Mr. Keynes and the "classics"5 - and Modern Keynesians

There are two main reasons for economists to study the evolution of Keynes's thinking about macroeconomics and related theoretical issues, such as competition, industrial organization, free trade, and free capital flows (see Chapters 7 and 11).

Keynes famously attacked the classical thesis that endogenous forces in a market economy will always force full-employment AD or spending to equal the aggregate supply (AS) of output and income at full employ­ment. This hoary proposition is known as "Say's Law." Anyone who has taken an introductory course in macroeconomics that included Keynesian theory will be familiar with the basic argument, which I summarize here in its simplest form. The AD for or spending on goods and ser­vices is composed of consumption spending by households and invest­ment spending by businesses. The value of the AS of goods and services, which is assumed in the simple model to equal total household income, is composed of household saving plus consumption spending. If AD equals AS at full employment, the economy will be in equilibrium because sales balance production and firms have no profit incentive to alter the level of production. If in a classical model AD or spending is smaller than AS or the value of production and income at full employment, it must be the case that investment is smaller than saving at full employment.⁷

Suppose that at some point AD falls below full-employment AS because investment spending has declined due to an increase in business pessimism about future profits.

Nominal wages will fall because unemployed workers will com­pete with employed workers for scarce jobs and prices will fall because firms will compete to increase sales.⁸ Classical theory assumes, with little if any supporting empirical evidence according to Keynes, that the real or price-adjusted wage will fall when there is an excess supply of labor, leading firms to hire more workers. This will raise production and income. Mainstream Keynesian theory incorporates the classical view that when wages and prices are fully flexible downward, high unemployment cannot persist. Therefore, a stable equilibrium with high unemployment is possible only if strong unions refuse to accept lower money wages or if workers irrationally confuse money wages with real wages in a dysfunc­tion referred to as "money illusion," one that is not mentioned anywhere in The General Theory.⁹

Keynes insisted to the contrary that if a rapid wage and price defla­tion set in, it could completely destabilize the economy (see chapters 2, 14, and 19 of The General Theory and Chapter 3 of this book). Deflation is likely to be especially destabilizing, Keynes said, in a period such as the early 1930s when both real-sector and financial-sector balance sheets were incredibly fragile due in part to the fact that the value of their assets were in a state of collapse in the severe commodity and financial asset price deflation of the period. Keynes stressed the dangers of deflation in what he called a "regime of money contract" in which the sum of all nominal legally binding commitments to pay was large relative to the size of the economy - as in the USA in the early 1930s.

It follows therefore that if labour were to respond to conditions of gradually [rising unemployment] by offering its services at a grad­ually diminishing money wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them... The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner of that in which we live. To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authori­tarian society, where sudden, substantial, all-around changes could be decreed that a flexible wage-policy could function with success.

(CW 7, p. 269)

On this crucial issue of the effect of deflation on production and employ­ment, then, both Mainstream Keynesian theory and classical theory are in direct conflict with Keynes's theory.

Second, in the basic classical model, savings out of current income were understood to be the flow demand for newly issued corporate bonds and investment the supply of newly issued corporate bonds. Thus, a sharp drop in investment spending at full employment would cause the supply of bonds to decline. This temporary excess demand for bonds would cause bond prices to rise and interest rates to fall, stimulating both investment and consumption spending.¹⁰ Rising AD would thus match the rising level of AS caused by real-wage deflation. These disequilibrium process must continue until a full-employment equilibrium is restored.

Keynes insisted (see chapters 13-15 and 22 of The General Theory, his defense of The General Theory in the Quarterly Journal of Economics in 1937 and Chapters 9, 15, and 16 of this book) that the classical thesis that long­term interest rates will assuredly fall in response to a serious downturn in AD is badly mistaken.

To understand Keynes's thinking about the nature of financial markets, we must first understand the revolution he created in micro theory or the theory of agent choice, a revolution not recognized by or incorporated in Mainstream Keynesian theory or in neoclassical micro theory. Keynes built his theory of agent choice on the assumption of "fundamental," "radical," or "Keynesian" uncertainty about future states of the economy.¹¹ Keynes's assumption of uncertainty is different from the classical, neoclassical, and Mainstream Keynesian assumption of "risk" in which the probability distributions that determine future economic outcomes are knowable in the present and unaffected by agent choice in the current period. Keynes said of future economic conditions: "About these matters there is no sci­entific basis on which to form any calculable probability whatever. We simply do not know" (Keynes 1937, p. 214).

In conditions of radical uncertainty, investors in risky real and finan­cial assets are not able to make assuredly optimal decisions in situations in which the result of their choice will not be determined until substan­tial time passes. In the case of long-term capital goods, this period can be measured in decades. Keynes's theory of agent choice thus requires a completely different kind of agent - a fallible and psychologically complex human being in a world of incomplete and inadequate information who knows he or she does not know the future and thus cannot possibly make assuredly optimal decisions.

The importance of radical uncertainty is that Keynes's agents are forced to base their financial asset acquisition decisions on fallible expectations about future security price movements formed on the basis of "conven­tional" or behavioral or psychological heuristics or rules of thumb that they know are not the "truth" about future security prices.

One conventional mode of expectation formation emphasized by Keynes is through extrapolation from the behavior of the relevant variables over the recent past. If financial asset prices have been rising for a substantial period of time, investors will come to expect this trend to continue. Moreover, Keynes argued, the longer prices continue to rise, the more "confident" - his word - investors will become that their optimistic expectations are likely to be validated by future outcomes. Confidently held optimistic investor expectations can generate bubbles in which security prices eventually outpace the real-sector cash flows needed to sustain them. If an expansion lasts long enough and, in Minsky's words, the financial system becomes "fragile" because excessive borrowing by firms and households and excessive lending by financial institutions per­meate the economy, panic may set in when it eventually becomes clear that security prices are substantially overvalued. This can lead to a frantic sell-off, resulting in an accelerating rate of decline in bond and stock prices. Falling bond prices mean rising interest rates that cause invest­ment and consumption spending to fall, reinforcing the rate of decline in AD, output, and employment, which adds momentum to the process of financial asset price collapse. This is a destructive disequilibrium process absent from both classical and Modern Keynesian theories.

Keynes theory of disequilibrium dynamics is qualitatively different from the out-of-equilibrium dynamic processes assumed in both classical theory and Mainstream Keynesian theory. The former creates stability at full employment; the latter creates stability at any equilibrium level of employment. In Keynes's theory, disequilibrium dynamics can be stabil­izing or destabilizing depending on conditions in the economy. The reader might be surprised to know that about forty percent of The General Theory is devoted to an analysis of out-of-equilibrium processes that are often destabilizing.

The outcome of the Mainstream Keynesian theory of interest rate deter­mination lies between the positions taken by Keynes and the classicists. The reason for this is important to understand. Like classical theory, Modern Keynesian theory either assumes that the probabilistic future is knowable in the present or that the agent subjectively believes she knows the true distributions of future states of the economy. Therefore, the mathematician­agents can make assuredly optimal decisions about buying and selling real and financial assets. You cannot generate the Keynes-Minsky theory of the inherent instability of financial markets based on the Mainstream Keynesian assumption of correct expectations and the optimizing agent.

Like classical theory, Mainstream Keynesian theory concludes that the interest rate will always fall if the economy receives a negative shock to AD, an anti-Keynesian conclusion; see, for example, John Hicks's well-known IS/LM model (and Chapter 19 in this book). However, unlike classical theory, Mainstream Keynesian theory assumes that the decline in interest will always be too small to restore AD to its full-employment equilibrium. With the assumed ability of wage deflation to raise AS blocked by strong unions and the fall in interest rates too small the push AD back to its full­employment level, Mainstream Keynesian theory can logically explain why stable high-unemployment equilibriums exist.

The systemic forces generating and reproducing the financial and eco­nomic instability of the late 1920s and 1930s or of the recent global finan­cial crisis cannot be explained within Mainstream Keynesian theory, in part because it rejects Keynes's assumption of radical uncertainty and the fallible and psychologically complex human agent it creates. Keynes repeatedly referred to US financial markets in the 1930s as destructive, destabilizing, "insane" "gambling casinos" that not only were more likely to magnify rather than repair serious damage caused by problems in the real sector, but were also themselves capable of initiating real-sector downturns. You cannot generate such financial instability in Mainstream Keynesian theory. In an article published in The Economic Journal in September 1932, Keynes argued that US financial markets were inherently subject to bouts of instability. They were:

dominated by insane gambling to get in at the bottom, just as they were dominated in the boom by insane gambling to get out at the top... For this is no more than a vivid illustration of the disadvantages of running a country's development and enterprise as a bye-product of a casino.

(CW 21, pp. 120-121)

In The General Theory, Keynes constructed a theory that, when combined with the evolution of economic and political institutions and practices over time - what he referred to as "the facts" of each historical period - could be used to explain the historical record of real-world capitalisms. This record contains periods of relatively stable economic evolution in "normal times," long periods of mostly rapid growth as in the "glorious" nineteenth cen­tury, typical business cycles, periods beset by destructive disequilibrium processes, endogenously created bouts of extreme instability in both real and financial markets in what he called "interesting times," and secular stagnation or prolonged depressions that cannot be eliminated by free- market processes and can threaten social and political stability.

Contrary to conventional wisdom, there is more than one applied economic model that can be found in The General Theory. In Chapter 19, I discuss five such models: (1) a long-term model of sustained high unemployment or secular stagnation; (2) a short-term model of high- unemployment equilibrium embodied in the "Keynesian" IS/LM model that is typically understood to be the sole model in the book; (3) a dynamic intermediate-run model of the business cycle that focuses on endogen­ously generated instability in real and financial markets; (4) a model of destructive disequilibrium processes focused on wage and price deflation and instability in financial asset prices; and (5) a short-run quasi-model or mini-model of periods or points of extreme instability, especially in finan­cial markets. These five models contained the main arguments used in The General Theory to explain the facts of the interwar period and to support his core policy belief that capitalism had to be replaced by Liberal Socialism in Britain in order for long-term prosperity to be achieved.

The main contribution of the IS/LM model to our understanding of Keynes's economic theory is that it provides a clear and logical explan­ation of why a capitalist economy can exist in a stable high-unemployment equilibrium state in the short run. A major problem with reliance on the IS/LM model as the only model in The General Theory is that its policy message was understood by Modern Keynesians to be that we can save capitalism through a combination of activist monetary and fiscal policy in the context of a high average level of government spending. You cannot generate Keynes's favored Liberal Socialist policy regime from an IS/ LM economic model. As we have seen, Schumpeter argued that the "pre- analytic vision" of secular stagnation permeated The General Theory even though, in his view, its single formal model was short run in character. He thought it could be used to create a framework for a narrative as opposed to a formal model of the causes of secular stagnation, a narrative consistent with Keynes's support for Liberal Socialism. But it has not been used for this purpose by Modern Keynesians.

In various chapters of this book, I show that Keynes used combinations of his five models to explain both the episodes of extreme economic and financial instability that took place in the interwar years and the long-term stagnation that afflicted Britain starting in the early 1920s and the USA after the late 1920s. Keynes's focus on secular stagnation somehow disappeared when Modern Keynesians adopted the short-run IS/LM model as the sole model Keynes bequeathed us. Yet as I show in Chapters 13 and 14, Keynes relied primarily on his long-run model and secondarily on the models of destructive disequilibrium processes to explain stagnation in the interwar era over and over and over again throughout The General Theory. These chapters also demonstrate that Keynes believed that there were no fore­seeable changes on the British horizon - such as system-transforming technological progress, or faster population growth, or restoration of its dominant position in the international economy - that might return the British economy to its nineteenth-century prosperity or the US economy to its pre-1930s prosperity. He concluded that only Liberal Socialism could bring sustained prosperity to Britain or the USA and simultaneously pre­serve the democratic nature of their political systems.

The IS/LM model thus cleansed Keynes's work of many of its most ser­ious criticisms of the nature of capitalism, including its potential for secular stagnation, its destructive disequilibrium processes, the "insane" behavior of lightly regulated financial markets, and its endogenous creation of instability. When the profession accepted and propagated the view that the IS/LM model incorporated all of Keynes's important contributions in The General Theory, the reasons for his persistent commitment to Liberal Socialism got lost in translation.