The "Other" Macroeconomics

John Maynard Keynes

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"The general character and agreement in the periodic turn in movements of factors of circulation -- these are the specific problems of business cycle theory which have to be solved within the closed interdependent system....If a business cycle theory which is system-conforming cannot be built, then "general overproduction" will not only drive the economy but also economic theory into a crisis."

(Adolph Lowe, "How is Business Cyle Theory Possible at All?", Weltwirtschaftliches Archiv, 1926).

"But if the classical theory is not allowed to extend by analogy its conclusions in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have. For it has no method of analysis wherewith to tackle the problem. Professor Pigou's Theory of Unemployment seems to me to get out of the Classical Theory all that can be got out of it; with the result that the book becomes a striking demonstration that this theory has nothing to offer, when it is applied to the problem of what determines the volume of actual employment as a whole."

(J.M. Keynes , The General Theory, 1936: p.260)

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(A) The Great Delay
(B) The Macroeconomic Revolution

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(A) The Great Delay

John Maynard Keynes is often credited with having created "macroeconomics". However, before his 1936 General Theory, there were several economists whom attempted, in several ways, to address the similar types of issues which Keynes tackled: the determination of output and employment in the economy as a whole. These "other macroeconomists" whom Keynes referred to collectively as the "classics" were really contemporary proponents of a still rudimentary "Neoclassical" theory of the macroeconomy -- one which Keynes himself had helped build.

Yet this infamous "Neoclassical" model of the economy, at which John Maynard Keynes (1936) directed so much of his fire, was not very old by most standards. In most discussions of the "macroeconomy" before the 1920s, Neoclassical economists tended to have little to say. They might mumble something about Say's Law, the Quantity Theory (or some version thereof) and perhaps a few words about how it would all "equilibrate" again in the long run. The more interesting economist might add some conjectures about the pattern of "business cycles" and possibly even growth, but that would be about it.

The reason why all this is surprising is that Say's Law, the Quantity Theory, business cycle and growth theory were not part of Neoclassical economics. Or, more precisely, the Classical economists -- Smith, Ricardo, Malthus, Mill, Marx, etc., --- and even the Historical and Institutionalist schools, possessed practically this same book of tales about the economy. Thus, as far as the macroeconomy was concerned, most Neoclassicals were content to merely adopt the conclusions of others.

This state of affairs was surprising for one rather important reason: presumably, in the Marginalist Revolution of 1871-4, the Neoclassicals had forged a whole new theoretical apparatus, distinctly different from the Classical School and certainly quite apart from the Historical and Institutionalist schools. In those frenzied years, they constructed a brand new theory of value, production and distribution. Yet, where was this new theory when they spoke about the economy as whole? Why did they retreat into the language and concepts of their predecessors? Why was there no distinctly Neoclassical theory of the macroeconomy?

There are several tentative ways of answering this question. The first is that the distinctiveness of Neoclassical theory lay in the issue of allocation. Allocation, of course, presupposes that there is "something" to be allocated. Their tools were created to answer the question of how the pie gets divided up, and not about what the size of the pie will be. Thus, if asked about the latter, they simply did not have the tools at hand to answer that. So, in such a situation, why not just import the older Classical story?

A second item would be that the Neoclassical theory was based on the concept of equilibrium. Questions about the macroeconomy inevitably centered around the question of fluctuations in output as a whole. Equilibrium is a center of gravitation. If the economy jumps around without going there, there must be something wrong with the economy. But the object and tools of Neoclassical economics are geared to analyzing equilibrium situations only. Fluctuations are a phenomena that Neoclassical theory is not designed to discuss.

A third possibility is simply that the Neoclassicals lacked the time, interest, patience, disposition or imagination to analyze questions about the macroeconomy too carefully. The first half-century after the Marginalist Revolution of 1871-4 were spent on other issues -- such as distribution, utility, demand, the firm, capital, international trade, etc., all the while fending off methodological attacks by other rival schools. They simply did not get around to thinking about how to incorporate "macro" questions of money, macrofluctuations and growth into a proper "Neoclassical" theoretical system.

A fourth possible explanation was simply that these "macro"questions were not considered "economic" questions anyway. For instance, it was not clear during these early years that "business cycles" really existed anyway, much less that they had an "real economic" explanation. Money, and indeed finance as a whole, was not supposed to be part of the "real" economy to begin with, so it did not merit much "serious" attention. Growth was supposed to be about increasing factor supplies. Capital got some attention, but not labor -- heaven knows what causes laborers to procreate! Unemployment? Well, if we are to draw any conclusions from good old Victorian mores, the unemployed were seen as idlers, morally failed people, who just chose not to work. The "cure" for unemployment, as was evident social policy in those days, was just a good dose of harrowing workhouse discipline. In short, all these macroeconomic questions could be seen to be outside the realm of economics itself.

A fifth possibility is that the Neoclassicals had couched their theories in a manner that was not amenable to take to the aggregate level. They either had, like the Lausanne economists, large, unwieldy "general equilibrium" systems depicting "idealized" situations which were hard to apply to the real world as there were too many factors in the story. Alternatively, like the Cantabrigians, they tended to base their reasoning on "representative" situations at the very partial, microeconomic level, where everything else was "held constant". But in treating the economy as a whole, there is no "other" part that can be held "constant" and so permit the analysis to go forward. Representative reasoning is not easy to generalize to the aggregate economy.

There is probably an element of truth to all these propositions and doubtlessly more can be added. Whatever the reasons, they conspired to end up with the strange result that there never really was a clear "Neoclassical" theory of the macroeconomy -- up until the 1920s.

(2) The Macroeconomic Revolution

So what exactly happened in the 1920s? Effectively, Neoclassical theory came into contact with business cycle theory at last. The Cantabrigians confronted it a bit earlier, but for most others Neoclassical economists, the meeting was forced upon them by the post-World War I economic crisis in Europe which they were at a loss to explain. The Great Depression that was initiated after 1929 only spurred them further. Thus, it is throughout the 1920s and 1930s that economists began finally to confront the issue theoretically and Neoclassical "macromodels" finally began being constructed.

The energy in the construction was palpable. Old hands such as Gustav Cassel (1918), Alfred Marshall (1923) and Irving Fisher (1930) shared the task with younger contemporaries such as Friedrich Hayek (1929, 1931), the Cambridge Marshallians (Pigou, Hawtrey, Robertson and young Keynes himself) and the Stockholm School (Myrdal, Lindahl, Ohlin, Lundberg).

The streams of influence that went into the construction of Neoclassical macroeconomic theory were varied, and thus we cannot say that there was a single, uniting "model" that resulted. Roughly two distinct approaches to the task can be discerned, which we shall divide into the "Fisherian" and "Hayekian" approaches.

The "Fisherian" approach is what we shall term the canonical "Neoclassical Macromodel" -- i.e. the one with money neutrality, Say's Law and full employment equilibrium. This is the approach that was completely "Anglo-American" in its creation and propagation. It was to the Fisherian tradition that the Cambridge Marshallians contributed. This is the version that the Keynesian Revolution was directed against.

The Hayekian approach is a considerably different but ultimately more interesting approach, deriving its inspiration from a long Continental European tradition of structural analysis. It is one with financial and monetary non-neutrality, where Say's Law is violated, where macrofluctuations are real phenomena, endogenously driven by "disproportionalities" between sectors, where growth is part of the story and where there can be unemployment equilibrium. It is striking to realize how different macroeconomics might be today had Neoclassicals taken the Hayekian rather than the Fisherian route. Dennis H. Robertson and the Stockholm School can be, with some reservations, considered part of this "Hayekian" tradition.

After 1936, the Neoclassical macromodel effectively disappeared. Of course, the Neoclassical-Keynesian Synthesis model - as pursued by such eminent figures such as Franco Modigliani (1944), is very different from the older Neoclassical model -- which should be no surprise. If Neoclassical macroeconomics only broke out of its Keynesian shadow to return to the spirit of the 1920s only after the Monetarist and New Classical revolutions of the 1970s and 1980s.

However, we should make note of two particularly famous post-1936 attempts at resurrecting static Neoclassical macrotheory, namely those by John Hicks (1939) and Don Patinkin (1956), which spawned, in turn, the late 1960s-early 1970s attempt at creating a "Walrasian-Keynesian" synthesis. This movement, which deserves considerably more attention than it is given today, can be considered as part of the "Hayekian" legacy.

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