self-reinforcing cycle.
The fact that macroeconomic policies can help to stabilise the economy, and prevent deep
downturns, by reducing the heightened state of uncertainty prevailing among economic
agents does not mean that they are always effective, under all circumstances. On the
contrary, experience has shown that these policies may well turn out to be destabilising,
especially if they are implemented in a way which increases the state of uncertainty, instead
of reducing it. This may happen, in particular, if the size of the fiscal and/or monetary
injection is such that irreducible uncertainty is increased, rather than reduced.
A case in point is when a government runs up a succession of very large deficits and ends
up accumulating an excessive stock of national debt. At the limit, this may even lead to a
dislocation of inflation expectations, as financial markets start to expect that part of the
national debt will be simply "inflated away" - that is, it will be eroded via higher inflation18 -
with a resulting increase in interest rates. By definition, preventing a dangerous build-up of
national debt requires keeping budget deficits under control. When this is especially difficult
because of the sheer magnitude of the recession, governments should - at the very
minimum - provide financial markets with a clear "re-entry plan", carefully specifying both the
timeframe within which the deficit will be brought under control, and the specific measures
the particular government intends to take.
The need to avoid creating excessive uncertainty about a country's long-term fiscal solvency
represents the fundamental limit to the extent of the fiscal stimulus which can be injected into
the economy. As Skidelsky19 observes, Keynes himself would not have excluded balanced
budgets even during a recession, if this was needed to minimise the risk of sowing doubts
about long-term fiscal solvency in the minds of market operators. The alternative is an
increase in the risk premia that financial markets require in order to absorb government
bonds, and therefore an increase in interest rates. In turn, this results in lower capital
accumulation, and therefore, ceteris paribus, in lower productivity and output per capita.
Empirical evidence suggests that countries whose level of national debt exceeds a certain
threshold are also characterised by comparatively lower growth: Reinhart and Rogoff (2010),
analysing a dataset which spans the last few centuries and comprises several dozen
countries, show that, for those countries with a government debt-to-GDP ratio of over 90%,
median GDP growth tends to be about one percentage point lower than it would be
otherwise. Although at first sight this may appear small, when cumulated over decades it
leads to significantly lower standards of living.
Empirical evidence also shows that higher deficit-to-GDP and debt-to-GDP ratios lead to
higher interest rates even when there are no doubts about fiscal solvency. A study by
Thomas Laubach20 based on US data, for example, estimates that every percentage point
increase in the projected deficit-to-GDP ratio results in an increase in long-term interest rates
of 20 to 29 basis points, whereas a percentage point increase in the debt-to-GDP ratio is
associated with an increase of about 3 to 4 basis points. Once again, although such effects
may seem tiny, when cumulated over long periods of time their impact becomes significant.
Another fundamental problem of fiscal policy is its lack of timeliness, or, to put it differently,
implementation
its lags. Whereas automatic stabilisers such as unemployment benefits are
built into the system, and therefore have no implementation lags to speak of, decisions
concerning taxation and expenditure are legislated by parliament. As a result, as extensively
discussed in standard macroeconomic textbooks, a fiscal stimulus may come to be
implemented with a potentially significant delay. A conceptually related problem with using
fiscal policy as a stabilisation tool is that its need to "pass through the political process"
inevitably decreases its predictability. Fiscal stimulus packages, quite inevitably, become part
of a larger bargaining process between competing interest groups, so that not only the
timing, but also the extent and composition of the fiscal stimulus become comparatively
uncertain.
Monetary policy has also its limitations when it comes to stabilisation purposes. One problem
is that low interest rates, if protracted, may fuel new imbalances, in particular bubbles in
asset markets, increasing uncertainty across the board, rather than decreasing it. Once
again, this is nothing but an illustration of the same general point I previously made with
reference to the need to guarantee fiscal solvency: the fundamental limit to government
stabilisation policies is that such interventions should never increase overall uncertainty, and
they should rather decrease it.
This point was very clear to Keynes, but it was unfortunately lost on many of his followers
during the early decades of the post-WWII period, who advocated government intervention
under all circumstances, in order to keep the economy as close to potential as possible - that
is, to "fine-tune" it. The dangers intrinsic to such an approach to stabilisation policy were
pointed out by Federal Reserve Chairman William Martin in his February 1965 testimony
before the Joint Economic Committee of the US Congress when he stated that: "There is,
inevitably, an element of brinkmanship in our laudable efforts to push our economy closer
and closer to its full potential without straining it ". The "brinkmanship" Martin mentioned has
to do with a key limitation of "fine-tuning" policies which had long been discussed by
monetarists such as Milton Friedman and Karl Brunner:21 the use of stabilisation policies
under all circumstances is predicated on a reasonably precise knowledge of equilibrium
levels, such as potential output and the natural rate of unemployment. Since they are both
unobserved, and they both change over time, the use of such policies under normal
circumstances, in order to keep the economy constantly close to potential, is inevitably
bound to fail. And indeed, one of the dominant explanations for the Great Inflation of the
1970s in the US traces its origins to the combination of "fine-tuning" policies and the inability
of the Federal Reserve to detect the productivity slowdown of the 1960s-1970s in real time,
thus resulting in a systematic over-estimation of the true extent of slack in the economy.22
Since output gap measures were a key ingredient in the Fed's monetary policy process, this
automatically resulted in an excessively loose monetary policy, thus igniting and then
perpetuating the Great Inflation.
The fact that the origin of the inflationary upsurge of the 1970s is to be found in the
finetuning policies of that era provides a stark illustration of the dangers associated with
systematic government intervention under normal circumstances - specifically, under
circumstances which are not characterised by irreducible uncertainty. As extensively
discussed by Milton Friedman in his critique of so-called "Keynesian stabilisation policies",
even in a best-case scenario the systematic use of such policies injects noise into the
economy, thus increasing uncertainty across the board. This was the key rationale for
Friedman's rejection of discretion in favour of a simple monetary policy rule such as the
"k-percent rule", according to which the central bank should focus on stabilising the rate of
growth of the money supply at a specific value.
There is a further, and subtler aspect to this. As was demonstrated by the rational
expectations school back in the 1970s, if agents are rational, only the unsystematic
component of policy - that is, only a policy surprise - has an impact on macroeconomic
outcomes. But this implies that a policy-maker who aims to pursue stabilisation policies can
only do that by systematically surprising the private sector, which is an obvious contradiction
in terms, as policy surprises, by definition, cannot be systematic: if they were systematic,
indeed, they would be taken into account by private agents when forming expectations, and
they would therefore be nullified. The conclusion, once again, is that, unless the economy is
in a state of extreme uncertainty, systematic government intervention injects noise into the
system, therefore increasing overall uncertainty.
To be sure, this does not imply that any kind of government intervention per se is
counterproductive: structural policies aimed at (e.g.) fostering productivity growth, or
increasing labour force participation rates, are examples of beneficial government
interventions. The key reason why such policies are beneficial, however, is that rather than
attempting to stabilise the economy around an unobserved and imprecisely estimated
equilibrium level, they aim to increase such a level. As a consequence, structural policies do
not suffer from the drawbacks afflicting systematic stabilisation policies under normal
circumstances.
Conclusions
Keynes'
major contribution has been to challenge common wisdom, which rests on human
beings' innate tendency to tackle the problems they face in the same way as they did in the
past, expecting to achieve the same outcome, even when circumstances differ. After the First
World War, he accused the leaders of the time of "attacking the problems of the post-war
world with unmodified pre-war views and ideas".23 He repeated this charge after the Great
Depression. Their failure to listen led to even greater problems.
What are the lessons for our critical times?
Let me elaborate on my personal views, considering in particular the role of policy-makers.
Keynes has taught us to assess carefully the state of the world we live in before designing
the policies that authorities should implement. When heightened uncertainty prevails,
government has a role to play in adopting measures that contribute to reducing the state of
uncertainty and in helping economic agents coordinate expectations towards a socially
optimal outcome. This raises a few difficulties for policy authorities. First, they have to assess
whether the state of uncertainty is such as to justify active intervention. Second, they have to
design policies that help to reduce uncertainty, rather than increase it. History is full of
examples of policy mistakes made in both directions, i.e. of states of heightened uncertainty
which were not recognised and were not accompanied by adequate actions, and states
which were considered as being of heightened uncertainty even though they were not and
were accompanied by policy actions which increased uncertainty instead of decreasing it.
These are the typical type I and type II errors recognised in statistical analysis.
How can we avoid making these mistakes, in the midst of the deepest economic slump since
the Second World War? In particular, how can we avoid the temptation to address the
problems of the post-crisis world with unmodified pre-crisis views and ideas?
At the start of the crisis, authorities around the world intervened massively, using both
monetary and fiscal instruments. This prevented a total collapse of economic activity, which
has now started to recover. The type I error has been avoided. Keynes' lesson has been
understood.
The key question, from now on, is how to avoid the type II error, which consists of overstating
the conditions of uncertainty and implementing policies which may increase uncertainty,
rather than decrease it. I see here a risk that the lessons of the crisis will be quickly forgotten
if the analytical framework underlying the policy decisions is not substantially improved. Let
me give some examples.
First, most models continue to assume that markets price assets in an efficient way and that
agents form expectations in a fully rational way. The state of uncertainty in the economy
continues to be assessed on the basis of market indicators, which have proven in the recent
past to be potentially quite misleading. For example, the sustainability of monetary and
economic policies is often evaluated in accordance with market-based indicators related in
particular to inflation expectations and credit risk premia. Low inflation expectations and
default premia are often interpreted as a sign that markets are attributing a low probability to
the risk that policies may become unsustainable. However, we have seen in the recent past
that markets tend to adjust prices in a discontinuous way. Analysing policy sustainability
exclusively on the basis of market indicators may create the illusion that inflation
expectations are well anchored or that markets are willing to continue finance large budget
deficits, thus creating an incentive for unduly prolonging very expansionary policies.
Second, most models continue to be based on an unchanged belief about the capacity of
monetary and fiscal policy action to pilot the economy towards full employment. As
mentioned previously, Keynes taught us that policy multipliers change depending on the
underlying state of the economy and on its prospects. This insight was rationalised in the
mid-1970s by Robert Lucas, a neo-classical economist, in his se