More on Keynes vs the Neoclassical Synthesis

Yesterday (here) I linked to a post by Matias Vernengo on Keynes’ theoretical contribution in light of the capital debates. I thought it might be worthwhile to elaborate on a central aspect of Vernengo’s post, particularly as it concerns the fundamental differences between Keynes’ ideas and the interpretation of neoclassical synthesizers of his work. Vernengo’s perspective on the significance of Keynes’ theoretical insights and the deep flaws in the marginalist interpretation is one that is probably held by most heterodox economists working in Sraffian and Post Keynesian traditions. I would think MMT economists also tend to share this perspective.

Briefly, the perspective is as follows. Keynes argued that unemployment is caused by a deficiency of aggregate demand. The neoclassical followers of Keynes – including the Neoclassical Synthesis, Old Keynesians, New Keynesians, etc. (but not Keynes’ immediate circle at Cambridge, Post Keynesians or the Sraffians) – tried to maintain the neoclassical notion that unemployment is caused by “market imperfections” that prevent real wages and the real rate of interest from adjusting to their “natural” levels.

The neoclassical position was simply a reversion to pre-Keynesian, marginalist modes of thought, in which it was considered legitimate to conceive of an aggregate labor market determining the real wage and an aggregate capital market determining the real rate of interest. It was already well recognized within neoclassical economics that imperfections could cause wage and price stickiness. If Keynes had been trying to say only that wages and prices could be sticky, he would not have been saying anything different to the prevailing orthodoxy.

But Keynes clearly rejected the orthodox position on employment and interest. In chapter 19 of the General Theory, he argued that even if wages and prices were flexible, this would not eradicate unemployment. To the contrary, if anything it would be likely to make matters worse during economic downturns, because of the impact on demand of a redistribution of real income from workers to capitalists and rentiers. Keynes argued that, in general, nothing very decisive could be said about the impact of falling wages on aggregate demand and employment.

Keynes also rejected the notion of an aggregate labor market because the demand for labor is a derived demand. It is derived from the demand for the final products that labor is being employed to produce. Similarly, demand for capital goods is a derived demand.

An implication of Keynes’ reasoning is that alterations in wages and interest rates can impact on the demand for the neoclassical “factors” of production – labor and capital – in unpredictable and “strange” ways, because in impacting on the purchasing power of various income groups and product prices, these alterations in factor prices produce a complex of substitution and income effects that can operate in different directions. It suggests that there is no level of employment that the economy automatically gravitates toward (no natural rate of unemployment) and no tendency for the real rate of interest to move to a level that induces just the right amount of private investment to sustain full employment (Keynes explicitly rejected Wicksell’s notion of a natural rate of interest).

Vernengo, in the linked post, then discusses how the two opposing views – Keynes’ position that unemployment is the result of demand deficiency and the neoclassical position that unemployment is due to wage and price rigidities – fare in light of the capital debates.

The debates showed, among other things, that the marginalist claim of an automatic tendency to the full utilization of the factors of production had no sound basis. If there was unemployment, neoclassical reasoning suggested that a fall in the real wage would cause a substitution of labor for capital goods and a rise in employment. But this reasoning was shown to be incorrect. A wage reduction will cheapen not only labor but also capital goods that are produced through the employment of labor, complicating the substitution effects. Even if the substitution effects operate in the assumed direction, income effects associated with workers receiving lower real wages, capitalists receiving lower prices (though higher relative to wages) and rentiers receiving a higher real interest rate due to falling product prices (which redistributes income from capitalists to rentiers), could have an overall impact on demand that was negative, depending on propensities to spend of the various groups, and so could cause less of both labor and capital goods to be employed.

In general, the impact on employment of a fall in real wages is ambiguous and will depend on circumstances. At the moment, with demand depressed globally and domestic private sector demand also weak, falling wages would seem, if anything, more likely to exacerbate the employment situation than improve it.

The same difficulties afflict the neoclassical notion that investment responds inversely to the real rate of interest. It cannot be supposed, in general, that a lower rate of interest will be associated with a greater employment of the factor capital, because the change in interest impacts on the price of capital goods and product prices, therefore impacting on real wages, the distribution of income between workers, capitalists and rentiers, and therefore aggregate demand and the employment of labor and capital goods. This means that strange things can occur – referred to as “reswitching” and “capital reversing” – as Samuelson conceded in “A Summing Up” of the debates in the Quarterly Journal of Economics (see Nobel-nomics):

The phenomenon of switching back at a very low interest rate to a set of techniques that had seemed viable only at a very high interest rate involves more than esoteric difficulties. It shows that the simple tale told by Jevons, Böhm-Bawerk, Wicksell and other neoclassical writers — alleging that, as the interest rate falls in consequence of abstention from present consumption in favour of future, technology must become in some sense more ‘roundabout,’ more ‘mechanized’ and ‘more productive’ — cannot be universally valid.

The ramifications of the capital debates for pre-Keynesian neoclassical theory are therefore severe. The notion of a well-behaved demand for capital function and, with it, the supposed real determination of the rate of interest, is invalid. The supposed determination of real wages through the interaction of supply and demand in an aggregate labor market is similarly deprived of legitimacy. The neoclassical marginal productivity theory of distribution is also a casualty. As Vernengo concludes, there is no automatic tendency to full employment, and the natural rates of unemployment and interest do not exist.

In contrast, Keynes’ position that unemployment is due to a deficiency of aggregate demand and interest is a monetary phenomenon is left unscathed.

In my previous post, I mentioned in closing that it is partly this understanding that informs Sraffian and Post Keynesian (and MMT) approaches to the determination of employment and interest. Specifically, output and employment are considered demand determined and the rate of interest to have a monetary determination.

For example, in MMT, it is contended that unemployment will occur when the non-government, in aggregate, attempts to spend less than it earns but is unable to do so to the extent desired due to insufficient government deficit expenditure. The pre-Keynesian neoclassical response to that contention would have been that falling real wages would result in higher demand for labor and at the same time the real rate of interest would adjust in such a way as to induce the non-government to alter its aggregate investment and saving behavior so that it was rendered consistent with full employment, irrespective of the government’s fiscal position. Keynes’ argument suggested that wage and interest-rate adjustments could not be relied upon to render aggregate investment and saving behavior consistent with full employment. The capital debates vindicated his position.

Despite this, neoclassical Keynesians of various stripes, including Krugman today, have continued with pre-Keynesian reasoning. Although Krugman correctly rejects excessive wages as an explanation of unemployment, he persists with the invalid notion of a natural rate of interest that would supposedly adjust investment to the level sufficient to sustain full employment if only there weren’t the imperfection of the liquidity trap (which involves a supposed failure of the real rate of interest to adjust to its “natural” rate). Not only is Krugman applying flawed neoclassical reasoning in this argument – the capital debates demonstrated beyond dispute that a freely adjusting real rate of interest cannot play the role he claims the liquidity trap is preventing – but he claims to be following Keynes in doing so.

By pushing his faulty liquidity trap explanation for the current economic situation, Krugman is doing as much as anyone to keep Keynes’ actual insights marginalized. By claiming to have a satisfactory explanation for the crisis – one he did not possess prior to the crisis, but rather concocted after the event through a misreading of Keynes via Hicks – he is able to present mainstream economics as essentially sound as long as the “Dark Age” extremists (Chicago School, New Classicals, Real Business Cycle theorists, etc.) are ignored.

But as Vernengo discusses in his post, neoclassical Keynesians such as Krugman share the same tradition and basic model as the Chicago School, New Classicals and Real Business Cycle Theorists. They all believe in the invalid notion of an automatic tendency to the full utilization of productive factors. The only difference is the latter group seeks to eradicate the market imperfections rather than resort to the desperate measure – supposedly only permissible in a liquidity trap! – of fiscal policy.

Addendum March 3, 2012

In a recent post, Vernengo has provided another in-depth explanation of the capital debates and its implications. It is an excellent and accessible introduction to the topic:

The capital debates: A brief introduction

3 thoughts on “More on Keynes vs the Neoclassical Synthesis

  1. Krugman is doing as much as anyone to keep Keynes’ actual insights marginalized.

    Couldn’t agree more and it’s a real important point to keep making considering his perceived liberal credentials.

    Jim

  2. But IS-LM was recanted by Hicks in 1981 due to several fundamental mistakes in it.

    It can only tell you what rate of interest and GDP represents equilibrium in an economy. It can’t model dynamics.

  3. Another very interesting post, congrats. It complements very well another post (Sectoral Balances and Keynesian Causation)

    Peter, let me be clear: I accept your arguments about the effect (or rather lack of systematic effect) of interest rates on investment and aggregate demand: the logic is quite similar to the one used with wages and labour demand.

    However, there is something that bugs me: among others, Dean Baker (whom I greatly respect as observer of how and why policies are adopted) gives great importance to monetary policy as a determinant of employment, via aggregate demand.

    I am not claiming that Baker is always right on theoretical issues, but his opinion on practical matters does carry a lot of weight in my view.

    In his The Conservative Nanny State he dedicates a whole chapter (Chapter II: The Workers are Getting Uppity) to describe how interest rates are used as a means to influence labour demand:

    “Through these various channels, higher interest rates reduce demand in the economy, slowing growth and job creation. This is the incredible power of the Fed. When it wants to slam the brakes on the economy, it raises interest rates.
    Higher interest rates effectively prevent the economy from growing, and keep workers from getting jobs.”

    And it sounds quite convincing.

    Are Baker’s ideas compatible with what you exposed here?

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