Saturday, February 28, 2015

Old Keynesian Financial Frictions

I had forgotten this passage from The General Theory which may be Brad DeLong's favorite.

Brad made very good use of

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.
But I am interested in a paragraph which I forgot entirely until I just read it. I now suddenly find it interesting because it is Keynes on risk premia (and so financial frictions) and Keynes's view is notably different from that of the New Keynesians I discussed in my last post.

The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even though it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually assailed by doubts concerning the future, he would turn in his perplexity towards more consumption and less new investment.
After long consideration I have decided to be honest (as I would have been caught anyway) and admit that Keynes is discussing the strange country in which financial intermediation is absolutely banned so individual income must be divided between consumption and investment. However note that he assumes that, in this strange case, risky returns cause high consumption. This doesn't have to be true (it is easy to come up with a model in which risky returns on capital cause more precautionary saving or in Keynestopia precautionary investment). But it is completely unlike the disturbance term which is called epsilon superscript b in Smets Wouter 2007 and "b" in Del Negro, Giannoni, and Schorfheide (2013 last revised 2014). This is justified as a risk premium but appears in the Consumer's problem as an increase in a totally safe interest rate.

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