Okay, this is Karl.
Can you hear me?
Actually, on my left side, it's Finneberestis
from the University of Cambridge
and the University of Past Country.
And I met him a few years ago
at one of these conferences for the first time
and he was the only English-speaking
around a lot of Germans, Austrians,
and people from Switzerland.
And what it shows is not that he's some kind of dissenter,
feeling well among others who do not understand him also,
no, what it shows is that he's always willing
to present his ideas,
to engage in institutional work,
to engage in the production of books, editing books,
and so on.
And what I mentioned before
is that he has strengthening weak ties
and so he's a really, really, really important person
for post-Cainting economics within Europe
and within the world.
So, yes, I'm very happy to have him here.
And as you can see, he will talk about new Keynesians
and post-Cainting in comparison.
Thank you very much for being here, Philip,
you're for also.
Thank you very much.
And I must say this,
it must have been about 20 years ago.
Can you hear me?
No, not really.
Carol?
No.
I rearranged it a little bit.
We sort it out, don't worry.
Is that better?
Yes.
Good, thank you.
So it must have been 20 years ago, I think.
So we're gonna have to do it again.
Is that better?
Why does it go like that?
Carol, can you hear me?
Thank you.
So it must have been 20 years ago, I think,
when I first came to Berlin.
Is that okay?
For this, for a similar event, conference,
and I was the only non-German.
And I cannot remember, was it you
who was translating all the time?
From German to English.
Anyways, so it's a pleasure to be back
for the nth time, I think.
And today I'm going to talk about
essentially New Keynesian economics.
I wouldn't dare say anything about post-Keynesian economics
after Mark has, I'm sure, given you a wonderful lecture
on post-Keynesian economics.
What I would do instead
is to talk about New Keynesian economics
from a post-Keynesian perspective,
if that's okay with you.
And let me start by saying that
I am going to give you a short introduction.
And then I'm going to talk about the economics
of the new consensus macroeconomics,
which is another way of saying New Keynesian economics.
And I'll explain the slight difference in a minute.
Then the economic policy that follows
from the theory of this New Keynesian economics.
And then, most importantly,
there has to be a critique from post-Keynesian-Keynesian
perspective, and that would justify the title.
And of course, at the end of it,
hopefully by one o'clock,
I'll be able to summarize and conclude.
So if we start with another bit of introduction,
which is that what is this New Keynesian economics
and how has it evolved?
And the answer to that question is not very difficult,
or at least not very difficult from my perspective.
And to do that, I have to take you back
to the post-war period up to, say,
the late 60s, early 70s,
when we had, in some way or another,
the first consensus in macroeconomics,
namely, these ISLM type of macroeconomics,
but most importantly from the policy point of view,
whereby fiscal policy was very important,
not that monetary policy was not important,
but the rate of interest had to be as low as possible
for development purposes.
Now, I say consensus in the sense that
the traditional part of economics,
the orthodox economists, were more or less
agreeing on this principle, but there were exceptions.
We had the militaries, of course,
who would not quite go along with that,
and of course, we had other schools of thought,
Marxists, et cetera, and at the same time, more or less,
we had what Mark explained to you earlier,
the development of post-Kensian economics.
Now, let me just say a couple of words about that.
Essentially, I think post-Kensian economics,
and I hope I don't disagree with what Mark said,
was developed in America, in the United Kingdom,
especially Cambridge, but also in Canada,
and Mark is responsible on that score,
but also there was another post-Kensian tradition,
which somebody in this room is sitting very quietly,
but I am going to expose him,
and this is the gentleman here, Thanos Kuras,
who was in London, he's now in Greece,
but he was in London at that time,
and he was the creator of what we came to know
in tense papers in political economy,
although the name might suggest a slightly different approach,
it was nonetheless very post-Kensian, was it not, Thanos?
Now, when we were together at an institution,
and when we left, that became,
well, that disappeared, didn't it?
But more recently, and I say more recently,
about 20, 30 years ago, Malcolm Sawyer and myself,
we decided to promote further this journal of,
it was tense papers in political economy,
we decided to relabel it slightly
into international papers in political economy,
which are going very strong, my dyad,
and tomorrow we ask the Macmillan people who will be here,
where the latest issue is,
which is on 21st century Keynesian economics,
but still from a very, very post-Kensian perspective.
So that is, in a nutshell,
a little bit of history on the post-Kensian economy,
it has taken place more or less,
starting, I don't know, 50s, 60s,
and progressing very, very strongly now.
But in terms of the first consensus in macroeconomics,
that appear to be weakening in the late 60s, early 70s,
when there were inflationary pressures,
and apparently that particular way of thinking
was not very strong in terms of accounting
for inflationary pressures,
although I think people at the time, early 70s,
took advantage of that in order to sell
their own political, and I emphasize that,
political beliefs by the way of inventing
something which had already been invented
in the early 60s, rational expectations,
but I think if you look carefully in any journal
of the traditional type between 1963 and early 70s,
I don't think you'll find the word
rational expectations mentioned anywhere
except that famous paper in 1963 by Muth.
But all suddenly, in the early 70s,
everybody in terms of their traditional economics
was full of rational expectations,
and rational expectations of course,
to put it very simply, is the idea that
economic agents know exactly how the economy works,
and they can predict very, very precisely
the future economic events.
And this becomes very important,
as we are going to see later on,
in terms of fiscal policy,
because it has certain implications
to which I will come back later.
So with that, with the acceptance of rational expectations,
we had the development of the so-called
new classical macroeconomics,
whereby new classical macroeconomics
relied heavily on the power of the market,
and that the state should be minimized as much as possible,
should not interfere with the economic system,
because the markets can do a wonderful job,
and you don't need economic policies like this
in the short run or in the long run.
But then the people who might, at the time,
call themselves sort of Keynesians,
although some of us would have doubts
whether Keynesians is the right name to use,
the so-called new Keynesians,
said, hang on a minute, we accept your position
in terms of rational expectations,
but be careful, because in the short run,
and there has to be a difference
between short run and long run,
in the short run, you have price and wage rigidity.
And when you have price and wage rigidity,
you have to help the market.
The market cannot do all the job by itself,
and consequently, in the short run,
we could have some government interference,
some government intervention,
but of course, in the long run,
we have to revert to the new classical macroeconomics
proposition that no policy is necessary
because the markets would give you
the non-accelerating inflation rate of unemployment,
namely Nairo, or natural output,
or whatever you like to call it.
Call it, if you like, the long run output.
So we had, thereby, the development
of the new Keynesian economics,
which people, the orthodox people,
seem to be accepting in a big way.
At the same time, however,
and I'm talking now about late 70s, early 80s,
there was another interesting development,
especially in the United States and in the United Kingdom.
In the United States, we have the presidency of Reagan,
and in the United Kingdom, we had Mrs. Thatcher,
and they both tried to implement
what we know, the monetarist principle,
namely trying to control inflation
through the money supply.
But that was a disaster, really disaster,
for the very simple reason that Reagan abandoned it
by August 1981 and Mrs. Thatcher a little bit later,
but these ideas were abandoned
for a very, very simple reason.
The first is that the central banks discovered
that you cannot control the money supply.
And secondly, the demand for money,
which is very important in that particular approach,
was extremely unstable.
Now, this idea, however, of controlling the money supply
in order to control something else
in the economy inflation in this particular case
was, in terms of monetary policy implementation,
a very, very new type of policy.
In the history of central banking,
no central bank has ever tried to control the money supply.
There are, of course, exceptions,
but exceptions merely prove the rule,
and the two exceptions are the ones that I mentioned.
Traditionally, central banks control the rate of interest,
and the money supply becomes really endogenous,
and then we could talk about
how the endogenous money supply should be determined.
And this particular observation, my dyad,
was only recently been appreciated by a number of people,
namely that ever since, for example,
the creation of the Bank of England in 1694,
up to this day, with that exception
that I mentioned earlier in the case of Thatcher,
never, ever the money supply has been attempted
to be controlled by the central bank.
It's the rate of interest.
Now, when we had these failures by the central bankers
to control the money supply and the failure of monetaries,
the development of new Keynesian economics,
in this analysis of new Keynesian economics,
there is the notion that inflation
is a monetary phenomenon,
and if it is a monetary phenomenon,
it therefore has to be controlled through monetary means.
Well, the money supply was tried, it failed,
so there has to be something else,
and this something else is the idea that
you can control the inflation rate
by manipulating the rate of interest,
which is in the hands of the central bank,
and when you manipulate that rate of interest,
accepting the new Keynesian economics,
which means that you have wage
and price rigidity in the short run,
manipulating the rate of interest
changes the real rate of interest,
and the real rate of interest would have
all sorts of effects in the short run
in terms of the level of economic activity,
and in the long run, the only impact would be on inflation.
Thereby, we have a slightly different
kind of macroeconomic model,
and this is the kind of model which
a lot of traditional economists,
orthodox economists have accepted,
but more importantly, central banks
implementing it in their economic,
in their monetary policy.
As we talk, maybe I shouldn't say that,
I should say at least by 2007,
before August 2007 when we had the new,
the great recession, up to 2007,
there were about 23, 24 central banks
very, very faithful to the kind of model
which I have just roughly explained,
the new consensus macroeconomics.
There were about another number
which would take us up to 50 something,
which were more or less pursuing inflation
targeting these type of policies,
and then if we add another number
which were pursuing these policies,
but they lacked credibility,
and we see later on the importance of credibility,
it brings you to something like 90-odd central banks
which up to 2007 had been pursuing
these particular policies.
Now you might ask, why do you say up to 2007, not since?
Well, since 2007, things have become
a little bit difficult in the sense,
for that perspective, in the sense that
the rate of interest now in most cases
is nearly zero or near enough,
and consequently this idea of controlling
the rate of interest to fix the inflation rate
may be work, may be not work, we don't know.
We have to wait and see what happens
with these central banks once interest rates
begin to go up again.
So hopefully this particular paradigm
is going to disappear, and what Mark was saying
towards the end of his lecture,
that post Keynesianism might, might, just might replace it,
we think, we hope.
I doubt it, but never mind, that's a possibility.
So that is the, that's why although in the title
we had New Keynesian Economics,
I think it's better to call that type of economics
as new consensus macroeconomics.
And let us now get on to examining
what is these new consensus macroeconomics
in at some length, at some detail.
And I have six equations in order to explain
these new consensus macroeconomics.
Let me just very quickly explain the symbol
so that we know what we are talking about.
Why superscript G is output gap,
the difference between current output
and trend output, potential output.
The letter E in front of a variable
is expected value of the variable within the brackets.
Capital R is the nominal rate of interest,
expected PT plus one inflation,
and therefore what's in the brackets over there,
over there, that's the real rate of interest.
RER is the real exchange rate.
Little p, I should have explained it there,
is of course inflation.
Changes in the exchange rate.
That there.
Capital R, I explained it.
RR star is the long run equilibrium rate of interest.
I don't know how many of you know
the Vixellian rate of interest.
That's more or less what it is,
but from a more detailed explanation,
it is, as I said, the long-term rate of interest,
that rate of interest for which
investment and savings are equal.
And we explain its role in a minute.
This little p superscript capital T
is the inflation target,
which is very important as we see in a minute.
RER is the real exchange rate.
Capital R minus, that is the real interest rate
of the country we are talking about.
That R subscript W is the world interest rate,
and therefore what's in those brackets
is the world real interest rate.
CA is current account.
There it is there,
and current account is,
we have the real exchange rate, wage gap, output gap,
and then the final one is the,
how the nominal exchange rate
is related to the real exchange rate,
where capital P is the price index,
domestic hour price index,
and P subscript W is the world price index,
not inflation index.
But the question is,
where do these equations come from?
That's much, much more important.
And how does this model work
in this particular analysis?
The first equation,
which we call the aggregate demand equation,
comes from the idea that you can begin by talking
in terms of the representative agent,
and then through aggregation of the behavior
of that particular representative agent,
you can have an aggregated relationship
as on that particular slide number one.
Now this representative agent,
sorry, the fact that you have a representative agent
immediately excludes any distribution of considerations,
which I'm sure Mark demonstrated earlier,
they are very, very important
in terms of post Keynesian economics,
no distributional effects at all
in this particular paradigm.
This representative agent
is full of rational expectations,
therefore rational expectations by definition are there,
but also these rational representative agent
consequently all agents in this particular economy,
and within this particular paradigm,
they are very trustworthy.
They are never, ever going to default on anything.
The implication of that,
of that particular assumption
is that you don't need to worry about money,
and you do not need to worry about the financial sector.
Financial sector is very sound, don't worry about it,
it's going to produce the goodies,
and the goodies are what the market
expect the financial sector to provide.
Now, I don't need to remind you
what happened in August 2007,
and this particular assumption funnily enough,
if you look at the macro-econometric models
of all the central bank, Bank of England,
European Central Bank, the Federal Reserve System,
and many, many other central banks,
that's exactly the assumption that they at least
had accepted up to August 2007.
Therefore, this representative,
this wonderful representative agent,
he or she is faced with a utility function,
and the arguments in that utility function
are consumption today and consumption tomorrow.
Therefore, this particular representative agent
optimizes this utility function,
subject to his or her budget constraint, income,
all the time, so we are talking about
an inter-temporal optimization activity,
and when you do the mathematics properly,
what you come up with is that particular first equation.
To repeat, output gap, the level of economic activity,
the difference between current output and trend output
is related to what happened yesterday to itself,
to expectations about what it will be tomorrow,
the real rate of interest, and in the case
of an open economy in terms of the real exchange rate.
So that particular relationship is underpinned
by all these assumptions which I mentioned,
and they are very, very important assumptions to remember.
Then we have this Phillips curve,
where inflation is related to an economic activity variable,
Y superscript G, to expectations of inflation,
and then to prices, well prices,
and of course, the nominal exchange rate.
In this particular relationship, B2,
that coefficient B2 plus B3 are equal,
by definition, is equal to one,
which means that in the long run,
this Phillips curve is simply vertical,
and it is vertical, it touches the horizontal line
to the point where you get your narrow,
non-accelerating inflation rate of unemployment.
So that's your Phillips curve
with that expectations variable embedded in it.
That expected inflation rate is very, very important
in terms of implementing monetary policy
for the very simple reason that to the extent
that the central bank, when introducing,
it's manipulating the rate of interest
in order to achieve a specific inflation target,
as I said earlier, to the extent that they are credible,
to the extent that what they say they are going to do,
they stick to it, the underlying assumption is
that agents are going to be very much influenced
in terms of their expectations about inflation,
and they are going to do the right thing
in the way that the central bank would dictate.
The third equation is the monetary policy rule,
which comes from the assumption that the central bank
has a loss function, and this loss function
is determined by the differences of current output
from potential output, and by the differences
between inflation, current, and the targeted inflation,
and when you minimize that particular loss function
subject to your Phillips curve, you're going to get
this monetary policy rule, technically speaking.
But this monetary policy rule is the way
that the central bank behaves, and the central bank
manipulates that fruit there, the nominal rate
of interest, which is within its hands,
with respect to changes of current inflation,
or yesterday's inflation, to the targeted inflation,
and also taking on board this particular variable,
the output gap, and of course, expectations of inflation.
But the most important variable in this relationship
is that difference there, the difference
between current inflation, or inflation yesterday,
and targeted inflation.
That fruit there, that RR, which is the long-term
rate of interest, is the ultimate objective
of the central bank, because it should,
by manipulating capital, the nominal rate of interest
within their hands, is to achieve, in the long run,
these RR star, and therefore the question is,
does the central bank know what the hell RR star is?
So that, by manipulating capital, the nominal rate
of interest within their hands, they can achieve
that particular RR star, and as we are going to see later,
that is a very, very difficult proposition to implement,
because no central bank knows what these RR star is.
Even, if I may say so, Axel Weber,
if I pronounce his name properly, he was in Cambridge
giving a talk about three years ago,
and he was bitterly complaining that his econometricians,
every time they are asked to estimate these RR star,
they get a different number, and the poor guy said,
how I, as the, you call him governor, or president,
of the Bundesbank, how am I expected
to implement this policy, but he meant
the European Central Bank, of course,
not strictly speaking the Bundesbank,
how are we expected to be able to apply
this particular way of thinking about monetary policy,
and we have no idea what these RR star is going to be,
and he was absolutely right.
I don't know whether he realized or not,
but Keynes had already complained bitterly
about that RR star, as we are going to see in a minute.
So these are the, sorry, and then we have the,
you know, if we open the economy,
usually it's those three first equations
that people talk about, for the very simple reason
I suppose they were invented in the United States,
and normally people look at the United States
as a closed economy, but you know,
economies these days are open economies,
and we have to take on board what's happening
when you open the model to the rest of the world,
and you know, we can have these other three relations
just to close the model.
How does it work?
And the way that this model works is that
the central bank either gives itself a target
in terms of inflation, as the case is
with the European Central Bank,
or else the Ministry of Economics
gives to the central bank an inflation target.
Yes, for example, the case in the United Kingdom,
I believe in Canada, Sweden, New Zealand,
Australia, and so on and so forth.
So that particular inflation target
is that particular fruit there,
that particular variable there,
as in the way I've explained it.
So if I use the model of the United Kingdom,
then we have a committee, the Monetary Policy Committee,
they meet every month, first Thursday,
normally of each month, and they decide
whether to change that capital R.
And the first thing that they look into
is that difference there.
That's the most important variable
in that particular Monetary Policy Rule.
And led to the extent that PT minus one
differs from the inflation target,
they are going to change the rate of interest,
hoping that in the long run,
they are going to hit the particular inflation target
which either, which in the case of the United Kingdom,
the Minister of Economics has given to them
to achieve in the long run.
Therefore, changing the nominal rate of interest
will change the real rate of interest
for the very simple reason that prices and wages
are rigid in the short term.
That change in the real rate of interest
would affect your output gap.
Output gap would affect inflation,
but in the meantime, agents in this particular formulation
know for sure that the central bank
will stick to its guns, and consequently,
their expectations about inflation is affected,
and consequently, the argument goes,
the central bank over the period that they are operating
will probably have to reduce the rate of interest,
sorry, change the rate of interest
by a smaller amount than otherwise
because they manage so well to affect inflation expectations,
and consequently, all in all, that little p
is going to be affected in the long run,
and to the extent that they've done their job properly
in the long run, that p superscript t
is going to be achieved.
In the long run, that Phillips curve is vertigo.
And as I said, it is vertigo at the point of Nairo.
And therefore, the question is, who determines Nairo?
Who determines the level of economic activity?
And the answer to that question
within this particular paradigm is that
we are sure policy cannot influence output
in the long run or unemployment or employment
in the long run.
What determines Nairo in the long run
will depend on the factors of production you have,
how efficient your markets are,
and how well you manage to combine
your factors of production
to determine your total output.
Those are the variables, and no way can
monetary or fiscal policy or anybody else
from the government affect your output in the long run.
So, in very, very simple language,
that's how this particular theoretical framework works,
operates.
Now, let's just check with a couple of slides
that I haven't missed anything.
As I said, we have six equations,
and six unknowns, as I have shown you.
The basic assumption is the intertemporal optimization
of utility function, which reflects
optimal consumption smoothing.
It's based on this assumption
that all debts will be paid ultimately,
and nobody's going to default,
and what they, the technical language there
is that the transversality condition
is very, very much assumed,
and that all economic agents are credit-worthy,
all IOUs are perfectly acceptable in exchange,
nobody but nobody is liquidity constrained.
It is a non-malletary model, as I said.
There is no money, there is no banking
or any other financial sector or monetary variable.
The objective, as I hope I've explained,
is price stability.
Again, inflation is a monetary phenomenon,
and inflation is controlled directly via changes
in the rate of interest, as I explained.
A change in the nominal rate of interest
followed by a change in the real rate of interest,
as I explained, and changes in the real rate of interest
can only affect aggregate demand in the short run,
as that first equation, and that the Phillips curve
is vertical in the long run at NIO.
Changes in the rate of interest affect inflation
only in the long run, NIO is a supply-side variable,
as I explained, and of course, Zay's law holds.
The level of effective demand does not play
an independent role in the long run
on the level of economic activity.
That's a very, very important assumption
in this particular theoretical framework.
Now, let's talk a little bit about the economic policies
which, again, is summarizing what I've said.
Inflation targeting is embedded in those three equations
that I've shown you.
Inflation targeting is a monetary policy framework
where a public announcement
of fissure inflation target is undertaken.
Equations two and three entail this important variable
for the model, the expected rate of inflation,
and credibility is obtained through pre-commitment
to the inflation target without government interference,
and that's where the notion of an independent central bank
comes into fall, and that independent central bank
comes for contributions for these people
in the late 1970s, where the independence
of central bank is important.
Little these people, they know that it was somebody else
who introduced the notion of an independent central bank,
and it was, who was it?
Anybody knows?
Who was the first to talk about independent central bank?
Some, a German colleague said,
Bundesbank, if the name was Bundesbank in the 20s,
or was there another name?
Bundesbank.
Sorry?
Bundesbank.
Probably, probably.
Anyway, the central bank of Germany introduced the notion
in the 20s, but I think there was somebody else earlier,
probably 2012, 1912, 1921,
more forcibly and certainly in 1933,
and that was John Maynard Keynes.
Keynes began in 1912 talking about the notion
of an independent central bank.
He made the comment again in the early 20s,
but in 1932, 16th of September, 1932,
and 23rd of September, 1932, he had two pieces
in a journal, in a magazine, rather,
not a journal, in the United Kingdom,
because the Labour Party government of the time,
they produced a paper which was to be discussed
at their conference following October,
August they produced the paper following October,
we're going to discuss this paper.
What, the question was, what the hell are we going to do
with the banking sector?
Are we going to nationalize them?
After all, we are a socialist party,
and they were a socialist party at the time.
They might not be now, but they were at the time, or not.
And this magazine, New Statesman,
asked Keynes to comment on this particular
proposition of the Labour Party.
And Keynes said, well, you are socialist,
you can do whatever you like with the commercial banks,
I don't care, do anything you like.
But with the central bank, the Bank of England,
you've got to nationalize it first,
because it was a private bank, it became nationalized,
it was nationalized later on in 1940.
Keynes died in 1946.
This bank became nationalized in 1947.
So 1932, we are talking about, the Bank of England was still,
as it had been in 1694,
a private financial institution,
but with the functions of a central bank, but private.
So Keynes said, you nationalize it,
but make it independent, because monetary policy,
something which, these people who run the bank
now haven't got a clue, you have to have proper economists
to run this independent central bank,
independently, completely, from whatever the politicians
might or might not do.
But, in terms of the objectives of this central bank,
should be full employment, or high levels of employment.
Don't worry about inflation, inflation is a problem which
probably emanates from wrong exchange rates and all that.
This is what this central bank should do.
Of course, in the late 1970s, the idea of a central bank,
unfortunately, was very different from the Keynesian idea,
and the central bank should be independent, of course,
from the politicians, but alongside the model
we have discussed, should the central bank
try to achieve an inflation target,
and don't worry about anything else,
because anything else would be determined by the markets.
The markets are wonderful in terms of arranging,
deciding what the real equilibrium,
real economic activity would be.
Anyway, that's by the by.
Transparency of inflation forecasts is very, very important,
because if you cannot forecast,
what can you say about the future inflation
which you try to control?
But, of course, the centrality of forecasts
can create all sorts of problems, because we know
that we economists, in terms of, when it comes to forecasting,
we are not doing very well.
And all these ingredients are supported by the publication
of the minutes of the meetings
that these Monetary Policy Committee people have.
They have an inflation report, at least in the United Kingdom,
and, of course, the members of the Monetary Policy Committee
give speeches all the time trying to explain
how they understand monetary policy,
how monetary policy is implemented,
so that the credibility of the French
framework is maximized.
And other important ingredients are,
they try to be accountable, credible, as I said,
and, of course, the individual reputation of these members
is very, very important, especially in those cases
where the outcome of the voting is revealed.
For example, in the case of the United Kingdom,
and in other cases, I'm sure in the case of Canada
it's the same, no, the voting is clear-cut.
Mark, I'm talking about the United Kingdom,
Mark voted against raising the rate of intern,
Philip voted, leave it the same, and so on and so forth.
And in doing so, the argument is that credibility is enhanced.
How about fiscal policy?
I mean, if we go back to this equation,
or any equation, those six equations,
which I put on those two slides,
there is no fiscal policy.
The best that you can do with fiscal policy is to say,
well, maybe it is in that particular constant.
That's a constant, doesn't mean anything, really.
So why not fiscal policy?
And of course, as I said earlier,
the model that these people passionately believe in
makes the assumption of rational expectations,
and another assumption, which is called conveniently
the Ricardian equivalence assumption,
or the Ricardian equivalence theorem,
which tells you that because economic agents
are so rational, they know exactly how the economy works,
and they have the right expectations.
So if you have a silly government which attempts
to control the economy by creating deficits,
they are very wrong, because these economic agents,
they know that if you create deficits today,
tomorrow, you are going to have to pay taxes.
And therefore, what you do today
is you increase your savings,
and therefore, cut down on your expenditure,
and therefore, the government tries to increase
its expenditure through creating a deficit,
but that is completely outweighed by the reduction
in private expenditure, and therefore,
at the end of the day, this deficit would have no impact
on the level of economic activity,
therefore, don't touch fiscal policy.
The only way you can use fiscal policy in some quarters,
for example, in the United Kingdom in particular,
is that maybe over the long term,
you might think of some investment projects
which would help the economy, but nothing else,
and especially, do not use fiscal policy
as a short-term stabilization instrument.
And we have the apotheosis of that particular argument
in the activities of our government
over in the United Kingdom, when last Wednesday,
they decided to, over three or four years,
to cut substantially government expenditure increased taxes
so that the deficit would disappear in four or five years' time.
And I bet you the United Kingdom is going to go through
a lot of problems soon, for the very simple reason,
that if that is the basis of the argument
about not using fiscal policy,
the question is, are people rational in that way?
Are we, how many of us in this room
are rational in that particular way?
I am not, and I'm sure Mark is saying no, Philip,
I'm not either.
So how many people in an economic system are rational?
People from these, support normally this particular paradigm
have done a lot of research, actually,
in this particular rationality behavior,
and they have demonstrated that the minute you begin
to make the assumption that not everybody in the system
is rational, which is more realistic assumption
for everybody, then they have demonstrated
that fiscal policy at the end of the day does matter.
So unless everybody is rational,
then fiscal policy is very effective.
But for some people, like, for example,
our present government, you know,
this rationality condition is very, very important,
and that's what they have tried to do.
So fiscal policy for this particular framework
is out of the question, don't use it.
The apotheosis of this particular argument, I think,
is every time that the ECB
decides about whether to change or not the rate of interest,
and there is this
conference, as they call it,
of the governor of the ECB with the press,
and he makes a statement,
and it's so standard ever since January 1999.
We have decided today to do change rate of interest,
not change rate of interest,
and in doing so, we have done,
we've implemented two type of policies, monetary policy,
and, sorry, monetary considerations
and economic considerations, ba-ba-ba-ba.
But I must add two things.
Markets must be cleared.
We must ask every member of the European Monetary Union
to introduce policies which would free the labor markets
as much as they can.
And most important, every government member of the EMU
should introduce policies so that the deficit disappears.
Not only does the deficit should,
not only should the deficit disappear,
but also we should have some surplus
just in case we need to use it in difficult circumstances.
Take it for granted, this is exactly what,
not just the current, the previous one,
ever since January 1999,
when we had the establishment of this committee
that meets every Thursday, we meet today, in fact,
every Thursday, first Thursday of each month,
in order to decide about the rate of interest,
that's exactly what happens.
And this is what this,
it comes from this particular framework.
And in terms of whether the policies are discretionary
or rules of what they tell us is constrained discretion.
It's neither rule nor discretion
is some kind of constrained discretion.
That's what they call it.
Now, are there any problems with this particular way
of thinking about macroeconomics?
And I think there are a lot of problems,
and serious problems.
The first one is that there is no liquidity preference
in this particular theoretical framework.
And that is precisely because of these transversality
condition that we talked about.
Central bank changes the rate of interest,
and it influences the term structure of interest rates
in an extremely stable manner,
in which liquidity preference of anybody,
marks or mine or anybody else, is not important.
But of course, we know that the term structure
of interest rates is influenced
by a host of other variables,
and it's not necessarily stable,
but most importantly, it is influenced
by the liquidity preference of the banking sector.
An argument, a hypothesis, which is very, very important,
of course, in Keynesian economics,
but not in this particular framework.
As I said, there are no banks,
all monetary aggregated, aggregating the model,
and the absence of banks in this new consensus
microeconomics, of course, implies all sorts of problems,
serious problems.
We know banks and their decisions play a very,
very important role in the transmission mechanism
of monetary policy, that's ignored.
And since decisions by banks as to whether or not
grant credit plays a very important role
in the expansion of the economy,
in the sense that a failure of banks to supply credit
would imply that expansion of expenditure
cannot, okay, all this is completely ignored
by this particular framework, and consequently,
there is a disjuncture between the analysis
and the role of monetary policy.
And to quote Farnus's cousin, Demosthenus,
commerce proceeds not from the borrower,
but from the lender, without whose assistance?
No vessel, no captain, no passenger can stay.
And I came across, not that I read Demosthenus every day,
but I came across this from this British newspaper,
the Observer Sunday, and this very good friend,
William Kicken, used this quote,
which I think is very, very appropriate
for this particular case.
Now, there is a lot of recent research
which has exposed these problems,
and this research, funnily enough,
does not come from people like these four gentlemen,
including me, sitting in this, or standing right here,
it comes from people who have some favorable,
ideas in terms of these new consensus macroeconomics.
And what these people do is that they use
these standard new consensus macroeconomics model
that I put on that particular slide,
and they compare this model, which has no banks,
and it has no monetary aggregate,
with a similar and large border,
which is endowed by including banks
that create deposits and, of course, make loans.
And let's see what they come up with.
This enlarged new consensus macroeconomic model
introduces real money balances,
essentially cash and bank deposits,
the M2 definition of money stock,
which is used, of course, for transaction purposes.
And they also have real government bonds
on the assumption that economic agents
use government bonds to manage their liquidity
in the representative household utility function.
So these people, you see,
they compare the pure NCM model,
which I demonstrated in those,
what I showed in those two slides,
with these expanded optimization
of these utility functions,
subject to the budget constraint,
by introducing money and government bonds.
Canzoneri and others, not long ago, 2008,
calibrate the two models in an attempt
to decide whether there are differences.
Calibrate, I hope we understand the word calibrate,
as opposed to simulate.
They don't estimate their models.
They play around with these models,
by assuming certain coefficients were ever necessary.
And therefore, they make all sorts of assumptions
about the variables involved,
and they ask relevant questions.
And instead of simulating,
they use similar technique in order to derive
the impact of the variables
that they are interested in changing
on the variables, the main variables
that are of interest.
And they use also impulse response functions
to study how various shocks infiltrate through their models.
And two conclusions are relevant for our purposes.
Monetary indicators are useful in forecasting inflation
in the enlarged new consensus macroeconomic model,
but not so in the standard
new consensus macroeconomic model.
And that would tempt you to say,
ah, that's taking us back to monetarism.
Money is important.
Well, not so, I'm afraid,
because these authors do not recommend
M2 targeting monetary policy in the monetarist way.
This is the reason why they don't do so,
is that they play around with other definitions of money,
and they find that the broader the measure of money
that they use, the better the results that they get.
And therefore, they readily admit,
these are people who normally support these models,
that we need a great deal more research and scrutiny
of this particular theoretical framework.
And therefore, the inevitable conclusion
from this kind of work is that maybe what is important
and very much missing from these new consensus macroeconomics
is bank lending and not any form of money.
And to the extent that it is bank lending,
then I think Mark must have mentioned earlier
that in post-Kensian economics,
bank lending is what is important
and not necessarily any form of M, M0, M1, or whatever.
Now, a compelling question in this particular exercise
is how are we going to justify credit or money
or whatever in that particular equation
that we inter-temporarily optimize?
And this, of course, can be undertaken under the assumption
that marginal utility of consumption
depends on credit variables.
And the standard way is to resort
to the utility function models
where credit variables affect
the marginal utility of consumption.
And therefore, as such, enter in that first equation
that I showed you of the six equation model.
And what this is labeled in this analysis
is the non-separability principle.
And a utility function is additively separable
between consumption and credit variables.
If it can be separated into two functions,
one containing only consumption
and the other one only credit.
And if the utility function is not additively separable,
then the credit variable will enter equation one.
So, you know, this is a testable hypothesis.
The evidence, and this comes from Friedman,
not Milton Friedman, but another Friedman in 2003,
where he says that integrating the credit market
into both the theoretical and the practical analysis
of monetary policy is going to be harder.
Therefore, you know, more and more research is needed
in terms of this particular approach.
Furthermore, in a recent EJ paper
with some colleagues, we consider an otherwise
new consensus macroeconomic theoretical framework
that allows a role for money.
And we depart from the static money demand formulation
and posit a forward-looking money demand function instead.
The implication is that money can become
an information variable that can help produce
more precise estimates about the unobserved variables
of the model.
And again, you see, this kind of exercise
shows us that, yes, you know, money could have some role,
but there again, the wider the definition of money you use
and in the limit bank credit,
the better results you get.
Here we go again back to the post-Kensian approach,
where if you are going to use any monetary variable,
bank credit, et cetera, is the best.
Another problem with this particular approach
is that price stability has been associated with benefits
to the economies pursuing it.
But there are, of course, problems
with this particular assumption.
Price stability might not be sufficient
to avoid serious macroeconomic instability.
And there are numerous examples in the history,
economic history, of mankind to demonstrate that.
In the 30s, the 20s was a remarkable period
of price stability, and all suddenly,
God helped those who lived in the 30s.
In the more recently 1997 Southeast Asian crisis,
prior to that, there was remarkable price stability
in all Southeast Asian countries.
And all suddenly, macroeconomic instability emerged
after June 1997, and according to some people,
including Joe Sticklich, there are problems still today.
And do I mention there is an example
of August 2007?
We've had the wonderful stability
from around the middle of 80s until 2007.
Why we had the price stability is an interesting question,
and we'll come back to that a little bit later.
But all suddenly, we had the very nasty instability,
macroeconomic instability, which we are going through
as we talk.
So price stability is the only objective,
macroeconomic objective, is neither necessary nor sufficient
to give you macroeconomic stability.
Indeed, monolithic concentration on price stability
does not guarantee economic stability of the economy,
a point which has been even accepted by people
like the Governor of the Bank of England
in a recent speech, and I've just given you
the reference there, where he's complaining
and saying that price stability alone
is not going to give us macroeconomic stability,
a point which even the IMF more recently has accepted.
Another problem is what I have touched upon earlier,
and that is the determination of the equilibrium rate
of interest, rr star in equation three,
which of course, as I said, corresponds to the Vixellian
natural rate of interest, and that is very, very problematic.
I've mentioned the Axel Weber lecture in Cambridge,
which was subsequently published in the Cambridge
Journal of Economics in April 2008,
and all those worries which I've talked about.
Keynes in 1936, 30, in his Treatise of Money,
accepted actually the notion of this natural rate of interest.
But in 1936, in the general theory,
he explicitly rejects the idea of a unique natural rate
of interest, and in effect, argues that there is
a natural rate of interest corresponding
to each level of effective demand,
which would bring savings and investment into balance,
and to quote from Keynes, in my Treatise on Money,
I defined what proposed to be a unique rate of interest,
which I call the natural rate of interest,
namely the rate of interest which in the terminology
of my treaties preserved equality between the rate
of saving and the rate of investment.
I had, however, overlooked the fact that in any given
society there is on this definition a different natural
rate of interest for each hypothetical level of employment.
And he goes on in the same, those two pages,
42, 43, to say how wrong he was initially
to accept that there was a unique natural rate of interest.
But there are further problems that when we account
for bank credit as the main source of financing for firms,
loan rates become, of course, important,
something which this model completely ignores.
Under such circumstances where the rate of interest
on bank loans differs from the policy rate of interest,
RR*, may not be a useful indicator for monetary policy,
for the very simple reason that nobody knows
what the hell it is.
And these people, De Fiore and Tristani,
show that under such circumstances,
and on the assumption of asymmetric information
and of credit treated in nominal terms,
in another wise NCM model, RR is heavily model dependent.
No wonder why Weber was complaining that every time
I ask the econometricians to come up with a sensible RR,
precise value, they fail to do so.
And, you know, those are arguments that support
what I have just said.
Further problems is that inflation targeting
is designed to find demand shocks.
That is demand pool type of inflation.
This particular theoretical framework cannot fight,
if you like, an inflation which is of the cost push variety.
And we had a lot of examples over these recent crisis
where clearly inflation was emanating
from cost push elements and the central banks
couldn't decide how to anticipate
for that kind of inflation.
In the case of the Bank of England,
in a couple of cases, they decided to do nothing.
To do nothing because there is the belief
that when you have these supply type of shocks,
they are of very short term nature, they come and go.
So don't worry about them.
But then I ask you in the United Kingdom,
as we talk the rate of inflation
is above the inflation target for about two years now.
And two years is a long time.
So these supply side shocks needn't be as short term
as these people claim.
There is insufficient attention paid to the exchange rate.
Exchange rate is not included in equation three
in the monetary policy rule of the central bank.
A strong real exchange rate can contribute
to imbalances in the economy
through its impact on the domestic composition output.
You can have when the exchange rate appreciates
as we had in the United Kingdom from about 1996
until the crisis.
And we had these imbalances in the economy,
that is the manufacturing and exports decline
and we have increases in services
and current account deficit.
There is thus the danger of having a combination
of price stability and exchange rate instability.
And the question then is, in order to account
for this problem, should we not include exchange rate
in equation three if we are to stick
with that particular theoretical framework.
The pass through effect of a change in the exchange rate
first on import prices and subsequently
on the generality of prices, both goods and services
has weakened substantially since the late 1980s
and there is a lot of evidence for that.
Consequently, the stronger real exchange rate
has had less offsetting effect on domestic prices
than in earlier periods.
Consequently, the stronger real exchange rate
has had less offsetting effect on domestic prices
than in earlier periods.
And the argument normally used to justify appreciation
in the exchange rate, that such a move shows inflation
is no longer valid under the circumstances.
The idea here is that there are occasions
where the central bank would have
to keep increasing the rate of interest to fight inflation.
And of course, exchange rate appreciates
and could have all sorts of, it would help the central bank
in its fight against inflation, but this mechanism whereby
higher interest rates, higher exchange rate
would have this slowdown effect in inflation
is no longer there.
Impact of interest rate changes may
have become more ambitious.
Evidence seems to show that capital movements are based
more now on equities rather than government debt.
A change in interest rates then may have the opposite effect
on capital movements than otherwise.
If it is equities that these capital movements comprise of,
it's very different from bonds.
An increase in the rate of interest
is a good thing if it comes from bonds,
because capital movements exploit a higher rate
of interest.
But a higher rate of interest, to the extent
that your portfolio is simply equities, it's a bad thing.
Higher interest rate equities are going to go down.
And consequently, you have outflow of capital movements
rather than inflow of capital movement.
A secondary instrument in the form of direct intervention
under those circumstances may be necessary.
Central banks should engage in intervention on their own
as a monetary mechanism.
So it takes us away from inflation targeting.
Countries that do not pursue IT type of policies
have done as well as those who do.
We have done a lot of work on this question.
And we have demonstrated that whether you
are an inflation targeting country or not,
you were very good in terms of fighting inflation
over the period mid-'80s to just before the crisis.
So it follows from that that inflation targeting countries
probably have not been as successful as they
claim in terms of taming inflation,
for the very simple reason that there
may be other reasons why we've had
this period of stable inflation between the late 1980s
and just before the crisis.
And the reason for that could be globalization.
And therefore, not so much inflation targeting.
Now, monetary policy and fiscal policy, we discussed it.
We demonstrated in that model that monetary policy is
more important, fiscal policy isn't.
Does it work in practice like that?
Another type of work we've done is
to look at the macro-econometric models of the Bank of England,
the Federal Reserve, and the European Central Bank.
And believe it or not, you get completely different results.
We get the result that fiscal policy is very, very important
and powerful.
And monetary policy, by contrast,
it would take about a couple of years at any rate
for a change in the rate of interest
to have a small effect on the rate of inflation.
Nothing of the kind that these people suggest theoretically.
And the transmission of monetary policy
has changed because of the huge debt in the economy.
And I have in this slide some interesting statistics
about the huge increase in debt in the United States.
For example, we had an increase of 52%
in the financial sector debt and the US private debt to GDP
rose by 101%.
Under these circumstances, the dangers
with the new consensus macroeconomics
type of conduct of monetary policy
could have serious effect.
Low interest rates caused bubbles.
We know that.
High interest rates were through applying economic pressures
on vulnerable social groups.
Regulatory and prudential controls
become, therefore, necessary.
And this type of new dimension to monetary policy
is financial stability.
And as I am going to talk on such a day,
this financial stability is, of course,
a new way of doing monetary policy.
But there are enormous problems in terms
of its implementation, starting from the United States,
moving to Europe, United Kingdom, and many, many
other countries.
How do we conclude?
Well, I'll try to explain these new consensus macroeconomics
from a Keynesian perspective.
There have been numerous problems.
The financial crisis of August 2007,
the way countries had been implementing
these new consensus macroeconomic policies
had a lot to do with the crisis, the way
of thinking along the lines of the new consensus
macroeconomics, again, to some extent, a great extent,
responsible for the crisis.
And I suggest that more serious research is desperately
needed on the current state of macroeconomics
and economic policy.
And to some extent, my final, final conclusion,
I refer you to the last slide of mark with which I agreed
very much.
And with that, I think I should stop.
And thank you very much for listening and not disturbing
at all.
Thank you.