A Question for the Keynesians

I have been thinking about Keynesianism a bit, and I want to get some traction on a back-and-forth you sometimes see.  I should say from the outset that I am broadly sympathetic to what I take to be the Krugman viewpoint, which I won't try to summarize here.  I am just curious about one particular nuance in the debate.

So here are the basic positions:

Non-Keynesian:  "We are not as rich as we thought we were.  We need to cut back!"

Keynesian:  "Look, asset prices might have been inflated during the bubble, but the production was genuine.  We really were producing a lot more back then, which shows that we are not up against any kind of limit to how much we can produce.  Rather, we face inadequate aggregate demand."

While I would generally agree with the Keynesian in this scenario (and while I certainly don't think recessions are a good time for the government to "cut back"), I am not sure the Keynesian response, as I have rendered it, is adequate.  I'll use a little model to explain my thinking.

The world of the model has two sectors:  agriculture and manufacturing.  Each sector makes one undifferentiated good, food or machines.  However, while the quality of food is easily observable, the quality of machines is observable only with a lag.  (Alternatively, machines last a certain amount of time, and consumers cannot perfectly predict when each machine will stop working.)

The economy starts in equilibrium, with each farmer working the optimal number of hours given his preferences for food and machines.  Likewise, factory workers are working the optimal number of hours given their preferences.  However, at some point, the population comes to believe that there has been a big quality improvement in its machines.  As a result, farmers are willing to pay a higher price for the machines.  The farmers work more hours to produce more food, so as to buy more machines.  The factory workers, enjoying higher incomes, also work harder to meet increased demand.  Everyone works more hours and consumes more.  Measured GDP rises.

But then it emerges that the machines have not actually improved in quality.  It was all a mistake.  Now farmers are only willing to pay the old equilibrium price for machines.  The production of both food and machines falls back to the old equilibrium, along with measured GDP.

At this point the Keynesian can rightly point out that the economy is capable of producing more food and machines.  After all, just a short time ago, it was doing just that.  But what the economy can't do is produce more food and machines that people are willing to pay for.  In other words, if you measure production not by kilograms but by the amount of wealth created, production was actually not so high, even during the bubble.  It was an illusion.  (Although, interestingly, agricultural production really was that high - it's just that once reality sets in, incomes aren't high enough to support that level of food consumption.  And manufacturing production, too, was higher at peak than afterward, even though it was exaggerated by the quality illusion.  I guess the way to put it is that incomes were inflated, and that based on those inflated incomes production was high.  But based on "sustainable" or "true" incomes, production was excessive.)

So what is the Keynesian to say at this point?  I think one thing to point out is that my model doesn't really have a concept of unemployment (or even of money), so we don't want to extrapolate too wildly.  But the fact remains that "we aren't as rich as we thought we were" seems as though it might be a coherent way to view the world, and you can see how peak production may be difficult to restore in a sustainable way.  You can produce that many kilograms, sure, but you can't create that much (perceived) value.

Of course, maybe the right answer is that we'll know we're up against production boundaries when fiscal stimulus creates significant inflationary pressure, and since that isn't happening there is not much reason to think this dynamic is in play.  I'm fine with that answer, but I want to be sure I'm not missing a more fundamental reason that the model isn't capturing what might happen in a typical bubble.  In other words, is there a better answer to the non-Keynesian claim that "we are not as rich as we thought we were"?

The Closing of the Liberal Mind

Krugman is not such a fan of "reformish" conservatives.  Krugman lists several issues on which conservatives are allegedly not allowed to dissent from the party line, on pain of expulsion from the movement:

1.The existence of anthropogenic climate change
2.The effects of fiscal stimulus/austerity
3.The effects of monetary expansion, and the risks of inflation
4.The revenue effects of tax cuts
5.The workability of universal health care

I am not so sure about these - there is a big difference between the conservative movement and the conservative base (which is, yes, downright crazy on these and any number of other points).  But anyway here is a list of issues on which it seems to me liberals are at least equally conformist (that is, you can't be a liberal while dissenting on any of these questions):

1.  That fetuses are not people (or, if they are people, that it is morally permissible to kill them).  (You do see the occasional pro-life Democrat, but then again, you also see the occasional Romneycare-supporting Republican.)

2.  That there is no role for religious beliefs or authority in public life (not just in the law, but in norms of behavior).

3.  That the family has no social value beyond the material advantages it brings to its adult members (that is, it is always better to dissolve a family in any case in which at least one adult member of the family would be made better off by its dissolution).

4.  That society has no legitimate interest in the sex lives of its constituents (note:  this principle can, and in fact must, be put aside when it conflicts with a punitive child-support regime).

5.  That there are no social benefits to one parent (of either gender) staying at home to raise children.

6.  That working-class people can be made better off through a government subsidy but never through cheaper goods and services facilitated by deregulation and low taxes.  (Similarly, I don't think a liberal is allowed to believe that a person who cannot afford to live in New York City should be expected to move to a location with a lower cost of living - people are equally entitled to a "living wage" in Manhattan, New York and Manhattan, Kansas, even if this requires far greater public expenditure in New York.)

Now these are all debatable points, and I don't mean to imply that the conservative movement is open-minded about any or all of them.  But it's worth considering whether modern liberalism has any flexibility when it comes to different conceptions of human thriving.

Or to put it another way:  There are people who can do very well with minimal support from public institutions.  A core tenet of traditional liberalism is that it is not good enough for this kind of person to do well - society must work for everyone.  But while this has (rightly) remained a key liberal commitment in the economic area, it has fallen away with respect to other important areas of life such as family, faith, and sexuality.  There are a lot of conservatives very thoughtfully engaged with these questions, and liberals would do well to join the discussion.  In many ways, these ideas ought to fit better with liberalism than with conservatism, which has too little respect for human differences and, I think it is fair to say, too little grounding in reality.  Liberals should not repeat those mistakes - liberalism should work for everyone.

Keynes and the BIS

Yesterday Krugman blogged about the inflation hawkishness of the Bank for International Settlements (BIS).    As some commenters noted, he passed up a good opportunity to title his blog post "Faulty Basel" or "Basel, Faulty" (Krugman, above all other commentators, loves wordplay).  Anyway it put me in mind of this, from John Maynard Keynes:  Fighting for Freedom (by Robert Skidelsky):

There was a last-minute Keynes explosion over the Bank for International Settlements.  Set up as a club for central bankers in Basle, Switzerland in 1930, it had maintained contacts with both sides during the war:  it had accepted the transfer of Czech gold to Germany, it had a German director, and Emil Pühl, deputy president of the Reichsbank, was a frequent visitor to Basle.  A resolution proposed by Keilhau of Norway and supported by other Europeans demanded its immediate liquidation.  The Americans and British had agreed to support a milder version recommending eventual liquidation, but at a meeting of Commission III on 18 July, the American representative Luxford put forward a resolution making membership of the BIS and IMF incompatible.  This passed over British and Dutch objections.  Keynes heard about it that evening, and it put him into a towering rage.  He stormed into Morgenthau's room, accused the Americans of double-crossing the British, and said that unless the American resolution was withdrawn he would quit the conference.  Mrs Morgenthau, who was present, reported Keynes as 'quivering, he was so excited about it'.  Morgenthau quietened him down, and Keynes left with a promise to send him a a new resolution next morning.  The eventual agreement was to call for liquidation of the BIS 'at the earliest possible moment'.  This moment never arrived, and the BIS continues to this day.  Keynes's intervention probably saved it.  He thought that the American action was part of a US Treasury sub-plot to discredit New York bankers opposed to the IMF who had had associations with the BIS.  Kept in existence, the BIS revived in the late 1940s as a centre for intra-European financial co-operation when the IMF was dormant.

 History is pretty weird.