This continues from previous post on New Directions in Macroeconomics. Among the heterodox responses to the crisis in economic theory created by the Global Financial Crisis 2007, we will briefly discuss the following: Post-Keynesian Economics, Modern Monetary Theory, Political Economy, Evolution of Global Finance, Ecological Economics, Complexity Economics, Islamic Economics. This post is about Post-Keynesian Economics.
The response of mainstream macroeconomists to this crisis has been disappointing; see for example Antara Haldar (2018) “Economics: The Discipline that refuses to change”. The failure of classical economics in the Great Depression of 1929 led Keynes to the create the field of macroeconomics, which was revolutionary many different ways. Unfortunately, as Romer remarks, the profession went backwards, losing hard-won insights. All of the revolutionary Keynesian insights (discussed in greater detail below) have since been rejected by the orthodoxy. Similarly, there has been little or no response to the demonstrated failure of macroeconomic models following the Global Financial Crisis. In “Models and Reality: How did Models Divorced from Reality become Epistemologically Acceptable?”, I have explained how current economic methodology prevents economists from creating better models in response to empirical failure. Instead of re-thinking economics, mainstream economists have closed ranks along a defense of the orthodoxy. A consensus has emerged that no major change is required. For example, Krugman attributes the failure of macro to three factors: (i) a “Black Swan event” of such low probability that it could not have been foreseen by anyone, (ii) prolonged maintenance of low interest rates by the Fed (flawed monetary policy), and (iii) emergence of a huge shadow banking sector not taken into account by macroeconomists monitoring the economy. The point of this deeply flawed defense is to argue that there is no need to change the fundamental frameworks for macroecnomics. As a result of this failure to reform theory, the same macro models which failed catastrophically in the Global Financial Crisis continue to be used all over the world. DSGE-based macro models with no role for money and banking, and GARCH models forecasts of volatility, are still in use at Central Banks throughout the world, because no viable alternative has emerged.
While mainstream economists have failed to respond, there has been substantial recognition of the challenge, and many important heterodox responses to the crisis in macroeconomics created by the Global Financial Crisis. We have listed some of the major schools of heterodox response in the opening paragraph. In the remaining post, we will discuss
By now, this is an advanced and sophisticated school of thought which builds upon multiple revolutionary insights of Keynes, rejected by mainstream macroeconomics. We discuss three of these briefly below. A fourth insight of great importance was the understanding that macro phenomena did not emerge by aggregating the micro phenomena – the system is not just the sum of its parts. This is now called “complexity economics” and is discussed in a separate subsection.
Money matters, in the short run and in the long run. It is surprising that this needs to be said, since it seems entirely obvious to everyone except economists, who teach that money is neutral. Real Business Cycle Models of the economy currently in use for monetary policy have no direct role for money and no financial sector. As somebody quipped, this is like trying to figure out how birds fly, without taking into account their wings. Romer (Trouble With Macro) expresses his exasperation at major league macroeconomists who write that money plays no significant role in the economy, and provides strong empirical evidence for the importance of money by study monetary policy of Volcker. Arestis and Sawyer (2006) provide a comprehensive review in their Handbook of Alternative Monetary Economics. An example of how these post-Keynesian theories affect orthodox views of growth, interest, and money is provided by Dutta and Amadeo (1993),
Radical Uncertainty: Keynes argued that the future is inherently uncertain and unpredictable. Unfortunately, some erroneous technical arguments were used to show that rational decision making could be based on probability estimates of future events, denying the possibility of radical uncertainty. John Kay (2019) writes the “To acknowledge the role of radical uncertainty is to knock away the foundations of finance theory and much modern macroeconomics.” For example, rational expectations is at the heart of modern theories of finance and macroeconomics, and makes events like the Global Financial Crisis impossible. A landmark book on Radical Uncertainty by Kay and King (2020) argues that rejection of Keynesian uncertainty was a central reason for the blindness of economists, and economic theories, to the possibility of the Global Financial Crisis. These theories continue to dominate, while recognition of radical uncertainty is a necessary preliminary to the rebuilding of a more relevant economic theory. For a deeper discussion of the technical arguments which led to the rejection of uncertainty, see Zaman (2019).
Demand Driven Output: Keynes opens his famous book by rejecting Say’s Law, which states that supply creates its own demand. In contrast, he argued for the principle of effective demand, that demand matters in the long as well as the short run. Unfortunately, modern macroeconomics has re-instated Say’s Law, and ruled out the possibility of long-run unemployment of labor or other resources. The success of the counter-revolution of Chicago style free market economics, launched against the Keynesian revolution, has left economists blind to the mysteries of the labor market. For example, Borjas (Labor Economics) agrees that ‘marginal productivity theory bears little relation to the way that employers actually make hiring decisions’. He writes that “We do not yet fully understand why the recent evidence differs so sharply from the evidence presented in the earlier literature, and why the implications of our simple-and sensible supply and demand framework seem to be so soundly rejected by the data.” Similarly a recent conference on the mystery of rising productivity together with stagnant wages was the subject of a recent conference, where top economists admitted to being bewildered by this phenomenon. See Denning (2013) for a collection of quotes displaying the confusion and frustration of economics, and an explanation of the problem based on the evolving structure of corporate finance. Post-Keynesian theories build on Keynesian ideas to provide deep insights into the functioning of the labor market. Providing good jobs to everyone is arguably the most important function of an economic system, and one which modern economies fail miserably to do. To create full employment, it is essential to fix economic theory, which solves the problem by pretending it does not exist.
For full article, with references, see Zaman & Basci: “New Directions in Macroeconomics”, International Econometric Review, Vol 12, Issue 1, p1-23. Next Post: Modern Monetary Theory.