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Critiques of Economic Theories

Part 2 of Lecture on Spirituality and Development: Friday, 27th Jan 2017 by Dr. Asad Zaman, VC PIDE — for Students of Religion & Development Paper, Center of Development Studies, University of Cambridge. Link for part 1: Spirituality . 50m Video lecture:

OUTLINE OF LECTURE:

  1. The meaning of development has varied dramatically across time, space, cultures.
    1. When Britannia ruled the Waves:
      Development definition suited Britain: Sea-Power, Coal Mines, Industry, Climate, Race
      No entry for “democracy” in Encyclopedia Brittanica, 1930
    2. Post-War Rise of USA
      Initial Definition: Democracy, GNP per capita – both criteria serve to ensure leadership of USA.
    3. Later, some Oil Economies had Higher GNP/Capita than USA
      So REDEFINE Development to include Income Distribution, so as to keep US on top
    4. Later, Switzerland, Japan and some other Scandinavian countries had Higher Wealth + Lower Gini. How to measure development to ensure USA is on top? Answer: Redefine Development to include Infrastructure
    5. Conclusion: Definition of Development Changes to suit the powerful. Criteria are chosen to ensure that the powerful are on top.
  2. Read More

jobsThis is the 9th Post in a sequence about Re-Reading Keynes. In chapter 2 of General Theory, Keynes wishes to develop a theory of employment. He claims that classical economics does not have a theory of employment, because it assumes that all resources will be fully employed. But the theory that unemployment will always be 0% – except for frictional – is not a theory which can explain observations of high and persistent unemployment. Taking this post-Depression observation for granted, the question arises how we can create a theory in which the labor resources can be utilized at different levels. In order show that classical theory cannot explain the observed fluctuations in the level of employment, Keynes lists the four possibilities under classical theory which could create a change in the quantity of labor being employed:

  1. A more efficiently organized labor market, which find faster matches between the unemployed and job opportunities, would lower frictional unemployment and increase employment.
  2. A decrease in the disutility of labor would mean that laborers would be willing to accept lower wage offers, which would lead to expansion of the employment.
  3. An increase in the productivity of labor would bring greater rewards to the employers and induce them to hire more labor at a given wage.
  4. An exogenous decline in price of consumer goods purchased by laborers would increase the real wage and thereby employment. Exogenous means that demand for these goods by non-laborers decreases, causing the price decline.

These factors constitute the classical theory of employment in the sense that the variations in the equilibrium quantity of labor can only be brought about by varying these four factors. Keynes argues for the necessity of radical revision in the classical theory by showing that employment levels following the Great Depression cannot be explained by these factors.

Keynesian theory is going to be built around the rejection of the 2nd Postulate: labor is supplied until the marginal disutility of additional units of labor is exactly offset by the real wage. This means that the fourth possible explanation based on changes in real wages is not valid. The evidence for this is the NON-FUNDAMENTAL argument of Keynes. Laborers react to cuts in nominal wages by going on strike. They do not respond similarly to general increases in the price of consumption goods. It follows that the decision to offer labor is not a function of the real wage.

The Scientific Method: There is a huge amount of confusion regarding the nature of science and the scientific method. See for example, the best-selling, widely used textbook by Chalmers: “What is this thing called science?” for clearing up many widespread myths. Making minimal claims, I would argue that an important aspect of science is the revision of theories to match discordant observations. Contrary to Popper, observations in conflict with theories do not falsify the theory. Rather, they create a puzzle, an anomaly in Kuhn’s terminology. This is a challenge for researchers to find a modification of the theory which will explain the anomaly. If all such attempts fail, or such attempts create a degenerating research program which adds ad-hoc assumptions without explanatory power, to protect core axioms of the theory [Like Ptolemaic astronomy], then situation becomes ripe for a scientific revolution.

The fundamental conflict between classical theory and empirical observation is the existence of involuntary unemployment:

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. Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or in its productivity. Labour is not more truculent in the depression than in the boom; far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis.

Just like observations of elliptical orbits conflict with the circular orbits assumptions of Ptolemy, so the above observation of Keynes conflicts with the standard postulates of economic theory (both pre-Keynesian and modern economics) about the labor market. Once we have an observation in conflict with our fundamental theory of the labor market, we have two options which are routinely used in science.

OPTION 1: (Normal Science) Work on finding ways to explain these conflicting observations while retaining the postulates. The standard explanations for lower equilibrium employment would follow the FOUR possibilities that Keynes has listed. These are all the possibilities available which allow for changes in the volume of employment in a way consistent with the classical postulates of the labor market.  He rejects all of these possible explanations in the paragraph above. Another possibility is that strong unions keep wages above equilibrium; he discusses and rejects this possibility elsewhere. In the above passage, he indicates that Labour is not more truculent in the depression. This does not end the possibilities. It is part of normal science to look at the situation carefully and try to find other ways to create a compatibility between the observed long and persistent unemployment and the postulates.

OPTION 2: (Kuhnian Revolution). Keynes became convinced that the classical postulates for labor market CANNOT be reconciled with the observation of large fluctuations in volume of employment, as well as the observation of different reactions of labor to cuts in wages and rise in price levels. Therefore, he proposes to overthrow the second postulate, while retaining the first one. This really is a revolutionary step, because it amounts to rejecting Supply & Demand theory in the Labor Market. It also amounts to rejecting the efficacy of the free market mechanism in the labor market. These ideas are sacred ideologies – for example, when David Card published research showing that raising minimum wages did not lead to increased unemployment, “It cost me a lot of friends. … (economists) became very angry … They thought that in publishing our work we were being traitors to the cause of economics as a whole.” Keynes is also aware that his revolutionary ideas might anger some people, and lose him some friends:

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. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

(Non)-OPTION 3: (Ostrich Mode) One can try to explain it away, or revise core theories, but the option to ignore, or to assume away, empirical evidence is not available to scientists. Yet this is precisely the route that was followed by macro-economics since the 1970’s. This is why Romer has said that the Chicago School ignored basic principles of science. What Romer fails to realize is that the entire edifice of modern economics is based on an anti-scientific methodology in which validity of statements is determined by authority and reputation, and not by consistency with empirical evidence. The Nobel Prize in 2010 seeks to re-habilitate the “friction” explanation (modernized as search theory) for unemployment, which Keynes rejected because it was obvious that the frictions remained the same while the volume of employment fluctuated. Anti-scientific hostility to empirical evidence was reflected in the response by mainstream journals to my paper “The Empirical Evidence Against  Neoclassical Utility Theory: A Review of the Literature” [with Mehmet Karacuka] International Journal for Pluralism and Economics Education Vol. 3 (4)  2012, p 366-414. This paper provides overwhelming empirical evidence against the vaunted micro-foundations of economics. Referee’s reports from the leading Economics Journals did not say that the paper was wrong, but rather that it was too insulting to economists. Given strong evidence of dramatic conflicts between the models and reality, scientific methodology would demand an urgent search for alternative bases for a theory of consumer behavior, which is at the foundation of all modern economic theory. Instead, a few token behavioral economists are hired to deflect criticism, while homo economicus continues business as usual within mainstream economics departments. Since criticisms of economic methodology conflict with ideological commitments, I have criticized econometric methodology, which is less charged emotionally. In my paper, Methodological Mistakes and Econometric Consequences, I have shown how contemporary methodology of econometrics is based on logical positivist ideas and is deeply flawed.

The upshot of all this is that the Keynesian Revolution was aborted before it got started. Keynes observed that empirical evidence of behavior of laborers conflicts with the standard homo economicus model of rational behavior of laborers; this conflict strikes at the root of modern economic theory. In an extremely ironic twist, instead of accepting his insights, economists rejected Keynesian theory on the very grounds that it is not compatible with rational behavior of laborers – when this incompatibility was the raison d’etre of Keynesian theory.

To continue his analogy, Keynes told the Euclidean geometers that your axioms conflict with observations, so let us drop the parallel postulate, and instead use another axiom which is compatible with what we see around us. The Euclideans rejected this theory on the ground that it lacks “micro-foundations” — meaning that it is not compatible with the Euclidean parallel postulate, which is the foundation of Euclidean thought, and cannot be questioned.

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.

roulettefinancePrior to the Global Financial Crisis (GFC 2007), many senior economists and policy makers expressed confidence that they had finally solved the problem of business cycles, booms and busts, that plagues capitalism. Because of this over-confidence, early warnings of a looming crisis by Nouriel Roubini, Ann Pettifor, Peter Schiff, Steven Keen, Dean Baker, and Raghuram Rajan, were ridiculed and dismissed. Even after the crisis, many economists thought this was a minor glitch, which would soon be remedied. Now however, while conventional economists continue to search for reasons for the mysterious stagnation besetting capitalistic economies, the weak and jobless recovery from the GFC has been labeled as an illusion and a false dawn by Schiff. Like him, deeper analysts are converging on the idea that the problems run deep, and that radical changes in the global financial architecture are required to solve current problems and prevent future crises.

For instance, consider Lord Mervyn King, the Governor of the Bank of England from 2003 to 2013. His experience at the heart of the global financial system led him to the conclusion that   “Of all the many ways of organising banking, the worst is the one we have today. … (can we) think our way through to a better outcome before the next generation is damaged by a future and bigger crisis?” Similarly, Minneapolis Federal Reserve President, Narayana Kocherlakota , after viewing the stark conflicts between the empirical evidence and the macroeconomic theories over the past ten years, writes the economists use “Toy Models” which do not work in face of the complexities of real life

There are two central elements which lie at the core of the fragility of the financial system. The first problem is credit-creation by banks. This means that when banks give loans, they create credit out of thin air. This ability enables corporate raiders to buy multi-billion dollar corporations without any money in their pockets using financial gimmicks. The second problem, closely related to the first one, is the use of interest instead of equity in the lending process. This means that banks can lend for mega-projects designed to fail, because they are guaranteed a return of their money regardless of outcomes. Bankers have successfully created the illusion that they are necessary, so that when borrowers can’t pay back outrageously risky loans, the government re-imburses the banks for their losses. Both of these problems at the heart of the financial system can be fixed, but the ability of high finance to create huge amounts of money at will gives the financiers ample resources to block any attempts at solving the problems. The 1% who benefit from this financial system have created a robust and resilient multidimensional system of defense to protect, preserve, and sustain the current fragile and crisis prone financial architecture. Using billions of dollars of funding, many different institutions, which include academia, media, think tanks, policy makers, regulators, politicians, and the military-corporate-industrial complex, have been co-opted by high finance. In an article entitled “It Takes a Village to Maintain a Dangerous Financial System,” Stanford professor Anat Admati describes how these different institutions work together to maintain and perpetuate the current financial system. In this article, I focus on the how economic theory itself has been captured by the top 1% and changed to serve their interests.

The role of economic theory should have been to clarify and expose the structure of the economic system, so that economists could understand it and make it work better for all. Instead, economic theory has been captured by the financiers and turned into a propaganda machine, which hides the realities of the system. Modern economics textbooks continue to teach myths which are overwhelmingly contradicted by the empirical evidence. In particular, they teach that the quantity of money and the levels of debt do not have any long run effects on the economy. They teach that consumers and businesses can accurately foresee that path of future prices, and of government policy, and plan purchases and investments accordingly. They teach that levels of inequality do not matter because wealth will trickle down. The distinction between needs and wants has been erased from the textbooks. Economists used to be concerned about rentiers – people who earn money without doing any work to deserve it. Current economics textbooks no longer mention the concept. Instead they teach that markets efficiently recognize and reward participants: if you make money, it means that you deserve to make money. This leads to the idea that the more wealthy you are, the greater is your contribution to society. When this myth is combined with the trickle-down myth, it leads to tax cuts for the rich advocated by Trump, and a guiding policy principle in the USA since the Reagan era. Small wonder that ex IMF Chief Economist Olivier Blanchard wrote that modern models used for conduct of monetary policy are based on “assumptions profoundly at odds with what we know about consumers and firms”.

Like Blanchard, economists who have contact with reality have come to recognize the deep flaws in the economic theories used for the conduct of monetary and fiscal policy around the globe. Highly respected economist Paul Romer, recently appointed Chief Economist at the World Bank, has created shock waves among economists by a trenchant critique entitled “The Trouble with Macroeconomics.”  He writes that for more than three decades, macroeconomics has gone backwards, losing knowledge instead of gaining it. Since banks, financiers, money, unemployment, debt, inequality, rentiers, and all other major drivers of the modern economy have been removed from the picture by economists, contemporary macroeconomic models  “attribute fluctuations in aggregate variables to imaginary causal forces .”  Romer notes that economists’ blatant disregard for facts in conflict with their imaginary theories is so extraordinary that it deserves its own label – he suggests “post-real”.   Even though there are formidable obstacles in the path from this imaginary post-real world of economists to reality, humanity urgently needs to find a way, if the bottom 99%, and the planet we live on, is to survive.

Originally published in Express Tribune, Dec 4, 2016. Related materials on the Global Financial Crisis. My author page on LinkedIn Index to my writings: AZPROJECTS. Closely related: Unlearning Economics. 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.

PRELIMINARY REMARKS: Philosopher Hilary Putnam writes in “The Collapse of the Fact/Value Distinction” that there are cases where we can easily and clearly distinguish between facts and values — the objective and the subjective. However, it is wrong to think that we can ALWAYS do so. There are many sentences, especially in economic theories, where the two are “inextricably entangled” .

This is the fourth post in a sequence about Re-Reading Keynes. This post is focused on a single point which has been mentioned,  but perhaps not sufficiently emphasized earlier: the entanglement of the economic system with the economic theories about the system. Our purpose in reading Keynes is not directly to understand Keynesian theory — that is, to assess it as an economic theory in isolation, and whether or not it is valid and useful for contemporary affairs. Rather, we want to co-understand Keynesian theory and the historical context in which it was born. This is an exercise in the application of Polanyi’s methodology, which I described in excruciating detail in my paper published in WEA journal Economic Thought recently:

Asad Zaman (2016) ‘The Methodology of Polanyi’s Great Transformation.’ Economic Thought, 5.1, pp. 44-63.

I must confess that I am not very happy with the paper; I was struggling to formulate the ideas, and could not achieve the clarity that I always try for. It is a difficult read, though it expresses very important ideas — laying out the foundations for a radical new methodology which incorporates political, social and historical elements that have been discarded in conventional methodology for economics. One of the key elements of Polanyi’s methodology is the interaction between theories and history — our history generates our experiences of the world, and this experience in understood in the light of theories we generate to try to understand this experience. This obvious fact was ignored & lost due to the positivist fallacy that facts can be understood directly by themselves. The truth is that they can only be understood within the context of a (theoretical) framework. Once we use theories to understand experience, then these theories are used to shape our responses to this experience, and so these theories directly impact on history — history is shaped by theories, and theories are shaped by history. The two are “inextricably entangled.”

A key mistake of logical positivism is the attempt to separate the objective and the subjective — an idea that we have all swallowed in the course of our education. In fact reality is shaped by a complex interaction of the two. When we taste a fruit, the flavor is determined partly by the objective characteristics of the chemicals in the fruit, but also by the characteristics of the taste buds on our tongues, and ALSO by the interpretative apparatus within our brains which interprets the stimuli coming into the brains. To reduce this complex process to the external and objective characteristics of the fruit would be a great mistake. It is this mistake which is embodied in conventional economic methodology. Economists do not understand that they are very much a part of the economic system. How the economic system operates is STRONGLY influenced by the theories propounded by economists. The economy of communist Russia was created under the influence of Marxist theories, and cannot be understood without understanding Marxist theory. The operation of the US economy is strongly influenced by the dominant economic theories. Quantitative Easing, QE, is a brainchild of Bernanke, based on Friedman’s understanding of the Great Depression. QE has strongly affected economic conditions in the USA and throughout the globe. The observer cannot be detached from the system being observed.  Just taking this one methodological insight from Polanyi on board is sufficient to completely invalidate the current methodological approach used by economists.

I have a 45 minute video lecture on “The Methodology of Polanyi’s Great Transformation” which attempts to explain these methodological ideas in a more user-friendly way. This is linked below:

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.

HOMEPAGE for Re-Reading Keynes. Links to more material on Methodology