Snowdon & Vane Modern Macroeconomics

the ‘new’ Keynesian research programme, which emerged as a response to the critiques of the neoclassical synthesis by the new classical school, contains no ‘Keynesian beef’ (Davidson, 1994). In the light of these developments, from a Post Keynesian perspective, the ‘Keynesian revolution’, in the sense of representing a successful and radical break with classical thinking, never took off.

According to Holt (1997), most economists who call themselves Post Keynesians have traditionally been divided into two broad groups, namely the ‘European’ and the ‘American’ camps. The ‘European’, or Cambridge UK, group includes the body of work associated with economists such as Geoff Harcourt, Richard Kahn, Nicholas Kaldor, Michal Kalecki, Joan Robinson and Piero Sraffa. Throughout the 1950s and 1960s some of Keynes’s former Cambridge colleagues, in particular Joan Robinson, consistently and repeatedly highlighted what they interpreted as the misinterpretation of Keynes’s main insights by leading mainstream (‘bastard’) Keynesian thinkers (Robinson, 1972). The second broad camp identified by Holt includes the work of economists such as Victoria Chick, Alfred Eichner, Jan Kregel, Hyman Minsky, Basil Moore, George Shackle, Sidney Weintraub and Paul Davidson. Although Holt labels this latter group as ‘American’, it is the style and emphasis of analysis, rather than nationality, that matters in deciding who is in which broad group. For example, George Shackle is English and Victoria Chick, though born in America, has spent most of her professional career in England.

As a broad generalization Holt’s ‘European’ group, like all classical economists, has emphasized the behaviour and functioning of the real economy while ignoring, or at least downplaying, monetary and financial implications. Some but not all in Holt’s American grouping have typically concentrated their attention on the impact of uncertainty, and monetary and financial influences, on the economy (see Hamouda and Harcourt, 1988; Chick, 1995; Davidson, 1991, 1996, 2002; Arestis and Sawyer, 1998).

Although Eichner and Kregel (1975) have argued that Post Keynesian economics represented a coherent alternative school of thought to mainstream macroeconomic analysis, controversy still surrounds this claim (Coddington, 1976, and Patinkin, 1990b, have provided excellent surveys of the various interpretations of Keynes’s General Theory; see also Arestis, 1996; Walters and Young, 1997; and Snowdon and Vane, 1997a). In fact, there is some basis for this lack of a coherent view because many who claim to be Post Keynesians among Holt’s European group and at least one in the American group utilize variants of a classical model rather than Keynes’s financial and monetary analytical approach. Accordingly, in the remainder of this chapter, rather than survey the complete body of work created by this heterogeneous group of economists all wanting to display the label of Post Keynesians, I argue that only those analytical models that adopt Keynes’s

principle of effective demand and recognize the importance liquidity preference plays in the General Theory (Keynes, 1936) are entitled to use the appellation of Post Keynesians. The main thrust of this argument implies that the true theoretical legacy of Keynes cannot be found within any branch of mainstream Keynesianism, old or new.

8.2The Significance of the Principle of Effective Demand

Post Keynesian economics accepts Keynes’s (1936, chap. 2) ‘Principle of Effective Demand’ as the basis for all macroeconomic theory that is applicable to an entrepreneurial economy. Keynes was primarily a monetary theorist. The words money, currency and monetary appear in the titles of most of his major volumes in economics. Post Keynesian theory evolves from Keynes’s revolutionary approach to analysing a money-using, entrepreneur economy.

Addressing the General Theory chiefly to his ‘fellow economists’ (Keynes, 1936, p. v), Keynes insisted that:

the postulates of the classical theory are applicable to a special case only and not to the general case … Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience. (Keynes, 1936, p. 3)

Elsewhere I (Davidson, 1984) have argued that all variants of mainstream macroeconomic theory, whether it be rational expectations (new classical) theory, monetarism (old classical theory), old (neoclassical synthesis) Keynesian or new Keynesian theory, are founded on three fundamental classical postulates and, as Keynes specifically noted:

the classical theory is only applicable to full employment, [and therefore] it is fallacious to apply it to the problems of involuntary unemployment. … The classical theorists resemble Euclidean geometers in a non-Euclidean world, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions that are occurring. Yet in truth there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required today in economics. (Keynes, 1936, p. 16)

Keynes’s principle of effective demand basically overturned three restrictive classical postulates. Once freed of these postulates, Keynes (1936, p. 26) could logically demonstrate why Say’s Law is not a ‘true law’ when we model an economy which possesses real-world characteristics; and until we get our theory to accurately mirror and apply to the ‘facts of experience’, there is little hope of getting our policies right. That message is just as relevant today.

To throw over an axiom is to reject what the faithful believe are ‘universal truths’. Keynes’s revolution in economic theory was therefore truly a revolt since it aimed at rejecting basic mainstream axioms in order to develop a logical foundation for a non-Say’s Law model more closely related to the real world in which we happen to live. In the light of Keynes’s analogy to geometry, Post Keynesian theory might be called non-Euclidean economics!

The restrictive classical axioms rejected by Keynes in his revolutionary logical analysis were (i) the gross substitution axiom, (ii) the neutrality of money axiom and (iii) the axiom of an ergodic economic world. The characteristics of the real world which Keynes believed could be modelled only by overthrowing these axioms are:

1.money matters in the long and short run; that is money and liquidity preference are not neutral, they affect real decision making;

2.the economic system is moving through calendar time from an irrevocable past to an uncertain future. Important decisions involving production, investment and consumption activities are, therefore, often taken in an uncertain environment;

3.forward contracts in money terms are a human institution developed to efficiently organize time-consuming production and exchange processes. The money-wage contract is the most ubiquitous of these contracts. Modern production economies are on a money-wage contract based system, or what Keynes called an ‘entrepreneur system’; and

4.unemployment, rather than full employment, is a common laissez-faire situation in a market-oriented, monetary production economy.

8.3Taxonomy

A precise taxonomy is a necessary precondition for all scientific enquiry. All too often, common words used in economics have a multitude of connotations. Consequently, many of the arguments among economists often involve semantic obfuscation where participants are using the same words to connote different meanings or, even worse, the same participant uses the same word to suggest different concepts at various points of their argument. Nowhere is this more obvious than in the use of the word ‘money’ in economic discussions. To avoid such semantic confusion, it is necessary to provide a dictionary of oft-used, and misused, words up front to explain exactly what the concept denotes. For example, how many economists have carefully read and comprehended Keynes’s definitional Chapter 6 and its Appendix in his General Theory? Similarly, how many have worked through Chapters 1 and 2 of Friedman’s (1957) Theory of the Consumption Function and realized that Friedman defines saving (p. 11) to include the purchase of new durable goods

including clothing and so on while, for Keynes, saving involves the decision not to purchase durables or non-durables by households? Harrod (1951, pp. 463–4), with typical lucidity, highlighted the essential nature of Keynes’s revolution when he wrote:

Classification in economics, as in biology, is crucial to the scientific structure … The real defect in the classical system was that it deflected attention from what most needed attention. It was Keynes’ extraordinarily powerful intuitive sense of what was important that convinced him that the old classification was inadequate. It was his highly developed logical capacity that enabled him to construct a new classification of his own.

8.4Keynes’s Taxonomic Attack on Say’s Law

When Keynes became convinced that the vocabulary of orthodox economics was not sufficient to explain why an economy might become mired in unemployment, he developed an expanded classification and new definitions to demonstrate that Say’s Law ‘is not the true law relating the aggregate demand and supply functions … [and hence] there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile’ (Keynes, 1936, p. 26).

Keynes’s General Theory is developed via an aggregate supply–aggregate demand function analysis to achieve a point of effective demand (Keynes, 1936, pp. 25–6). The aggregate supply function (Z) relates entrepreneurs’ expected sales proceeds with the level of employment (N) entrepreneurs will hire for any volume of expected sales receipts. This aggregate supply (Z) function indicates that the higher entrepreneurs’ sales expectations, the more workers they will hire. The aggregate demand function relates buyers’ desired expenditure flows with any given level of employment (see Davidson, 1994).

Say’s Law specifies that all expenditure (aggregate demand) on the products of industry is equal to the total costs of aggregate production (aggregate supply) including gross profits. Letting D symbolize aggregate demand and Z aggregate supply, if:

‘for all values of N, i.e. for all values of output and employment’ (Keynes, 1936, pp. 25–6). In other words, in an economy subject to Say’s Law, all costs of production are always recouped by the sale of output. There is never a lack of effective demand. The aggregate demand and aggregate supply curves coincide. In a Say’s Law economy, there is no obstacle to full employment.

The aggregate demand and supply functions will be coincident only if money is neutral, everything is a good substitute for everything else (gross substitution) and the future can be reliably predicted in terms of probabilities (the ergodic axiom).

To challenge the applicability of Say’s Law to the real world in which we live, Keynes had to develop a model where the aggregate demand and aggregate supply functions, fd(N) and fz(N), were not coincident. Since Keynes accepted the normal firm short-run flow-supply function developed in Marshallian economics as the micro-basis for the aggregate supply function, he could therefore differentiate his approach only via the concept of aggregate demand. Keynes divided aggregate demand into two classes, that is,

D1 represents all expenditures which ‘depend on the level of aggregate income and, therefore, on the level of employment N’ (Keynes, 1936, p. 28). D2, therefore, represents all other expenditures which are not related to income. Even if D2 is related to aggregate income (that is, D2 = f2(N) so long as f1(N) + f2(N) fz(N) for all values of N, then Say’s Law is not applicable.

Explicit recognition of the possibility of two classes of demand expenditures must make Keynes’s analysis a more general theory than the orthodox theory since the latter recognizes only a single demand class. Classical theory is ‘a special case’ (Keynes, 1936, p. 8) where:

and

for all values of N.

By proclaiming a ‘fundamental psychological law’ associated with ‘the detailed facts of experience’ where the marginal propensity to consume was always less than unity (Keynes, 1936, p. 96), by decree, Keynes declared that f1(N) would never coincide with fz(N) in the real world, even if D2 = 0. Say’s Law could not be applicable to ‘the facts of experience’.

8.5Can Relative Price Changes Induce D2 to Fill the Gap?

Keynes’s primary level of attack on classical theory involved the expansion of demand into two distinct classes with different determinants. Keynes’s claim that the classical demand relationship, where all spending was related and equal to income, is required to validate Say’s Law and this classically assumed demand relationship was not compatible with ‘the facts of experience’.

The next step required Keynes to demonstrate that a change in relative prices via a gross substitution effect could not resurrect Say’s Law. In classical theory, all income earned in any accounting period is divided – on the basis of time preference – between spending income on currently produced consumption goods and services and spending on current investment goods that will be used to produce goods for future consumption. In other words, all income earned in this period is always spent on the current products of industry. In Keynes’s analysis, however, time preference determines how much of current income is spent on currently produced consumption goods and how much is not spent on consumption goods but is instead saved by purchasing liquid assets. Accordingly, in Keynes’s system, there is a second decision step, liquidity preference, where the income earner determines in what liquid assets should his/her saved income be stored in order to be used to transfer purchasing power of saving to a future time period. Since all liquid assets have certain essential properties (Keynes, 1936, chap. 17) – namely they are non-producible and non-substitutable for the products of industry, the demand for liquid assets does not per se create a demand for the products of industry.

Keynes developed his theory of liquidity preference in order to demonstrate that any explanation of involuntary unemployment required specifying ‘The Essential Properties of Interest and Money’ (Keynes, 1936, chap. 17), which differentiates his theory from old classical, new classical, old Keynesian and new Keynesian theory, that is, from all mainstream macroeconomic

theories not only in Keynes’s time but in mainstream economics of the twenty-first century.

These essential properties are:

1.the elasticity of productivity of all liquid assets including money was zero or negligible; and

2.the elasticity of substitution between liquid assets (including money) and reproducible goods was zero or negligible.

The zero elasticity of productivity of money means that when the demand for money (liquidity) increases, entrepreneurs cannot hire labour to produce more money to meet this change in demand for a non-reproducible (in the private sector) good. In other words, a zero elasticity of productivity means that money does not grow on trees! In classical theory, on the other hand, money is either a reproducible commodity or the existence of money does not affect, in any way, the demand for producible goods and services; that is, money is neutral (by assumption). In many neoclassical textbook models, peanuts are the money commodity or numeraire. Peanuts may not grow on trees, but they do grow on the roots of bushes. The supply of peanuts can easily be augmented by the hiring of additional workers by private sector entrepreneurs.

The zero elasticity of substitution ensures that the portion of income that is not spent on consumption producibles will find, in Frank Hahn’s terminology, ‘resting places’ in the demand for non-producibles. Some forty years after Keynes, Hahn rediscovered Keynes’s point that Say’s Law would be violated and involuntary unemployment could occur whenever there are ‘resting places for savings in other than reproducible assets’ (Hahn, 1977, p. 31). The existence of non-reproducible goods that would be demanded for stores of new ‘savings’ means that all income earned by engaging in the production of goods is not, in the short or long run, necessarily spent on products producible by labour.

If the gross substitution axiom were applicable, however, any new savings would increase the price of non-producibles (whose supply curve is, by definition, perfectly inelastic). This relative price rise in non-producibles would, under the gross substitution axiom, induce savers to substitute reproducible durables for non-producibles in their wealth holdings and therefore non-producibles could not be ultimate resting places for savings. As the price of non-reproducibles rose the demand for these non-producibles would spill over into a demand for producible goods (see Davidson, 1972, 1977, 1980). Thus the acceptance of the gross substitution axiom denies the logical possibility of involuntary unemployment as long as all prices are perfectly flexible. To overthrow the axiom of gross substitution in an intertemporal context is

leisure and effort. We know this as the axiom of the absence of money illusion, which it seems impossible to abandon in any sensible sense.

To reject the neutrality axiom does not require assuming that agents suffer from a money illusion. It only means that ‘money is not neutral’ (Keynes, 1973b, p. 411); money matters in both the short run and the long run, in affecting the equilibrium level of employment and real output. As Keynes (1973b, pp. 408–9) put it:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

Once we recognize that money is a real phenomenon, that money matters, then neutrality must be rejected. Keynes (1936, p. 142) believed that the ‘real rate of interest’ concept of Irving Fisher was a logical confusion. In a monetary economy, moving through calendar time towards an uncertain (statistically unpredictable) future, there is no such thing as a forward-looking real rate of interest. In an entrepreneur economy the only objective for a firm is to end the production process by liquidating its working capital in order to end up with more money than it started with (Keynes, 1979, p. 82). Moreover, money has an impact on the real sector in both the short and long run. Thus money is a real phenomenon. This is just the reverse of what classical theory and modern mainstream theory teach us. In orthodox macroeconomic theory the rate of interest is a real (technologically determined) factor while money (at least in the long run for both Friedman and Tobin) does not affect the real output flow. This reversal of the importance or the significance of money and interest rates for real and monetary phenomena between the orthodox and Keynes’s theory is the result of Keynes’s rejection of a neoclassical universal truth – the axiom of neutral money. Arrow and Hahn (1971, pp. 356–7) implicitly recognized that money matters when they wrote:

The terms in which contracts are made matter. In particular, if money is the good in terms of which contracts are made, then the prices of goods in terms of money are of special significance. This is not the case if we consider an economy without a past or future … if a serious monetary theory comes to be written, the fact that contracts are made in terms of money will be of considerable importance. (Italics added)

Moreover, Arrow and Hahn (1971, p. 361) demonstrate that, if contracts are made in terms of money (so that money affects real decisions) in an

economy moving along in calendar time with a past and a future, then all existence theorems demonstrating a classical full employment equilibrium result are jeopardized. The existence of money contracts – a characteristic of the world in which we live – implies that there need never exist, in the long run or the short run, any rational expectations equilibrium or general equilibrium market-clearing price vector.

8.7What Type of an Economic System is ‘Irrational’ Enough to use Money Contracts?

A fundamental axiom of neoclassical theory is the neutrality of money. Hence economic agents in a neoclassical world are presumed to make decisions based solely on ‘real’ valuations; they do not suffer from any ‘money illusion’. Thus in a ‘rational’ classical world, all contracts should be made in real terms and are always enforceable in real terms.

The economy in which we live, on the other hand, utilizes money contracts

– not real contracts – to seal production and exchange agreements among self-interested individuals. The ubiquitous use of money contracts has always presented a dilemma to neoclassical theory. Logically consistent mainstream classical theorists must view the universal use of money contracts by modern economies as irrational, since such agreements, fixing payments in nominal terms, can impede the self-interest optimizing pursuit of real incomes by economic decision makers. Hence mainstream economists tend to explain the existence of money contracts by using non-economic reasons such as social customs, invisible handshakes and so on – societal institutional constraints which limit price signalling and hence limit adjustments for the optimal use of resources to the long run. For Post Keynesians, on the other hand, binding nominal contractual commitments are a sensible method for dealing with true uncertainty regarding future outcomes whenever economic activities span a long duration of calendar time.

In order to understand why there is this fundamental difference in viewpoints regarding the use of money contracts, one must distinguish between a money-using entrepreneur economy and a cooperative (barter) economy. The distinction between a cooperative economy and an entrepreneur economy was developed by Keynes in an early draft of the General Theory (see Keynes, 1979, pp. 76–83). A cooperative economy is defined as one where production is organized such that each input owner is rewarded for its real contribution to the process by a predetermined share of the aggregate physical output produced. Examples of cooperative economic systems include monasteries, nunneries, prisons, or even an Israeli kibbutz. In each of these cooperative economies, a central authority or a predetermined set of rules governs both the production and payments in terms of real goods distributed