Posted by: Dirk | February 28, 2009

Robert Barro attacks unidentified Keynesians

I have just read an article called Voodoo Multipliers by Barro. After recently finding that Gregory Mankiw does not understand Keynes, this is the latest case of macroeconomic dogma. Apparently, the non-Keynesians do not understand Keynes at all. It is hard to argue with those kind of people. Let’s have a look at some things that Barro says:

1. To think about this assumed multiplier, suppose first that it took on the lower value 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP).

So far so wrong. In an economy with idle resources, let`s assume that the government spends $1 on a bridge. The (tiny) bridge is build by a construction worker, who saves 25% of his income, spends 25% on taxes and spends the rest on 50c of goods and services as he sees fit (goods and services that would otherwise not be demanded in a depressed economy). Whoever gets that money, will again save 25% of it, pay a marginal tax of 25% and spend the rest. And so it goes on and on and on. In the end, almost $2 will be spent, of which $1 is spent by the government and $1 by the people. You can argue about the size of the multiplicator, but a base case of 1 assumes that the whole income is spent on savings and taxes, which is completely unrealistic.

2. So, where is the flaw in the argument? The theory (a simple Keynesian model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff.

Well, Barro is attacking a straw man here. White male, Keynesian, … What Keynes said in his General Theory said was that only if monetary policy fails to work there would be a case for fiscal policy. So, the flaw is that Barro attacks some Keynesian ghost instead of dealing with real arguments of real people. Since only a few lines above he compares the Keynesian free lunch with a Ponzi scheme, it becomes clear that this article is not aimed at serious economists who want arguments and discussion, but a polemic tract in order to save “everything we have learned about macroeconomics since 1936”. (Which, I might add, may be less than we have forgotten during this time.  See Paul Krugman’s post here.)

3. Keynes thought that the problem lay with wages and prices that were stuck at excessive levels.

Again, this is plain wrong. In his General Theory, Keynes pointed out that the interest rate is not determined by the loanable funds theory, but that there would a liquidity preference that heavily influences the price of money. It is when relative prices of investment goods and consumption goods are misaligned that a crisis breaks out, caused by over-investment. By the way: a cautious interpretation of the General Theory can show that a decrease in GDP happens in a deflationary environment, while a boom causes inflationary pressures.

Barro ends his article with comparing the Keynesian fiscal spending advocates to extremists like the tax cut supply siders, but this comparison is not backed up by any valid arguments, if you think about it. On this blog, I have often advocated for fiscal policy during this crisis. I have made clear how much of it should be just right, and how a rise in the interest rate can reign in any inflationary pressure. I do not think that government is better than business in running in an economy except in the case of the failure of monetary policy (so I agree with Keynes’ General Theory). That happened twice in the last 100 years: during the Great Depression and now.

It would be helpful for economists that want to participate in the debate to have read and understood the main arguments of Keynes as put forward in the General Theory (and if I am not asking too much, also try to understand the interpretation of Minsky about our economy being a financial one, where money does not only buy goods and services but also establishes financial relations). It is getting boring to see repeats of attacks on Keynesian strawmen over and over again. Read the original, for our economies’ futures sake!

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Responses

  1. […] Keynesian multiplicator and the role of price stickiness in the General Theory over one month ago here. But since the Economists’ Voice is a better medium than my blog (since I am just one, and […]

  2. This is to perpetuate the myth that something can come from nothing, which is worse than wrong. The multiplier is a fantasy, a magician’s ruse, that leads to complacency, as all myths tend to do.


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