Keynes's attack on classical theory
In the chapters that follow, I will show that The General Theory focused on three fundamental errors in classical theory that Keynes had been attacking since WWI: (1) its conclusion that a capitalist economy has a unique equilibrium point at full employment; (2) its conclusion that high unemployment created by exogenous shocks would be quickly eliminated by stabilizing market disequilibrium processes; and (3) its conclusion that there are no endogenous sources of destabilizing disequilibrium dynamics in capitalism.
As Schumpeter put it, classical theory was not an evolutionary theory.His attack on the first conclusion is well known. Everyone who studied economics in college is familiar with the "Keynesian Cross" and perhaps the IS/LM model that demonstrate the potential multiplicity of underemployment equilibriums.
His attack on the second classical conclusion is not at all well known. In mainstream interpretations of The General Theory, it is explicitly or implicitly assumed that all equilibriums are stable, an assumption sometimes bolstered by phase diagrams unsupported by historical or empirical studies. This assumption, shared with classical theory, is a necessary condition for the ubiquitous use of comparative statics in "Keynesian" models - including, at times, by Keynes himself in several places in The General Theory, a point to which we will return. But the fact is that the book devoted substantial space to the analysis of precisely those destabilizing out-of-equilibrium dynamic processes of wage and price deflation and rising real interest rates that had been the focus of his attacks on conservative laissez-faire policy for over a decade. These destabilizing dynamic processes are ruled out by assumption in standard comparative static analysis. Yet seven chapters totaling almost 140 pages of The General Theory - over a third of the book - plus many scattered comments in other chapters are devoted to his war against the thesis that high unemployment would selfcorrect if only the government left the economy alone and unions did not interfere with downward money wage flexibility.
In February 1930, in testimony before the Macmillan Committee, Keynes addressed the issue of disequilibrium processes, an issue to which, he said, "I attach enormous importance."
Economists spend most of their time describing and discussing what happens in a position of equilibrium, and they usually affirm that a position of disequilibrium is merely transitory. I want to study what happens during the process of disequilibrium.
(CW 20, pp. 72-73)
Keynes's attack on the third classical conclusion that there are no endogenoussources of thedisruption of equilibriumisrarely acknowledged in mainstream macro theory, though it is often stressed in Post Keynesian theory. The General Theory puts heavy emphasis on endogenous disruption of equilibrium positions that create instability that is at times seriously dysfunctional, occasionally leading the economy into unsustainable economic booms and financial bubbles followed by self-reinforcing processes of economic collapse. Endogenously generated instability in financial markets is especially likely to be destructive. Destabilizing endogenous disequilibrium processes are an integral part of The General Theory, yet they are missing in both classical and Modern Keynesian theory. Chapter 19 of this book discusses the incompatibility of Keynes's theory and Modern Keynesian theory in this regard.