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complexThis continues the sequence of posts on re-reading Keynes. The fundamental point about the labor market which is made in Chapter 2 is that the micro level negotiations on wages between firms and laborers do not determine the real wage in the macro-economy. Before explaining this point in detail, we want to show how it is just a special case of the general idea that the economy is a complex system which cannot be understood by looking at simple sub-systems.

The idea of complex systems is beautifully illustrated by the parable of the blind men and the elephant. Each one understood correctly and accurately one small part of the big picture. When we don’t understand the system as a whole, the descriptions of subsystems appear conflicting and contradictory. Once we have an understanding of the complex system, we can assemble the partial insights into a coherent whole. The main contribution of Keynes can be understood as an attempt to describe the economy as a complex system. Unfortunately, most of his followers were blind to the main insights of Keynes. Accordingly, there have been many different interpretations of Keynes; some followers saw the trunk, others the legs, and yet others the tail of the system that Keynes was describing. But no one appears to have understood the fundamental insights of Keynesian complexity: the system as whole does not act as a simple aggregate of the actions of the individual agents within the system. Pre-Keynesian macroeconomics was based centrally on the misunderstanding that the macroeconomy can be understood by scaling up the microeconomic behaviors of individual agents. While Keynes forcefully rejected this thesis, and created a complex system view of the macroeconomy, simple-minded followers failed to understand complexity, and went back to the pre-Keynesian views.

Blind Men Thesis:  20th Century Economists as a whole failed to understand the central insight of Keynes that the economy is a complex system. This means that what happens in the macroeconomy cannot be reduced to the microeconomic behavior of the agents.

Proof of the Blind Men Thesis: When we simplify an economy by creating a representative agent, we have thrown out the baby with the bath water in the process of simplification. A complex economy cannot be understood by reducing to a single agent, and then replicating this one agent. Similarly, aggregation of micro-behavior cannot be done to get macro-behavior. The very fact that this is widely done exhibits a failure to understand the central thesis and the fundamental contribution of Keynes.  We now list some commonly used approaches to understanding the macro-economy which illustrate the widespread failure to understand complexity:

  1. The Sonnenschein–Mantel–Debreu theorem illustrates complexity of the demand function. The properties of the micro-agents are not replicated at the macro level when we aggregate the demand functions.  Frank Hahnregarded the theorem as the most dangerous critique against the micro-founded mainstream economics. Nonetheless, modern economics textbooks blithely ignore complexity and continue to assume that macro level aggregate demand satisfies microeconomic assumptions.
  2. The widely used DSGE model with a representative agent reflects a failure to understand complexity. In his testimony to the Congress on the failure of economics, Solow understood this problem with the DSGE model and explained that “One important consequence of this “representative agent” assumption is that there are no conflicts of interest, no incompatible expectations, no deceptions.” Complex phenomena like unemployment and irrational exuberance cannot be captured in such models.
  3. Solow himself fails to understand complexity. The Solow growth model which aggregates Labor and Capital, illustrates exactly the same problem. If the complex interactions between laborers and capitalists create macro-phenomena which are not reflected in the micro-economy, then aggregation will miss crucial elements of the system behavior and fail to capture the process of economic growth. In the same testimony cited above, Solow writes that aggregation is a good first approximation. The main point of complexity is that this is not true – in a complex system aggregation of micro behavior is a hopelessly bad approximation to system-wide behavior.
  4. The Cambridge Capital Controversy is another illustration of complexity. Can we add up all the capital in the hands of all the capitalists and pretend that there is one aggregated quantity Capital, to create the Solow growth model? In a complex system, obviously not. Joan Robinson made the case that capital cannot be aggregated, but not on complex system grounds. Because she was right, Solow eventually conceded the point, and called aggregate capital a “Parable”. Modern textbooks blithely ignore this controversy, and continue to describe an economy using aggregates of capital and labor, directly in conflict with the insight that the economy is a complex system.
  5. The widely used textbook examples of Supply and Demand Analysis in a single market is another failure to understand complexity. See Saglam and Zaman: The Conflict between General Equilibrium and the Marshallian Cross for an explanation of how the complex system captured by general equilibrium conflicts with insights obtained by looking at a simplified subsystem within one market.
  6. The fundamental point about the labor market (which will be discussed in detail in a later post) being made by Keynes in Chapter 2 is a complex system point. We cannot understand the behavior of the labor market as a whole, by aggregating our understanding of negotiations between firms and laborers at the micro-level.In particular, supply and demand of labor interact, since as more labor is hired, aggregate income and aggregated demand increases. Thus the labor market cannot be studied in isolation from the goods market, and there are strong emergent effects.
  7. Many other points made by Keynes depend essentially on complexity (for more examples, see John Foster (2006) Why Is Economics Not a Complex Systems Science?,Journal of Economic Issues, 40:4, 1069-1091). Among them, the central role of money in an economy emerges from complexity. If we can aggregate all the money, and similarly aggregate prices, neutrality may hold. However, if it is the interactions between agents which are of crucial importance, then exactly the same amount of aggregate money, distributed in different ways, will change system behavior. Modern macroeconomists fail to understand this, continuing to believe in the long run neutrality of money, even though Keynes explicitly denied it and provide clear (but complex) arguments for his position.

Ironically, failure to understand Keynes led to dismissal and contempt “Paul Samuelson felt he could say that “it is remarkable that so active a brain would have failed to make any contribution to economic theory . ..” (cited in John Foster 2006). Because Samuelson could not understand the complexity of Keynesian theory, he wrote that: “[The General Theory] is a badly written book, poorly organized; any layman who, beguiled by the author’s previous reputation, bought the book was cheated of his 5 shillings. It is not well suited for classroom use. It is arrogant, bad-tempered, polemical, and not overly generous in its acknowledgements. It abounds with mares’ nests and confusions: involuntary unemployment, wage units, the equality of savings and investment, the timing of the multiplier, interactions of marginal efficiency upon the rate of interest, forced savings, own rates of interest, and many others. In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding its relations to its predecessors.”

Samuelson’s arrogance in believing that he understood the Keynesian system better than Keynes created the biggest barrier to understanding Keynes for 20th Century economists. Because of his stature, he became the authorized interpreter of Keynes, and very few went back to original writings to try to understand them. Those who did also failed to come to grips with complexity, and as a result, it is impossible to count the variety of interpretations of Keynes — see for example, Backhouse and Bateman. The Keynesian elephant has a huge number of parts, it seems.

The current search for micro-foundations for macro is another expression of ignorance about Keynesian complexity. Keynes macroeconomic already has micro-foundations, but the macro does not replicate the micro. Failure to understand complexity leads to the complaint that since the macroeconomic system cannot be reduced to the behaviors of representative agent, it is not micro-founded.

This psycho-history is important because, as Keynes wrote: “The difficulty lies not in the new ideas, but in escaping the old.”   To the extent that we believe we already know what Keynes said, through his bastardized interpretation at the hands of Samuelson, his contribution will escape our understanding. Many recognized the illegitimacy of Samuleson’s interpretation, but provided equally wrong alternatives, which failed to capture the central Keynesian insight of complexity. The over-confidence of Krugman that we don’t really need to understand Keynes since we can independently arrive at the truth does not seem empirically justified in light of the numerous failures on this front. Perhaps it is true, as some complexity theorists have said, that human minds are not built to understand complexity. However, today we have the computational tools necessary to model, analyze and understand complex systems. Thus major progress is possible, with the help of agent based models and complexity theory.

unemploymentThis 7th post in a series about re-reading Keynes, starts the discussion of Chapter 2 of General Theory, which deals with the Classical (and neoclassical) Postulates characterizing the Labor market. The astonishing fact is that Keynes central arguments regarding how the labor market can fail to be at equilibrium, despite flexible wages, were never understood. As a consequence, the theory of the labor market is taught today exactly as it was prior to Keynes, and completely disregards Keynesian objections, and the Keynesian alternative. This post makes a start on Chapter 2, and the analysis will be continued in later posts.

In this chapter, Keynes formulates and rebuts the (neo)-classical theory of the labor market and presents an alternative theory of employment. This chapter was apparently never understood by economists, who mis-interpreted it as stating that unemployment arises due to price rigidities. In fact, Keynes held this position earlier, but renounces it explicitly in this chapter. His theory of employment states that the real wage is an “emergent” phenomenon. That is micro level decisions and actions of laborers and firms are based on nominal wages, but the complex economic system itself determines the general level of prices which is not in control of individual agents. So the real wage is out of reach of individual actors, and even though all parties may try to reduce real wages, they may fail to do so, because prices may respond in un-anticipated ways.

Keynes starts out be stating the classical postulates for the labor market, which continue to be the basis of modern labor economics.

Axiom I: The demand for labor by firms is determine by the marginal product of labor. As they hire more laborers, the marginal product will go down, while the wage goes up. Equilibrium will occur when the wage required for additional labor exceeds the revenue which will be generated by this hire (this revenue will be the profits from sales of the additional production, minus cost of all other inputs required in addition to labor).

Axiom 2: The supply of labor is determined by setting the wage equal to the marginal dis-utlity of work. Laborers will cease to offer labor when the going wage is less than the marginal disutility of work.

Keynes notes that these axioms allow for frictional unemployment and voluntary unemployment, but do not allow for involuntary unemployment. I assume this is familiar ground to most readers; for those who need a refresher, please see:  Zaman, Asad and Syed Kanwar Abbas, “Efficiency Wage Hypothesis – the case of Pakistan.”  Pakistan Development Review, Vol 44  number 4, Winter 2005, 1051-1066

Keynes notes that it is self-evident that involuntary unemployment is present – after the Great Depression, many workers would have been happy to work at the going wages, but could not find jobs. This sets up the problem that Keynes wishes to resolve: how to modify the axioms to allow for the observed existence of involuntary unemployment.

His first observation is that negotiation for wages between laborers and firms occurs in terms of NOMINAL wages and not in terms of real wages. He provides a very interesting and powerful empirical observation to support his assertion. In doing so, he deviates from the axiomatic methodology of economics; this observation is neither a self-evident axiom, nor can it be logically derived from any self-evident axioms. It does not conform to any principles of maximizing behavior. The observation is very simple. If firms would announce a cut in wages, the workers are likely to strike – this happened often enough in England. However, if there is an increase in the general price level, the workers do not go on strike; nor do they immediately require a compensating increase in wages. These observations firmly establish on empirical and non-axiomatic grounds that in the short run, it is the nominal wages which are the primary concern of the laborers.

 

IMPORTANT POINTS TO NOTE

1: Reshaping theories to conform to experience: This is a hallmark of science: empirical evidence trumps the beauty of mathematics. As Feynman said, “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.” In particular, observational evidence used by Keynes to construct his theories was specific to England at that time. These observations do not have universal validity. In other economic systems, strikes may not be possible, or workers may react negatively to general increases in the price level. The observations used by Keynes to construct his theory cannot be derived from a priori axiomatic reasoning, but are nonetheless of crucial importance. Note that modern economists do not follow this methodology. Despites overwhelming empirical evidence against neoclassical utility theory, economists not only continue to use it, they even seem to be satisfied that even though macroeconomics is in trouble, microeconomics provides a sound basis to build on.

2: Complexity: Partial Equilibrium Intuition Conflicts with General Equilibrium. Keynes argues that real wage is outside the control of individual actors. In particular, the asymmetry between laborer reactions to cuts in nominal wage and rises in general price level shows that partial equilibrium wage negotiations are conducted in terms of nominal wage. The real wage depends on the general price level which is not in control of the agents in any particular firm or industrial sector. He argues that general equilibrium effects may go in the direction opposite of the desires and intentions of the agents negotiating in smaller subsectors of the economy. In particular, rising nominal wages will generally be accompanied by declining real wages, because both represent conditions where employment and production is increasing. In this situation, as production capacity limits are approached, there will necessarily be a decline in the marginal productivity of labor in real terms. Thus nominal and real wage will move on opposite directions. This is a “complexity” argument – the actions of individual agents have unexpected aggregate effects.

3: Failure of Second Axiom: Keynes argues that involuntary unemployment is observed, and this proves that the second axiom is false. Laborers continue to work even after real wage has declined following a general increase in the price level. This means that they did not equate marginal disutility of work with real wages, else they would have left their jobs following a general increase in prices. Again this illustrates Keynes doing what neoclassical economists have repeatedly failed to do: revising fundamental axioms after observing empirical evidence to the contrary.

We will end this post by listing some insights from Brain Ferguson “Lectures on John Maynard Keynes’ General Theory (2): Chapter 2, “The Postulates of the Classical Economics

  1. This chapter is crucial, and lays out Keynes theory of employment, which differentiates Keynesian theory from Pigou and other classical economists. Ferguson writes:”the classical model doesn’t have a model of unemployment, treating it instead as a side-effect of the business cycle. What Keynes wants to do in the General Theory is to make the determination of unemployment the central issue in macroeconomics, rather than covering it with rather ad hoc explanations”
  2. Another argument for why nominal wages matter is that for conversion to real wage, laborers use a price index for the consumer goods they purchase, while firms use a price index for their inputs and outputs, and these two are different.
  3. The only way observation of involuntary unemployment – workers demanding but not finding jobs at going wages – can be reconciled with the classical postulates of the labor market is if some mechanism (like strong labor unions) prevents reductions in nominal wages. In this connection, Ferguson quotes Keynes as follows:

…the contention that the unemployment which characterises a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts. It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing.

  1. Ferguson uses this quote and additional evidence to show that while Keynes had earlier believed in price rigidities and lagged adjustment of nominal wages, he had abandoned this position by the time he wrote General Theory. The central features of the Keynesian theory of employment involve flexible nominal wages together with unemployment. Interpretations of Keynes have almost universally relied on wage rigidities as the source of Keynesian unemployment, and hence have missed the essence of the Keynesian model.
  2. To further elaborate, the previous point, Keynes states that he has two observations about the labor market: the first is a non-fundamental point and the second is fundamental. The first point is what we have discussed in the post: Labour resists cuts in nominal wage but does not reduce quantity of labour supplied in response to identical change in real wage caused by increases in price of consumption goods. This observation has been interpreted as meaning that Keynes argued for downward rigidities in nominal wages and that labour suffered from money illusion – that they judged their wages only in terms of the number of currency notes in their pay-packet and not in terms of the amount it could buy. These are mis-interpretations of Keynes

(re-reading & analysis of GT Chapter 2 to be continued. The second, fundamental point, of Keynes will be discussed in a later post.  …)

 

 

 

 

 

 

This post, 6th in a sequence about Re-Reading Keynes, continues to borrow heavily from Brian S. Ferguson, “Lectures on John Maynard Keynes’ General Theory of Employment, Interest and Money (1): Chapter One, Background and Historical Setting” University of Guelph Department of Economics and Finance Discussion Paper No. 2013-06. However the first three paragraphs are mine.

Distinguishing between ideologies and science:

Deduction: According to Lionel Robbins, economic theory uses an axiomatic deductive methodology, based on logical deduction from postulates which are “simple and indisputable facts of experience.” This means that there is no possibility of mistakes, and hence no possibility of learning from empirical evidence. If someone claims to have drawn a triangle where three angles do not sum to 180, we would not examine this triangle carefully to see if our law is empirically refuted. This is exactly the defining feature of an ideology – it does not waver in face of empirical evidence to the contrary.  For more details, see Economic Theory as Ideology. This is important because today we are still fighting the same battles, discussing the same questions, which were being discussed at the time of Keynes. Macroecconomics has been going backwards for decades, and there has been failure to learn from experience, due to the adoption of axiomatic-deductive methodology by economists

Induction: As opposed to this, scientific laws derived from induction are always falsifiable – the next experience may refute them. As a result, revisions are frequently necessary, as more and more experience comes in. The central insight of Kuhn is that scientific progress occurs via revolutions, which destroy one established way of looking at the world, and replace it with another. One of the key assertions of Polanyi is that when social change occurs, people devise theories to try to understand the new phenomena. These theories are often wrong, because lack of experience leads to misunderstandings. The ability to arrive at good theories depends crucially on the ability to revise theories in light of experience.

Learning from Experience: To understand economic events, we must study the wrong theories used by early theorists to understand these events, since responses to these events are shaped by these theories. To understand the impact of economic change, we must study both the (objective) events, and the (subjective) understanding of the events by leading theorists, since the response to the events will be shaped by the joint effects of the external objective circumstances and the internal subjective theories about these circumstances.

Flexibility of Keynes: Keynes had this ability par excellence. There are many anecdotes about how he was quick to change his mind, when confronted with empirical evidence to the contrary. In contrast, economists brought up on axiomatic-deductive methodology disregard conflicts with real world data to the extreme that Romer labeled “post-real.” Some of the ways that Keynes revised his theories in light of empirical evidence are discussed by Ferguson.

Keynesian Theories Developed in Light of Experience

“Hawtrey convinced Keynes that the analytical approach of the Treatise on Money was fundamentally wrong. In the Treatise, Keynes focused on the adjustment of prices to changes in economic conditions, with quantity adjustments being something of an add-on. Hawtrey convinced Keynes that the first thing firms do in response to a reduction in demand is not to cut prices, it is to cut output, with price adjustments following later. This ultimately led Keynes to the formulation in the General Theory in which prices are moved aside and the primary adjustment to changes in aggregate demand take the form of changes in aggregate output and employment.”

Many other instances of how Keynes took concrete practical details about the structure of the UK economy into account in formulating and revising his theories are cited by Ferguson. This is an important differentiating feature of Keynesian theory: it takes real world economic structures and experience into account, unlike conventional “post-real” economics.

Pre-War Prosperity in UK:  Ferguson quotes a long passage from Keynes’ Economic Consequences of Peace, idealizing the pre-war UK economy

What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914!  …(the poor were comfortable, and had the chance of escaping into) … the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages.”

The post-war slump experienced by UK was more disturbing precisely because it seemed that there should be a way to get back to the pre-war prosperity.

Classical Views on Post-War Transition to Peacetime Economy:   As a war economy has to transition to producing peace-time goods, there will a temporary period of transition. How long the transition takes depends on the mix between financial capital and fixed capital utilized in production. Financial capital can easily be transferred, while large proportions of fixed capital would result in delays in transition to new post-war equilibrium.

Initially, as a classical economist, Keynes thought that a return to equilibrium would occur speedily. However, as the 1920’s progressed, unemployment remained high in UK, and Keynes started to have doubts about the classical views. He advocated government intervention to the Macmillan Committee formed to investigate the depressed economy of Britain, because he felt that classical equilibrium mechanisms were taking too long.  Classical economists considered unemployment as part of the business cycle, Keynes came to the conviction that a separate theory of employment was needed.

Puzzle of Long-term Persistent Unemployment:  From a historical perspective, unemployment in the first few years after the First World War was not unusually high: it was, in fact, not much higher, if at all, than its pre-War peaks. What was different after the war was the fact that it didn’t come back down again anything like as quickly as pre-War experience would have predicted. (See Figure below, taken from Ferguson); see also, Creating Full Employment

ukunemployment

Classical Explanations: non-Keynesian explanations can be provided for this:

One: was the presence of unemployment insurance, and strong unions. Labor was able to negotiate an eight hour work week with no reduction in wages. All of these increased labor costs substantially, and may have been the source of higher unemployment

Two: There was a post-war boom because of increased earnings and demand by the poorer segments of society. An inflationary boom began in 1919. The government was slow to respond, but raise the the bank rate to 7% 1921 (Keynes had recommended raising it to 10% and holding it there to stamp out inflationary pressures). What had not been anticipated was the extreme sensitivity of economic activity to the interest rate. The result of the 1921 tightening was not just the end of the post-War boom but a drop into recession. In brief, bad monetary policy was responsible.

Three: The return to the Gold Standard, at the pre-World War One parity in 1925. This made the pound overvalued, made British exports expensive, and imports cheap. This caused substantial harm to domestic industries, and led to deepening and prolonging the slump. Furthermore, to prevent outflows of gold, Britain had to raise interest rates, leading to tight money and low investment, contributing further to the slump. Arguably, British recovery dates from 1931, when Britain went off the Gold Standard, this time for good.

Concluding Remarks

Ferguson argues that what we now call a Keynesian model is an intermediate stage of Keynesian thinking as it evolved and does not capture later stages of Keynesian thought as described in the General Theory. We need to study GT in detail to understand the special features of the Keynesian model, which include a different theory of the labor market.

The homepage for this project is  Re-Reading Keynes.My author page on LinkedIn Index to my writings: AZPROJECTS.  My personal webpage: Transforming Knowledge.

keynesgtFifth Post in a sequence on Re-Reading Keynes. 

Chapter 1 of General Theory is just one paragraph, displayed in full HERE

Briefly: Keynes writes that Classical Economics is a special case of his General Theory. Furthermore, the assumptions required for the special case do not hold for contemporary economic societies,”with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience”

The discussion below borrows extensively, without explicit point-by-point acknowledgement, from Brian S. Ferguson, “Lectures on John Maynard Keynes’ General Theory of Employment, Interest and Money (1): Chapter One, Background and Historical Setting” University of Guelph Department of Economics and Finance Discussion Paper No. 2013-06:

1.       RHETORIC: Keynes wishes to persuade fellow economists. Instead of saying that they are all wrong, blinkered idiots, he says that they are studying a special case, which he wishes to generalize. He also acknowledges that he was misled by the same errors, and creates common ground to enable dialog. He is also making a subliminal appeal to the hugely influential General Theory of Relativity published earlier by Einstein.

2.       INVENTION OF MACRO: The revolutionary contribution of Keynes is to study aggregates, instead of micro-level behavior. He is correctly labelled the inventor of macro-economics; prior to him, economists thought that the aggregate behavior would be obtained simply as a sum of the individual behaviors; there is no need to study macroeconomics separately. Parenthetically, it is this same position to which macro-economists retreated in the 70’s and 80’s with the development of DSGE model. Ferguson writes that:

Arguably, prior to the General Theory, most professional economists thought of the macroeconomy in a general equilibrium sense, as an aggregate of a large number of individual markets, and they assumed that the analysis of how individual markets behaved could be carried over pretty much unchanged to the collection of markets which constituted the economy as a whole. There was, it seemed, no need to think of the economy as anything other than the sum of its parts, and an understanding of how those parts worked was sufficient to understand how the economy as a whole worked. After the General Theory, that no longer held. Economists started to think in terms of aggregates.

3.       COMPLEX SYSTEMS: The flaws of this attempt to build macro on micro-foundations are still not well understood by modern economists due to the blinders of methodological individualism. These flaws include the failure to understand “Complexity Theory”, “Emergent Behaviors” and the influence of community and society on individual behavior. Basically, a complex system is one in which the behavior of the system as a whole cannot be inferred or deduced from the study of the individual parts, because it is the inter-relationships and linkages between the parts which create the system.  An extensive discussion of Keynes and complex systems is provided by John Foster, Why is Economics not a Complex Systems Science? Discussion Paper No. 336, December 2004, School of Economics, The University of Queensland. A brief quote from the abstract for the paper:

The macroeconomics of John Maynard Keynes is … an example of … (a) complex systems perspective on the economy. … the reasons why a complex systems perspective did not develop in the mainstream of economics in the 20th Century, despite the massive popularity of an economist like Keynes are discussed …

4.       MISUNDERSTANDING KEYNES: Very few read Keynes, and those who do fail to understand him for several reasons. Conceptual frameworks and background institutional structures (like the gold standard) are taken for granted and implicit in the analysis and discussion, but these have changed radically over time. In addition, “Keynes was inventing a new way of looking at the economy as a whole. He was struggling to develop concepts and invent terms, and many of the terms which he invented are not the ones we use today.” Because of this mis-understanding, revivals of Keynes (Like New Keynesians) often reject principles which Keynes considered central to his analysis, and accept propositions that Keynes firmly rejected.  Another reason for neglect of Keynes is the positivist reduction of scientific knowledge to binaries: true/false. What matters for a statement is whether or not it is relevant and valid for today, not whether or not Keynes said it, or what he meant. As Krugman puts it: Surely we don’t want to do economics via textual analysis of the masters. The questions one should ask about any economic approach are whether it helps us understand what’s going on, and whether it provides useful guidance for decisions. “So I don’t care whether Hicksian IS-LM is Keynesian in the sense that Keynes himself would have approved of it, and neither should you.” If theories have universal, time invariant, validity, then this would be a correct position. However, the basis premise of this re-reading of Keynes is that economic theories must be understood within their historical context.

5.       SAY’s LAW: The crucial issue under debate, tackled in the 2nd chapter of Keynes is: Can unemployment be reduced using fiscal policy and deficit financing? Keynes argues that it can, contrary to the view of classical that “unemployment” is not a problem – Supply and Demand for labor will equilibrate. Say’s Law holds so that the supply of labor will create the demand for it.

6.       CROWDING OUT: A crucial argument against Keynes is the Treasury View: Government investment will crowd out an equal amount of private investment. Government must borrow credit from the same market that private borrowers do. To the extent that Government succeeds in borrowing, private investors will fail in borrowing. This argument fails if the private sector expands the supply of credit in response to increased government demand for borrowing. Therefore the Treasury View is supplemented by two more pragmatic arguments. Second Treasury argument is based on extreme lags and inefficiencies in the governmental bureaucracies selection and launching of major public works projects. Such lags could mean that a intended counter-cyclical investment could be delayed so long as to become pro-cyclical.

7.       PRACTICAL PROBLEMS WITH PUBLIC WORKS: There were other practical, pragmatic aspects to the Treasury View, that governments cannot or should not spend their way out of a recession. To avoid the lags in fiscal policy, one needs “shovel-ready” projects to finance.  One of the most interesting quotes from Ferguson in this regard is:

cash-strapped local governments would cut back on their spending in response to increased central government spending in their areas. … Herbert Hoover, contrary to the image which he has acquired as a consequence of not being FDR, did not cut American federal government spending in response to the Depression, rather he increased it dramatically. … His first policy efforts involved spending federal money on shovel-ready public works projects, meaning projects which were already well into the planning stages and which needed only to have their commencement dates brought forward. In addition to finding that there weren’t anything like as many shovel-ready projects as he had hoped, Hoover found that state governments, whose own revenues were severely stressed by the Depression, responded to inflows of federal money by cutting their own relief spending, and moving to balance their budgets. (Many years later, officials from Franklin Roosevelt’s administration acknowledged that the bits of the New Deal which had actually worked were the bits they had simply taken over from Hoover. By then, though, Hoover’s reputation was pretty much beyond repair.)

8.       GOOD GOVERNANCE: Another very serious pragmatic Treasury concern was that Keynesian policy would lead to irresponsible excessive spending by politicians.

The need to keep the budget balanced had come to be accepted over the years by politicians as a matter of good governance. Treasury officials were concerned that if they accepted Keynes’ argument and gave politicians an excuse to spend in excess of revenue in some circumstances, the floodgates would burst and it would be impossible to prevent politicians from overspending under virtually all circumstances. The concern seems to have been that no matter what the circumstances, politicians would be able to come up for Keynesian reasons for deficit spending. In that fear, the Treasury officials seem to have been vindicated. As for staying on the Gold Standard the concern within the Treasury was similar: adherence to the rules of the Gold Standard was the best safeguard against unrestrained printing of money. (When Britain went off the Gold Standard for good in 1931, Sidney Webb, a member of a previous Labour party government, was reported to have lamented that when they had been in office nobody had told them that they were allowed to do that.)

Among the predecessors of Keynes, Ferguson writes that Keynes views were aligned with those of Malthus and against those of Ricardo on the following key dimensions:

9.       Against Comparative Statics: Keynes objected to Ricardian analysis on the grounds that it analyzed movements from one equilibrium state to another, without considering the disequilibrium transitional paths, and how long the transition would take. This is the context for his famous aphorism that in the long run we are all dead. He believed that studying transitional dynamics was more important than focusing on equilibrium conditions.

10.   Quick Movement to Equilibrium in Labor Markets:  Keynes objected strongly to Ricardian contentions that “labour markets worked efficiently and that wages would adjust quickly to restore equilibrium after a labour market shock.” This belief, widely held, was labeled “classical” by Keynes. Note that this belief is precisely what was resurrected by Lucas and the Chicago School, in their attack on Keynes.

This post covers about half of the Brian Ferguson article, which is about the “theoretical” context in which Keynes was writing. The second half is about the historical context, which we will cover in the next post. The homepage for this project is Keynes.

My author page on LinkedIn Index to my writings: AZPROJECTS. General Posts on Economics: Unlearning Economics. My personal webpage: Transforming Knowledge.

from Express Tribune: Nov 20, 2016
ozymandias

Ever since Ibn-e-Khaldun laid the foundations, the rise and fall of civilisations has been a favourite theme among historians. British Historian Arnold Toynbee, stated that Ibn-e-Khaldun’s Muqaddimahwas “a philosophy of history which is undoubtedly the greatest work of its kind that has ever yet been created.” Since then, countless authors, including Toynbee, have written volumes presenting their theories about the rise and fall of nations. Just like human beings, nations too have life-cycles, passing from youth to maturity to old age and death. Among these authors, the analysis of sociologist Giovanni Arrighi appears especially pertinent today. Arrighi identifies systematic cycles of accumulation of wealth associated with different hegemonic centres of civilisation. These hegemons last for about a century and then collapse, leading to the emergence of a new hegemon. Arrighi forecast the collapse of the latest hegemon (the USA in the post-war period), and emergence of a new hegemony cantered on Asia and led by China. Given that the last four hegemons have been of European origin, this would be a radical shift. The election of Trump is just one among myriad manifest symptoms of a civilisation in decline. We may live to see the fulfilment of Arrighi’s predictions of the end of Western hegemony.

Toynbee, one of world’s most widely read, translated and discussed scholars, studied the rise and fall of 26 civilisations in his monumental multi-volume Study of History. The most recent and youngest among these is the Western civilisation that dominates the world today. As usual, Eurocentric historians have sung countless paeans to the never-ending list of the unique glories of the Western civilisation. A whole library of books attributes the rise of the West to the intelligence, character, race, scientific talents, creativity, imagination, work ethics, courage, as well as good governance, democracy, and other social and political virtues. Naturally, these Eurocentric accounts portray the East as the diametric opposite, lacking all of these virtues. The book Eight Eurocentric Historians by James Blaut debunks more than 30 such self-congratulatory explanations of the rise of Europe. The task of constructing a non-Eurocentric history remains the need of the time. In this essay, we offer an initial rough sketch.

Far from being unique, the rise of Europe repeats an age old pattern of young, energetic but poor and primitive tribes on the periphery, overcoming old decaying and rich civilisations. From a long term historical perspective, the past three centuries of European ascendance are just a flash in the pan. For comparison, Muslims ruled Andalus for more than six centuries, and created an extremely rich culture, based on tolerance for all religions and respect for all types of learning. In all dimensions of life, France was primitive compared to contemporary civilisations in China and the Islamic world. Charlemagne’s emissaries were dazzled by the splendour of Haroun al Rashid’s court, and the gifts they brought back were avidly imitated, and became models of Carolingian art.

Whereas civilisations over the globe in China, Persia, Turkey, India, Africa and Latin America had substantial amounts of peaceful contacts, with trade and transfer of knowledge, the European city-states were in a constant state of war with each other. These hostilities spilled over in the form of the crusades against their Muslim neighbours. The conquest of Jerusalem repeats the standard patterns of energetic, poor and primitive outsiders looting rich, luxurious and decadent centres of civilisation. When they took Jerusalem, the European victors indulged in a bloodbath, killing all men, women and children so that their horses were up to their knees in blood. In contrast, when Saladin took Jerusalem back, he provided ships to take European prisoners back to their home countries.

Historian Henri Pirenne noted that “Europe” was created by Islam; a collection of warring nations with different languages and cultures was ‘united’ only in their opposition to Islam. Despite these hostilities, Europeans were able to learn much from the advanced science, technology, and culture of the Muslims. However, an unfortunate outcome of this hostility was the complete suppression of the debt to the Muslims in European accounts. As Andalus lapsed into decadence and degeneration, the re-conquest of Islamic Spain handed to the Europeans a treasure trove of knowledge and technology far beyond their wildest imaginations. The Cordoba library was a wonder of the world, containing advanced knowledge of medicine, chemistry, physics, astronomy and mathematics from around the globe, and from all civilisations. However the Catholic Church created a huge barrier to deriving benefits from this treasure. They forced all remaining Muslims to convert to Christianity, on pain of torture and death, and created the Spanish Inquisition to root out all remnants of Islamic thought and philosophies. Borrowing from Islamic sources was considered heresy, and was a deadly offence. Among the many prosecuted for heresy, Alexander Scultetus was a close friend of Copernicus. Even though the heliocentric hypothesis of Copernicus is available from many previous sources, and his mathematical model is a carbon copy of one exposited by Ibn Shatir, Copernicus became known as a revolutionary because he could not openly acknowledge his tainted sources. A Byzantine Greek translation of Ibn Shatir’s work was available in the Vatican library, and Copernicus knew Greek. Many contemporaries of Copernicus were familiar with various Arabic astronomy texts; they imported them and read them directly from Arabic. Mercator was arrested by the Inquisition, and in grave danger of being tortured to death in a painful way. The famous “Mercator projection” was already used in Chinese star maps of the 10th century. The construction of Mercator’s map, critical to European navigation, needed precise trigonometric values—readily available from India. Fearful of the Inquisition, Mercator hid his pagan sources. Similarly, high officials of the church made other such “independent rediscoveries” by hiding their real sources.

This unfortunate concealment and suppression of sources of the European Enlightenment has had grave consequences. Knowledge apparently sprang full blown, like Athena from the forehead of Zeus, into Europe. Even careful historians like Max Weber were deceived into believing that Europeans were uniquely capable of rational and scientific thought. This myth about European knowledge is at the root of a thousand other myths we have swallowed as parts and parcels of a Eurocentric history.

More articles on this theme: Eurocentric History

This 1000 word article is the third in a series of posts on Re-Reading Keynes. It traces the impact of Keynesian theories on the 20th century, as necessary background knowledge for a contextual and historically situated study of Keynes. It was published in Express Tribune on 4 Nov 2016.

The Global Financial Crisis (GFC) has created awareness of the great gap between academic models and reality. IMF Chief Economist Olivier Blanchard said that modern DSGE macroeconomic models currently used for policy decisions are based on assumptions which are profoundly at odds with what we know about consumers and firms. More than seven different schools of macroeconomic thought contend with each other, without coming to agreement on any fundamental issue. This bears a striking resemblance to the post-Depression era when Keynes set out to resolve the “deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory.”

Likewise, today, the inability of mainstream economists to predict, understand, explain, or find remedies for the Global Financial Crisis, has deeply damaged the reputation of economists and economic theories. Recently, World Bank Chief Economist Paul Romer stated that for more than three decades, macroeconomics has gone backwards. Since modern macroeconomics bears a strong resemblance to pre-Keynesian theories, Keynesian theories have fresh relevance, as described below.

In the aftermath of the Great Depression, economic misery was a major factor which led to the Russian Revolution and the rise of Hitler in Germany. Conventional economic theory held that market forces would automatically and quickly correct the temporary disequilibrium of high unemployment and low production in Europe and USA. Keynes argued that high unemployment could persist, and government interventions in the form of active monetary and fiscal policy were required to correct the economic problems. Many have suggested that Keynes rescued Capitalism by providing governments with rationale to intervene on behalf of the workers, thereby preventing socialist or communist revolutions. There is no doubt that strong and powerful labor movements in Europe and USA derived strength from the economic misery of the masses, and also took inspiration from the pro-labor and anti-capitalist theories of Marx. While it is hard to be sure whether Keynes saved capitalism, we can be very sure that Keynes and Keynesian theories were extremely influential in shaping the economic landscapes of the 20th Century.

Keynes actually met Roosevelt (FDR) to try to persuade him of the necessity of an aggressive fiscal policy and of running budget deficits, in order to lift the US economy out of recession. He was only partially successful. FDR, like nearly all political leaders as well as economists of the time, was convinced of the necessity of balancing budgets: this is the same ‘austerity’ being touted today as the cure for economic problems. Leading economists like Lionel Robinson and Friedrich Hayek argued in favor of austerity, and said that Keynesian remedies were dangerously wrong. They held the view that the Great Depression had been caused by excessively easy monetary policies in the pre-Depression period, and Keynesian interventions in the form of further easy monetary and fiscal policies would only prolong the agony.

FDR was not quite convinced by Keynes, but was politically savvy enough to announce that he would not balance the budget on the backs of the American people. Accordingly, he did go against his personal convictions, as well as his campaign promises of balancing the budget, which he believed to be a sound and necessary economic policy. Keynes felt that the economic policies of FDR were timid and hesitant, and prolonged the recession un-necessarily. In light of contemporary experience of the tremendously aggressive expansionary monetary policy in the post-GFC era, we can see that bolder steps by FDR would not have caused the harms that he was afraid of. In fact, after the economy recovered somewhat, FDR went back to conventional wisdom and started reducing budget deficits in 1936. This created a mini-recession which has been labelled the “Roosevelt Recession of 1937”. Duly chastened, FDR embraced Keynesian policies with greater conviction, and increased deficit spending right up to the second World War. It was the effectiveness of Keynesian policies that led even arch-enemy Friedman to state that “We are all Keynesians now,” though he later recanted. Indeed, he master-minded the Monetarist counter-revolution in the 1970’s which eventually led to a rejection of Keynesian insights, and a return to the pre-Keynesian ideas of austerity as a cure for recessions.  Forgetting the hard-learned lessons of Keynes led to a recurrence of problems very similar to those faced by Keynes in the form of GFC 2007.

Following the GFC, there has been a resurgence of interest in Keynes and Keynesian Theories. In the “Return of Depression Economics”, Krugman argued for the continuing relevance of Keynes, and stated that we could end the Great Recession immediately by implementing Keynesian policies.  China implemented Keynesian policies, and used a fiscal stimulus of $586 billion spread over two years, to successfully combat the global recession created by the GFC.  Unlike countries forced to implement austerity, which further wrecked their economies, the Chinese economy was able to perform well in the aftermath of the GFC. The Shanghai index had been falling sharply since the September 2008 bankruptcy of Lehman Brothers, but the decline was halted when news of the planned stimulus leaked in late October. The day after the stimulus was officially announced, the Shanghai index immediately rose by 7.3%, followed by sustained growth. Speaking at the 2010 Summer Davos, Premier Wen Jiabao also credited the Keynesian fiscal stimulus for good performance of the Chinese economy over the two years following the GFC.

Meanwhile, even IMF acknowledged the failure of austerity, the anti-thesis of the Keynesian policy. Massive damage was caused to Greece, Ireland, Portugal and other economies which were forced to tighten budgets in response to the recession. In the see-saw battle between Keynesians and Monetarists, after three decades of darkness, the Keynesian star seems to be rising. Strange as it may seem, many fundamental insights of Keynes were never actually absorbed by conventional economists. Keynes himself said that he had the greatest difficulty in escaping the habits of thought created by an economics education. Mainstream economists never made this escape. As a result, Keynesian theories remain an undiscovered treasure offering deep insights into current economic conditions.

The website page has many links to related materials on L3: Impact of Keynes

aaeaaqaaaaaaaahhaaaajdq5nmzhzwvllwmxn2utndg0yy05mtg2lwe5ymqxzjhhmji0nqThe first post on Reading Keynes provided an outline of the reasons why this is a good idea. It is clear that economics is broken. We need a new macroeconomics for the 21st century, one which can solve the massive problems which humanity as a whole is facing on political, social, economic, and environmental dimensions. Keynes faced similar problems, and found solutions which guided economic policy in the mid twentieth century. It is always useful to absorb the insights of our predecessors, before trying to build upon them. Such a methodology is essential for the advancement, progress and accumulation of knowledge. Our current stock of human knowledge is based on the collected insights and labors of hundreds of thousands of scholars, accumulated over the centuries. We would return to the stone ages if we were to reject it as being full of contradictions and errors (which it is). Instead, progress occurs by absorbing the past accumulated wisdom, and trying to remove the errors, or add missing insights, building on our heritage, rather than discarding it and starting over from scratch.

Several of the central Keynesian insights into the causes of the Great Depression never made it into the economics textbooks. However, our goal in studying Keynes goes far beyond just the re-discovery of these lost Keynesian insights.   A central goal is to apply and illustrate a radically different methodology for studying economics in particular, and social science in general. This is derived from a study of The Methodology of Polanyi’s Great Transformation. This is an extremely important point, which we proceed to amplify and explain further.

1.       Problems with contemporary economic theory arise from a fundamentally flawed methodology, which is incapable of learning from real world experiences. As Romer said, macroeconomics has gone backwards for the last several decades. This is because the methodology currently in use does not lead to progress and accumulation of knowledge. Very briefly, this is because current methodology is the Axiomatic-Deductive Methodology of Greek Geometry, which was never successful in dealing with natural phenomenon. Instead, what is needed is scientific methodology as practiced and demonstrated by Ibn-ul-Haytham. Unfortunately, logical positivism created massive confusions and misunderstandings regarding scientific methodology, which persist to this day, despite the fact that logical positivism has been rejected.

2.       Why have modern economists adopted and practiced a deeply flawed methodology? This is a complex and tangled tale, but its origins lie in the Battle of the Methodologies (Methodenstreit) in the 1890’s. In this battle, the German Historical School of Schmoller, which advocated a contextual and historical approach lost to the Austrian School of Menger, which advocated a more scientific, mathematical and a-historical methodology. The details and consequences have been explained at length in “How Economics Forgot History” by Geoffrey Hodgson. As a consequence of the economists’ search for scientific laws which are universal invariants, economic theorists have invented an artificial world of maximizing robots without history, culture, institutions, and social norms.The process of economic modelling — learning to think like an economist — involves translating economic problems to this artificial world and then calculating the results. This can be done because all the robotic agents behave in predictable ways, and the environment is sterilized of all particular historical, social, environmental elements. However, most often, economic outcomes in this artificial world bear no resemblance to outcomes in the real world. Mistaking a highly distorted map for the territory, economists are confused when real world phenomena do not match the results of their models.

Some of the key methodological issues which we will try to develop in this re-reading of Keynes are highlighted below:

3.       Theories cannot be separated from their historical context. Thus Keynesian theory can only be understood within its historical context. We cannot understand Keynesian theory as a collection of principles and/or mathematical laws, taken out of context and understood to apply to all economies across time and space. When placed within it historical context, Keynes becomes much easier to understand.

4.       Even more important, theories interact with history. Human being formulate theories in order to try to understand and explain changing social circumstances. When circumstances change rapidly, theories are devised to understand the change. These theories, whether right or wrong, are used to  respond to changes, and thus end up shaping history. From this perspective, it is important to study Keynes, regardless of whether his theories were right or wrong, because economic policies from mid-twentieth century onwards were guided by his views. Thus Keynesian theories have shaped economic history. There is a complex interaction of theories and history, and we cannot understand history without theories, just as we cannot understand theories without their historical context.

5.       Because of the central importance of point 4 above, we provide a simple illustration to clarify it. As described in greater detail by Polanyi, the process of enclosures of common land deprived the masses of access to livelihood and created poverty on a large scale in England. Large numbers of authors described the problems and searched for causes of this phenomena. However, the analysis of Malthus, which blamed the problem on the excessive fertility of the poor, came to dominate. His theories deeply influenced the Poor Laws, and the British response to poverty, and thus millions of lives. Even though Malthusian theories about the arithmetic increase of food and the geometric increase of population were empirically incorrect, we must understand Malthus to understand the economic policies and circumstances of England at that time.

Accordingly to widely accepted methodological principles underlying the development of modern economics, theories are formulated without historical context. In addition, economics is studied in isolation from politics and society. We propose to study Keynesian theories within their historical context. This will substantially enrich our understanding of Keynes. In addition, the historical context includes the political, social, and economic environment, which will allow us to see that economic events cannot be studied in isolation, since all these dimensions of human lives interact with each other. Again our approach goes against a core methodological commitment of modern economics, which insists that economics can be separated from political and social circumstances and studied in isolation.

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