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

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

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

Understanding Macro: The Great Depression

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

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

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

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[shortlink:] 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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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.



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.  …)