J.K. Galbraith & W. Darity, "Macroeconomics", Chap. 1, 1994.

REVOLUTION AND COUNTERREVOLUTION

Macroeconomics began with a decisive event: the publication in 1936 of The General Theory of Employment, Interest and Money, by the British economistJohn Maynard Keynes (1883--1946). In large measure, all subsequent developments in macroeconomics have been reactions, either direct or indirect, to that book.

The General Theory attempted in one blow to overturn most of economics as it then existed. Keynes considered the theoretical positions of his fellow economists to be both mistaken and dangerous. Indeed, he objected to positions that at one time he had himself held, although never uncritically. ¹ In the Preface to The General Theory, he wrote: "The composition of this book has been for the author a long struggle of escape . . . a struggle of escape from habitual modes of thought and expression." He warned his readers that they, too, would have to wage such a struggle if the "assault upon them was to be successful." ²

Escape from what? Assault on what?

THE CLASSICAL ECONOMICS

Keynes mounted his rebellion against a body of belief that he called "the classical economics." Classical economics had, by 1936, been dominant for precisely 160 years- since the publication of Adam Smiths Inquiry into the Nature and Causes of the Wealth of Nations in the American independence year of 1776. Classical theorys greatest nineteenth-century masters had included the Englishmen David Ricardo, W. S. Jevons, and John Stuart Mill and the Frenchman Jean-Baptiste Say. If there was, in Keyness mind, a single leading modern master of the classical economics, it was probably his own teacher, Alfred Marshall (1842-1924), author of the first authoritative textbook in economics and inventor of the modern analysis of supply and demand.

Classical economics was a loose set of doctrines, rooted variously in moral philosophy, Newton's physics, and Darwin's biology; substantially nonmathematical; and lacking the systematic development and internal consistency that has come to characterize economics in our own time. We will present a synopsis, or more precisely a model, of the classical system when we get to Chapter 4. For now, we content ourselves with a mere description of three main points of doctrine.

First and foremost, classical economics held that the total volume of employment in society was determined in a labor market, by the supply of labor and other resources available and by the demand for them. Wages were the price that balanced the supply of labor with the demand. If, for some reason, the supply of workers increased relative to demand for them, wages would decline. In that event, it would become attractive for the additional workers to be hired. Wages would continue to fall, and additional workers would continue to be hired, until there were no more workers who were willing to work at the prevailing wage. At that point, in a phrase, the labor market would clear. There would be no unemployment, except for workers between jobs and those who were unwilling to work at the prevailing wage. In particular, there could not be a persistent excess supply of labor, of people willing to work at the prevailing wage but unable to find jobs, a condition otherwise known as mass unemployment.

Second, classical economics held that the interest rate, which is the rate of return on savings, investment, and capital formation, was also determined in a market. The classical capital market weighed the demand for investment funds against the willingness of savers to defer present consumption; to classical economists, the interest rate represented the balance of these two forces. If savings went up, interest rates would come down, and investment would go up to match the savings. Consequently, thrifty and virtuous peoples- for so the Victorian English viewed themselves- would be rewarded by the accumulation of wealth, while the supposedly feckless and spendthrift peoples of other countries would remain mired in poverty. Since there was no possibility of mass unemployment, investment and consumption were the only possible uses of current production, and an increase in consumption (at the expense of savings) could come only at the expense of future investment, capital formation, and wealth.

The notion of a balance between savings and investment was captured by a classical proposition known as Says Law. Says Law asserted, in effect, that all savings would necessarily be invested, that resources withdrawn from consumption by savers would automatically and necessarily return, in the form of demand for investment goods, to the general flow of demand for goods and services. Therefore, there was no possibility of what nineteenth-century economists called a "general glut" or an "underconsumption crisis," a persistent excess supply of goods that could not be sold. In a popular phrase that summarized Says Law, "Supply creates its own demand."

The third main principle of the classical economic system concerned money. In an odd way, classical economics had almost no role for money. In an economy, according to the quantity theory of money, the total amount of circulating money in proportion to the total volume of circulating goods was responsible for the general level of prices. And the relationship between the two was thought to be quite steady over time. Since money earned no interest, whereas savings in other forms (such as bonds) did, it was not rational to hold money except as needed for transactions. And so, if the money supply increased more rapidly than the supply of goods, there would be price inflation; if it decreased, the general level of prices would fall.

Aside from that, classical economists believed, changing the quantity of money in an economy had no effects. It did not change the interest rate ³ and so would not change the balance between investment and consumption. It affective neither the supply of goods nor the demand forthem; neither the supply of labor nor the demand for it. People had no reason to hoard money (over and above what they needed for transactions), so there was no possibility that savings could disappear into idle money holdings, disrupting the smooth operation of Says Law. Inflation, deflation, or price stability would change nothing; the real volume of output, the level of employment, and the living standards of workers would remain exactly the same. Hence, in a phrase you will encounter again and again in this text, money was neutral.

KEYNESS REVOLUTION

By 1936, Keynes had come to reject each and every one of these ideas. He had come to believe that there existed no labor market mechanism that would automatically keep the economy at full employment. Nor did he believe that the smooth functioning of the capital market would ensure that realized investment would always equal planned savings. Instead, he now believed that the supply of goods and the volume of employment depended on the demand for them, on the levels of consumption and planned investment exactly the opposite of Says Law. Keynes had also come to believe that the realized supply of savings, the amount that actually occurred as opposed to the amount that savers might plan for, depended not on the interest rate but instead on the level of income- on whether the economy was at full employment. And contradicting the quantity theory, he had come to see an intimate link between the money supply and the interest rate, and through them on the level of demand for output and on employment. In these links between topics that classical economics had kept separate, we find the very origin of macroeconomics as a distinct subject.

In consequence, where classical economics emphasized the virtues of thrift and savings, monetary stability, and laissez-faire (nonintervention) in labor markets, Keynes came to exactly opposite conclusions. In a comprehensive and dramatic break from the orthodoxies of his time, Keynes called for increased mass consumption, public spending, low interest rates, and easy credit. And he opposed the classical remedy of wage cutting for the then-inescapable problem of mass unemployment.

For Keynes this was no academic parlor game; the stakes were extremely high. The Great Depression, an unparalleled disaster, had by that time been going on in Britain for more than a decade. Double-digit unemployment had emerged in Britain as far back as 1921, when the rate jumped from 3 to 19 percent. From 1930 to 1933, estimated British unemployment rates exceeded 20 percent. ⁴ Moreover, by September 1926 the index of economic production had declined to half of its September 1920 value; it was not to reach the 1920 level again until June 1936. ⁵

The Great Depression in the United States of America was no less dramatic. Between 1929 and 1933, the unemployment rate rose from 3 percent to 25 percent, the U.S. economys output fell by one-third, money wages and consumer prices both fell about 30 percent, and the prices of farm products fell by 50 percent. ⁶ The event that signaled the collapse was the crash of the New York Stock Exchange in late October 1929. By November 1929, the average price of fifty leading stocks was half of what it had been in September of the same year. ⁷ And the fall continued until July 1932, when the Dow Jones index of leading industrial companies stocks dropped to 41, a 90 percent decline from its high in September 1929.⁸

The crisis in the securities market also hit hard at American commercial banking. After the crash, bank failures soared as panicked depositors withdrew their funds. Without deposit insurance, those who were unable to withdraw their money before their banks closed lost everything. Between 1929 and 1933, eleven thousand U.S. banks failed, over 40 percent of those in existence in 1929. About $2 billion in deposits were lost.

Keynes was convinced that these phenomena lay outside the comprehension of the economics and the economists of his day. Worse still, he had concluded, habitual economic modes of thought led to policies that would prolong, and perhaps perpetuate, the calamity. New policies, which were urgently required, could not be built on the old foundations. Rather, a new vision of how the economy functions, a new theoretical basis for policy, was required.

At first, and for quite a long time, Keyness idea that the Depression broke with the past in a fundamental way was a minority view. There had been, particularly among Western countries, a long historical experience with financial panics and crashes, recoveries and collapses. The phrase "prosperity is just around the corner" was commonplace among political figures in 1930. Keynes, however, could be heard warning,"The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history". ⁹

Yet Keynes argued- and here was another radical departure- thatthe Depression was all a nightmare that could, with the design and execution of proper policies, be put right by tomorrow morning:

If our poverty were due to earthquake or famine or war- if we lacked material things and the resources to produce them, we could not expect to find the means to prosperity except in hard work, abstinence, and invention. In fact, our predicament is notoriously of another kind.It comes from some failure in the immaterial devices of the mind, in the working of the motives which should lead to the decisions and acts of will, necessary to put in movement the resources and technical means we already have. It is as though two motor-drivers, meeting in the middle of a highway, were unable to pass one another because neither knows the rules of the road. Their own muscles are no use; a motor engineer cannot help them; a better road will not serve. Nothing is required and nothing will avail, except a little clear thinking. ¹⁰

AFTER KEYNES: COUNTERREVOLUTIONS

Unfortunately for Keynes, the "clear thinking" for which he called has never seemed quite so clear to other economists. Despite the fact that the policies he advocated were widely implemented, Keyness theoretical perspective was never embraced in full by the economics profession. In that sense, Keyness revolution remains incomplete. The long history of "Keynesian economics" has been one, in part, of repeated efforts to explain in simple, precise, and rigorous terms "what Keynes meant," followed by repeated attacks both on these explanations and on the theoretical perspective behind them.

In the beginning, which is to say from the 1940s through the early 1960s, Keyness revolution certainly dominated the field. In this period, we see the elucidation of the simplest concepts of the Keynesian system, notably the relationship between the "multiplier" and the "marginal propensity to consume," from which Keynes had derived the first principles of his theory of the level of employment. These concepts provided a powerful way to explain why the mass unemployment of the 1930s did not reappear, as many expected it would, after the end of World War II in 1945. We explore multiplier models and theories of consumption behavior in detail in Chapter 4.

Multiplier models and consumption functions were, however, only a part of the whole Keynesian system. They helped explain how government spending could prop up consumption and so keep an economy out of depression. But they ignored the roles of money, of the interest rate, and of demand for investment with which, as we have seen, Keynes was greatly concerned. And as the Keynesian era matured, many economists, especially in the United States, were drawn toward a much more complete effort to capture and represent the insights of The General Theory. This was the IS-LM model, generally attributed to Sir John Hicks of Oxford and Alvin Hansen of Harvard.

IS-LM, which we present in Chapter 5, has long formed the core of textbook Keynesianism and still does to this day. It represents an effort to integrate a model of the market for physical output (commodities), which incorporates the consumption function and the multiplier, with a model of the market for money, which incorporates Keyness ideas about the determination of the rate of interest. IS-LM models are very broad, flexible, and useful. In more recent years, they have been modified to underpin models of international economic interrelationships (such as the exchange rate); we present an exposition of such a model in Chapter 11.

In the 1960s, another relationship was added to the Keynesian system, perhaps in an effort to make it even more relevant to the practical policy questions of the day. This was an empirical relationship between inflation and unemployment, known as the Phillips curve, after its originator, A. W. Phillips of the London School of Economics. The Phillips curve simply stated that the rate of inflation would be low so long as unemployment was high and that it would tend to rise when unemployment fell. There was, it was said, a trade-off between the desired objectives of full employment and price stability; policymakers could choose what sort of economy they desired by picking the particular combination of unemployment and inflation they might prefer from the Phillips curves menu of possibilities. We discuss the Phillips curve in Chapter 5.

There were only two problems with the Phillips curve. First, try as one might, one could not derive, in any fully persuasive way, the relationship observed in the data from theoretical first principles. Second, the relationship observed in the data disappeared, catastrophically, with the high inflation and low growth rates that began to plague the American economy after 1968. By pulling on that string, critics of the whole Keynesian system were able to reemerge, to reassert themselves, and in the end very nearly to cause the entire system to unravel.

The first round of countérrevolution emerged under the banner of monetarism, led by Milton Friedman. Monetarists, whose ideas we treat in Chapter 7, ¹¹ sought to reestablish the classical relationship between money growth and inflation and to refute the Phillips curve relationship between inflation and unemployment. In the long run, the monetarists argued, there was no trade-off between inflation and unemployment, and a slow rate of money growth would yield high employment with stable prices just as surely as a high rate of money growth would yield high employment with inflation.

The monetarist effort to overturn Keynesian theory and policy recommendations attracted wide support among economists but also generated a new round of theoretical criticism and innovation, largely among Friedmans own students and colleagues at the University of Chicago. This led, in the early 1970s, to a post-monetarist grouping that styled itself the new classical economics. We present new classical economics in Chapters 8 and 9.

The new classical economics combined monetarism with another idea drawn from the old classical repertory, namely the notion that markets for labor and capital are fully self-adjusting. To this, based on the notion that all individuals are able to make fully efficient use of all available information in making economic forecasts: proponents added a concept all their own: rational expectations. With the triple tools of montetarism, market clearing, and rational expectations, the new classical economists sought to demolish Keynesianism once and for all and to restore the basic noninterventionism policy conclusions that had prevailed among classical economists before the Great Depression.

They almost succeeded. For fifteen years or so, until the late 1980s, the new classical economists dominated the theoretical side of macroeconomics, and they remain highly influential to this day. But the initiative shifted with the emergence of yet another group in the late 1980s. This group, in conscious imitation of and opposition to the new classicals, has taken the designation of new Keynesians. The new Keynesians accept many of the theoretical arguments of the new classicals but reject the idea that markets self-adjust to ensure full employment. Thus, for new Keynesians, there remains an important role for the government to play in fighting unemployment, something that new classicals deny. We explore the new Keynesian position in Chapter 10.

In all of this complicated history, yet another group of macroeconomist^'s has remained active. This group, usually known as post-Keynesian, is distinguished by its strong continuing interest in certain theoretical and policy issues that the other groups have tended to neglect. In particular, post-Keynesians predicate their analysis on a world of uncertainty, in which public policy plays a powerful function of coordinating and shaping the expectations of businesses, consumers, savers, and other economic actors. Post-Keynesians believe that their formulations of macroeconomics are both closer to that of Keynes himself and more relevant to the politics of the modern world than are those of the other disputants. The post-Keynesian group is smaller and in many ways less influential than the Keynesians, monetarists, new classicals, and new Keynesians, but in our judgment their views are important. The post-Keynesians reject rational expectations and work with a model that stresses interest rates, the pricing of assets in capital markets, the level of effective demand, and the effects of technological change-all topics that are highly relevant to todays world. We round out our text with a presentation of post-Keynesian views in Chapters 12 and 13.

Thus, ever since Keynes invented macroeconomics in 1936, macroeconomists, whether self-consciously or incidentally, have supported either positions taken by Keynes in The General Theory or those from which he sought to escape. And even if the matter has not always been cast in these terms by its protagonists, the debate between those who have been with Keynes and those who have been against him has dominated macroeconomics for the past sixty years and still dominates it today. The flux continues, and the fact that the subject survives in part by a process of creative self-destruction provides another reason for learning about its evolution alongside its modern form. For one can be sure of only one thing about the subject on which you are about to embark: a few rears from now, it will be different.

SUMMARY

The starting point for modern macroeconomic theory is The General Theory of Employment, Interest and Money, by John Maynard Keynes. All theoretic formulations since its publication have been either direct or indirect reactions to it.

The General Theory was itself seen by its author as a rebellion against what he called classical economic theory. Classical economic theory is popularly said to have begun with Adam Smith, but its actual formulation owes more to the economists that came between Smith and Keynes. In Keyness view, classical economics has three basic tenets. The first, Says Law, holds that supply creates its own demand. The second is that the interest rate is determined in a market for loanable funds. The third tenet is the quantity theory of money for the determination of the price level.

Keynes rejected all three of these tenets. He instead offered an explanantion for the Great Depression that did not depend on the "real" explanations of, the classicals. In the chapters that follow, explanations of, reactions to, and extensions of the Keynesian system will be presented, including multiplier analysis, IS-LM analysis, the Phillips curve, monetarism, new classical economics, new Keynesian economics, and post-Keynesian economics. Also since it provides a convenient historical and theoretical counterpoint to Keynesian economics, the classical economic doctrine will be examined in some detail.

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1. Keynes was always less than orthodox in both his public and his private life. Robert Skidelskys masterful biography of the young Keynes, John Maynard Keynes:1883-1920, Hopes Betrayed, provides the essential details of Keyness early life, personal history, and philosophical development.

2. The General Theory (New York: Macmillan, 1986), p. viii.

3. At least not after taking out any (purely cosmetic) effects of inflation on the interest rate.

4. "Not until the British mobilization for World War II did the unemployment ratefall below 10 percent. See Forrest Capie and Michael Collins, The Inter- War British Economy: A Statistical Abstract (Manchester: Manchester University Press, 1983), pp. 62--69.

5. Ibid., p. 20.

6. Gary Smith, Money and Banking: Financial Markets and Institutions (Reading, Mass.:Addison-Wesley Publishing, 1982), p. 292.

7. "The Past," Business Week, September 3, 1979, pp. 9--10.

8. Smith, Money and Banking, p. 292.

9. J.M. Keynes, "The Great Slump of 1930," in Collected Writings, Vol. IX,p.126.

10. "The Means to Prosperity" in Collected Writings, Vol. IX, p. 335.

11. After a chapter (6) devoted to ideas about money.

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