Debunking Economics Part 13

Second, the effects of variations in prices and interest rates cannot be dealt with adequately with the simple multiplier models which usually form the basis of the a.n.a.lysis. (Phillips 1954: 290) Phillips instead proposed that economists should build dynamic models of the economy models in which time was embraced rather than ignored via the device of comparative statics and his underlying method here was the functional flow block diagram. This had been devised by engineers in the 1920s as a way to visually represent dynamic processes, which previously had been shown as either differential equations, or transformations of these equations into other mathematical forms.10 Phillips drew such a diagrammatic representation of a simple dynamic economic model (ibid.: Fig. 10, p. 306; see Figure 9.8), with symbols to indicate operations like time lags, differentiation and integration with respect to time, addition and subtraction, etc. The model recast the standard comparative-static, multiplier-accelerator models of the time into dynamic form.

This model was only the starting point of a project to develop a complete dynamic model of the economy, in which the feedback effects and disequilibrium dynamics that were ignored by the conventional 'Keynesian' models of the time could be fully accounted for.

9.9 The component of Phillips's Figure 12 including the role of expectations in price setting In particular, Phillips extended his model to consider the impact of expectations upon prices. Given how much his work has been falsely denigrated by neocla.s.sical economists for ignoring the role of expectations in economics, this aspect of his model deserves attention prior to considering the Phillips Curve itself: Demand is also likely to be influenced by the rate at which prices are changing [...] this influence on demand being greater, the greater the rate of change of prices [...] The direction of this change in demand will depend on expectations about future price changes. If changing prices induce expectations of further changes in the same direction, as will probably be the case after fairly rapid and prolonged movements, demand will change in the same direction as the changing prices [...]

If, on the other hand, there is confidence that any movement of prices away from the level ruling in the recent past will soon be reversed, demand is likely to change in the opposite direction to the changing prices [...]. (Ibid.: 311; emphases added) Phillips didn't merely talk about expectations: he extended his model to incorporate them see Figure 9.9.

As part of this project, Phillips also hypothesized that there was a nonlinear relations.h.i.+p between 'the level of production and the rate of change of factor prices [labor and capital]' (ibid.: 308), and he sketched a hypothetical curve for this relations.h.i.+p see Figure 9.10.

The role of this relations.h.i.+p in his dynamic model was to limit the rate at which prices would fall when unemployment was high, in line with 'the greater rigidity of factor prices in the downward than in the upward direction' (ibid.: 308). In a dynamic model itself, this does not lead to a stable trade-off between inflation and unemployment which is the way his empirically derived curve was subsequently interpreted but rather limits the volatility of the cycles that occur compared to what a linear relations.h.i.+p would yield.

9.10 Phillips's hand drawing of the outputpricechange relations.h.i.+p 9.11 A modern flow-chart simulation program generating cycles, not equilibrium This was hard for Phillips to convey in his day, because then functional flow block diagrams were merely means to describe a dynamic model they didn't let you simulate the model itself. But today, numerous computer programs enable these diagrams to be turned into active simulations. There is also an enormous a.n.a.lytic framework for a.n.a.lyzing stability and incomplete information supporting these programs: engineers have progressed dramatically in their capacity to model dynamic processes, while economics has if anything gone backwards.

Figure 9.11 ill.u.s.trates both these modern simulation tools, and this difference between a linear and a nonlinear 'Phillips Curve' in Goodwin's growth cycle model. One of these programs (Vissim) turns the six-step verbal description of Marx's cycle model directly into a numerical simulation, using a linear 'Phillips Curve.' This model cycles as Marx expected, but it has extreme, high-frequency cycles in both employment and wages share.

Embedded in the diagram is an otherwise identical model, which has a nonlinear Phillips Curve with the shape like that envisaged by Phillips. This has smaller, more realistic cycles and these have a lower frequency as well, closer to the actual frequency of the business cycle.

What this model doesn't have and this is a very important point is an equilibrium 'trade-off' between inflation (proxied here by the rate of change of wages) and unemployment. Instead the model economy is inherently cyclical, and Phillips's overall research agenda was to devise policy measures inspired by engineering control theory that might attenuate the severity of the cycles.

9.12 Phillips's empirically derived unemploymentmoney-wage-change relation Had Phillips stuck with just a sketch of his hypothesized nonlinear relations.h.i.+p between the level of production and factor prices, it is possible that he would be known today only for these attempts to develop dynamic economic a.n.a.lysis and possibly relatively unknown too, given how other pioneers of dynamics like Richard Goodwin (Goodwin 1986, 1990) and John Blatt (Blatt 1983) have been treated. Instead, he made the fateful decision to see whether he could find such a relations.h.i.+p in the UK data on unemployment and the rate of change of money wages.

This decision led to him being immortalized for work that he later told a colleague 'was just done in a weekend' while 'his best work was largely ignored his early control work' (Leeson 1994: 613).

To do his statistical a.n.a.lysis, Phillips a.s.sembled annual data for the UK from 1861 until 1957 from a range of sources. He then used the subset from 1861 till the outbreak of World War I to derive a nonlinear function that appeared to fit the data very tightly (see Figure 9.12). When he fitted the post-WWI data to this curve, the 'out of sample' data also had a relatively close fit to his equation (except for some deviations which he explained as due to negotiated inflation-wage deals between unions and employers, and the impact of World War II on forcing up agricultural prices in Britain).

He then summarized his results in the following accurate but poorly considered statement: Ignoring years in which import prices rise rapidly enough to initiate a wage-price spiral, which seem to occur very rarely except as a result of war, and a.s.suming an increase in productivity of 2 per cent per year, it seems from the relation fitted to the data that if aggregate demand were kept at a value which would maintain a stable level of product prices the a.s.sociated level of unemployment would be a little under 2 per cent.

If, as is sometimes recommended, demand were kept at a value which would maintain stable wage rates the a.s.sociated level of unemployment would be about 5 per cent. (Phillips 1954: 299; emphases added) To actually achieve the preconditions that Phillips set out here keeping aggregate demand 'at a value which would maintain a stable level of product prices' or 'at a value which would maintain stable wage rates' would have required a whole host of control mechanisms to be added, even to Phillips's model of the economy, let alone the real economy itself. As the Goodwin model indicates, a dynamic model of the economy will have endogenous tendencies to cyclical behavior, and these in turn are merely a caricature of the cyclical nature of evolutionary change in a capitalist economy.

Developing these control mechanisms was, as noted, Phillips's main research agenda, but the economics profession at large, and politicians as well, latched on to this statement as if it provided a simple menu by which the economy could be controlled. If you wanted stable prices (in the UK), just set unemployment to 2 percent; if you wanted stable money wages instead, set unemployment to 5 percent; and pick off any other combination you like along the Phillips Curve as well.

This simplistic, static 'trade-off' interpretation of Phillips's empirically derived curve rapidly came to be seen as the embodiment of Keynesian economics, and since the 1960s data also fitted the curve very well, initially this appeared to strengthen 'Keynesian' economics.

But in the late 1960s, the apparent 'trade-off' began to break down, with higher and higher levels of both inflation and unemployment. Since the belief that there was a trade-off had become equivalent in the public debate to Keynesian economics, the apparent breakdown of this relations.h.i.+p led to a loss of confidence in 'Keynesian' economics and this was egged on by Milton Friedman as he campaigned to restore neocla.s.sical economics to the position of primacy it had occupied prior to the Great Depression.

Phillips's empirical research recurs throughout the development of macroeconomics, as I am about to recount in the next chapter as Robert Leeson observed: 'For over a third of a century, applied macroeconomics has, to a large extent, proceeded from the starting point of the trade-off interpretation of the work of A. W. H. "Bill" Phillips. It is hardly an exaggeration to say that any student dest.i.tute of the geometry of the Phillips curve would have difficulty pa.s.sing an undergraduate macroeconomics examination' (Leeson 1997: 155).

However, even his empirical research has been distorted, since it has focused on just one of the factors that Phillips surmised would affect the rate of change of money wages the level of employment. Phillips in fact put forward three causal factors: When the demand for a commodity or service is high relatively to the supply of it we expect the price to rise, the rate of rise being greater the greater the excess demand. Conversely when the demand is low relatively to the supply we expect the price to fall, the rate of fall being greater the greater the deficiency of demand. It seems plausible that this principle should operate as one of the factors determining the rate of change of money wage rates, which are the price of labor services.

When the demand for labor is high and there are very few unemployed we should expect employers to bid wage rates up quite rapidly, each firm and each industry being continually tempted to offer a little above the prevailing rates to attract the most suitable labor from other firms and industries. On the other hand it appears that workers are reluctant to offer their services at less than the prevailing rates when the demand for labor is low and unemployment is high so that wage rates fall only very slowly. The relation between unemployment and the rate of change of wage rates is therefore likely to be highly non-linear.

Phillips then added that the rate of change of employment would affect the rate of change of money wages: It seems possible that a second factor influencing the rate of change of money wage rates might be the rate of change of the demand for labor, and so of unemployment. Thus in a year of rising business activity, with the demand for labor increasing and the percentage unemployment decreasing, employers will be bidding more vigorously for the services of labor than they would be in a year during which the average percentage unemployment was the same but the demand for labor was not increasing. Conversely in a year of falling business activity, with the demand for labor decreasing and the percentage unemployment increasing, employers will be less inclined to grant wage increases, and workers will be in a weaker position to press for them, than they would be in a year during which the average percentage unemployment was the same but the demand for labor was not decreasing.

Thirdly, he considered that there could be a feedback between the rate of inflation and the rate of change of money wages though he tended to discount this except in times of war: 'A third factor which may affect the rate of change of money wage rates is the rate of change of retail prices, operating through cost of living adjustments in wage rates' (Phillips 1954: 283).

In subsequent work, Phillips went farther still, and considered that attempts to control the economy that relied upon the historically observed relations.h.i.+p could change the relations.h.i.+p itself: 'In my view it cannot be too strongly stated that in attempting to control economic fluctuations we do not have two separate problems of estimating the system and controlling it, we have a single problem of jointly controlling and learning about the system, that is, a problem of learning control or adaptive control' (Phillips 1968: 164; Leeson 1994: 612, n. 13).

Phillips didn't consider the other two causal relations.h.i.+ps in his empirical work because, at the time he did it, and with the computing resources available to him (a hand-operated electronic desk calculator), quite simply, it was impossible to do so. But today it is quite feasible to model all three causal factors, and adaptive learning as well, in a modern dynamic model of the kind that Phillips had hoped to develop.

Unfortunately, Phillips's n.o.ble intentions resulted in a backfire: far from helping wean economists off their dependency on static methods, the misinterpretation of his simple empirical research allowed the rebirth of neocla.s.sical economics and its equilibrium methodology and ultimately, the reduction of macroeconomics to applied microeconomics.

10 | WHY THEY DIDN'T SEE IT COMING.

Why the world's leading macroeconomists were the last ones capable of realizing that a major economic crisis was imminent.

Proverbs become proverbs because they succinctly state a profound truth, and no proverb better describes the state of neocla.s.sical macroeconomics before the Great Recession than 'Pride goes before the fall.' The full proverb puts it even better: 'Pride goes before Destruction, and a Haughty Spirit before a Fall.' Before the 'Great Recession' (as the sudden economic downturn that began in 2007 is known in America), a popular 'topic du jour' in the leading macroeconomic journals of the world (which are dominated by neocla.s.sical economists) was explaining 'The Great Moderation' the apparent decline in both the levels and volatility of unemployment and inflation since 1990. It was a trend they expected to see continue, and they were largely self-congratulatory as to why it had come about: it was a product of their successful management of the economy.

Few were more prominent in promulgating this view than Federal Reserve chairman Ben Bernanke. In 2004, while a member of the board of governors of the Reserve,1 Bernanke gave a speech with precisely that t.i.tle, in which he observed that: One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility [...] the variability of quarterly growth in real output [...] has declined by half since the mid-1980s, while the variability of quarterly inflation has declined by about two thirds. Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation 'the Great Moderation.' (Bernanke 2004b) He nominated three possible causes of this phenomenon: 'structural change, improved macroeconomic policies, and good luck.' While he conceded that a definitive selection could not be made between the three factors, he argued that 'improved monetary policy' deserved more credit than it had received to date: improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. Moreover, because a change in the monetary policy regime has pervasive effects, I have suggested that some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks. This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s. (Ibid.) Equally confident that neocla.s.sical economics had delivered a better world was n.o.bel laureate Robert Lucas, who is one of the key architects of modern neocla.s.sical macroeconomics. In his Presidential Address to the American Economic a.s.sociation in 2003, he went even farther in his optimism than Bernanke, to a.s.sert that macroeconomic theory had made another depression impossible: Macroeconomics was born as a distinct field in the 1940's, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades. (Lucas 2003: 1; emphasis added) They had no idea of what was about to happen. And fundamentally, they had no one but themselves to blame for their ignorance.

The kernel.

Macroeconomics, the study of the behavior of the entire economy, was once an area of economic research independent from microeconomics, the study of individual markets. However, working with a cavalier ignorance of the many flaws in microeconomics, economists reshaped macroeconomics, not to increase its relevance to the economy, but to make it a branch of microeconomics. Today, macroeconomics is based on propositions which have been shown to be untenable in the preceding chapters. This process of decay was set in train first by Keynes's incomplete escape from conventional theory at the time he wrote The General Theory of Employment, Interest and Money, and accelerated by Hicks's dubious interpretation of Keynes as a marginalist.

From Hicks's IS-LM (investment and savingsliquidity and money) model on, the road was cleared for the novelty in macroeconomics to be eliminated, and for the key conclusion of pre-Keynesian economics that a market economy could not experience a depression to be restored, just in time for the next depression to occur.

The roadmap.

This is a complicated chapter, and not merely because the subject matter itself is difficult. An additional complication comes from the way in which the version of neocla.s.sical theory taught to undergraduates is very different to that taught to students in PhD programs.

Undergraduate courses teach what is known as the IS-LM (and/or AS-AD, aggregate supplyaggregate demand) model of macroeconomics, which is presented as a precis of Keynes's theory, but in reality was devised by Keynes's contemporary and intellectual rival John Hicks. PhD students, on the other hand, learn a cla.s.s of models that goes by the grandiose and utterly misleading name of 'dynamic stochastic general equilibrium' (DSGE) models.

Both IS-LM and DSGE models are derived from the microeconomic concepts that I have shown are fallacious in the preceding chapters. They differ only in how extreme their reliance is on microeconomic theory, and on the presumption that everything happens in equilibrium. But they are also very different models, and therefore they have to be discussed independently, so in some ways there are two chapters in this one.

I precede these mini-chapters with a discussion of the fallacy they have in common: the belief that macroeconomics can and should be derived from microeconomic theory.

Then in the first mini-chapter I outline Keynes's critique of 'Say's Law,' the argument that 'supply creates its own demand,' and embellish it by comparing it to Marx's critique of the same proposition. I next argue that a key concept in all of neocla.s.sical economics, 'Walras's Law,' is simply Say's Law in a more formal guise, and that it is false in a credit-driven economy. Keynes's and Marx's critiques of the conventional economics of their day are therefore still applicable to modern economics. Hicks's reinterpretation of Keynes as a 'marginalist' is debunked. Finally I detail Hicks's late realization that his interpretation of Keynes was untenable once uncertainty was taken into account as a key determinant of the level of investment.

In the second mini-chapter I cover the manner in which the DSGE approach to neocla.s.sical macroeconomics overthrew the IS-LM model, and show that the key motivations for this were the desire to reduce macroeconomics to applied microeconomics, and to prove that there was a natural rate of unemployment that could not be altered by government policy. The inevitable intrusion of realism into this story led to the dominance of what is called the 'New Keynesian' faction of neocla.s.sical macroeconomists. Neocla.s.sical economists were confident that they had finally managed to reconcile Walras with Keynes, and this confidence made them optimistic about the economic future.

Then the Great Recession hit.

Macroeconomics and the reductionist fallacy.

Humanity made great progress in understanding reality by ignoring the overwhelming complexity of the universe, and focusing on small components of it in isolation from each other. Compare, for example, the ancient vision of the physical world of consisting of four elemental factors, earth, water, air and fire, to our understanding of the periodic table and the quantum mechanical factors beneath that today. We would not have got from the ancient view of the world to the modern without ignoring the overall complexity of the universe and focusing on individual components of it, in isolation from all others.

The success of this approach known as 'reductionism' once led to the belief that there was a hierarchical ranking of sciences, in which more complex areas were merely simplified manifestations of the underlying fundamental determinants. For example, the biological processes in living organisms were thought to be merely a surface manifestation of the underlying chemical processes, and they in turn were just surface manifestations of the quantum mechanics that ruled chemical interactions. This att.i.tude, known as 'strong reductionism,' argued that, ultimately, all sciences could be reduced to physics.

This belief was best put by the man who first showed its true limits, Henri Poincare: This conception was not without grandeur; it was seductive, and many among us have not finally renounced it; they know that one will attain the ultimate elements of things only by patiently disentangling the complicated skein that our senses give us; that it is necessary to advance step by step, neglecting no intermediary; that our fathers were wrong in wis.h.i.+ng to skip stations; but they believe that when one shall have arrived at these ultimate elements, there again will be found the majestic simplicity of celestial mechanics. (Poincare 1956 [1905]: 166) In turn, strong reductionism implied that all large-scale systems could be understood by working up from the small-scale. In the case of economics, this implied that the behavior of the macroeconomy should be derived directly from microeconomics, and this belief indeed dominated the development of macroeconomic theory from shortly after the publication of Keynes's General Theory. Today, neocla.s.sical macroeconomics truly is applied microeconomics.

In the physical sciences, a very different development occurred. Poincare showed that there were limits to reductionism in 1899, when he proved that, while a gravitational system with two celestial bodies (one sun and one planet) was utterly predictable, it was impossible to predict the behavior of a solar system with more than one planet. Reductionism still dominated the physical sciences for another seventy years, however, until these limits became apparent with the advent of the computer.

Before the computer, reductionism had a natural ally in the inability of researchers to a.n.a.lyze nonlinear relations.h.i.+ps between variables. Strong reductionism implies that the behavior of any complex system can be entirely understood by considering the behavior of its const.i.tuents, and then summing their effects: 'the whole is the sum of the parts.' This belief was consistent with the limitations of linear algebra, which was relatively easy to do before computers.

Then the number-crunching power of computers enabled researchers to consider systems with nonlinear relations between variables as with Lorenz's model of the weather, where two of the three variables are multiplied by each other in two of the three equations and they consistently observed a remarkable result: in systems where variables interact in nonlinear ways, 'the whole is more than the sum of its parts,' and behaviors will occur at the aggregate level that cannot be found at the level of the system's elementary components. This phenomenon, the occurrence of behaviors at the aggregate level that could not be explained by behaviors at the component level, was christened 'emergent properties.'

Scientists then reconsidered the role of reductionism. It still had its place, but they were now aware of the fallacy in the belief that the best way to understand any systems was from the bottom up. In a paper tellingly ent.i.tled 'More is different,' the Physics n.o.bel laureate Philip Anderson called this fallacy 'constructionism.' It had two manifestations. First, even if a reductionist vision of a particular system was correct, the belief that the best way to understand the system was to construct it from its const.i.tuent parts was false: The main fallacy in this kind of thinking is that the reductionist hypothesis does not by any means imply a 'constructionist' one: The ability to reduce everything to simple fundamental laws does not imply the ability to start from those laws and reconstruct the universe. In fact, the more the elementary particle physicists tell us about the nature of the fundamental laws the less relevance they seem to have to the very real problems of the rest of science, much less to those of society. (Anderson 1972: 393) The second was that larger systems turned out to have behaviors which were unique to their scale: scale itself resulted in new behaviors which could not be deduced from the behavior of isolated components of a system: The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood in terms of a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new behaviors requires research which I think is as fundamental in its nature as any other. (Ibid.: 393) Anderson was willing to entertain the proposition that there was a hierarchy to science, so that: 'one may array the sciences roughly linearly in a hierarchy, according to the idea: "The elementary ent.i.ties of science X obey the laws of science Y"' (Table 10.1).

But he rejected the idea that any science in the X column could simply be treated as the applied version of the relevant science in the Y column: 'But this hierarchy does not imply that science X is "just applied Y." At each stage entirely new laws, concepts, and generalizations are necessary, requiring inspiration and creativity to just as great a degree as in the previous one. Psychology is not applied biology, nor is biology applied chemistry' (ibid.: 393).

TABLE 10.1 Anderson's ranking of sciences.

The physical sciences embraced this discovery of emergent behavior, and what was first dubbed 'chaos theory' (Li and Yorke 1975) and is now known as 'complexity theory' (May and Oster 1976) is a fertile aspect of research in fields as diverse as physics and biology.

Among neocla.s.sical economists, however, the reductionist fallacy held sway, and this is nowhere more evident than in the deliberate reduction of macroeconomics to applied microeconomics in the confident but false belief that this was possible.

Ironically, despite its adherence to strong reductionism, neocla.s.sical economics provides one of the best examples of emergent phenomena ever: the 'Sonnenschein-Mantel-Debreu conditions' that were discussed in Chapter 3. This research proved that a market demand curve derived from the preferences of individual consumers who in isolation obeyed the Law of Demand i.e. they had 'downward-sloping demand curves' will not itself obey the Law of Demand: a market demand curve can have any shape at all.2 This is emergence par excellence: a behavior which, under the a.s.sumptions of revealed preference, is provably absent from individual consumers demand curves that can rise as well as fall when price increases can occur at the level of single markets in a multiple-consumer, multiple-commodity economy.

The correct inference from that research is that, not only is macroeconomics not applied microeconomics, but even microeconomics itself can't be based on a simple extrapolation from the alleged behavior of individual consumers and firms. Thus, even within microeconomics, the study of markets cannot be reduced to the a.n.a.lysis of individual behaviors, while under no circ.u.mstances can macroeconomics be derived from microeconomics.

However, with some honorable exceptions (Kirman 1989, 1992), neocla.s.sical economists resiled from this discovery of emergent properties within economics. The result was misinterpreted, and buried in poor pedagogy, so that three generations of post-WWII neocla.s.sical economists continued to believe in the reductionist fallacy.

In this, they continued the behavior of their pre-WWII forebears. Ever since Adam Smith's Wealth of Nations, the dominant tendency in economics has been to a.n.a.lyze the economy from the perspective of the behavior of individual rational agents, and to derive from this the inference that, so long as prices are flexible, there can be no macroeconomic problems. Thinkers who took a different perspective, such as Malthus in his debates with Ricardo, or Marx and other critics, were driven to the periphery of economics.

In the language of the nineteenth century, the mainstream economists of that time argued that there could be no 'general glut': while individual markets might have more supply than demand, in the aggregate there had to be other markets where there was more demand than supply. Therefore, while there could be problems in individual markets, the entire economy should always be in balance, because a deficiency in one market would be matched by an excess in another. All that would be required to correct the imbalance would be to let the market mechanism work, so that the price of the good with excess demand would rise while the one with excess supply would fall. Macroeconomics, as we call it today, was seen as unnecessary.

Prior to the 1870s, this belief that there could be no macroeconomic problem involved a strange mishmash of ideas, because the cla.s.sical school of thought that dominated economics 'proved' the absence of macroeconomic problems by borrowing arguments from Jean Baptiste Say, who was effectively an early neocla.s.sical. After the 1870s, there was no such disconnect, as the neocla.s.sical revolution led by Menger, Walras and Marshall swept away the old cla.s.sical school. Economists continued to be confident that there could never be a general glut, and this macroeconomic belief was now derived from a consistent microeconomic theory.

Then the Great Depression began. As unemployment relentlessly climbed to 25 percent of the American workforce, and fascism broke out in Europe, neocla.s.sical economists of the day were in disarray. Into this breach stepped Keynes. With the publication of The General Theory of Employment, Interest and Money in 1936, Keynes effectively invented macroeconomics as a separate sub-discipline within economics.

From that point on, neocla.s.sical economists attempted to undermine it.

Say, Walras, and the self-equilibrating economy ...

The General Theory was conceived and published during capitalism's greatest slump, the Great Depression, when America's output fell by 30 percent in four years, stock prices fell by 90 percent, commodity prices fell by almost 10 percent a year in its first two years, and unemployment remained above 15 percent for a decade.

Prior to then, mainstream economists did not believe there were any intractable macroeconomic problems. Individual markets might be out of equilibrium at any one time and this could include the market for labor or the market for money but the overall economy, the sum of all those individual markets, was bound to be balanced.

The basis for this confidence was the widespread belief, among economists, in what Keynes termed Say's Law. As Keynes described it, this was the proposition that 'supply creates its own demand' (Keynes 1936). Some economists dispute Keynes's rendition of Say's Law (Kates 1998), and I concur that in several ways Keynes obscured what Say actually meant. So it is appropriate to turn to the horse's mouth for a definition: Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise. (Say 1967 [1821]) Say's core proposition is that overall balance is a.s.sured because, to quote Steve Kates, the strongest modern-day proponent of Say's Law: '[t]he sale of goods and services to the market is the source of the income from which purchases are financed' (Kates 1998).

This, according to the 'cla.s.sical' economists from whom Keynes hoped to distinguish himself,3 meant that there could never be a slump due to an overall deficiency in demand. Instead, slumps, when they occurred, were due to sectoral imbalances.

If the demand for one market such as labor was too low relative to supply, this was because demand exceeded supply in one or more other markets. The solution was for sellers in the market suffering from excess supply workers to accept a lower price for their commodity.

Money was also treated as a commodity in the pre-Keynesian model, and it was possible that, at some point in time, many people would want to hold money and very few would want goods. There could then be a serious slump, as producers of goods found that people did not want to part with their money. Physical commodity markets and the labor market could then be in excess supply with unsold goods and unemployed workers but this would be because of the excess demand for money, and not because of any overall deficiency of aggregate demand. In the aggregate, demand and supply would be in balance.

Keynes's attempt to refute this notion was, to put it kindly, rather confusing, and on this basis alone I can to some extent understand the inability of many neocla.s.sical economists to comprehend his theory. I reproduce Keynes's argument in its entirety in the next quote, and if you don't comprehend it completely on a first reading, don't worry in fact, I'd worry if you did comprehend it! After you've waded through this, I'll provide a far clearer explanation that Keynes was aware of at the time he wrote the General Theory, but which probably for political reasons he chose not to use.

OK: take a good swig of coffee, a deep breath, and read on: This theory can be summed up in the following propositions:.

1 In a given situation of technique, resources and costs, income (both money-income and real income) depends on the volume of employment N.

2 The relations.h.i.+p between the community's income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

3 The amount of labor N which the entrepreneurs decide to employ depends on the sum (D) of two quant.i.ties, namely D1, the amount which the community is expected to spend on consumption, and D2, the amount which it is expected to devote to new investment. D is what we have called above the effective demand.

4 Since D1 + D2 = D = f(N), where f is the aggregate supply function, and since, as we have seen in (2) above, D1 is a function of N, which we may write c(N), depending on the propensity to consume, it follows that f(N) c(N) = D2.

5 Hence the volume of employment in equilibrium depends on (i) the aggregate supply function, (ii) the propensity to consume, and (iii) the volume of investment, D2. This is the essence of the General Theory of Employment.

6 For every value of N there is a corresponding marginal productivity of labor in the wage-goods industries; and it is this which determines the real wage. (5) is, therefore, subject to the condition that N cannot exceed the value which reduces the real wage to equality with the marginal disutility of labor. This means that not all changes in D are compatible with our temporary a.s.sumption that money-wages are constant. Thus it will be essential to a full statement of our theory to dispense with this a.s.sumption.

7 On the cla.s.sical theory, according to which D = f(N) for all values of N, the volume of employment is in neutral equilibrium for all values of N less than its maximum value; so that the forces of compet.i.tion between entrepreneurs may be expected to push it to this maximum value. Only at this point, on the cla.s.sical theory, can there be stable equilibrium.

8 When employment increases, D1 will increase, but not by so much as D; since when our income increases our consumption increases also, but not by so much. The key to our practical problem is to be found in this psychological law. For it follows from this that the greater the volume of employment the greater will be the gap between the aggregate supply price (Z) of the corresponding output and the sum (D1) which the entrepreneurs can expect to get back out of the expenditure of consumers. Hence, if there is no change in the propensity to consume, employment cannot increase, unless at the same time D2 is increasing so as to fill the increasing gap between Z and D1. Thus except on the special a.s.sumptions of the cla.s.sical theory according to which there is some force in operation which, when employment increases, always causes D2 to increase sufficiently to fill the widening gap between Z and D1 the economic system may find itself in stable equilibrium with N at a level below full employment, namely at the level given by the intersection of the aggregate demand function with the aggregate supply function. (Keynes 1936: 289; emphasis added) You got that? Oh, come on, pull the other one! It's far more likely that your head is still spinning after reading that extract, and the same applied to the handful of leading neocla.s.sical economists who read Keynes, and tried to work out how he could argue that aggregate demand could be deficient.

It's a tragedy that what Keynes himself described as 'the essence of the General Theory of Employment' was expressed in such a convoluted and turgid fas.h.i.+on especially given his capacity for brilliant prose. It is therefore not altogether amazing that neocla.s.sical economists believed that Keynes either misunderstood what they believed was the true concept at the heart of Say's Law, or that he intended to refute the clearly incorrect belief that overall balance meant that there could never be involuntary unemployment whereas Say's Law allowed for involuntary unemployment as a by-product of sectoral imbalances.

The upshot is that the essence of Say's Law lives on in modern economics, though it now goes under the more respectable name of 'Walras's Law' (or, in some circles, 'Say's Principle'). Its modern definition is that 'the sum of all notional excess demands is zero,' and this proposition is accepted as valid indeed as irrefutable by modern-day economists.

However, I argue that this is precisely the concept which Keynes intended to refute, and that he was right to do so.

Say no more? The modern attempt to reconcile Keynes with Say and Walras (Leijonhufvud 1968; Clower and Leijonhufvud 1973)4 starts from the proposition that, on the average, agents in a market economy are neither thieves (who want to take more than they give) nor philanthropists (who want to give more than they get). Therefore the normal agent will intend to have balanced supplies and demands: the value of what he wishes to sell will equal the value of what he wishes to buy, so that 'the sum of his notional excess demands is zero.'

The excess demand for any single product by a single agent can be positive so that the agent wishes to be a net buyer of that product or negative so that the agent wishes to be a net seller. However, in sum, his excess demands will be zero.

This balance at the level of the individual agent necessarily carries over to the aggregate of all agents: if the intended excess demands of each individual agent sum to zero, then the intended excess demands of all agents sum to zero.

However, this ident.i.ty of aggregate supply and aggregate demand at the overall market level doesn't necessarily translate to ident.i.ty at the level of each individual market. In particular, as noted earlier, it is possible for excess demand for money to be positive in which case commodity markets would be 'glutted.' Excess demand for labor can also be negative the supply of workers can exceed the demand for them so that there will be involuntarily unemployed workers (and also a notional excess demand for the products that the unemployed workers intended to buy).

These two circ.u.mstances are both explanations of a depression. The former would involve a 'rising price' for money or in other words 'deflation' as the money price of all other commodities fell. The latter would involve a falling price for labor falling wages. However, both these forces would make a depression a temporary phenomenon. As Dixon puts it: [F]ollowers of Walras would say that involuntary unemployment cannot persist in a market economy with flexible wages and prices. They would argue that if the commodities market has excess demand then the prices of commodities will tend to rise and this will tend to reduce the level of excess demand in that market. In the labor market, where there is excess supply, they would a.s.sert that money wages will tend to fall. The joint effect of the rising price together with a falling money wage is that the real wage will tend to drop thus reducing (and eventually removing entirely) the excess supply in the labor market.

As a consequence of the above, many would see the p.r.o.nouncements of Keynes that the economy could find itself with an excess supply of labor and yet, in all (other) respects be in 'equilibrium,' as being in conflict with Walras' Law and therefore wrong or 'bad' in theory and so inadmissible. (Dixon 2000b) Keynes's critique Let's now simplify Keynes's argument from that pivotal pa.s.sage to see whether it's consistent with the way in which neocla.s.sical economists later interpreted it. Keynes divided all output into two cla.s.ses: consumption and investment. If the economy was in equilibrium, then Say's Law would argue that excess demand for consumption goods would be zero, and likewise for investment goods.

Keynes then imagined what would happen if demand for consumption goods fell, so that excess demand for consumption goods was negative (supply exceeded demand).5 Say's Law would argue that demand for investment goods would rise to compensate: notional excess demand for investment goods would be positive.

However, as Keynes argued extensively throughout the General Theory, demand for investment goods is driven by expectations of profit, and these in turn depend heavily upon expected sales to consumers. A fall in consumer demand now could lead entrepreneurs to expect lower sales in the future since in an uncertain environment 'the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future' (Keynes 1936: 148).

Dampened expectations would therefore lead entrepreneurs to reduce their demand for investment goods in response to a reduced demand for consumer goods. Thus a situation of negative excess demand for consumer goods could lead to a state of negative excess demand for investment goods too a general slump.

This clearly contradicts Walras's Law. Since economists regard Walras's Law as irrefutable, this led some economists to ridicule Keynes's argument, and others to attempt to find how Keynes's argument could be reconciled with Walras's Law. The most widely accepted reconciliation was achieved by Robert Clower and Axel Leijonhufvud.

Say's Principle Clower and Leijonhufvud a.s.serted that Keynes and Walras were compatible, because Walras's Law applied effectively only in equilibrium. Out of equilibrium, then, though the sum of notional excess demands was still zero, the sum of effective demands could be negative.

For example, if there was negative excess demand in the labor market so that some workers were involuntarily unemployed then it didn't help that these unemployed workers wanted to buy commodities. Without employment, their notional demands remained just that. Though they might want to buy commodities, without a wage their notional demand had no impact upon actual sales of commodities. Actual negative excess demand for labor might therefore not be balanced by actual positive excess demand for commodities, so that overall, the sum of excess demand could be negative. Keynes was vindicated as a disequilibrium theorist.6 Keynes and Walras were reconciled.

But were they? Prior to the publication of the General Theory, Keynes indicated that he rejected the very basis of Walras's Law the proposition that the sum of notional excess demands is zero when he praised the author of what he had once described as an 'obsolete economic textbook which I know to be not only scientifically erroneous but without interest for the modern world' (Keynes 1925): Karl Marx.

The circuit of capital Marx's critique of Say's Law went to the heart of Walras's Law (and Say's Law). Marx rejected Say's initial proposition that '[e]very producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product' (Say 1967 [1821]). Instead, Marx pointed out that this notion a.s.serted that no one in a market economy wished to acc.u.mulate wealth. If there was never any difference between the value of commodities someone desired to sell and buy on the market, then no one would ever desire to acc.u.mulate wealth. But an essential feature of capitalism is the existence of a group of agents with precisely that intention.

Believers in Say's Principle or Walras's Law might find these agents rather bizarre, since in their terms these agents are 'thieves,' who wish to take more than they give. However, far from being bizarre, these agents are an essential part of a market economy. They are known as capitalists. Far from their behavior being aberrant in a market economy, it is in fact the essence of capitalism and according to Marx, they do this without being thieves.

Whereas both Say's Law and Walras's Law a.s.sert that people simply desire to consume commodities, Marx a.s.serted that an essential aspect of capitalism is the desire to acc.u.mulate. He derided Say's belief that the ultimate objective of every agent in a market economy was simply consumption which is still generally accepted by economists today, as well as the economists of Marx's time as an ideologically convenient but misleading fiction which obscures the actual dynamics of capitalism: It must never be forgotten, that in capitalist production what matters is not the immediate use-value but the exchange-value, and, in particular, the expansion of surplus-value. This is the driving motive of capitalist production, and it is a pretty conception that in order to reason away the contradictions of capitalist production abstracts from its very basis and depicts it as a production aiming at the direct satisfaction of the consumption of the producers. (Marx 1968 [1861]: ch. 17, section 6) Capitalists are clearly fundamental to capitalism, and their behavior directly contradicts the Walras's and Say's Law presumption that every agent's intended excess demand is zero. As Marx put it: The capitalist throws less value in the form of money into the circulation than he draws out of it [...] Since he functions [...] as an industrial capitalist, his supply of commodity-value is always greater than his demand for it. If his supply and demand in this respect covered each other it would mean that his capital had not produced any surplus-value [...] His aim is not to equalize his supply and demand, but to make the inequality between them [...] as great as possible. (Marx 1885: ch. 4, section 'The meeting of demand and supply') The dilemma for Marx was to explain how this inequality could be achieved without 'robbing' other partic.i.p.ants in the market, and without violating the principle that commodities were bought and sold at fair values. His solution points out the fallacy underlying the economist's superficially appealing arguments in Say's Law, Walras's Law, and Say's Principle.