Monday, January 25, 2010

Keynes vs Hayek: the rap showdown

Russ Roberts' long awaited (by me at least) new music video is here. Roberts, an economist by trade, wrote the lyrics for a rap battle between John Maynard Keynes and F. A. Hayek on the nature of the business cycle:

Keynes and Hayek were certainly ideological opponents during their lives. Hayek was a central figure in the Austrian school of economics, whose focus on voluntary contracts between individuals and the organizing power of the price system saw little role for the government in the economy (or anywhere else). Keynes, on the other hand, argued that markets (capital markets in particular) can fail on their own; when they do, government has a crucial role to play in stabilizing the economy.

Roberts, himself an adherent of the Austrian school, is better positioned to argue Hayek's side (he blogs at "Cafe Hayek"). While Keynes' basic ideas are laid out in the video, much of the nuance is missing (as is probably to be expected in a 6 minute rap-debate on the subject). In particular, I felt Keynes' views on savings were somewhat misrepresented.

In the video, the Keynes character explains his "paradox of thrift" idea: people save money, which is good for them, but it reduces the amount that they spend, which in turns lowers other people's incomes, causing them to save more; this reduces the income of others, perpetuating the cycle. Thus an individually beneficial action (saving) has negative consequences if everyone does it.

Some take the paradox of thrift to mean that "Keynes opposed savings", but this interpretation is simply untrue. James Hamilton explains the distinction:
"...aren't I delighted that consumers are now, finally, saving more? Well, no. It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending. Here I am very much taking the side of Brad DeLong ([1],[2]) and Arnold Kling and against Eugene Fama ([1], [2]) and John Cochrane. The relevant question is whether, in response to an abrupt decrease in consumption spending such as we're now experiencing, some of the other variables (most importantly, Y) might adjust in response as well. It is certainly true that in a very simple economic setting-- for example, an economy that consists of a single farm producing only one good-- the decision to save more of your income (leave some of your wheat unconsumed) is necessarily identical to the decision to invest more (save the wheat for later). And one can write down more complicated models in which economic actors and markets adjust in a way to see through the veil of production and exchange and make sure it is I + X that adjusts in response to a higher saving rate, and not Y."
Much of Keynes' theory had to do with the translation of savings into investment. The classical economic perspective was that savings, by definition, equals investment. Thus, if people save more, then they invest more, leaving GDP unchanged. But Keynes argued that when people were fearful about the future, they would hoard money (e.g. stuff money in the mattress), diverting savings from investment. This means that sudden shifts in savings (for example, in response to a financial crisis that hurts household portfolios) can result in an economic contraction. In Keynes' mind, this was where government should enter with stimulus, to counter the drop in spending and soften the blow to the economy.

Is the paradox of thrift real? Not everyone would agree, but Paul Krugman provides some compelling evidence for it.

The point here is that one of the main differences between Keynes and Hayek (indeed between Keynes and most of the economists who came before him) had to do with the nature of the savings/investment relationship. Keynes was not advocating profligate spending for the sake of spending. Rather, he postulated that markets could fail and that government could play a role in mitigating the business cycle.

That being said, I thought the video was great; it was entertaining and provides a wonderful introduction to a major debate in the history of economic thought.

1 comment:

The Arthurian said...

Hi, Dan.

oh i suppose i'll get around to that music video eventually. Meanwhile, you've put together an excellent post here.

"Keynes argued that when people were fearful about the future, they would hoard money (e.g. stuff money in the mattress), diverting savings from investment."

If I remember my Keynes, he said and increase in savings (a decrease in spending) leads to an increase in inventories. And since inventories count as investment, Savings=Investment still holds true. But, he said, people mistakenly assume there is a "nexus" that causes money not spent on consumption to be used for productive investment.

(I'm not disagreeing with anything you said here. I'm just testing my memory.)

Nice to read a thoughtful post on the topic.