Thursday, June 2, 2011

The Keynesian path to global economic prosperity

Just finished reading Paul Davidson’s The Keynes Solution: The Path to Global Economic Prosperity. The book explains how the recent global financial and economic crises occurred (basically being hostage to neoliberal doctrines), the Keynesian alternatives to prevent such crises, and the Keynesian solutions to the recession. Davidson argues that Keynes’s original ideas have been distorted by “New Keynesians” to fit issues like sticky wages in neoclassical models, primarily to save and highlight the latter one.

He argues that Keynes recognized capitalism was the best system humans have devised to achieve a civilized economic system society, but it had two major faults:

  • its failure to provide persistent full employment for all those who want to work
  • its arbitrary and inequitable distribution of income and wealth

Keynes held the view that unless these faults were corrected, capitalism will always be unstable and subjected to economic booms and busts.

He cites Keynes’s letter to George Bernard Shaw (January 1, 1935) where Keynes expressed his belief on a new economic philosophy (later known as Keynesianism) that details economic faults of a “money-using, market-oriented capitalists” economic system and what policies would prevent these flaws while maintaining the benefits of a capitalist system. A year after that Keynes published The General Theory of Employment, Interest and Money.

To understand my new state of mind … you have to know that I believe myself to be writing a book on economic theory which will largely revolutionize not I suppose at once but in the course of the next ten years the way the world thinks about economic problems. When my new theory has been duly assimilated and mixed with politics and feeling and passions, I cannot predict what the final upshot will be in its effect on actions and affairs, but there will be a great change and in particular the Ricardian Foundations of Marxism will be knocked away.

Keynes was in favor of an expansionary policy in the short run to tackle rising unemployment and economic recession. In fact, observing the high unemployment rate in Europe before the Great Depression of 1929, he argued, “In the long run we will all be dead.” He was in particular against classical argument that whatever happened in the market (unemployment and recession) is a process of market adjustment. For Keynes, during economic distress, recovery must always be the first priority; this should be followed by reform (and concerns about deficit and debt should be secondary).

Davidson tries to dispel arguments that are frequently alluded to Keynes. For instance, he argues that Keynes maintained unemployment is primarily cause by lack of liquidity, not sticky wages:

[…] the fundamental cause of unemployment was not due to the fixity of wages and prices preventing a free market from operating to ensure full employment … the cause involves the fact that savers are demanding increased liquidity from the financial assets that they use to store their savings. The problem of unemployment was to be found in the operation of financial markets and the motives of savers to save.

[…] Keynes specifically stated that his theory of unemployment did not rely on the assumption of wage and/or price rigidities. He claimed that his theory provided a different analysis where the cause of unemployment was related to the operation of financial markets and the public's desire to hold liquid assets. (p. 163)

Davidson argues that the Keynesian solution during recession is to promote increased market demand (via government intervention) for the products of business firms, thus creating profit opportunities that will encourage enterprises to hire more people. Recovery should be the first strategy during recession, not fiscal deficit or debt. Then when recovery is achieved, reforms should be the strategy to fix inefficiencies in the market.

He is critical of neoclassical belief that government involvement is always bad for the economy. This is taken as an axiom by them and need not be proven. Any logical theory hinged on this axiom looks okay. But, the axiom itself is doubtful. However, “Keynes’s liquidity theory of an entrepreneurial economy demonstrates that government has the capacity to cure, with the cooperation of private industry and households, economic flaws inherent in the operation of a money-using, market-oriented capitalist economy.”

He argues that the reason why economists and analysts misinterpret the main message behind Keynes’s arguments is that they never read carefully what Keynes really said. Instead, they depend on some else’s information and analysis, leading to distortion of ideas as it filters down to successive people. He charges that present day neo-Keynesians attribute sticky wages to Keynes and blend it with neoclassical economics to get neoclassical Keynesian synthesis.

Davidson argues that even Paul Samuelson misinterpreted and misread Keynes. But, Samuelson saved Keynesian ideas in the US by making it compatible with some of the classical theories because it was hard to go against McCarthy anticommunist movement at that time.

[…] Samuelson admits he did not understand Keynes’s analysis. Instead, he assumed that Keynes was presenting a traditional general equilibrium classical theory model where wage and price rigidity caused unemployment. (p.170)

Davidson concludes:

Paul Samuelson saved the term “Keynesian” in economic textbooks from being completely destroyed by the McCarthy anticommunist movement at the time. The cost of such a saving, however, was to sever the meaning of Keynesian theory in mainstream economic theory from its General Theory analytical roots. Keynes’s revolution demonstrated that in a money-using, market-oriented capitalist economy, supply side market imperfections, including the fixity of money wages and/or prices or a liquidity trap, are not necessary conditions for the existence of significant and persistent unemployment. Furthermore, Keynes demonstrated that flexible wages and prices and pure competition are not sufficient conditions to ensure full employment in our economic system, even in the long run.

Samuelson’s view of Keynesianism prevented Keynes’s revolutionary analysis from sweeping mainstream economics off its classical theory axiomatic foundations. Neoclassical synthesis Keynesianism coming at the same time as mathematics in economics became popular provided a double whammy that aborted Keynes’s revolutionary theory. What passed as conventional economic wisdom of mainstream economists at the beginning of the twenty-first century is nothing more than high-tech and more mathematical versions of nineteenth-century classical Walrasian general equilibrium theory.

In winning the battle against the forces trying to prevent the teaching of suspected communist-inspired Keynesian economics in our universities, Samuelson ultimately lost the war that Keynes had launched to eliminate the classical theoretical analysis as the basis for real-world economic problems of employment, interest, and money. In 1986, Lorie Tarshis recognized this fact when he noted: “I never felt that Keynes was being followed with full adherence or full understanding of what he had written. I still feel that way.”

Today mainstream economics—whether it goes under the title of old neoclassical Keynesians, New Keynesians, old classical or new classical theorists, Arrow-Debreu-Walrasian economics, post- Walrasian theory, behavioral economic theory—still relies on the classical axioms that Keynes discarded in his attempt to make economics relevant to the real-world problems of unemployment and international trade and international payments. As a result, these problems still plague much of the real world in the globalized economy of the twenty-first century. [pp.177-179]

Meanwhile, David Gordon, senior fellow at the Mises Institute, takes on Davidson for discarding purchasing power of money while advocating increase in monetary units to increase productivity. He also argues that since future is uncertain and predictions about future based on mechanical view of efficient markets is wrong, then why would that change if government enters the scene by pumping money (stimulus).

I think Gordon get it wrong here. Future is uncertain and predictions based on the presumption of efficient markets usually turn up untrue because the baseline is prosperous period when everything seems right. When accidents happen (as Keynes says capitalist system is inherently unstable), then markets cannot recover by itself (or even it does, it will take long time and inflict a lot of pain in the form of loss of business confidence and increase in unemployment). It needs a jolt by an exogenous actor—the government pumping in money when liquidity dries up. This changes the scene because slumped demand from private sector is covered up by government spending. This applies when the economy is in distress and the monetary system cannot affect consumer and investment behavior to induce growth (reference to liquidity trap). During distress recovery should be a priority. Then follows reform of dysfunctional and inefficient policy and institutional settings.