Understanding Macro: The Great Depression (1/3)

{bit.ly/WEAgd29} Preliminary Remarks: “The trouble is not so much that macroeconomists say things that are inconsistent with the facts. The real trouble is that other economists do not care that the macroeconomists do not care about the facts. An indifferent tolerance of obvious error is even more corrosive to science than committed advocacy of error.” From The Trouble with Macroeconomics (Paul Romer)

I do not understand why indifference to error is worse than committed advocacy. Tor an illustration of committed advocacy of error, see postscript below on 70 years of economists’ committment to a fallacious theory. Furthermore, the problem is not confined to macro. Microeconomists are also dogmatically committed to utility maximization, when in fact this hypothesis about consumer behavior is solidly rejected by empirical evidence; see: The Empirical Evidence Against Neoclassical Utility Maximization: A Survey of the Literature.

For the followup post, see “Understanding Macro II: Post-War Prosperity”

Understanding Macro: The Great Depression

Published in The Express Tribune, February 21st, 2018.

Due to frequent headlines, there is a substantial public awareness of core macroeconomic issues like unemployment, trade agreements, exchange rates, deficit, taxes, interest rates, etc. However, even professionals are often ignorant of the intellectual battles which have shaped modern macroeconomics, since this is not taught in typical PhD programmes in economics. This article attempts to provide the history of ideas which led to the emergence of macroeconomics, since this is an essential background required for informed analysis of these issues.

Lord John Maynard Keynes invented the entire field of macroeconomics in response to the Great Depression in 1929, which could not be understood according to economic theories dominant until then. According to the classical economic theory, forces of supply and demand in the labour market would ensure full employment. Keynes starts his magnum opus, The General Theory of Employment, Interest, and Money, with the observation that the economic theory cannot explain the long, persistent and deep unemployment that was observed following the Great Depression. Keynes set himself the goal of creating a theory which could explain wide fluctuations in levels of employment that he observed. He discovered that creating such a theory involved rejecting deeply held convictions, central to economic theory.

The first of these new ideas is the failure of supply and demand theory in the labour market. According to conventional economics, unemployment represents an excess supply of labour. When there is excess supply, the price of labour, or the wage, will go down. This will encourage firms to hire more labour and also discourage people from working, increasing demand and decreasing supply, until the two are equalised at equilibrium. The Great Depression made it obvious that this theory did not work. Keynesian economics was created to explain this failure of supply and demand. Unlike conventional economists, who address such problems by doing mental gymnastics using mathematical models, Keynes looked at the economic conditions in the real world around him to find the answers to this puzzle. He observed that there was a huge strike by coal miners in England against a proposal to cut their wages. But there were no strikes against high inflation, which also reduces the real wages of the workers. Economic theory says that the two — decline in nominal wage, or an increase in prices of consumer goods — will have exactly the same effect on the labour supply. Keynes was able to see, unlike economists who hold their theories to be sacred, that his economic theory must be wrong. The supply of labour does not respond to real wages, but only to nominal wages in the short run.

After pondering as to why this might be the case, Keynes realised that it was because the real wage was determined by factors outside the control of firms and workers, due to the complex structure of the economy. Even if both firms and workers agreed to reduce nominal wages, this could lead to a decline in prices such that the real wage would not go down, preventing the mechanism which brings supply and demand into equilibrium from operating. This realisation led Keynes to two other major insights. If firms and workers negotiate in terms of money wages, rather than real wages, then the amount of money in the economy is extremely important. This contradicts the famous Quantity Theory of Money, according to which the amount of money is just a veil, which has no bearing on the real economy. Furthermore, Keynes argued the firms’ decisions about investment, and hire of workers, depended crucially on their expectations about the future. These expectations were not anchored by any real factors and could fluctuate greatly in response to many different types of stimuli. In particular, he argued that investments were governed more by the type of gambling involved in day-trading, and less by reasoned calculation of long-term yields. This suggests that wise long-term future investments require government interventions, contrary to free-market dogma.

Although Keynes succeeded in his long struggle to escape deeply held convictions created by classical economic theories, he could not succeed in making his fellow economists see the light. He complained that “professional economists… were… unmoved by the lack of correspondence between the results of their theory and the facts of observation.” Hicks and Samuelson cobbled together an uneasy compromise between classical theories and Keynesian ideas, which became known as Keynesian economics, even though it rejected nearly all of the central insights of Keynes. It was in response to this massive misinterpretation that Keynes said that “I am not a Keynesian.” Only one Keynesian insight survived the Hicks-Samuelson misunderstanding of Keynes: the government must take active steps to eliminate unemployment, since the forces of supply and demand will not do so. But even this little piece of Keynesian theory was enough to change the world dramatically.

Keynesian macroeconomics uses two tools to eliminate unemployment. Fiscal policy involves the government directly investing in public works to create employment, while monetary policy involves printing more money to stimulate creation of demand by the private sector. Keynesian policies advocate deficit spending and expansionary monetary policy. This runs counter to widely accepted and commonly held beliefs that governments should practise ‘austerity’ in recessions. Strangely enough, this ideological battle continues today, where the IMF continues to recommend austerity to the poor countries, while the rich countries combat recessions with expansionary Keynesian policies. These theoretical conflicts cannot be understood until we dig beneath surface appearances and ask which social groups benefit from which type of policy.

It should be immediately obvious that active government involvement in creating full employment helps the bottom 90%. It is slightly less obvious that monetary expansion, which may create inflation, is also helpful to the poorer segment of society. This is because the poor are generally borrowers of money, so the value of their debt in real terms becomes reduced. Similarly, easy money makes it easier for them to borrow. At the same time, Keynesian policies hurt the top 1%. This is because government guarantees of full employment makes the position of labour strong vis-à-vis the corporations, increasing the share of profits going to labour, and reducing business profits. Also, the wealthy make money by lending, so easy money lowers their profits from extending loans. It is this underlying power struggle, the eternal battle between the rich and powerful against the poor masses, which is hidden beneath the surface of the mathematical complexities of modern macroeconomics.

(To be continued) 

POSTSCRIPT: Amazingly, exactly the same conflicts that Keynes encountered between the economic theory and reality continue today, with economists stubbornly sticking to theories solidly refuted by facts. One of the leading textbooks in Labor Economics by George Borjas presents exactly the same model of supply and demand equilibrium, thoroughly refuted by empirical evidence. He makes no mention of the fact that Keynesian theory rejects the idea that supply and demand lead to equilibrium in the labor market; there are no references to Keynes in the entire book, justifying the Keynes quote that economists are unmoved by the lack of correspondence between their theories and the facts. Borjas does mention, with obvious reluctance, the strong evidence against S&D in labor market presented by Card & Krueger in Myth and Measurement. Then he goes on to the following, amazing, dismissal of facts in favor of theory:

We do not yet fully understand why the recent evidence differs so sharply … , and why the implications of our simple-and sensible supply and demand framework seem to be so soundly rejected by the data. One plausible reason is that  … (large number of implausible waffles, which have been rejected by Card & Krueger in later articles defending themselves from these critiques). (p 143, 3rd Edition)

Borjas follows standard axiomatic economic methodology, in which there is no room for the possiblity that observation of facts to the contrary may lead to revision of theory. As Keynes observed: “The classical theorists resemble Euclidean geometers in a non-Euclidean world who, 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 which are occurring.”

For more on this topic, see my lecture L08 of Advanced Micro II on”70 Years of Economists’ Failure to Understand the Labor Market.” This webpage provides slides, summary, and transcript of the lecture. A 90m YouTube Video-Recording of the lecture is also linked below:

3 thoughts on “Understanding Macro: The Great Depression (1/3)

  1. Pesky reality! 🙂 This reminds me of when I heard a builder say: “I’ve cut this board three times and it is still too short!”

    More seriously, Many of the economists who reject Keynes’ insights and stubbornly hold on to theories which are contradicted by reality are usually much more interested in the resulting political outcomes (that are of value to their benefactors) than in developing good economic theories. your insights regarding the 90 versus the 1 percent fit this exactly.

    1. I don’t think the “resulting political outcomes” are necessarily the reason that economists reject Keyes’ insights. I reject them too, though it would personally benefit me greatly if they were true.

      I’m guessing there are other reasons.

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