My short piece on Solow and his relation to the Review of Keynesian Economics

(1924-2023)

Robert Solow, who was a member of the editorial board of the Review of Keynesian Economics (ROKE), died in December 2023. Solow holds a special place in the history of macroeconomics, and he was a strong supporter of the ROKE project. In this brief note I want to honor Solow’s contribution to economics and to place on record his contribution to ROKE.

Histories of macroeconomics tend to emphasize the disputes between Keynesians and Monetarists, at least up to the 1970s. Those disputes very often pitted Milton Friedman against either Paul Samuelson, with whom he alternated in a famous Newsweek column, or James Tobin who was, perhaps, the most prominent of Friedman’s opponents when the Journal of Political Economy edited a debate with Friedman’s critics. In the broader cultural wars, Friedman was often pitted against John Kenneth Galbraith, and his Free to Choose series was seen as a response to the latter’s BBC series The Age of Uncertainty. Solow appears, if at all, as Samuelson’s co-author of a paper on anti-inflation policy (Samuelson and Solow 1960), which is widely viewed as introducing the Phillips curve to the American economics profession.

Yet Solow is, in many ways, the central figure of ‘American’ Keynesianism, and he was awarded the 1987 Nobel Prize in Economics. His work was central to the building of what Samuelson referred to as the Neoclassical Synthesis, which was dominant during the post-war era up to the 1970s. This synthesis combined microeconomic competitive general equilibrium theory, Keynesian macroeconomics, and Solow’s (1956) Neoclassical growth theory. It gave short-run space for Keynesian policy effectiveness but asserted a long-run belief in market forces and Say’s Law, which Solow defended in his growth model and in the Cambridge debates with more heterodox Keynesians. Additionally, Solow contributed decisively to the development of what eventually would be called New Keynesian Economics, with the development of the efficiency wage model in the late 1970s. He lived long enough to see fiscal policy rehabilitated after the Great Recession of 2007–2009, and to see what many view as the return of Keynesian Economics.

Read rest here.

Gatekeepers and herd behavior: On Tooze and the radicalization of Krugman

"But that one is holding the poop!"

Adam Tooze, the author of the monumental Crashed (who was, incidentally,  student of Wynne Godley, one of my mentors), wrote a piece for the London Review of Books that has received a lot of praise. While it reviews Paul Krugman's latest book, it provides an overview of the radicalization of New Keynesians, or at least some, that dominate both in academia, and in the corridors or power. The gatekeepers of knowledge and academic  and intellectual influence, with a close connection to power, so to speak. He tells us at the outset that Krugman, the economist that was a bulwark of free trade, even when the theories for which he received his Sveriges Riksbank Prize (aka the Nobel) suggested that some degree of intervention might be good, and that remained even after the 2008 crisis a defender of the conventional macroeconomic model, not only has moved to the left, but also that "in Joe Biden’s Washington, Krugmanism rules."

This is, however, a misinterpretation of the current situation. Tooze suggests that Krugman is one of the "high-powered centrists inching their way towards seemingly obvious political conclusions." The group includes "three centrists – Biden, Janet Yellen and Jerome Powell [that are] undertaking an experiment in economic policy of historic proportions." And he, also, argues that: "what sets Krugman apart within this cohort is the way he has, since the 1990s, stopped being a gatekeeper of the status quo and instead become its critic. In this respect his closest analogue is Joseph Stiglitz, also once of MIT, a member of the Clinton administration and chief economist to the World Bank. Both men have indisputable standing as members of the elite club of New Keynesians."

I see Krugman as being closer to what Colander, Holt and Rosser referred to as the cutting edge of the profession. The role of cutting edge of the profession, in my reply to them (see the paper in Fred Lee and Marc Lavoie's book here), is to make more reasonable policy propositions, while maintaining the notion that markets do produce efficient outcomes, in spite of the unsurmountable logical problems brought by the capital debates, and that led to the rise of vulgar economics. Krugman in that sense is the epitome of the cutting edge. Of course, in order to make reasonable points he would discard many of his own ideas. But he is no critic of the mainstream. The problem with Tooze's argument lies in there. Krugmanism cannot rule, if he basically had to discard his ideas in order to remain relevant. And relevant here simply means that he can be seen to be on the right side of history, more skeptical of free markets, free trade, and willing to accept significant expansion of deficits and debt.

The ideas that won the day and rule in Biden's America are heterodox ideas, that in fact, until very recently Krugman dismissed as not serious. The possibility of continuous expansion of the welfare state, and the expansion of fiscal deficits and debt were anathema to him. Not only he was against expansionary fiscal policy, but even 'Medicare for All,' the signature proposal of Senator Bernie Sanders, something that is common in all advanced economies, was dismissed as a political nonstarter. And certainly that idea, which is not that radical, has remained in the background, and is unlikely to be pushed by the 'radicalized' Biden administration. Perhaps even Krugman still thinks is far too lefty to be acceptable in the United States.

Biden might be the president, and he has a lot of power about what elements of the agenda to push, and he has certainly moved to the left. No doubt about that. Not surprisingly Heather Boushey and Jared Bernstein, economists with heterodox and labor connections, are defending the fiscal expansion from the Council of Economic Advisers (CEA), while Larry Summers, the quintessential insider of the Clinton and Obama administrations, is criticizing from outside. But the Democratic Party has moved to the left, and the politicians have followed. It is the party of Bernie and Alexandria Ocasio-Cortez (AOC). And the establishment knows they need to move if they want to remain relevant, and have a fighting chance in 2024, since the working class is radicalized, and many will abandon the party if Biden does not deliver.

They are like the French politician that, seeing the masses pass in protest, tells his friends in the café he must leave and follow them, since he is their leader. This is, it goes without saying, more like herd behavior, than leadership. Krugman is, in that sense, the leader of an intellectual sea change about views on the role of the state in the economy.

Tooze may think that these arguments are just the diatribes of those in the left that are angry,* infuriated he argues, with the slow pace of change in the center. The issue is that, even though Krugman is following the herd, he certainly is a central gatekeeper in the economics profession. A profession that has been attacked for good reasons, for its excessive influence in policy, and the recurrent blunders of its luminaries.

Krugman still argues in terms of the conventional model, that he defends, as having done a good job explaining the 2008 crisis. People like Wynne Godley, that truly foresaw the 2008 crisis, often only received the acknowledgement ex-post, sometimes too late, after passing away.** Krugman dismisses heterodox economists as not serious. A type of red-baiting of heterodox economists with significant impact on the ability of the profession to change. He also validates some of worst within the mainstream and is willing to play by their harsh rules.+ This is, of course, because the prestigious teaching positions he held, and still holds, the 'Nobel', that was created to give respectability to certain ideas, the weekly column in the NYTimes are all powerful platforms. The danger in this, in accepting Krugman's narrative that he has been right all along, is to convince ourselves that the profession has indeed changed. Now the dangers of neoliberalism and their main defenders, mainstream economists, are gone. The profession is rehabilitated. But the retreat of neoliberalism is only temporary. Krugman and other gatekeepers will change their tune when the current Keynesian moment passes. If the Bidenomics experiment ends up being of historic proportions, and I do hope it does, although that is still too soon to tell, it will not be a victory of Krugmanism. It will be a victory in spite of it.

* I am not as angry as Paul Romer, though.

** On Krugman critique of Godley's 'hydraulic' model, and my response go here.

+ He famously said: "By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote." [Italics added] See the quote and a discussion of the role of another gatekeeper in France that also won a 'Nobel' here.

Larry Summers on Effective Demand

On of the issues between more mainstream Keynesians and their more heterodox counterparts is whether frictions are central for Keynesian results or not. Since the Neoclassical Synthesis the conventional view is that some rigidity or friction was behind the problems of unemployment, be that the liquidity trap (the Keynesian case with the flat LM, since Hicks 1937), the rigidity of wages (since Modigliani 1944), or some other coordination problem (mostly in the New Keynesian literature).

In this recent thread (worth reading all) Summers (as shown above) notes that posties might have been right on emphasizing the fundament issue of effective demand. That of course is closer to what Keynes himself would have thought. The paper he cites, by Tom Palley, co-editor of the Review of Keynesian Economics (ROKE) is free and available here.

Tom Palley on Zero Lower Bound (ZLB) Economics

From the abstract:

This paper explores zero lower bound (ZLB) economics. The ZLB is widely invoked to explain stagnation and it fits with the long tradition that argues Keynesian economics is a special case based on nominal rigidities. The ZLB represents the newest rigidity. Contrary to ZLB economics, not only does a laissez-faire monetary economy lack a mechanism for delivering the natural rate of interest, it may also lack such an interest rate. Moreover, the ZLB can be a stabilizing rigidity that prevents negative nominal interest rates exacerbating excess supply conditions.

Read full paper here.

Simon Wren-Lewis on New Classical Economics and the Financial Crisis

New paper by Wren-Lewis titled "Unravelling the New Classical Counter Revolution." It provides a strong New Keynesian critique of the New Classical/Real Business Cycle schools. He argues, correctly in my view, that the problem is the abandoning of the Keynesian method of analysis. I'm less keen on microfoundations. Or at least on marginalist microfoundations. But it is important to understand how much the fundamentalist views of Lucas and Prescott have affected the profession.

From the abstract:

To understand the position of Keynes's The General Theory today, and why so many policy-makers felt they had to go back to it to understand the Great Recession, we need to understand the New Classical Counter Revolution (NCCR), and why it was so successful. This revolution can be seen as having two strands. The first, which attempted to replace Keynesian policy, failed. The second, which was to change the way academic macroeconomics was done, was successful. Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. 

As a result, most academic macroeconomists today would see the foundation of their discipline as not coming from The General Theory, but as coming from basic microeconomic theory – arguably the ‘classical theory’ that Keynes was so keen to cast aside. Students are also taught that pre-NCCR methods of analysing the economy are fatally flawed, and that simulating DSGE models is the only proper way of doing policy analysis. This is simply wrong. The problem with the NCCR was not the emergence of microfoundations modelling, which is a progressive research programme, but that it discouraged the methods of analysis that had flourished after The General Theory. I argue that, had there been more academic interest in these alternative forms of analysis, the discipline would have been better prepared ahead of the financial crisis.

Read the whole paper here. 

The rise of vulgar economics and the end of dissent

Funny thing, the rise of vulgar economics, which I discussed before (here, here, and here; see also this and this papers for more on the topic) didn't just lead to the ostracism of heterodox approaches to economics. It also led to a significant decrease in the debate within the mainstream. Or at least is what the figure below, from the interesting blog post by Joe Francis, seems to indicate. At some point in the 1960s, more than 20% of the papers in the main journals were a reply, a comment or a rejoinder to the work of someone else. Not anymore.

It is clear that the Great Depression and the Keynesian Revolution seemed to increase debate within the mainstream, and that, as Joe says, the: "decline in debate... appears to have been associated with the emergence of a ‘neoliberal’ hegemony from the 1970s onwards." That's essentially correct.

And the decline in debate explains why Lucas could say in the early 1980s that: "at research seminars, people don't take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another." And also why if you wanted to publish you basically had to accept the crazy New Classical models. Krugman admitted to that before, as I've already noticed. He argued that: “the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable.” You must remember, you don't publish, you don't get tenure. So crazy models became the norm.

Not only heterodox economists were kicked out of mainstream departments, and had to create their own journals in the 1970s, but also the pressure within the mainstream to conform and silence dissent was strong indeed. Note that many, like Blanchard and Woodford for example, in the mainstream continue to suggest that there is a lot of consensus between New Keynesians, and Real Business Cycles types. In fact, they say there is more agreement now than in the 1970s. How is the consensus methodology in macroeconomics, you ask. From Blanchard's paper above:

"To caricature, but only slightly: A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment."

And yes that is also the basis of New Keynesian models. The haiku basically describes the crazy models in which reasonable results must be disguised if you're to be taken seriously in academia. When everybody agrees, there is little need for debate. And you get stuck with crazy models. The lack of debate within the mainstream to this day is also, in part, what provides support for austerity policies around the globe, even when it is clear that they have failed.

Lars P. Syll on how wrong Krugman & Mankiw are on loanable funds

By Lars P. Syll

Earlier this autumn yours truly was invited to participate in the New York Rethinking Economics conference. A busy schedule didn’t allow me to “go over there.” Fortunately some of the debates and presentations have been made available on the web, as for example here. Listening a couple of minutes into that video one can hear Paul Krugman strongly defending the loanable funds theory. Unfortunately this is not an exception among “New Keynesian” economists. Neglecting anything resembling a real-world finance system, Greg Mankiw — in the 8th edition of his intermediate textbook Macroeconomics — has appended a new chapter to the other nineteen chapters where finance more or less is equated to the neoclassical thought-construction of a “market for loanable funds."

Read rest here.

For an explication and presentation of the extent to which LFT is derivative of modern neo-Wicksellian macroeconomics, see here.

Krugman is actually right on ISLM and Minsky

I tend to disagree a lot with Krugman, at least on theoretical issues. His brand of Keynesianism supposes that the system doesn't work because of imperfections. For him, the current slow recovery is due to the fact that the natural rate of interest is basically negative and you cannot use monetary policy to stimulate the economy (see critique of this here). However, on his recent debate with Lars Syll (and here; Brad De Long also posted here), a post-Keynesian, with whom I probably share a more radical interpretation of Keynes and its relevance for economic theory, Krugman seems to get things right.

The main points in Lars initial post, based on Minsky's book John Maynard Keynes is that traditional representations of Keynes do not emphasize the cyclical component of Keynes' theory and that true or fundamental (non-probabilistic) uncertainty is often ignored. Lars adds a little bit more on his response to Krugman and De Long, but essentially is the same argument. Keynes didn't like the ISLM (which is from a historical point of view difficult to defend, after all the only stuff he wrote on this, to Hicks, was quite positive, even if it is of little relevance), that it is static (not paying attention to cyclical or dynamic phenomena), and perhaps more interestingly that the interaction of real and monetary variables in the model is simplistic.

Krugman points out that the General Theory (GT) is NOT about cyclical fluctuations per se. It is about the determination of the long run level of output and employment, around which the economy fluctuates, and he correctly notes that cycles only appear as an afterthought in chapter 22 of the GT. And that is precisely correct. The GT is revolutionary because it suggests that with price flexibility (not price rigidity as in the old Neoclassical Synthesis or the New Keynesian stories) the system gets stuck in a situation of unemployment equilibrium. Emphasis on equilibrium. Yes, unemployment at less than full employment and output below its potential level are both together in an equilibrium situation.

Patinkin suggested that Keynes meant unemployment disequilibrium, since within the neoclassical framework, unless there is a rigidity of some sort, and the system should go to its long run equilibrium position with full employment. Minsky (1975, p. 268), in the book cited above, says that Keynesian economics should be seen as the: "economics of permanent disequilibrium." That has no basis on the GT. Actually, the GT would be a less radical book if it only said that with instability the system might be always in a disequilibrium position. Keynes was very radical since he argued that the very notion of a natural rate should be abandoned (on this Paul and Brad have a lot to learn). Some Post Keynesians tend to dislike the idea of equilibrium (echoes of Joan Robinson's late critique of the idea), which ends up making them closer in many respects to the modern mainstream authors with their dislike for long term equilibrium positions.

So the GT is not about cycles (Keynes' Treatise on Money, a very conventional and Wicksellian book was about cyclical disequilibrium caused by differences between the natural and banking rates of interest, which, interestingly enough is closer to Krugman's way of thinking than the GT, or than to Lars, who is aware of the limitations of the natural rate concept). But that's not all that Krugman got right this time.

He quotes the famous passage in which Keynes says that the system is not violently unstable (GT, p. 249). And while Post Keynesians are correct to note the relevance of fundamental uncertainty, it is important also to consider the stabilizing role of conventions and institutions, to which Keynes alludes. Expectations play a role, but investment is not completely volatile, and it was a problem for Keynes only when "the capital development of a country becomes the by product of the activities of a casino" (GT, p. 159). In fact, given the relevance of the accelerator in determining investment, the central role of expectations is about the level of demand. For example, in the US investment has been subdued since demand is not growing fast and there are not reasonable expectations that it will any time soon.

Where New Keynesians go wrong, and in this case is actually Brad, not Paul (but he would certainly agree) is on the relevance of the marginal efficiency of capital, criticized by Minsky (even though it's far from clear that Minsky abandoned it). Brad thinks that Minsky critique of it is myopic and basically a PR problem. He says that it is: 

"Short-sighted, in that it is not Hicks who would be Minsky’s long-run intellectual adversary but rather Freidman [sic], Lucas, and Hayek, and so building bridges to the Hicksians ought to be a very high priority."

Probably true, but from a policy point of view. From a theoretical point of view, Hicks use of the marginalist notion of an investment function inversely related to the rate of interest (something Keynes also used) implies that there would be a rate of interest low enough that would produce full employment, that is a natural rate, which would preclude Keynes' claim about unemployment equilibrium (and the absence of a natural rate). In other words, with the marginal productivity of capital you have that unemployment must be a disequilibrium situation caused by some imperfection that inhibits the system from reaching the natural rate.

And yes the capital debates are relevant since they show that the inverse relation is only possible in a one commodity world. No natural rate, and no need to think about imperfections. And that's why the comment by Lars on the connection between real and monetary variables being simplistic within the ISLM is right on the mark. The idea that the central bank controls a monetary rate, that may get out of whack with the natural, and that by manipulating it can affect real variables is limited at best.

PS: For my previous defense of a modified ISLM go here and here. 

Notes on the Policy Implications of the New Macroeconomic Consensus

The New Macroeconomic Consensus (NMC) model is based on three simple equations. An IS equation that, contrary to what most discussions within the heterodoxy suggest, is based on a Ramsey model intertemporal approach to savings and investment, a Phillips curve (PC) equation, normally with rational expectations, and a monetary policy (MP) rule, typically Taylor’s rule. From the IS and the MP an aggregate demand (AD) curve is derived, while the PC provides an aggregate supply (AS) curve, similar to Lucas’ supply curve. Business cycles are seen as being determined by shocks, either monetary, that affect the AD curve, or real, which impact the AS curve.

A few things are important to note with respect to the NMC model. First, the IS curve now is not based on the traditional Keynesian multiplier process, by which savings adjust to investment (or in more sophisticated models with endogenous investment, to autonomous demand) as a result of variations to the income level. Agents make intertemporal decisions on consumption and savings, and investment adjusts, in the absence of imperfections, to full employment savings as in the pre-Keynesian models. That is the reason why in order to stimulate the economy it is often suggested that what is needed is higher inflationary expectations (which in this framework could be caused by the central bank announcing a higher inflation target), which would in turn lead to an increase in current consumption (since inflation would reduce future consumption possibilities; see my critique of this view, which I refer to as the inflation expectations fairy, here).

Second, both the New Keynesian Phillips Curve and the Taylor rule presuppose the existence of a natural rate of unemployment, in line with Milton Friedman. Further, stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level, a result sometimes referred to as the ‘Divine Coincidence.’ Thus, inflation is always the result of a level of unemployment that is below its natural level, or in other words caused by demand-pull. Supply-side shocks may eventually cause inflation too, but those are seen, at least by most New Keynesians as being of secondary importance. Even Lucas, who has accepted for the most part the Real Business Cycle story, admits that one cannot explain the Great Depression and other such crises with real shocks.

Third, the MP rule implies that money is endogenous, and that central banks control the rate of interest and NOT the quantity of money. In other words, the old Monetarist rules about the rate of growth of money supply are out, since actual central banks very rarely have behaved in that way. This ‘innovation’ (not much of an invention since Wicksell used more than a century ago) within the mainstream took place without ever acknowledging the contributions of Kaldor (accomodationist tradition to endogenous money), Minsky (financial innovation tradition to endogenous money), Moore and other post-Keynesian authors.

Finally, it is rather clear that the NMC is essentially a neo-Wicksellian model (for a simple description go here), rather than Keynesian (New or otherwise). Not only the multiplier model was abandoned (and with it even the basis for fiscal policy activism, since the logic of Barro’s Ricardian Equivalence has been incorporated; see Wren-Lewis here), but also the concept of the natural rate that Keynes at least tried to get rid of has become central for policy analysis. And here is the Achilles’ heel of the NMC model.

Note that if the natural rate is not fixed, and in particular if it presents hysteresis or path dependence, and moves with the actual level of unemployment, then the basis of the NMC model falls apart. In other words, expanding demand might reduce the natural rate of unemployment and would not trigger inflation, and as a result would not require the central bank to hike the rate of interest to lean against the wind. That was, in a sense, the rationale for not hiking the rate of interest when unemployment fell below 6%, which many identified as the natural rate, during the Clinton boom. Greenspan suggested that productivity was going up (note that he didn’t necessarily say that productivity went up, and the natural rate down, as a result of the expansion of demand).

There are good logical reasons for not believing the natural rate story, as we know, associated to the limitations of the marginalist theory (see here). However, there are also reasonably well-established empirical problems with the natural rate hypothesis. The Real Business Cycles authors, in particular Nelson and Plosser in their classic paper (here), have long ago shown that output follows a random walk. In other words, changes in output are permanent, and there is no tendency for output to revert to its former trend following a shock, contradicting the natural rate hypothesis, or suggesting if one prefers that the natural rate moves with supply-side shocks and that the business cycle is the result of agents adjusting their behavior to the change in the natural rate.

As I noted before (here), the actual measure of productivity (Total Factor Productivity, TFP) used by RBC authors does NOT measure productivity, and most of their conclusions are irrelevant really. Also, as suggested above, it would be impossible to pin down the real shock that caused the Great Depression or the Great Recession, that have structural causes that are profound (in the patterns of consumption, private indebtedness and inequality) and that were triggered by financial shocks. However, the notion that the natural rate is not fixed, and that it changes significantly is actually quite important, since as we indicated, it suggests that policies that try to lean against the wind hiking the rate of interest when the economy is below the natural rate of unemployment are without foundation.

Heterodox authors would add to the RBC empirical observation about the fact that output is not mean reverting, that the supply or capacity limit of the economy is endogenously determined by autonomous spending (the supermultiplier that extends Keynes’ effective demand to explain potential output; for more go here). This does NOT mean that one can expand the economy without limits, since if the expansion of demand is faster than the movement of the capacity limit, eventually full employment would be reached and inflation (demand-pull inflation) might follow. Note, however, than since the 1930s in the US unemployment was below 4% (to say a relatively low number) only for four short periods, during the mid-40s, early 50s, late 60s and late 90s, with inflation occurring in the first three periods. Also, it suggests that the main barrier to the use of demand policies to achieve full employment, at least in developed countries with no balance of payments problems, is political. As Kalecki noted long ago, sound finance would be the political instrument to keep workers’ demands for higher wages in line. The NMC model is the modern incarnation of what Kalecki’s referred to as sound finance. So who is really surprised with the dominance of austerity policies?

Tom Palley on New Keynesianism as a Club

Tom Palley discusses the fact that New Keynesian have 'rediscovered' several of the ideas that other Keynesians, in particular the more heterodox sort (but not only, he includes James Tobin too), without properly acknowledging them. In his words:

"For almost thirty years, New Keynesians have dismissed other Keynesians and not bothered to stay acquainted with their research. But now that the economic crisis has forced awareness, the right thing is to acknowledge and incorporate that research."

Read rest here. By the way, Tobin, in his little book Asset Accumulation and Economic Activity, discusses why even with price flexibility the system does not have a tendency to full employment, being the closest to the alternative Keynesian ideas, or arguably to Keynes' own views. For Minsky's review of that book, in which he also criticizes Tobin for dismissing the research of post-Keynesians, go here.

A debate on Endogenous Money and Effective Demand: Keen, Fiebiger, Lavoie and Palley

The last issue of the Review of Keynesian Economics (ROKE) has a debate between Steve Keen with Brett Fiebiger, Marc Lavoie and Tom Palley. Two papers are available for download (Keen and Lavoie's). Tom's paper is available as a working paper here.

The basis for Steve's defense of endogenous money is based on the works of Schumpeter, as developed by the latter's student Hyman Minsky. In his words:

"The proposition that effective demand exceeds income is not a new one: it can be found in both Schumpeter and Minsky (and arguably in Keynes's writings after The General Theory, though not in as definitive a form – see Keynes 1937*, p. 247). A difference between income and expenditure, with the gap filled by the endogenous creation of money, was a foundation of Schumpeter's vision of the entrepreneurial role in capitalism. Minsky's attempt to reconcile endogenous money and sectoral balances is the closest antecedent to the argument I make, but I will start in chronological order with Schumpeter's analysis."

I have noted before that the idea of endogenous money is NOT central for heterodox approaches, since Wicksell and the whole modern New Keynesian consensus adopts it. And perfectly conventional authors like Irving Fisher had introduced debt in their models too. I also noted that Schumpeter is essentially a Real Business Cycle (innovations are nothing but exogenous productivity shocks) author, which thought that both short-run output and employment and long-run growth were determined by supply-side factors. So in general I'm not a great fan of having Schumpeter as a staring point, or the notion that to introduce debt and endogenous money is per se a critique of the mainstream.

In that respect, I tend to agree with Tom's point that it is the way in which endogenous money and debt are introduced in the model that matters. Keen's use of a variation of Fisher's equation of exchange, as pointed out by Tom, is troublesome. In Tom's words:

"The Fisher equation constitutes the monetarist framework for macroeconomics. Income-expenditure accounting constitutes the Keynesian framework and it offers an alternative approach to understanding the AD, credit, endogenous money nexus."

In fact, in the equation of exchange framework the presumption is that demand would adjust (in Steve's approach with endogenous money) up to the point that it meets supply at the optimal level (also something that would be perfectly in line with  Schumpeter). The whole point of the income-expenditure framework is that it puts demand in charge of the level of activity.

At any rate, a good debate that it's worth checking out. Enjoy!

* J.M. Keynes (1937), "Alternative Theories of the Rate of Interest," 47, Economic Journal, pp. 241-252. Available here (subscription required).

Tom Palley on Milton Friedman’s economics and political economy

By Thomas Palley

Milton Friedman’s influence on the economics profession has been enormous. In part, his success was due to political forces that have made neoliberalism the dominant global ideology, but Friedman also rode those forces and contributed to them. Friedman’s professional triumph is testament to the weak intellectual foundations of the economics profession which accepted ideas that are conceptually and empirically flawed. His success has taken economics back in a pre-Keynesian direction and squeezed Keynesianism out of the academy. Friedman’s thinking also frames so-called new Keynesian economics which is simply new classical macroeconomics with the addition of imperfect competition and nominal rigidities. By enabling the claim that macroeconomics is fully characterized by a divide between new Keynesian and new classical macroeconomics, new Keynesianism closes the pincer that excludes old Keynesianism. As long as that pincer holds, economics will remain under Friedman’s shadow.

Read paper here.

What is the 'Classical Dichotomy'?

Fields, David (Forthcoming), “Classical Dichotomy,” Edward Elgar Encyclopedia on Central Banking, edited by L.P. Rochon et. al, Edward Elgar

The classical dichotomy (Patinkin, 1965) refers to the idea that real variables, like output and employment, are independent of monetary variables. In this view, the primary function of money is to act as a lubricant for the efficient production and exchange of commodities. This conception of money rests on “real analysis”, which describes an ideal-type economy as a system of barter between rational utility-maximizing individuals (Schumpeter, 1994, p. 277).

In this sense, money is “the unpremeditated resultant, of particular, individual efforts of the members of society, who have little by little worked their way to a determination of the different degrees of saleableness in commodities” (Menger, 1892, p. 242). Hence, money is considered simply as a social technology for the adjudication and determination of “terms of trade”, which are inherently specific to individual dyadic economic exchanges (Dodd, 1994, p. 6). It is thus a social “vehicle” that has no efficacy other than to overcome transaction costs concerning the inconveniences of barter, which result from the absence of a double coincidence of wants (Jevons, 1875, p. 3).

The classical dichotomy is, essentially, a derivation of the quantity theory of money, which is captured by the formula MV = PY, where M stands for the money stock, V is the velocity of money circulation, P is the price level, and Y is the level of income. The monetary value of output (PY) is thus equal to overall aggregate monetary expenditure. Exogenous changes in the money supply (M) ultimately condition the price level for a given level of economic activity. If an economic system is at full employment, the only effect of increases in the money supply is a proportionate increase in the domestic price level, which gives rise to a depreciation of its currency’s exchange rate. The direction of causality runs therefore from an exogenous money supply to the price level.

This is intrinsically connected to the so-called “natural rate of interest theory” of New Keynesian economics (see Woodford, 2003). A natural rate of interest is determined in the long run by the equilibrium of savings and investment. This is a full-employment position for a given economy. A market interest rate that is either above or below this natural rate is a disequilibrium situation, which is eventually equilibrated through a long-run process of market clearing.

Exogenous changes in the supply of money are what shift market rates of interest. This is the process by which discrepancies between market rates and the natural rate of interest are generated. A market rate of interest below the natural interest rate occurs when investment exceeds savings. Firms will demand more credit for investing. The result is an excess of investment over savings. If the economy is at the full-employment position, defined by the natural rate of interest, a cumulative process of inflation unfolds. The rise in the price of consumption goods leads to a decrease in consumption; involuntary savings rise until the excess of investment over savings is eventually eliminated. If market rates of interest are above the natural rate of interest, by contrast, savings exceed investment and a cumulative process of deflation ensues.

From a heterodox perspective, however, the natural rate of interest is a conventionally-determined exogenous distributive variable. The implication is that it is strictly a monetary phenomenon. For a given level of output, the price level is the result of distributive conflict between capitalists and workers. Hence, the net impact on the general price level depends on the effects the central-bank determined interest rate exerts on aggregate demand. If a restrictive monetary policy, via higher market interest rates, leads to a higher price-to-wage ratio, a lower inflation rate will result if the workers’ bargaining power is weakened, ensuing nominal wage reductions.

Further, if conventional rates of interest are artificially set high and effective demand is not sufficient for businesses to meet profit expectations, and for governments to afford deficit spending, there is an actual possibility of an unemployment equilibrium. Deflation that is caused by higher real interest rates does not produce a wealth effect that offsets increased costs of production through the expansion of consumption. This puts pressure “on those entrepreneurs [and consumers] who are heavily indebted […] with severely adverse effects on investment” (Keynes, 1936, pp. 262–4). If the interest rate is set low and is followed suit with appropriate fiscal policy via aggregate demand management, any so-called burden of private and public debt accumulation is sustainable, and, as a result, provides impetus for output and employment expansion (Domar, 1944).

In conclusion, the classical dichotomy implies that real variables and monetary variables are independent of each other. From a heterodox perspective, by contrast, both kinds of variables are explained by the relationship established between the central bank, bank lending, and entrepreneurs’ “animal spirits” every time effective demand is deemed profitable, reversing thereby the causality of the quantity-theory-of-money formula.

REFERENCES:

Dodd, N. (1994), The Sociology of Money, New York: Continuum.

Domar, E. (1944), “The ‘burden of the debt’ and the national income”, American Economic Review, 34 (4), pp. 798–827.

Jevons, W.S. (1875), Money and the Mechanism of Exchange, London: Appleton.

Keynes, J.M. (1936), The General Theory of Employment, Interest, and Money, London: Macmillan.

Menger, K. (1892), “On the origins of money”, Economic Journal, 2 (6), pp. 239–55.

Patinkin, D. (1965), Money, Interest and Prices, New York: Harper & Row, second edition.

Schumpeter, J.A. (1994), A History of Economic Analysis, London and New York: Routledge.

Woodford, M. (2003), Interest and Prices, Princeton: Princeton University Press.

More on flimflam and lack of understanding of the capital debates

Paul Krugman has responded to Tom's article and here is his reply. Let me just add my two cents. Krugman says that:

New Keynesians assert — as Keynes did, although I don’t think it matters for this debate what he said — that both liquidity preference and loanable funds are true. There are conditions under which one or the other is the main one to focus on — at full employment, loanable funds are crucial, in a liquidity trap, liquidity preference.

Oh Lord. Paul can you send us the quote were Keynes says that Loanable Funds is correct? And again this is NOT about irrelevant exegesis. If you do have that Investment and Savings are equilibrated by a natural rate of interest, then that means that you must, with interest rate flexibility, reach a point at which investment would equate the full employment level of savings. Krugman and other New Keynesians argue then for a version of what they call a Liquidity Trap (actually a zero lower bound problem), in which the monetary rate of interest (of the Liquidity Preference Theory) is not capable of equating the natural rate (of the Loanable Funds Theory).

Note that here Keynes has a problem. Although Keynes clearly rejected the concept of a natural rate of interest (Keynes, 1936, pp. 242-4), and said very clearly that savings are equated to investment by changes in the level of activity (Effective Demand), his acceptance of the notion of the marginal efficiency of capital implies that there is a sufficiently low interest rate that would be associated with an investment that would produce the full employment level of savings, very much like Krugman. Excluding imperfectionist arguments related to the downward rigidity of the interest rate, or the possibility that a negative interest rate would be required to increase investment to its full employment savings level, it would seem that the acceptance of the marginal efficiency of capital is in contradiction with the notion of a “highly conventional” rate of interest (ibid., p. 203).*

So as noted here you do need to abandon the notion of a natural rate of interest and the marginalist theory of distribution (besides the evidence is that investment does not react to cost of capital, but it does to expected sales, that is expected demand). Here Krugman's comments are disingenous at best. He says:

I think, is a fairly desperate attempt to claim that the Great Recession and its aftermath somehow prove that Joan Robinson and Nicholas Kaldor were right in the Cambridge controversies of the 1960s.

As I noted it is logically required to get rid of the idea of the natural rate, and there is no need to argue that in the 1960s capital debates Robinson and Kaldor (Sraffa really, dude) were right, since Samuelson (1966; subscription required) already did.

* The capital debates show that there is no correspondence between the intensity of the use of capital and its remuneration. No natural rate of interest that would lead to more intensive use (full utilization) of capital. And that's what Samuelson admited. To understand the capital debates go here, and to get its relation to Keynes' theory go here.

PS: Krugman also gets a bit testy suggesting that: "as for wage and price inflexibility as the cause of unemployment — grrr. I’ve written again and again on this subject, pointing out that in a liquidity trap price flexibility probably makes things worse, not better." Yes, grr. Dude, first it's not a liquidity trap that you're talking about, but a lower limit to nominal rates of interest. And debt-deflation and negative effects of income distribution discussed in chapter 19 of the GT occur even if you are not at the lower bound (or the real liquidity trap). And Keynes said that the liquidity trap was irrelevant to explain the Great Depression, it's worth noticing, since really it seems you never read the GT (even though you wrote a preface to one edition). So price flexibility in a world with extensive debt contracts and where income distribution affects spending is always kind of bad. That's Keynes' message. Tom is correct on that one too.