Thursday, August 12, 2010


It isn't even the long run yet.

This is my last Keynes post ever. Unlike Jay-Z I won't bring him back on a later blog post, even as a "feat.".

I'm sick of writing about him and I'm sick of this love-hate relationship. I'm laying all my opinions of him out here, fully exposed. I'm wrapping up what has truly been an unbelievably numerous and verbose series of posts with him, extending back to what I still think is my best post on him here, on the mathematical appreciation of his methodology in the context of the history of economic thought. Later attempts introduced the nuanced view of him that I've always had, but nothing was ever resolved. That's what I'm doing here: being explicit about all of the suggestions made in earlier posts.


Keynes' theory is significant for how he proposed to solve the unemployment problem -- by the end of the General Theory it is clear that the policy implications are that the state should maintain investment levels as well as decisions to change those levels when it is deemed appropriate. These are seemingly-radical conclusions that are, nevertheless, perfectly supported by his analysis of investment behavior in capital markets. They are stated toward the end of the General Theory.

What these conclusions give rise to is a feudal state, the main job of which is to maintain full employment and direct resources across the economy as it sees fit, in the interests of optimizing total wealth and employment growth. There is nothing in Keynes' model about shifting political control to workers, or other more fundamental ways of changing social relations in the economy. We are primarily concerned with the changing actions of the state. The only other noteworthy change is the minor point that unions would undoubtedly play a more central role in such an economy. Unions would act as representatives for labor in making decisions about wage and employment levels and so on, communicating issues from the ground level similar to how peasants would set up villages on parts of the lord's estate in feudalism. In other words, this is not an active labor movement.

This is the fundamental contribution of Keynes to understanding the macroeconomy: solving the unemployment problem, pushing for full employment, through state control of investment. This policy proposal links the core findings of his investment theory to the real economy (i.e., resource allocation among the factors of production -- labor, capital, land, entrepreneurship). Now, what about all the other parts of Keynes, such as the Keynes mostly everyone talks about? In order to address those points we turn to the practical and then theoretical implications of the General Theory.


As for the stimulus policies I've discussed recently -- they represent the most relevant mainstream perspective on Keynes' system. In order to appreciate this, I take one of the main ideas which economists of the time took away from the General Theory: his theory of labor markets. Consider the following small (but significant, as it was the first) exchange between Leontief and Keynes in the Quarterly Journal of Economics. In Leontief's review of the General Theory, he identifies the homogeneity postulate as the target of Keynes' alternative system. It is formally stated by Leontief as follows.

All supply and demand functions, with prices taken as independent variables and quantity as a dependent one, are homogeneous functions of the zero degree ("The Fundamental Assumption of Mr. Keynes' Monetary Theory of Unemployment," QJE 51: 1 (1936): pg. 193)

In order to gain a sense of this postulate, envision an economy composed of 2 markets: apples and oranges. You have $40 in your pocket. Apples cost $2, oranges cost $4, and so you decide to buy 10 apples and 5 oranges. Now, suppose both prices as well as your income doubles. Then You have $80, apples are $4 and oranges $8. The homogeneity postulate says that you will still buy 10 apples and 5 oranges. Now, what Keynes said -- his critique of the homogeneity postulate -- is that there is at least one market where things don't go this way. Suppose for some reason when the price of apples increases to $4, you only buy 8 instead of 10, even when your income increases and all the market forces are telling you to buy the same amount of each. Something structurally is wrong with that market, and the entire system is now misallocated. For example, you might buy a little more oranges (or something else, if we admit a third market into our economy) with the $8 you have left over after skipping out on two apples.

The same, of course, may be true in the reverse way: if income goes down from $40 to $20 and prices decrease to $1 for an apple and $2 for an orange, you may want 12 apples instead of what the market forces tell you to demand -- i.e., 10. In Keynes' model, he thought such things can happen in the labor market. Say you have two markets now, but one of them is a labor market and the other is apples. Start again with initial income of $40. Your wage is $2, apples are $4. If income declines to $20, wages decline to $1 and apples to $2, Keynes believed that you will want to work more than 10 hours in this scenario. This, of course, would then cause a misallocation in the demand for apples. A decline in your income and all of your wages will not have you wanting the same hours of labor(apples) that you did before -- for whatever reason, you will probably want more hours at that lower wage. Maybe you are trying to maintain a standard of living or maybe the union is supporting a higher wage, or maybe the actual money which caused the price decrease or increase is now a factor determining your wage (for example, maybe there is a misallocation in some other market which is in turn affecting how business respond in the labor market). But the result, of course, is that there is a fundamental misallocation once again.

So of course, it is the labor supply function which interests Keynes the most as an exception to this homogeneity postulate -- nevertheless, the fact that at least one of the functions is non-homogeneous means the whole system explodes, with monetary neutrality completely absent from the system. ("Monetary neutrality" would be what we saw in the first apples-oranges example -- demand for either didn't change when all prices and income doubled or halved.)

Now, recall the point made above: this idea is one of the mainstream's central focus points on the General Theory. It remains to show how to translate this idea into policy. Since labor markets could be an important example of non-homogeneity, it leaves a key problem for policy makers: what determines supply and demand of labor, and the resulting wage rate? Well, whatever determines it, it is clear that the resulting misallocations, described above, could affect essential aspects of the product market as well as other areas of the economy, leading to widespread crisis. Therefore, it makes perfect sense to stimulate the economy with boosting incomes, leading to less of a misallocation of labor, ideally so that the misallocations are minimized. And there you have it: the central mainstream critique (Leontief's, one year after the release of the General Theory) is converted into a fiscal policy tool still debated over today.

But there is one other point I want to bring up, aside from demonstrating one of the key ideas behind the Keynesian model (as presented in the General Theory) and its relationship to policy.

It is clear that while the stimulus policy was first seen in practice in FDR's early policies (pre-General Theory), and while the stimulus has been viewed as Keynesian, contemporary news reports show that Roosevelt's policies were primarily being driven for other reasons. One is the idea of a corporatist welfare state, a philosophy where the government plays a big role in the economy in order to sustain capitalism. Keynes was a corporatist, but not the Keynes most talked about in the literature. Another reason is the political pressure from labor, which was much stronger at that time than it is today. Union policies and strike threats were central to some of the key institutional changes of the Great Depression.

In other words, the stimulus policy as we know it today is more in line with the orthodox critique, and overall understanding, of Keynes' General Theory. The New Deal was of course Keynesian and was influenced by many of his ideas, but I would still maintain that there were other, more pressing political and economic forces which gave rise to New Deal policy.


Let's switch gears a bit to Keynes' inherent conservatism from a theoretical standpoint. This is how Leontief describes the homogeneity postulate:

Let us modify the set-up of the frictionless, lagless and 'homoegeneous' economic system by assuming that one demand or one supply curve of any single household or enterprise is not homogeneous... A discrepancy would arise incompatible with conditions of general equilibrium. This shows that in a frictionless system with at least one or more non-homoegeneous elements, the quantity of money ceases to be a 'neutral' factor. On the contrary, the equilibrium amount of every commodity or service produced or purchased by any household or business unit must be now considered to be a function of this quantity. ("The Fundamental Assumption of Mr. Keynes' Monetary Theory of Unemployment," QJE 51: 1 (1936): pg. 194, emphasis in the original)

For good measure, this is Keynes' reaction:

"Mr. Leontief is right, I think, in the distinction he draws between my attitude and that of the 'orthodox' theory to what he calls the 'homogeneity postulate'." And as for Leontief's call for empirical disproof of this postulate (i.e., the claim that what is at work here is primarily an empirical verification or disproof of an orthodox conclusion), "I should have thought... that there was abundant evidence from experience to contradict this postulate" ("The General Theory of Employment," QJE 1937, pg. 209).

In other words, Keynes is quite explicit that he agrees with Leontief's framing of the issue. There are no big ideological fights to be had here.

Leontief makes the point near the end of this small piece that the assumptions of the classical system are untouched by Keynes (pg. 197) -- the homogeneity postulate is derived from the assumptions, and so really what Keynes is arguing is that the empirical basis for one of the conclusions of the classical model of the real economy is wrong.

And this is what I've been saying about the weakness of Keynes' approach in several recent posts. The fundamental system of Keynes' theory is classical in nature -- forget about morality differences – they don’t exist if you accept the fundamental conclusions of a system. Keynes accepts the basic model but is looking to link investment climate changes to real economy issues. The result for the system? A misallocation of resources. The policy prescription, from Keynes himself near the end of the General Theory? Government control of capital flows.



  1. This comment has been removed by the author.

  2. First of all, for some reason I have the feeling that this can't be your last post on Keynes. Maybe because it is always difficult to give an end to love-hate relationships which contain the feeling of being sick as a natural and accustomed part of them :)

    Just for clarification (since I've not read the General Theory yet, will be dealing with it in a few months and I can't guarantee not to provoke you about writing him again:), you are saying that he is describing the classical system as based on two postulates. Second one is the assumption that wage is equal to its marginal product (that you mentioned in the previous post and I really like his analogy there too). Is the first one homogeneity principle?

    First, I m really curious about how he dealt with the second postulate if he could. Second, the importance of non-homogeneity comes from the fact that it calls for government intervention to reduce misallocations in labor market as an important example of non-homogeneity, right? I'm not sure if I understand the Leontief's point that classical assumptions are untouched by Keynes. For him, it is not enough to reject homogeneity on the basis of empirical evidence against it but a theoretical discussion is needed about the assumptions underlying homogeneity principle (not enough for putting a real alternative to classical system which actually makes sense). So what are those assumptions which have to be challenged to reject homogeneity?

  3. Interesting questions, thanks for the comments!

    On your point: "you are saying that he is describing the classical system as based on two postulates. Second one is the assumption that wage is equal to its marginal product (that you mentioned in the previous post and I really like his analogy there too). Is the first one homogeneity principle? "

    I don't have a copy of the General Theory with me right now, so I can't list both postulates as originally described by Keynes. But the first one is that the wage is equal to marginal product. The second one is summarized by Leontief:

    From Leontief's paper: "One of these fundamental assumptions - that which Mr. Keynes is ready to repudiate - defines an important uni- versal property of all supply and demand functions by stating that the quantity of any service or any commodity demanded or supplied by a firm or an individual remains unchanged if all the prices upon which it (directly) depends increase or decrease exactly in the same proportion"

    I think Keynes discusses the second postulate in terms of the adjustment of the marginal disutility of labor to the wage.

    On your point: "First, I m really curious about how he dealt with the second postulate if he could. "

    Interestingly, Leontief notes that Keynes ultimately fails in dealing with the second postulate, so you are right to be curious of this proposal.

    On your point: "For him, it is not enough to reject homogeneity on the basis of empirical evidence against it but a theoretical discussion is needed about the assumptions underlying homogeneity principle (not enough for putting a real alternative to classical system which actually makes sense),"

    note what I said above in the "practical implications" part. If wage is determined by other forces other than the supply and demand of labor, then the theory may admit some new variables, and this is where the theoretical discussion of investment behavior comes in. Basically, the absence of monetary neutrality means we need a theory of money to explain labor market dynamics. Keynes believed that the second postulate is obviously false based on the empirics, so he didn't have to show it (he notes this in his rebuttal to Leontief). Leontief wanted more. But I side with Keynes here. I don't think Keynes' method is incorrect-- that is, his method of finding an empirical inconsistency in the existing theory, going back to adding some variables (theory of money) to the model. What do you think about this method of approach?

    On your point: "So what are those assumptions which have to be challenged to reject homogeneity?"

    At a more basic level, you would need to discuss the labor supply curve in detail, proposing alternative assumptions about worker behavior and deriving a new model based on those assumptions. These are assumptions about the efficient allocation of resources by the worker, and other assumptions about the classical model of labor markets. I'd like to reinforce that Keynes is definitely not interested in doing this -- he accepts these assumptions.

    Thanks again and let me know if anything is unclear!

  4. Thanks for the detailed explanation, it is clearer now.

    I m not saying that this method is incorrect. Obviously it is quite legitimate to refute theories using empirical evidence against them. But to present a new alternative, you have to deal with theory, too. So if underlying theory (assumptions) is about supply curve -- actually I was thinking about labor supply curve when I asked that questions about underlying assumptions--and Keynes accepts classical assumptions about it. Is not there an inconsistency here, even if it is not a methodological one?