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Wednesday, December 3, 2008


  1. Today's Buggy Topic

The work of the greatest economist of the early-to-mid 20th century, John Maynard Keynes, sparked a revolution in the entire discipline of economics, creating a radically new approach to the economy on a macro-level --- the cumulative components of national income as determined by aggregate demand.

Neo-Classical Economics Before Keynes 

Until then, with only a few exceptions --- interestingly, early in the 19th century mainly: plus the innovative work of Knut Wicksell, a Swedish economist a generation older than Keynes --- economists focused on what we would now call micro-economics:

  • Assumptions about the motives and behavior of individual economic agents like entrepreneurs, managers, workers, savers, and investors (seen in the new classical revival since 1970 as not just rational calculators, but fully informed about the economy as much as any economist's complex model of its workings);
  • Analyses of supply and demand for the products of individual competitive firms.
  • A focus on opportunity costs: an individual work engages in trade-offs between how much work and income he or she wants as opposed to leisure (part-time work, full-time work, re-education, upgrading skills and the like), just as that worker as a consumer knows that spending money, subject to a household budget, on a fancy car might come at the expense of a summer vacation with the family
  • Marginal and cost-benefit analysis: the trade-offs here by workers, consumers, business owners and managers, and savers and investors should b analyzed at the margin: how much benefit as opposed to costs of spending money and time will, say, the head of a manufacturing firm will his or her firm's spending money at the margin for each new machine --- as opposed to using the old machine --- entail in raising profits at the margin over a certain amount of time, taking into account the interest-rate of getting a bank loan for the machines?
  • The price mechanism as an effective and indispensable set of signals used by businesses to increase or decrease out-put or --- the price signal as the relevant interest-rate --- as a way of bringing savers and investors together and coordinating on an aggregate level, efficiently, through supply and demand in various markets, all the interactions of individual and rational self-seeking workers, consumers, investors, savers, and business owners.

More Microeconomic Concerns: Criteria for Measuring the Efficiency of a Market Economy

Early in the 19th century, moreover there were also efforts by Jeremy Bentham and the utilitarian school --- using a rigorous individualistic view of the economy (specific, self-seeking, and rational agents) --- to come up with criteria for measuring the overall efficiency a national economy's workings. 

In particular, the aim was to have an ideal but realizable measure of  how efficiently a market economy was operating: above all, whether it operates or not with market failures and self-correction so that the economic decisions of tens or hundreds of millions of individual agents within a national economy like the US's (not to forget several billion agents in a global system of growing economic interdependence) will be coordinated by the price mechanism for goods and services, wages for workers, and profits for business owners and for savers who lend their money in order to generate maximum productivity with existing resources and full employment.

  • Since 1900, the major criteria used go back to the work of an Italian economist, Vilfredo Pareto.  He postulated that given a certain distribution of income and wealth, a free-market economy will end up with maximum efficiency at the "Pareto frontier" (as it's called): at the frontier, there's no way for the economy to be reorganized differently, including, remember, the once-and-for-all permitted re-distribution of income and wealth for theoretical purposes, without reducing the well-being of at least one agent in the economy.  Until the frontier is reached, Pareto improvements would be made by a free-market that would bring the free-market economy to the frontier by improving at least one individual's economic well-being (in money-terms) without harming the well-being of anyone else.   

The overall result according to neo-classical economists who set out the modern agenda of micro-economics in roughly the period between the 1870s and the early 1930s?  Easy enough to say:

  • Once an economy is at the Pareto frontier in this way --- remember, by the price-coordinated decisions of hundreds of millions or more individuals --- it will also be in a condition of general equilibrium, though shocks such as a war or a natural disaster or a stock-market boom and burst might cause temporary dislocations and require some time to pass before the market economy returns toward the Pareto frontier again and in a condition of general equilibrium. 

The Key Outcome for Our Concerns Here?

In a condition of general equilibrium, two pivotal outcomes will ensue.

  1. Full employment will automatically occur. 
  2. And so, similarly, will the economy's allocative uses of capital, labor, and natural resources be at maximum efficiency --- at the Pareto-optimum frontier.  At that point,  no one individual's economic well-being (measured in money terms) could be improved except at the expense of the well-being of others.  In game-theoretical terms --- game theory not developed until near the very end of WWII by two genius mathematicians at Princeton (the most famous being John von Neumann) --- there are Pareto-improvements in a market economy not operating at the Pareto frontier: at least one person's well-being could be improved without harming others.  At the frontier, though, any efforts to improve one worker's or investor's or individual business firm's well being will be fully at the expense of others . . . a zero-sum condition: someone's benefits add up to someone else's losses, even if those losses were spread over tens of millions of other individual economic agents' well being.


Enter the Keynesian Revolution of the 1930s 

Fortunately, what with the length of the foregoing comments --- pounded out at high-powered speed and extending longer than prof bug thought they would 25 or 26 minutes ago when he started --- he can end sketching in the necessary introductory-background for understanding Keynes' great originality in economics by linking to a more germane, to-the-point analysis that prof bug left earlier today at the Marginal Revolution.

Be careful though.  As it happens, there are actually two links you need to access at the Marginal Revolution.  The first one was Prof. Tyler Cowen's posted commentary that started the thread: click here.  Apparently, after he posted it, his web site wouldn't let others comments on it, and so he started an alternative thread uniquely devoted to his commentary that doesn't appear in that alternative.  It's here you'll find prof bug's stuff on Keynes. 

What remains uncertain is whether Keynes great work is mainly relevant to major recessions accompanied as in the 1930s and maybe again by a system-wide financial meltdown.




More Recent Work in What's Called NEW Classical Microeconomics

We'll be talking more in tomorrow and later about Keynes' work and its relevance (or not) to today's financial and economic crisis . . . the first recession since the start of the Great Depression in late 1929 after both a systemic financial meltdown and its far-flung economic fall-out not just in the US, but (as today) on a global scale. 

Remember, though.  We've been discussing economic theory as it developed in 19th and early 20th-century classical and neo-classical economics as background for understanding Keynes' revolutionary work.  From post-Keynesian viewpoint, all that theory was microeconomics --- focused on the behavior individual economic agents, whether workers, consumers, savers, investors, farmers, and business firms as they interacted in various competitive markets: stock-markets, markets-for-labor, markets for end-products, intermediate markets, and so on.  Including, of course, their equivalents in foreign countries who interacted with, say, Americans through international trade and investment.

Keynes, the Father of Macroeconomics

Keynes himself  was the pioneer of analyzing the economy on a macro-level --- in particular, with a focus on of aggregate demand such as the components of GDP as they led the economy to full employment with low inflation or not.  (Yes, Keynes was concerned with inflation.  His earlier works in the 1920s focused on its danger: there was a need for a stable price level if the market economy were to function properly.  And his work after the Great Depression was concerned again with inflation . . . Keynes, as Milton Friedman noted, the pioneer among other things of modern monetarism.)  Those components of aggregate demand are familiar to everyone: aggregate consumption, aggregate business and residential investment, and government consumption and investment (minus taxes), along with exports-imports.  (If imports exceed exports, then that subtracts from annual GDP).    

Whether or not the economy is capable of leading to full employment was, of course, the major concern of Keynes work in the Great Depression as set out in his pivotal book of 1936: The General Theory of Employment, Interest, and Money . . . discussed, as noted before, by prof bug in length at the Marginal Revolution.

Note though, just in passing here.  There's also a very influential free-market set of macro-economic developments that have emerged since the 1950s and 1960s that challenge Keynesianism and a strong role for government in the workings of the market economy, not just on the micro-level of dealing with market failures, but on the macro-level.  Far from ignoring these important free-market challenges to Keynes and his contemporary followers, prof bug will in fact deal with them starting tomorrow.  In particular, we'll look, among other things, at the criticisms of Keynesian inspired fiscal stimuli as a way of reducing or reversing the impact of a recessionary economy of the sort we're in right now. 

But that's for tomorrow.  In the meantime, shift your mind . . .

Back to Theoretical Developments in Microeconomics Since 1945 

In simplified shorthand, nothing more, two sets of theoretical work can be mentioned.  One supports an important role for government regulation in the market economy, the other disputes it.

  • In favor of such extensive regulation --- based on cost-benefit analysis --- there's been important work illuminating various kinds of market failures that prevent an economy from reaching a Pareto-optimal frontier: above all, monopolies, externalities (negative ones like pollution or insufficiently produced god ones), public goods subject to free-riding (such as national defense), and information problems (as in the recent explosive financial-derivatives markets).  In the financial realm, as we now know, there's also been rigorous criticism even before the current meltdown and credit-crunch of the problems that envelope all the big financial innovations since 1980 --- the start of both those innovations and de-regulation of financial services by both Republican and Democratic administrations and Congresses.  These criticisms underscore the need for regulation to deal with market failures caused by 1) big information and 2) agent-principal problems --- such as investment bankers as the agents, say, of their principal's money in their equity-funds running up huge liabilities of a risky sort; or credit-rating agencies (agents) giving triple AAA ratings to toxic-assets that reassure those (principals) who then bought mortgage-backed bonds . . . all leading to of lack of fiduciary responsibility, transparency and accountability.  Plus, as we know, a breakdown in proper credit-analysis and risk-taking by banks and other financial institutions.

    And hence the need to remedy these market failures by government regulation or spending. 

  • As a counter-thrust by free-market new classicists --- now, of course, very much on the defensive in the financial realm --- there's been systematic analysis of government failures in regulation and wasted taxpayer money that are likely on their theoretical premises to make the overall economy worse off and hence move it further away from a Pareto-optimal frontier. 

The Core of the Free-Market Counter-Thrust in Microeconomics Is Three-Fold

In particular, it's charged,

  1. Politicians and bureaucrats are no less self-centered and concerned with advancing their individual interests as economic-man: simply because the domain for pursuing self-interest shift to the political arena changes nothing about human nature and behavior.  Appeals to the public interest, accordingly, are largely rationalizations of these self-interested pursuits in the government arena.
  2. If, additionally, you analyze the way government actors make policies --- spending, regulation, taxes, distributive and re-distributive matters ---what do we find on this view?  Major policymaking defects exist compared to the transparency, accountability, and specific goal-oriented decision-making by businesses in a competitive market setting. 

    In particular, so the argument goes, self-interested politicians and bureaucrats suffer from major information problems when they intervene in the private economy;  they tend to think in short-term political advantages (get re-elected, expand your agency's personnel, tasks, and money irrespective of performance);  they tend to be influenced as well by powerful interest groups that, as with tariff barriers, expand the interests of a particular industry at the expense of consumers and overall economic efficiency;  and they don't  have to be as careful as private firms are with the money they spend.  Politicians' money comes from taxes, not from profits, investment equity, or bank loans; and if their policies are wasteful or fail outright, it will be tax-payers who ultimately pay the costly bills . . . especially if there is a long lead-time before the policies have a noticeable impact on our economic, social, or national-security well-being.   In that case, the Presidents, Congressmen, and Senators might not even be in office once the wasted money or failures of other sorts materialize clearly. 

  3. As if all that weren't bad enough, as the updated free-market case goes, a national government like the US is a monopoly provider of goods and services in return for tax money.  In a competitive market-setting, a consumer who dislikes a company's product --- say, Verizon cell-phone service --- can quickly and easily switch to several alternative wireless services.  For that mater, he or she can decide to stop those wireless services and switch to a web-based service. 

    By contrast, a voter who likes President Bush's defense policies, but dislikes his administration's bailout policies for the financial sector --- trillions and trillions of dollars worth of loan guarantees and other commitments --- can't continue to live in the US and shift to the tax policies of Singapore or Dubai.  In the upshot, accordingly, politicians and bureaucrats have an added reason to be less than careful when they implement risky-policies.

Remember, Developments in Free-Market Theory in the Last Four or Five Decades Are Also Macroeconomic

And just as free-market economists find governments will likely worsen the workings of the free-market on a micro-level --- such as regulating airlines or the telephone industry before 1980 --- so, they argue, Keynesian criticisms of the failure of a free-market economy to arrive on its own at full-employment are wrong and will, if anything, interfere with its ability to act self-correcting when recessions and unemployment emerge . . . just as, in inflationary times, it's governmental policies (or those of the Federal Reserve following expansionary monetary policies), that causes inflation.