Rethinking Keynes and the Neoclassical Synthesis

In a blog post at the Financial Times’ Economists’ Forum (h/t Mark Thoma), Roger Farmer, a professor of Economics at UCLA, discusses forthcoming work that offers a new interpretation of Keynes distinct from “sticky price” arguments. I think Farmer makes a couple of really good points about how Keynes is often interpreted in a way that limits the type of market intervention called for.

Keynes was a pragmatist first and a social scientist second and the General Theory is, to say the least, ambiguous. Economists have debated its meaning for more than half a century in an attempt to reconcile Keynes with microeconomic principles. The orthodox contender for this reconciliation is the ‘neo-classical synthesis’ which holds that the economy is Keynesian in the short-run because prices are `sticky’. It is classical in the long-run when prices have found their right level.

However, there was always an undercurrent of thought that rejected the neo-classical synthesis. UCLA economists such as Axel Leijonhufvud and Robert Clower and post-Keynesians including Paul Davidson and Hyman Minsky argued that Keynes did not rest his argument on sticky prices. But if Keynesian economics is not about sticky prices then how is one to reconcile the main message of the General Theory with the established body of microeconomic theory? [...]

I explain there, how any unemployment rate can persist forever. The market does not provide participants with enough prices to allow them to decide if a given number of jobs should be filled by many unemployed workers chasing a small number of vacancies: Or by many vacancies chasing a small number of unemployed workers. In classical economics, the free market contains a self-correcting mechanism…In my interpretation of Keynesian economics, there are missing markets. As a consequence, any unemployment rate can persist forever as an equilibrium in which no firm makes excess profit. Each equilibrium is accompanied by a different value for the stock market…

Why is this important? The neo-classical synthesis implies that, to restore full employment, we simply need to realign nominal prices with nominal demand. This can be done either with monetary policy to stimulate private spending or with fiscal policy to replace private spending with public spending. But if income depends on wealth then fiscal policy may be less effective than the Keynesians claim…

Where does this leave us? Keynes was right about three key points. 1) High unemployment can persist forever because the market is not self-correcting. 2) Confidence matters. 3) Government can and should intervene to fix things. But the orthodox Keynesians are wrong: fiscal policy cannot provide a permanent fix to the problem of high unemployment. We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention. That is the main message of my forthcoming books.

I think these 3 points are very important takeaways. Of course, I think that Farmer is probably too trusting in the idea of equilibrium, and that what he attributes to “missing markets” is probably better explained by Minsky’s financial instability hypothesis. Nevertheless, it’s always important to reevaluate the “popular” interpretation of a given economist (for a great example of this, see Gavin Kennedy’s blog, Adam Smith’s Lost Legacy, to which I’ve linked here before). In this case, it’s particularly important, because the neoclassical synthesis that has literally become our textbook macroeconomics is entirely reliant on orthodox Keynesianism.

About these ads