Finding a New Macroeconomics: (1) Introduction

Introduction

John Maynard Keynes ended the preface to his monumental opus, The General Theory of Employment, Interest and Money, with this unusual confession:

The composition of this book has been . . . a struggle of escape from habitual modes of thought and expression.  The ideas which are here expressed so laboriously are extremely simple and should be obvious.  The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. [1]

The “old ideas” Keynes referred to were some of the major, in his view erroneous, ideas of the classical theory of economics, which his new book intended to correct.  In 1935, Keynes was living in the Great Depression, and he had developed a more modern theory with insights into decline and instability that classical theory lacked.  Keynes knew he was playing with fire, and it was important to get it right:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. [2] 

But the economics profession was still immature, lacking data and the electronic processing tools we take for granted today.  The discipline of economics was still transitioning from philosophy to science.  Knowing how hard it can be to accept new ideas that force us to revise or discard old ones, especially when it is not possible to test the new ideas with factual evidence, Keynes also warned:

It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics (along with the other moral sciences), where it is often impossible to bring one’s ideas to a conclusive test either formal or experimental. [3]

Keynes hoped to persuade his fellow economists that the classical theory to which they, along with himself and his father before him, had clung so tenaciously for decades, was seriously flawed.  Indeed it was.  But he was determined to soften the blow:

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world.  But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. [4] 

Still, he was attacking classical economics on the level of its core concepts, and this had to seem to classical economists like extremely faint praise.  For to argue that the classical model was merely a description of an economy at full employment was like arguing that a stopped clock is only correct twice a day:

For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation — a discrepancy which the ordinary man has not failed to observe. * * * The celebrated optimism  of traditional economic theory, which has led [economists to teach] that all is for the best in the best of all possible worlds  provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand.

For there would obviously be a natural tendency towards the optimum employment of resources in a Society which was functioning after the manner of the classical postulates.  It may well be that the classical theory represents the way in which we should like our Economy to behave.  But to assume that it actually does is to assume our difficulties away. [5]

Here’s the irony: Keynes himself did not quite get it right.  Yes, he brilliantly explained the dynamic processes of demand-driven market-based systems, and that accomplishment, however controversial, was revolutionary.  Keynes gave the world a full employment model:

[T]he national income depends on the volume of employment, i.e. on the quantity of effort currently devoted to production. . . [T]here is a unique correlation between the two. * * * Our present object is to discover what determines at any given time the national income of an economic system and (which is almost the same thing) the amount of its employment. [6]

Keynes conceded at that point that because the study of economics is so complex that “we cannot hope to make completely accurate generalizations,” his objective was to find those factors that mainly (original emphasis) determine income.     

His full employment model overlooked, however, what would prove to be the most important factor: the distribution of wealth and incomes. To his credit, Keynes highlighted his awareness of the importance of distribution, and he discussed it intelligently, without speculating very much about it.  But he lacked the data needed to analyse it, and he had no model incorporating distributional variables.  The bottom line is this:  Keynesian economic models fail to account in any way for changes in the distribution of money.

Unavoidably, Keynes had overreached.  There are two key assumptions reflected in his theory, more express than tacit:

(1) optimal demand will produce full employment; and

(2) maintaining full employment solves the “poverty” problem; [7] 

And there is a third, tacit assumption in his model, one that like the assumptions in the classical model he rejected is “seldom or never satisfied:”

(3) the distribution of wealth and incomes either never changes, or it completely lacks economic significance.

Now that his model has been subjected to the “conclusive test” of experience, Keynes’s error of omission is shown to be so enormous as to have overwhelmed his claim to have solved the issues of instability, stagnation and depression. It turns out that the management of income and wealth inequality is far more important to growth and prosperity, and to the maintenance of full employment, than is the management of demand (expenditures on consumption and investment) levels.

This was no small oversight: the consequences of that omission, I will argue, have led to massive confusion and miscalculation and abetted the rapid decline of the United States economy and other economies around the world into the early stages of Great Depression II.  And this is not just about plugging the holes in Keynesian theory: it’s also about slaying the “trickle-down” dragon and discrediting the “austerity” doctrine, patently false and non-economic notions that have come to dominate popular ideology today, with scant professional challenge in the media beyond the valiant efforts of Paul Krugman. The recent flurry of discussion about the Reinhart/Rogoff econometric thesis, as explained in this series of posts, fortuitously helps to bring all of these points into sharper focus.

Much of my discussion, I am bold to say as Keynes did, “is extremely simple and should be obvious.” But this is an interesting and strange situation: economists have been slow to react to the emergence of vast databases of income distributions, covering very long time periods, in the United States and around the world.  That is not surprising: the import of those databases potentially changes everything.  The world of economics has been turned upside down.  

In support of the claim I am making — that economic theory has gone astray from the start — I humbly submit that with each passing month the facts I rely on are  are becoming ever clearer; and people are increasingly in a questioning frame of mind. Even four years ago, in the aftermath of the Crash of 2008, the relatively conservative periodical The Economist opined:

[T]there is a clear case for reinvention, especially in macroeconomics. Just as the Depression spawned Keynesianism, and the 1970s stagflation fueled a backlash, creative destruction is already under way.

And, it reported:

Paul Krugman, winner of the Nobel prize in economics in 2008, [recently] argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” [8]

They did not, however, have my perspective in mind.  As my argument suggests, mainstream Keynesian traditionalists, as did Keynes himself, have likely missed the core problem with current economics, its marginalization of wealth and income distribution issues. Himself among that group, Krugman argued in his latest book that inequality is most likely just a “political” problem. [9]

You will want proof, and reasoned discussion. This is the first of several posts, drawn from my two and one-half years of research and writing on inequality, the PowerPoint presentation I have developed on the topic, and an expansion of an article encapsulating that presentation that has been submitted for publication.  I will publish these posts serially, and hope to be finished with this series in two to three weeks.

JMH – 4/25/2013

_____

[1]  John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1935, New York and London, Harvest/Harcourt, Inc., 1953, 1964 ed., 1991 printing, Preface, p. viii.

[2] Id. at 382.

[3] Id. at  pp. vi-viii.

[4] Id. at 378.

[5] Id. at 33-34. (Emphasis in original.)

[6] Id. at 246, 247. (For a fuller  understanding of Keynes’s General Theory  and his full employment model, see especially: pp. 30-32; Book 3, “The Propensity to Consume”; Book  4, “The Inducement to Invest,” esp. Chs. 11-14, and 18, “The General Theory of Employment Restated”; and Ch. 24.)

[7] Id. at 30.

[8] “What went wrong with economics,” The Economist, July 16, 2009 (here).

[9] Paul Krugman, End This Depression Now!,  W.W. Norton & Company, NY (2012), Ch. 5, “The Second Guilded Age,” pp. 71-90.

This entry was posted in - FEATURED POSTS -, - MOST RECENT POSTS -, Economics, Wealth and Income Inequality. Bookmark the permalink.

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