Are they all Keynesians again?

American politics

Democracy in America

Uncertainty

Are they all Keynesians again?

by M.S.

JONATHAN CHAIT criticises Republican claims that the weakness of the economy is due to uncertainty over future government taxes by noting that when the GOP had a chance to provide some certainty on taxes, it refused. Republicans could have accepted a Democratic proposal to "end uncertainty by making the tax cut on income below $250,00 permanent, while returning to Clinton-era tax rates on the rich," but instead they struck a compromise in which "the Bush-era rates will live on for two years, after which nobody knows if they'll be extended or not." In other words, Republicans exacerbated tax uncertainty in order to get lower rates for the rich. Last week Christina Romer made some similar, if less pointed, observations in a New York Times op-ed, arguing that while uncertainty is key to the weak economy, the main sources of uncertainty aren't the short-term issues of the Bush tax cuts or EPA regulations; it's the unpredictable and potentially catastrophic funk of the American and global economies.

The main thing that strikes me here is how interesting it is that Republicans are embracing the idea that economic weakness can be caused by uncertainty. Why is that so interesting? Well, basically because it's the central insight of Keynesian economic thought. Neither the Ricardian classical economists who preceded Keynes nor the Friedmanite neo-classical economists who gained ascendancy from the 1970s assign much of a role to uncertainty. They tend to model the economy as consisting of rational actors who base their decisions on the totality of available information, making calculations of different kinds of risks that are then reflected in prices. As Robert Skidelsky puts it in "Keynes: The Return of the Master":

Classical economists believed implicitly, New Classical economists believe explicitly, that market participants have perfect knowledge of future events. This is equivalent to saying that they face only measurable risks. In making investments, they are in exactly the same position as life insurers: they know the odds. Keynes believed that in many situations market participants face irreducible uncertainty. They have no basis on which to calculate the risks they face in making an investment...From this follows the crucial role of money in Keynes's theory as a 'store of value'. Money is one of the 'conventions' which human societies have adopted to guard themselves against uncertainty, by allowing people to postpone decisions about whether and what to buy.

Hence Keynes's idea that a recession can be caused when a rise in uncertainty drives people to increase their preference for holding money or equivalent instruments of value, rather than goods or services. And hence Keynes's idea that in a severe recessionary spiral, the government should intervene to restore confidence by spending money on goods and services to get the economy moving again, ie stimulus.

Conservatives have not usually found this emphasis on uncertainty as an economic force congenial; they generally prefer models of the economy in which rational self-interested agents act on the basis of calculable incentives. The most conservative, freshwater, Chicago-school, general-equilibrium economic models tend to be those which grant the least role to uncertainty. To be sure, politicians aren't economists, and conservative politicians have been eager enough to pass tax cuts that function as Keynesian stimulus. They sometimes justify them in Keynesian terms, as a way of putting money in people's pockets and restoring confidence, but more often conservative politicians advocate tax cuts during recessions for the same reason they advocate them during recoveries, because they think cutting marginal tax rates reduces deadweight loss and increases economic efficiency. This way of thinking is appropriate in a Friedmanite world where people are making rational economic decisions on the basis of available information, such as a possible 3% hike in the top marginal tax rate. It has no traction in a Keynesian understanding of a recessionary spiral driven by uncertainty, where businesses don't hire because they're afraid no one will buy anything, and workers don't buy anything because they're afraid they'll lose their jobs. So why the current vogue for "uncertainty" on the right?

You could start with Mitch McConnell's comments on the December 5th attempt by Democrats to pass a bill that would have preserved the Bush tax cuts only up to the first $250,000 in income:

Two years of out-of-control spending and big-government policies have led to record deficits and debt, chronic unemployment, and deep uncertainty about our nation's fiscal future.

Mr McConnell is saying that the uncertainty causing the recession is mainly about the national debt, and that the source of the uncertainty is the government's attempts to re-establish confidence through stimulus spending. As Ms Romer writes, this strains credulity:

The deepest and most destructive uncertainty we face centers on the overall health of the economy and its prospects for growth... Some forecasters say that consumer spending is on the rebound and that housing construction will bounce back as the normal demographic determinants of housing demand reassert themselves. Others say that the process of deleveraging—getting debt burdens back down to normal levels—will continue to inhibit the growth of consumer spending and business investment... Such uncertainty about future economic conditions can make people hold off on any spending that is difficult to undo.

...In a paper I wrote many years ago, I found that such macroeconomic uncertainty helped start the Great Depression. The stock market crash in October 1929 didn’t destroy a particularly large amount of wealth or make people highly pessimistic. Rather, it made companies and consumers very unsure about future income, and so led them to stop spending as they waited for more information.

As Ms Romer writes, uncertainty over the prospects for growth in the American and global economies dwarfs uncertainty over America's long-term debt problems. I mean, think about it: in the last two weeks, what has been the biggest source of uncertainty? It's clearly the possibility that the euro could collapse under a wave of speculative attacks by private-sector bond traders. Such a collapse would be triggered by the inability of governments to cover foreign debts amassed by private-sector banks in Ireland, Spain and Italy. Collapsing European growth would make it that much harder for America to recover, and a protectionist China is unlikely to offer much relief. There is no obvious new champion industry on the horizon to play the role of the tech sector in the 1990s. Nobody knows how much a barrel of oil will cost in a year to within a factor of 2. Exchange rates are fluctuating wildly as forex trading has exploded over the past decade. The foreclosures mess could still come back and tank who knows how many financial institutions. And so on.

Basically, I think Republicans are self-evidently right that uncertainty is dampening business investment to a large degree. But it seems bizarre to attribute that uncertainty mainly to the risk of tax hikes, whether today or in the future. My guess would be that conservatives tend, as Mr Skidelsky says, to hold a view of the economy in which a free market naturally returns to a beneficent natural equilibrium state barring external shocks. That view of the market has no place for radical uncertainty; if uncertainty reigns, as it clearly does right now, then for conservatives, the source of the uncertainty must somehow lie in politics and government, however implausible that may seem. Keynes's insight was that capitalist economies themselves intrinsically generate radical uncertainty, there is no natural equilibrium state, and the role of government should be to create confidence in a marketplace whose nature devolves periodically into chaos. Unfortunately, a bitterly divided government half-opposed to the very idea of intervening in the market may be incapable of generating any such confidence.