History versus equilibrium: a false dichotomy

The title comes from Joan Robinson's famous essay. However, the motivation is to clarify some comments on a previous post on what Keynes meant by unemployment equilibrium (sent to me, but not published). There is a relatively widespread notion among some post-Keynesians that neoclassical economics assumes always a single unique equilibrium, and that Keynes, or at least his closer followers like Robinson, believed in multiple equilibria. The idea is that post-Keynesians believe in an unstable, uncertain capitalist system in which full employment is only one possibility.

Beyond what one may think about equilibrium, there is no basis in the history of economic ideas for that view. Keynes was a Marshallian, and as such did believe in the notion of a single stable long run equilibrium of the system. The radical element in Keynes analysis is that such equilibrium might be suboptimal, that is, one in which resources are not fully utilized. He is very clear when he says in the General Theory that:

"it is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. Moreover, the evidence indicates that full, or even approximately full, employment is of rare and short-lived occurrence. Fluctuations may start briskly but seem to wear themselves out before they have proceeded to great extremes, and an intermediate situation which is neither desperate nor satisfactory is our normal lot."

So what Keynes said is pretty clear, fluctuations around a normal equilibrium. Unemployment is the normal position, the long run equilibrium around which the system fluctuates. Like the old classical political economists (e.g. Smith, Ricardo, and Marx) and the marginalists of his time (e.g. Pigou, and Marshall) Keynes believed in a single stable long run equilibrium position. Note that nothing in Keynes analysis implies that the long run equilibrium is ever attained, or that it cannot be affected by the process by which it is approached, and, hence that it would be path-dependent [the supermultiplier story with a Kaldor-Verdoorn process is path dependent and is still a long run equilibrium position].

The problems associated to the negative impact of uncertainty, and failed expectations, and the institutions and conventions that are relevant in a certain historical context to minimize the effects of instability are all part of the normal operation of the economy for Keynes, and not, like in neoclassical models, superimposed on an essentially stable system. In other words, Keynes equilibrium theory is not a-historical, and hence does not require the addition of more realistic (historical?) elements to provide explanation of say why the system is stuck below full employment equilibrium.

For example, lack of demand (caused by stagnant wages and not enough fiscal stimulus) means that the US economy will the near future fluctuate around levels of unemployment that are above the previous normal levels. In the graph below (source) that is visible in a trend that was lower in the 1950s and 1960s, and goes up in the 1970s and 1980s, only to go down (as a result of a series of bubbles) in the 1990s, and, as I suggested, is likely to go up again. This trend represents the normal position to which Keynes alluded in the passage cited above. Unemployment fluctuates, but is not violently unstable (sometimes it might be; asks the Greeks). In the neoclassical model, in contrast, without imperfections, be that price rigidities or lack of information or any other kind, the system would move to full employment. That's why they often resort to change what the meaning of full employment is (the natural rate goes up; nudge, nudge; wink wink).

However, the interesting thing is that while the old neoclassical authors shared the classical political economists and Keynes notion of a stable long run equilibrium (optimal for the neoclassical, and not so for Keynes and the classical authors), they have departed from that view after the capital debates. In fact, it is in the Walrasian world of Arrow-Debreu's intertemporal equilibrium, that the notion of multiple equilibria becomes relevant (for the reasons why the mainstream changed their views on equilibrium go here; Garegnani classic paper titled "On a Change in the Notion of Equilibrium in Recent Work on Value" is the source of this idea). But in that world, anything could happen, it is wildly unstable and there no forces bringing the economy back to its normal position. Certainly not what Keynes thought, and also not an accurate description of the graph above.

More importantly, the very idea of long run equilibrium is central to our ability to theorize about the functioning of real, historically and institutionally specific economies. It is the fact that there are persistent forces, with regularities, which allows to say something meaningful about the functioning of the economy. If uncertainty rendered economic calculation impossible, then even Keynes' theory about how effective (autonomous) demand determines income, would be irrelevant, and in that case post-Keynesians would have (notice I said would have, since I don't think this is the right way to describe post-Keynesian economics) more in common with the modern neoclassical economists that have embraced multiple equilibria and all sorts of imperfections.

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.