Keynesian vs Newtonian economics

14 Jul, 2020 at 17:11 | Posted in Economics | 12 Comments

To complete his theory, Keynes tied these elements together. The market for money determined interest. Interest (and the state of business confidence) determined investment. Investment, alongside consumption, determined effective demand for output. Demand for output determined output and employment. Consumption out of incomes determined savings. Employment determined the real wage.

diffIn this world, a change in monetary policy, such as a cut in interest rates leading to an increase in bank credit, now had fundamental real consequences. The classical dichotomy, in economics as in physics, had been broken. And with the deconstruction of labor and capital markets, the reductionist idea of microfoundations had also to be abandoned. Workers, Keynes pointed out, bargain for money wages, not real wages. The act of dropping money wages would generate feedbacks through previously unrecognized–monetary–channels in the system … The system interacts with itself, and a full employment equilibrium cannot be achieved within the labor market. Economic space-time is curved.

In the long run, Keynes did not achieve what he hoped … In the United States, the prevailing view became that of Paul Samuelson, who transposed Keynes’s unemployment theory into the proposition that wages are “sticky” … What Samuelson did was to push the daemon of Keynesian relativity back into its box. And modern American Keynesians, even down to the New Keynesians currently in fashion around Harvard, MIT, Princeton, and the Council of Economic Advisers, are Newtonian and Samuelsonian to the core …

Too bad. For one cannot say, as one can with Newtonian physics, that Newtonian economics is good enough for practical situations … The failure of Keynesian macroeconomics to establish full theoretical independence from the classical labor market and the classical neutrality of money means that we are, in effect, now denied fair discussion of Keynesian solutions to policy problems. The end result is that we cannot cope now, any more than could the classics in their day, with stagnation and involuntary unemployment.

James K. Galbraith


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  1. I’ll confine my observations to physics though the implications for economics will be obvious (to some). Physics went wrong imo when it ceased to engage with the problem of dealing analytically with non linearity. The advent of powerful digital computing allowed physicists to explore the behavior of nonlinear systems empirically, ie by numerical simulation. This in turn resulted in a cop out of sorts for analysis. In the 70’s the best and brightest still struggled to establish analytic methods for dealing with nonlinearity. Stability theory, perturbation method, asymptotic analysis, chaos theory, as well as failed efforts to establish error bounds for the formally divergent power series methods that so offended pure mathematicians of the time. This has all been replaced by brute force computational simulations. The result: even today the Navier Stokes equations of Fluid Mechanics remain analytically intractable. Indeed, the number of solutions, their basic properties, continuity, differentiability, smoothness, dependence on initial data, are no better understood now than In my youth. It would be understatement to say this path chosen away from analysis has put a crimp on our understanding.
    Steve Keen has done a terrific job accessing and employing the techniques of that era in macroeconomic modeling. Even he however has not framed the Minsky Financial Instability Hypothesis as a stability problem. Rather, he treats it as an initial value problem by numerical simulation. The phase space behaviors he sees are fascinating but I yearn for an analytic approach where the stability of a macroeconomic system becomes unstable, ie, branches or bifurcates away from its basic state as a parameter (eg total private debt/GDP increases). In this framing, that parameter doesn’t grow relentlessly within a simulation. Rather it would appear as a parameter we control explicitly just as we control Reynolds number in the engineering world. The analysis would treat the system as a stability problem, like Euler Column Buckling, or transition to early turbulence.

  2. “The market for money determined interest.”
    Since interest rates have declined over 700 years (see Paul Schmelzing, “Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018”), has supply of money outstripped demand? The price of money has deflated?
    “The failure of Keynesian macroeconomics to establish full theoretical independence from the classical labor market and the classical neutrality of money”
    If money isn’t constrained by neutrality then why not print more to fund a basic income and end poverty?

    • I fail to understand your view that a UBI is grounded in ending poverty when its earliest proponents viewed it as a mechanism to to end targeted state programs as a safety net and then as a means to support uplift – it’s completely left to the machinations of market dynamics.

      Its akin to selling the old family house only to be subjected to what ever price the market demands to relocate and no consideration to more fundamental human social or psychological dynamics.

      • The earliest proponents include Thomas Paine, when there was no safety net to replace; also, C. H. Douglas in the 1930s was an early modern proponent of basic income who said nothing of replacing existing social programs.

        • Yeah but … the currant modern back drop is an agenda supported by Friedman and the Chicago school which is contra to your suggestion, highlights include reduced democracy because the mob will just vote for more money. Albeit they saw nothing wrong with capital voting with the democracy of money to the same effect … funny how that works.

          • If your story is true, why didn’t Mnuchin cut social spending to pay for pandemic stimulus payments? No one in the private sector listens to Friedman anymore. Lord Mnuchin (trained by Goldman Sachs) understands how Treasury Inflation Protected Securities and inflation swaps eliminate supposed inflation constraints; in Friedman’s time those hadn’t been invented yet.

  3. The Long Divorce Between the Economy and Financial Markets
    by Ken-Hou Lin and Megan Tobias Neely

  4. Galbraith’s essay curiously fails to even mention the fundamental ground distinguishing classical economics from Keynes’s proposal, the condition that raises money from mere neutral numeraire into independent force. He does mention that Keynes of the General Theory chose not to confront directly the axiom of diminishing returns, diminishing returns being the logical rationale of supply-and-demand, but did attack the idea of supply-and-demand in markets driving the macro economy.
    Galbraith does acknowledge that Keynes failed in his Promethean ambition, though he blames Keynes’ academic successors, in particular Samuelson. “What Samuelson did was to push the daemon of Keynesian relativity back into its box.” Say what?! “daemon” ? “Box”? These metaphoric elements appear nowhere else in his essay. Talk about mixed metaphor!
    Sad really that after more than 80 years, the last Keynesian cannot be clear.

  5. Keynes in the GT accepted the “first classical postulate” that the real wage equals the marginal product of labor. That looks like accepting dimishing returns, although he later rejected them in response to Kalecki.

    • “The difficulty lies not so much in developing new ideas as in escaping old ones.”
      The author of the General Theory struggles openly in his attempt to escape the prison of the neoclassical system.
      If you could go back in time, what you tell him about the relation of wages to marginal product?
      I have an answer, and I wonder if it would surprise my own contemporaries? It should not. It is unoriginal, even unconventional.
      I would tell Keynes that there is no such thing as a “real wage” nor is there a labor market in any literal sense. People are paid wages in money and wages are enumerated and agreed or fixed in the unit of account and that is is it. The context for wages is an administrative hierarchy of work under supervision, not a putative, imaginary market of bid and ask. Be realistic in your observations and apprehensions and you may become useful, I would tell Lord Keynes in my message from a far-seeing future.
      Is the wage equal to the marginal product of labor? Understanding that marginal product cannot practically be understood or assessed in “real” terms, though trying to do so is the usual upshot of talk of productivity in contradistinction to measurements in money expenses and revenues, the answer is properly, yes. Not because marginal product is the outcome of allocating labor as a factor of production thru a market using a market price, but because labor’s marginal product is the outcome of application to control of a production process under management. Management, having fixed the wage administratively, will manage the application of labor to work in such a way as to make the marginal product approximately equal the wage promised and paid. They may not succeed in a particular firm or instance, but they will try to make it so.
      Management offering a wage and then managing hired labor to make marginal product equal to the wage is not the glorious optimizing process attributed to imaginary competitive markets by neoclassical economists. Low wages promote wasteful, low marginal-product applications of labor services.
      This is how pervasive uncertainty plays out in the actual world: firms organize around their limited understanding and sunk-cost capital investments are committed to exploit that limited base and scope of knowledge. The result is that most firms most of the time are operating in a range of output such that marginal cost of unit output is both less than average unit cost and declining with increasing rates of output. Most firms would like to sell more at current prices than they can. Technically, no market-clearing market-equilibrium price is even theoretically possible. Moreover, in many industry sectors, elaborate price discrimination schemes are necessary for firms to recover their total costs. Firms must secure through a strategic combination of property rights and technical choices, sufficient market power to earn a quasi-rent return on their sunk-cost capital investment both to maintain the investment stock and to service debt or equity used to finance that investment.
      The insistence on talking ideologically as if the metaphor of an imaginary market economy presented by Econ 101 theory is realistic prevents thought now as it did more than 80 years ago.

      • “firms organize around their limited understanding and sunk-cost capital investments are committed”
        My only quibble with this paragraph is that firms such as Tesla borrow to pay “sunk costs” then sell financial goods to make the bulk of their profit. Car companies are really finance firms; the real output of cars is like a side effect. Tesla’s stock provides more value than its cars, and its stock value is based on traders. Note: in its most recent quarterly disclosure, Tesla reported far more income from sales of “regulatory credits” than from cars. Tesla is really a finance firm producing cars on the side …
        It is possible the $430 million Tesla reports as “regulatory credit” income is fraudulent. But how will you prove it? I fear regulations will lead to more profit-generating items on company balance sheets as an unintended consequence. Another unintended consequence of financial regulation is to create more barriers for someone like myself, who wants to trade lumber futures to generate enough profit to borrow money to buy logging contracts not to log them. Rather than try to regulate fraud in markets, we can use markets against themselves, and insure our green hedge fund with the Fed …

  6. Well, look, among(st) myriad other activities JMK tried to run the Cambridge Arts Theatre and had a hard time hiring chefs for the cafe. He was well aware of the problems Wilder raises. But if you are doing macroeconomics you need a macro metaphor about the functional income distribution. Kalecki’s was slightly better, which Keynes ended up accepting.

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