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Tuesday, February 17, 2009

WHY THE KEYNESIAN PARADIGM DIVIDED INTO DIVERSE THEORETICAL MODELS IN THE 1970S, EVEN AS IT WAS MORE BASICALLY CHALLENGED BY NEW CLASSICAL THEORY

Today's Buggy Topic

Those efforts mentioned in the subject title emerged in the 1960s and 1970s, pioneered by a handful of macroeconomists from  within the Keynesian research paradigm who were dissatisfied with the dominant macroeconomic Keynesian theory as set out in the  IS-LM model . . . with its roots back to the late 1930s.  The model was developed originally in 1937 by Professor John Hicks of Oxford, a gifted economist who would figure on anybody's list of the 5-10 most influential economists of the 20th century . . . and not just for his IS-LM model of Keynes complex, hard-to-pin-down work in The General Theory of Employment, Interest, and Money (1936), but also for Hicks' updating neo-classical economics published in an influential book Value and Capital (1939) and elsewhere.  

 Click here for a good brief survey of Hicks' important work, for which he later won a Nobel Prize in Economics.   (Prof bug had the honor and pleasure of participating in a small discussion group that Hicks led back in the 1960s.)

Some Background Reading of a Fairly Easy Sort

Start with Hick's IS-LM model --- by far, the most influential interpretation of Keynes that ever emerged, with some modifications added about the same time by the USA's leading Keynesian in the 1930s and 1940s, Alvin Hansen.  For an intelligent summary of the model, click here.  

By the end of the 1960s and into the next decade, the IS-LM model was under attack --- and not just from a revival of free-market economics that was associated above all with Milton Friedman, his theory of monetarism, and the growing influence of the entire Chicago University economics department where Friedman was located.  No, the IS-LM model was also being criticized from a different angle by some younger Keynesians themselves --- among them, Axel Leijonhufvud, a Swedish economist by origin who obtained his Ph.D. at Northwestern and had a flourishing career for several decades at UCLA. 

These Keynesian dissidents divided into two groups. 

  *One group --- called New Keynesianism and now the prevailing Keynesian theoretical model --- sought to come to terms with the increasingly influential macroeconomics theories being launched by rational-expectations specialists out of Chicago and elsewhere. . . . these New Classical theories rejecting, please note, all forms of Keynesianism as wrong --- defective from top to bottom, including all its theoretical assumptions.  

In its place, the New Classical paradigm revived and updated pre-Keynesian free-market theories of the economy, with a stress on its self-adjusting tendencies to equilibrium in all markets: labor, production-oriented firms, retail and wholesale businesses, and financial markets.    These self-adjusting, self-regulating  tendencies, so the new classicals argued, were now anchored in a firm theoretical base --- unlike Keynesianism --- in the preferences, expectations, and behavior of all individual economic agents: whether workers, business owners and managers, or savers and investors. 

(For a more thorough analysis of New Classical economics --- yet still very readable even for non-economic specialists --- click here.   Similarly, for a readable, more probing tratment of New Keynesianism, do your clicking here.)

 *The other assault on the IS-LM model came from a much smaler group of Keynesians, specialists in trying to work out a more dynamic, disequilibrium theory of the economy that would update Keynesian assumptions and theoretical work without making any concessions to the new classicists. 

Who Were These Disequilibrium Specialists?

This second group --- one of whose members  (Axel Leijonhufvud) is the subject of prof bug's fairly lengthy commentary left at the Marginal Revolution a couple of days ago --- produced some stimulating work, even if all of it was soon eclipsed by the New Keynesian approaches.   They  found the IS-LM model too static.  Their aim was to develop a "disquilibrium" theory of Keynesianism that would account much more thoroughly for all the ups and downs of the market-economy along its long-term growth trend.

The  Core Background Problems of Old-Fashion IS-LM Keynesianism Shared by All the Critics, Keynesian or Free-Market 

By the late 1960s and even more in the next decade --- when the economies of the world were struck by a series of unexpected shocks that dislocated them --- several problems the dominant Keynesian IS-LM model had emerged that underpinned all this ferment, both within the larger Keynesian research-paradigm that Keynes had set out in the General Theory and that had been modeled by Hicks and Hansen, and --- more threatening to the entire Keynesian paradigm --- within the ever more confident circle of free-market New Classical theorists.  (Those dislocating shocks were the two major oil-price increases by OPEC, the collapse of the Bretton Woods monetary system of the IMF fixed exchange rates, the surge of inflation throughout the decade . . . accompanied by rising unemployment around the world.)   In particular --- confronted with this new turbulent economic environment, domestically and globally --- the old-fashioned Keynesian IS-LM model came apart at its seams on several counts.

  1. It couldn't effectively explain, let alone offer a good policy-guide, for the growing concerns in the late 1960s and 1970s of increasing inflation.  That's because Keynesians tended to downplay an effective policy-making role for monetary policy, preferring instead fiscal policy for dealing with both recessions and inflationary periods.
  2. A related reason followed: the main IS-LM policy-guide for dealing with both unemployment and inflation  --- the Phillips curve --- turned out  to have no firm grounding in microeconomics: which is to say that it couldn't deal with the change in the expectations and preferences of individual economic agents . . . whether workers, business managers, savers, and investors, and especially in the new inflationary environment amid rising unemployment..  The free-market work of rational expectations theorists --- explained briefly in prof bug's comments at the Marginal Revolution --- could explain why there was no stable tradeoff between a little more inflation and a little less unemployment at the margin.  Rather, rational expectations showed that once inflation got under way, workers that inflation would continue upwards, and press managers for higher (nominal) wages ---- which created not only a self-fulfilling prophecy of higher inflation, but a spiral of escalating price-levels.  And by 1981, the US faced an economy with double-digit inflation, even as unemployment had risen in the Carter era.
  3. Keynesians of the old-fashioned sort, moreover, had no notion on the microeconomic level again why --- as Milton Friedman and especially Edmund Phelps had formulated convincingly in the 1960s: Phelps a New Keynesian himself, who would eventually win a Nobel Prize --- the inflationary spiral could be tamed only by credible monetary policymaking that would not seek to lower unemployment below the rate of natural unemployment.   Any effort to lower it below that threshold by expansionary monetary or fiscal stimuli would only backfire.  If the natural rate seemed to high to policymakers in the Fed or in the US government, then only improvements in labor productivity would help --- along with policy revisions that sought to lower the minimum wage and remove further restrictions in labor markets generally . . . such as shorter unemployment compensation, and better information about the availability of jobs, all of which would add to labor mobility.
  4. All these problems essentially undermined the standard Keynesian focus on aggregate demand and fiscal policy for dealing with recessions or  unemployment and inflationary rises . 
  5. And finally, as the free-market theorists especially stressed, IS-LM Keynesianism of the old-fashioned sort lacked effective understanding of long-term economic growth and hence how such growth depended on the supply side inputs of savings and capital investments, labor growth and improvements in its quality and education, and above all technological progress.

No Need To Say More By Way of Introduction to the Buggy Commentary

Remember, it's found at the Marginal Revolution web-site.  Click here for the original Tyler Cowen post that started the thread, and prof bug's two lengthy replies.