Post-Keynesian Observations

Understanding the Macroeconomy


with 18 comments

[NOTE: Be sure you have read part 9 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

[EDIT: I did this one in one draft last night and went through and tidied it up just now. I hope that made it more readable!]

What I’ve given you so far isn’t a comprehensive analysis of the macroeconomy, but I think it’s enough to a) explain the basics of our current situation and b) offer some policy prescriptions. I would like to go ahead and do the latter first (and save the former for part 11). Bear in mind that these policies are being suggested as applicable even without the current economic problems. I would have argued for them even if we were in the midst of an expansion.

Economics is ultimately about policy. Recommending policy requires first deciding our goal. On this, you actually won’t find too much disagreement among economists. Our hope is to help the average person; we want that person’s life to become more and more comfortable. This requires increasing growth, rising productivity, and low unemployment (a broader analysis would need to consider low inflation and production of those goods consumer most want to buy–I hope to get to this eventually). Fortunately, these all seem to vary together so that encouraging one should encourage all three. That will make the following a little easier.

A couple of preliminaries. First, we aren’t going to come up with some perfect set of regulations, institutional structures, organizations, etc. Unfortunately, that’s not the way life works. In fact, even assuming that we could for this moment in time, the economy evolves. It will be necessary to, as the Marines, say, adapt, improvise, and overcome, time and again. We should be in a constant state of evaluation of our current system.

Second, it is necessary to understand that the market is not the natural or default system for human society. It evolved and is a human, social invention. It is not, as I have heard people say (including some of colleagues!), the way we act when there are no rules. Capitalism is a particular set of rules. Because they are our rules, however, they feel natural to us, just as one’s native language does. Capitalism does some things very well and some things very poorly. Capitalism should serve us and not the other way around, so when we find something we don’t like, we should feel perfectly free to change it without upsetting some “natural” order. This is not to say that we shouldn’t be careful to think through the secondary and tertiary impacts of any policies, but that’s true regardless of what our topic is.

According to my analysis so far, where does the market let us down in our quest for output and employment? I have identified three specific problems:

1. The short-term focus of the stock market means that resources are misallocated and prices are overly volatile (see parts 5 and 6);

2. Because of the fact that the market for physical investment and consumer durable goods can be saturated, we get the irony of the fact that at the very moment when we should be enjoying the highest standards of living, the economy slips into recession (see parts 3 and 4);

3. Overconfidence leads people to take on too much debt (see part 7) and causes shock as agents panic when the economy turns down at the top of the expansion (see part 9).

I will explain each in turn, tell how it interferes with our goal, and how to stop it. I won’t waste your time with a complete review of each section, but if you need a refresher I have listed the relevant posts in parantheses above.

SHORT-TERM FOCUS OF STOCK MARKET: The stock market prices are driven by psychology rather than in-depth studies of which firms are really the most likely to earn profits. Are we to truly believe that the variables that determine Microsoft’s profitability change on an hourly basis? Certainly not on the scale we witness every day. It just doesn’t make sense. The consequence is that the best firms are not really the ones who experience rising stock prices because the primary players in the market, those setting the prices, don’t really care which firm is best? They aren’t going to hold the stock all that long and all they need to do is guess how everyone else is going to react. Sometimes “best” and how everyone else reacts is the same thing, but given the extremely weak incentive to bother to do research this is very unlikely over the long run. This is inefficient and retards growth. Furthermore, the obsession we have with finance has forced firms to think far too short term, working to raise stock prices today rather than profits tomorrow. This, too, is inefficient and retards growth.

A policy to address this is very simple and straightforward–and doesn’t stand a chance in hell of passing given the strength of Wall Street in Washington. We don’t want to stop everyone from buying stock, but we need them to care about the firm and not about market psychology. Keynes said in the General Theory, what if once you bought a stock you had to keep it forever, earning only dividends? You would sure do one helluva lot of research! You’d know that company and it’s competitors forward, backwards, and sideways, and the stock prices would reflect what they really should. This would encourage efficiency and growth.

Of course, making people hold the stock forever is a bit much, so how about a sliding scale of taxes instead? You could charge a rate of, say, 50% of the selling price for any stock sold within one month of purchase, 40% within two months, and so on down to 0%. We thereby discourage the hot money and encourage long-term investors. It doesn’t have to be a tax–anything that punishes speculators and rewards research is good (I kind of like the idea of a tax so we can get some of the bailout money back!).

SATURATION OF INVESTMENT AND CONSUMER DURABLES: This is a serious issue that creates a terrible irony in our economy: just when we should be enjoying the fruits of our productivity, large segments of our population find themselves unable to join the party. We have the massive buildup in investment and consumer durables in the expansion, only to have that plenty lead to layoffs and recession.

Most people’s first reaction to learning this is to assume that the solution should be some sort of thinning out of the expansion. If only we didn’t build all the factories and sell all the cars so quickly, then the expansion wouldn’t end so soon. I thought the exact same thing when I read the relevant section of Keynes’ General Theory some twenty years ago–and he immediately says, “No, dummy, that doesn’t make sense!” Oh yeah. Why would we want an economic system that encouraged us to not use our productive capacity to our fullest? If, in terms of our capacity and efficiency, we can afford for all of us to have big-screen TVs (or houses or health care or interstate systems or whatever) today, why should we, as a society, have to put it off because our system is screwy? Who is in charge here, us or the system? US! So we change the system.

What we can do is the sort of thing we are doing right now with the stimulus, but I have reservations in terms of that being a long-term solution. It’s too ad hoc and susceptible to political maneuvering. What I suggest instead is an agency along the lines of the Federal Reserve, but whose responsibility is maintaining full employment: the Full Employment Commission, or FEC. It would work like this. Like the Fed, the FEC would be charged with certain responsibilities. Central would be keeping unemployment at a particular level. When it exceeded that level, the FEC would have the power to immediately start projects in the states most needing them (not in someone’s home state because they want to be reelected). This agency would constantly research to see what sort of projects could be undertaken in each state, just in case. In this way, they don’t have to waste three to six months figuring out what could be done as they already know. Furthermore, these projects should be unprofitable (profit is the realm of the private sector and we don’t want the government competing with them) but of social value. This could be schools, infrastructure, long-term research, cleaning up the environment, military spending, etc. When we run out of social problems then we figure out what else we can do! Last, I would envision these projects as being based on grants. These individuals so employed would not become government employees, but employees of private sector firms paid by the government. The idea here is to supplement the private sector, not replace it. Note, too, that any such spending creates a multiplier effect. When the workers so funded take their pay checks and go to WalMart, that creates another job. The FEC would be in charge of monitoring the impact of their spending so that they know when to scale back.

A quick word about the debt and the deficit–there is no better way to get a huge deficit than have lots of unemployment. Tax revenues fall precipitously and government social programs shift into high gear. Economic expansions, on the other hand, generate surpluses. So, if you want to pay down the debt, don’t bitch and complain about the deficits we undertake when we are in recession (I wish I had more time to go into this, but this entry is getting long–maybe in a later entry)!

OVERCONFIDENCE: Overconfidence leads to firms and households taking on too much debt, making the financial sector increasingly fragile, and it causes expectations in general to get out of line with reality. We get tangible evidence of the latter in the rise of stock prices and other assets (real estate and commodities, for example).

What we need to address this are trip wires and speed bumps (an idea Ilene Grabel of U of Denver develops in one of her articles on financial markets in the developing world). Trip wires are signals that something may be getting out of line. For example, we could take a look at historical stock prices (and crashes) and set a target rate of appreciation that, once reached, acts as a warning to the Federal Reserve and Securities and Exchange Commission. Other rates could trigger speed bumps, or policies that kick in to slow the process (by closing the market or other such means). These could be employed in other markets and with respect to debt levels, too. The idea is to build into the system signals to ourselves that something may not be right so that we can act BEFORE a crisis, and not after. And I don’t mean just looking at the rate of appreciation or depreciation over the course of hours or days (which we already do to an extent), but over months and years. It isn’t fool proof, but it’s better than what we have now.

Here are the core set of recommendations for how to keep unemployment at a reasonable level, growth high, and productivity rising. There’s a lot to add and specify, of course, but it’s a start. The central idea is to keep and encourage those parts of the market system that work very well while suppressing those that don’t. Sorry this one ended up quite a bit longer than my usual installments, but there was a lot to say!


Written by rommeldak

January 27, 2009 at 10:40 am

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18 Responses

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  1. “When we run out of social problems then we figure out what else we can do!”



    January 27, 2009 at 9:38 pm

  2. so how can we get these in place? do you have obama on speed dial maybe?

    seriously though, is any of this feasible? and more importantly, what are the ramifications of not doing these, or worse, putting in place policy that is counteractive?


    January 29, 2009 at 12:56 am

  3. Jeez, zero, I dunno. I guess I am particularly downhearted at the moment, reading about the Republicans trying to block Obama’s stimulus in favor of a tax-break heavy one. That makes no sense. Tax cuts are not nearly as stimulative as increasing in government spending because people will, in these uncertain times, save them.

    This near-religious obsession many people have with the market scares the hell out of me. It must be similar to the feeling of Arabs who live in countries being taken over by the Taliban. The market is a freaking tool, and that is all it is. If just that simple idea could get into people’s heads then we would take a giant leap forward, a leap from ideology to pragmatism.

    ANY stimulus package is better than none, but what a terrible waste if we screw this up. Obama isn’t putting foward anything nearly as progressive as needed as it is. To imagine that folks are trying to block it scares me.

    So, zero, I figure our chances of getting this programs put into place are pretty close to your adopted online nickname (the first part, anyway).



    January 29, 2009 at 1:15 am

  4. I dunno, I think “a leap from ideology to pragmatism” is exactly what we’ve just done in switching from Bush to Obama. Pragmatism always has this advantage: it’s very hard to argue with success. Ideology’s main advantages are that it sounds good and appeals to emotion — two advantages that apply to Obama too, in many ways. I guess I’m only talking in vague generalizations here, but in general I feel that a pragmatic, charismatic president is exactly what we need right now, and so I’m optimistic in spite of the economy.


    January 29, 2009 at 5:25 am

  5. I largely agree with you, Jason, I just think I’m reeling in the shock of seeing the Republicans wanting to block a stimulus plan that I think is already overly weakened by trying to please them. The Republicans keep saying that the Democrats want to make the US a communist state; the Republicans are doing their best, however, to make us a third world country.


    January 29, 2009 at 6:03 am

  6. well, at least you can go back to the UK, not that they look much better ATM..

    on the plus side i bought a majority share of RBS with the change in my pocket..

    i guess a better question is why do people not see something so elementary (even i save my tax refund when i get it, no wait, i don’t get them anymore and it’d go straight to debt anyhow) – i’m betting that it isn’t that they don’t see it, but instead they see this louder:

    tangible refund to voters = votes for me next go-round

    i mean this thing is cyclic, right? shit’ll just right itself and in the meantime we spend some money on votes, am i rite?

    the part that annoys me most is that i see qualities in both parties that appeal to me, i could easily split myself over both and that should be good because compromise should fall directly on my position, only the wrong things are winning the compromise, making some sort of alternate-universe opposite position to what i’d like to see..

    so while we have a pragmatic, charismatic leader, i’m sure the asshats who are running the country (into the ground) along with him will force a compromise that lands on the crap side of the fence.. but i’m cynical guy..


    January 29, 2009 at 10:20 am

  7. Don’t forget that I’m in a minority school of economic thought. This is not the story you’d hear from the mainstream, and if the folks in my school of thought are right and they are wrong, that’s why something so elementary is missed: they don’t think the economy works the way I described.

    They have this love affair with the market–it’s rational and perfect to them. When stuff like this happens, they come up with some quick theory as to why it’s out of the ordinary, stick on a bandaid, and move on. But the market is a tool, not a gift from the gods.

    This is an incredible opportunity to fix it up right, but I’m afraid the demagogues and idealogues will screw it up. We can hope…


    January 29, 2009 at 11:11 am


    2.2 trillion to put the national infrastructure in good shape. There’s a good thing to start spending money on.

    Here’s my problem with what you’re saying Rommel. The president has an unprecedented high approval rating right now. Democrats in the house have a 70 seat majority. By the end of all the election challenges they’ll have a 59-41 advantage in the senate. How any of that could possibly result in Republicans “blocking” any thing is beyond me. What Democrats are looking for is political cover for if/when this stimulus doesn’t work. Obama now famously reacted with “we won” when challenged by Republicans on why there aren’t more tax cuts in the stimulus. Well with power comes responsibility. At some point the boogie man the Republicans represent will have to be put down and finger of responsibility need to be pointed at where it belongs.

    Some people are already a little ahead of the curve.


    January 29, 2009 at 10:28 pm

    • Ken, I’m not sure how the Republicans are a bogey man when they have been in charge and it has largely been policies that clearly in their camp that have spurred the crisis. They have an 18th century conception of how the economy works, one that probably wasn’t correct in the 18th century! The threat is real, and it scares the hell out of me.

      Regarding blocking Obama, what concerns me is not so much policies not passing, but having been watered down to gain the support of the other side of the aisle.

      Funny, I was thinking the same thing about the Republicans in terms of shifting blame–this is just posturing to get into the record that they were against this. But the stimulus will work, of that I have no question. My fear, again, is that it loses some of its bite.


      January 29, 2009 at 10:49 pm

  9. I agree that Republicans (in the main) are to blame for the problem, but how can they be the blame for the solution when they’re in the wilderness now politically. You’re trying to have your cake and eat it too. One could make the argument that Republicans caused the problem by not keeping to conservative principles like controlling spending and now your trying to blame them for blocking the stimulus by… not keeping to conservative principles like controlling spending.

    The political (and here we may be at cross purposes as I tend to view things through that prism and you don’t) facts are, this stimulus bill is going to be the product of the Obama administration and Democrats in the Senate. Will Republicans influence it? Sure, but the level of influence is going to be very, very small.

    It will be years before any real voices come out of the Republican Party and it will probably be a Gingrich-like back bencher who will come from nowhere to effectively change the sorry state of the party in Congress.

    In the Obama honeymoon period the important movie to watch is The Candidate with Robert Redford. And its real relevance for Obama and the Democrats is for the last line, “What do we do now?”


    January 30, 2009 at 12:51 am

  10. Gah, that one line should be…

    One could make the argument that Republicans caused the problem by not keeping to conservative principles like controlling spending and now your trying to blame them for blocking the stimulus by… keeping to conservative principles like controlling spending


    January 30, 2009 at 1:07 am

  11. Ken, you are arguing from a false premise. You write that I want to “have my cake and eat it too” by making the argument that “Republicans caused the problem by not keeping to conservative principles” while blaming them for “blocking the stimulus by…not keeping to conservative principles.” But I am making no such argument. First, not controlling spending did not cause our current problem. Second, we did, indeed, follow conservative principles in the economy since Reagan and that is a huge source of our problem right now. I am not being inconsistent–I am objecting to “conservative principles” both historically and right now.

    More on this as I develop the blog further. I hope to develop a section on the financialization that started under Reagan and the massive redistribution of income that has occurred under the Republicans (something that happened before the Depression, too, incidentally).


    January 30, 2009 at 6:05 am

  12. Let me put it a different way because I think we’re talking about two different things. (That is something that’s been happening to me a lot lately either because of my own thick-headedness and limitations as a writer and/or the limits of this kind of mode of communication)

    You might make the argument that we face the position we do because of “financialization” (can’t wait to find out what that is) or irresponsible tax cuts. A conservative might make the argument that we’re here because GWB didn’t restrain or cut spending. I’m personally agnostic because that’s something I just don’t know enough about. At some point it’s water under the bridge however, and we have to ask where do we go from here?

    You’re giving us your prescription and I may agree or disagree with it. The economic history lesson you’re going to give us is also important to see how we got here and I thank you for it, but at some point it comes down to who is going to implement the solution? Republicans are in no position to influence much of anything. My point is you’re putting your spurs to the wrong horse. The flea bitten old nag is broken down by the side of the road. You’ve got a shiny new stallion that needs the goad.

    I’ve been impressed with President Obama’s efforts to reach out to Republicans but that really boils down to political theater. The stimulus package (and the rumored 2 trillion dollar bad bank legislation also soon to be coming down the pike) is going to be the product of the White House, the House Appropriations and Banking Committees and the debating society that is the US Senate. All of those instruments are firmly in the hands of the Democratic Party. If you’re not happy with the policy at the end of the day you’re going to have to blame them.


    January 30, 2009 at 9:01 am

  13. Ken, I’m not real sure you understand what this blog is about (not trying to be rude, but did you read the parts leading up to this one?). It’s not Democrat versus Republican, it’s an explanation of what happened and what needs to be done (with both parts of that equation still requiring further development). I have actually said very little about politics. In fact, in my main text, I don’t believe there’s a single word. That only came up in my comments when Zero asked how to get this done (and Fenris continued it). It was not my intent to discuss at length how to go about getting my policies adopted (or who might do it). And, anyway, I know how to get my policies accepted, and it has nothing to do with political parties. Once the mainstream of economics adopts this approach, so will politicians. Believe me, us Post Keynesians are trying, but the odds are stacked against us! That’s a whole different story and it’s internal to my discipline.

    But, to take up your gauntlet, let me say this. Do I think that Republicans are the likely standard bearers for the policies of Post Keynesian economics? No. Republican economics is of the “trust the market, it’s perfect” variety. That could change, of course, but at present it is one of the cornerstone’s of the party platform. Here are excepts from the official party platform (from

    “America’s free economy has given our country the world’s highest standard of living and allows us to share our prosperity with the rest of humanity.”

    “Economic freedom expands the prosperity pie; government can only divide it up.”

    “The U.S. government should end mandates for ethanol and let the free market work.”

    I just picked a couple of quotes, but it is loaded with “free market” stuff.

    As I mentioned in post 8, the market can do lots of good stuff, but it’s a freaking tool, not a cure-all handed down by the gods. Therein, the Republican party is wearing blinders. One of the core differences is that they think that the rich are the heart and soul of the economy. The Republicans figure they (the rich) make it work, so therefore they deserve the rewards. And the more we reward them, the better the economy will get. But the places where the rich are richest are called third world countries. Income distributions in developed states are much more even, and that’s what capitalism needs to thrive: a large, stable middle class without so much weight at either extreme (the US, incidentally, has one of the most uneven income distributions of any developed state, and it’s been getting much worse). It’s what creates the market to which the entrepreneurs can sell their goods. Without a strong middle class, we become increasingly prone to stagnation. The Republicans do not understand how the economy works, and their mistakes over the past several administrations had nothing to do with a lack of fiscal conservatism or not holding true to their principles–they were plenty true to them, they are just wrong.

    Here are some interesting stats:

    Using data from the Federal Reserve Bank of St. Louis, you can show the following (data are 1953 through 2007, or Eisenhower through Bush):

    Avg Rate of Unemployment
    Democrats: 5.11
    Republicans: 5.94
    Difference: Democrats lower by 0.83

    Avg Rate of Real (i.e., inflation-adjusted) GDP Growth
    Democrats: 4.23
    Republicans: 2.82
    Difference: Democrats higher by 1.41

    One might argue that it is not fair to count the first year of an administration after there has been a change in party, so here are those data with the transition years excluded (1953, 1961, 1969, 1977, 1981, 1993, and 2001):

    Avg Rate of Unemployment
    Democrats: 4.87
    Republicans: 6.10
    Difference: Democrats lower by 1.23

    Avg Rate of Real (i.e., inflation-adjusted) GDP Growth
    Democrats: 4.37
    Republicans: 2.83
    Difference: Democrats higher by 1.54

    Note that the margin by which Democratic administrations are superior increases in each instance. Some of my Republican friends have suggested that this pattern is because of a lag, wherein the Democrats are reaping the benefit of the superior Republican policies. First off, I wonder if they would be so quick to suggest that had the numbers been reversed?! Second, if so, it’s a very strange lag as it waits just long enough for the Republicans to get out of office, no matter how long they were in–four years, eight years, twelve, etc. What seems much more likely is that, as imperfect as Democratic policies are, they are still superior what the Republicans have thought up. Did you know that the rich actually fare better under Democrats? I’ll bet they don’t, either.

    This is a bit of a sidetrack from what I wanted to do with the blog, but I’m happy to continue it as needed! However, I really need to try to finish my last couple of “here is what just happened in the subprime crisis” posts, too.


    January 30, 2009 at 10:33 am

  14. “By the end of all the election challenges they’ll have a 59-41 advantage in the senate.”

    and once judd gregg gets appointed to secretary of commerce and the democrat governor of NH appoints a democrat into senate, it’ll be 60-40.. 🙂


    January 30, 2009 at 12:07 pm

  15. I’ll end this exchange on my part just saying that I was not responding to the blog post at all. I _was_ responding to your comment to zeroday of 29 Jan 09 at 1:15 am, particularly the line, “I guess I am particularly downhearted at the moment, reading about the Republicans trying to block Obama’s stimulus in favor of a tax-break heavy one.” I should have made that more clear in my first post.

    Now I’m going to sit down because I feel like the guy that’s always taking up time arguing with the lecturer from the front row.


    January 30, 2009 at 6:32 pm

  16. FWIW Pops, I learned as much from Rommel’s responses to you as from any one of his blog posts, so I think it’s good that you’re here arguing from the front row.


    January 31, 2009 at 5:04 am

  17. […] and as set out by our newish-on-the-scene and very good American friend at Post Keynesian Observations: The same $10 million dollar salary spread over 100 people generates much more spending that it […]

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