Skidelsky Warwick Lecture

In my third and fourth lectures examine the pecuniary and pecuniary confusion which as reigned in the tole score five course of studys -the experiments with atypical monetary form _or_ system of government and the austerity withdraw in fiscal polity -as insurance form _or_ system of government makers sought a driveway to recovery. In my fifth lecture 1 kick at the causes Of the crisis from the standpoint of the world monetary system. Fin on the wholey, I make the question what should post-crash economics be like? What guidance should economics ecstasy the insurance-maker to pr sluicet further calamities of the kind we have just experienced?What should students of economics be taught? In this lecture I get out consider and those bits of pre-crash orthodoxy relevant to policy making, tit main emphasis cosmos on UK developments. Theories of appearation formation played an overwhelming parting shaping the plainspokening of macroeconomic policy with changes in the way economists instanceed forebodings marking the divergent phases of speculation. I will treat these in or so chrono uniform order, head start with the Keynesian theory. II.UNCERTAIN EXPECTATIONS Keynesian macro theory dominated policy from roughly 1945-1975. The minimum doctrine - non in Keynes, however in accepted versions of Keynesian theory -to justify policy intercession to stabilize economies is SLIDE 1 1. Uncertain expectations, particularly important for enthronisation, leaving investment to depend on conventions and animal spirits. 2. Relative interest-inelastic of investment. 3. A) sticky nominal profits (unexplained) and b) sticky nominal interest range (explained by liquidity preference).The first point suggested investment was subject to severe fluctuations the last suggested thither was a lack or weakness of spontaneous recovery mechanisms- ii the hatchway of under-employment correspondence. This led to a prescription for macro-policy to prevent or minimize fluctuations of investment bring. Point 2 in combination with b suggested primacy of fiscal over monetary policy for stabilization. SLIDE 2 For Keynes, it was the vogue for the private sector, from time to time, to want to debar spending and to accumulate monetary assets instead that lay behind the problems of slumps and unemployment.It could be checked by deficit spending. (C J. Also and D. Makes (1985), in D. Morris (De. ) The Economic arrangement in the UK, 374) In the standard Keynesian economic model, when the preservation is at less than full capacity, step for state of wardput is de edgeined by demand and the management of economic activity and hence employment is effected by managing demand. (ibid, 370) p bent in passing, that in that location was a theoretical and social radicalism in Keynes blotted out in the standard postwar Keynesian model.For example, he thought light demand was chronic and would get worse and that, in consequence, the longer term survival o f a free enterprise system depended on the redistri besidesion of wealthiness and income and the reduction in hours of wrench. I will return to these points in my last lecture. Demand- management The government used fiscal policy (variations in taxes and spending) to hold in full employment, while pass oning s slewt(p) term interest points close to some normal (or expected) level. Eel. Monetary policy was largely bypassed as a tool of demand-management.The government forecast real GAP for the followe year by forecasting year on movement of its expenditure components consumption, contumacious roof formation, stock building spending, and net exports. Budget deficits then change to maintain full employment. in that respect was no explicit simulation of expectations, though attention was paid to the issue of confidence. The prevalent view was that the confidence of the cuisines company was best maintained by a commitment to full employment. It was incompatible with the bala nce of payments.With sterling convertible into foreign currencies at a set exchange rate, governments also needed to retain confidence of non-resident holders of sterling, so the 2 requirements of confidence index pull in diametric directions. Stop-Go was the result. Stop-Go not withstanding, fiscal activism proved highly successful, aided by the long post-war boom. The budget remained in surplus with current consider revenues exceeding expenditure and with borrowing in the main stricter to finance public investment not covered by current-account surpluses.Chancellors from Crisps to Macmillan were even tempted to extend this-above-the-line surplus to an over both surplus by covering capital expenditure infra the line from revenue yet this was not achieved 1 . Nonetheless, the public-sector borrowing requirement (ESP.) fell from an average of 7. 5% of GAP (1952-1959) to 6. 6% of GAP (1960-1969). The national debt-to-income ratio fell from 31 in 1950 to 0. 71 in 19702. Unemploym ent was consistently below 2. 5% and puffiness was low. Ill. THE RISE AND FALL OF PHILLIPS CURVE KEYNESIAN The post-war problem turned out to be not unemployment but pretension.With full capacity utilization, whether generated by Keynesian policy or by benign world conditions, there was of all time going to be pressure on termss. So the attention of Keynesian policymakers was increasingly turned to fighting swelling, using twain fiscal and monetary tools. In this they were also successful for a time. barely from the late asses, inflation started to creep up and the unemployment cost of restraining it started to rise we enter the era of stagflation. The primal theoretical question was what caused inflation? Was it extra demand or cost-push?There was no single Keynesian answer to this question. Some Keynesian economists argued that toil grocery was like any other(a), with price being chequerd by the balance amidst supply and demand. A reduction in the demand for labor wou ld lower its price. Deflation would slow the rise of nominal wages, and hence a rise in the common price level. The question of course was how some(prenominal) deflation would be needed for st adequate to(p) prices? This was not an easy case for Keynesian to argue. Given their belief in sticky nominal wages, the unemployment cost might prove very high.Most Keynesian economists were more(prenominal) comfortable with the cost push theory of inflation unions pushing up wages ahead of productiveness. Prices rose because tune managements raised them managements raised prices because their costs had risen costs rose owing to pay add-ons and pay appendd because otherwise unions would come out on strike. Higher unemployment would not stop them because most of the unemployed could not do the strikers jobs. In fact, cost-push could occur at levels well below full employment.Short of bringing back mass unemployment, deflating demand would not stop inflation. What was required was a comp act with the unions to restrain pay push incomes policies. Anti-inflation policy in the 1 sass and asses wobbled between fiscal and monetary measures to restrain demand and attempts to set about a crap pay deals with the unions. The Keynesian were rescued from this dilemma by the econometric work Of A. W. Phillips. In 1 958, A. W. Phillips published a famous hold which claimed to dispute a well-determined relationship between the unemployment rate and the rate of wage increases.The Phillips submit implied that there was a stable trade-off between unemployment and inflation. The prize was price stability with a small increase in unemployment, way short of the depression. More generally, policy-makers were supposed to have a menu of choice between different rates of inflation and unemployment. SLIDE 3. ORIGINAL PHILLIPS CURVE The Keynesian policy of demand-management unraveled with the attack on the Phillips dilute by Milton Friedman of Chicago University. In a single lecture in 1 968, he demolished Phillips deviate Keynesian and started the monetarist counter-revolution.Adaptive medical prognosiss Friedman restated the pre-Keynesian idea that there was a unique equilibrium rate of unemployment which he called the natural rate. Inflation was caused by government attempts to reduce unemployment below the natural rate by increasing the amount of money in the frugality. Friedman accepted that there was a trade-off between inflation and unemployment, but that it was temporary, and existed nevertheless because workers were fooled into accepting lower real wages than they wanted by not taking into account the rise in prices.But if government recurrently resorted to monetary expansion (for example by running budget deficits) in order to educe unemployment below its natural rate, this money illusion would disappear and workers would put in increased wage demands to match the now expected rise in prices. In short, after a time workers developed inflationary ex pectations they create the expected inflation into their wage bargaining. genius could not use the Phillips Curve to control inflation in the long run since the Curve itself shifted collectable to the level of inflation rising. SLIDE 4.FRIEDMANS EXPECTATIONS AUGMENTED PHILLIPS CURVE SLIDE 5. One simple version of adjustive expectations is stated in the following equation, where micturate is the next years rate of inflation that is currently expected p-Eel is this years rate of inflation that was expected last year and p is this years actual rate of inflation where is between O and 1. This says that current expectations of future inflation bound old expectations and an shift-adjustment term, in which current expectations ar raised (or lowered) correspond to the gap between actual inflation and previous expectations.This error-adjustment is also called partial adjustment. Friedmans work had massive anti-Keynesian policy price reductions. The five main Ones Were First, ma cro-policy brush aside influence nominal, but not real variables the price level, not the employment or output level. Second, Friedman re-stated the mensuration Theory of Money, the theory that prices (or nominal incomes) change proportionally with the quantity of money. Conversely, fiscal fine tuning operates with long and variable lags it is liable to land the economy in the wrong place at the wrong time.Consequently, such stabilization as was needed is much better done by monetary policy than fiscal policy. It lies within the power of the central bank, but not the Treasury, to keep nominal income stable. Provided the government kept money supply growing in line with productivity there would be no inflation, and economies would normally be at their natural rate of unemployment. Third, Friedman argued that inflation was always and only a monetary phenomenon.It was the total money supply in the economy which determined the general price level cost pressures were not independent s ources of inflation they had to be validated by an accommodating monetary policy to be able to get away with a mark-up based price determination system Fourth, Friedmans permanent income hypothesis -dating from the early 9505 -suggested that it is households average long-run income (permanent income) that is likely to determine total demand for consumer spending, rather than fluctuation in their current usable income, as suggested by the Keynesian consumption function.The reason for this is that agents Want inactive consumption paths. This implied that the degree of self-stabilization of the economy was greater than Keynes suggested, and that consequently multipliers were smaller. Keynesian tested to fight the monetarist onslaught by strengthening Keynesian micro-foundations, especially of discover nominal rigidities. They plopped models with menu costs, insider-outsider labor markets, asymmetric discipline. These kept the door open for policy interventions to sustain aggregate demand. Nevertheless, Friedmans impact on macro-policy was swift and decisive.SLIDE 6 We used to think that you could spend your way out of a recession, and increase employment by riseting taxes and boosting Government spending. Tell you in all tummydor that that option no longer exists, and that in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of employment as the next step. Prime parson James Callaghan (1976), Leaders speech, Blackball The conquest of inflation should be the objective of macroeconomic policy.And the creation Of conditions conducive to growth and employment should be the objective of microeconomic policy. Chancellor of Exchequer Engel Lawson (1 984), Mass Lecture Discretionary demand-management was out equilibrise budgets were back. The unemployment target was replaced by an inflation target. The natural rate of unemployment was to be lowered by su pply-side policies, which included legislative curbs on trade unions. V. RATIONAL EXPECTATIONS AND THE NEW unsullied ECONOMICS With sharp expectations we enter the world of bracing Classical Economics. RE is the radical wing of monetarism Est. go throughn for the startling policy conclusion that macro-economic policies, both monetary and fiscal, are ineffective, even in the short-run4. demythologised expectations first appeared in the economic theory literature in a famous article by J. Mouth in 1961, but only filtered through to policy discussion in the early 1 sass with the work of Robert Lucas and doubting Thomas Sergeant on cable cycles, and Eugene Fame on pecuniary markets. The Lucas critique Of adaptive expectations (1976) put paid to the idea Of an exploitable trade-off between employment and inflation.Friedmans adaptive expectations rely on gradual adjustment of expectations to the experienced behavior of a variable. But our knowledge includes not just what we have experienced but current pronouncements of public authorities and theoretical knowledge of aggregate relationships. For example, the pastor of Finance announces that he will increase money supply by 10% a year to stimulate employment. STEM tells us that an increase in the money supply will ease prices proportionately. So it is apt to expect inflation to be a year.All nominal values -interest rates, wage rates- are instantly adjusted to the expected rate of inflation. There is not even a brief interval of higher employment. Friedmans distinction between a Keynesian short run in which agents can be fooled and a Classical long run in which they know what to expect disappears. Adaptive behavior is a description of ir sharp behavior if agents know what to expect already. Notice though that in this example, rational expectations is defined as belief in the STEM.SLIDE 7 Expectations, since they are informed foresights of future events are essentially the same as the predictions of the re levant economic theory Expectations of firms (or more generally, the subjective probability distribution of outcomes) tend to be distributed for the same information set, about the prediction Of the theory (or the objective probability distribution Of outcomes) (G. K Shaw (1 984), 56) Formally, the rational expectations hypothesis (ERE) says that agents optimally utilities all available information about the economy and policy to construct their expectations.As such, such they have rational expectations. They are also rational in that they use their expectations to maximize their utility or profits. This does not implicate that agents never make mis constructs agents may make mistakes on occasion. However, all that is there to be learnt has already been learnt, mistakes are assumed to be random, so that agents are fructify on average. Agents learn the true value of parameters through repeated application of Bases theorem. Eel they turn their subjective bets into objective probabil ity distributions.An equivalent literary argument is that agents behave in says consistent with the models that predict how they will behave6. Since the models suppress all the available information, ii. They are rational expectations models, following the model minimizes the possibility of making expectation errors. At the core of the rational expectations hypothesis is the presumption that the model of the economy used by individuals in making their forecasts is the correct one -that is, that the economy behaves in a way predicted by the model.The math is simplified by the device of the Representative Agent, the sum of all agents, feature of identical information and utility preferences. This micro-economic device dream up values that the framework can be used to analyses the impact of policies on aggregate offbeat, as welfare is the utility of the agents. The implication of the ERE is that outcomes will not differ systematically from what multitude expect them to be. If w e take the price level, for instance, we can write SLIDE 8 This says that the price level will only differ from the expectation if there is a surprise.So ex ante, the price anticipated is equal to the expectation. EP is the rational expectation based on all information up to date is the error ERM, which has an expected value of zero, and is independent of the expectation. With rational expectations the Phillips Curve is vertical in the short-run and in the long-run. SLIDE 9. THE SERGEANT-LUCAS PHILLIPS CURVE. With rational expectations, government action can hazard real variables only by surprise. Otherwise they will be fully anticipated. This rules out any fiscal or monetary intervention designed to improve an existing equilibrium.More generally any portion Of policy that is a response to publicly available information -such as the unemployment rate or the index of leading indicators -is irrelevant to the real economy 7. Policy can influence real variables only by using informatio n not known to the public. The Efficient Market Hypothesis The application of rational expectations to financial markets is known as the Efficient Market Hypothesis (MME), made normal by Eugene Fame (1970, 1976). The MME postulates that shares are always correctly priced on average because they adjust instantaneously and accurately to any newly released information.In the words of Fame, l take the market efficiency hypothesis to be the simple statement that certificate prices fully reflect all available information 8. So prices cant be wrong because if they were, someone would seek to profit from the error and correct it. It follows that according to the efficient market hypothesis, it is impossible to consistently achieve returns in excess of average market returns (beat the market). In an RE joke, two economists spot a $10 bill on the ground. One stoops to pick it up, whereupon the other interjects, Dont.If it were unfeignedly $1 0, it wouldnt be there anymore. The efficient ma rket hypothesis is the upstart manifestation of Adam Smiths invisible hand. Increased regulation can only aka markets less efficient because regulators have less information than those engaged in the market, risking their own money. There are different versions of the efficient market hypothesis. In its weak form, investors make predictions about current prices only using historical information about past prices (like in adaptive expectations).In its semi-strong form, investors take into account all publicly available information, including past-prices. (This is the most accurate and the closest to rational expectations). In its strong form, investors take into account all information that can possibly be known, including insider information. wise expectations models rely heavily on math. Lucas defined expectations as the mean Of a distribution of a random variable. The greater the number of observations of a random variable, the more likely it is to have a bell shaped or Normal d istribution.The mean of the distribution, in ordinary parlance the average of the observations, is called the Expectation of the distribution. In the bell-shaped distribution, it coincides with the peak of the bell. Those who are supposed to hold Rational Expectations (ii all of us) are assumed to know how the systematic parts of he model determine a price. We use that knowledge to generate our prediction. This will be correct except for random influences. We can assume that such random events will also adhere to the bell-shaped distribution and that their mean/expectation will be zero.Thus the systematic or deterministic prediction based on theory is always correct. Errors have zero expectation. The tendency of the MME, as is readily seen, is to rule out, or minimize, the possibility Of bubbles -and so crashes more generally to rule out the possibility of crises being generated within the financial system historically he most important source of crises. This being so, policy did n ot have to pay much attention to banks. by-line the acceptance of the MME, the financial system was extensively De-regulated.Real Business cycle DOGS DOGS modeling takes root in brisk Classical macroeconomics, where the works of Lucas (1975), Jutland and Prescott (1982), and presbyopic and Peoples (1983) were most prominent. The earlier DOGS models were pure real business cycle (RIB) models. ii models that attempted to explain business cycles in terms of real productivity or consumption shocks, abstracting from money. The logic behind RIB models is clear. If money cannot affect real variables, the source of any disturbance to the real economy moldiness be non-monetary.If we are all modeled as having rational expectations, business fluctuations must be caused by real and unanticipated shocks. (Notice the use of word shock). These shocks make the economy dynamic and stochastic. Unemployment is explained in these models by rational adjustments by workers of their work/ waste trade o ff to shifts in productivity. This is a fancy way of axiom that there is never any unemployment. As a result of infinitely re-optimizing agents, economies in DOGS models re always in some form of equilibrium, whether in the short run or long run.The economy always starts from an equilibrium mail, and even when there is a shock, it immediately jumps onto an equilibrium time path the saddle path. So the economy never finds itself in a position of disequilibrium. SLIDE 10 The model provides an example of an economy where real shocks drive output movements. Because the economy is Wallabies, the movements are the optimal response to the shocks. Thus, contrary to the naturalized wisdom about macroeconomic fluctuations, here fluctuations do not reflect NY market failures, and government interventions to excuse them can only reduce welfare.In short, the implication of real-business cycle models, in their strongest form, is that observed aggregate output movements represent the time-va rying heighten optimum. (Roomer (2011 ) Advanced Macroeconomics, 204) Translated into English depressions are optimal any attempt to mitigate them will only make things worse. Later came the New Keynesian who maintain the basic framework of the New Classical RIB/DOGS models, but added market frictions, like monopolistic competition and nominal rigidities, to make the models more relevant to the real world. Critiques 1 .The fundamental criticism is that this whole class of New Classical models carries an intellectual theorem -that agents are rational optimizers to an extreme and absurd conclusion. By postulating complete information and complete markets, ii. By abolishing Keynesian or Knighting uncertainty, they cut off enquiry into what might be rational behavior under uncertainty -such as herd behavior. They also exclude irrational expectations. behavioral economics only really took off after the crisis. 2. The aim of New Classical economics was to unify macro and micro by bi ghearted macro-economic secure micro-foundations.Macroeconomic models should be based on optimization by firms and consumers. But New Classical models are not well grounded in micro-economics since their account of human behavior is seriously incomplete. 3. Ay defining rational as the mean of a random distribution, the New Classical models rule out as too exceptional to worry about fat tails that is extreme events with disproportionately large consequences. 4. The vast majority of DOGS models utilities log-landslides utility functions which eliminate the possibility of dual equilibrium. 1 5. New Classical models have no place for money, and therefore for money hoarding, which depends on uncertainty. In pure DOGS models there is no financial sector. DOGS models depend on what Goodhearted calls the transversally condition, which says that by the end of the day, or when the model stops, all agents shall have repaid all their debts, including all the interest owed, with certainty. In other words, when a person dies he/she has zero assets left 12. Defaults cannot happen. This is another kind of logical madness.