During major economic crises proponents of modern money theory (MMT) are tempted to form alliances with mainstream Keynesians since economists from both theoretical camps tend to support counter-cyclical fiscal (and/or monetary) responses against economic recessions. However, there are important disagreements between the two camps when it comes to the macroeconomic role of government deficits (and monetary policy). Mainstream Keynesians are generally deficit doves who see countercyclical deficit spending as necessary only in times of emergency but harmful in the long run and advocate that governments should strive for balancing their budgets (or even obtaining surpluses) and controlling the debt under normal times. MMTheorists, on the other hand, understand that properly managed government deficits are in fact normal requirements for eliminating the economic waste of involuntary unemployment and for achieving macroeconomic stability. While the mainstream Keynesian policy advice is less destructive than the deficit hawk position of radical supply-sider¾especially as the world fights off a second Great Depression¾it is still a dangerously misguided policy advice based on a questionable understanding of capitalist economies.
In this four part essay, I address some of the major flaws in mainstream Keynesian theory and explain how they have mislead to off-target conclusions about the long-run neutrality of money and aggregate demand in general and about the long term effects of economic activism by governments in particular. In the first part, I question the mainstream interpretation of Keynes's macroeconomic theory and the adoption of the logically handicapped IS-LM-BP macroeconomic model as basis for economic analysis. In the second part, I advocate for replacing IS-LM-BP with the stock-flow coherent GD-NGSd (or the Sectoral Balances) model. In the third part, I show with the help of the Sectoral Balances model how properly managed government deficits are, under normal conditions, indeed a requirement for full employment and macroeconomic stability to be achieved. Finally in the fourth part, I show that, unlike what is argued by mainstream Keynesians, sustained government deficits need not produce inflation and cannot ever drive a monetarily sovereign government into bankruptcy.
Part 1: The Emperor has no clothes!
The Comeback of "bastard" Keynesianism
"Those countries with serious fiscal challenges need to accelerate the pace of consolidation. […] We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions." Just when we thought that policy makers around the world had begun to let go the old economic myths of a magically self-correcting free-market and evil-doing government deficits, finance ministers of the G20 countries offer the above piece of economic ignorance in their most recent communiqué (June 5th 2010). The endorsement of fiscal austerity by G20 governments at a time when most economies are still struggling to escape the city limits of Depressionville is perhaps the clearest of many recent signs of a disappointing (but really not surprising) turn in economic discourse and practice.
A little over a year ago, policy makers and influential commentators announced to the world that they were ready to replace their modern economic manuals with dusty copies of John Maynard Keynes's The General Theory. It was supposed to be the triumphant comeback of Keynes. In the immediate aftermath of the financial collapse of 2008 (one that was rivaled in terms of severity only by the Great Crash of 1929), it was cool once again to be a self-proclaimed Keynesian. Sure, there were a few chaps whose faith in the magical invisible hand of the markets was just too strong to be shaken by any amount of impossible to miss evidence in contradiction with their Panglossian beliefs. For everyone else, it was pretty clear that this was an economic disaster that could not be avoided if governments simply sat back and waited for the economy to spontaneously fix itself. Well, forgive me if I am not too impressed by the guy with enough sense to call the fire department when his house is on fire just because there are lunatics who believe that fires are optimal adjustments to unknown changes in the fundamentals of the house.
True Keynesian macroeconomics is not simply about supporting emergency stimulus packages and monetary easing to save the economy when finance hits the fan. It is about understanding real world capitalist economies without exaggerating their merits and their flaws and using that knowledge to devise policies that eliminate avoidable human suffering at all times. In spite of their advertized newfound appreciation for Keynes, most of the post-subprime bandwagon Keynesians never really got to investigating Keynes's macroeconomic theories at the source¾I'd bet their copies of The General Theory are as dusty as they were before the 2008 financial cataclysm. If they were sincere about their desire to seek Keynesian alternatives to mainstream market fundamentalism (and I believe many of them were), recovering supply-siders should have consulted Keynes's work and the work of those who advanced macroeconomic theory along genuinely Keynesian lines. The rich post Keynesian and modern money literature by people who devoted whole careers to understanding, improving and expanding Keynes's arguments is easily available (in fact, just a few mouse clicks away) for anyone who cares to look for it.
The disappointing reality is that, while Keynes, MMTheorists and other post Keynesians are a lot more popular now than they were before the crisis, it has been mainstream or "bastard" Keynesianism that has enjoyed the real comeback. "Bastard" Keynesianism was the term used by Joan Robinson, one of Keynes's true disciples, to refer to those economic theories that attempted to incorporate Keynes's principle of effective demand without challenging the idea that free-markets are always tending to an optimal state of no involuntary unemployment. Not many things were as offensive to Robinson as macroeconomic theories presented by their proponents as Keynesian that attempted to resolve the conflict between Keynes's and the neoclassical view. Robinson understood that for Keynes that conflict was irresolvable simply because his and the neoclassical paradigms were descriptions of completely different economic realities (or unrealities in the case of neoclassical theory).
The type of economic thinking that Joan Robinson accused of being a bastardization of Keynes's work we know today as "saltwater", new Keynesian economics or simply modern mainstream Keynesianism. It is the perfect compromise for those who do not blind themselves to the recurring crises of unmanaged capitalist economies, but are not quite ready to abandon their faith in self-adjusting, waste-minimizing free-markets. If neoclassical economics is like young Earth creationism, bastardized Keynesianism is more like intelligent design¾an attempt to make a faith based belief sound less absurd and disconnected from reality and more palatable to the scientifically inclined. For bastard or mainstream Keynesians, free markets are not always perfect, but their long run inherent tendency is to seek perfection, and government deficits may be tolerated in the short run when the economic engine is suffering from a defective starter, but are still ultimately an impediment for sustained economic prosperity and ought to be avoided.
The origins of mainstream Keynesianism can be traced back to the works of John Hicks and Alvin Hansen as the IS-LM macroeconomic model (later the IS-LM-BP after the contributions to international economics of Robert Mundell and Marcus Fleming). The model was supposed to present as elegantly simple diagrams the macroeconomic models of Keynes's General Theory. It did no such thing. Instead, it neutralized the revolutionary elements of the macroeconomic theory of Keynes by reducing it to a parenthetical explanation of involuntary unemployment under abnormal economic conditions. As a result, what came to be known as Keynesian macroeconomics is in many important ways indistinguishable from the very neoclassical theory that Keynes had wished to demolish with his book.
Keynes's Revolution: the rebuttal of supply-side economics
Before the publication of The General Theory in 1936, conventional economic theory ¾back then neoclassical economics¾fully denied that an underperforming capitalist economy could be the result of insufficient aggregate demand. According to that view, capitalists would always fully utilize the productive resources available, in spite of fluctuations in the nominal level of aggregate demand. For neoclassical economists, a change in the value of aggregate nominal demand¾determined, as they believed, by the supply of money in the economy multiplied by a stable average velocity of money-circulation¾could not affect the real quantity of output produced in the economy as long as prices were allowed to adjust (which was the normal case). Hence, fluctuations in aggregate expenditures would simply lead to fluctuations in the price level leaving the size of aggregate output unchanged and the labor force fully employed.
In this neoclassical world, government interventions in the economy via fiscal or monetary policies would not only be unnecessary (since free markets already took care of securing full employment) but harmful. For neoclassical economists, monetary policy (which they understood as controlling the supply of money) would affect no other variable¾yes, including the real rate of interest¾but the level of prices. Stimulative deficit spending, on the other hand, would either produce inflation or lead to a suboptimal composition of aggregate output. When financed by creation of new money, a fiscal stimulus would simply lead to inflation. When financed by borrowing funds from the private sector, an increase in government spending would cause the rate of interest to rise as the market of loanable funds adjusted to its new supply and demand equilibrium. Instead of adding to aggregate demand, the additional spending by the government would be exactly offset by the loss in investment and consumption due to rise in the interest rate. While total demand would be maintained at the same level as before, its composition would no longer represent the optimal combination of investment and consumption goods given the population's combined inter-temporal preferences.
Back in those innocent pre-1929 days, neoclassical economists could be more or less excused for believing in the existence of magically flawless capitalist economies. During the roaring 1920s it would have appeared to the naïve observer as if the only constraints faced by capitalist entrepreneurs to expand the production of desired goods and services was their own diligence, inventiveness and the material conditions of production. Those who sought economic success needed only to channel their own efforts into the production of useful goods and services and bring them to markets where they would always find willing and able buyers. For neoclassical economists, the decade long economic expansion may have provided the undisputable proof that good old Jean-Baptist Say had got it right all along: that the production of any amount of output would bring with it the very demand for output that would ensure that no quantity of utility-giving goods and services ever went unsold (except for self-adjusting frictional supply-demand mismatches). What policy advice for such a world? Laissez faire, laissez passer: the freer individuals were to apply their entrepreneurial talents to the production of goods and services, the more prosperous materially a society would become.
Unfortunately for everyone who lived through those trying years, the economic events of the 1930s showed just how immensely mistaken neoclassical economists were. Not only was it possible for a fall in aggregate demand to severely depress the production of output and the level of employment, but the self-healing powers of free markets seemed to be no match for the self-reinforcing dynamics of a full blown recessive vortex. Nothing in the theoretical toolbox of neoclassical economists could explain the events triggered by the financial disaster on that ominous 1929 Tuesday. Before then, private spending had been booming in the US and with it production of output and employment. After the Stock Market Crash, production and employment collapsed as violently as they would have if the most unforgiving natural disaster had punished the nation and obliterated the country's capital stock. And yet, the material conditions for production¾ technology, the capital stock, productivity of workers¾were no worse in 1930 than they had been before October of 1929. Contrary to the neoclassical myth, the crisis had not been triggered by changes in supply conditions, but by the contraction of aggregate spending which followed the financial breakdown of 1929. The obvious lesson was: demand shocks were able to produce economic hardships much more real than simply nominal adjustments.
A comprehensive macroeconomic theory that explained the functioning of a demand driven economy did not become available until 1936. In the early years of the Great Depression, neoclassical economics was the only theoretical game in town. A committed market fundamentalist, President Herbert Hoover may have seen the 1929 Crash and the slump of the early 1930s as a test of his faith in the invisible hand. Hoover's deep seeded dislike of government deficits and his naïve belief that American volunteerism alone could bring the national economy to prosperity made him particularly inadequate to lead the US economy through the slump. By November of 1932 when the presidential elections took place, Hoover's unwillingness to unleash the countercyclical powers of government deficits into the sluggish economy had allowed for the initial slowdown that begun in 1929 to escalate into the mother of all economic depressions killing his chances for reelection. And still no more than a handful of common sense people were ready to rebel against the conventional economic wisdom and call for the substantial deficit spending that was needed. Surprisingly, many in the Democratic Party challenged the Republican Hoover not because his deficit was much too small given the fiscal stimulus needed by the struggling US economy, but because they saw it as too large and even Franklin Delano Roosevelt was not particularly enthusiastic about advocating for deficit spending during his campaign.
Luckily, FDR the president had no problem understanding the need for government deficits. Once elected, Roosevelt proceeded to quickly replace with the policies of his New Deal for America the irresponsible laissez faire attitude of his predecessor. Slowly but surely, the neoclassical stronghold on economic thinking had begun to weaken. Only a few days before Roosevelt took power, the US Senate's finance committee had heard testimonies from supposed economic experts about the causes of the depression and their proposed solutions. What the senators heard was the usual neoclassical nonsense with the exception of the testimony offered by a certain banker from Utah by the name Marriner Eccles. It was Eccles's one of the very first logically and factually sound explanations for the Great Depression and what was needed to resolve it:
"(…) it must be recognized that the breakdown of our present economic system is due to the failure of our political and financial leadership to intelligently deal with the money problem. In the real world there is no cause nor reason for the unemployment with its resultant destitution and suffering of fully one-third of our entire population. We have all and more of the material wealth which we had at the peak of our prosperity in the year 1929. (…) The problem of production has been solved, and we need no further capital accumulation for the present, which could only be utilized in further increasing our productive facilities or extending further foreign credits. We have a complete economic plant able to supply a superabundance of not only all of the necessities of our people, but the comforts and luxuries as well. Our problem, then, becomes one purely of distribution. This can only be brought about by providing purchasing power sufficiently adequate to enable the people to obtain the consumption goods which we, as a nation, are able to produce" (Eccles 1933)
When Roosevelt first addressed the nation as president on March 4th of 1933, his understanding of the depression and the plan he presented for restoring a healthy economy was strikingly similar to that of Eccles (whom he appointed as Fed Chairman a year later) and almost indistinguishable from what Keynes or an MMTheorist would have proposed. Eccles and Roosevelt had anticipated the fundamental message of Keynes's general theory: that in a capitalist/monetary economy the production of material output is not independent of the money-making conditions faced by those who decide how much and when to produce. In other words, since in capitalism producers are driven primarily by the goal of expanding their monetary wealth (i.e. their wealth measured in nominal terms) they will not commit their wealth to the production of material output unless that alternative represents a monetary gain at least equivalent to the alternative of doing nothing, regardless of the availability of idle productive resources. Simply put, people will refrain from production if they do not expect to sell their output causing the economy to underperform.
Keynes's general theory was primarily concerned with the curious asymmetry peculiar to a capitalist economy. In such an economy, you can always obtain useful goods or services¾given the material limits to what can be produced¾if you pay sufficient money for them, but you cannot always obtain money for the useful goods or services you can produce. That asymmetry¾that money spent leads to the production of output, but output supplied does not lead to the production of money¾is the key to understanding economic fluctuations and why free markets alone would generally not secure full employment. For Keynes, the performance of a capitalist economy was primarily determined by the behavior of aggregate spending. Demand, not supply, was the cause of observed economic phenomena, including the Great Depression of the 1930s.
To be sure, Keynes (and MMTheorists) would not deny that real limits to production exist: insufficient resources, poor technology, low productivity of the factors of production, legal and social constraints faced by producers, etc. may all impose powerful barriers to the expansion of the material wellbeing experienced by a society. Surely there are and have been economies in which supply-side limitations are and/or have been responsible for significant human suffering. However, in true capitalist/monetary economies such supply side conditions are secondarily relevant for understanding the dynamics of such economies and the mechanics of such interesting economic phenomena as business cycles. Macroeconomics should focus on the systematic determinants of aggregate expenditures because in capitalist economies those determine the level of material production up to the production from full employment.
Keynes noted that neoclassical economics was only useful for understanding the rare situations in which demand conditions posed no impediment for full employment to be achieved. At full employment, the level of output would indeed be limited by the material conditions of production and further increments in aggregate demand would lead to inflation only. Therefore, neoclassical theory would describe only the upper limit for the production of output and employment in a capitalist economy: the point where the marginal product of labour was just equal to the real wage. Keynes's theory is a general theory because it describes how a capitalist economy can find itself producing any level of output between none and the output achieved by all factors of production fully employed, whereas neoclassical theory explains the determination of total output in a very special case. Furthermore, even the upper limit to aggregate production at full employment described by neoclassical theory is not independent of demand conditions. Though at a point in time maximum output is determined by the set of supply-side conditions, dynamically those conditions are influenced by investment decisions that are driven by money-making conditions. Capitalists invest towards the expansion of their future output by financing the research and development of new technologies and by adding to the capital stock only when they foresee monetary gains from those investment decisions.
At the core of Keynes's general theory was the idea that in capitalist economies the level of employment and production is determined by effective demand¾i.e. capitalists utilize the available factors of production in order to produce the amount of output expected to generate just enough monetary proceeds to fully compensate the expected costs of production. Though under certain conditions the level of output determined by effective demand could coincide with the product achieved by full employment, Keynes demonstrated that those who subscribed to the neoclassical faith had no logical basis for claiming that such was the only possible case. In fact, full employment was/is quite the unusual situation for an unmanaged capitalist economy.
Figure 1 above is a diagrammatic representation of Keynes's principle of effective demand as presented in Chapter 3 of The General Theory. The horizontal axis (N) represents the economy's level of employment¾i.e. the number of workers employed in the production of output. The vertical axis (PY) represents aggregate prices¾i.e. the sum of all money transactions or the average price (P) multiplied by the quantity of output sold/purchased (Y) for each level of employment (N). The aggregate supply price curve¾
¾represents the sum of money proceeds expected by capitalists to generate just enough revenues to "make it worth the while" producing an output that requires N workers. The aggregate demand price curve¾
¾represents the money receipts expected by capitalists as result of the production and sale of the output produced by N workers. Simply put, D represents the amount of money that capitalists expect to receive if they hire N workers whereas Z represents the amount of money that capitalists feel like they need to earn in order to avoid a money loss when they hire N workers.
Keynes argued that in a capitalist/monetary economy the D and Z curves were determined by different factors, thus almost invariably producing a single point of effective demand (E) as intercept. The aggregate price functions are generally such that the aggregate supply price (Z) is less than the aggregate demand price (D) for any amount of employed workers (N) fewer than N* and greater than D for any amount of employed workers above N*. Hence, the level of employment in the economy described by figure 1 would be given by N*, since money-seeking capitalists would have an incentive to hire additional workers only as long as the expected monetary gain from doing so (given by the point on the D curve) was no less than the monetary loss (given by the point on the Z curve).
It is not hard to understand why capitalists would form such opinions about the behavior of the two aggregate price functions and limit employment to N*. Assuming for simplicity a stable nominal wage and other nominal costs of production, the task of forecasting the relevant supply price for any given number of employed workers is fairly straight forward. The expected aggregate supply price in the economy is also the expected total income (wages and profits) received by the community for participating in the production of output during the period. Therefore as production is undertaken and paid for, the community receives just enough income to repurchase the whole output of the period at current prices. We know from experience that consumption is largely influenced by the community's income during the period, being larger when income is larger. As a result, when capitalists envision expanding the level of output, they can be fairly certain that aggregate consumption will also be expanded. However, as income is received, only a fraction of it is used up in consumption of goods and services, the rest being saved. Thus, in order for the output produced during the period to be fully purchased, there must be other forms of spending that fill the gap between the aggregate demand price for consumption goods and the aggregate supply price.
