Like many others, I’ve enjoyed the Keynes-Hayek raps and the recent Keynes-Hayek debate. Today, while browsing through the Roy Harrod (1951) [amazon_link id=”0140214402″ target=”_blank” ]Life of Keynes[/amazon_link] – which is so good for its insight into the evolution of Keynes’s thinking – I came across the following quotation from a letter Keynes wrote to Hayek in 1944, about [amazon_link id=”0415253896″ target=”_blank” ]The Road to Serfdom[/amazon_link]:
“In my opinion it is a grand book. You will not expect me to accept quite all the economic dicta in it. But morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement with it, but deeply moved agreement…. Your greatest danger ahead is the probable practical failure of the application of your philosophy in the US in a fairly extreme form. No, what we need is the restoration of right moral thinking – a return to proper moral values in our social philosophy. If you could turn your crusade in that direction, you would not look or feel quite so much like Don Quixote.” (p515 Harrod, 1972 paperback edition)
This is fascinating for at least two reasons – the heartfelt agreement, and the warning about the extreme application of the ideas in The Road to Serfdom in the US.
The real reason I was browsing in the first place was to try to get my head around the role of changes in wealth and household assets and saving in a situation of excess demand in labour and goods markets. Malinvaud’s [amazon_link id=”063117690X” target=”_blank” ]Theory of Unemployment Reconsidered[/amazon_link] highlights this variable. Adverse wealth effects for the household sector have been enormous, and of course interest on savings is more or less zero at present. But, not being a macroeconomist, I’ve not made much headway with this. More another time.
[amazon_image id=”0393300242″ link=”true” target=”_blank” size=”medium” ]The Life of John Maynard Keynes[/amazon_image]
Good discovery! Nice to see that there was a bit more mutual respect between these two than between many of their followers. Their ideas are not so incompatible as participants in this debate imply. If your view of intellectual debates is that there’s one right answer to any question, and that only one person can provide it – well then at least one of K & H must simply be wrong. Then it’s a straightforward Today-programme-style fight. But it’s not hard to come up with a synthesis of the two worldviews that is more plausible and satisfying than either on its own.
As for wealth effects in macroeconomics, the permanent income hypothesis provides what I think is the mainstream approach to this question. Each agent is supposed to smooth consumption across their life, so a £100k fall in wealth for someone with a life expectancy of 25 years should result in spending of £4k less per year (give or take, with a bit more added for the interest I would have earned on the money, and a bit taken away for time discounting).
However, there are some subtleties to this and some probable flaws in the theory too.
The first of these is the key macroeconomic question: how do these individual changes in wealth aggregate up? Some of them – change in value of stockmarket holdings – represent real changes in (current estimates of) the productive capacity of assets. Clear enough. But a change in the value of your house – a fall in wealth for you – is a gain in wealth for whomever you will sell it to in the future! So this should (in the theory) have no net effect on consumption.
The second subtlety is that most people have a buffer on lifetime wealth, which is their inheritance. If the value of my house falls, I may well not compensate for it in consumption at all – instead, my kids will take the hit when they inherit it (there may be a wealth effect for them if they expect this).
But my main caveat is that surely the PIH is not an accurate description of our behaviour. If I believe that my spending will be, say, £30k/year, and my wealth falls by £100k – will I really just accept a reduction to £26k/year? Or will I try to cut back this year, maybe earn more, or even postpone retirement by a couple of years, to get back to my previous position? The same happens when my income increases – I spend more of it in the short term than the PIH would suggest. Essentially, wealth effects have an exaggerated effect in the short term. The PIH turns out to be more a normative framework for how we should behave to maximise utility, than a valid descriptive one.
I don’t think we have very good analytic models of how these behavioural effects really do impact macroeconomic performance. There are some econometric measurements which look at these questions, but I don’t know the results offhand. Like other debates such as the effect of income taxes on productivity, the data will never be persuasive to someone who has a convincing theory in their head. I think Keynes knew something about that.
Your point about aggregation is absolutely right, especially when you add in the intergenerational effects of asset price changes. I haven’t seen any recent work on this but it must be a key question now that there are large (nominal) debt burdens, large asset price falls and close to zero interest on savings. As for the PIH, surely this is exactly the kind of decision making where we need to know more about the descriptive regularities – decisions under uncertainty about future financial values? Again, I’m not aware of recent work on it in the current context, although you would know better than I do.