Vernengo on Keynes vs Neoclassical Synthesis

In previous posts, I have made frequent reference to the Cambridge Capital Controversy and its significance for macroeconomic debates. Robert Vienneau, who often writes on issues relating to this controversy, draws attention (here) to a recent post by Matias Vernengo which very clearly distinguishes Keynes’ contribution from the marginalism of the neoclassical synthesis and New Keynesian economics.

Vernengo emphasizes that in neoclassical approaches, including neoclassical Keynesianism, the cause of unemployment is either excessive real wages or real interest rate rigidity. For instance, at the moment, neoclassical Keynesians are appealing to a liquidity trap, which involves a supposed failure of the real rate of interest to adjust to its ‘natural’ level.

Vernengo points out that this is in sharp contrast to Keynes’ own contention (especially in chapter 19 of the General Theory) that real wage flexibility could not be relied upon to eradicate unemployment. It also contradicts Keynes’ view on interest. He did not consider a liquidity trap to be the cause of unemployment and rejected Wicksell’s notion of a natural rate of interest.

Having made this important distinction, Vernengo argues:

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes’ analysis, can ONLY be properly understood in light of the 1960s capital debates.

These debates showed, among other things, that the marginalist claim of an automatic tendency to the full utilization of the so-called factors of production, labor and capital, was without sound foundation. This automatic tendency was thought to occur on the basis of factor substitution. If there was unemployment, a fall in the real wage was meant to cause a substitution of labor for capital goods.

The capital debates, as Vernengo explains, demonstrated that this rise in employment in response to a falling wage is not certain. First, since labor is employed in the production of capital goods, both labor and capital goods are likely to cheapen as a result of the real wage reduction, giving no guarantee that the substitution effects will operate in the right direction. Second, even if in a given case the substitution effects do operate in the right direction, they may be more than offset by the income effects associated with workers receiving lower real wages, with the negative impact on demand possibly causing less of both labor and capital goods to be employed.

The point is not that employment must necessarily fall in response to a reduction in the real wage (although that scenario seems more likely than the reverse under present circumstances), but rather that there is no systematic effect. It could go either way.

The ramifications of the capital debates for marginalist theory are substantial. The notion of a well-behaved ‘demand for capital’ function and, with it, the supposed real determination of the rate of interest, is invalidated. This was acknowledged by Samuelson in his “Summing Up” of the debate. The supposed determination of real wages through the interaction of supply and demand in an aggregate labor market is similarly deprived of legitimacy. As Vernengo concludes, it means:

… there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

Whereas the marginalist approach is severely undermined by the capital debates, Keynes’ position – that unemployment is due to demand deficiency, not wage or price rigidities, and that the rate of interest has a monetary, not real, determination – is left unscathed.

It is partly this understanding that informs Post Keynesian and MMT approaches to the determination of employment and interest.