New Keynesians Finally Reject Keynes's General Theory
"Classical Economics Provides the Right Answers to Many Fundamental Questions"
SEPTEMBER 01, 1996 by MARK SKOUSEN
“When people attempt to save more, the actual result may be only a lower level of output . . .”
—Paul A. Samuelson
“Higher saving leads to faster growth . . .”
—N. Gregory Mankiw
The two quotations above dramatically demonstrate the stark contrast between the “old” Keynesians and the “new.” Samuelson and the old-style Keynesians start with the “general” theory of unemployment equilibrium and end with the classical model of full employment as a “special” case. As long as there are unemployed resources—which, according to the old Keynesians, is most of the time—thriftiness is bad and expansionary monetary and fiscal policy (i.e., inflation and deficit spending) are good. For 50 years, this “demand-management” model has been the standard approach in college economics.
The New Keynesian Revolution
Now along comes a new generation of economists, known as “new” Keynesians, who have wisely changed their way of thinking. In the most popular textbook on macroeconomics, author N. Gregory Mankiw reverses the standard Keynesian pedagogy. Mankiw, you may recall, is the young Harvard economist who was paid a $1.4 million advance last year to write the next “Samuelson” textbook. (See my column, The Freeman, October 1995.)
His mammoth advance was due, in part, to the success of his previous textbook on macroeconomics, last published in 1994. Macroeconomics may be a harbinger of what’s to come. In a brilliant move, he begins with the classical model and ends with the Keynesian model, just the opposite of Samuelson & Company. Mankiw states in the preface, “in the aftermath of the Keynesian revolution, too many economists forgot that classical economics provides the right answers to many fundamental questions.”
Under Mankiw’s long-run “general equilibrium” model, what are the effects of an increase in government spending? Crowding out of private capital. “The increase in government purchases must be met by an equal decrease in investment. . . . Government borrowing reduces national saving” (p. 62).
Economic growth is discussed up front, not at the end, as most textbooks do. Using the Solow growth model, Mankiw takes a strong pro-saving approach. He maintains that “the saving rate is a key determinant of the steady-state capital stock. If the saving rate is high, the economy will have a large capital stock and a high level of output. If the saving rate is low, the economy will have a small capital stock and a low level of output” (p. 86). What is the effect of higher savings? It’s positive. “An increase in the rate of saving raises growth until the economy reaches the new steady state,” although the law of diminishing returns suggests that “it will not maintain a high rate of growth forever” (p. 86). Mankiw writes favorably toward those nations with high rates of saving and capital investment, and even includes a case study on the miracles of Japanese and German growth (examples virtually ignored in Samuelson’s textbook). He supports efforts to increase the rate of saving and capital formation in the United States, including the possibility of altering Social Security from a pay-as-you-go system to a fully funded plan, though he does not discuss outright privatization (pp. 103-4).
The cause of unemployment? Relying on the “natural” rate of unemployment hypothesis, Mankiw suggests that unemployment insurance and similar labor legislation reduce incentives for the unemployed to find jobs (pp. 121-5). He provides evidence that unionizing labor and adopting minimum-wage laws increases the unemployment rate (pp. 127-30). He offers a case study on Henry Ford’s famous $5 workday as an example of wages determined by productivity.
He approvingly quotes Milton Friedman on monetary theory: “Inflation is always and everywhere a monetary phenomenon.” Mankiw uses numerous examples, including hyperinflation in Interwar Germany, to confirm the social costs of inflation (pp. 161-9).
Inverse Relationship between Taxes and Savings
Source: Edwin G. Dolan and David E. Lindsey, Economics (The Dryden Press, 1988, Perspective 11.1)
Sins of Omission
Not all is right with Mankiw, however. In Mankiw’s model, tax cuts have the same effect as deficit spending—by raising consumption, it “crowds out investment and raises the interest rate,” he says (p. 64). However, he fails to realize that tax cuts also stimulate savings, as the graph (below) from Dolan and Lindsey clearly demonstrates. Not all tax cuts will be spent on consumer goods.
Further more, Mankiw apparently assumes that government spending remains the same when tax cuts are put into effect, thus raising the deficit. He repeats the common historical error that the Reagan tax cuts enlarged the deficit, and thereby raised interest rates and lowered national savings. (p. 65) In fact, while marginal tax rates declined, tax revenues rose during every year of the Reagan presidency. Tax cuts didn’t cause expanding deficits, excessive federal spending did.
The second half of Mankiw’s textbook introduces all the standard tools of Keynesian modeling—aggregate supply (AS) and aggregate demand (AD), the multiplier and accelerator, and IS-LM model. The author presents real business cycle theory, wage rigidity, money neutrality and the Ricardian Equivalence Theorem, all in a bewildering effort to explain economic fluctuations “in the short run.” Although he includes a section on Robert Lucas, Jr., and the Rational Expectations School, he has virtually nothing to say about the supply-siders and the Austrians, a major omission. These two schools could have cleared up a lot of confusion about macroeconomic theory and policy.
Still, free-market economists should celebrate in knowing that the profession is slowly moving in the right direction— toward fundamentally sound economics.
That’s quite a feat for a man (Mankiw) who named his dog “Keynes.”
Source: Edwin G. Dolan and David E. Lindsey, Economics (The Dreyden Press, 1988, Perspective 11.1)