The Keynesian Revolution and the Monetarist Counter-Revolution

{bitl.ly/KRMCR} Post 4/4 about Economic Methodology

Before Keynes, Classical Economic Theory (CET) was based on three principles. The First Principle is that Unemployment is automatically eliminated by the free market. The Second Principle is the Quantity Theory of Money, which states that money supply makes no difference to real economic outcomes. The Third Principle is that private investors automatically find the right investment opportunities to create the best economic outcomes for future. The realities of the Great Depression of 1929 clashed violently with these three principles which hold only in an imaginary world bound by axioms and logic. Keynes followed scientific methodology to create a new theory which rejected all three axioms of CET, so that Keynesian theory would match the experienced realities of the Great Depression. This is the distinguishing feature of science, that theories are devised and changed in light of experience. In contrast, Greek axiomatic-logical methodology disregards conflict with observational evidence.

The experience of the Great Depression showed that free markets cannot eliminate unemployment. The role of expansion of money stock in the boom, and of restrictive money in the recession, became clear to economists. Keynesian theory incorporates this experience and asserts the extreme importance of money in the real economy, contrary to the Quantity Theory of Money. Also, Keynes argued that the future was unpredictable. Investor sentiment and expectations about future governed their investment decisions, but these could become artificially depressed. This would choke off investment and badly affect the future of the economy. In such situations, the government should step in with investments to compensate for shortfalls in private investments. This type of fiscal policy would be able to restore full employment and generate growth. This Keynesian prescription is diametrically opposed to the Third Axiom of CET which argues that governments should not intervene in economic activity. Keynesian theories were “scientific” in the sense that they were based on observations and economic experiences, and conflicted with the Greek axiomatic approach of CET.

Banks had lost fortunes, and wiped out lifetime savings of many depositors in the Great Depression. Soon afterwards, a strong set of laws were enacted which sharply regulated financial institutions, prohibiting them from speculation, and placing many other restrictions on their activities. Financial regulation restricted the power of the wealthy to generate income from their existing wealth. This meant a sharp reduction in money generated by non-productive financial activities like interest based loans. At the same time, the main thrust of Keynesian theory was that the government had the responsibility to maintain full employment, and undertake investments necessary for growth. Investments flowed to the real sector, instead of the financial sector, and full employment meant that all the productive capacity of the economy was utilized. Empowering the working classes, investing in growth, and restricting the financial sector, led to decades of prosperity in the Western world.

In order to understand what happened next, we have to look at the dramatic impact of the three Keynesian policies of financial regulation, full employment, and government investments, on the income distribution in the USA. From 1930 to 1980, the share of wealth accruing to the bottom 90% increased from a low of 15% to a high of 35%. At the same time, the share of wealth accruing to the top 0.1% decreased from a high of 25% to a low of 5%. (For a graph, see The Power of Economic Theory: Graphically Illustrated)This reversal of fortunes was not acceptable to the extremely wealthy, who plotted a coup against Keynesian theories with patience and persistence. Their last bastion and stronghold was Chicago University, which was virtually solitary in its advocacy of free market economics in the days of dominance of Keynesian theories. In their paper “Winning Ideas”, Sabena Alkire and Angus Ritchie have provided detailed information about the campaign to spread, popularize and implement free market ideas. One key strategy was the utilization of economic and political crises and disasters to rush in with revolutionary changes. Naomi Klein has documented this aspect in her brilliant book “The Shock Doctrine: The Rise of Disaster Capitalism” which details how crises were used or generated all over the world as a means of introducing free market policies which could not be achieved by popular vote.

In the USA and UK, the oil crisis in early 1970’s created an opportunity which was seized upon by the Chicago School to create the Monetarist Counter-Revolution against Keynesian ideas. All economic troubles were blamed on Keynesian policies and financial regulation, and a strong push was made for financial liberalization, and for restricting the authorities and power of the government. One weakness of Keynesian theory was that while macroeconomics was scientifically based on observed behavior of real world economies, microeconomics was based on an axiomatic-logical Greek approach to consumer theory. Progress would have involved changing microeconomic theories to match observations of real world consumer behavior. Instead of this, the monetarist counter-revolution succeeded in dislodging Keynesian theory by arguing that these macro theories were not consistent with the axioms for consumer behavior in microeconomic theories. This return to Greek axiomatic methodology effectively divorced economics theories from reality. Keynesian Nobel Laureate Robert Solow remarked:  “Since I find the fundamental framework [of Chicago economists Lucas & Sargent] ludicrous, … I respond by laughing.” Financial liberalization together with repeal of Keynesian economics had exactly the effects desired by the wealthy. The share of the top 0.1% has steadily risen from its bottom at 5% to the current 25% and is steadily rising. The share of the bottom 90% has fallen from its top value of 35% to its current 15% and is steadily declining. The Global Financial Crisis has wiped out the middle classes and further enriched the wealthy financiers. The use of a Greek methodology which confines economists to the study of an imaginary world is extremely helpful in perpetuating the current state of affairs as it prevents the public from noticing essential aspects of the economic system. This is why scientific methodology, which would be based on close observations of contemporary realities of the economic system, is shunned by economists.

POSTSCRIPT: See also  “Completing the Circle: From GD ’29 to GFC 2007”,  “The Keynesian Revolution and the Monetarist Counter-Revolution“,  (Understanding Macro I ,  Understanding Macro II, and Understanding Macro III) and a 90m youtube video-lecture  introducing “Core Macroeconomic Concepts”