Keynes on the methodology needed to study capitalist economies
We discussed key differences between Keynes's methodology and the positivism of mainstream theory in Chapter 12 of this book. The overwhelming majority of mainstream economists accept Milton Friedman's dictum that the realism and completeness of the assumption set used to construct a theory has no bearing on the truth content of hypotheses derived from these assumptions.
The only legitimate test of a theory, he argued, is the consistency of its derived hypotheses with relevant empirical data. However, the Duhem-Quine thesis in the philosophy of science correctly asserts that is not possible to adequately test the empirical validity of hypotheses derived from a theory based on the theory alone. Assumptions from outside the theory must be added to the theory to make it empirically testable. Consider econometric tests of the investment demand function of the neoclassical firm. This requires, among other things, specifying the firm's expectations of the profit flows to be generated by the new capital goods over their expected lifetime. This information is not provided by neoclassical theory; rather, it must be added to the theory by specifying a separate theory of expectation formation. Therefore, the empirical tests may be passed even if the theory is wrong because its errors are compensated for by errors in the expectation-formation assumption, and the tests may fail to support the theory even if it is correct because of compensating errors in the expectation-formation assumption.Keynes, to the contrary, insisted that you cannot build a realistic theory of capitalism based on a crudely unrealistic and/or significantly incomplete assumption set. The realism and completeness of the assumption set matters. In the one-page opening chapter of The General Theory, Keynes sought to differentiate his general theory of capitalism from what he saw as the special case embedded in classical theory.
The assumption set of classical theory, he said, is "applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium" (CW 7, p. 3). In the last chapter of the book, Keynes made a fundamental attack on classical methodology.Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the problems of the actual world.
(CW 7, p. 378)
I believe that it is of the utmost importance that the economics profession reject positivism and adopt Keynes's belief that you must build economic theory on a realistic and reasonably complete assumption set.
Consider one rather extreme example of this problem. During the period from the early 1980s to the global financial crisis starting in 2008, mainstream financial economists relied on the "efficient financial market" hypothesis to construct theories of modern financial markets.2 Efficient financial market theory was built on a stunningly unrealistic assumption set that posited, among other things, that investors had "rational" or correct expectations of the stationary probability distributions that determine future states of the economy. They therefore knew the probability distributions of the cash flows associated with all securities. Investors could thus never be fooled into taking more risk than they wanted to take: they could organize their investment portfolios according to their true risk-return characteristics.3 This theory, in which nothing can go wrong in financial markets, infected the dominant theories of the macroeconomy. The fact that the economics profession gave the theory its imprimatur made it easier for government legislators to support the process of radical financial market deregulation that took place in the era and also reinforced the widespread belief among investors that the emerging financial boom of the era might never end, which helped sustain the boom and worsen the bust.
Almost all mainstream economists celebrated the wonders of global financial markets just as they were about to collapse after 2007. Some economists who adopted Keynes's approach to the theory of financial markets made popular by Hyman Minsky understood that a financial crisis had become quite likely in the mid-2000s.4 The realism of assumptions matters.There is a methodological corollary to the insistence that the realism of the assumption set affects the truth content of derived hypotheses that I stressed in Chapter 12. In the historical record, there is no such thing as a generic capitalism - there are only historically, institutionally, and behav- iorally unique social formations within which private property and market processes play different roles. Keynes attacked classical theory because its assumption set did not incorporate the actual "facts" of then-current British capitalism, but rather was selected in order to demonstrate that laissez-faire capitalism created the best of all possible worlds. This led to the conclusion that the full-employment equilibrium was the only possible equilibrium position of the economy and that disequilibrium dynamics would always adjust wages, prices, and interest rates in a manner that ensured that this equilibrium position was stable. Incorporation of the institutional and behavioral "facts" specific to time and place that determine the actual behavior of wages and the price of goods and financial assets led Keynes to the conclusion that while nineteenth-century British capitalism may have been "glorious," interwar British capitalism was destructive and could not be reformed. It needed to be replaced by Liberal
Socialism. The message Keynes bequeaths to us here is that economists should build theories that incorporate the distinct character or the institutional and behavioral "facts" of the economies they study and not rely solely on abstract-level models of generic capitalism.