What is Post Keynesian Economics?

30 May, 2017 at 12:41 | Posted in Economics | 6 Comments

encyc John Maynard Keynes’s 1936 book The General Theory of Employment, Interest, and Money attempted to overthrow classical theory and revolutionize how economists think about the economy. Economists who build upon Keynes’s General Theory to analyze the economic problems of the twenty-first-century global economy are called Post Keynesians. Keynes’s “principle of effective demand” (1936, chap. 2) declared that the axioms underlying classical theory were not applicable to a money-using, entrepreneurial economic system. Consequently, the mainstream theory’s “teaching is misleading and disastrous if we attempt to apply it to the facts of experience” (Keynes 1936, p. 3). To develop an economic theory applicable to a monetary economy, Keynes suggested rejecting three basic axioms of classical economics (1936, p. 16).

Unfortunately, the axioms that Keynes suggested for rejection are still part of the foundation of twenty-first-century mainstream economic theory. Post Keynesians have thrown out the three axioms that Keynes suggested rejecting in The General Theory. The rejected axioms are the ergodic axiom, the gross-substitution axiom, and the neutral-money axiom … Only if these axioms are rejected can a model be developed that has the following characteristics:

•Money matters in the long and short run, that is, changes in the money supply can affect decisions that determine the level of employment and real economic output.

•As the economic system moves from an irrevocable past to an uncertain future, decision makers recognize that they make important, costly decisions in uncertain conditions where reliable, rational calculations regarding the future are impossible.

•People and organizations enter into monetary contracts. These money contracts are a human institution developed to efficiently organize time-consuming production and exchange processes. The money-wage contract is the most ubiquitous of these contracts.

•Unemployment, rather than full employment, is a common laissez-faire situation in a market-oriented, monetary production economy.

•The ergodic axiom postulates that all future events are actuarially certain, that is, that the future can be accurately forecasted from an analysis of existing market data. Consequently, this axiom implies that income earned at any employment level is entirely spent either on produced goods for today’s consumption or on buying investment goods that will be used to produce goods for the (known) future consumption of today’s savers. In other words, orthodox theory assumes that all income is always immediately spent on producibles, so there is never a lack of effective demand for things that industry can produce at full employment … Post Keynesian theory rejects the ergodic axiom.

In Post Keynesian theory … people recognize that the future is uncertain (nonergodic) and cannot be reliably predicted.

Paul Davidson

The financial crisis of 2007-08 hit most laymen and economists with surprise. What was it that went wrong with our macroeconomic models, since they obviously did not foresee the collapse or even made it conceivable?

There are many who have ventured to answer that question. And they have come up with a variety of answers, ranging from the exaggerated mathematization of economics, to irrational and corrupt politicians.

0But the root of our problem goes much deeper. It ultimately goes back to how we look upon the data we are handling. In ‘modern’ macroeconomics — Dynamic Stochastic General Equilibrium, New Synthesis, New Classical and New ‘Keynesian’ — variables are treated as if drawn from a known “data-generating process” that unfolds over time and on which we therefore have access to heaps of historical time-series. If we do not assume that we know the ‘data-generating process’ – if we do not have the ‘true’ model – the whole edifice collapses. And of course it has to. I mean, who honestly believes that we should have access to this mythical Holy Grail, the data-generating process?

‘Modern’ macroeconomics obviously did not anticipate the enormity of the problems that unregulated ‘efficient’ financial markets created. Why? Because it builds on the myth of us knowing the ‘data-generating process’ and that we can describe the variables of our evolving economies as drawn from an urn containing stochastic probability functions with known means and variances.

4273570080_b188a92980This is like saying that you are going on a holiday-trip and that you know that the chance the weather being sunny is at least 30%, and that this is enough for you to decide on bringing along your sunglasses or not. You are supposed to be able to calculate the expected utility based on the given probability of sunny weather and make a simple decision of either-or. Uncertainty is reduced to risk.

But as Keynes convincingly argued in his monumental Treatise on Probability (1921), this is not always possible. Often we simply do not know. According to one model the chance of sunny weather is perhaps somewhere around 10% and according to another – equally good – model the chance is perhaps somewhere around 40%. We cannot put exact numbers on these assessments. We cannot calculate means and variances. There are no given probability distributions that we can appeal to.

In the end this is what it all boils down to. We all know that many activities, relations, processes and events are of the Keynesian uncertainty-type. The data do not unequivocally single out one decision as the only ‘rational’ one. Neither the economist, nor the deciding individual, can fully pre-specify how people will decide when facing uncertainties and ambiguities that are ontological facts of the way the world works.

wrongrightSome macroeconomists, however, still want to be able to use their hammer. So they decide to pretend that the world looks like a nail, and pretend that uncertainty can be reduced to risk. So they construct their mathematical models on that assumption. The result: financial crises and economic havoc.

How much better – how much bigger chance that we do not lull us into the comforting thought that we know everything and that everything is measurable and we have everything under control – if instead we could just admit that we often simply do not know, and that we have to live with that uncertainty as well as it goes.

Fooling people into believing that one can cope with an unknown economic future in a way similar to playing at the roulette wheels, is a sure recipe for only one thing — economic disaster.

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6 Comments

  1. I personally very much like Davidson’s interpretations of Keynes’s GT. However, questions have been raised about his tying Keynes’s notion of uncertainty to the concept of non-ergodicity. Three papers were recently published dealing with the issue. I’m not sure what was resolved if anything, but I found them very interesting reading.
    .
    Rod O’Donnell – “A critique of the ergodic/non-ergodic approach to uncertainty”, Journal of Post Keynesian Economics, Winter, 2014-15, vol 37, no.2, 187-210.
    .
    Paul Davidson – “A rejoinder to O’Donnell’s critique of the ergodic/non-ergodic explanation of Keynes’s concept of uncertainty”, Journal of Post Keynesian Economics, 2015, vol 38, 1-18.
    .
    J. Barkley Rosser Jnr., – “Reconsidering ergodicity and fundamental uncertainty”, Journal of Post Keynesian Economics, 2015, vol 38, 331-354.

  2. I don’t see what is wrong with the gross substitution axiom. It should stand, although the ergodic axiom is not a good way of ensuring that our subject is scientific and consequently should not be regarded as an axiom. The neutral money axiom can be rejected since today governments do influence the progress through monetary controls.

  3. “Money matters in the long and short run, that is, changes in the money supply can affect decisions that determine the level of employment and real economic output.”

    No doubt that “the money supply can affect decisions that determine the level of employment and real economic output.”

    However, Keynes says this: “There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment; — any more than for the belief that an open-market monetary policy is capable, unaided, of achieving this result..”

    https://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/chapter24.html

  4. That penultimate paragraph of the Davidson quote is wrong in its logic.

  5. I hope JKH explains. In the meantime I will guess that the problem might be in the transition from
    “The ergodic axiom postulates that all future events are actuarially certain, that is, that the future can be accurately forecasted from an analysis of existing market data”
    to
    “Consequently, this axiom implies that income earned at any employment level is entirely spent either on produced goods for today’s consumption or on buying investment goods that will be used to produce goods for the (known) future consumption of today’s savers.”
    Because, I don’t understand why that necessarily is the consequence, but that’s just me, and I don’t understand a lot of things. But why would an idea that the future can be accurately forecasted imply that all income will be spent on consumption and/or investment?


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