Tuesday, September 19, 2017

Roger Farmer vs. George A. Akerlof and Robert J. Shiller on Monetary and Fiscal Expansion in 2009

Roger Farmer is among the most idiosyncratic, innovative, and provocative economists of his generation, a first class mathematical economist who’s willing to explain his theories and models in words, and to engage with heterodox economists on a variety of theoretical and practical issues.  In his most recent endeavor, Farmer aims to make "the case for unity between Post-Keynesian and General Equilibrium Theory under the banner of Post-Keynesian Dynamic Stochastic General Equilibrium Theory" (2017, p. 1).
I'm working on a paper challenging Farmer’s claim that he’s created an authentically Post Keynesian DSGE model or something superior to it.  In the course of my research, I came across a book review Farmer wrote in September 2009 (2009a) about Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller (Princeton University Press, 2009).  It turns out that this review is quite revealing, at least to my mind.  
To begin with, Farmer contends that Akerlof and Shiller’s “definition of animal spirits is far too broad,” “too broad” because it would require “jettisoning” neo-classical economics “almost all at once” even though "there’s still much to like about it," and “too broad” because there’s an ongoing and productive research program in which “animal spirits” are defined as “the self-fulfilling beliefs of market participants” (2009a, p. 357).  (Note: Farmer wrote a book entitled Macroeconomics of Self-Fulfilling Prophecies (1993, 1st ed.).
Farmer worries that, “by attacking classical theory on so many fronts at the same time, Akerlof and Shiller have torn down the house and left us without a shelter from the storm” (ibid., p. 358).  Although Farmer agrees that “the message of the book is that Keynes was right and that aggregate demand must be managed to restore full employment,” he also believes that “Keynesian economics was discredited in the 1970s and there are compelling grounds to be skeptical that fiscal and monetary policy will work today in the way that Akerlof and Shiller believe” (ibid.).
And then, in a statement that sounds very much like what Robert Lucas and Thomas Sargent wrote in their 1979 polemic, “After Keynesian Macroeconomics,” Farmer writes,
“Akerlof and Shiller’s book criticizes classical economics but does not offer a viable or coherent alternative.  Instead they advocate Keynesian policies that were discredited in the 1970s, a massive expansion of liquidity, and a massive fiscal expansion. History has taught us that a massive expansion of liquidity will lead to inflation. Logic tells us that a massive fiscal expansion will lead to a big transfer of resources to the baby-boomers from their grandchildren. The lesson of 1970s stagflation is that neither of these two policies alone can be guaranteed to restore full employment” (ibid., my stress).”
Let me draw your attention to the sentence I italicized, viz.,  History has taught us that a massive expansion of liquidity will lead to inflation.”  The chart below displays “Total Assets of the Federal Reserve,” which is sometimes used as a measure of liquidity.
                                     
                    Total Assets of the Federal Reserve (source: Federal Reserve)

       Every economist makes mistakes, but this one is rather stark given the confidence with which Farmer made his predictions.  Farmer is writing in 2009, during a period when the Fed was in the process of doubling its assets.  This process continued until 2015, as Fed’s balance sheet reached about $4.3 trillion.  Yet there was no acceleration of inflation.  Quite the contrary, the rate of inflation actually decreased during this “massive expansion of liquidity” to use Farmer’s own words.  Apparently, the economic history of the 1970s, properly understood, does not teach us that “a massive expansion of liquidity will lead to inflation.”
       The other Keynesian policy “discredited in the 1970s” was “a massive fiscal expansion,” like the one that’s “been applied already by the Obama administration” (ibid., p. 358).  So, to recap, we have Akerlof and Shiller arguing for more “fiscal and monetary stimulus” in 2009, and Roger Farmer warning that these policies, “like the Keynesian policies that were discredited in the 1970s,” are unlikely to the produce the effects Akerlof and Shiller are hoping for.  
       Let's take a moment to assess.  During this post-2009 period, the U.S. government’s fiscal stimulus (deficit/GDP for simplicity) decreased from almost 10% in 2009 to about 2.5% in 2015.  Akerlof, Shiller, Krugman, DeLong, Summers, and many other Keynesian and Quasi-Keynesian economists argued for more debt-financed investment spending during this time.  Would a fiscal expansion in 2010 or shortly thereafter have been a good thing for the economy?  Let me just say that pointing to Lucas and Sargent's claims about the supposed Keynesian policy and intellectual "failures" of the 1970s isn't sufficient to discredit the notion that additional fiscal stimulus following the Financial Crisis would have been good for the economy, especially in light of what has turned out to be false predictions of rising inflation.
When we look at the issue of fiscal expansion alongside Farmer’s confident, but, it turns out, false claim that “a massive expansion of liquidity will lead to inflation,” then we may begin to wonder whether Farmer’s mathematical constructions are really affording him a better view of the world.  I think it’s fair to say that Akerlof and Shiller’s predictions, real and implied, were closer to the truth than Farmer’s predictions, real and implied.  Perhaps Farmer’s next theory – A Post Keynesian DSGE Theory – will cast a brighter light on its subject.  This new theory will the subject of a forthcoming post.


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