Bruce Bartlett wrote:
> Unfortunately, Keynes himself was to a large extent responsible for
> giving this criticism of his work currency. That is because he titled
> his most important work “The General Theory of Employment, Interest
> and Money.” The term “general theory” obviously implies that it is
> applicable at all times, in all economic situations.
>
> This was an unfortunate error, because the core insight of Keynesian
> economics is that there are very special economic circumstances in
> which the general rules of economics don’t apply and are, in fact,
> counterproductive.
As PK points out, the phrase "general theory" says that in general
there are two cases, i.e., the full employment case and the stagnation
case. (There would also be an in-between case, but let's ignore that.)
The Classical economists -- including the majority of contemporary
macroeconomists with their DSGE models -- deal with only the first
case. It's not just a matter of their formal models (as PK says) but
instead infests their basic _world-view_. It's almost instinctual:
they have a very hard time imagining that any free-market economic
situation can exist that does not involve full employment of
resources. Scarcity of resources (including labor-power) is the rule,
just as in microeconomics. Even when labor is unemployed, these folks
presume that capital goods are fully employed, as seen in all the
major macro textbooks.
The exception is the non-free market case, i.e., when prices and
(especially) wages do not adjust quickly in response to the forces of
supply and demand. Then, it is possible that unemployment can exceed
the "full employment" or "natural" level. The solution, to the
Classicals, is to force prices and wages to be flexible, i.e., to fall
in response to underutilized resources. The problem is that the
real-world market isn't perfect or free enough, so we should force
reality to fit the model!
The other case -- stagnation -- case involves more than just the
liquidity trap. In addition, like the US neoclassical economist,
Irving Fisher, Keynes saw the cutting of money wages and prices as
potentially destructive, as hurting aggregate demand and making
stagnation _worse_. This fit the US experience of the early 1930s,
during which wages and prices did indeed fall and economic conditions
did indeed get worse. In short, though Keynes saw money wages as
sticky (non-responsive to the forces of supply & demand) as a matter
of empirical reality, it was a mistake to try to end that reality.
Thus, Paul Davidson points out that for Keynes, sticky money wages are
a _good thing_, helping to stabilize aggregate demand. To most
Keynesians, the solution to sticky money wages was to encourage higher
prices, lowering real wages, which (in theory) spurs higher
employment.
> Although Keynes’s theory was most appropriate to the Great Depression,
> his followers did indeed believe in its general applicability and the
> Keynesian medicine was overapplied and misapplied during much of the
> postwar era, leading to stagflation in the 1970s. Conservatives like
> Professor Buchanan were right about that.
After 1936, a lot of younger economists embraced Keynes' ideas and
created a "Keynesian revolution" of macroeconomic thought. This
involved a lot of extensions and applications of the original theory,
along with a lot of productive debate. But these Keynesians knew about
what they called the "inflation barrier," where unemployment got "too
low" so inflation took off. (In his _General Theory_, Keynes himself
warned about pumping demand up beyond the point where the supply
response became inelastic.) In essence, Classical economics applied in
those cases. Abba Lerner, for example, discussed the case where high
inflation (at low unemployment) became built into expectations of
future inflation, which in turn caused actual inflation as people
acted on their expectations. This produced the dreaded disease of
"accelerating inflation," which the profession later gave Milton
Friedman credit for discovering.[*]
The problem with the Keynesians after Keynes might be summed up by two
words: Paul Samuelson. He tried -- and largely succeeded -- in his
effort to subordinate Keynesian economics to neoclassical economics
(including general equilibrium theory), encouraging the idea that the
the problem of unemployment was due to imperfect adjustment of wages
and prices. He also championed the idea of the Phillips curve as an
unchanging relationship, so that falling unemployment rates would
cause rising inflation and nothing more, so policy-makers could choose
the "optimal" combination by balancing the benefits of low
unemployment against the costs of higher inflation. Of course, this
went against Abba Lerner's contribution, in which at some point the
economy hits the wall and accelerating inflation results even without
falling unemployment rates. Something like this was actually seen in
the late 1960s and early 1970s, due to the overheated Vietnam war
economy.
In addition, the 1970s saw "supply shocks" due to sudden decreases in
the world availability of oil. The fact that these could cause
inflation wasn't really seen by the Keynesians, but Friedman and the
Monetarists (including Buchanan, I believe) _denied_ that they could
have any effect. But these shocks imply nothing but bad policy
choices. This means that if the Keynesians hadn't been blamed for high
inflation, they would have been blamed for high unemployment! Strictly
speaking, however, as usual it's the politicians, not the economists,
who deserve the blame on this one. But in terms of economic theory,
_both_ the Keynesianism of the 1960s and Monetarism should have been
rejected. Instead, the latter won, later morphing into Mankiw-style
"new Keynesian" economics or into "new Classical" full-employment
(Say's Law) economics.
>... The criticism that Professor Ferguson implicitly leveled at Keynes of
> being excessively short-term oriented, therefore, has a grain of truth
> in it. But the much greater truth is that we are now holding the
> economy hostage to policies that are proper for the long-term – like
> stabilizing the debt-to-gross-domestic-product ratio – at a time when
> we face special circumstances that make such policies perverse.
The idea that Keynes' theory is a short-term one makes a lot of sense
to me. Keynes assumed, for example, that even though businesses
invested in new fixed capital equipment, that did not raise the amount
of fixed capital on hand. That makes the story simpler to tell, but I
believe that Keynes made the mistake of applying this short-term view
(which also included constant "autonomous consumption") to discuss
long-term issues. This kind of mistake is likely inevitable given the
fact that his effort to create a new vision of macroeconomics involved
a struggle not only with the Classical orthodoxy which had a
stranglehold on the profession but also with the Classical economics
which still controlled a lot of his thinking. (Thus, Robinson said
that he really didn't understand the implications of his own theory.)
However, there is no reason why this error should be identified with
Keynesian economics. The British Keynesian Roy Harrod, for example,
developed a simple growth model in which the growth of the stock of
fixed capital goods is central. So did Keynes' evil twin, Michal
Kalecki. These ideas faded as the Samuelson-led campaign to geld
Keynesianism proceeded, with assumptions of full employment
prevailing.
--
Jim Devine / "Segui il tuo corso, e lascia dir le genti." (Go your
own way and let people talk.) -- Karl, paraphrasing Dante.
[*] whereas the MF saw the full employment unemployment rate as a
single number (which he dubbed the "natural" rate of unemployment),
Lerner saw two values. "Low full employment" had high unemployment
because it was needed to keep labor relations in check (sort of like
Marx's reserve army of labor) avoiding inflation, while "high full
employment" had low unemployment. The latter could achieved by
improving labor relations, e.g., with wage and price controls
("incomes policies").
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