I am not well versed in Keynesian business cycle theory. Therefore I have a very naive question for the Keynesian economists:
Here’s why I ask: According to what I take to be an orthodox Keynesian view, we are now in a liquidity trap. (My question does not apply to Keynesians, new or old, who believe otherwise.) That means that people want to hold lots and lots of money instead of spending it. Cool! We can provide money at almost zero cost. So it should be easy to make people very happy. What’s the problem?
Of course, people are working less, but that makes perfectly good sense in a world where people prefer to consume less. Why spend all day on an assembly line churning out widgets that people prefer not to buy?
A quick and obvious answer is that the people who are choosing to accumulate money and the people who are out of work are not the same people. In other words, to put this in slightly more technical language, you can’t address this question in a so-called “representative agent model” — a model that abstracts from interpersonal differences.
Still: The theory, as I understand it, is that vast numbers of people are choosing to hold vast amounts of money. Since money can be produced costlessly, this ought to count as a very good thing — which should offset a lot of very bad things, no?
Whatever answer there is might vary from one Keynesian economist to another, so let me subdivide my question into two:
- Why aren’t “old Keynesians” perfectly happy with the current state of the economy?
- Why aren’t “new Keynesians” perfectly happy with the current state of the economy?
An old Keynesian — a Keynesian in the tradition of, say, Sir John Hicks — would, as far as I can tell, be stricken mute here because old-style Keynesianism provides no yardstick for measuring the desirability of different outcomes. The model makes no clear assumptions about what people value (in more technical language, there are no utility functions in the old Keynesian model), so it offers no way to judge whether you’ve made people happier. In a recession, we consume less, which is presumably bad, and we work less, which is presumably good, and if the recession is accompanied by a liquidity trap, we voluntarily accumulate piles of money, which is also presumably good, but nothing in the model is capable of telling us whether the good outweighs the bad.
Maybe the old Keynesian will reply that he’s out to maximize some rule-of-thumb variable that can be described without regard to utility. But what could that variable be? Short-run consumption? But if that were really the target variable, the corresponding policy prescription would be to quash all saving. Surely that can’t be right. (On the other hand, I suppose it’s impossible to even contemplate quashing saving in a model where people automatically save a fixed fraction of their incomes.)
A new Keynesian, by contrast — a Keynesian in the tradition of, say, Michael Woodford — could at least address the question, because new Keynesian models do start by specifying people’s utility functions, so we know something about the trade-offs people are willing to make and can therefore talk meaningfully about whether times are (relatively) good or bad. But I’m still unclear on why, given that model, we should expect the current state of the economy to count as bad.
After all, when people hold money, they do it for a reason. That reason will vary from one new strain of new Keynesianism to another: Either money contributes directly to people’s utility, or it’s a prerequisite for transacting business. If we’re in a liquidity trap — that is, if people are hoarding money — there’s no problem transacting business, so (as far as I can see) they must be holding money for utility’s sake. In other words, if they’re hoarding, it’s because they like to hoard. Which brings me back to my question: Why, as the stock of money continues to grow, shouldn’t the joy of hoarding eventually compensate for the annoyance of not having food on the table?
I will be mildly surprised if there is a satisfactory “old Keynesian” answer to this question, but not at all surprised if there is a satisfactory “new Keynesian” answer. I’d like to understand that answer, and I’ll be very glad if someone can explain it.