Epitaph and Anthem

John Maynard Keynes


Between 1937 and 1977, the macroeconomics world was, without a doubt, the Neo-Keynesian's world. Some ungenerous commentators have since argued that it was a deviation, or an aberrant turn, on what has proved to be a Neoclassical thoroughfare from 1871 until today. We believe that not only is this assessment unduly harsh, it is also patently untrue. That Neo-Keynesianism is a thing of the past itself is not even clear. As James Tobin wrote, as late as 1993:

"In the last 20 yeas, the dominant trend in macroeconomics has dismissed Keynesian theory. Nevertheless, Keynesian models continue to prove useful in empirical applications, forecasting and policy analysis. Macro-econometric models are mostly built on Keynesian frameworks. The gulfs between doctrine and observation, between theory and practice, are chronic sources of malaise in our discipline."

(Tobin, 1993: p.45)

So, if rumors of the death of Neo-Keynesianism seem to be unduly exaggerated, then what follows, which might otherwise have been considered an epitaph, can alternatively be considered an anthem.

What was the significance of Neo-Keynesianism? Beyond its obvious policy-effective empirical appeal, the theoretical success of Neo-Keynesianism was based on one feature which, in fact, it shares with the Neoclassical counter-revolution which toppled it: namely, formalization. To economists of the time, Keynes's theory, and particularly the Neo-Keynesian theory, was a rigorous formalization of what, previously, was only "sensed" by many: namely, that "capitalist societies are vulnerable to very costly economy-wide market failures." (Tobin, 1993: p.47). The major features of this theoretical framework can by summarized as follows:

(1) that output is determined by the level of aggregate demand or, equivalently, the level of savings is determined by the level of investment.

(2) that disequilibria in the goods markets are solved via the multiplier as output adjusts to a given level of aggregate demand.

(3) that investment is independently determined by interest rates.

(4) that interest rates are determined in financial markets by an asset portfolio allocation decision.

(5) that the money market and, in particular, the preference for liquidity, is one of the dominant features of the portfolio allocation decision.

(6) that the portfolio allocation decision and the consumption-savings decision are two different decisions made largely independently of each other

(7) that the different markets aforementioned - goods markets, money markets, other asset markets, form a distinct "general equilibrium" system which is balanced to determine the equilibrium levels of output and interest rates whose central dominant determinants are the level of effective aggregate demand and the preference for liquidity.

(8) that the level of employment is determined by output and thus ultimately aggregate demand.

(9) that this level of employment need not be full employment.

(10) that real wages are determined by the marginal product of labor which is in turn determined by the level of employment and output - and hence, ultimately, aggregate demand.

(11) that the price level is determined by the money wage level.

(12) that the money wage level is determined by labor market bargaining (somehow) and is, in some views, assumed rigid or sticky, in other cases, flexible but incapable of relieving unemployment or even destabilizing - thus, there are no inherent tendencies in the system to bring the economy to full employment.

(13) that government fiscal and monetary policy can impact output and interest rates and thus the level of employment and thus can be used to bring about full employment.

All these features are central and, to a greater or lesser degree, subscribed to by the constructors of the Neoclassical-Keynesian Synthesis. The central message is that, in a modern capitalist economy with a financial sector, output is determined by aggregate demand and that this can naturally lead to a situation of involuntary unemployment which price and wage flexibility not cure or will take too long to cure. The ambiguity of the very last part of this summary, the flexibility of money wages, is what divides many Neo-Keynesian economists to this day.

Why was it successful? George J. Stigler (1969) and Harry G. Johnson (1971) have attempted to lay down criteria for "successful" economic revolutions, which include such standard items as the inability of the old orthodoxy to explain a new empirical phenomenon, the ability of the new theory to engage the old one in debate, its ability to incorporate at least some of the old concepts, the presence of a charismatic leader among the revolutionaries (succeeded by an oligarchic elite), the introduction of an appealing new methodology, a new set of distinct policy conclusions, its ability to create an "age gap" between orthodoxy and its challengers, etc. All of these elements were present in the Keynesian Revolution back in the 1930s and 1940s, and, to a good extent, also in the New Classical Counter-Revolution of the 1970s and 1980s.

Formalization, however much it contributed to the success of the Neoclassical-Keynesian Synthesis, proved to be a double-edged dagger. The increasing demand that the old Keynesian aggregative relationships be strapped to formal, optimizing microeconomics was inherently troublesome. Optimization is intricately involved with the issue of equilibrium and allocation, yet the whole essence of Keynes's General Theory was that before one even begins allocating the output of an economy, one must first determine what that output will be.

With one foot in allocation theory, and another foot in aggregate theory, the Neoclassical-Keynesian Synthesis bore within itself a theoretical contradiction - a contradiction which severely undermined its defenses against theoretical challenges. There were plenty of Neoclassical viruses introduced at the outset into the Neo-Keynesian system, thus it was no surprise that these would slowly grow to dominate the system, render it incapable of operation and, in the end, bring it crashing down.

Theoretically, then, the Neo-Keynesian system was incomplete, confusing, contradictory and thus unsatisfying. As a result, Neo-Keynesian economics simply could not rely on its theoretical impressiveness alone. Instead, it justified itself on its policy-effectiveness and its apparent empirical relevance. However, even this was a limited relevance as it seemed largely limited to explaining situations of protracted underemployment in modern, Western capitalist economies. It had little or nothing to say about the more pressing economic problems of the 1970s: stagflation in the Western world and development in the Third World. The Phillips Curve, which was erected to give it its "overemployment" side was an empirical phenomenon without a theory, grafted clumsily into Neo-Keynesian analysis and inherently weak. It was a wooden board holding up an unbalanced marble edifice. It was bound to snap eventually, whether by empirical phenomena or by the theoretical disorientation which it produced.

As it happens, the stagflation of the 1970s proved to be aberrant and thus a resurrection of Neo-Keynesianism was not inconceivable. However, the very success of Western economies since the 1980s and particularly after the end of the Cold War, has given economists and laymen alike the intuitive sense that "markets work" and that the problems identified by Keynes - involuntary unemployment in advanced economies - are simply non-existent (at least in the United States) and, for some revisionists, even inconceivable. Furthermore, Neo-Keynesian economics tells us very little, if anything, about things such as underdevelopment and poverty, perhaps the only really pressing economic problems of the modern day.

Of course, all this is quite a reversal of affairs from the 1930s, when Neoclassical macroeconomics was at a loss to explain the economic situation in the Western world, where the central problems were involuntary unemployment and deflation and where the conventional wisdom was precisely that markets did not work. This was the situation Neo-Keynesianism was built to study, and it did not seem clearly equipped to handle other phenomena. It is consequently easy to ascribe its eclipse in the past decade or so to the loss of its subject of study.

Finally, let us recall that, above everything, the Neoclassical-Keynesian Synthesis was largely an American affair. Although most of its components, such as the IS-LM, the Phillips Curve and, of course, the General Theory itself, were born in England, the Neo-Keynesian world was an American world. In its excessive optimism, in its pragmatism, in its scientism and in its contradictions, it exhibited the stamp of the country in which it was raised, flourished and met its demise. The demise was inevitable because the American intellectual code does not tolerate reliance on informal, intuitive reasoning - as the British does - nor does it value pure theory without practical results - as the Continental European does. Consequently, Americanism ensured that the Neo-Keynesian theory combined a formal, but not watertight, theoretical structure with an empirical, but not intuitional, applied side.

In sum, the theoretical implosion of the Neo-Keynesian edifice coupled with the loss of its policy-relevance, rendered it unacceptable by American standards. We would identify this, rather than the emergence of any "new truth", as perhaps the best reason for the demise of the incomparably most powerful and influential school of thought in the history of economics.

We permit Goethe, as always, to deliver the parting words:

Where once imagination on daring wing
Reached out to the Eternal, full of hope,
Now, that the eddies of time have shipwrecked chance on chance,
She is contented with a narrow scope...
Why do you grin at me, you hollow skull?
To point out that your brain was once, like mine, confused
And I looked for the easy day but in the difficult dusk,
Lusting for truth was led astray and abused?
You instruments, I know you are mocking me
With cog and crank and cylinder.
I stood at the door, you were to be the key;
A key with intricate wards -- but the bolt declines to stir.

(J.W. Goethe, Faust: Part I, 1808)

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