Money, Business Cycles and Macroeconomics
In monetary theory proper, concerned with the determination of “the value of money”, Pigou’s (1917) contribution consisted in a refinement of Marshall’s approach towards a stock demand for money.
His well-known formula of the cash-balance approach, P = kR/M, marks an important step towards, but does not fully anticipate, the modern idea of money demand as the solution to a portfolio allocation problem as in Keynes’s liquidity preference theory. In particular, it lacks the explicit recognition of wealth as a balance-sheet constraint and it confuses the demand schedule with that of equilibrium loci (when M signifies an exogenous money supply).In his explanation of the business cycle Pigou (1927a) combined “psychological” and monetary factors with expectations, the optimism and pessimism of the business community, playing the active role and money merely an accommodating, passive role. Thus the initiating cause of the cycle were fluctuations in investment demand, and not the banking system’s arbitrary injections of money into the economy, that is, in modern terms, he considered the cycle to be due to real and not monetary shocks. The Theory of Unemployment (1933), a treatise on labour economics, in which Pigou focused on the macroeconomics of the labour market and wage formation, owed him the label of a “classical economist”. It is, indeed, “classical” inasmuch as it explains unemployment by the interaction of a fluctuating demand for labour (which in his theory of the business cycle Pigou had derived from the changing expectations driving investment demand) and a fixed real or money wage, which combined with a given value of full employment produces an inversely L-shaped supply curve of labour. Accordingly it confirmed the accepted classical view on the causes of unemployment in attributing it to wage rigidity. Furthermore, taking his earlier monetary analysis of the cycle for granted, Pigou overemphasized the capacity of a purely real analysis to capture the significant aspects of unemployment, for example, by confining the concern with money wage rigidity to a small part of the whole book.
Yet Pigou’s approach was not “classical” in the specific sense in which Keynes (1936) used the term in the General Theory, especially in his chapter 19 attack on Pigou, because nowhere did Pigou deny the possibility of involuntary unemployment. Moreover, with regard to business-cycle policy, Pigou was ready to refine and supplement his theoretical structure so as to accommodate for expansionist policy proposals, “proto-Keynesian” in nature, in extraordinary circumstances like the Great Depression of the 1930s, when he aligned with Keynes and other advocates of expansionist policy against the orthodox prescriptions put forward by London School of Economics (LSE) economists.Within the field of macroeconomics most of Pigou’s fame or notoriety derives from his controversy with Keynes. After having been singled out in the General Theory as the archetype of a “classical economist” and Pigou’s striking back in a highly critical review, the conflict culminated in the debate between Pigou, Keynes and Kaldor in the Economic Journal (1937). Here Pigou’s aim was to demonstrate the effectiveness of wage cuts in expanding employment in general, and specifically to show that “a money wage cut is not simply a piece of ritual that enables the real cause of employment expansion - a fall in the rate of money interest - to take effect” (Pigou 1937: 411). In defending the framework of the General Theory, Kaldor (1937) responded by proving, by means of a small “Keynesian” macro model, that indeed the reaction of the rate of interest, later termed the “Keynes effect”, is crucial; and in fact Pigou (1938) conceded this point. Nevertheless Pigou (1943) soon reconfirmed his belief in the principal stability of the economic system by pointing out that a decline in wages and prices will in the end generate an increase in the real value of cash balances, which may directly affect consumption expenditures, later termed the “Pigou effect”. Typically the verdict on the Pigou effect has been to accept its logical validity but to deny it empirical relevance.
Thus, although in the contemporary debate Pigou obviously lost his case against Keynes, there is some irony in this judgement. First, Kaldor’s refutation relied on just that type of model (IS-LM combined with a supply side modelled on the principle of profit maximization and marginal productivity) that later on came to be denounced as “Bastard Keynesianism”. Second, Pigou’s ideas appear as surprisingly resilient: the combination of short-run sticky wages giving rise to unemployment and long-run wage flexibility bringing the economy back to full employment is as much Pigovian as it is familiar from present-day introductory macroeconomics textbooks. Possibly Pigou himself would readily recognize in this framework analytically polished, yet familiar, elements from his own thought.In conclusion, both failure and accomplishment can be found in Pigou’s work. He failed in his attempts to preserve the skeleton of Marshallian analysis, even at the price of thinning out its vent for descriptive realism, in particular when facing the onslaught of the Keynesian revolution in macroeconomics and the neo-Walrasian approach propagated by Hicks’s introduction of a general equilibrium framework. Yet Pigou, the classical economist, has resurfaced, veiled in modern clothes, in the new types of theorizing about the macro economy that have turned away from the Keynesian diagnosis and instead emphasize all kinds of frictions as the sources of (transitory) deviations from equilibrium. In this respect, part of present-day economics comes rather close to Pigou’s, although it apparently does not share his presumption of the prevalence of market failures and his view of welfare economics as the basis for interventionist economic policy.
Hansjorg Klausinger
See also:
Cambridge School of economics (II); Macroeconomics (III); Alfred Marshall (I); Piero Sraffa (I); Theory of the firm (III); Welfare economics (III).