The Keynes Era
The arrival of Sraffa in Cambridge in 1927 marked the onset of upheaval with new and subversive ideas. He had criticized Marshall in the famous 1925 and 1926 articles which had driven Keynes to invite him to Cambridge, showing that Marshall’s supply curve of an industry in perfect competition was built on assumptions both unrealistic and inconsistent with the partial equilibrium approach.
Inconsistent because decreasing costs must be explained by “external” economies, since in perfect competition “internal” economies would turn the most efficient firm into a monopoly. Yet external economies also usually affect the other sectors, so the clause ceteris paribus does not hold. Similarly, Sraffa argued, it is hard to conceive of the price of a factor that increases in one sector only and generates increasing costs exclusively in that sector.Keynes thought Sraffa’s criticism disruptive and indeed it deeply impacted on the Marshallian hegemony, marking a new phase. The old guard of Marshall’s disciples (Robertson and Shove) tried to defend Marshall’s theory of value and his supply curve. In their defence an important role was played by marketing expenses and by the idea that the firm is subject to a life cycle and natural decline (Robertson 1930; Shove 1930). Their arguments, however, failed to convince the younger generation, who enthusiastically pursued the way out of Marshall’s inconsistencies suggested by Sraffa’s 1926 article: the idea was to drop the assumption of perfect competition and to focus on markets where each firm faces its own negative sloping demand curve.
The original idea of developing a theory of imperfect competition has always been credited to Sraffa. However, it is still doubtful how convinced he himself was of its fruitfulness, apart from its role in exposing Marshall’s weaknesses. Sraffa did not follow this line of research for long, and during the preparation of his course on advanced theory of value, which he taught in Cambridge from 1928 to 1931, he took a completely different
route.
This was based on two elements. The first was a reappraisal of the theory of value of classical political economy as antagonist to the Marshallian “fundamental symmetry” of supply and demand and based on a definition of cost as “physical” cost, which does not include any subjective factors, such as “sacrifice” and “waiting”. The second element was investigation into the exchange ratios between commodities that enable the exchanges between productive sectors which warrant reproduction of the economic system. However, very little of what Sraffa was working on was known to his Cambridge colleagues, and the prolonged work on the book, which was to appear 33 years later, has only recently been reconstructed on the basis of his unpublished papers.In the period under consideration two major works, The Treatise on Probability (1921) and The General Theory of Employment, Interest and Money (1936), signpost Keynes’s contribution to Cambridge economics. During the same period Keynes produced another landmark work, the Treatise on Money (1930), besides A Tract of Monetary Reform (1923). Philosophically and methodologically he remained faithful to the approach to human behaviour resting on the two pillars of conventions and expectations, supported by a notion of probability, to be evaluated with evidence and judgement, as guide to action. Understanding how opinions are formed is instrumental to transforming them through the joint effects of persuasion and artfully designed institutions, with the ultimate aim of attaining the common good.
The premise of Keynesian economics, as we find it in the General Theory, is that the economic system is not ruled by “natural forces” that economists can discover and order in a neat pattern of causes and effects, but that their task, rather, is to control and manage the key variables for attainment of a social goal. Against the “classical” conclusion that market forces are at work to bring the economic system to the full employment of resources, Keynes counter-posed the argument that aggregate economic behaviour does not have the same outcome as the pursuit of individual self-interest, so that what is good for the individual may not be good for the whole.
It was not against the market, but rather against unfettered laissez-faire that his economics stood, for, as he wrote in the last chapter of the General Theory, it is “wise and prudent statesmanship to allow the game to be played, subject to rules and limitations” (CWK VII: 374, emphasis added).Keynes’s first tenet against traditional thinking is based on reverting the causality relation between budget deficit, income and expenditure; the means to reduce unemployment is through an increase in effective demand (having public expenditure to supplement private investment when necessary) rather than adjusting supply to the existing level of demand. The “digging holes in the ground” argument - it does not matter how public money is spent, as long as it is spent - is meant to illustrate the principle that expenditure will generate income and through the multiplier the savings necessary to finance it.
Keynes’s other fundamental contribution to macroeconomics, besides effective demand, is the notion of liquidity preference. He argued against the “classical tradition” whereby thrift and capital productivity are the “real forces” at work in determining the rate of interest, considering it a highly conventional phenomenon, determined by the strength of the desire of individuals to hold money (as protection against an uncertain future) and the quantity of money provided by the banking system.
At the international level he struggled to make the logic of cooperation and coordination prevail over the working of blind market forces, which would not be able to correct imbalances and asymmetries between creditor and debtor countries. He fought for the creation of international institutions to oversee the system of payments and the allocation of international capital.
These pillars are the foundations of the Keynesian full employment policies and reforms of the international monetary order, which informed the so-called Keynesian consensus in the post-war years.
In all his activities, Keynes could rely on his “favourite pupil” Richard Kahn, who stood for the preservation of Keynes’s heritage. At the beginning of his career, following a path opened up by Marshall, Kahn stressed the importance of the short period because of the nature of the particular decisions involved, characterized by the time horizon to which they apply. The “Economics of the short period” was the title of the dissertation which in 1930 earned him a Fellowship at King’s College and was much later (it remained unpublished for nearly 50 years) to be recognized as a landmark in the “imperfect competition revolution”. However, Kahn’s association with Cambridge economics in the period under consideration is certainly to be identified with the Keynesian revolution, to which he contributed more significantly than anyone else in the circle around Keynes. First, there is the forging of a formidable analytical tool - the multiplier - which allowed Keynes to reverse the causality relationship between saving and investment: it is investment which generates savings. Secondly, again expanding on Marshall’s apparatus, Kahn introduced the aggregate supply function as a means, together with the aggregate demand function, to determine the price level. Many years later he prided himself on “finally disposing of the idea that the price level is determined by the quantity of money” (Patinkin and Leith 1977: 147). Unlike Keynes, adept in the use of rhetoric as a technique for persuasion, Kahn invariably favoured the use of deductive reasoning. His “great repugnance to the thought that there might be an error attached to his name”, according to Joan Robinson (JVR papers i/8/7, King’s College, Cambridge) did not make him a prolific writer, but his extraordinary influence is to be seen in the two most important books of the Cambridge economics of the 1930s, the Economics of Imperfect Competition (Robinson 1969) and the General Theory (Keynes 1936).
Joan Robinson, “after Keynes....
the most prominent name associated with the Cambridge School of Economics” according to Kaldor’s obituary written for the King’s College 1984 Annual Report (p. 34), was a latecomer and potentially an outcast in the all-male club of Cambridge economists. Early on she gained Kahn’s enthusiastic support and Keynes’s consideration, which sustained her in the production of many articles and books in the 1930s and 1940s. Her contributions span from imperfect competition to extension of the General Theory to an open economy and the long period, and they include the attempt to legitimate some Marxian concepts within the accepted box of tools drawn upon by the economist. Her encounter with Kalecki (who was in Cambridge during 1937-39) and constant engagement with Sraffa made her more willing than Kahn to enlarge her approach beyond the boundaries of Keynesian economics. “For me” - she wrote much later - “the main message of Marx was the need to think in terms of history, not of equilibrium” (Robinson 1973: x). Pursuit in this direction became her main endeavour in the last part of her life, when she strongly argued that Kalecki, who “brought imperfect competition into touch with the theory of employment” (Robinson 1969: viii), had a system of analysis in some respects superior to Keynes’s (Robinson 1979: 186).The very idea of a Keynesian “revolution” was resisted and, to some extent, opposed by the old Marshallian guard. Robertson, on the basis of his own approach to the problems of economic fluctuations and cycles in terms of a succession of periods, objected to Keynes’s short-period approach whereby the current level of saving is a function of current income, without any reference to the past level of savings. Moreover, he challenged Keynes’s theory of liquidity preference, adhering to the theory that the rate of interest is the price that brings the demand and supply of loanable funds into equilibrium. In the case of Pigou, the main point of disagreement was whether a cut in money wages would cure unemployment. In October 1937 Pigou presented his argument, based on the quantity theory of money, that “if a cut in wages leaves employment unchanged, money income has no ground for change” (CWK XIV: 256-7); Keynes’s position was, instead, “that, if there is a cut in wages, unemployment being unchanged, there is a ground for a change in money income” (CWK XIV: 257). At the time there was no room for conciliation, and notwithstanding Pigou’s later admission that he did not grant Keynes due recognition (Pigou 1950), the ground was paved for presenting the main result of the General Theory - equilibrium with unemployment - as dependent on wage rigidity only, as Marshall and subsequent neoclassical economics would have it.