I actually have to get a bunch of “real work” done before flying to Vienna this weekend, and I’ve yet to earn the luxury of blogging a full response to Karl Smith on this gnome business. But for now, let me just point out that Daniel Kuehn tried to jump in on the action, and broke a battle over Maynard’s head without realizing it.
Remember, the whole point of my post–if you don’t believe me, look at where I summarized its lesson here right after it ran–was that I thought I had come up with a clear-cut “supply side” scenario that the Keynesians would mistakenly diagnose in the same way that they are treating our current recession.
So in that light, look at what Daniel Kuehn ironically had to say, after mulling over Karl and my exchange:
So the gnome attack thought experiment has to do with the capital heterogeneity issue.
I’m not sure I entirely get Bob’s point here. If gnomes attack like this, how would Keynesians talk about it? They’d say it’s a sharp fall in the marginal efficiency of capital, wouldn’t they? Bob acts like Keynesians have no way of talking about specific capital that doesn’t work well, so they try to fit the square aggregate demand peg into the round hole in the observed data. That seems wrong to me.
Now – as I’ve pointed out previously – Keynesianism relies on heterogeneous capital…
Keynesians wave their hands at specific distortions of the capital structure, but they at least have a way of incorporating it into their models – namely the marginal efficiency of capital. There are lots of ways that the capital structure could be distorted. Gnome attacks. Zombie attacks (not as effective as gnomes). Ninja attacks (this would probably be even more effective than gnomes). Pirate attacks, etc. Of course if you really stretch your imagination you could also consider technological advance and obsolescence, political instability, interest rate distortion of the time structure, changes in regulations, wars, bottlenecks in energy supplies, and other problems messing up a heterogeneous capital structure too. It’s not clear to me why we would want to stake a business cycle theory on any single problem with the capital structure, particularly when we typically think entrepreneurs are more or less rational and profit maximizing. I prefer the more general Keynesian approach which explains how – given a particular marginal efficiency of capital – the economy can sit at an equilibrium below full employment.
Yet Daniel is leaving out a biggie in terms of what Keynesians think can push down the marginal efficiency of capital: a drop in expected future demand for a business’ products. That’s the mechanism through which “animal spirits” can lead to a slump, after all.
In any event, how does a Keynesian propose to fix a drop in the marginal efficiency of capital? It would depend on why the marginal efficiency dropped, wouldn’t it? If the Keynesians knew it had fallen because of a supply shock, then (hopefully) they’d sit back and let nature take its course. In contrast, if it fell because of a drop in demand, then they would recommend monetary or fiscal stimulus.
Incidentally, I hope Daniel’s point isn’t that the Keynesians could look at video footage of the gnomes moving stuff around, and then declare, “Whoa, supply shock! Nobody touch the fed funds rate!” Obviously it’s cheating to know what the actual cause is.
Rather, my point is that the standard Keynesian diagnostics would react to a gnome attack the same way they’d react to a balance-sheet driven drop in AD. Daniel Kuehn’s post confirms my claim.