ems fz fpr Post Keynesian Macroeconomic Theory, Second Edition A Foundation for Successful Economic Policies for the Twenty-First Century Paul Davidson Editor, Journal of Post Keynesian Economics and Senior Fellow, Schwartz Center for Economic Policy Analysis, New School University, New York, USA Edward Elgar Cheltenham, UK * Northampton, MA, USAJ. Pacipzcono mit & Keynesio~ Ecorowne $ + gmies Hislory- rf century ¢ ~ oN" © Paul Davidson A\ll rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, ' mechanical or photocopying, recording. or otherwise without the prior ; permission of the publisher. j Published by Edward Elgar Publishing Limited The Lypiatts 1 15 Lansdown Road i Cheltenham Glos GL50 2A UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book i is available from the British Library | Library of Congress Control Number: 2011924198 ! Mix aps ton r ESS rscecorss7s ISBN 978 1 84980 979 5 (cased) f : ISBN 978 1 84980 980 | (paperback) é ; ‘Typeset by Servis Filmsetting Ltd, Stockport, Cheshire \ Printed and bound by MPG Books Group, UK :Contents ‘The background for Keynes's revolution 2. The essential difference between the general theory and the classical system. 3. Taxonomy, axioms and expenditures related to income: Keynes's D, category 4 Investment spending 5 Government and the level of output 6 Delving further into the relationship between money, liquidity and uncertainty 7 Liquidity preference - the basis of Keynes's revolution 8 The finance motive and the interdependence of the real and monetary sectors 9 Financial markets, fast exits and great depressions and recessions _ 10 Inflation: causes and cures 11 Keynes’s aggregate supply and demand analysis, 12. The demand and supply of labour 13. Money in an international setting 14 Trade imbalances and international payments 15 International liquidity and exchange rate stability 16 Financing the wealth of nations 17 Export-led growth and a proposal for an international payments scheme 18 Epilogue: truth in labelling and economic textbooks Index ie) a: 63 87 cds 14 oo 147 166 190 200 224 = 265 215 284 320 |‘1. The background for Keynes’s revolution On New Year’s Day in 1935 the English economist, John Maynard Keynes, wrote a letter to George Bernard Shaw. In this letter he stated: To understand my new state of mind, however, you have to know that I believe myself to be writing a book on economic theory which will largely revolution ize not I suppose at once but in the course of the next ten years the way the world thinks about economic problems. When my new theory has been duly dssimilated and mixed with politics and feelings and passions, I cannot predict vhat the final upshot will be in its effect on actions and affairs, but there will be 2 great change and in particular the Ricardian Foundations of Marxism will be knocked away. T can't expect you or anyone else to believe this at the present stage, but for myself I don’t merely hope what I say. In my own mind Iam quite sure.! A little over a year later, Keynes published a book that, for several decades, did revolutionize the way most economists and politicians thought about developing economic policies to deal with unemployment. That book was entitled The General Theory of Employment, Interest, and Money. Keynes’s book produced innovative thinking in policy discussions. Yet, mainstream economists failed to adopt the logically consistent innova- tive theoretical analysis laid down by Keynes. Instead, what developed in mainstream professional writings and popular economics textbooks was a modernized version of the pre-Keynesian classical system where Keynes's policy suggestions for solving the unemployment problem were grafted on to the axiomatic foundations of classical microeconomic theory. In the first three decades following World War Il, the resulting Neoclassical Synthesis Keynesianism? (or what is sometimes referred to as Old Keynesianism) conquered mainstream academic discussions as completely as the Holy Inquisition conquered Spain (to paraphrase one of Keynes’s more colourful expressions)., Keynes began work on his revolutionary book in 1932, Unlike the United States, Great Britain had been suffering from a great recession since the end of World War I, Between 1922 and 1936 the unemployment rate in Britain fell below 10 per cent in only one year. In 1927 it was 9.7 per cent.Post Keynesian macroeconomic theory, second edition In the United States, during World War I, the national debt increased from $6 billion in 1916 to over $27 billion in 1919. The decade of the ‘roaring twenties’ was a period of unbridled prosperity. With prosperity, tax revenues exceeded government expenditures and the national debt declined to $16.9 billion in 1929. This 1920s experience demonstrates that when the private sector is spending sufficiently to buy all the products and services that private enterprise can produce in a fully employed economy, there is no need for government deficit spending to maintain a prosper- ous economy.’ In 1929, only 3.2 per cent of American workers were unemployed. In 1920, the Dow Jones Stock Index stood at 63.9. By 1929, the Dow Jones average peaked at 381.2, an increase of more than 500 per cent in a little over eight years. During the 1920s stock market boom, people were able to buy stocks on ‘margin’ — that is, for as little as 5 per cent down and borrowing the rest, thereby leveraging their stock position by a ratio of 19 to I, In other words, they could borrow $19 for every $20 they invested in the stock market. By 1929, small individual investors, including blue-collar workers who had never invested in anything and knew little or nothing about the firms they invested in, were buying into the stock market on margin. Often these margin buyers relied on brokers or bankers to tell them where the profit- able action was. Nevertheless, everyone in America seemed to be getting h. Just a few days before the stock market crash of October 24, 1929, ‘one of the most eminent classical economists of the time, Professor Irving Fisher of Yale University, told an audience that the stock market had reached a high plateau from which it could only go up. Then, suddenly, the bottom fell out. By June 1932, the Dow Jones had dropped by 89 per cent from its 1929 high. It is said that Professor Fisher, who had put his money in what he believed in, lost between $8 million and $10 million - a vast sum in 1929 ~ in this stock market crash. The Great Depression had hit America. From 1929 to 1933 the American economy went downhill. It seemed as if the system was enmeshed in a catastrophe from which it could not escape. Unemployment went from 3.2 per cent in 1929 to 24.9 per cent by 1933. One out of every four workers in the United States was unemployed by the time Roosevelt was elected president. A measure of the standard of living of Americans, the real gross national product per capita, fell by 52 per cent between 1929 and 1933. By 1933, the average American, family \vas living on less than half of what it had earned in 1929. The American capitalist dream appeared to be shattered. The economic experts of those times argued that the high levels of unemployment being experienced in the United States in the early 1930sThe background for Keynes's revolution 3 could not persist. The economy would soon right itself.as long as the government did not interfere with the workings of the market-place. The prevailing orthodox classical theory provided the rationale for the ‘laissez-faire’ or ‘no government intervention’ philosophy that dominated economic discussions before Keynes’s General Theory was published. It is claimed that, in 1751, the Marquis d’Argenson was the first writer to use the phrase ‘laissez-faire’ in his argument for removing the visible hand of government from economic affairs. He said that ‘To govern better one must govern less’. Although the phrase laissez-faire does not appear in the writings of the founding fathers of classical theory such as Adam Smith or David Ricardo, the idea is there. The pursuit of self-interest, unfettered by government interference is at the heart of the philosophy of classical economics. : In his 1776 classic, The Wealth of Nations, Adam Smith wrote: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from regard to their own self-interest. We address our- selves, not to their humanity but to their self love, and never talk to them of our necessities, but of their advantage. . . . Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed and not that of society which he bas in view, . .. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.* Classical theory argued that if the government intervened in economic matters during any ‘temporary’ period of unemployment, then the eco- nomic situation would deteriorate and the economy would take a longer time to right itself. If the government did not interfere with the invis- ible hand of the market processes operating during this transient period of unemployment, then only the weak and inefficient would be weeded out, leaving a stronger, more powerful economy to carry on. In true Social Darwinian fashion, what was being asserted was that the Great Depression was merely a symptom of Nature’s providing for the ‘survival of the fittest’. When the economic system righted itself, it would regenerate full employment and prosperity for all. In the very first paragraph of his book, The General Theory, Keynes challenged this orthodox dogma when he wrote: I have called this book the General Theory of Employment, Interest and Money. . .. The object of such a title is to contrast the character of my argu- ‘ments and conclusions with those ofthe classical theory of the subject... which dominates economic thought, both practical and theoretical of the governing4 Post Keynesian macroeconomic theory, second edition and academic classes of this generation, as it has for a hundred years past. . .. The characteristics of the special case assumed by the classical theory happen not (o be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.* Keynes explicitly tailored the exposition of his book to change the minds of his ‘fellow economists’ while hoping *it will be intelligible to others’. Keynes's purpose was to persuade ‘economists to critically reexamine certain of their basic assumptions’. Keynes believed that the fatal flaw of the classical system lay in the special unrealistic axioms that were necessary to demonstrate the self-correcting tendency of an unfettered competitive economic system. For several years before publication, Keynes circulated drafts of his work to world-famous professional colleagues in England. He took extraordinary time and effort to elicit comments from, and respond to, these economists as well as his students in Cambridge. As a result of this ongoing dialogue, Keynes was fully aware of the arguments that his fellow economists would marshall to defend the classical orthodoxy. If he was to convince his professional colleagues of the errors of their ways, Keynes had to develop persuasive arguments to rebut the many comments he received The English experience of stagnating high levels of unemployment since World War I had convinced Keynes that the capitalist system was unlikely to survive unless proper policy actions were taken immediately. What was needed to galvanize professional support for his policy suggestions was something other than a tedious and contentious professional formaliza- tion of his model. Rightly or wrongly, in 1936, Keynés felt that tis a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis . . . that they expressly assume strict independ- ‘ence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials ‘at the back’ of several pages of algebra which assume that they all vanish. Too large a propor- tion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols." Keynes, a master expositor and essayist, developed his general theoreti- cal analysis as an essay in persuasion just at the time that the economicsThe background for Keynes's revolution 5 profession was becoming more imbued with the belief in the necessity of presenting economic arguments in terms of formal mathematical models Since World War I, generations of economists have been trained to think solely in terms of mathematical formula models. Accordingly, they have great difficulties in comprehending the analytical basis of Keynes's General Theory essay. In an early draft of the Introduction to his General Theory, Keynes explained why he chose to de-emphasize formalisms when he wrote: In economics you cannot convict your opponent of error, you can only con vince him of it. And, even if you are right, you cannot convince him . . if his head is already so filled with contrary notions that he cannot catch the clues to your thought which you are trying to throw to him.” Keynes believed that the classical formal analysis could never provide a meaningful explanation of the level of unemployment that actually occurred in a market-oriented, money-using entrepreneurial economy Nor could the classical theory provide public policies that would cure this unemployment problem of the real world that we inhabit. Keynes catego- rized the classical proposal for curing unemployment by reducing wages and prices as an ‘ignoratio elenchi’.* Classical theorists, Keynes claimed, were engaged in offering a proof irrelevant to the proposition: in ques- tion. Keynes compared classical economists to Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight ~ as the only remedy for the unfortunate collisions which are occurring. Yet in truth, there is no remedy ‘except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is today required in economics. We need to throw ‘over . .. postulate[s} of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.” To explain the existence of involuntary unemployment in the real world, Keynes developed the economic theory analogue to non-Euclidean geometry where three fundamental classical axioms were overthrown. If, however, one accepts these classical axioms as a basis for one’s analysis of unemployment, then the only logical basis for explaining unemployment involves some supply condition that causes wages and prices to be less than perfectly flexible. ‘Accordingly, during the depression, many classical theory trained economists argued that unemployment would end when the market would self-correct this supply imperfection. In the long run market forces would6 Post Keynesian macroeconomic theory, second edition cause wages and prices to fall sufficiently to restore full employment. Keynes, on the other hand, argued ‘We must not regard the conditions of supply . . . as the fundamental sources of our troubles... . [I]t is in the conditions of demand which our diagnosis must search and probe for an explanation’."” In 1936, the rigorous axiomatic foundations of classical demand theory had not been specified." It is not surprising, therefore, that Keynes did not identify all the specific classical axioms that his analysis had thrown out. At the time (and even today) many readers were (are) not clear as to what were the specific classical axioms Keynes rejected in developing his ‘non-Euclidean’ general economic theory, and why he had rejected them, Many of the cleverest young economists who were entering the eco- nomics profession in the United States and England during the Great Depression (c.g., Paul Samuelson, James Tobin, J.R. Hicks, James Meade) recognized that the unemployment problem of the economic system seemed too deep and long to be sloughed off as merely a temporary aberration or friction that a self-adjusting market could cure. Common sense told them that the invisible hand might not be able to resurrect a prosperous economy in their lifetime. They were too impatient to wait for the long-run revival that was promised by classical theory. Yet these young economists of the 1930s had been trained in the clas- sical economics tradition. They, therefore, did not find Keynes's essay in persuasion an easy one to comprehend. As classically trained economists, these ‘young Turks’ were unwilling to dispense with any of the implicit fundamental axioms required by the classical theory of demand. For those disciplined to believe in the beneficence of the invisible hand, all classical axioms are, by definition, universal truths. It is a herculean task to ques- tion what one has been trained to believe in as self-evident verities. This younger generation of economists were unwilling, or unable, to free their formal models of these classical restrictive axioms underlying demand conditions. Their minds were so filled with ‘Euclidean’ notions that they could not catch the ‘non-Euclidean’ analytical insights that Keynes was throwing to them. Instead, this younger generation of professional economists tried to translate Keynes’s conclusions into formalizations of the evolving axi- omatic {neojclassical theory that was coming into vogue during this period as a result of the work of Hicks, Meade, Samuelson, and others. Unable to decipher Keynes's ‘non-Euclidean’ message, they tried to develop his insights through the classical theory that they had been brought up on by introducing ad hoc supply constraints (e.g., the fixed money wages and fixprice models) on the workings of the ‘invisible hand’. For example, Nobel prize winner economist Paul Samuelson has been quoted as stating ta: 1 1 > s oi The background for Keynes's revolution 7 that he [Samuelson] found Keynes's analysis ‘unpalatable’ and not com- prehensible, Samuelson stated ‘The way I convinced myself was to stop worrying about it (understanding Keynes’s analysis}. .. . | was content to assume that there was enough rigidity in relative prices and wages to make the Keynesians alternative to Walras operative’. In other words, Samuelson admitted he did not understand what we will develop in this book as Keynes's liquidity analysis of a money-using economy. Instead Samuelson assumed that Keynes was merely present ing a simple classical general equilibrium model where wages and price rigidity cause unemployment, But, of course, economists in the nineteenth century had already argued that the absence of flexibility of wages and prices was sufficient to explain unemployment. So Samuelson was merely providing sophisticated mathematical window dressing for what classical economists always ‘knew’ was the absolute truth about unemployment. Today, most economists, especially at our most prestigious university economics departments, are even more rigorously trained in the math- ematical formalisms of classical axiomatic value theories than earlier generations. These mainstream economists’ theories, therefore, are still wedded to the axioms of classical analysis. These economists appar ently are unwilling to contemplate the throwing over of their most ba cherished classical universal truths, Accordingly, textbook mainstream macroeconomic models are still founded on the special classical axioms. The resulting policy implications are, as Keynes noted, ‘misleading and dangerous’ if applied to the real world in which we live. Until mainstream classical economists are willing at least to contemplate more general economic theories that are free of the restrictive demand axioms of classical theory. it is unlikely that the applicable general. theory of unemployment in a monetary economy will be the basis of widespread public discussions. Mainstream economists do not have the relevant theo- retical tools to develop proper policies for resolving the major economic problems of the day. Instead they invent some ad hoc constraint that prevents the inevitable (in their view) long-run full employment solution. Beginning in the 1980s a New Keynesian macroeconomic school, of thought developed. Like the earlier generation of Old Keynesians, the New Keynesians still profess allegiance to the axioms of classical demand theory as the bedrock microfoundations of macroeconomics. The New Keynesians’ advance over the Old Keynesian model is the development of very sophisticated ad hoc constraints on the conditions of aggregate supply (in terms of fixed nominal values, coordination failures and/or asymmetric information upon which supply decisions are made). These constraints are justified by claiming that, at least in the short run, nominal fixities exist in the real world." If prices were only perfectly flexible and8 Post Keynesian macroeconomic theory, second edition existing information freely available to all, then the logic of the New Keynesians would force them to admit that full employment is the inevita- ble outcome of an unfettered market system. In the long run with sufficient price flexibility assured by a free market mechanism, though we may all be dead, New and Old Keynesians can agree with their classical brethren who profess monetarism theory, efficient market theory and rational expecta- tions theory, that full employment and economic prosperity are inevitable. ‘These Oid and New Keynesian explanations of the existence of unem- ployment are the modern-day logical equivalent of rebuking the appar- ent parallel lines ‘for not keeping straight’. In truth, these Old and New Keynesian models accept that the classical system is the general theory, while Keynesian unemployment is a special case that occurs in the short run because of some unfortunate market (supply) imperfection. More than seven decades after Keynes's General Theory, these mainstream Keynesians still fail to see that Keynes was attacking the beliefs in the ‘universal truths’ that formed the very foundation of classical demand analysis, Keynes’s squabble with the classical theory was not over whether temporary wage and price stickiness is the cause of unemployment. In attempting to differentiate his product from classical analysis, Keynes noted For Classical Theory has been so accustomed to rest the supposedly self adjust- ing character of the economic system, on the assumed fluidity of moncy-wages; and, when there is rigidity, to lay on this rigidity the blame for maladjustment. .. My difference from this theory is primarily a difference of analysis.'* Any supply failure that produces a wage and/or price inflexibility — whether ephemeral or not ~ is not the essence of Keynes’s analysis of unemployment. Keynes always insisted that it is the conditions underlying demand, and not supply, that are the fundamental cause of unemploy- ment in a monetary economy. We will explain, in what follows, that even if wages and prices were perfectly flexible, unemployment could still be a long-run problem of an entrepreneurial economy. Keynes's theoretical analysis was immediately shunted onto a wrong track by the writings of Hicks, Samuelson, Meade and others who claimed to have the analytical key to explain Keynes’s general system. The result was that Keynes's revo- lution was aborted almost as soon as it was conceived. More than a half- century later, Keynes's ‘non-Euclidean’ revolutionary approach remains undiscovered in the modern mainstream economics literature. There is, therefore, an analytical void that needs to be filled if Keynes’s revolution in economic thought is to be understood and revived. Hopefully, thisis The background for Keynes's revolution 9 volume will fil the theoretical (and resultant policy) gap that mainstream ‘economists have failed to close. In the 1970s, Neoclassical Synthesis Keynesianism was declared dead by a younger generation of technically trained classical scholars who called themselves New Classical economists. They emphasized the beauty of an intellectually precise, highly mathematical system that would demonstrate with hi-tech precision that the economic system could always achieve a full employment equilibrium as long as mechanisms consistent with the classical axioms are the fundamental analytical building blocks. One of the founders of the New Classical school, Robert Lucas, agreed that the axioms required made New Classical analysis ‘artificial, abstract, patently unreal’.'" Lucas insisted that these postulates were necessary They embodied the only scientific method of doing economics. These axioms permit the development of logical conclusions that are independent of political and economic institutions. The resulting immutable economic Jaws’, it is alleged, are the sovial science equivalent of the unchanging sci- entific principles established by the ‘hard’ sciences.'* Lucas’s designation of what is the only scientific approach to economics means that Keynes's rejection of some classical axioms can be dismissed as ‘unscientific’ and not worthy of serious study. No wonder Keynes's analytical system was ignored in mainstream textbooks.'” Yet when the Great Recession hit the global economy in 2008, Nobel prize winner Robert Lucas (in. the October 23, 2008 issue of Time magazine in an article entitled ‘The Comeback Keynes’) is quoted as saying ‘I guess everyone is a Keynesian in a foxhole’ In contrast to this rigid mind set methodology of mainstream economic theory, the goals of this volume are: 1. to explain the classical axioms that must be ‘thrown over’ to obtain at logically consistent Post Keynesian macroeconomic theory analogue to non-Euclidean geometry. The classical postulates that Keynes's analytical framework rejected are (a) the axiom of the neutrality of money; (b) the gross substitution axiom: and (c) the ergodic axiom; 2. to describe what most mainstream Keynesian economists believe is Keynes's formal model and to explain why these mainstream ‘Keynesian’ models depart from Keynes's explicit analytical argu- ments. They are not logically representations of what Keynes believed was his general analytical system. These models could be correctly named Non-Market Clearing Classical Models or NMCCM. They are modern-day variants of the kinds of classical (Euclidean) models that. in Keynes's time, were used by classical economists to explain unem- ployment asa temporary phenomenon. They typify the same mode of thinking that Keynes condemned as ‘misleading’ in the 1930s;10 Post Keynesian macroeconomic theory, second edition 3. to develop the Post Keynesian analysis that has been evolved from Keynes’s original logical framework; 4, to demonstrate that the analytical differences between the Keynes- Post Keynesian approach and the mainstream Keynesian and classical systems lead to significantly different long-term policy implications for dealing with the relevant economic problems facing modern money- using, entrepreneurial economies, This is especially evident given the Great Recession that engulfed the global economy beginning in December of 2007; and 5. to complete the task that Keynes hoped to do more than a haif- century ago, namely to convince the reader that the Keynes-Post Keynesian analytical framework is the general case applicable to the facts of experience. This task is undertaken with some hope that, in current turbulent times, economists’ minds are again open to the possibility ofa fresh, non-classical axiomatic analysis to apply to the real world’s economic problems of the twenty-first century. This belief in the possible receptivity of mainstream economics to Keynes's ‘difference in analysis’ is suggested in the follow- ing quote from Alan Blinder, co-author of one of the most popular ‘New Keynesian’ textbooks. Blinder, almost two decades ago, recognized that ‘New Classical economics is no longer an attractive intellectual fad in large part because it is not a theory about the world we actually live in. That approach was essentially a mathemati cal construct that really doesn't apply to the real world, In contrast, Keynesian economics was never intended to be an abstract theory, but a model for prac- tical policy to solve a real world problem. Keynesian macroeconomics was theoretically messy. it wasn't neat mathematically, it didn’t have all the strings tied, it had a lot of loose ends and still does. The whole thrust of the intellec- tual revolution led by Robert E. Lucas, Jr, of the University of Chicago and others was to tie up all the theoretical strings in nice, neat mathematical bows. Everything had to be precise. There was some masquerading among some people, not necessarily by Lucas, that this theorizing had something to do with the real economy." Yet, in the 1990s and early years of the twenty-first century, this clas- sical theory still captured the minds of politicians and economists. Alan Greenspan, the chairman of the Federal Reserve from 1987 to 2006 was one of the greatest advocates of this classical theory. After the col- lapse of financial markets in 2007, however, Greenspan, in testimony to a Congressional committee (on October 23, 2008) admitted that he had overestimated the ability of free financial markets to self-correct and he had entirely missed the possibility that deregulation could unleash such aor ¥ The background for Keynes's revolution un \ destructive force on the economy. In his prepared testimony discussing the financial crisis, Greenspan stated: ‘This crisis, however, has turned out to be much broader than anything I could have imagined . . . those of us who had looked to the self-interest of lending | institutions to protect shareholder's equity (myself especially) are in a state of \ shocked disbelief. . . . In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications tech- i nology. ‘A Nobel Prize fin economics] was awarded for the discovery of the [free market] pricing model that underpins much of the advance in [financial] deriva- tives markets, This modern risk management paradigm held sway for decades. : i The whole intellectual edifice, however, {has} collapsed. Under questioning by members of the congressional committee, Greenspan admitted that the events in financial markets forced him to ; reappraise his view that financial regulation is not required. He then stated: e . 1 found a flaw in the model that I perceive is the critical functioning structure - that defines how the world works. That's precisely the reason I was shocked. . . . v : I still do not fully understand why it happened, and obviously to the extent that t | 1 figure it happened and why, I shall change my views. Hopefully, if Mr Greenspan reads this textbook, his understanding of economics will be improved sufficiently that he will be able to understand the cause of the Great Recession and what policy steps must be taken to restore prosperity to the global economy of the twenty-first century. NOTES 1. The Collected Writings of John Maynard Keynes, 13, edited by D. Mogeridge, London. Macmillan, 1973, p. 492. 2. Joan Robinson designated this synthesis as bastard Keynesianism’ to warn readers that the resulting analytical system was a perversion of Keynes's analytical framework. 3. The 1920s prosperity, however, was partly the result of significant speculative bubbles 5 in the stock market and the real estate market. (Shades of the dot.com bubble of the y 1990s and the housing bubble of the early 2000s.) . 40S Ini i The Wet of ations, New York, Modern Library. 1937. P. ic 5, IM. Keynes, The General Theory of Employment, Interest and Money, New York, ; Harcourt, Brace, 1936, p.3. 6. Ibid. p. 297 d 7. Quoted by Austin Robinson in his inaugural Keynes lecture before the British Academy 1e on April 22, 1971 8. Keynes, op. cit.,p. 259.Post Keynesian macroeconomic theory, second edition Keynes. op. cil. pp. 16-17. “Poverty in the midst of plenty: is the Economic System Self Adjusting” in The Collected Writings of John Maynard Keynes, 13, edited by D. Moggridge, London, Macmillan, 1973, p. 486. Economists began working on this task in the late 1930s as they developed consistent axiomatic value theory that evolved ultimately into the Arrow-Debreu model of the 1950s and later rational expectation and the New Classical model of the 1970s. D. Colander and H. Landreth, The Coming of Keynesianism to America, Cheltenham, UK and Brookfield, USA, Edward Elgar, 1996, pp. 159160. For example, see the ‘Symposium on Keynesians Economics Today" in the Journal of Economie Perspectives. 7, 1993 Keynes, op. cit.,p. 257. RE, Lucas, Studies in Business Cyele Theory. MIT Press, Cambridge, MA, 1981, p. 271, Lucas has argued that ‘Progress in cconomic thinking means getting better and better abstract, analogue models. not better verbal observations about the real world’ (ibid. p. 276) For example, see RE. Lucas and T.J. Sargent, Rational Expectations of Ecomometrie Practices. University of Minnesota, Minnesota. 1981, pp. xi-xit. ‘AS we will explain below, Lucas's claim to having the only ‘scientific’ methodology is bused on conflating the ergodic axiom with scientific methodology (see for example, P.A. Samuelson, “Classical and Neoclassical Theory’ in Monetary’ Theory edited by R.W. Clower, London, Penguin, 1969, p. 12, where it i specifically claimed that ergo- dicity is necessary for science). This elaim is not correct, Modern physics as well as other “hard sciences’ have. in recent years, recognized that some processes that they deal with are nonergodic. Also see P. Davidson, ‘Rational Expectations: A Fallacious Foundation For Studying Crucial Decision Making Processes’. Journal of Post Kexnesian Economies. 8, 1982-1983. A. Blinder, "A Keynesian Restoration is Here’, Challenge, 35, September-October 1992 ' ist er 2. The essential difference between the general theory and the classical system It seems to me that economics is a branch of logic: a way of thinking. . .. One can make some quite worthwhile progress merely by using axioms and maxims. But one cannot get very far except by devising new and improved models. This requires ... vigilant observation of the actual working of our system. Progress in economics consists almost entirely in a progressive movement in the choice ‘of models. — J. M. Keynes (1938)! Unlike lower life forms, thinking human beings have tried to understand the world around them and what causes things to happen, Until the seventeenth century, the conventional wisdom of most humans was that whatever happened was the work of God or the Gods. In the seventeenth century, the Age of Reason (or Enlightenment) began by philosophers who thought that the explanation of observed events could be developed by reasoning of the mind rather than religious beliefs. Order and regularity was seen as a human interpretation of one’s environment, Thus reason- ing created theories that humans could use to explain observable events. ‘Through reasoning humans could construct theories regarding the truth of the world around them A theory is essentially an exercise in logic where a model of the observed phenomenon is developed starting from a few fundamental axioms. The theorist uses the resulting model to reach conclusions that ‘explain’ events No theory is ever accepted as the final explanation; rather theories are accepted until they are supplanted by ‘better’ theories. In economics there are two fundamental different economic theories that attempt to explain the operation of a money-using, market-oriented entrepreneurial economy that we often label capitalism. In this chapter we will discuss the different axioms underlying these two theories and how that results in different models of explanation of the operation of the economy in which we live. B4 Post Keynesian macroeconomic theory, second edition SAY’S LAW ‘The nineteenth-century economic proposition known as Say’s Law is the foundation of the classical theory explanation of why a free market system inevitably generates full employment. This classical law evolved from the writings of a French economist, Jean Baptiste Say, who in 1803 claimed that ‘products always exchange for products’. In 1808, the English econo- mist, James Mill, translated Say’s French language dictum as ‘supply creates its own demand’. Mill's phraseology has since been established in economics as Say's Law. It was this economic law that Keynes railed against in his General Theory. Keynes stated: Say's Law ... is the equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating aggregate demand and supply Functions, there is'a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.? To write this ‘vitally important chapter’ required Keynes to throw over three restrictive classical axioms in order to develop a more general theory, ive..a theory requiring fewer axioms. ‘A simplified explanation of Say’s Law is as follows: The sole explana- tion of why people produce, that is supply things to the market, is to earn income. In orthodox theory, engaging in income-earning productive activities is presumed to be disagreeable. Humans are presumed to be maximizing their utility or pleasure with every decision they make. People will work, therefore, only if they can earn sufficient income to buy the products of industry that can provide them with sufficient pleasure to com- pensate for the unpleasantness of the income-earning activity. If people are rational utility maximizers, then all income earned in the market by the selling of goods and services is spent to buy (demand) things produced by others. Say’s Law implies that a recession or depression will never occur. ‘The very act of production generates enough income, and demand, to pur- chase everything produced. Businessmen seeking profits are always able to find sufficient market demand at profitable prices to sell all the output produced by workers. Under Say’s Law, goods always exchange for goods. Money is only a ‘veil’ behind which the real economy operates unhampered by financial considerations. This ‘money is a veil’ idea is encapsulated in the classical axiom that money is neutral, i.e. money is merely used as an intermediary in the exchange of goods for goods. Changes in the quantity of money have no effect on the level of goods produced. In a Say’s Law world, there is no inherent obstacle in the economic system to prevent output andle ure put General theory and the classical system 15 employment from being at the maximum flow possible given the size of the population and the technology available to producers. Money is merely a lubricant that oils the wheels of production and exchange If Say's Law prevails, then the economy can always be fully employed ‘Any change in the quantity of money by itself cannot induce a change in production. An increase in the money supply, for example, can only be spent on the same quantity of goods produced by an already fully employed economy. Increasing the money supply therefore only creates too much money chasing too few goods. The result is an increase in the market prices of all goods. Thus, if one initially puts the rabbit called the ‘neutral money axiom’ into the classical theorist’s hat, then it should not be a surprise when a logically consistent economist-conjurer pulls from his classical chapeau the conclusion that inflation is ‘always and everywhere ‘a monetary phenomenon’ caused by ‘too much money chasing too few goods’. Say’s Law and the underlying belief in the neutrality of money became a fundamental tenet of nineteenth-century classical theory. By the early twentieth century, this neutrality of money became one of the basic axioms of the prevailing orthodoxy in economies textbooks. An axiom is defined as ‘a statement universally accepted as true. . . a statement that needs no proof because its truth is obvious’. Even today, for those who are trained in classical economic theory, the neutrality of money is an article of faith, requiring no proof or justification. For example, Blanchard, who is (as this is being written) the chief economist of the International Monetary Fund [IMF has claimed that all models that are relevant for the study of mac- roeconomics ‘impose the long-run neutrality of money as a maintained assumption. This is very much a matter of faith, based on theoretical considerations rather than on empirical evidence’.* ‘A religious person who accepts the existence of a Divine Being as a fundamental truth would reject any ‘scientific’ evidence that purports to demonstrate that there is no God. Similarly, a true believer in the axi- omatic foundations of classical theory will deny that money can be shown to be ultimately non-neutral in the long run.‘ To presume the long-run neutrality of money is to reject, without proof, the possibility that changes in financial markets and therefore the quantity of money can affect either the number of workers employed by entrepreneurs or the total volume of goods and services produced by firms. Any empirical data that purport to demonstrate that changes in the quantity of money per se can affect the real economy must be summarily rejected by classical theorists if they are to remain logically within their long-run analytical framework. It should not be surprising, therefore, that mainstream economists have a difficult time explaining why the apparent collapse of some financial markets in16 Post Ke ynesian macroeconomic theory, second edition 2007 led to the Great Recession since classical axioms assured that money and its related financial markets can not affect the real economy. Yet Keynes, and a modern group of Post Keynesian economists fol- lowing Keynes’s analytical lead, have developed a logical system that rejects the neutrality of money as a necessary initial axiom in either the short run or the long run. The resulting Keynes-Post Keynesian ana- lytical framework provides a more general theory of the economy since it requires fewer initial restrictive axioms such as the neutral money axiom. Once money neutrality is rejected as an axiomatic building block, then Say’s Law is no longer applicable as the organizing principle for studying ‘a market system where money is used as a means of settling contractual obligations. Keynes explicitly threw out the classical neutrality of money assump- tion in 1933, when he described the principles that were guiding him in developing his General Theory. Keynes drew a distinction between clas- \sical theory and the theoretical framework that he was developing in the * following manner: ‘An economy which uses money but uses it merely as a neutral link between transactions in real things and real assets and does not allow it to enter into motives or decisions, might be called — for want of a better name ~ a real- exchange economy. The theory which I desiderate would deal, in contradistine~ tion to this, with an economy in which money plays a part of its own and affects motives and decisions and is, in short, one of the operative factors in the situa- tion, so that the course of events cannot be predicted either in the long period ‘or in the short, without a knowledge of the behavior of money between the first State and the last. And it is this ‘hich we ought to mean when we speak of @ monetary economy. « Booms and depressions are peculiar to an economy in which . . . money is not neutral. | believe that the next task is to work out in some detail such a monetary theory of production. That is the task on which | am now occupying myself in some confidence that I am not wasting my time.* Here. in Keynes’s own words, is the claim that a theory of production for a money-using economy rejects a classical “universal truth’, the neu trality of money. Yet this neutrality axiom had been the foundation of classical economic theory for 200 years, ever since Mill introduced Say’s Law into English economics. And, as the previous quote from Blanchard indicates, the neutral money axiom is still the foundation of all main- Stream macroeconomic models. No wonder Keynes's General Theory wvas considered heretical by most of his professional colleagues who were wedded to the classical analysis. Keynes was delivering a mortal blow to the very foundation of classical faith ~ the neutrality of money. No wonder Keynes's original analysis and the further elaboration and evolution of { t teu- 1 of ay's ard ain- ory vere y to der n of General theory and the classical system 7 Keynes's system by Post Keynesian economists in recent decades has been snubbed by the majority of economists who are ideologically bonded to either the old or new classical tradition. The Keynes-Post Keynesian axiomatic logic is heresy. To accept Keynes’s logic and its Post Keynesian development threatens the Panglossian conclusion that, in the long run, an unfettered market economy will always assure full employment for all those who want to work, The more general (i.¢., less restrictive) axiomatic foundation of Keynes's analysis permits the possibility that an entrepreneurial system might be flawed. Consequently, there can be a permanent role for govern- ment to correct any imperfections. The Keynes-Post Keynesian logic is as antithetical to the classical philosophy as the views on the origin of human life as asserted by the ‘scientific theory of evolution’ are to the ‘scientific creationism’ biblical view of some fundamentalist Protestant religions. REVIVING KEYNES’S REVOLUTION Keynes argued that Say's Law is not a true law for any economy possess- ing the characteristics of the economic system we live in. Keynes's model demonstrates that the economic ‘system is not self-adjusting, and, without purposive direction, it is incapable of translating our actual poverty into potential plenty’.* This message is just as relevant today as it was in the 1930s. Keynes expressly indicated that he rejected the neutrality of money axiom in his analysis. Keynes's logic also required him to throw over two other classical axioms: (1) the gross substitution axiom that asserts that everything is a substitute for everything else and (2) the axiom of an ergodic economic environment, i.e., the presumption that future eco- nomic events can be reliably predicted by studying the economy's past and current market price data. There are five essential characteristics of the real world which Keynes believed could be properly captured only by overthrowing these three axioms which are the basic foundations of classical economic theory. These features are 1. Money matters in both the long and short run, Money affects real decision making and employment and output outcomes.” In con- trast, classical analysis presumes money to be neutral and therefore economic outcomes are determined entirely by real forces. 2. Time is a device that prevents everything from happening at once. The economic system is moving through calendar time from an irrevocablePost Keynesian macroeconomic theory, second edition past to an uncertain and statistically unpredictable future. Yet house- holds and firms know they must make spending decisions today which will effect their economic circumstances in the uncertain future. Past and present market data will not necessarily provide correct signals regarding future outcomes. This means, in the language of statisti- cians, that economic data are not necessarily generated by a’stochastic ergodic process.’ Hicks has stated this condition as: ‘People know that they just don’t know’? Contracts denominated in money terms are a ubiquitous human institution in an entrepreneurial economy. The civil law of contracts evolved to help humans efficiently organize time-consuming produc- tion and exchange processes in a world of nonergodic uncertainty." In any money-using entrepreneurial economy, entrepreneurs’ decisions regarding production and hiring depend on expectations of receiving contractual sales revenues (cash inflows) in excess of the contractual money costs of production (cash outflows). Since the money-wage contract is the most ubiquitous of these efficiency-oriented contracts, modern economies can be characterized as money-wage contract- based systems." In money-using, market-oriented entrepreneurial systems, liquidity is defined as being able to meet contractual obligations as they come due. Since production and exchange in an entrepreneurial system is organized on a money-contract basis, liquidity implies having access to money to meet purchase and/or debt contractual payments as they come due. When the future is uncertain and hence cash flows over time cannot be reliably predicted, it is quite sensible to demand and hold money and other liquid assets (readily resalable for money) to protect oneself from being unable to meet unforeseeable net cash outflow commitments. In a classical system, where goods essentially exchange for goods, there is no rational need to hold money for liquidity purposes. Keynes insisted that money (and all other liquid assets) possesses two essential elasticity properties that differentiate it from the products of industry. These properties describe why (a) money does not grow on trees (money's elasticity of production is zero), and (b) why produc- ible goods are not good liquid stores of contractual settlement values (the elasticity of substitution between liquid assets such as money and producible goods is zero). If money has these peculiar but essential clasticity properties, Keynes argued, then ‘[uJnemployment devel- ops, that is to say, because people want the moon; ~ men cannot be employed when the object of desire (j.¢., money) is something which cannot be produced and the demand for which cannot be readilyal iS, ft General theory and the classical system 1” choked off, There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (ie.,a central bank) under public control’.! Thus, if people save a part of their income in the form of money or any other liquid asset, then the decision to save is a nonemployment inducing decision. 5. Unemployment, rather than full employment, is a normal outcome in any entrepreneurial, market-oriented, money-contract-using system operating in a laissez-faire environment. Ina classical system, on the other hand, money is just another producible commodity, like peanuts, Consequently whether people spend their money income on other producibles or save a portion of their money income in the form of peanut money, all of today’s earned income is spent on today’s products of industry, Since income that is earned must be the result of production (supply) of producible goods and services, then supply of producibles creates its own demand for producibles. Full employment is the inevitable outcome of a classical market economy as long as the only things that provide utility are producibles. For Keynes, uncertainty about the future is essential to understand- ing why unemployment can occur in an economy that uses money and legal money contracts to organize production and exchange transactions. Money contracts are tused to gain some control by firms and households over their cash inflows and cash outflows as they venture into the uncer- tain future. Keynes's revolutionary liquidity preference analysis is impor- tant only in such a money contracting economy since liquidity implies the ability to meet all money contractual obligations when they fall due. Clearly the possession of money per se provides one with liquidity as long as one’s future contractual obligations do not exceed the stock of money currently held. The role of liquid financial markets in a money contracting world is to assure holders of these liquid financial assets that are traded on well organ- ized, orderly financial markets that these liquid assets can be readily con- verted into cash whenever additional funds are needed to meet an existing, or even a potential, contractual cash outflow commitment or to prevent a feared future capital loss in the value of the financial asset." KEYNES’S AGGREGATE SUPPLY AND DEMAN! ANALYSIS : Before Keynes, classical economists admitted that temporary unemploy- ment could develop if supply imperfections (perhaps due to the existence20 Post Keynesian macroeconomic theory, second edition Expected sales proceeds $a $m Sk #N mN nM Employment Figure 2.1. The aggregate supply curve of labour unions or monopolies) prevented prices from responding instan~ taneously to exogenous changes (shocks) in the level or composition of total (aggregate) market demand. If, however, market prices quickly and freely adjust to demand changes, then competitive market forces will induce a change in relative market prices that reflect any change in the composition of demand. As long as everything is a gross substitute for everything else (i.e., the gross substitution axiom) then changes in market prices assure that all markets clear simultaneously. The long-run policy implication of this view is that the government should stand aside and permit the free market to right itself. Government action interferes with free market adjustment and postpones the restoration of full employment any time there is a shock to classical economic system. The historical record of double-digit unemployment rates throughout most of the 1920s in Great Britain convinced Keynes that this classical view was in error. Even if supply conditions are perfect, one cannot rely on supply to create its own demand. Keynes's task was to explain why the determinants of aggregate demand were not identical with the determinants of aggregate supply as the clas- sical analysis presumed, In other words, why did people not spend every penny of income they earned on the products of industry? Since production takes time, entrepreneurs must hire workers today to produce goods that will be available for sale at some future date, Keynes's aggregate supply function represents the relationship between entrepre- neurs’ expected sales revenues tomorrow and the amount of labour hiring that the entrepreneurs require today to produce sufficient output to meet tomorrow's expected demand. In Figure 2.1, the aggregate supply curve (Z) emanates from the origin to indicate that if entrepreneurs expect zero cpu neers te meni tean nd vill the for ket ley and vith ent ical 20s ror. cate and clas very y to 1es's ring meet urve zero nyse General theory and the classical system a Planned spending D Employment Figure 2.2. The aggregate demand function sales revenue tomorrow they will hire zero workers today. If, on the other hand, they expect to sell $k worth of goods in the future they will hire kN workers today. Alternatively, if they expect a greater profit-maximizing sales revenue of Sm tomorrow (where m > k), they will hire mN workers today, while if Sn sales are expected then nN workers will be hired (where n> m > k). Accordingly, the aggregate supply curve is drawn (in Figure 2.1) as upward sloping to represent the common-sense notion that if entre- preneurs expect to sell more tomorrow, they will hire more workers today. ‘The aggregate demand function (D) represents the desired expenditures of all buyers at any level of aggregate employment. In Figure 2.2, D is drawn as upward sloping, but different than the aggregate supply func- tion (Z). (The rationale for the difference in the position of the aggregate demand function from the aggregate supply function will be elaborated on in Chapter 3.) The positive slope of D represents the notion that if employment is larger, more income is earned, and therefore the demand (spending) on goods and services will be larger. Clee ILLUSTRATION OF KEYNES’S GENERAL, ‘The curves in Figure 2.3 are drawn to illustrate why a less than full employ- ment equilibrium situation can persist. For descriptive simplicity assume that the production of the economy can be represented as an aggregation of what happens on a single tomato farm. On Monday morning, our rep- resentative entrepreneur, Farmer Brown, has to decide on the number of workers to hire to harvest sufficient tomatoes to maximize profits at next2 Post Keynesian macroeconomic theory. second edition Expected sales proceeds, planned spending n, 1 n ns Employment Figure 2.3 Why a less than full employment equilibriun situation can persist Saturday’s market. Assume (as in Figure 2.3) that Farmer Brown expects his profit-maximizing sales next Saturday to be z, dollars (say $1000) worth of tomatoes. According to this supply schedule he has calculated that hiring m, workers to produce g, tomatoes will bring in revenues of z (where 2, = pig, and p, is the price at which Farmer Brown expects to be able to sell g, tomatoes). The resulting », workers hired by Farmer Brown toil all week and receive their week’s pay on Friday night from their employer.'* On Saturday morning, Farmer Brown takes his harvested tomatoes to market. At 8 a.m. the market opens and consumers (mainly, but not only, the employees of Farmer Brown and the other entrepreneurs in the system) come to market with the income (wages) they received the night before, Farmer Brown expects to sell the last tomato he has brought to market to the last customer expected to arrive a few seconds before closing time (5 p.m.). If his expectations regarding demand are met, then he cor- rectly guessed the size of the market when he made his hiring decision last Monday morning. From Figure 2.3, we can see that if, in the aggregate, all entrepreneurs hire the equivalent of 7, workers, then the planned spending of buyers that make up the level of aggregate demand will be equal to d, (= p.qi)- ‘As drawn in Figure 2.3, planned spending exceeds the amount entrepre- hneurs expected to sell (d, > z,). Several hours before the market closes (say 3 pun.) Farmer Brown (representing all entrepreneurs in the system) finds | | i | i [ie eto aagrr General theory and the classical system a he has sold his last tomato. For the rest of the market day disappointed buyers arrive at Farmer Brown’s counter trying to purchase tomatoes, but his shelves are bare." On the following Monday morning Farmer Brown must again choose the number of workers to hire based on this Monday's expectations of sales for the following Saturday. Assume that Farmer Brown kept a record of how much money last Saturday's disappointed buyers said they would have spent had he still had tomatoes for sale. Brown may adopt the d, potential expenditures of last Saturday as the best estimate of next Saturday's sales proceeds (2,), i.e. 2: (= puis). According to Figure 2.3, Farmer Brown will therefore hire n, workers in the expectation of earning z, revenue. Again, the workers labour in the fields and are paid on Friday evening. Farmer Brown arrives at Saturday's market with q, tomatoes that he expects to sell at a price of p;. The market doors open at 8 a.m. and buyers keep arriving at Farmer Brown's counter during the market day. From Figure 2.3, we see that Farmer Brown has underestimated demand that this Saturday will be d; (= p.g;). (The presumed unforeseen increase in demand is the result of more workers being hired and therefore swelling the number of tomato buyers.) As drawn in Figure 2.3, Farmer Brown's underestimate of market demand is less than it was last Saturday, i.e., (dy = 23) < (d, — 2 Consequently, this Saturday Farmer Brown will not run out of tomatoes to sell until later in the day, say 4:15 p.m. How many workers will representative Farmer Brown hire on the fol- lowing Monday, and on each Monday after that? If this hypothesized process of adjusting expectations of next week's sales proceeds in the light of the past week's revenues plus evidence of disappointed buyers continues, then Farmer Brown’s hiring decisions will tend to follow the dotted line in Figure 2.3 until Farmer Brown expects sales proceeds equal to z,, when he hires n, workers. Since d. = z, on that Saturday, Farmer Brown will sell his last tomato just as the clock strikes 5 p.m. and the market closes, There are no frustrated buyers. Farmer Brown (and all the other entrepreneurs) are just realizing their expectations of sales and there should be no further incentive to change employment plans. Consequently, as long as the aggregate demand curves remain as drawn in Figure 2.3, then once entrepreneurs have hired the equilibrium level of employment (n,), their expectations of sales are just being fulfilled by buyers’ demands and there is no reason for them to alter their hiring plans. This intersection of the aggregate supply and demand functions, point24 Post Keynesian macroeconomic theory, second edition Ein Figure 2.3, is designated the effective demand by Keynes. The point of effective demand can occur at any level of employment - even one where ail workers who wish to work at the going real wage will not be employed. nee DEMAND AND SUPPLY AND SAY’S LAW The main difference between the classical Say's Law analysis and Keynes's General Theory depends on the shape and position of the aggregate demand function vis-d-vis the aggregate supply function. Say’s Law speci- fics that all expenditure (aggregate demand) on the products of industry is always exactly equal to the total costs of aggregate production including rents and gross profits (aggregate supply). This implies that the aggregate demand curve must be coincident to the aggregate supply curve, as drawn in Figure 2.4. The aggregate demand curve is merely superimposed on top of the aggregate supply curve, and, in Figure 2.4, whatever is supplied will be demanded. Using our Farmer Brown example to illustrate Figure 2.4; if Farmer Brown expects sales revenue of $2;, then he will hire », workers. On market day, as Figure 2.4 indicates, buyers will spend exactly $d, (= 21). Entrepreneurial expectations will be exactly met. Alternatively, if Farmer Brown expects z, sales revenue, then he will hire n, workers. Again sales expectations will be exactly met, In a Say's Law regime, ‘effective demand, instead of having a unique equilibrium vaiue, is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as. . . {the full employment level of 1, (in Figure 2.4)] Expected 4 sales a proceeds, planned spending mt % Employment Figure 2.4 Aggregate supply and demand in a Say's Law worldbil ee / } I i General theory and the classical system 25 sets an upper limit’.'* In a Say’s Law world, there is no inherent obstacle to prevent the economy from achieving full employment ~ as long as entrepreneurs are willing to hire all the workers who want to work. KEYNES’S TAXONOMIC ATTACK ON SAY’S LAW In his biography of Keynes, Harrod highlighted the essential nature of the Keynesian Revolution. Harrod wrote ‘classification in economics, as in biology, is crucial to the scientific structure’.” Harrod noted: ‘The real defect with the classical system was that it deflected attention from what most needed attention. It was Keynes’ extraordinarily powerful intuitive sense of what was important that convinced him that the old classification was inadequate. It was his highly developed logical capacity that enabled him to construct a new classification of his own." Keynes's taxonomic attack on the classical system can be algebraically demonstrated. Let Z represent aggregate supply (or entrepreneurial expectations of sales receipts) in monetary terms, D aggregate demand (or planned expen- ditures) in money units, the money-wage rate, and N the number of workers, The aggregate demand function is, D=f,lw,d (2.1) The aggregate supply function is Z = flw.N). (2.2) Say's Law asserts that fbow,N) = f.00,) (2.3) ‘for all values of N, i.e., for all values of output and employment’. In other words, in an economy subject to Say’s Law, the total costs of aggre- gate production incurred by firms:(for any given degree of competition or monopoly) at any level of employment are always recouped by the sale of that output. The aggregate demand and aggregate supply curves coincide (Figure 2.4). There is never a lack of effective demand to prevent entrepreneurs from hiring all who are willing and able to work at the going wage. To challenge the applicability of Say’s Law, Keynes had to develop a26 Post Keynesian macroeconomic theory, second edition model where the aggregate demand and aggregate supply functions, f,(w, N) and f(w, N),are not coincident (Figure 2.3). Keynes accepted the ‘age-old’ normal (Marshallian) supply condi- tions based on the marginal cost function plus any monopoly mark-up” as a micro-basis for the aggregate supply function of equation (2.2). The existence of monopolistic power in the product and/or the labour markets is not a necessary condition for the existence of a barrier to full employ- ment. A purely competitive market system with perfectly flexible wages and prices could still suffer from unemployment due to a lack of effective demand. Keynes's heretical explanation of unemployment required explaining why aggregate demand does not coincide with aggregate supply, inde- pendent of the degree of competition in the market-place, i.e., why supply oes not create its own demand, whether or not competitive conditions prevail. Keynes developed an expanded taxonomy for the components on the aggregate demand relationship to differentiate his general case from the classical special case. In the classical system, there is only a single cat- egory of spending. All demand expenditure is a function of (and is equal to) income earned (supply). Keynes split aggregate demand into two categories, D, and Dy, i.c., D=D,+ Dy (2.4) Keynes's D, demand category represented all expenditures which ‘depend on the level of aggregate income and, therefore, on the level of employ- ment N' ie. Di = Aw, N)5 (2.5) Dy therefore, represented all expenditures not related to income and employment, i.e. : # fw N). (2.6) “These two categories make up an exhaustive list of all possible classes of spending. (Keynes's task was to show that special postulates were required by the classical theory to demonstrate that the aggregate demand function con sists solely of expenditures equal to current income, and if these axioms are dropped, then f(w, N) is never equal to f(w, N) forall levels of N, while D, spending = 0. inag teristics of the special case assumed by classical theory happen not to be i those of the economic society in which we actually live’ In other words. General theory and the classical system 27 aw, The microfoundations of the classical economics case assure that all income is spent on the products of industry. In the simplest classical case, di- all current expenditures are related to current income and are therefore p? classified under D, which is immediately spent. The marginal propensity rhe to spend out of current income is unity and any additional supply creates ets its own additional demand. (In an intertemporal setting with gross substi- oy- tutability over time agents plan to spend lifetime income on the products ges of industry over their life cycle, i.e. the long-run marginal propensity to tive spend is unity.) Consequently, in a classical economic model in either the short run or the long run, f,(w, N) = fw, N) for all values of N and Figure ing 2.4 is relevant. ide- Keynes's second expenditure category, D,, is not related to current oply income and employment by being equal to ‘planned’ savings (which can ions be defined as fw, N) —fi(w, M)). To demonstrate why D, is not equal to planned savings, Keynes assumed the existence of an uncertain future the that cannot be either foreknown or statistically predicted by analysing | the past and current market price signals. In such a nonergodic environment. cat- future profits, the basis for current D, investment spending, can neither qual be reliably forecast from existing market information, nor endogenously two determined from today’s ‘planned’ savings function (f.(w, N) — fiw. NY). Rather investment expenditures depend on the exogenous {and therefore by definition, sensible but not rational) expectations of entrepreneurs, or (2.4) what Keynes called ‘animal spirits’. Thus, in either the short run or the long run, D, expenditures cannot be a function of current income and pend ‘employment and inequality (2.6) applies. ploy- Explicit recognition of the possibility of two different classes of current + demand for producible goods and services based on fewer axioms than t required by the classical taxonomy makes Keynes’s analysis the more (2.5) | general case. Classical theory where Say’s Law prevails and where income- generating supply activities (/,(1v, N)) create their own identical demand so 2 and | that all markets clear becomes ‘a special case’ where i Qn (2.6) | } and ses of | i D, = fiw, N) = fl, N) = Z (2.8) by the | n con- | for all values of wand N. . eee i ‘The next logical task for Keynes was to demonstrate that ‘the charac- while28 Post Keynesian macroeconomic theory, second edition Keynes had to demonstrate thai even if D, = 0, the D, function would not be coincident with his macroanalogue of the age-old supply function. To accomplish this, Keynes had to reject the special classical ubiquitous gross substitution axiom and the ergodic axiom as applicable to any economy that organizes on a money contractual basis in the face of an uncertain future and where liquid assets have ‘essential’ elasticity properties. Under these more general conditions, some portion of a utility-maximizing agent’s income might be withheld from the purchase of producible goods, i.e. the marginal propensity to spend out of current income on the products of industry is less than unity. In an uncertain world income recipients may not know all the producible goods they will need in the future when their future expected income may not be sufficient to pay for all their needs. Consequently income earners today will not spend their entire income. Instead they will ‘save’ some portion of their income in order to have future liquidity to meet possible future contractual liabilities. As we have already noted, liquidity provides utility by protecting the holder from fear of not being able to meet future contractual commitments. Savers then have to make another decision: in what form of possible liquid assets should they hold their savings in order to be able to meet possible future cash outflows in the future? No matter what liquid assets savers choose, as long as they possess the essential elas- ticity properties so that all liquid assets can only be nonproducibles, i.e., they do not grow on trees and hence cannot be harvested by employing workers when savers in the aggregate demand new liquid assets. As long as producible goods are not gross substitutes for holding non- producible liquid assets (including money) for liquidity purposes, then no change in relative prices can induce income earners to buy producibles with that portion of income we call savings that savers wish to use to pur- chase additional security by buying liquid assets. Or as Hahn put it: ‘there are in this economy resting places for savings other than reproducible assets’ and the existence of ‘any non-reproducible asset allows for a choice “between employment-inducing and non employment-inducing demand In an uncertain (nonergodic) world, where money and all other liquid assets possess certain essential properties, agents can obtain utility (by being free of fear of possible illiquidity or even bankruptcy) only by holding. portion of their income in the form of nonproducible money or other liquid assets. As long as the gross substitutability between nonpro- ducible liquid assets (including money) and producible goods is approxi- mately zero then money is not neutral, even with perfectly flexible prices. Thus, the general case underlying the principle of effective demand is: Dy = fiw) # f.00.N) Q9) | | | I | |non- en no cibles ) pur there acible hoice nd’2* liquid ry (by ly by ney or npro- proxi- prices. st 2.9) | General theory and the classical system 29 while the propensity to save (/0, N) — fw, N)) isequal to the amount out of current income that utility-maximizing agents plan to use to increase their holdings of nonproducible liquid assets. By proclaiming a ‘fundamental psychological law’ associated with ‘the detailed facts of experience’ where the marginal propensity to consume is always less than unity, Keynes finessed the possibility that equation (2.8) was applicable to the real world, If the marginal propensity to consume is always less than unity, then f(w, N) would never coincide with fw, ). even if D, = 0, and the special classical case of Say’s Law is not applicable to ‘the economic society in which we actually live’.”* ; In sum, Keynes's principle of effective demand demonstrates that, in a nonergodic world, it is the existence of nonproducible assets that are held for liquidity purposes and for which the products of industry are not gross substitutes that is the fundamental cause of involuntary unemploy- ment, The lack of perfect price flexibility is not a necessary condition for demonstrating the existence of unemployment: CAN FLEXIBLE WAGES ASSURE FULL EMPLOYMENT? Pre-Keynesian classical economists claimed that unemployment occurred because wages were too high to sustain full employment. If money wages and prices were perfectly flexible and immediately declined if there was a drop in demand, then classical theory claims that full employment would be restored. Unemployment could therefore be attributed to the ‘fact’ that workers (and unions) fixed the wage too high and then refused to cut wages in the face of unemployment. Keynes rejected this view.** Keynes's principle of effective demand is not merely a novel way of demonstrating that wage inflexibilities are the necessary cause of unem- ployment. In Keynes's analysis, unemployment can develop even if wages are perfectly flexible. Changes in the money-wage rate induced by some exogenous change in demand will not automatically restore full employment ‘At this stage in our overview of Keynes’s system, it is not practical to delve into the details of Keynes's answer to the classical ‘too high’ wage problem. It is sufficient to note that if both aggregate demand and aggregate supply money proceeds are deflated by the money wage, then Keynes's effective demand analysis is presented in terms of his wage unit Equations (2.1) and (2.2) would be written as: Z. = LAN) Q.by)30 Post Keynesian macroeconomic theory, second edition Expected sales proceeds, planned spending N,N, Employment Figure 2.5 The general theory of aggregate supply and demand in wage units and SAN) (2.2) where the subscript w indicates measured in wage units. Equations (2.1) and (2.2) are drawn in Figure 2.5 for a given money wage, ,. The point of éffective demand in Figure 2.5 is point £, and the equilibrium level of employment is V, where Dy = SuN) = LAN) = Zoe (2.30) What is the effect of a change in the money wage on this underemployment point of effective demand? By construction, any change in the money wage, say from iv, to W,, where 1°, > W,, will not cause any change in the position or shape of the aggregate supply function in wage units. Consequently, if a change in the money wage is to increase the employment point of effec- tive demand and move the economy toward full employment equilibrium (N) in Figure 2.5, then the aggregate demand curve in wage units must be induced to shift upwards as a direct effect of the hypothesized decline in the money wage. As Keynes put it ‘the precise question at issue is whether the reduction in money-wages will or will not be accompanied by .. . an aggregate demand . . . which is somewhat greater measured in wage units!.”” Accordingly, Keynes’s ‘difference of analysis’ involves tracing how a change in the money wage affects D, and/or D; when both are measured in wage units relative to the unchanged aggregate supply function when the latter is also measured in terms of wage units. In other a aaaa S325 —— eege 2.2W) 2.1) point vel of 2.31) ment wage, sition tly, if effec brium must ecline sue is vanied asured volves n both supply other S32 Ge a: General theory and the classical system uM 4 words, ‘Keynes's parametrization of the money wage forces the analyst to eValiate how any change in the money wage works through the D, and D, cdmponents of aggregate demand if one is to claim that a too high wage caues unemployment and a change in the wage (i.e., flexible wages) per sll cure the unemployment problem. (This evaluation is carried out in Chapter.12.) ‘Herrod’s argument regarding the importance of Keynes's new clas- sification scheme is right on the mark. The classical taxonomy deflected .attention away from the necessity of studying the components of aggre- gate jdemand to explain involuntary unemployment, whether money " “wages (and prices) were flexible or not. The absence of flexible wages and of prices per se is not a necessary condition for underemployment equi- librium. Nor is the existence of perfectly flexible wages and/or prices sufficient condition for guaranteeing full employment. CONCLUSION This chapter has explained how Keynes developed a more general theory than the classical one based on Say’s Law. The revolutionary aspect of Keynes's approach involved eliminating three restrictive classical axioms that underlay the classical vision of the aggregate demand function. The chapters that follow will systematically, and in greater detail, develop Keynes's argument and indicate how it differs not only from the pre- Keynesian classical theory, but also from the New Classical, and Old and New Keynesian analyses that have dominated mainstream economics since Keynes’s death NOTES 1. The Collected Writings of Joln Maynard Keynes, 4, edited by D. Moggridge, London, Macmillan, 1973, p.296. IM. Keynes, The General Theory, p.26 10.5. Blanchard, ‘Why Does Money Affect Output? A Survey" in Handbook of Monetiry Eronomis, I ebted by BM. Friedman and FH, Ha, New York, Evi, 19, p. 828. : 4, Thisis not to deny that some New Keynesians and Old Classical economists will accept the notion that money may be non-neutral inthe short run because of some “temporary supply side failure ofthe free market, Nevertheless all members of the mainstream eco nomic theorists accept money is neutral in the long run, We shall see Keynes rejected the idea that money was neuiral in either the short run or the long run. 5. ILM. Keynes, "A Monetary Theory of Production’ in the Collected Writings uf Jolin ‘Maynard Keynes, 13, edited by D. Moggridge, London, Macmillan, 1973, p. 409 (some italics added)16 "7. 18. 9. 20. a 2. 23, 24, 25, 26. 28. Post Keynesian macroeconomic theory, second edition JM. Keynes. ‘Poverty in the Midst of Pienty: Is the System Self-adjusting?” The Collected Wriigs of John Maynard Keynes, 13, edited by D. Moggridge, London, acrnillan, 1973. p. 491 Despite Friedman's use of the motto ‘money matter cal neutral money axiom. P. Davidson, ‘Is Probability Theory Relevant for Uncertainty: A Post Keynesian Perspective, Journal of Economic Perspectives, 5, 1991. 10 order for the historical data to provide a statistical base for drawing reliable inferences about future outcomes, the dla must be generated by an ergodic stochastic process. Such inferences are labelled “rational expectations’ by New Classical economists JER. Hicks, Causality in Economies, New York, Basic Books, 1979, p. xi P, Davidson, ‘The Dual Nature of the Keynesian Revolution’. Journal of Post Keynesian Economics, 2, 1980. ; With the legal abolition of slavery. only forward labour contracts enforceable in terms of money are permitted in modern economies. J.M. Keynes, Te General Theors, p. 235. How many of the stockholders of British Petroleum stocks on April 20, 2010 (includ- ing many very sophisticated investors) wish they could have foreseen the plunge of BP stock after the oil spill in the Gulf of Mexico? One of the world’s largest money manage- ‘ment firms, Blackwater, held more than 1. billion shares worth $14.57 billion on April 20. By June 16 these shares held by Blackwater were worth $7.5 billion. “The payroll will probably be financed by a working capital loan from Farmer Brown's banker. Out of the =; sales revenue received Farmer Brown pays off his working capital loan ‘om his banker that financed his payroll. Whatever remains is his gross profits Keynes, The General Theor, p. 26. RCE. Harrod, The Life of John Maynard Keynes, London, Macmillan, 1951, p. 464, Ibid... p. 463. Keynes, The General Theory. p. 26. Keynes (The General Theor’, p- 245) specifically indicated that any degree of competi- tion was compatible with his generalized aggregate supply function, Ibid... p. 28. Ibid. p. 210. Ibid. p. 3. FH. Hahn, ‘Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates’ in The Microfoundations of Macroeconomics, edited by G.C. Harcourt, London, Macmillan, 1979, pp. 31, 39 Keynes, The General Theory p. 3 Ibid. p. 257 Ibid, pp. 259-60. Ibid. p. 257. "he remains faithful to the classi-"The don, lassi- esian | data s, the pelled ’ Post terms nelud- of BP anage- 1 April al loan 64, >mpeti- ions on ry GC. 3. Taxonomy, axioms and expenditures related to income: Keynes’s D, category ee ‘What's in a name? That which we call a rose by any ‘other name would smell as sweet, ~Shakespeare It is Keynes's taxonomy that fundamentally distinguishes his analysis from classical theory. All successful classification schemes require the tax- onomist to define each category in terms of those necessary and sufficient common properties possessed, and/or common functions provided by any item for it to be a member of a specific class For example, even though a whale looks like a fish, swims like a fish, and will die (like a fish) if it is out of water for too long, a whale is not a fish. The taxonomy of biologists classifies all whales as mammals despite their obvious similarities to fish. Biologists have agreed that the necessary and sufficient characteristics for a species to be labelled a mammal are that the species bears its young alive and suckles the young. A creature’s physi- cal appearance, its habitat, or its swimming propensity are neither neces- sary nor sufficient for some biologists’ classification, No matter that the uninstructed layperson perceives a whale to be more similar to a fish than to his/her own mammalian self, Nor does it make any difference to the lifestyle of the whale who, oblivious to the biologists’ taxonomy, continues to look, swim and die like a fish. In the physical sciences, taxonomists often invent words to define spe- cific categories. Thus certain things that share common ‘properties are ‘quarks’, even though the average layperson has not the slightest idea what a quark is or what it feels, smells, tastes, looks, or sounds like. The word ‘quark’ does not appear in everyday conversation. Physicists are free to define a ‘quark’ any way they see fit. All physicists have to agree on the same definition if a meaningful investigation and conversation amongst physicists is to be carried on. Unfortunately, economists do not have the linguistic freedom of physicists. To communicate with policy makers and intelligent laypeople regarding economic matters, economists tend to use words adopted from nonstandardized, everyday speech to try to designate rigorous economic 33a4 Post Keynesian macroeconomic theory, second edition categories. All too often the result is that defenders of some economic position are using an economic term to mean one thing, while their antagonists use the same word to connotate something different. This ambiguity in economic lariguage often perpetuates semantic confusions rather than shedding light on economic problems. We shall note that this is especially true for the following concepts: (a) uncertainty, (b) spending and saving out of income, (c) the essential characteristics of money and money contracts, and (d) the role of capital (financial) markets, THE UNCERTAIN FUTURE There are two fundamental different concepts of uncertainty in econom- ics; the classical mainstream theory concept and the Keynes concept. The explanation of how economic agents make decisions under uncertainty regarding future outcomes in various classical and Keynes-type models depends on (a) the analyst’s conception of the cause of uncertainty in the external economic reality in which decision-makers operate, and (b) the ability of agents to understand that reality. Uncertainty in classical theory is an epistemological concept where the future is already predetermined and the only question differentiat- ing various classical theories is the analyst’s assumptions regarding how humans can ‘know’ the preprogrammed future based on past experience. Uncertainty in Keynes's theory, on the other hand, is an ontological concept where the economic future in many dimensions is not predeter~ mined but crucial decisions made today can create the future, often in ways today’s decision makers did not expect. The economy is a process in historical time. Time is a device that pre- vents everything from happening at once. The production of commodities takes time; and the consumption of goods, especially durables, takes con- siderable time. Economies is the study of how households and firms make decisions regarding today's production, consumption, savings and invest- ment expenditures when the outcome (pay-off) of today’s decision occurs ata later future date, Accordingly, any study of the behaviour of economic decision makers requires the analyst to make some assumption regarding what today’s decision makers ‘know’ about future outcomes. Ricardo, the father of classical economics and his nineteenth-century followers, assumed a world of perfect certainty. All households and enterprises were assumed to possess a full knowledge of a presumed pre- programmed external economic reality that governed all past, present dnd future economic outcomes. The external economic environment was assumed immutable in the sense that it was not susceptible to changemic heir This jons this ding and nom- The ainty odels n the ) the vhere ntiat- | how ience. gical deter- fen in t pre- sdities s con- make nvest- occurs nomic arding entury s and d pre- resent nment ‘hange Taxonomy, axioms and expenditures related to income 35 induced by human action. The path of the economy, like the path of the planets under Newton's classical theory of celestial mechanics, was deter- nined by timeless natural laws. Economic decision makers had complete knowledge of the outcomes determined by these laws. Households and firms, therefore, never made errors in their spending choices. They always made decisions that were in their own best self-interest by spending every- thing they earned on producible things with the highest "known’ future pay-out in terms of utility for households and profits for businesses. Accordingly, there could never be a lack of demand for the products of industry or for workers who wanted to work to produce the things that people valued most highly. The assumption of perfect: foreknowledge PF the future by all buyers and sellers in the market place permitted nineteenth-century classical economists to justify a laissez-faire market philosophy for the economic system since government policy actions could ever provide a higher pay-out for the use of resources today than that obtained by individuals making fully informed decisions in a free market system, Or as President Ronald Reagan often said ‘Why should bureau rats in Washington know how better to spend your income then you do?” Tn the early twentieth century, classical economists tended to substitute the notion of probabilistic risk for the perfect knowledge of the future presumption of earlier nineteenth-century classical theorists. Probabilistic risk calculated from an existing probability distribution allowed decision makers to see the future, not with perfect certainty but with a probability of some known risk or error. In essence, the future was assumed to be acte- arially certain, As long as we accept the assumption that “self-interested” buyers and sellers ‘know’ the future (at least in an actuarial statistical sense), then it logically follows that decisions made in a free, competi- tive market place will result in the best possible allocation of all available resources and free markets are efficient. While rejecting Ricardo’s nineteenth-century perfect foreknowledge model, today’s mainstream economists follow the dictum of Nobel Prize- winners, neoclassical synthesis Keynesian Paul Samuelson and New Classical theorist Robert Lucas, that for economics to be a ‘science’ one must accept as a universal truth, the existence of a predetermined, pre- programmed economic reality that can be fully described by unchanging objective conditional probability functions.' This notion of economic science requires one to assume what Samuelson called the “ergodic hypothesis” by analogy with this term in statistical mechanics’. The future economic reality is conceived as immutable in the sense that the future path of the economy and the future conditional consequences of all pos- sible choices are predetermined (i.e., programmed by natural laws) and cannot be changed by either individualistic human behaviour or group36 Post Keynesian macroeconomic theory, second edition action. This does not preclude an economy that is moving or changing over time. It does mean that all future movements and changes are already predetermined by the fundamental real parameters of the system. Robert Lucas has implicitly used this ergodic axiom in his New Classical Theory of ‘rational expectations’ where individuals make deci- sions regarding future outcomes based on their subjectively formed prob- ability distributions that they form as they learn from their experience. If these expectations are rational then it is presumed that the subjective prob- ability distributions of decision makers are equal to the presumed-to-exist immutable objective probability distributions that govern the external real world that the decision makers live in. Decision makers do not make per- sistent errors since the future is ‘known’ in a probabilistic statistical sense. This classical device of presuming the existence of statistically reliable estimates of probabilistic risk for the meaning of uncertainty permits mainstream economists to preserve intact most of the analysis that had been developed under the nineteenth-century classical Ricardian perfect certainty presumption. Unlike the perfect certainty model, however, conflating the concept of uncertainty with the probabilitistic risk permits each individual decision maker to make an occasional erroneous choice (in the short run) just as a single sample mean can differ from the true universe value. In the long run, however, the assumption that people with rational expectations already “know’ the objective probabilities assures correct choices on average for those ‘fittest’ decision makers who survived in the Darwinian world of free markets. Consequently, the laissez-faire approach to economic problems is again justified by assumption. The difference between the classical mainstream concept of uncertainty and Keynes's uncertainty concept is that the former requires the ergodic axiom as a foundation for its models while Keynes's analysis dispenses with this highly restrictive classical axiom. In relying on fewer restrictive axioms, Keynes provides a more general theory than orthodox theory where the latter becomes a ‘special case’? What exactly is this ergodic axiom? If the path of the economy over time and into the future is governed by what statisticians call a stochastic (probability) process, then the future outcome of any current decision ig determined via a probability distribution. Logically speaking to make statistically reliable forecasts about any future economic outcome or event, the decision maker should obtain and statistically analyze sample Gata from the future to obtain a statistically reliable probabilistic estimate of the future outcome. Since its impossible to obtain a sample from the future, the assumption that the economy is determined by an ergodic stochastic process permits the analyst to assert that samples drawn from past and current data are equivalent to drawing samples from the future. SEE eeetainty godic penses rictive heory y over shastic cision make me or ample timate om the rgodic n from future. er Taxonomy, axioms and expenditures related to income 7 In other words, the ergodic axiom implies that the outcome at any future date is the statistical shadow of probability distributions calculated solely from past and current market data. ‘The ergodic axiom therefore assures that the outcome associated with any future date can be reliably predicted by a statistical analysis of already existing data obtained either from time-series or cross-sectional data. The future is therefore never uncertain. The future is (actuarially) known. Future outcomes, in an ergodic stochastic system, are probabilistically risky but réliably predictable. If one accepts the ergodic axiom as a bedrock for economics, then it is easy to illustrate why government interference cannot improve the sitt- ation no matter how Kindhearted the legislators are. The ergodic theory of astronomy, for example, states that since the ‘Big Bang’ moment of creation of the universe, the path of heavenly bodies is predetermined by natural immutable laws and cannot be changed by any human action. By using past data measurements of speed and direction of heavenly bodies. astronomical scientists can predict accurately when and where. the next solar eclipse will be visible on earth. If economics is an ergodic science like astronomy, then legislators could not pass an effective law that would prohibit the next solar eclipse from occurring, even if the purpose of such a law was to permit the Earth to be exposed to additional sunshine in order to increase agricultural produc- tion. The philosophy of /aissez faire is grounded on the ergodic axiom. In non-probabilistic (deterministic) classical theory, the ordering axiom plays the same role as the ergodic axiom. The ordering axiom assumes that at any point of time people ‘know’ with certainty all the possible future outcomes of any decision taken today and therefore they can correctly order these possible outcomes associated with various choices in a list from most preferable to least desirable prospect. In deterministic models. true uncertainty would occur only if an individual cannot specify and/or order a complete set of prospects regarding the future, either because: (1) the decision maker cannot conceive of a complete list of consequences that will occur in the future; or, (2) the decision maker cannot assign preferabil- ity weights to all consequences because ‘the evidence is insufficient’ so that possible consequences ‘are not even orderable’.* With Keynes's concept of uncertainty neither the ergodic nor the ordering axioms are applicable. In essence, mainstream economic theory, whether it is labelled New Classical or New Keynesian, presumes that the future outcome of any deci- sion made today can be predicted with a high degree of scientific accuracy. Rejecting the ergodic axiom means that the future is uncertain in, the sense that it can not be reliably predicted by examining existing market data. Or as Nobel Prize-winner Sir John Hicks stated: ‘economic models should be38 Post Keynesian macroecoftomic theory, second edition built where people in the model do not know what is going to happen and know they do not know what is going to happen. As in history!” By contrast, one of the founders of the rational expectations hypothesis basis of New Classical economics has noted that by presuming the ergodic axiom ‘rational expectations . . . imputes to the people inside the model much more knowledge about the system they are operating in than is’ available to the economist or econometrician who is using the model to try and understand behavior’.* In other words, new classical theory assumes people already know more about the future than the economists who are assuming such clairvoyant inhabitants. ‘The terminology of the ergodic axiom was explicitly developed by the Moscow mathematical school of probability in 1935, and did not become popular in Western Europe and the United States until well after the Second World War and Keynes had died. Keynes never used this ergodic terminology in his emphasis on the importance of uncertainty and the demand for liquidity in his 1936 book or any other writings. Nevertheless. Keynes noted that ‘It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain, . . . By “very uncertain” I do not mean the same thing as “very improbable””.” Moreover, as Keynes noted in his criticism of Tinbergen’s econometric methodology, no reliable information existed today for providing a reli- able forecast of future economic outcomes because economic data is not homogeneous over time.* The homogeneity of economic data over time is a necessary condition for an ergodic system. Keynes emphasized the difference between his ‘general theory’ and classical orthodoxy where in classical theory [facts and expectations were assumed to be given in a definite form; and risks v -wore supposed to be capable of an exact actuarial computation. The calcu jus of probability ... was supposed capable of reducing uncertainty to the same calculable state as that of certainty itself. . . . T accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future... .. [Every classical economist} has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.” Keynes's rejection of the ergodic axiom means that realistic theories of our economic system cannot demonstrate that unregulated financial markets can:optimally automatically assure full employment and allocate resources and finance into those projects that in the future will earn the greatest return, In non-ergodic circumstances, Keynes's analysis suggests, 3s we will explain below, that the primary function of financial markets oe : is tc thec mer ber reas denand esis ean etric reli- snot me is and i risks calcu- = same nomic 0 deal about ture of nd the eories ancial locate m the ggests, arkets Taxonomy, axioms and expenditures related 10 income 29 is to provide liquidity and not to optimally allocate capital as classical theory contends. Once the theorist recognizes that the economic énviron- ment involves a nonergodic stochastic process where the future can not be reliably predicted, then the role of money, the savings decision and the reason why Say’s Law is not a ‘true’ law for such a system can easily be demonstrated. Accordingly we turn now to that task WHY SUPPLY DOES NOT CREATE ITS OWN DEMAND ‘The primary objective of Keynes's revolutionary analysis was to show why Say's Law was not applicable to a money-using, market-oriented entrepre- neurial economy where money contracts are utilized to organize produc- tion and exchange transactions, As we have already noted Keynes's D, spending category is related to income, the greater the level of income, the more D, spending on the products of industry. Keynes hypothesized that all income recipients allocated their income into two categories. The first category, D,, which for simplicity Keynes called consumption, involved all spending out of current income on the produets of industry. That portion of income that was not consumed Keynes called ‘savings’. Of course not all savings out of current income is saved by households. Business firms that retain profits in the form of cash or other liquid assets are also saving out of profit income. And, in Keynes's analytical frame- work, it is the tendency to save of both households and/or enterprises in the form of liquid assets that is a non-employment-inducing decision which makes Say’s Law inapplicable. In an economic environment where income earners ‘know’ that they can not reliably predict the future, then after earning income by contributing to the production of goods and service, Keynes's analysis suggested that income earners face a two-stage decision in terms of how to spend their income. In the first stage, the decision maker must determine how much of his/her income to spend on the products of industry (D, spending or consumption) and how much to save (non-consumption). This first stage the classical economists labelled time preference, because if households know the future the only reason not to spend all one’s income today, i.e. to save, is that savers want to buy something specific at a specific future date that will cost more than their income earnings at that date and therefore they will need to supplement that date’s income with saved funds to make the purchase. The name ‘time preference’ decision therefore involves how much income one spends immediately and how much of one’s income one prefers spending at a specific future rimeand in