Monday, February 18, 2013

Stephen Williamson Does *Not* Sort Out Keynesian Economics



Stephen Williamson took a break from haranguing Paul Krugman to post a working paper about Keynesian economics.  A newer version of the paper, entitled “Sorting Out Keynesian Economics: A New Monetarist Approach,” can be found on Professor Williamson’s academic website here.  (All citations below are from the newer working paper.)

Williamson is puzzled by the persistence of Keynesian economics given the “revolution in thought” that took place after 1970. “However, to be fair to the Keynesians,” Williamson allows, “we should at least try to understand what they are up to, and evaluate the work,” an evaluation which culminates in Williamson's judgment that “there is nothing about [my] paper that should make us any more comfortable with Keynesian analysis.  All of the basic questions remain unanswered." 

Williamson claims his model is closest to the model developed by Roger Farmer in his 2012 Economic Journal article, "Confidence, Crashes, and Animal Spirits."  
“We can imagine a world – Farmer’s Keynesian world - where a matched worker and producer in our model have difficulty splitting the surplus.  Then, there exists a continuum of equilibria, indexed by wages and labor market tightness.  In general, an equilibrium with a high (low) wage is associated with low (high) labor market tightness . . . In this static model, the equilibrium can be suboptimal, in that labor market tightness is too high or too low. Indeed, the unemployment rate could be too high or too low.”
Later, Williamson modifies his simple search model to include a dynamic framework, consumers, and money.  Throughout these refinements, Williamson’s basic conclusion holds:

“Inefficiencies arise in Keynesian models because private sector economic agents somehow do not get the terms of exchange right.  In our model, what goes wrong is that there are no incentives determining how producers, workers, and consumers split up the gains from trade.”

Although this putative market failure seems to invite corrective policy, a successful policy, according to Williamson, requires civil servants who can see things that aren’t visible to market participants.  
“As in typical Keynesian policy analysis, those agents who are assigned the job of working out optimal monetary and fiscal policy somehow see through these inefficiencies and are able to design policies that correct the problems.  In this sense, our analysis is no more, and no less, sensible than what the average Keynesian does.” 
 Quite a devastating assessment it would seem.  Yet, in spite of the paper’s self-assured tone, there’s much less here than meets the eye.  To begin with, Williamson’s characterization of Farmer’s model as one “where a matched worker and producer . . . have difficulty splitting the surplus” actually bears very little resemblance to Farmer’s Old Keynesian model.  Here’s Farmer’s own characterization,

In this article, I propose a new approach.  Instead of searching for a fundamental explanation to close an indeterminate model of the labour market, I close the model with the assumption that firms produce as many goods as are demanded. Demand, in turn, depends on beliefs of market participants about the future value of assets.  By embedding the indeterminate labour search market into an asset pricing model, I show that the unemployment rate can be explained as a steady-state equilibrium where the indeterminacy of equilibrium is resolved by assuming that the beliefs of market participants are self-fulfilling.”

In other words, Farmer assumes: 1) firms produce goods to meet demand; 2) demand, in turn, depends on beliefs about the future value of assets; 3) these beliefs are self-fulfilling, which means; 4) the unemployment rate is determined by self-fulfilling beliefs about future asset values.  Thus, unemployment in Farmer’s model, far from being the consequence of “not getting the terms of trade right,” as Williamson suggests, is, in fact, due to a lack of aggregate demand that’s rooted in self-fulfilling pessimism about future asset values.  In short, Williamson has stripped away the most Keynesian element in Farmer’s model, viz. the role of beliefs, or “animal spirits,” in determining the level of employment via their effect on asset values, which, in turn, influence demand.

The bearing of Williamson’s modeling exercise on “Keynesian economics” is also put in question by the particular search model he’s chosen to work with.  In Williamson’s model, producers, workers, and consumers must find one another and then come to agreement regarding the “terms of exchange.”  This agreement is the subject of bargaining, which, in the absence of certain constraints, won’t produce an efficient outcome.  

By contrast, Farmer builds on Peter Diamond’s search model, where an increase in the availability of potential trading partners raises the profitability of engaging in trade, thereby generating externalities and multiple equilibria.  In fact, Farmer sees “no reason to treat the search model differently from any other competitive model with externalities,” adding that he views “the addition of the bargaining equation as arbitrary.”  So, the externalities that are the centerpiece of the search model Farmer employs have also disappeared in Williamson’s version of Farmer’s model.

We are now in a better position to evaluate Williamson’s conclusion:

“There is nothing about this paper [i.e., Williamson’s own paper] that should make us any more comfortable with Keynesian analysis.  All of the basic questions remain unanswered.  Why are private sector agents so bad at determining the terms of exchange, while public sector agents are so good at it?  How could such seemingly small difficulties in setting prices and wages lead to such large aggregate problems with the allocation of resources?”

Not to put too fine a point on it, but the reason there’s nothing in Williamson’s paper “that should make us any more comfortable with Keynesian analysis” is because the paper has very little to do with Farmer’s Old Keynesian model (and even less to do with Keynes’ own theory).

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