Will the Real Keynes Please Stand Up: On Keynesianism and Crisis Theory

Michael Roberts

An argument has broken out among top Keynesian economists about what is the Keynesian theory on economic fluctuations in capitalist economies (i.e, crises and slumps). The debate has taken the usual form of arguing about what Keynes ‘really meant’, whether he was really a radical that dispensed with neoclassical equilibrium theory or whether followers and supporters of Keynesian economic theory have distorted the master’s ideas so much as to reduce their insights to nothing.

This argument reminds me of the unending one within Marxian economics that some of us have been engaging in yet again recently. Did Marx have a clear theory of crises under capitalism in his works that he stuck to consistently; or were his ideas so sketchy that followers like Friedrich Engels distorted them (see my posts on the debate with Michael Heinrich)? And is the theory of value as the basis of Marxian economics founded on realistic premises and logically consistent as a fundamental explanation of accumulation and social relations in the capitalist mode of production? Moreover, does the theory fit the facts (see my posts on the debate with Professor David Harvey)?

Well, this sort of debate also takes place with Keynesians. What did Keynes really mean? What is his theory of macroeconomic fluctuations in modern economies?

There are two running debates within mainstream macroeconomics at the moment. The first is that between former Fed chief Ben Bernanke (in his new blog site at the prestigious Brookings Institution) and Larry Summers, the Keynesian reviver of what he calls the theory of ‘secular stagnation’, the situation he fears that capitalist economies are currently in (see my post).

Bernanke dismisses secular stagnation, saying that global capitalism is just having a temporary weak recovery (probably caused by deflationary over-saving by China, Germany and other countries) but it will soon pick up as the ‘natural rate of interest’ rises to provide more profitable opportunities to invest and grow. Summers doubts this and reckons that because ‘demand’ is so low and interest rates are locked into zero (‘zero bound’), economies are stuck in a low investment-low growth trajectory that requires government investment to get it out, or a series of monetary infusions that lead to successive stock market and property bubbles. For more on this, see my post.

The other debate is, as I say, about whether Keynes had an answer both to the cause of slumps like the Great Recession and how to get out of them. And flowing from that, just what Keynes did stand for.

As usual the doyen of modern Keynesianism, Paul Krugman, kicked off the latter debate off when he claimed that the John Hicks ‘revision’ of Keynes’ theory of ‘economic fluctuations’ was realistic and worked. I have commented on Krugman’s claims for the (limited) success of this version of a Keynesian explanation of the Great Recession here. But what upset more radical Keynesians was that Krugman should claim that the ‘general equilibrium’ version of Keynes as expounded by Hicks should be accepted as that of the master.

Krugman retorted that “Keynes said a lot of things, not all consistent with each other. (The same is true for all of us.)”. That’s true – see my paper on Keynes’ inconsistencies (Contributions of Keynes and Marx). Krugman went to claim that Keynes was a neoclassical general equilibrium man – namely that“the ups and downs in a capitalist economy are really movements towards restoring the equilibrium between aggregate supply and demand and there is no permanent instability in the Keynesian model. Right at the beginning of the General Theory, Keynes explains the “principle of effective demand” with a little model of temporary equilibrium that takes expectations as given. If that kind of modeling is anti-Keynesian, the man himself must be excommunicated.”

And anyway, who cares, because as long as modern Keynesian theory works as an explanation, it does not matter what Keynes actually said or thought. And as Krugman says, “surely we don’t want to do economics via textual analysis of the masters. The questions one should ask about any economic approach are whether it helps us understand what’s going on, and whether it provides useful guidance for decisions. So I don’t care whether Hicksian IS-LM is Keynesian in the sense that Keynes himself would have approved of it, and neither should you. What you should ask is whether that approach has proved useful – and whether the critics have something better to offer.”

Krugman goes on to dismiss those Keynesians who reckon that economic crises are all about ‘irrational expectations’ or ‘uncertainty’ when the Hicksian IS-LM model (investment and savings moves into equilibrium with liquidity preference-money supply) works just fine.

But is Krugman right to say that it does not matter what Keynes said as long as we have workable model; and perhaps even more important, does he really have one that explains economic crises and the Great Recession? On the first point, as Krugman’s radical critics say, you can learn important insights from reading in detail the masters of any school of thought or theory in science and that can lead to better understanding. On the second point, does the Hicksian equilibrium model really start from realistic assumptions about modern economies and logically lead to an explanation that can be tested in reality?

As I said in a previous post on modern Keynesian macroeconomics, “Keynesian insights were reduced the infamous IS-LM curve that argued an unemployment equilibrium would not occur under capitalism unless there was ‘stickiness’ in wages or other ‘shocks’ to the market system. In other words, market capitalism would not have slumps if labour did not resist wage cuts and governments did not interfere.”

This reduces Keynesian insights to developing Dynamic Stochastic General Equilibrium (DSGE) models. These models assumed equilibrium because they started from the premise that supply would equal demand ideally; they were dynamic because the models incorporated changing behaviour by individuals or firms (agents); and they were stochastic as ‘shocks’ to the system (trade union wage push, government spending action) were considered as random with a range of outcomes, unless confirmed otherwise). Sticky prices (or wages) – the cause of the Great Recession? So it would seem from the Krugman-Hicks-Keynesian school.

Another Keynesian economics blogger with many interesting ideas, Noah Smith, recently wrote in Bloomberg view on what causes recessions? He recalled that “One time, at a dinner, I asked a famous macroeconomist: “So, what really causes recessions?” His reply came immediately: “Unexplained shocks to investment.” Smith comments so “we really just don’t know the answer”.

But Smith goes on to say that we do have an answer: sticky prices/wages. “The market adjusts by the price mechanism. If the cost of something goes up, the price goes up to match. If demand falls, the price drops until the market clears. So if you want to show that the market doesn’t naturally self-regulate, the simplest and easiest way is just to show that prices themselves can’t adjust in response to events. This phenomenon is called “sticky prices.” If prices are sticky, then someone – the Federal Reserve, or perhaps Congress and the Treasury – needs to nudge markets back into their long-run equilibrium after a big shock.”

Smith cites various papers from macroeconomists that purport to ‘prove’ that sticky prices (wages) are the grit in the wheel of the natural movement of capitalist economies towards equilibrium: “sticky prices are enjoying a hard-fought place in the sun. The moral of the story is that if you just keep pounding away with theory and evidence, even the toughest orthodoxy in a mean, confrontational field like macroeconomics will eventually have to give you some respect”.

However, Larry Summers, that other prominent Keynesian, would not agree with Krugman and Smith that the Hicksian and DSGE models along with ‘sticky prices’ have provided an explanation of crises. He recently commented: “In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought. Is macro about-as it was thought before Keynes, and came to be thought of again-cyclical fluctuations about a trend determined somewhere else, or about tragic accidents with millions of people unemployed for years in ways avoidable by better policies? If we don’t think in the second way, we are missing our major opportunity to engage in human betterment. And inserting another friction in a DSGE model isn’t going to get us there.”

Krugman is right in one aspect: the real Keynes is inconsistent and you can find several theories of slumps under capitalism. You can find in Keynes a theory of crises based on sticky wages causing an economic slump or at least sustaining it. But you can also find a theory of the ‘trade cycle’ that “the predominant, explanation of the crisis is… a sudden collapse in the marginal efficiency of capital”.

The marginal efficiency of capital is Keynes’ term for the rate of profit on capital and the nearest to Marx’s definition. In Chapter 22, of Keynes famous book, The General Theory, he goes on that “the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough…. The interval of time, which will have to elapse before the shortage of capital through use, decay and obsolescence causes a sufficiently obvious scarcity to increase the marginal efficiency, may be a somewhat stable function of the average durability of capital…. When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious….”

Thus slumps or depressions are the consequence of a “sudden” drop in the profitability of capital (unexplained by Keynes, except as a psychological change in ‘animal spirits’) that no amount of cuts in interest rates can restore. What must happen is the destruction of obsolescent capital over time (and cuts in real wages) in order to restore profitability before capitalism can accumulate under its own steam again – shades of Marx’s profitability theory!

What is interesting about this version of Keynesian crisis theory is that has nothing to do with sticky prices or with some ‘shock’ to ‘effective demand’ as mainstream Keynesian economists all look to. It depends on a drop in profitability (if unexplained). But you hear nothing of this ‘profitability model’ from modern Keynesian economists as they argue about whether it is ‘sticky wages’ or uncertainty and instability in financial markets that cause crises.

Even radical economists with an allegiance to both Marxian and Keynesian models do not refer to Keynes’ ‘profitability’ model. Recently, radical economists Lance Taylor and Duncan Foley of the New School received the Leontief Prize for Advancing the Frontiers of Economic Thought at Tufts University’s Global Development and Environment Institute. In an interview for the prize, Foley and Taylor attacked Krugman’s model for its equilibrium assumptions. For them, full employment is not an equilibrium outcome under capitalism and not Keynesian: “Keynes saw capitalism’s general state as allowing almost arbitrary unemployment: hence his “General Theory.” Full employment was a lucky exception… calling full employment the general state and allowing one unlucky exception turns Keynes upside down.”

But does that mean we should look in Keynes for the profitability model as an alternative? Well, no. For Taylor, the problem of slumps lies with “weak demand”. Taylor says “he follows Keynes in insisting that the first is demand. He treats demand as generally driving long-run growth, not just the ups and downs of business cycles.” And he reckons that Keynes really saw crises as being due “the distribution of income between profits and wages, and between high-earners and low-earners.”

However, Taylor reckons that the US economy is “profit-led” i.e. it grows if profit share grows. A higher profit share boosts growth. So if wage share rises, the US capitalist economy will suffer. This is the opposite of the current radical ‘post-Keynesian’ view that higher wages would improve the capitalist economy that Foley seems to support. According to this view, the Great Recession was caused not by a ‘sudden fall in profitability’ but by low wage share from high inequality so that consumer demand was too low (see my post ).

So is it sticky wages or prices?; uncertainty and instability in financial markets?; or weak demand and low wages?; or sudden drops in profitability? Will the real Keynes stand up?

Originally posted on Michael Roberts’ personal blog, The Next Recession.


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