Hah! Not really. The point of this thread is to quickly show how neo-Keynesian, new Keynesian, and monetarist economics are all essentially self-refuting when it comes to the supposed need for fiscal and monetary stimulus in a laissez faire economy.
All three of these macroeconomic schools of thought are based on neoclassical microeconomics. The basics of neoclassical economics are that individuals and households maximize utility whereas firms maximize profits.
So what do these basic insights show? Well, if households really do maximize utility and if firms really do maximize profits, then presumably households and firms would save during booms and "dissave" during busts, thereby completely eliminating booms and busts.
"But kaju," you ask, "booms and busts still occur so you must be wrong!"
Well then, that must indicate that for some reason households and firms don't save during booms and don't dissave during busts. But why is this? Some reasons could include:1. Unemployment Insurance, Welfare, and Medicaid - Because households expect to collect money, goods, and services from the government when/if the members of the household become unemployed, they do not save during booms. Instead, the role of saving/dissaving over the boom-bust cycle is handed to government, and we all know how good politicians are at running budget surpluses during boom years.2. Social Security and Medicare - Similar to the above, but only for seniors who can leave the labor force all together during difficult times and seek early retirement as an alternative.3. Government Manipulation of Real Interest Rates - When central banks set interest rates too low, aggregate demand increases beyond what it would normally increase (a boom), but when central banks set interest rates too high, then aggregate demand decreases below its equilibrium (a recession). Of course, central banks have no way of knowing the correct real interest rate, thus making it likely that they will either set interest rates too low (thereby reducing saving and causing a boom) or too high (thereby increasing saving beyond its necessary amount and creating a recession).
What I'm arguing for here is the removal of government fiscal and monetary activism. This (obviously) isn't a full scale refutation of Keynesian or monetarist economics. Instead, it shows how Keynesians and monetarists should oppose government activism in favor of "micro" fiscal and monetary stimulus, since households and firms would save money when the economy is "overheating," thereby reducing the "overheating," and spend money when the economy is "slumping," thereby reducing the "slumping." The end result would be an economy where real GDP (or aggregate demand) is roughly equal to potential GDP (or aggregate supply) at all times.
P.S. I'm stickying this for a week to see if it gets any worthy replies.
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Also, for anyone interested, this thread was partially inspired by Milton Friedman's permanent income hypothesis, which led to the theory of consumption smoothing, which states that individuals dissave when they're young, then save when they're middle aged, and then dissave again when they're elderly. The general idea is that individuals will shoot for a steady level of consumption, so they need to borrow to spend on goods and services (e.g. RFB + college education) when they're young, save to pay off the debt they accumulated and save more for retirement, and then spend what they saved when they finally retire. I figured that consumption smoothing should also be true on a shorter time horizon given the assumption that households attempt to smooth their consumption over time.
Just a quick point, neo-Keynesian and monetarist macroeconomics aren't based on neoclassical microeconomic theory. Or if they are, only loosely so.
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At this point I became lost. Why would do you think consumption smoothing would eliminate booms and busts?
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Although the economic reasoning is sound, what you are showing is the inherent contradiction between neoclassical microeconomics and Keynesian macroeconomics. Or as macroeconomists prefer to put it, the difference between the focus on the long run of microeconomists (markets tend to clear), and the observation of macroeconomists that many markets have sticky aspects such as wages, thus showing how markets are in disequilibrium in the short run.
You haven't shown any inherent contradiction, since Keynesians believe that markets are already broken, hence the proposed government interventions.
Yes, yes they are. All monetarists and all mainstream Keynesians agree on the basic principles of neoclassical economics (e.g. profit and utility maximization, the determination of prices via supply and demand, etc.). When it comes to microeconomics, there are only minor disagreements between the various large macroeconomic schools of thought (for example, Keynesians take the basics of neoclassical economics and add Keynesian "microfoundations" such as sticky wages and prices). The most principled school of macroeconomics is the new classical school, which takes neoclassical economics to its logical conclusion.
Student: So what do these basic insights show? Well, if households really do maximize utility and if firms really do maximize profits, then presumably households and firms would save during booms and "dissave" during busts, thereby completely eliminating booms and busts. At this point I became lost. Why would do you think consumption smoothing would eliminate booms and busts?
I think he meant that if that is truly what ought to be done (as Keynesians believe), then it would already be going on if people were maximising utility.
Real GDP = Aggregate Demand
Potential GDP = Aggregate Supply
Broad Definition of Recession (Includes "Growth" Recessions) = When Real GDP < Potential GDP
In other words, the standard doctrine is that recessions are caused by deficient demand. Consumption is not only the greatest component of aggregate demand (in the West, at least), but it is also considered the leading component, since a fall in consumption would presumably cause a fall in profits and thus a fall in investment. So even in countries like China and Japan, where investment constitutes a huge portion of GDP, a reduction in consumption would cause a reduction in investment.*
So consumption smoothing would keep the main component of aggregate demand stable, thereby avoiding endogenous recessions. Exogenous recessions would still occur, of course.
Basically, I'm trying to show that in a laissez faire economy, there is no need for "fiscal stabilizers" or anything of the like. The standard doctrine states that when consumption falls, government spending should make up the shortfall. I'm saying that consumption should remain stable.
*This is using ceteris paribus, since a fall in consumption would likely result in a fall in real interest rates, so in the long run any fall in C would ideally be replaced by I.
Fred Furash:You haven't shown any inherent contradiction, since Keynesians believe that markets are already broken, hence the proposed government interventions.
No mainstream Keynesian economist will disagree with the statement "households maximize utility and firms maximize profits." Sticky wages and prices don't disprove my argument, since sticky wages and prices are only a problem when aggregate demand falls (and thus the average price level must fall). My point is that, due to consumption smoothing, aggregate demand should remain stable. Then, I proceed to show why consumption smoothing doesn't hold over the short run due to government interventions.
krazy kaju:Yes, yes they are. All monetarists and all mainstream Keynesians agree on the basic principles of neoclassical economics (e.g. profit and utility maximization, the determination of prices via supply and demand, etc.). When it comes to microeconomics, there are only minor disagreements between the various large macroeconomic schools of thought (for example, Keynesians take the basics of neoclassical economics and add Keynesian "microfoundations" such as sticky wages and prices). The most principled school of macroeconomics is the new classical school, which takes neoclassical economics to its logical conclusion.
No micro-foundations--just pure aggregation ("macroeconomics"). They distinguish between the "macro world" and the "micro world" (one focuses on money, the other on labor).
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krazy kaju:since sticky wages and prices are only a problem when aggregate demand falls (and thus the average price level must fall).
Sticky wages and prices are always a problem. They hinder, impede, and prevent the market from readjuting itself according to the wishes of the consumers, regardless of aggregate demand.
sticky prices are a bogeyman that keeps keynesians awake nights. perhaps the lack of sleep explains the muddled thinking ?
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DD5:Sticky wages and prices are always a problem. They hinder, impede, and prevent the market from readjuting itself according to the wishes of the consumers, regardless of aggregate demand.
They're a problem, but do they do not cause a recession as long as aggregate demand remains stable (according to Keynesians). The importance of sticky wages and prices is that a fall in aggregate demand must cause a recession, since equilibrium prices will be below real prices, causing labor and inventory surpluses. In the absence of sticky wages and prices, there would be no recessions since a fall in aggregate demand would occur along with a fall in the price level.
nirgrahamUK:sticky prices are a bogeyman that keeps keynesians awake nights. perhaps the lack of sleep explains the muddled thinking ?
Yeah. But this isn't the only bogeyman, there's also, "asymmetric information," and, "the coordination problem" (savings doesn't automatically equal investment ex ante--and not Hayek's coordination problem). They basically attack straw-men all day.
nirgrahamUK: sticky prices are a bogeyman that keeps keynesians awake nights. perhaps the lack of sleep explains the muddled thinking ?
lol. But I wouldn't say sticky prices are just a bogeyman. They obviously do exist in the form of labor contracts, menu costs, and monopoly power. The catch is that sticky prices aren't much of a problem in a free market economy, due to the lack of coercive labor and trade unions in a free market.
menu costs are a bogeyman, you put up a sign saying discount on all prices of 10% or buy 1 get 1 free or whatever. firms can change retail prices rapidly.at practically no cost.
nirgrahamUK:menu costs are a bogeyman, you put up a sign saying discount on all prices of 10% or buy 1 get 1 free or whatever. firms can change retail prices rapidly.at practically no cost.
I agree. That's why sticky prices wouldn't be a problem in a free market. The main problem is sticky wages, which are caused by non-market forces.
I don't think I have ever heard any economist say that consumption was the leading component of aggregate demand. Indeed, consumption remains a relatively steady portion of aggregate demand (GDP) from year to year. I think it was Lester Thurow that said that if you knew what GDP would be next year you could almost exactly predict what consumption would be, but that the hard part for economic forecasters was figuring out what GDP would be.
Investment on the other hand is quite volatile. And this was where Keynes as most of his intellectual followers thought the secret to understanding business cycles lay. So I don't think you are on the right trail in "refuting" Keynesian economics. Better to check out Barro's Macrotextbook or Bernanke & Abel's textbook. Both have lengthy, intermediate level discussions of consumption smoothing and its relation to macroeconomic policy making.
PS* I also remember wanting to make a point about how your notion in the original post about firms about how all firms and households would attempt to "dissave" in a bust was more fundamentally flawed because not everyone can "dissave" at the same time (on net)--think of an example where I want to sell the stocks in my portfolio for cash, someone would have to be willing to buy that stock (be willing to "save") for me to do that. But I am just now getting home from an extended night on the town so I am not sure if I am reading your statement correctly in my weary condition. Feel free to ignore this last paragraph if you find it unhelpful.
Student, I'm not saying that consumption is the leading economic indicator (it's actually a coincident indicator, which goes along with my argument), what I am saying is that it is the most important component. Think: Say's law.
Investment is quite volatile, but I don't think it's possible to make the case that volatility in investment spending is the cause of recessions (unless you justify it using ABCT). Investment spending can fall for several years in a row before the economy tanks. For example, investment spending has been downtrending since 2005, yet a recession didn't occur till the last quarter of 2007.
I've also been thinking about income smoothing and Austrian economics. I know this is an old post, but I would like to discuss my idea with someone. Wouldn't income smoothing behavior coupled with rational expectations lead to recession? Let me explain. If someone invests large amounts in a roundabout investment which never really comes to fruition (malinvestment), they must believe that it will come to fruition, otherwise they wouldn't have invested. If they believe that, then they expect to make more money in the future, which means that they will dissave in the present believing that their lifetime income will be higher. When their investment fails, they take on a new smoothing strategy at a lower consumption level, meaning they save in a recession. Isn't this actually how people behave? In this case, it is when our expectations don't meet reality that our consumption smoothing behavior actually leads to dissaving and likely debt. Isn't this exactly what's predicted by Austrian economics? That malinvestment occurs at the same time as consumption (an idea which scares keynesians)?
krazy kaju: Student, I'm not saying that consumption is the leading economic indicator (it's actually a coincident indicator, which goes along with my argument), what I am saying is that it is the most important component. Think: Say's law.
Investment is the most important part. That's why "Business Cycles" were formerly known as "Investment Cycles".
Say's law not holding in a monetary economy is the entire basis of demand-side theory. If Say's law holds then aggregate demand can't be "insufficient".