Monday, January 28, 2013

Keynesianism and Ricardo

In an amazing essay on "fat tails", British banker Daniel Davies declares Keynesianism proven and the only proven economics:

 I think people are underestimating quite how well-tested Keynesian theory is, by now, in the Popperian sense. It not only works, as shown in dozens of recession cases, it’s also seemingly the only thing that works, also demonstrated by many of the same cases.

Down in the comments section, someone asks if Keynesianism wasn't disproven by the Stagflation of the 1970's.   One other posted seconded that.  Davies only answered that Keynesianism passed that test too.  But sadly no details are given.  So as much as I am inclined to believe this is correct, I can't forward the argument.

Oh wait, here's an introduction to the new Review of Keynesian Economics, a new free online journal.  This is worth following.  In this introduction Palley et al echo what Davies says about stagflation.  While stagflation was indeed used by the opponents of Keynesianism to discredit it, they were wrong.  A good accounting of stagflation is given by Keynesian theories of conflict inflation.

Now at the same time, Davies links to an interesting argument he had on twitter.

I need to read this argument some more.  But my current assessment in that Ricardo's Comparative Advantage argument taken at face value is worse than useless in designing trade policies.  Primarily because it takes so many things as given which are in fact should be variables affected by the model.  The bottom line for me is that comparative advantage is only a fleeting state.  If a country builds up its industrial capabilities through a protectionist regime, that may be best for it's long term advantage, as it may develop a comparative advantage it originally lacked.  Or, through misguided free trade policy, it may loose what comparative advantage it earlier had.  The first of these arguments is well developed by Ha-Joon Chang in his book Bad Samaritans.  The second to my mind immediately follows.  This effect is amplified by free capital flows, another variable not considered by Ricardo.

James K Galbraith also presents a series of problems with Comparative Advantage in his book Predator State.  He concludes with a simple summary: Ricardo was wrong.  I also go with his critiques and summary.  IIRC the core of his primary critique is that Comparative Advantage ignores the developmental effects I mentioned above, notably ignoring changes that can occur as a result of improved division of labor and producer network effects.  I believe there is also an argument that Ricardo's mathematics only works for two trade items.  When you add a third trade item, it fails.

But this is an area where Krugman's old neoclassical side won't entirely let go.  He of course cut his professional teeth on trade (albeit "domestic trade").  Krugman continues to insist that Ricardo was right.  That commentary by Krugman is now fairly old, and he now makes allowances for the liquidity trap now when writing about trade in his blog.  But the problem is not with the qualifications, the very notion of Comparative Advantage itself is fundamentally wrong in many ways.  Comparative advantage is not something you just have, it's something you try to build up and try to hold on to, and those things may require regulation of trade and investment.  Meanwhile, the utility which is maximized through Ricardian Comparative Advantage is not something that people make goals to attain, it's something they are willing to give up to hold onto comparative advantage.

In most other matters, BTW, Krugman is spot on and I read his blog and editorials first thing every day.  Krugman the blogger and editorialist is a great Keynesian.  Krugman the professional economist is (or at least used to be) an equilibrium modeler, and equilibrium modeling is simply apologia for plutocracy.

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