The biggest mistake in the history of macroeconomic thought

8 May, 2016 at 15:35 | Posted in Economics | 6 Comments

The Keynesian economics of the General Theory is static. It purports to explain how employment, GDP and the interest rate are determined at one weekly meeting, taking the price level as fixed. Modern macroeconomics is dynamic. It purports to explain how employment, GDP, the interest rate and the price level are determined in a sequence of weekly meetings. To knit together the temporary one-week Keynesian equilibria, Samuelson, in the new-classical synthesis, used the Phillips curve, which he saw as a price adjustment mechanism in which the wage adjusts in response to an excess demand or supply of labor. This was the biggest mistake in the history of macroeconomic thought and we are still suffering the consequences as central banks work with false ideas and broken models.

prosperityIn Prosperity for All I articulate the evolution of an alternative research agenda. I argue that it is beliefs that are sticky: not prices. At each weekly meeting, the auctioneer finishes his job. The demands and supplies of all goods are equal and all markets clear; including the labor market …

The differences of this theory from all of modern macro, both classical and New-Keynesian, are profound. In my view, high involuntary unemployment is an equilibrium phenomenon. A market economy can get stuck in a Pareto inefficient equilibrium with high unemployment forever. It is the job of government to design political institutions that provide the equilibrating mechanisms that are missing from laissez-faire market economies.

Roger Farmer

Farmer has always — as did e. g. Wicksell and Keynes — made a point of the fact that equilibrium and optimality are not the same thing. That also implies that the economy being in equilibrium does not have to be inconsistent with high and persistent unemployment rates. Farmer uses a search theoretical approach to underpin this view. Although yours truly do not share his faiblesse for the Mortensen-Pissarides-Diamond modeling of Keynesian ideas re labour markets and unemployment, it will sure be interesting to take part of his hopefully more fully-fledged argumentation for his view when the book is out in September.

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  1. Supposing that there is “a weekly meeting” abstracts away from the hazards posed by the possibility of race conditions, in which people learn of change and adjust their affairs, but at an inconveniently uncoordinated pace.

  2. ” In my view, high involuntary unemployment is an equilibrium phenomenon. A market economy can get stuck in a Pareto inefficient equilibrium with high unemployment forever.” Pretty much what Keynes said, wasn’t it?

    • my understanding also

      what’s new ?

    • This is one of several areas where Keynes’s argument was less than complete, coherent or lucid. Not really a fault in Keynes, who was trying to birth a new understanding, but certainly a fault in us, that we are stuck in the unformed mud instead of firing bricks and erecting a structure, eighty years later.
      .
      Stasis isn’t the issue here; homeostasis is. If you can find a hard constraint, a conservation law, you can derive an equilibrium analysis. That’s what Newtonian physics is all about: deriving an analysis of forces from a conservation law, such as the Newton’s requirement that energy and mass can be neither created nor destroyed. The most basic equations of aerodynamics, for example, can be derived from the conservation of momentum or the conservation of energy. The equilibrium of forces always obtains whether the plane is flying or crashing.
      .
      That’s what the classical economists were trying to do — find a reliable principle of conservation from which they could derive an analysis, and failing to do so convincingly. The labor theory of value functioned as such a conservation principle and though Smith handled it gently, it didn’t hold up so well in the rougher hands of Ricardo and Malthus, let alone Marx. The neoclassical economists gave up on finding a conservation law, and turned the problem around: they assumed a market equilibrium as homeostasis, and derived an analysis from that assumption.
      .
      Keynes, in his way, was self-consciously returning to Smith. His aggregate demand is a kind of mirror image of Smith’s labor theory of value, as both are focusing on the capacity of the economy as a constraint. Involuntary unemployment is a direct assault on neoclassical homeostasis. .
      Keynes tried to make neoclassical homeostasis a special case, but only fumbled toward deriving an equilibrium analysis from the constraint of full employment.
      .
      Another emergent concept got in his way: that the economy was like an engine, whose actual efficiency might be analyzed and empirically measured as a deviation from some ideal, and attributed to the design and working of the engine itself. That the “magneto trouble” of the world or British or American economy of the time might be fixed by a technical intervention to repair a broken component — perhaps in the monetary and financial institutions — and then restarted or reflated — this was a common metaphor at the time, though not one given much formal elaboration. It remains the basic idea of New Keynesian economics: that the economy can be theoretically understood as an ideal machine, but managed as a machine the efficiency of which is inhibited by all kinds of “ad hoc” deficiencies that reasonable people may recognize, “sticky prices” being the prime example.

  3. Roger Farmer’s mishmash is finally out. I’ll need a search function of common sense to get through it!

  4. “The Keynesian economics of the General Theory is static. ”

    If anything Keynesian economics based on IS/LM analysis is static. Whether the economics of the GT is static is another thing.


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