Neorational Keynesonomics

Continuing from the previous post, chapter 4 of Lekachman’s The Age of Keynes is entitled “The General Theory,” and comprises a terse outline of the major ideas and critiques presented in Keynes’s General Theory.  Like Chapter 3, and I can only assume this is true for the rest Lekachman’s book, it is quite accessible and well-written.  I picked up a copy of The General Theorya few days ago for about eight bucks, and after reading about 18 pages over the course of two days, I can attest to Lekachman’s statement that the book is “…a difficult, technical treatise…”  Still, it is manageable with careful reading and a bit of knowledge of Keynes’s intellectual forbears.

The full title of the book is The General Theory of Employment, Interest, and Money, and it tackles in turn each of these matters and seeks a way to tie them together.  Keynes work was motivated by the failures of classical postulates to account for any economic state that did not exhibit full employment; hence his belief that classical economics, rather, was a special case of a more “general theory” which accounted for the possibility of any number of equilibria where employment was less than full.  He first sets out to call Say’s Law (”Supply creates its own demand”) into question; supply was only one part of the story.  It becomes necessary to define an aggregate demand, independent from aggregate supply (at least in the short-run which is all that with which Keynes concerns himself; keep that in mind as you read on).  Aggregate demand for wage-goods - those products demanded for consumption by wage earners - is determined primarily by income.  If a rise in the price of wage-goods relative to wages - which would increase the marginal product of labor, thus giving producers the incentive to hire more labor, and which would increase the level of income desired by both workers and the unemployed - causes both a shift in the aggregate supply of labour and in the aggregate demand for labour, then it can not be said that the economy is currently at full employment.  But then this offers one a way out of an equilibrium of less-than-full employment: increase aggregate demand.  How to do this?  Increase income.  How to increase income?  Public works funded with deficit spending. 

Keynes’s conclusion on this point arises from his observation that classical economics committed a logical fallacy by assuming that if it behooves one firm to lower the wages it must pay, it must thereby behoove all firms to do so. Yet this is incorrect, since lower wages across the board reduce income, thereby reducing aggregate demand, and therefore leading to an equilibrium level of employment below full.  It strikes me that Keynes’s analysis here implicitly assumes that markets are imperfectly competitive, and that wage earners are wage takers, and not on an equal footing with the employer in the wage-bargaining process.  Indeed, I think this becomes fairly clear in the first 18 pages of his book, and it would seem to jive with Keynes’s populist/Labour Party tendencies that Lekachman evokes in chapter 3. 

Another piece of Keynes’s system was his discussion of investment.  Here Keynes seems to reduce investment decisions to a rather unsatisfactory set of notions about investor moroseness or exuberance about the potential or actual marginal efficiency of capital on which investment dollars are spent.  The beneficent state, by taking some control over the investment reins, might stabilize the environment, allowing for more predictable outcomes to investment.  Under the assumption that investment decisions are so loosely and unscientifically determined, then only large interest rate changes will have an appreciable effect in one direction or another on investment.  I’m not a big fan of this point, if it is indeed as unsubstantiated as Lekachman seems to characterize it. 

I’m not perfectly clear on this, but there seems to be an alternative framework for investment.  Keynes apparently rejects the classical idea of a savings/investment equilibrium determined by calculations of time preferences, marginal efficiencies of capital, etc.,  which in turn determine an equilibrium interest rate.  For savings, he seems to think that it is determined not by time preference but by liquidity preference as well as the interest rate.  Money held in stock for a variety of reasons was not by any means saved, and so had nothing to do with determining the interest rate.  Instead, it was speculators, focused solely on the expected rise and fall of securities’ prices, which made predictions of and thereby determined the interest rate; in other words, interest rates are self-fulfilling prophecies.  When equities prices fall then the potential yield (the interest rate) on that equity must rise, since a marginal increase in the equity’s value will be a larger percentage rise at a lower price than at a higher price.  The corollary is also true.  Says Lekachman:  “…the rate of interest is indeed a premium, but a premium paid for surrendering cash, the perfectly liquid asset, for securities, imperfectly liquid assets.”  

But if investors expect interest rates to rise and thereby divest themselves, then the government can step in and purchase securities to hold interest rates down.  This is precisely what open market operations, performed by central banks, achieve.  Furthermore, it is well within the purview of public policy to smooth the movement of interest rates and prevent large fluctuations.  Here is yet another entrance for the public sector to perform in various and sundry ways to regulate the private.  The multiplier process discussed in chapter three (see previous post) suggests that small changes in investment will lead in turn to large increases in consumption (aggregate demand) and therefore monetary and fiscal policy both are viable means for the government to intervene and bring an economy out of an equilibrium of less-than-full employment.

I hope have that I have done justice to a single chapter that attempts to do justice to an entire book.  He was a bright guy, this Mr. Keynes, but I see some of those flaws upon which others would fixate in hindsight, and I’m looking forward to reading those critiques and seeing it culminate in a resurrection of classical thought.   

Source:  Lekachman, Robert.  The Age of Keynes.  Chapter 4.  New York:  Random House, 1966.   

I’m going to do this commentary over two entries since this is a fairly large reading. 

Chapter 3 of Lekachmen’s The Age of Keynes is entitled “The Road to The General Theory,” and, as the name suggests, it focuses - somewhat on the material and historical but primarily on the intellectual and theoretical - background upon which Keynes’s General Theory was formulated.

Lekachmen first reminds us of the context, which is always important.  The Treaty of Versailles required massive reparations from the Central Powers and redrew political boundaries, upsetting the status quo of the pre-WWI era and leading to serious social and economic difficulties both domestic and international.  Keynes recognized that this put a serious strain on, among other previously tried and true features of the contemporary economic policy, future primary use of the international gold standard upon which most currencies were based.  This was exacerbated by the fact that in the new economic world order, the United State Federal Reserve had enormous power to affect the ebb and flow of gold-backed currency in and out of the economy, and in general most of the power over the value of gold was more and more concentrated in the hands of a few central banks.  Already a man with a taste for the heretical, Keynes did little to hide his distrust of the gold standard, and advocated that, at best, governments should hold tightly to the reins of the precious metal. 

Over the course of the 1920’s and through to 1933, Keynes published a series of works in which one can observe the birth and adolescence of Keynes iconoclasm and the development of thought that would lead to the General Theory.  In due course, he would come more and more to question the validity of Say’s Law (”Supply creates its own demand”) and the notion that troughs in the business cycle called for more savings and lower real wages.  To the contrary, Keynes’s suspicion grew that there was no automatic mechanism that matched savings to investment, that thrift was by no means the path to success, and that government machinations may be the only means to kick an economy in the direction of full employment.  All of this was flying in the face of most of his colleagues at Cambridge and elsewhere, who like Keynes were students (one way or another) of the neoclassicists like Marshall and Pigou and their intellectual predecessors.  Yet it seems no one, not even Keynes, was fully aware of his work’s implications; he was still carving out a niche for himself in his profession. 

Keynes would adopt the concept of the multiplier from one of his younger colleagues, R.F. Kahn, and he would come to apply it in a way that made deficit spending and other public expenditures very tempting to policy-makers in his 1933 book “Means to Propserity.”  Keynes flirtations with government interference in the market required fair mix of theoretical mastery and political savvy, and the multiplier gave him the means to maintain the latter without leaving the confines of the former.  We all know the idea of the multiplier from intermediate macro, but for Keynes it was something of a selling point.  Yes, you might spend 4.5 million pounds now, but a third of that will be covered by the new tax revenues resulting from new employment as the money trickles through economy, and who knows how much more of a tax receipt windfall will result from a sustained increase in economic prosperity?

I have provided here only a gloss but I really do recommend this reading; Lekachman is quite the lucid writer and one can only benefit from knowing the foundations from which Keyne’s built his General Theory.  I don’t have any substantive commentary on the content of this chapter except that I am extremely curious to see how, with the advent of neoclassical growth, economists of either persuasion begin to reconcile the Keynesian with the neoclassical.  It almost seem to me as if the two are well-nigh incompatible, at least with regards to bridging the gap between short-run economic fluctuations and long-term growth.

Source:  Lekachman, Robert.  The Age of Keynes.  Chapter 3:  New York:  Random House, 1966.   

What is valued and how do we value it?  This is a question humans asked and attempted to answer long before the classical school of economics was born with Smith’s Wealth of Nations. Aristotle believed that value was intrinsic to an object, a property of its underlying substance.  While David Hume would reject this claim to powerful effect in the mid-1700’s, the field of economics would not fully shake itself free of this conception until the late-19th century.  The labor theory of value, elaborated and utilized tenaciously by Karl Marx in his attacks against capitalism, was not merely some communist delusion; it was the basis of the classical economists’ explanation of prices, which were thought merely to fluctuate around a commodity’s “real” value - the amount of labor accumulated in the commodity.  This came from the immediate physical labor of the worker, but also from the machinery (itself built by labor) that was used in the production process.  The money fetched by the commodity, then, was thought to be distributed according to the labor each member of the production process could mobilize.  Thus did the capitalists, mobilizing labor through their tools and machines, get their piece in the form of profits, the workers get their piece in the form of wages, and so forth. 

This conception of value was problematic, in that it consistently failed to predict the buyer’s willingness to pay for an item given what it was worth.  A paradigm shift took place, its intellectual roots in David Hume’s work in which he argued that their was nothing intrinsic to any object (including humans); rather, knowledge was based on the juxtaposition of things and their qualities, and thus so was value.  This in mind either explicitly or implicitly, late-19th century economists became less interested in the real “worth” of an object and more in how buyers and sellers seemed to value items in relation to one another.  This was the groundwork of the so-called marginal revolution, which suggested that people were not interested in the “real” value of a commodity - that is, it’s value in terms of labor - but rather in the extra utility (revenue) that purchasing (producing and selling) one more unit of the commodity would provide to the buyer (producer), relative to the costs of acquiring (making) it.  When theses costs and benefits are in equilibrium, no more units will be bought or sold.  Value becomes linked to notions of scarcity and unlimited wants, and the tensions between the two is worked out in markets.  This is the basis for supply and demand analysis, and it also clarifies market entrance and exit on both sides of the exchange.  Along with the help of a few simplifying assumptions, it comprises the foundations of what we now call neoclassical economics.

These assumptions, as discussed in the article, are threefold:
1) People have rational preferences among outcomes.
2) Individuals maximize utility and firms maximize profits.
3) People act independently on the basis of full and relevant information.

Neoclassical economics atomizes the individual so that her decisions come down to the solutions to one or two simple equations, and when economists aggregate those decisions they can develop workable theories of markets for just about anything one can conceive - from Playstation 3’s and the labor used to build them to marriage partners.  It was the mathematization of economics, as the author of this article discusses, that gained it acceptance as something on par with physics as a science.  The insatiable appetite for that which satisfied notions of modernism - the idea that the world can only benefit from progress and development technologically, intellectually, morally, and so on (and that the ‘modern’ society embodies those ideas) - encouraged these developments and made them concrete.  Once neoclassical, mainstream economics gained recognition as a science, it became extremely difficult to challenge in the countries that most esteem this label, such as the UK and USA. In these bastions of economic thought, it is the neoclassical conception of economics that students are taught, to the exclusion of alternative approaches, such as Marxian, Austrian, neo-institutional, and so on.  For the most part, neoclassical economics does not abdicate authority to these heterodox groups when it fails to explain certain phenomena, but rather borrows from them and implements their ideas as necessary and in such a way as satisfies the neoclassical notions of optimization.  

In neoclassical economics, outcomes are considered best in the Pareto-efficient sense when “any other allocation of goods and services would leave someone better off,” meaning that if someone were to take an equilibrium defined by a well-functioning market and redistribute the resultant allocation, the total utility experienced at equilibrium would be less than the one produced by the unfettered machinations of the “invisible hand.”  Much of the frustration that spawns alternative schools of economic thought arises from disagreement with the mainstream’s fundamental assumptions as outlined above.  In my opinion, the resilience of the mainstream seems to arise from two factors.  First, it aligns quite readily with how westerners buy and large tend to think of themselves and others.  We often see ourselves as rational, autonomous individuals that make the decisions that are most satisfying to us given the outcomes we expect, and as we are the ones most often under study in economics, we are prone to impute such assumptions into our analyses.  Second, evidence that goes against the assumptions is often and easily construed in a way that it is made to fit the framework.  Notions of “incomplete information”, “bounded rationality”, and cultural peculiarities can be modeled or otherwise understood with a fair degree of accuracy using probability distributions, cognitive neuroscience, or careful study of the subject and subsequent retooling of the fundamental decision equations.  Neoclassical economics is notoriously flexible as an analytical framework, is able to maintain an acceptable level of clarity even after some relaxation of its assumptions, and on these facts turns its continued support and utility as the main school of thought in economics.

This article is short and easily understood, but some may question the author’s objectivity as a commentator on such important information (though certainly not as an economist); his judgment in calling detractors from the mainstream “kooks” or “antiscientific” is not only a gloss - it is outright wrong.  Except to the extent that adherents often downplay these alternative views, however, there is nothing “wrong” with neoclassical economics.  In any event, the idea of value in economics has some very deep and fascinating roots that one can learn in any class or book on the history of economic thought. 

Reference:  Weintraub, E. Roy, “Neoclassical Economics”, The Concise Encyclopedia of Economics. Liberty Fund, Inc. Ed. David R. Henderson. Library of Economics and Liberty. 18 January 2008. <http://www.econlib.org/library/Enc/NeoclassicalEconomics.html>.

Irving Fisher was one of the most prolific economists of the 20th century, both because of the magnitude of his contribution and his ability to relate his ideas to readers with a comprehensible and pithy writing style.  Says the author of the article “…graduate economics students, who to this day still study [Fisher’s Theory of Interest, one of his most important works], often find that they can read - and understand - half the book in one sitting.” 

According to the article, Fisher’s contributions to economics lie in his work on money and interest, and also in his sensible use of mathematics to sharpen his analysis.  In the book just mentioned, Fisher’s Theory of Interest, he fleshed out what continues to be the mainstream conception of interest rates - that they are indexes “‘of a community’s preference for a dollar of present [income] over a dollar of future income.’”  Furthermore, the value of capital is the income it produces - net of initial costs and depreciation - vis a vis the interest rate.  Finally, with respect to interest rates, Fisher was the first to make a clear distinction between the real and nominal interest rates and to show that the former was equal to the latter less inflation.  All of these notions are central to how economists conceptualize interest and the relationship between capital and income.

Fisher was also one of the first to construct and utilize price indices, and no doubt this was empirically useful in his work on the quantity theory of money, laying the groundwork that allowed the monetarists like Friedman and his ilk to interrogate Keynesianism to near-revolutionary effect in the 1960s.  The equation of exchange is a very useful identity, formulated by Fisher, that can be used to ‘check the math’ on a variety of statements about economic policy effects.  It states that MV = PT, where M is the stock of money, V the velocity (or circulation rate) of money, P is the price level, and T is the total volume of transactions (we now use y instead of T, where y is stands for real income).  If any one variable is changed, at least one of the others must change to maintain the equality. 

From the author’s description, Fisher was something of a jack-of-all-trades and a man of many firsts.  He earned the first PhD in economics from Yale before the ivy league school even had an economics program.  He had a somewhat dubious social agenda, being a supporter of eugenics, Prohibition, and “peace.”  He also lost some face when, during the Great Depression, he insisted that recovery was imminent for several years.  (Incidentally, Fisher himself lost a great deal of wealth in the crash of 1929). 

Overall, the article was interesting but too much of a gloss to glean too much information.  I was, however, intrigued by the suggestion that he was a good writer, and since Fisher’s work is older, it is generally available for free on the internet.  For instance, you may find Fisher’s Theory of Interest here.

 Source:  “Biography of Irving Fisher.”  The Concise Enyclopedia of Economics.  Liberty Fund, Inc. Ed.  David R. Henderson.  Library of Economics and Liberty. 18 January, 2008.  http://www.econlib.org/library/Enc/bios/Fisher.html