Schools of Thought and a Crisis of Conscience Part II

[2nd in a series of posts on economic schools of thought]

Following on from my first post in this series, I’m covering today thoughts on this audiobook:

1. "Struggle Over the Keynesian Heritage: Neoclassical Synthesists vs. the Post Keynesians"

Bear in mind that a 2hr plus audiobook isn’t going to delve very deeply into doctrinaire differences; nor is my understanding of it going to be very complete or meaningful. I’d also point out that the script for this audio was written by Paul Davidson, who is one of the leading figures in Post-Keynesian thought, i.e. you can’t discount bias in the treatment (the Austrian book I listened to was noticeably one-sided). So bear these caveats in mind when reading through the rest of this post.

First some background: the prevailing schools of thought in economics are primarily either New-Classical, which emphasises perfect competition, complete markets and fully adjusting prices, and New-Keynesian, which specifies imperfect markets and “sticky” prices. The “New” attached to these labels reflects the developments in economic modelling after the Lucas Critique, and the subsequent incorporation of microeconomic foundations to mainstream economic models (this distinction isn’t covered in the audiobook by the way). There are some offshoots to these analytical frameworks (notably monetarism), but as a rule these are the two most prominent strands of current economic thought.

What’s truly ironic to me is that despite the Keynesian moniker, New Keynesians and their neo-Keynesian predecessors aren’t really the intellectual descendents of Lord Keynes at all, but rather a bastardised version of neo-classical ideas and some Keynesian ideas in what came to be known as the “neo-classical synthesis”. The term isn’t new to me, but the exposition of the fundamental differences between Keynes ideas (as expounded by the Post-Keynesian school) and classical ideas was.

All that stuff you learn in undergraduate macro about aggregate demand and supply, and Hicks’ prototypical IS-LM model, are really adaptations of some of Keynes’ insights into a neo-classical equilibrium (or Walrasian) framework. I’ve understood this part for some time now, largely due to the writing of Gavin Kennedy at the Adam Smith’s Lost Legacy blog (well worth a visit if you want to understand anything to do with classical economics, and the myth and theology of the “invisible hand”).

But what caught me off guard is that in the Post-Keynesian view, Keynes wasn’t working within an equilibrium framework at all. And he rejected the concept of neutrality of money, or else considered it irrelevant (“In the long run we are all dead”).

I have to digress here and explain what both concepts mean – they’re fundamental to understanding how truly revolutionary Keynes’ ideas really were, and why it differs so much from most of the economic theorising and research of the past two centuries.

You can find a more detailed exposition of what equilibrium means in an economic context on Wikipedia, but generally it’s taken to mean that there are a set of prices where the supply and demand of all goods in an economy converge to a steady state in the long run. Under certain conditions this equilibrium is unique and Pareto-optimal (i.e. you can’t make someone better off without making someone worse off), and the economy has maximised social welfare – if you narrowly define social welfare as maximising utility in the consumption and production of goods. This is often conflated with Say’s Law in it’s modern form – supply creates its own demand (it’s a lot more nuanced in it’s original form). Taken together, that means that a market economy is not only efficient at allocating resources to their best uses, but will also converge in the long run to full employment.

The neutrality of money also follows from Say’s Law in it’s original formulation – people produce goods for the ability to procure other goods. If that is the case, then money doesn’t matter economically except as a medium of exchange, and as a store of value (if you consider intertemporal effects). Hence, you can limit economic models to “real” factors like production and consumption, and ignore their monetary aspects – which has been the basis of classical thought and its antecedents ever since.

Because of Keynes’ influence, the neo-classical synthesis held that money was only neutral in the long run, but not in the short run due to a variety of real world phenomena (fixed contracts, menu costs, etc leading to sticky prices). So monetary policy can only affect real variables in the short run, but this effect will only be temporary. In this view, there still exists a long-run steady state of the economy to which it will converge, which maximises social welfare and employment, but we suffer short term disruptions where government intervention may be desirable.

The Post-Keynesian thought is rather dramatically different – there is no long run, steady state where employment and income/consumption are maximised, and money is not neutral even in the long run. That makes government intervention not only desirable, but necessary – a completely different mindset from what I’m used to or am comfortable with.

In this view, government deficits don’t matter – at least within certain constraints. If you want to see the difference between New Keynesian and Post-Keynesian thought in action, catch this debate between Paul Krugman (NK) and James Galbraith (PK). They agree on short term policy, but are completely at odds in terms of long term policy.

Moreover, the primary policy tool (at least from Davidson’s point of view) under which Post-Keynesian thought attacks the problem of full employment and low inflation is an incomes policy, a social contract between all economic agents to limit income increases and returns from output. Note that this is quite distinct from most historical attempts at incomes policy, which tended to be aimed at maintaining incomes in the face of higher inflation or recession. There’s obviously an incentive problem here – why would you want to limit your income? Sounds like a classic prisoner’s dilemma problem, and moreover turns on its head the allocative efficiency of the market.

I’ll admit that Post-Keynesian thought has some attractions – the micro-foundations of it are highly appealing as being more representative of the real world than orthodox thought has been able to come up with. But the macroeconomic implications of it are tough for me to swallow, at least until I’ve read deeper on the subject than this fairly shallow source can provide.

Technical Notes:

1. Davidson, Paul, "Struggle Over the Keynesian Heritage: Neoclassical Synthesists vs. the Post Keynesians", Narrated by Louis Rukeyser, Blackstone Audio, Inc., 2006