Some decades ago the British economist Joan Robinson – one of John Maynard Keynes’ most brilliant students who helped him with the original draft of his General Theory – half-jokingly referred to some of her colleagues as “Bastard Keynesians”. These colleagues were mostly American Keynesians, but there were a few British Bastard Keynesians too – such as John Hicks, who invented the now famous ISLM diagram. What Robinson was trying to say was that these so-called Keynesians were fatherless in the sense that they should not be recognised as legitimately belonging to the Keynesian family. The Bastard Keynesians, in turn, generally assumed that this criticism implied some sort of Keynesian fundamentalism on the part of the British school. They seemed to assume that Robinson and her colleagues were just being obscurantist snobs.

Such a misinterpretation exists to this day. The second and third generation Bastard Keynesians – which include many of those who generally collect under the title “New Keynesian” – have reinforced this criticism. Paul Krugman, for example, in response from criticisms that he was misrepresenting the work of Keynes and his follower Hyman Minsky wrote:

So, first of all, my basic reaction to discussions about What Minsky Really Meant — and, similarly, to discussions about What Keynes Really Meant — is, I Don’t Care. I mean, intellectual history is a fine endeavor. But for working economists the reason to read old books is for insight, not authority; if something Keynes or Minsky said helps crystallize an idea in your mind — and there’s a lot of that in both mens’ writing — that’s really good, but if where you take the idea is very different from what the great man said somewhere else in his book, so what? This is economics, not Talmudic scholarship.

This is a classic misrepresentation of those who accuse Krugman and his ilk of Bastard Keynesianism. When people accuse Krugman and others of distorting the work of others it is not because of some sort of sacredness of the original text, but instead because Bastard Keynesianism is racked with internal inconsistencies that its adherents cannot recognise because, blinded as they are by their neoclassical prejudices, they never get beyond a shallow reading of actual Keynesian economics. What is more, these inconsistencies are not simply some sort of obscure doctrinal or theoretical nuance that only matters to hard-core theorists; rather they generate concrete policy responses that may well cause a great deal of trouble and, quite possibly, discredit Keynesian economics itself if and when they fail spectacularly should they be implemented.

We turn now to one of the most egregiously incorrect postulates of the modern-day Bastard Keynesians, one which regularly arises in policy discussions; namely the so-called “natural rate of interest”. We will focus on the work of Paul Krugman. Not because he has engaged in any sin that his Bastard Keynesian colleagues have not also engaged in but simply because he is the most public face of the movement today. He is also a rather clear writer (unusual for a neoclassical) and so can easily be pinned down in the claims he makes.

What is the Natural Rate of Interest and How Does it “Work”?

The natural rate of interest is the interest rate at which the economy reaches full employment without generating substantial inflation. Any interest rate lower than the natural rate would lead to inflation as individuals spent and invested too much money because of the cheapness of borrowing; while any rate higher than the natural rate would generate unemployment as individuals spent and invested too little money because borrowing rates were too expensive. The idea lying behind this is that in order to bring the economy to a low-inflation level of full employment all the central bank has to do is set the interest rate at the level at which the supply and demand for savings generates a sustainable quasi-equilibrium result.

Yes, the whole idea is essentially based on the classic supply and demand graph – only applied to savings and investment rather than, say, the demand for apples or bananas at any given price. Neoclassicals find it remarkably difficult to think outside such a framework because it has been drummed into them since day one. Indeed, one would not be exaggerating too much by saying that neoclassical economics – and consequently, Bastard Keynesianism, which is an offshoot – is just a great big pile of crude supply and demand graphs piled one on top of the other. The idea of a natural rate of interest is simply the supply and demand graph being applied to the economy at large.

The supposed fact that a natural rate of interest exists leads many neoclassicals to assert that central banks have full control over the level of economic output in an economy at any given point in time. This, in turn, leads many neoclassicals to assert that other policies, like government expenditure programs (stimulus packages), are completely ineffective and only generate inflation. After all, if central banks can set the interest rate in line with the natural rate to generate Economic Bliss then why on earth would we need the government to intervene at all? Looked at in this way, the argument in favour of a natural rate of interest can be interpreted as a strong case against any macroeconomic stabilisation policies that involve the government in any meaningful way.

However, the Bastard Keynesians came up with an argument against this way back in the 1930s. They call it the “liquidity trap”. They claim that when the economy is in a so-called “liquidity trap” – as it supposedly has been since 2008 – then the natural rate of interest is actually negative. The problem here, according to the Bastard Keynesians, is that the central bank can only really drop the interest rate to the zero-bound level and, because the natural rate is negative, the economy fails to return to full employment levels of growth. Paul Krugman summarises as such with reference to the post-2008 world:

Right now the interest rate that the Fed can choose is essentially zero, but that’s not enough to achieve full employment. As shown above, the interest rate the Fed would like to have is negative. That’s not just what I say, by the way: the FT reports that the Fed’s own economists estimate the desired Fed funds rate at -5 percent.

Although rarely actually explained, the idea behind this is that in a negative interest rate environment money would, in a sense, decay. Holding onto money like an Ebenezer Scrooge character – which is effectively what the Bastard Keynesians believe is going on in a liquidity trap environment – would actually cost the holder money. Thus they would, in a tidy supply and demand manner, be incentivised to spend and invest their cash holdings. On the back of this consumption and investment would rise together with the level of employment until we were back to a state of Economic Bliss.

Inconsistencies in the Bastards’ Arguments

From a policy standpoint the problems with this are immediately obvious to anyone who actually follows financial markets (which, many are surprised to know, most economists do not): even if the central bank could succeed in creating a negative interest rate environment by generating inflation, it is by no means clear that now hoarded money would flow into real investment or consumption. Instead it might inflate asset price bubbles across the financial markets – from commodities to stocks – which would do nothing more than increase economic instability and, in the process, discredit Keynesian policies.

The reason why the Bastard Keynesians miss this is because there is a major inconsistency embedded deep in their worldview and in their theories. In fact, it is embedded so deep that they themselves are completely unable to recognise it. The problem lies in that, while these economists often reject the notions of perfectly rational agents and perfectly efficient markets, their theories actually implicitly rely on such notions without their even recognising it. In modern Bastard Keynesian theory, as in the theories of the earlier Bastard Keynesians, there exists a massive blind spot that distorts their perspective on many important issues.

In order to understand this we must again consider what these economists mean by a natural rate of interest. Note carefully that they refer to this interest rate in the singular, not in the plural. This is because, as we have already seen, they assume that the rate that needs to be set in line with the natural rate is the central bank overnight interest rates – what used to be called the “money rate of interest”. However, the central bank overnight interest rate is but one of many interest rates in the economy. There are, in fact, distinct interest rates on every financial asset in the economy. There are separate interest rates, for example, on triple-A rated company debt and on low-rate junk bonds; there are separate interest rates on personal mortgages and on credit-card debt – and so on and so on.

The reason that the Bastard Keynesians ignore this fact is that they assume – quite correctly – that when the central bank raises or lowers the overnight interest rate, all these other interest rates respond accordingly. The central bank rate of interest can properly be seen as the “risk-free” rate of interest while all the other interest rates integrate whatever risks the borrower is seen to represent. To understand this better let us imagine that the central bank risk-free rate is set at, say, 4%. Investors and savers know that by parking their money in government bonds they can get this 4% without incurring any risk. So, if they are to put their money into, say, a risky junk bond that has a high risk of default they will demand maybe 15%.

Now, say that the central bank lowers the risk-free rate to 0%. Well, now the investors and savers are going to be willing to accept a much lower return from the risky junk bond. Their choice is no longer between a risk-free rate of 4% and a risky rate of 15% but is instead between a 0% rate of return that incurs no risk and a risky asset with a high default risk. Thus they might be willing to buy the junk bond if it has, maybe, an 11% rate of interest or so.

This is all well and good if we assume that savers and investors are perfectly rational and price in risk perfectly. After all, if investors and savers are not subject to irrational swings and do not misprice risk because they essentially know the future then this whole process should work like clockwork – or, more poignantly, like an enormous series of neoclassical supply and demand curves that exist all across the money markets. However, if investors and savers are not perfectly rational and cannot price in risk perfectly because they do not know the future, then the interest rates on everything except the risk-free rate set by the central bank is completely and utterly indeterminate and is subject to the whims of investors.

In our example above, the very fact that other investors are piling into junk bonds due to the 0% risk-free rate might cause a burst of herd behaviour among investors who then drive yields on said junk bonds down to freakishly low levels – in fact, this is precisely what we have seen in recent weeks and, as I have written elsewhere, I have yet to see a convincing explanation for this shift that does not relate this to some sort of irrational behaviour.

The idea of a natural rate of interest then implicitly rests on the idea that investors and savers in the economy are perfectly rational and have perfect information about the future. Indeed, it actually implicitly relies on the Efficient Market Hypothesis in its strongest form. In order for the overnight interest rate as set by the central bank to line up all interest rates in the economy with the low-inflation, full-employment optimum rate investors and savers would have to set all these rates at their own “natural rates” – this, in turn, would require a Herculean level of rationality amongst investors and savers. What is more, if such Superhuman rationality and foresight is lacking all we will get are speculative bubbles and chaos as well-advertised shifts in the central bank’s monetary policy leads to irrational bursts of herd behaviour amongst investors which is then further influenced by the fear of “money decay” that comes with a negative rate environment.

For They Know Not What They Do…

It is at this point at which the irony of the Bastard Keynesian position reaches fever-pitch. Most of the Bastard Keynesians do not believe in such unrealistic rationality and yet they continue on with their natural rate nonsense regardless. Paul Krugman, for example, has been highly critical of the Efficient Markets view of financial markets and has written eloquently on the properly Keynesian idea that financial markets are inherently speculative. He appears to take this view largely in line with his support for the school of Behavioural Economics. In his blurb to his colleague Robert Shiller’s “Irrational Exuberance” Krugman approvingly writes that:

Robert Shiller has done more than any other economist of his generation to document the less rational aspects of financial markets.

Yet Krugman and his Bastard Keynesian colleagues seem completely unable to integrate these insights into their macroeconomic theories. Why? I would argue because of poor scholarship. It is certainly true that paying too much deference to the work of our forbearers may result in dogmatism. Certainly this is often the case with Marxists and Austrians. But the alternative is arguably much worse. By engaging in poor scholarship, as the Bastard Keynesians habitually do, one risks completely missing discrepancies and inconsistencies that arise upon adopting work that is being done in a completely different framework to one’s own neoclassical framework. This can lead to embarrassing misunderstandings that, frankly, make Keynesians appear sloppy and intellectually lazy. It also leads to desperately bad policy advice that could, if ever implemented, lead to Keynesian ideas being discredited.

Perhaps the most unfortunate aspect of all this is that the Bastard Keynesians, with only a very few exceptions, are today the main representatives of Keynesian economics to both policymakers and the general public. By fitting somewhat comfortably into the mainstream – because, arguably, they are not really Keynesians at all – they have managed to secure social positions of influence from which they preach what they and others think to be the Keynesian message.

Such can be quite troubling. While I think all those in the Keynesian camp appreciate the Bastard Keynesians pushing for common-sense fiscal policy in these dark days, nevertheless it is hard not sometimes to feel that the people representing these ideas are playing with forces that they do not comprehend or understand. It sometimes feels a bit like being at a civilised political debate in which the position you represent is completely underrepresented when suddenly someone shows up that agrees with you. On the surface this looks promising; they have a good position in society, better than your own, and people seem to know their name. Unfortunately all they do is rant and shout and prove completely unable to handle nuance.

As they stand there making threatening gestures and frothing at the mouth you wonder to yourself: “Should I distance myself from this person altogether or should I just throw my lot in with them? Is it better to approach this debate from the point-of-view of coherence, integrity and consistency; or is it better to approach it from the point-of-view of brute force and sheer decimal volume?” I would imagine that those who put themselves in the Keynesian camp can come up with the answer to that question on their own and after careful reflection; however, it should be pointed out that more and more people will likely be asking it in the coming years as within the halls of academia and within certain growing circles true Keynesian ideas are beginning to blossom.