WEBVTT NOTE Keynesians and Neo-Keynesians 1 00:00:00.000 --> 00:00:05.200 If there had been no Great Depression in the 30s, there would have been no Keynesian Revolution. 2 00:00:05.200 --> 00:00:09.740 The world of economists was thrown into a state of crisis as a result of the economic 3 00:00:09.740 --> 00:00:10.740 collapse of that time. 4 00:00:10.740 --> 00:00:15.000 The prevailing paradigm of English neoclassical economics was better suited for the analysis 5 00:00:15.000 --> 00:00:19.760 of long-term problems of economic growth rather than problems of discoordination. 6 00:00:19.760 --> 00:00:23.960 In today's conventional wisdom, it is customary to assert that the analysis of the English 7 00:00:23.960 --> 00:00:30.680 This neoclassical school led to the conclusion that recessions could not occur. 8 00:00:30.680 --> 00:00:35.240 Know this to be gross oversimplification, but it is not at all unfair to claim that 9 00:00:35.240 --> 00:00:41.020 the prevailing orthodoxy of the English neoclassical school established a thought framework that 10 00:00:41.020 --> 00:00:46.820 was incompatible with disturbances other than those of short duration, wherein self-correcting 11 00:00:46.820 --> 00:00:50.080 mechanisms would quickly be apparent and effective. 12 00:00:50.080 --> 00:00:55.760 The depression of the 1930s did not cause a crisis for theory because it was severe. 13 00:00:55.760 --> 00:01:01.040 The crisis arose because the contraction appeared to exhibit no self-correcting tendencies. 14 00:01:01.040 --> 00:01:05.140 In short, the economies of Europe and America were not only depressed, but appeared to be 15 00:01:05.140 --> 00:01:08.660 in a state of equilibrium to the economists of that day. 16 00:01:08.660 --> 00:01:12.480 This appearance of equilibrium was what created the dissonance between the apparent state 17 00:01:12.480 --> 00:01:17.920 of the world and perceptions engendered by the prevailing orthodoxy. 18 00:01:17.920 --> 00:01:24.920 Keynes and those who listened to them were in search of an explanation of how such a collapse could take place and what could be done about it. 19 00:01:24.920 --> 00:01:36.920 Keynes offered such an explanation, but more importantly, the analytical apparatus that he offered led to some simple and direct conclusions as to what could be done in the way of collective action to remedy the depression. 20 00:01:36.920 --> 00:01:42.920 After a while, the Keynesian vision of the way in which an economy functions became the prevailing orthodoxy. 21 00:01:42.920 --> 00:01:59.920 Over the succeeding five decades, the depression economics of Keynes has created an unconscious depression myopia that has constrained the abilities of mainstream economists in their analyses of the workings of the economy and it has led to substantial failures of misguided policies. 22 00:01:59.920 --> 00:02:07.920 Just as Keynes once envisioned himself as trying to free economists from what he saw as the intellectual straight jacket of the pre-Keynesian worldview, 23 00:02:07.920 --> 00:02:12.400 Econimists are now faced with the necessity of unshackling themselves from a Keynesian 24 00:02:12.400 --> 00:02:17.080 world view that is unsuited to the analysis of the functioning of the real world economy 25 00:02:17.080 --> 00:02:23.280 in which we live. Granted that the Great Depression was the event that spawned the Keynesian world 26 00:02:23.280 --> 00:02:28.280 view, the ascendancy of Keynesian economics was by no means inevitable. The early twentieth 27 00:02:28.280 --> 00:02:33.480 century development of what we now call macroeconomics in the hands of the Austrian School, most 28 00:02:33.480 --> 00:02:39.040 Those particularly, Ludwig von Mises and later Friedrich Hayek, provided an analytical apparatus 29 00:02:39.040 --> 00:02:43.120 that could have been the source of answers for which the profession was searching. This 30 00:02:43.120 --> 00:02:49.340 outcome might have come to pass, one can speculate, had Anglo-Saxon economics not evolved so much 31 00:02:49.340 --> 00:02:53.360 in isolation from the very rich development of the Austrian tradition, particularly with 32 00:02:53.360 --> 00:02:58.120 respect to capital theory. It is indeed the case that most students of economics of the 33 00:02:58.120 --> 00:03:05.280 in the last four decades are unaware of what John Hicks reminds us, that in the early 1930s, 34 00:03:05.280 --> 00:03:10.840 the new theory of Hayek rivaled the new theory of Keynes, and that it was by no means clear 35 00:03:10.840 --> 00:03:16.160 which perspective would prevail. Of course, Austrian cycle theory was a lot newer to British 36 00:03:16.160 --> 00:03:21.320 economists than to European economists. Whereas much of Keynes' theory was slapped together 37 00:03:21.320 --> 00:03:26.160 in response to the economic collapse, the theories of Mises and Hayek, as elucidated 38 00:03:26.160 --> 00:03:30.880 during the 1920s were built upon the earlier works of Wichsel and Boehm-Bawerk and were 39 00:03:30.880 --> 00:03:36.300 capable of predicting the collapse of the 1930s before the fact. Even Keynesian economists 40 00:03:36.300 --> 00:03:41.080 must admit that the theory of Keynes can at best explain why a depressed economy cannot 41 00:03:41.080 --> 00:03:46.080 recover quickly, but cannot even pretend to explain why the collapse of aggregate demand 42 00:03:46.080 --> 00:03:51.780 takes place. Explaining a depression by a collapse of aggregate demand is to use a depression 43 00:03:51.780 --> 00:03:57.260 to explain a depression. It is very circular type of reasoning. Resort to speculative market 44 00:03:57.260 --> 00:04:05.260 collapses and animal spirits is an intellectual refuge. Ironically, the epicentricity of Anglo-Saxon 45 00:04:05.260 --> 00:04:10.540 economics rendered the simplistic Keynesian mechanisms easier to understand for economists 46 00:04:10.540 --> 00:04:16.140 reared in the Marcellian tradition than the richer, much more complete Austrian analysis, 47 00:04:16.140 --> 00:04:21.300 despite the fact that Austrian analysis was much more consistent with the basic microeconomic 48 00:04:21.300 --> 00:04:26.620 Principles that form the basis of pre-Keynesian neoclassical economics. 49 00:04:26.620 --> 00:04:30.660 That the lack of familiarity with the Austrian mode of analysis made the contest difficult 50 00:04:30.660 --> 00:04:35.980 for Hayek seems clear, but the most important reason for the eventual prevalence of the 51 00:04:35.980 --> 00:04:38.900 Keynesian perspective is more fundamental. 52 00:04:38.900 --> 00:04:43.980 The psychological trauma associated with the collapse led to an intense desire for a policy 53 00:04:43.980 --> 00:04:48.340 prescription, a collective action that would end the depression. 54 00:04:48.340 --> 00:04:54.820 Office and politicians intensely wanted intellectual support for their desire to direct the economy. 55 00:04:54.820 --> 00:05:00.940 Keynes provided the academic respectability to governmental actions such as the New Deal 56 00:05:00.940 --> 00:05:05.520 that were already underway and that office holders would have wanted with or without 57 00:05:05.520 --> 00:05:11.420 academic respectability. Austrian cycle theory could not possibly rationalize Keynesian-type 58 00:05:11.420 --> 00:05:18.300 Policy Prescriptions. As Schumpeter put it, there cannot be any doubt that it, that is 59 00:05:18.300 --> 00:05:24.580 the general theory, owed its victorious career primarily to the fact that its argument implemented 60 00:05:24.580 --> 00:05:31.180 some of the strongest political preferences of a large number of modern economists. Politically, 61 00:05:31.180 --> 00:05:37.140 Hayek swam against the stream. The contention, such as Schumpeter's, that there is a demand 62 00:05:37.140 --> 00:05:41.780 for Keynesian Theory that is derived from a demand for Keynesian conclusions is an important 63 00:05:41.780 --> 00:05:46.780 one. It is important not only as an explanation of how Keynesianism came into its original 64 00:05:46.780 --> 00:05:51.820 dominating position, but also as an explanation of much of the subsequent history of twists 65 00:05:51.820 --> 00:05:56.260 and turns in the development of Keynesian reasoning. It is particularly important in 66 00:05:56.260 --> 00:06:01.140 explaining the reaction of Keynesian economists to their own intellectual crisis during the 67 00:06:01.140 --> 00:06:07.060 1970s and 80s, and that reaction is at the core of much of what follows in this assessment. 68 00:06:07.060 --> 00:06:12.780 In Keynes, Keynesian economics developed along two lines that although linked by a common 69 00:06:12.780 --> 00:06:18.260 ancestry to Keynes, have evolved so distinctly as to be incompatible with one another. One 70 00:06:18.260 --> 00:06:22.980 of these is the school that in time came to label itself post-Keynesian. Because that 71 00:06:22.980 --> 00:06:28.100 school of thought essentially rejects marginalism, its evolution has been cut off and isolated 72 00:06:28.100 --> 00:06:32.700 from virtually all of the rest of subsequent development of economic thought, as the acceptance 73 00:06:32.700 --> 00:06:41.700 The second line of development is that which most American students of economics are familiar. 74 00:06:41.700 --> 00:06:46.540 As that second line of development emerged, different labels were attached to it as it 75 00:06:46.540 --> 00:06:52.940 went through various phases. Stemming from Hick's development of the ISLM analysis, 76 00:06:52.940 --> 00:06:58.820 the second line has sometimes been labeled neoclassical, other times as bastard Keynesian. 77 00:06:58.820 --> 00:07:04.400 I would prefer to use the label Orthodox Keynesian to distinguish it from the most recent evolutionary 78 00:07:04.400 --> 00:07:10.420 strain of Keynesian economics to which the label Neo-Keynesian or New-Keynesian applies. 79 00:07:10.420 --> 00:07:16.580 The Orthodox Keynesian approach is characterized by an adherence to the ISLM apparatus, an 80 00:07:16.580 --> 00:07:22.080 inflation-unemployment trade-off, i.e. the Phillips curve, and an intertemporally persistent 81 00:07:22.080 --> 00:07:27.460 structure of the economy that permits the use of monetary and fiscal policies as devices 82 00:07:27.460 --> 00:07:34.140 for Stabilizing or Fine-Tuning the Economy. Orthodox Keynesianism is also associated with 83 00:07:34.140 --> 00:07:38.740 the notion of quantity adjustments and thus income as the principal equilibrating mechanism 84 00:07:38.740 --> 00:07:45.620 of the economy. More importantly, it is associated with the potentiality of a macroeconomic equilibrium 85 00:07:45.620 --> 00:07:50.700 of less than full employment. A distinction needs to be made between Orthodox Keynesianism 86 00:07:50.700 --> 00:07:56.460 and the Neo-Keynesian school now emerging as the dominant strain. The essential distinction 87 00:07:56.460 --> 00:08:01.980 is that while the neo-Keynesian school maintains an essentially Keynesian flavor, it is very 88 00:08:01.980 --> 00:08:06.840 much influenced by the challenge raised in the 1970s by the rational expectations or 89 00:08:06.840 --> 00:08:15.220 new classical critique of orthodox Keynesianism. At one and the same time, neo-Keynesian analysis 90 00:08:15.220 --> 00:08:22.020 incorporates some aspects and reacts against other aspects of the new classical economics. 91 00:08:22.020 --> 00:08:27.420 For example, the neo-Keynesians accept the long-run non-exploitability of an inflation 92 00:08:27.420 --> 00:08:32.020 unemployment trade-off, unlike earlier Keynesians. 93 00:08:32.020 --> 00:08:37.180 On the other hand, despite its influence by the rational expectation school, neo-Keynesian 94 00:08:37.180 --> 00:08:42.820 analysis maintains a stabilizing role for monetary and fiscal policy. 95 00:08:42.820 --> 00:08:49.940 It is probably safe to say that orthodox Keynesianism is in a state of eclipse, but that the Keynesian 96 00:08:49.940 --> 00:08:55.300 and policy conclusions have re-emerged through the neo-Keynesian response to the intellectual 97 00:08:55.300 --> 00:09:01.140 demise of orthodox Keynesian analysis. However, there's an obvious geographic dimension to 98 00:09:01.140 --> 00:09:07.180 the current state of Keynesian economics. Post-Keynesian method seems to dominate as 99 00:09:07.180 --> 00:09:12.380 it has for some time in Great Britain and to a degree in Europe, whereas neo-Keynesianism 100 00:09:12.380 --> 00:09:17.540 is developing almost entirely in the United States. To be sure, there are American adherents 101 00:09:17.540 --> 00:09:24.740 to the post-Keynesian paradigm. Eichner and Galbraith are obvious examples, but their influence 102 00:09:24.740 --> 00:09:30.060 among academicians is quite small on this side of the Atlantic. I suspect that one reason 103 00:09:30.060 --> 00:09:35.020 for this geographically based difference has to do with the fact that post-Keynesian analysis 104 00:09:35.020 --> 00:09:40.420 revolves around the distribution of income, and European economists, the British in particular, 105 00:09:40.420 --> 00:09:46.180 seem always to be obsessively concerned with distributional issues. At least in technical 106 00:09:46.180 --> 00:09:51.760 Analysis, Efficiency is the primary focus of neo-Keynesian economists. While the most 107 00:09:51.760 --> 00:09:57.720 modern of neo-Keynesians rejects the standard ISLM apparatus, it is clear that the primary 108 00:09:57.720 --> 00:10:04.160 agenda of neo-Keynesian economists is to rationalize some of the ad hoc mechanisms of more primitive 109 00:10:04.160 --> 00:10:10.800 Keynesian forms in order to preserve the major policy conclusions. The earlier Keynesian 110 00:10:10.800 --> 00:10:16.120 chain of logic was most vulnerable in its analysis of the labor market wherein workers 111 00:10:16.120 --> 00:10:41.360 The post-Keynesian solution was to deny the existence of a labor market, but the neo-Keynesian 112 00:10:41.360 --> 00:10:47.160 and Solution is to try to portray the appearance of sticky wages and other Keynesian aspects 113 00:10:47.160 --> 00:10:53.360 of the labor market as the result of individual optimizing behavior which is nonetheless inconsistent 114 00:10:53.360 --> 00:10:59.440 with a social optimal, in other words, full employment. In other words, it is the outcome 115 00:10:59.440 --> 00:11:04.840 of a market failure and market failure always provides the statist with all the justification 116 00:11:04.840 --> 00:11:08.440 that he deems necessary for government intervention. 117 00:11:08.440 --> 00:11:15.080 The identification of acceptance of the ISLM apparatus with Orthodox Keynesians but not 118 00:11:15.080 --> 00:11:24.080 with the most recent collection of Neo-Keynesians is, I believe, correct but potentially confusing. 119 00:11:24.080 --> 00:11:31.080 The ISLM apparatus was accepted by Friedman and like-minded monetarists after all, but 120 00:11:31.080 --> 00:11:36.400 it was thoroughly rejected by the new classical economists. It is just as thoroughly rejected 121 00:11:36.400 --> 00:11:39.040 by Post-Keynesians. 122 00:11:39.040 --> 00:11:43.560 For someone wanting a way out of this taxonomical confusion, I recommend the book by Warren 123 00:11:43.560 --> 00:11:44.560 Young. 124 00:11:44.560 --> 00:11:49.440 Besides, I don't want to trespass too far into the territory that has been assigned 125 00:11:49.440 --> 00:11:51.080 to others in this symposium. 126 00:11:51.080 --> 00:11:55.440 A bit more trespass is necessary, though, in order to complete the historical setting 127 00:11:55.440 --> 00:12:00.020 of the present state of the Keynesian episode, which for now has come to reside in the schools 128 00:12:00.020 --> 00:12:04.240 of post-Keynesian and neo-Keynesian economics. 129 00:12:04.240 --> 00:12:09.960 For this purpose, I find the classification of each of the five decades since the general 130 00:12:09.960 --> 00:12:15.200 theory by Peter Sinclair to be highly useful, though I interpret much of the historical 131 00:12:15.200 --> 00:12:23.280 detail differently. Sinclair labels the first decade after Keynes, that is 1936 to 1946, 132 00:12:23.280 --> 00:12:28.880 as the decade of distilling. This is the decade of the mechanization of the Keynesian model 133 00:12:28.880 --> 00:12:35.080 in the mislabeled neoclassical synthesis that produced the ISLM apparatus as the main tool 134 00:12:35.080 --> 00:12:42.440 of analysis of orthodox Keynesianism. The years 1946 to 56 are identified as the decade 135 00:12:42.440 --> 00:12:48.600 of data and dispute. Much of what went on during this decade dealt with the empirical 136 00:12:48.600 --> 00:12:55.160 realization that the Keynesian consumption function could not hold as a long-run proposition. 137 00:12:55.160 --> 00:13:00.400 Eusenberry's Relative Income Hypothesis, Modigliani's Life Cycle Hypothesis, and Friedman's Permanent 138 00:13:00.400 --> 00:13:05.940 Income Hypothesis all emerged as alternatives to the primitive Keynesian consumption function, 139 00:13:05.940 --> 00:13:09.720 although Friedman did the best job of reconciling the short-run Keynesian function with the 140 00:13:09.720 --> 00:13:15.440 statistical relative constancy of the long-run average propensity to consume. 141 00:13:15.440 --> 00:13:19.700 None of this caused any crisis for Keynesian economics, although it did bury the stagnation 142 00:13:19.700 --> 00:13:25.080 thesis of Alvin Hansen, which thesis took the Keynesian consumption function as a 143 00:13:25.080 --> 00:13:30.400 as a serious long-term proposition. Otherwise, these developments were seen as refinements 144 00:13:30.400 --> 00:13:35.560 of the basic Keynesian model. And to this day, macroeconomic textbooks tend to employ 145 00:13:35.560 --> 00:13:40.080 the primitive Keynesian consumption function in their expositions, relegating Friedman, 146 00:13:40.080 --> 00:13:46.740 Modigliani and Duesenberry to separate and quite separable chapters or appendices. 147 00:13:46.740 --> 00:13:54.680 The next decade, that is 1956-66, is labeled by Sinclair as the Decade of Dynamics. It 148 00:13:54.680 --> 00:14:00.040 It is this decade that Keynesian economics begins a process of mutation, one eventually 149 00:14:00.040 --> 00:14:04.520 leading in the post-Keynesian and the other in the neo-Keynesian direction. 150 00:14:04.520 --> 00:14:10.080 Solow's so-called neoclassical growth model brought relative factor prices into play and 151 00:14:10.080 --> 00:14:14.680 gave a place for capital labor substitution within a one-sector model. 152 00:14:14.680 --> 00:14:21.000 In significant contradistinction to Austrian capital theory, capital was treated as homogeneous, 153 00:14:21.000 --> 00:14:22.480 much as it was by Knight. 154 00:14:22.480 --> 00:14:29.480 Knight, however, did not conceive of an aggregate production function, which in Austrian analysis is a logical impossibility. 155 00:14:29.480 --> 00:14:36.480 Impossible or not, the aggregate production function has become a mainstay of mainstream dynamic economics. 156 00:14:36.480 --> 00:14:43.480 They developed another strain of growth models in the Cambridge-England tradition that formed the basis of post-Keynesian dynamics. 157 00:14:43.480 --> 00:14:49.480 These include the models of Kaldor and others who share a common ancestry going back to Kalecki. 158 00:14:49.480 --> 00:14:59.480 Issuing any role for substitution, these models are driven entirely by income effects and they render determinate the distribution of income between the owners of capital and labor. 159 00:14:59.480 --> 00:15:09.480 The absence of substitution effects from these models makes the concept of an aggregate production function meaningless in post-Keynesian analysis, and post-Keynesians have remained true to this concept. 160 00:15:09.480 --> 00:15:17.480 But the rejection of the concept of an aggregate production function is based on the alleged nonexistence of factor markets, as conventionally perceived, 161 00:15:17.480 --> 00:15:28.480 not on problems of aggregation over homogeneous capital goods, which problems form part of the basis for the Austrian rejection of an aggregate production function. 162 00:15:28.480 --> 00:15:39.480 In any event, this is the decade in which Keynesian economics splits into mutually contradictory paradigms and which has produced a distinction today between post-Keynesians and neo-Keynesians. 163 00:15:39.480 --> 00:15:48.380 The ten years of 1966-76 are labeled by Sinclair as the decade of disillusion. The disillusion 164 00:15:48.380 --> 00:15:52.760 stems from the inability of the orthodox Keynesian model to explain what was going on in the 165 00:15:52.760 --> 00:15:58.100 world at the time. The most primitive Keynesian models assumed fixed prices, hence the models 166 00:15:58.100 --> 00:16:02.920 were inapplicable to questions about inflation, accepted full employment, beyond which the 167 00:16:02.920 --> 00:16:08.360 so-called classical model involving a crude quantity theory of prices held as a so-called 168 00:16:08.360 --> 00:16:15.240 Special Case. The introduction of the Phillips curve in the early 60s, at first as a Deus ex machina, 169 00:16:15.240 --> 00:16:20.720 supposedly provided the missing link between the real sector and the price level. In time, 170 00:16:20.720 --> 00:16:25.720 Phillips-type phenomena were incorporated into the most sophisticated Keynesian-based econometric 171 00:16:25.720 --> 00:16:31.200 models, some of which ran into hundreds of equations. Even with the assistance of the 172 00:16:31.200 --> 00:16:36.440 Phillips curve, however, the existent varieties of orthodox Keynesian models were utterly 173 00:16:36.440 --> 00:17:05.440 The Uncompatibility with Stagflation was perhaps the key issue leading to the crisis for Keynesian orthodoxy and the demise of its mechanistic worldview. 174 00:17:05.440 --> 00:17:14.440 The seeds of this intellectual crisis were sown by Milton Friedman's well-known presidential address, in which he described the transitory nature of the Phillips curve. 175 00:17:14.440 --> 00:17:24.440 His depiction of labor market processes argued that money illusion, the key ingredient in Cain's weakest link, was a disequilibrium phenomena, 176 00:17:24.440 --> 00:17:30.440 the effects of which would dissipate so that in the long run there could be no inflation-unemployment trade-off. 177 00:17:30.440 --> 00:17:35.200 Now there were several responses among mainstream economists to the intellectual crises associated 178 00:17:35.200 --> 00:17:40.560 with the demise of orthodox Keynesianism. One response was a growing popularity of post-Keynesian 179 00:17:40.560 --> 00:17:45.500 economics. In many respects, this response was a return to the most primitive version 180 00:17:45.500 --> 00:17:51.360 of Keynesian economics, wherein output determination is the subject of economic analysis, but money 181 00:17:51.360 --> 00:17:57.000 wage and price level movements are seen as sociologically determined in a tussle over 182 00:17:57.000 --> 00:17:59.000 for the Distribution of Income. 183 00:17:59.000 --> 00:18:01.000 Hence, the crisis in Keynesian theory 184 00:18:01.000 --> 00:18:04.000 over the incompatibility of rising inflation 185 00:18:04.000 --> 00:18:07.000 coupled, at least sometimes, with rising unemployment 186 00:18:07.000 --> 00:18:10.000 was resolved by in effect ignoring it 187 00:18:10.000 --> 00:18:12.000 through seeking refuge in what is really 188 00:18:12.000 --> 00:18:14.000 a non-economic theory of inflation. 189 00:18:14.000 --> 00:18:17.000 The most dramatic mainstream response to the crisis 190 00:18:17.000 --> 00:18:19.000 in Keynesian economics was the development 191 00:18:19.000 --> 00:18:23.000 of the rational expectations approach to macroeconomics. 192 00:18:23.000 --> 00:18:26.000 In the hands of Lucas, Sargent and Wallace, Barrow and others, 193 00:18:26.000 --> 00:18:30.360 and others, the rational expectation story was at one and the same time a critique of 194 00:18:30.360 --> 00:18:35.280 orthodox Keynesian reasoning as well as an alternative to it. The grounds on which the 195 00:18:35.280 --> 00:18:41.080 early rational expectations proponents criticized orthodox Keynesian models were quite sound. 196 00:18:41.080 --> 00:18:48.080 In its simplest form, their argument was that Keynesian models, particularly Keynesian policy 197 00:18:48.080 --> 00:18:54.120 conclusions, were based on the illogical proposition that economic agents, in reacting to fiscal 198 00:18:54.120 --> 00:18:59.640 and Monetary Variable Changes will make systematic errors. Rather than learning from the experience 199 00:18:59.640 --> 00:19:04.120 of past policy, they will react the same way each time to say counter-cyclical changes 200 00:19:04.120 --> 00:19:08.920 in the money supply. It would be impossible to gauge the amount of stimulus or restraint 201 00:19:08.920 --> 00:19:15.080 needed in a given situation if agents react differently with learning, but orthodox Keynesian 202 00:19:15.080 --> 00:19:20.980 models, even the most complicated, were based on assumptions of an intertemporally stable 203 00:19:20.980 --> 00:19:23.980 School, behavioral structure of the economy. 204 00:19:23.980 --> 00:19:28.740 As Roger Garrison and I have pointed out elsewhere, this basic truth of the Rational Expectation 205 00:19:28.740 --> 00:19:33.620 School was anticipated by Mises as early as 1953. 206 00:19:33.620 --> 00:19:38.220 The response of Orthodox Keynesian economists during the decade of disillusion was essentially 207 00:19:38.220 --> 00:19:39.900 defensive. 208 00:19:39.900 --> 00:19:44.700 The presidential address of Franco Medigliani, presented at the end of that decade, is a 209 00:19:44.700 --> 00:19:47.800 good example of that response. 210 00:19:47.800 --> 00:19:54.640 The best way to get the flavor of the response of the established Orthodox Keynesians is 211 00:19:54.640 --> 00:20:00.680 to read the sections on Tobin and Solow in our Joe Klamers' conversations with economists. 212 00:20:00.680 --> 00:20:06.280 What comes across quite clearly in that is a belief on their part that the rational expectations 213 00:20:06.280 --> 00:20:12.480 or new classical approach is entirely too abstract and over-mathematically formalized, 214 00:20:12.480 --> 00:20:15.800 but highly unrealistic in its basic assumptions. 215 00:20:15.800 --> 00:20:21.240 Allegedly, it is the mathematical elegance of the new classical economists that accounts 216 00:20:21.240 --> 00:20:26.280 for their widespread appeal to the mainstream of technically trained young economists. 217 00:20:26.280 --> 00:20:29.960 This observation is entirely correct, but how ironic it is. 218 00:20:29.960 --> 00:20:34.480 The cult of admiration of economic models for their mathematical elegance, after all, 219 00:20:34.480 --> 00:20:38.240 is the product of the so-called Keynesian Revolution. 220 00:20:38.240 --> 00:20:43.000 Rivals to Keynesian orthodoxy have always been scuffed at because they lacked such mathematical 221 00:20:43.000 --> 00:20:44.500 rigor. 222 00:20:44.500 --> 00:20:49.100 It seems now that orthodox Keynesianism has died upon the sword by which it once lived. 223 00:20:49.100 --> 00:20:54.260 To Austrian economists, of course, the irony is hardly comforting. The rational expectation 224 00:20:54.260 --> 00:20:59.100 school may have beaten the orthodox Keynesians at their own game, but the game was not worth 225 00:20:59.100 --> 00:21:04.540 playing. Moreover, the game itself is a distraction from the serious task of building an understanding 226 00:21:04.540 --> 00:21:10.060 of economic events. Sinclair labels his last period, which I believe can be extended to 227 00:21:10.060 --> 00:21:14.060 The Decade of Debt, Doubt and Deflation 228 00:21:14.060 --> 00:21:21.060 I'm not here concerned with the debt or deflation aspects, and in any event, disinflation would have been a more appropriate term. 229 00:21:21.060 --> 00:21:28.060 The doubt to which Sinclair refers is the exceedingly unsettled state of affairs in macroeconomic analysis, 230 00:21:28.060 --> 00:21:33.060 particularly the present disagreements between the new classical and neo-Keynesian economists. 231 00:21:33.060 --> 00:21:37.880 Economists. This last period is also characterized by the coalescence of the 232 00:21:37.880 --> 00:21:43.440 Neo-Keynesian, or as its adherents like to label it, New Keynesian school. 233 00:21:43.440 --> 00:21:48.660 Neo-Keynesians, particularly during the 1980s, have not been content to 234 00:21:48.660 --> 00:21:53.700 defensively react to the new classicals, but have in a sense gone on the 235 00:21:53.700 --> 00:21:58.020 offensive. They have incorporated what they can of the rational expectations 236 00:21:58.020 --> 00:22:02.180 perspective, and they have attempted to derive from individual maximization, the 237 00:22:02.180 --> 00:22:07.180 and behavioral postulates that were just ad hoc mechanisms in Keynes. 238 00:22:07.180 --> 00:22:14.180 Most significantly, they have directly confronted the policy and effectiveness conclusion of the new classical economists. 239 00:22:14.180 --> 00:22:19.180 So at present, the Keynesian paradigm no longer commands the adherence that it once did. 240 00:22:19.180 --> 00:22:24.180 And that paradigm is now represented by two schools, post-Keynesian and neo-Keynesian, 241 00:22:24.180 --> 00:22:28.180 which are analytically distinct from one another and from Keynes. 242 00:22:28.180 --> 00:22:34.880 However, these two subspecies of Keynesianism, like their predecessor species, continue to 243 00:22:34.880 --> 00:22:40.540 provide the academic rationale for government control and manipulation of the economy, based 244 00:22:40.540 --> 00:22:46.800 on a nearly religious belief in an inherently unstable private economy, and in the ability 245 00:22:46.800 --> 00:22:50.120 of central authority to improve its workings. 246 00:22:50.120 --> 00:22:55.700 Thus these schools and their associated cast of characters mirror to closer inspection. 247 00:22:55.700 --> 00:23:02.100 So I'd like to turn first to the post-Keynesians. The post-Keynesian model has several distinctive 248 00:23:02.100 --> 00:23:08.180 critical elements. The first of these is what I would call a Leontief view of production. 249 00:23:08.180 --> 00:23:14.540 In this perception, fixed technical coefficients connect labor and capital, and this technical 250 00:23:14.540 --> 00:23:20.620 fixity removes any possibility of varying the proportions in which inputs are used. 251 00:23:20.620 --> 00:23:28.120 Hence, relative prices of capital and labor have no role in post-Keynesian analysis in determining the techniques of production. 252 00:23:28.120 --> 00:23:34.620 Moreover, as a consequence of this view of production, per-unit variable costs do not increase as output expands. 253 00:23:34.620 --> 00:23:46.120 Thus, the standard conception of an upward-sloping marginal cost curve and the derivative concept of an upward-sloping industry supply curve is seen by post-Keynesians as mythical. 254 00:23:46.120 --> 00:23:51.120 The post-Keynesian view of production is most comprehensively stated by Piero Schraffa, 255 00:23:51.120 --> 00:23:56.120 and his work on this topic has become the standard reference for the paradigm. 256 00:23:56.120 --> 00:24:01.120 He has taken this view of production to its logical conclusion and value theory. 257 00:24:01.120 --> 00:24:06.120 That conclusion is that relative product demand has no effect on relative prices. 258 00:24:06.120 --> 00:24:12.120 Relative prices of inputs and the techniques of producing various products determine relative product prices. 259 00:24:12.120 --> 00:24:16.620 The value theory that emerges is very much like the early 19th century labor theory of 260 00:24:16.620 --> 00:24:22.320 value except that a composite called the basic commodity replaces labor as the origin of 261 00:24:22.320 --> 00:24:27.480 all value. Perhaps it is this connection that leads some post-Keynesians to describe themselves 262 00:24:27.480 --> 00:24:33.840 as neo-Bracardian. While the story of production of commodities by means of commodities, to 263 00:24:33.840 --> 00:24:39.040 use their phrase, cannot be simply told within a limited space, the details of the story 264 00:24:39.040 --> 00:24:44.320 are not necessary for a general overview of post-Keynesian economics. 265 00:24:44.320 --> 00:24:49.980 It is sufficient to note that Shroff's contribution makes national output independent of wages 266 00:24:49.980 --> 00:24:55.680 and prices. Wages and prices determine the distribution of income, and that distribution 267 00:24:55.680 --> 00:25:00.760 depends on the struggle between organized labor and capitalists, government efforts 268 00:25:00.760 --> 00:25:06.800 to alter that distribution, and on the rate of private investment. Thus, John Stuart Mill's 269 00:25:06.800 --> 00:25:27.040 Post-Keynesians can pursue their grandest redistributive 270 00:25:27.040 --> 00:25:32.800 schemes without any fear, on their part anyway, of its consequences for the well-being of 271 00:25:32.800 --> 00:25:34.920 mankind. 272 00:25:34.920 --> 00:25:39.560 is also subscribed to a markup theory of pricing. Having determined that price has nothing to 273 00:25:39.560 --> 00:25:44.440 do with demand, they contend that the oligopolistic firms that dominate the economy determine 274 00:25:44.440 --> 00:25:50.520 prices not in response to demand conditions, but rather in order to achieve a targeted 275 00:25:50.520 --> 00:25:55.840 level of profits. That targeted level is determined by whatever amount of funds are necessary 276 00:25:55.840 --> 00:26:00.380 in order to undertake the firm's investment plans, which in turn are determined by their 277 00:26:00.380 --> 00:26:05.220 are perceptions of the capital necessary to meet future product demands. 278 00:26:05.220 --> 00:26:10.280 The post-Keynesian perception of production and pricing also divorces inflation from any 279 00:26:10.280 --> 00:26:15.540 demand considerations. Most particularly, the basic truth of the quantity theory is 280 00:26:15.540 --> 00:26:21.240 emphatically denied. With markup pricing, inflation is all of a cost-push variety and 281 00:26:21.240 --> 00:26:27.900 it is determined, nebulously, by the struggle over the distribution of income. Money is 282 00:26:27.900 --> 00:26:32.780 is seen as endogenous, but in a peculiar way. The causal relationship between money and 283 00:26:32.780 --> 00:26:39.780 prices that is seen by monetarists is reversed by post-Keynesians. As costs rise, businesses 284 00:26:39.820 --> 00:26:44.500 apply their markup to prices. The higher prices may create a higher demand for credit, which 285 00:26:44.500 --> 00:26:50.000 causes the banking system to expand the money supply out of excess reserves. If these excess 286 00:26:50.000 --> 00:26:53.700 reserves run out, there are other sources of credit, such as expanding the repayment 287 00:26:53.700 --> 00:26:59.820 Term. In most situations, this won't be necessary, as the central banking systems will usually 288 00:26:59.820 --> 00:27:05.300 expand the system's reserves. If it doesn't, a liquidity crisis may result, but even then 289 00:27:05.300 --> 00:27:11.300 the effect is on output exclusively. Within very broad limits though, monetary policy 290 00:27:11.300 --> 00:27:18.300 really doesn't work at all in this view. As I mentioned before, the post-Keynesian view 291 00:27:18.300 --> 00:27:23.980 The view of the labor market, as conventionally defined, is that it does not exist. 292 00:27:23.980 --> 00:27:29.220 In the words of one post-Keynesian, neither the demand for labor nor the supply of labor 293 00:27:29.220 --> 00:27:31.820 depends on the real wage. 294 00:27:31.820 --> 00:27:36.460 It follows from this that the labor market is not a true market, for the price associated 295 00:27:36.460 --> 00:27:44.020 with it, the wage rate, is incapable of performing any market clearing function, and thus variations 296 00:27:44.020 --> 00:27:49.020 Money Wages in the Wage Rate Cannot Eliminate Unemployment 297 00:27:49.020 --> 00:27:54.100 Money Wages, on the other hand, are determined by the relative power of unions and oligopolistic 298 00:27:54.100 --> 00:27:59.940 corporations. This relative power can be affected somewhat by the degree of slack in the labor 299 00:27:59.940 --> 00:28:06.620 market, but public policy and social custom are seen as much more important determinants 300 00:28:06.620 --> 00:28:12.340 of that power. In any event, markup pricing dictates that prices will move with money 301 00:28:12.340 --> 00:28:18.220 Wages. With wages, both money and real, as well as prices playing no role in employment 302 00:28:18.220 --> 00:28:25.020 determination, it is simply aggregate demand variations, usually investment variations, 303 00:28:25.020 --> 00:28:29.300 that given fixed proportions determine the level of employment. There's a great deal 304 00:28:29.300 --> 00:28:34.260 more of course to post-Keynesian economics than can even be touched upon here. There 305 00:28:34.260 --> 00:28:38.980 are two important surveys by post-Keynesians that are fairly comprehensive. One is an article 306 00:28:38.980 --> 00:28:45.820 by Eichner and Kregel in the 1975 Journal of Economic Literature and another book edited 307 00:28:45.820 --> 00:28:52.820 by Eichner. The articles in that book by Peter Kenyon, by Kregel, Applebaum and Bazelmore 308 00:28:52.820 --> 00:28:57.460 are particularly useful. An important source of particulars of the post-Keynesian framework 309 00:28:57.460 --> 00:29:02.580 are contained in articles published over the years in the Journal of Post-Keynesian Economics 310 00:29:02.580 --> 00:29:07.980 which began publication in 1978. While there is an internal consistency in the post-Keynesian 311 00:29:07.980 --> 00:29:14.420 model, it is clearly built on a set of ad hoc assertions and ideological jargon. As such, 312 00:29:14.420 --> 00:29:18.780 post-Keynesian economics appears as a collection of non-sequiturs to most other economists, 313 00:29:18.780 --> 00:29:25.260 even other Keynesians. In one sense, the development of post-Keynesian thought is stark apology. 314 00:29:25.260 --> 00:29:30.180 It has no microeconomic foundations except for primitive pre-marginalist ones, and it 315 00:29:30.180 --> 00:29:34.580 serves mostly to rationalize a collectivist control of the division of income according 316 00:29:34.580 --> 00:29:42.040 to Class. With Marxism falling in credibility, the post-Keynesian effort to justify government 317 00:29:42.040 --> 00:29:47.540 control of investment decisions and perpetual wage and price controls provides the next 318 00:29:47.540 --> 00:29:51.620 best hope for those who just cannot accept economic individualism. 319 00:29:51.620 --> 00:29:58.260 I'd like to turn now to an examination of the neo-Keynesians. Now post-Keynesians like 320 00:29:58.260 --> 00:30:02.780 to think of their perspective as a direct outgrowth of the line of thought initiated 321 00:30:02.780 --> 00:30:09.140 and the General Theory intend to view Orthodox Keynesianism as a distortion of Keynes' message. 322 00:30:09.140 --> 00:30:13.600 There have been so many interpretations of what that message was that it is no simple 323 00:30:13.600 --> 00:30:19.260 matter to determine the correctness of the post-Keynesian ancestral claim. What is easily 324 00:30:19.260 --> 00:30:24.100 established is that the post-Keynesian system is quite distinct from Orthodox Keynesian 325 00:30:24.100 --> 00:30:29.180 thought. The distinction between Neo-Keynesian and Orthodox Keynesian strains is far less 326 00:30:29.180 --> 00:30:34.460 For one reason or another, some economists that I think of as Orthodox Keynesians are 327 00:30:34.460 --> 00:30:41.620 sometimes referred to, without their objection, as New Keynesian, such as Tobin and Modigliani. 328 00:30:41.620 --> 00:30:46.700 My basis of distinction is the identification of certain characteristics that mark a distinct 329 00:30:46.700 --> 00:30:51.900 Neo-Keynesian strain. These characteristics are individual optimizing behavior, implicit 330 00:30:51.900 --> 00:30:58.020 contracting, asymmetric information in the labor market, and efficiency wages. All of 331 00:30:58.020 --> 00:31:02.660 These elements, when put together, are used to arrive at Keynesian conclusions, persistent 332 00:31:02.660 --> 00:31:07.700 involuntary unemployment, and an effective role for demand management. 333 00:31:07.700 --> 00:31:11.860 Put in the simplest terms possible, the task that Neo-Keynesians see themselves facing 334 00:31:11.860 --> 00:31:18.140 is to explain equilibrium in markets, particularly labor markets, without market clearing. 335 00:31:18.140 --> 00:31:23.220 The principal device for doing so is reliance on the concept of implicit contracting and 336 00:31:23.220 --> 00:31:26.540 the related concept of efficiency wages. 337 00:31:26.540 --> 00:31:32.540 The basic notion of implicit contracts is that both firms and workers would prefer wage stability 338 00:31:32.540 --> 00:31:38.020 to employment stability. Hence a firm will respond in the short run to economic disturbances 339 00:31:38.020 --> 00:31:44.520 by reducing output and employment rather than wages. To reduce wages in response to transitory 340 00:31:44.520 --> 00:31:50.200 demand decreases would weaken the long-run profitability of the firm in this view. Moreover, 341 00:31:50.200 --> 00:31:54.500 the firm may find that paying higher than market wages, and by inference that does not 342 00:31:54.500 --> 00:32:11.500 The notion of higher than market clearing wages, called efficiency wages, seems to be one of the major empirical preoccupations of the most popularly known neo-Keynesian, Lawrence Summers. 343 00:32:11.500 --> 00:32:17.500 Even when firms regard a change in demand as permanent, their workers do not know this. 344 00:32:17.500 --> 00:32:32.500 Due to this asymmetric information, the only way labor, especially if organized, can be convinced to accept the wage reduction over the long run is for the firm to not attempt an immediate wage cut, but to first cut output and employment. 345 00:32:32.500 --> 00:32:36.500 I guess anything kinder and gentler won't be believed. 346 00:32:36.500 --> 00:32:48.500 And the workers displaced by the imperfection of asymmetric information in one firm won't find employment at lower wages elsewhere because other firms have implicit contracts with their own workers which prevent absorption. 347 00:32:48.500 --> 00:32:56.500 Because these propositions are derived from models of utility maximizing workers and profit maximizing firms, subject to rational expectations, 348 00:32:56.500 --> 00:33:04.500 Neo-Keynesians see themselves as having completed the task of providing a sound microeconomic foundation to Keynesian notions of how the world works. 349 00:33:04.500 --> 00:33:11.500 Moreover, Keynesian rigidities, as explained by imperfect markets with asymmetric information, 350 00:33:11.500 --> 00:33:13.940 are easily extended to other markets. 351 00:33:13.940 --> 00:33:17.620 Joseph Stiglitz, one of the most important neokanesians, has done so for product and 352 00:33:17.620 --> 00:33:20.140 credit markets. 353 00:33:20.140 --> 00:33:24.060 Neokanesians perhaps should be applauded for their efforts at undermining the equilibrium 354 00:33:24.060 --> 00:33:29.420 always mindset of the rational expectations or New Classical School. 355 00:33:29.420 --> 00:33:35.740 The neo-Keynesian mindset seems to suggest that if they can convincingly argue that markets 356 00:33:35.740 --> 00:33:41.940 do not clear continuously and that unemployment is not necessarily a disguised form of voluntarily 357 00:33:41.940 --> 00:33:46.880 chosen vacation, then they can conclude that the basics of Keynesian economics, including 358 00:33:46.880 --> 00:33:52.980 its policy prescriptions, are maintained intact. But that conclusion does not follow. The literature 359 00:33:52.980 --> 00:33:57.300 on implicit contracts, at the basic level, provides some insights into the complexity 360 00:33:57.300 --> 00:34:00.140 of Real World Labor Markets. 361 00:34:00.140 --> 00:34:05.200 But the contention that a perpetually inefficient labor market results is simply erroneous. 362 00:34:05.200 --> 00:34:09.820 In the real world, workers face an array of implicit contracts, offering a wide range 363 00:34:09.820 --> 00:34:14.580 of opportunities to trade off earning stability for employment stability. 364 00:34:14.580 --> 00:34:20.580 The existence of such a range is welfare enhancing, not a market imperfection. 365 00:34:20.580 --> 00:34:24.980 The implicit contracting idea may be quite incompatible with the continuous market clearing 366 00:34:24.980 --> 00:34:39.420 Hayek's thoughts on the evolution of rule-following behavior are quite amenable to the basic notions 367 00:34:39.420 --> 00:34:41.460 of implicit contracting theories. 368 00:34:41.460 --> 00:34:46.980 Yes, we know that we live in a world of uncertainty and imperfect information, and that this affects 369 00:34:46.980 --> 00:34:47.980 behavior. 370 00:34:47.980 --> 00:34:52.440 If some want to label the resulting behavior as a mark at imperfection, so be it. 371 00:34:52.440 --> 00:34:57.040 But to conclude that a case is thus made that government intervention into markets can improve 372 00:34:57.040 --> 00:35:02.280 the overall performance of the economy is just wrong. It is a conclusion that does not 373 00:35:02.280 --> 00:35:07.260 follow from the fact that we live in a complex, uncertain world. The whole thrust of modern 374 00:35:07.260 --> 00:35:12.480 Austrian analysis points to the conclusion that complexity and uncertainty make it impossible 375 00:35:12.480 --> 00:35:19.480 for government to improve the coordinating tendencies that underlie market activity.