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In previous parts of this article (Understanding Macro I & Understanding Macro II), we have described how strict financial regulation and Keynesian prescriptions for full employment brought prosperity for the masses, but reduced corporate profits. This last part describes the successful counter-attack by corporations which reversed this state of affairs, causing a massive rise in the income shares of the wealthy 1% and a decline in the fortunes of the bottom 90%.

In the mid 70’s, when I was studying for my Ph.D. in Economics from Stanford, Keynesian economics ruled the roost; pre-Keynesian free market economics was confined to the Chicago School, and not considered intellectually respectable. This situation was reversed in the 90’s, when the Chicago School became dominant, while Keynesian economics was no longer considered respectable. The multi-dimensional strategy used to create this revolution on the academic front is described by Alkire and Ritchie in “Winning Ideas”, while the global strategy to transform socialistic economies into capitalistic free markets is described by Naomi Klein in The Shock Doctrine: The Rise of Disaster Capitalism. A common thread between the two is the patient preparation of detailed plans, while waiting for a crisis, which provides an opportunity to implement these plans.

The intellectual crisis that Chicago had been waiting for occurred in the early 70’s when the Arab Oil embargo, in retaliation for US support of Israel, led to stagflation in the USA. The simultaneous occurrence of high inflation and high unemployment was said to be in conflict with Keynesian theories, while the Chicago School theory of Milton Friedman was said to provide an explanation for the unexpected phenomena. This became widely accepted, and led to a substantial rise in the prestige of the Chicago School, and a blow to the Keynesians. The 1% capitalized on this by providing funds to Sveriges Riksbank, the Central Bank of Sweden, to create a simulated Nobel Prize for Economics, named the Sveriges Riksbank prize in honor of Alfred Nobel. The Nobel family protests against this appropriation of the prestige of the Nobel Prize were ignored, and the public was fooled into accepting this just like the genuine Nobels. In quick succession, roughly half of all the Nobel prizes were awarded to Chicago economists, interspersed with 50% going to randomly chosen others to create a semblance of neutrality. This led to a rapid rise in the academic prestige of the Chicago school.

The Chicago School lost no time in reversing all of the gains in knowledge made by Keynes. They argued that supply and demand did hold in the labor market, and free markets did eliminate unemployment. Against common-sense as well as Keynes, Chicago School star Robert Lucas argued the unemployment was a free choice. According to Lucas, the Great Depression was actually the Great Vacation, where people chose to abandon jobs in order to enjoy leisure. Eugene Fama created the theory of rational expectations, arguing that people could accurately foresee the future, against Keynesian views to the contrary. Friedman re-instated the Quantity Theory of Money, and argued that there was a natural rate of unemployment, which could not be affected by economic policy, in direct opposition to Keynesian insights. Thus, the Chicago School went back to pre-Keynesian economics, which strongly favors the 1%, and abandoned Keynesian ideas, which are more favorable to the bottom 90%. These theories had a dramatic impact on economic policies and outcome.  Influenced by these monetarist views, many Central Banks abandoned the goal of creating full employment, and instead switched to “inflation targeting” as a goal of monetary policy. Throughout the world, the laboring masses have been losing ground, and there has been an astonishingly rapid increase in the fortunes of the wealthiest 1%.

The Global Financial Crisis (GFC) of 2007 was a great setback for the Chicago School on the theoretical front. It showed clearly that expectations were not rational, that monetary policy had real effects, unemployment could be deep and prolonged, and could be affected by policy. Many avid free-marketeers were forced to reconsider their views. Paul Romer, trained by Lucas at the Chicago School, recently renounced his mentors, and stated that “Macroeconomics has been going backwards for the past several decades.”

In many ways, the GFC is similar to the Great Depression. An unregulated finance industry, created a bubble worth trillions of dollars to make profits at the expense of the masses. The aftermath wiped out lifetime savings of many, and created millions of homeless and hungry. However, there was one major difference.  Unlike the Great Depression, the 1% was well prepared for the Global Financial Crisis. In the decades leading to the GFC, media became increasingly concentrated in the hands of major corporations, as independent sources were purchased or driven out of business. Following the GFC, the public was told that we should not protect the “irresponsible” borrowers who lost their homes. However, it was essential to compensate banks for their trillion dollar losses, in order to keep the system running. All efforts to re-instate the post-Great Depression regulations were successfully resisted in the Congress.

Despite its theoretical bankruptcy, and complete failure to explain the GFC or to offer solutions the Chicago School is deeply entrenched, and retains the upper hand in the academia. There is little sign of change in the syllabi, in response to the GFC, at leading universities all over the globe. The top 1% is well aware of the strong linkage between the academic prestige of Chicago, and the rapidly rising wealth of the extremely wealthy. They are fighting hard to maintain the status quo. They are also making backup plans, introducing schools of heterodoxy which accept many alternative views, while protecting the entrenchment of the wealthy — this is just in case, their reliable and trustworthy workhorse — ET1%: The Economic Theory of top 1% — gets washed away in a wave of protests.  There are many signs that the next financial crisis is on the horizon. If the bottom 90% can manage to get their act together, and create a coherent alternative to the disastrous financial institutional architecture currently in use, they might be able to seize the advantage, using the same shock strategy perfected by Chicago. The other alternative is increasing wealth for the top 1%, and increasing misery for the rest.

Postscript:

For a related post, see “Completing the Circle: From GD ’29 to GFC 2007”. See also, a 90m youtube video-lecture  on “Core Macroeconomic Concepts

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Lectures on First Steps towards Understanding Macroeconomics, on Friday 4th May 2018 in AR Kemal Rm at PIDE, by Dr. Asad Zaman, VC PIDE. 1hr 20m Video Lecture( shorlink: bit.do/azifa)

3100 word summary of lecture:

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My article about the Battle of Methodologies, published in March 2018 issue of NewsLine Magazine:

Because of the universal spread and impact of Western educational systems, necessary for survival in the modern world, we have all learned to view the world through glasses manufactured in Europe. Just as a fish is unaware of the waters in which it swims, so we are unaware of the currents of history which have shaped European thought. Yet to understand the world we live in, and how our perceptions have been shaped by the dominance of West, it is essential to acquire an understanding of how the Western worldview has been radically transformed over the past few centuries. In this brief essay, we will discuss the “Methodenstreit”, the battle of methodologies, which took place in the late nineteenth century. While this is only one piece of the complex and multi-dimensional historical experiences of Europeans, the methodenstreit had a decisive impact on modern social science, which shapes our current understanding of human beings and their social, political and economic lives. The title of the book “How Economics Forgot History” about the methodenstreit by Geoffrey Hodgson accurately describes the impact of this battle on the discipline of Economics. In this battle, the German Historical School, championed by Schmoller and his colleagues, lost to the Austrian School of Menger, who favored a scientific and quantitative approach to economics.

But what is wrong with taking a scientific approach to the formulation and solution of economic problems, the reader might ask. This essay provides an answer to this question. The idea that economics is a “science” is firmly embedded in the foundations of modern economics. This means that economics provides us with a set of laws which have universal applicability across time and space, independent of social, political, geographic, and historic context. In fact, there are no such economic laws. How we organize our economic affairs differs in different societies, and also varies across time. The attempt to create a “scientific” economics resulted in forcing mathematical laws upon human behavior. Over the past few decades, psychologists who study actual human behavior have established that humans do not behave according to these laws. This has resulted in the creation of field of “Behavioral Economics,” and many researchers working in this area have been awarded Nobel Prizes (most recently, Richard Thaler) for discoveries which contradict the laws of behavior still being taught across the globe to students of economic theory. Despite discoveries that human beings are temperamental, driven by diverse and conflicting emotions, and free to make sudden changes in behavior, the scientific methodology of modern economics currently being taught to students across the globe continues to describe human beings as predictable robots subject to mathematical laws. The insights from behavioral economics are so radically in conflict with economic theory, that economists have not been able to assimilate them into the mainstream curriculum.

Similarly, the scientific method leads economists to ignore specific historical events in their vain quest for universal laws which describe economic systems. Essential insights about economics are lost due to this disregard of history.  For example, the two world wars, The Great Depression, The Bretton-Woods agreement, and Nixon’s revocation of gold backing for the dollar are events of central importance for understanding the economics of the twentieth century. However, economists do not study these events since they are particular and specific historical events, which cannot be described using universal scientific laws. On a larger scale, the birth of modern market society can be traced to the industrial revolution, which created possibilities of massive overproduction of goods in 18th century England. This overproduction concentrated a massive amount of wealth and power in the hands of a small group of people, who were able to use favorable historical circumstances to increase their wealth and power by expanding the role and influence of markets to the point that they came to dominate and destroy traditional societies all over the world. The deep insights which emerge upon connecting the historical context with economic theory have been brought out by Karl Polanyi in his magnum opus: “The Great Transformation: The Political and Economic Origins of Our Times.” One of the central themes of Polanyi is the dramatic contrast and opposition between values of traditional societies and the emerging modern market society. Traditional societies organize their economies on principles of redistribution and reciprocity, cooperatively taking care of all members. Furthermore, traditional societies value many characteristics like heroism, generosity, knowledge, spirituality, literature, arts, sports, etc. over and above the possession of wealth. In contrast, wealth becomes the primary marker of status in market societies, and becomes the main object of personal and collective endeavor. Studying the evolution of economic system and the co-evolution of economic theories adapted to the study of these systems in historical context yield deep insights not available using the currently dominant ‘scientific’ methodology.

An important consequence of the opposition between market values and social values is that traditional societies do not and cannot evolve into becoming market societies – this change is always brought about by a revolution, which destroys traditional values and replaces them by anti-thetical values of a market society. This revolution occurs on both the physical and material dimension, and, more importantly for our present essay, it also occurs on the ideological dimension. As Marx realized, capitalism produces laborers conditioned by education, tradition, and habits into thinking of the economy as subject to natural laws, and accepting their own exploitation as a necessary, fair, and just part of the system. Similarly, even though the market society provides enormous amounts of wealth and power for a few select members, expansion of the market into all human affairs requires this minority to create and popularize market ideologies. At the core of market ideologies is the idea that markets are governed by natural laws which provide equitable outcomes to all participants and create maximum wealth for all. This ideology runs counter to traditional ideas about social responsibility for the poor and disadvantaged, and suggests that interfering with market mechanisms will cause harm to everyone.

To understand the “origins of our times,” it is necessary to understand the parallel growth of market institutions which expand the scope and power of the marketplace, and the accompanying market ideologies which counter and negate traditional ideas about social norms. For example, exploiting the possibilities of massive overproduction created by the industrial revolution required the creation of consumers for these products. The globe was occupied by traditional societies which prized self-sufficiency as a virtue, and did not have markets for British goods. The productive capacities of the industrial society created the power to physically take over and colonize weaker societies all over the world. The destruction of local institutions for provision of social welfare, and the harnessing of all factors – labor, land, natural resources – to the global production of capitalist wealth was also accompanied by ideologies promoting the idea that this was the best path for all concerned. In particular, the economic theory of “comparative advantage” was invented to justify the absurd idea that it was in best interest of the colonies to remain engaged in the production of raw materials, leaving England to specialize in the production of industrial manufactures. Since it is easily refuted by empirical evidence, comparative advantage cannot be understood as a “scientific theory”. It can only be understood as a product of historical circumstances, as a part of a collection of theories required to justify the brutal processes of colonization and the accompanying destruction of local economies.

Since ‘comparative advantage’ was a manifestation of political power, effective counters also required political power. In Germany,  Friedrich List created the ‘infant industry argument” to support protectionist policies in Germany and Europe, which allowed European industries to catch up to England. Similarly, the American Revolution allowed the USA to implement protectionist policies which developed strong industries in North America. Colonies which did not have the political power to resist the ideology of comparative advantage remain agricultural economies providing raw materials to advanced economies to this day.  Like all major modern economic theories, comparative advantage can only be understood within its historical context, by seeing how the interests of the powerful imperialists were protected and advanced by the spread of this theory. The theory of free trade, which remains popular and widely believed by economists, is very similar. Wars by European powers against China and Japan were concluding by signing treaties which opened these countries to European goods, creating a market for industrialized European economies. Not only was free trade forced upon them by war, but the ‘theory of free trade’, which says that this was in their best interest, was forced upon them by the corresponding ideological war. It was the ability of China and Japan to resist this ideological war that has led to their economic success today. Similarly, it has been our failure to resist the invasion of ideologies and theories of the economic hit-men that has led to our poor economic performance for several decades.

The most important insight which emerges from studying history, politics, geography, and society in conjunction with economics is the deep inter-connections between all these spheres of human lives, and the impossibility of studying them in isolation. Like all of social science, modern economic theory derives directly from the analysis of economic systems of Western capitalist societies. The victory of the scientific and quantitative school over the German historical school in the battle of the methodologies created the misconception that this analysis is a “science” which is universally valid across time and space, for all societies. This has led to the current situation, where we teach and study capitalist economics relevant to modern European and USA economies but largely irrelevant to our economy, which is structured along different lines. At the same time, we do not study the success stories in patterns of the miraculous growth achieved by China and East Asian economies, which followed radically different policies. Discarding the blinders created by “scientific” pretensions of Western economics would create much-needed skepticism about the applicability of Western economic  theories to our radically different historical and cultural context, and also open our eyes to non-European models for prosperity which offer us substantially greater chances of success.

PostScript: For a more detailed discussion, see Origins of Western Social Sciences

Because of Western dominance, brilliant thinkers from the East get very little attention in global media. Even though brilliant economists from East Asia and China have created globally acknowledged economic miracles in their countries, none of them have received a Nobel Prize. On the other hand, Western economists whose theories were demonstrably in conflict with the events that took place in the global financial crisis — like Lucas, and Fama — have received Nobels. One of our greatest un-sung Eastern Heroes is Mahbubul Haq. My recently published article describes the revolution he created in economic thought:
HDI

Goethe starts his famous East-West Divan with a poem about the journey (Hegire), both physical and spiritual, from the West to the East. In this essay, we consider the analogous journey from Western to Eastern conceptions of development. This involves switching from viewing humans as producers of wealth, to viewing wealth as a producer of human development. To start with the Western conceptions, both Adam Smith and Karl Marx defined economic growth as the process of accumulation of wealth. The range of diversity of Western thought is bounded by the Left-Right spectrum. Ideas on which both extremes agree command widespread consensus in the West. Consequently, a core concept of modern economic theory is that wealth is the means and ends of the process of economic development. Unfortunately, due to the dominance and influence of Western paradigms, this concept has been widely accepted and adopted in the East today.

Mahbubul Haq was indoctrinated into the Western development paradigm which gives primacy to wealth at leading universities, Yale and Harvard. He got the chance to apply these economic models as the chief economist in Pakistan during the ’60s. However, because of his Eastern upbringing and heritage, he was able to see the murderous message at the heart of the cold mathematics of the Solow-Swan growth models. These models focus on savings, created by reducing present levels of consumption, as the only route to the accumulation of greater future wealth.

Mahbubul Haq realised what is not mentioned in the economics textbooks: obsession with production of wealth requires us to use the sordid and cruel tactic of making workers produce wealth, and refusing to allow them to consume it, in order to buy machines and raw materials. He was clear-sighted enough to see the consequences of these policies: wealth did indeed accumulate, but it went into the pockets of the 22 families, without providing relief to the misery of the masses. Today the global application of capitalist growth strategies has led to a dramatic increase in inequalities both inside nations and across nations. Just one among many horrifying inequality statistics is that the top 13 individuals now have more wealth than the bottom 3.5 billion on the planet.

Dissatisfaction with state-of-the-art Western growth theories led Mahbubul Haq to a revolutionary insight, taken from the heart of the traditions of the East, and having no parallels in current Western economic theories. Instead of capital, Mahbubul Haq placed human beings at the centre of the process of economic growth, returning to the ancient wisdom that “human beings are the means and ends of development”. Even though he was called a heretic for going outside the boundaries of contemporary economic thought, the pragmatic genius of Mahbubul Haq sought to minimise differences and create bridges to conventional thinking in order to achieve acceptance for his radically different approach to development.

His Human Development Index (HDI) was a master stroke, combining two inherently incompatible conceptions of development in a compromise which ceded ground to wealth in order to create international visibility for poverty. His friend and classmate Amartya Sen was reluctant to accept the HDI because of certain inherent flaws in this marriage of fire and water, but eventually agreed to its practical necessity. The pragmatic approach of Mahbubul Haq paid off handsomely when the HDI measure achieved global recognition as rectifying major defects in the standard GDP per capita. Widespread acceptance and use of HDI has led to a radical change in the discourse on development, by adding poverty, health, education and other soft social goals to the pure and simple-minded pursuit of wealth. The revolutionary ideas of Mahbubul Haq have led to improvements in the lives of millions, as global consensus developed on the social goals embodied in the MDGs and SDGs.

The Human Development approach of Mahbubul Haq was carried further by Amartya Sen, who defined development as the freedom to develop human capabilities. This notion, closely aligned with Eastern thought, was so alien to orthodox economists that they rejected it. Consequently, a new human-centred field of development studies emerged, which combined many streams of dissent from orthodoxy. Unfortunately, leaders at the helm of policymaking in the poor countries of the world are trained in orthodox economic theories, and have not assimilated the radical lessons of Mahbubul Haq, acquired from bitter experience. The paths to genuine development lie open, but with their backs to the doors, they are unable to see them.

Conventional growth theories create the mindset that the game is all about wealth creation. We will worry about our poor population only after we acquire sufficient wealth to feed them. The poor are a burden on the development process because providing for them takes away from money desperately needed to finance development of infrastructure, purchase of machinery and raw material, and industrialisation. We cannot afford to feed the poor, if we want to grow rapidly. The human development paradigm stands in dramatic contrast to this currently common mindset among planners. Instead of utilising humans to produce wealth, we utilize wealth to develop human capabilities. Our human population, our poor, are our most precious resource. This point of view receives strong support in the empirical findings of a recent World Bank study entitled “Where is the Wealth of Nations?” The study finds that the wealthiest nations are rich because they spend money to develop their human resources, and not because of natural resources.

Thus, instead of being a burden, our poor are our most efficient means to development. If we use available wealth to improve their lives, to empower them, to educate them, and to provide them with the support they need, they can rapidly change the fate of the nation. Furthermore, they are also the end of the development process — that our goal is NOT to produce more and more wealth, a la Adam Smith and Karl Marx — but to ensure that our people lead rich and fulfilling lives. If we use our energies to achieve this goal, we have already arrived at the destination — we do not need to wait for a distant future where sufficient wealth will accumulate to enable us to take good care of our people.

Published in The Express Tribune, May 20th, 2017.

This is an outline of the lecture 3 in Advanced Microeconomics — expands somewhat on the slides available from the link. This should be useful to heterodox economists looking for ways to teach an alternative course, radically different from conventional approaches. First two lectures consisted of some preliminary math, and can be skipped without lack of continuity.  Video of the lecture (90m) is available at the bottom of the post.

Supply & Demand is Central to Economics: This is the modern Theory of Value. The market price determines the value – this is in conflict with classical conceptions of value.

BUT, this theory is WRONG!  The central question in theory of Value is: HOW are prices determined? Why are water and tomatoes cheap, and why are diamonds expensive?

Current answer is the Supply and Demand theory of economics. Classical economists’ answers were  Labor Theory of Value.

Modern Answers are seriously deficient. Classical Schools had substantially more insight into these questions. We will be discussing classical thinking (Adam Smith, Ricardo, Marx, Sraffa) later in the course. This lecture deals with: Failure of Supply & Demand in Labor Market. This failure was the Raison-d’etre of Keynesian Economics

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ideologyinequalityEven though very few people have more than a vague idea about them, macroeconomic theories deeply affect the lives of everybody on the planet. Writings of Piketty, Stiglitz and many others, as well as personal experience of the 1% — 99% divide, have created increasing awareness of the deep and increasing inequalities which characterize modern capitalist economies. However, the link between inequality and macroeconomic theory has not been pointed out clearly. The fact that since the 1970’s top corporate salaries have increased by 1000% while the average worker only earns 11% more is closely linked to the revolution in economic theory that occurred over the 70’s and 80’s. We will try to sketch some parts of the complex and coordinated efforts which led to the emergence of theories which provide the invisible foundations and the enabling environment for this inequality.

The oil crisis of the early 70’s destroyed the consensus on Keynesian macroeconomics, and created the opportunities for ideologies disguised as economic theories to emerge. Chicago school economist Robert Lucas attacked the dominant Keynesian theories which argued that governments must play an important role in eliminating unemployment. Guided by free market ideology, Lucas created macroeconomic theories which suggested that government interventions are always harmful. Some elements of the Lucasian methodology provided genuinely superior alternatives to defects in existing Keynesian models. However, other elements were bizarre. Even though unemployment is a painful reality to vast numbers of people, defender-of-free-markets Lucas argued that this was a free choice. According to Lucas, the Great Depression was really the Great Vacation, where vast numbers of people suddenly decided to stop working in order to enjoy leisure. This, and many other strange assumptions of the Lucasian alternative led famous economists like Robert Solow to say that to engage in a serious discussion with the Chicago school would be analogous to discussing technicalities of the Battle of Austerlitz with a madman who claimed to be Napoleon Bonaparte. For example, Solow wrote that “Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.”

Recent remarks of eminent economist Paul Romer, a student of Lucas, regarding the dramatic failures of contemporary macroeconomic models have generated shock waves which continue to reverberate among economists. Romer wistfully suggests that if Solow had engaged with the Chicago school, instead of subjecting them to sarcasm, contempt and ridicule, they might have been amenable to reason. Lucas, Sargent, and their followers responded to hostile attacks by closing ranks, ignoring all who disagreed with them, and giving up on basic scientific principles such as using evidence to evaluate models.  Even though Romer criticizes Solow for ridiculing Lucas, he also finds it difficult to take the macroeconomic theories of Lucas and Sargent seriously. Since these models remove essential real factors like money and unemployment from the picture, Romer writes that modern macroeconomic models are reduced to using mythical objects like phlogiston and gremlins to explain real world economic events. What is frightening about this is that these models, which have been blamed for their inability to see the looming global financial crisis, continue to be used by Central Banks for monetary policy decisions throughout the world.

The mystery of how ludicrous theories which invoke mythical objects and causes, came to dominate the scene is not easily resolved. One important element in the success of the Chicago School was their lack of scruples. Stigler, one of leaders of free market thought at the Chicago School, explained that “… new economic theories are introduced by the technique of the huckster” (a door-to-door peddler who sells fake items as if they were genuine}. He defended this intellectual fraud on the grounds that a warrior against ignorance must subordinate the lesser truths to his quest to spread the grand truth. The grand truth, or the ideological conviction, that governments must not intervene in free markets guided the development of modern macroeconomics at the hands of Lucas, Sargent and Prescott. Ideological convictions of the Chicago School are impervious to facts – they ignore the long lines of the unemployed at the soup kitchens, and the strong empirical evidence of correlations between tight monetary policies and high unemployment.

A second crucial element was the creation of an artificial Nobel Prize in economics. Private financiers and bankers who stood to gain massively from the spread of free market theories of the Chicago School decided to purchase respectability for them. The bankers donated funds to create a prize in Economics in 1968 which was deceptively and fraudulently named after Alfred Nobel: “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”. The conditions and methods for granting the prize were made to resemble the genuine Nobel prizes sufficiently to deceive the masses into thinking that this was one of the genuine Nobel prizes. After creating an imitation Nobel prize, the Swedish bank proceed to award about half of all of them to Chicago School economists, giving half to assorted others to maintain a semblance of objectivity. This has resulted in a tremendous rise in the prestige of Chicago school doctrines, catapulting them from an eccentric minority to the entrenched and dominant orthodoxy in economics.

This intellectual revolution, the displacement of Keynesian economics by the Chicago School, has been used to justify economic policies to enrich the wealthy, and caused massive damage to the general public. As policies based on free market theories have been enacted globally, wealth has concentrated in the hands of the top 1%, while the fortunes of the bottom 90% have been declining. Seeing that the economic system in place has led to reduction in job opportunities and incomes, and rising costs of necessities like education and health facilities, the bottom 90% have expressed their discontent and desire for radical change in the form of Brexit and Trump. However, fundamental change requires addressing the root cause of the problem, replacing defective ideology based macroeconomic theories with more empirical and evidence based theories.

Published Express Tribune, 9 Jan 2107. My author page on LinkedIn. Other works: Index .Related articles: Economic Theory Creates our World and our Worldview. The Fairy Tale of GNP per Capita.

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.