Keynes’s Legacy and the Classical Revival
Although the word ‘macroeconomics’ does not make its appearance in the
economics literature until De Wolff’s 1941 article in the Economic Journal, it
was John Maynard Keynes who first pulled together in a single formal framework
all the real and monetary variables necessary to investigate macroeconomic
phenomena (Blanchard, 2000; Woodford, 2000). The dominance of Keynes in
the emerging field of macroeconomics before his death in 1946 is clearly
illustrated in the data on citations for the period 1920–44 contained in Tables
The outstanding feature of this information is the extent to which Keynes
came to dominate ‘macroeconomics’ by the mid-1930s. However, as we will
see in the remaining chapters, the development of macroeconomics since 1936
has been a process of evolution overlain with periodic counter-revolutions and,
as a result, in the 30 years after his death in 1946, ‘Keynes’s reputation soared
and then crashed’. To a large extent, this change of fortune is related to the
over-enthusiastic application of ‘Keynesian’ expansionary policies. Skidelsky
(2000) concludes his third and final volume of his biography of Keynes by
Keynes v. the ‘old’ classical model 87
highlighting four important elements in ‘the Keynesian mindset’ that prevailed
during the ‘Golden Age’ from about 1950 until the early 1970s:
1. economies are viewed as ‘sticky, not fluid’, so they adjust to shocks
relatively slowly;
2. there is a powerful political-economy argument that liberal democracies
will not tolerate for long high and persistent levels of unemployment
such as those experienced during the interwar period of the twentieth
century; so while ‘in the long run we are all dead’, in the short run, high
unemployment may lead to revolution;
3. investment opportunities may flag in rich societies leading to secular
stagnation;
4. many Keynesians professed a serious faith in statistical forecasting.
While Keynes certainly adhered to the first three of these elements, he was
always ‘deeply sceptical’ of ‘Joy through Statistics’. His followers exhibited
less restraint. The long shadow cast by the experience of the Great Depression
combined with a fear of secular stagnation was sufficient to fuel the case
for frequent stimulation of aggregate demand and also led to the neglect of
important supply-side considerations (see DeLong, 1998). While Keynes
(1936, p. 16) was well aware that there were other sources of unemployment
than demand deficiency, he understandably paid little attention to these in the
General Theory. While Keynes understood that much of interwar British
unemployment had a large structural component, to try to explain the simultaneous
international outbreak of increasing rates of unemployment across
the major capitalist economies after 1929 in terms of changing structural or
frictional factors seemed completely implausible to him. The expected secular
stagnation via a lack of investment opportunities also failed to materialize.
As Abramovitz (1986, 1990) notes, a large backlog of unexploited technological
opportunities arising from the interwar stagnation and failure of Western
European industrialized countries to adopt the American system of mass
production manufacturing, provided enormous scope for ‘catch-up’. As a
result capital investment had a high marginal productivity and the West
experienced a long boom during the Golden Age.
Jeffrey Sachs (1999) has also argued that the impression given by the more
extreme enthusiasts of demand management, that the Great Depression might
somehow represent the normal functioning of market economies, turned out
to be wrong. As discussed in section 2.14, we now know that the Great
Depression was exceptional and largely the result of a perverse policy response.
Sachs writes:
The importance of the Great Depression in economic history is probably on a par
with the First World War in political history. The Great Depression taught many
lessons, most of them wrong. Keynes, the greatest political economist of the
century, made a grave mistake when he titled his text The General Theory of
Employment, Interest and Money. He left the impression that the Great Depression
was a ‘general’ situation of market economies, not a one-time fluke of grotesque
proportions. He failed to make clear that it occurred because of the international
gold standard, a monetary arrangement that Keynes had heatedly attacked and
abhorred, but strangely under-emphasised in the General Theory. In any event, the
Great Depression left the world deeply sceptical about the self-organising market
system. It took decades to revive robust confidence in market economies.
So, from this perspective, Keynes’s General Theory was ‘not quite as general
as he believed’ (Skidelsky, 2000, p. 499).
Throughout the period after 1936 there have been numerous developments
and contributions which reflect a hostile response to Keynes’s General Theory
and have ultimately contributed to a classical revival. The influence of Friedman
and the monetarist counter-revolution represented a major challenge to
the more simplistic versions and policy conclusions associated with hydraulic
Keynesianism. In Friedman’s (1983) opinion, ‘While the General Theory is a
great book, I do not regard it as his best … I have been led to reject it …
because I believe that it has been contradicted by the evidence.’
In Chapter 4 we examine the important challenge to the Keynesian orthodoxy
posed by monetarist analysis. Following this we examine the emergence
of the new classical school, which launched a much more fundamental attack
against Keynesianism during the 1970s. To many, this critique represents the
most important challenge to date for the Keynesian conventional wisdom. For
Lucas and Sargent, it is a simple matter of ‘fact’ that the predictions of
Keynesian models were ‘wildly incorrect’ and based on a doctrine which is
‘fundamentally flawed’. The ‘spectacular failure’ of Keynesian models in the
1970s has led to more attention and respect being accorded to ‘the theoretical
casualties of the Keynesian revolution, to the ideas of Keynes’s contemporaries
and of earlier economists whose thinking has been regarded for years as
outmoded’ (Lucas and Sargent, 1978, emphasis added).
Charles Plosser, a leading advocate of the new classical real business cycle
approach to macroeconomic fluctuations, is also of the view that the Keynesian
model is fundamentally flawed. In his opinion, ‘the underpinnings of our
understanding of economic fluctuations are likely to be found somewhere
other than a suitably modified version of the Keynesian model’ (Plosser,
1989). Minford and Peel (1983), in commenting on the impact of rational
expectations on macroeconomics, feel that ‘It has turned a body of knowledge
– macroeconomics based on the neo-Keynesian or neo-classical systems
of the late 1960s – upside down; virtually every topic … has been found to be
in need of rethinking’. In Chapters 5 and 6 we examine the development of
the new classical ideas particularly associated with Lucas, Sargent, Barro,
Prescott, Kydland and Plosser.
From the Austrian viewpoint, Friedrich von Hayek throughout his life
remained a stern critic of Keynes and Keynesians. In Hayek’s own words,
Keynes was ‘wholly wrong in the scientific work for which he is chiefly
known’ (Hayek, 1983). The powerful Austrian critique associated with the
work of Hayek and his followers is reviewed in Chapter 9.
Although we do not deal with the ‘public choice’ perspective as a specific
school, the perspective offered by Buchanan and Wagner (1978) is worth
noting, given the influence such ideas have had on popular opinion. Buchanan
and Wagner accuse Keynes of ‘Intellectual error of monumental proportions’
and assert that Keynesian economics ‘has turned politicians loose; it has
destroyed the effective constraint on politicians’ ordinary appetites to spend
and spend without the apparent necessity to tax’ (see Chapter 10).
Only a great economist could stir up such reactions. In writing to Roy
Harrod in 1935, Keynes made it clear that his attack on the classical economists
in his forthcoming book was quite deliberate because he wanted ‘to
force the classicals to make a rejoiner’. His objective was, ‘so to speak, to
raise a dust’ (see Skidelsky, 1992, p. 534). We can only conclude that in this
objective Keynes was spectacularly successful!
Although the word ‘macroeconomics’ does not make its appearance in the
economics literature until De Wolff’s 1941 article in the Economic Journal, it
was John Maynard Keynes who first pulled together in a single formal framework
all the real and monetary variables necessary to investigate macroeconomic
phenomena (Blanchard, 2000; Woodford, 2000). The dominance of Keynes in
the emerging field of macroeconomics before his death in 1946 is clearly
illustrated in the data on citations for the period 1920–44 contained in Tables
The outstanding feature of this information is the extent to which Keynes
came to dominate ‘macroeconomics’ by the mid-1930s. However, as we will
see in the remaining chapters, the development of macroeconomics since 1936
has been a process of evolution overlain with periodic counter-revolutions and,
as a result, in the 30 years after his death in 1946, ‘Keynes’s reputation soared
and then crashed’. To a large extent, this change of fortune is related to the
over-enthusiastic application of ‘Keynesian’ expansionary policies. Skidelsky
(2000) concludes his third and final volume of his biography of Keynes by
Keynes v. the ‘old’ classical model 87
highlighting four important elements in ‘the Keynesian mindset’ that prevailed
during the ‘Golden Age’ from about 1950 until the early 1970s:
1. economies are viewed as ‘sticky, not fluid’, so they adjust to shocks
relatively slowly;
2. there is a powerful political-economy argument that liberal democracies
will not tolerate for long high and persistent levels of unemployment
such as those experienced during the interwar period of the twentieth
century; so while ‘in the long run we are all dead’, in the short run, high
unemployment may lead to revolution;
3. investment opportunities may flag in rich societies leading to secular
stagnation;
4. many Keynesians professed a serious faith in statistical forecasting.
While Keynes certainly adhered to the first three of these elements, he was
always ‘deeply sceptical’ of ‘Joy through Statistics’. His followers exhibited
less restraint. The long shadow cast by the experience of the Great Depression
combined with a fear of secular stagnation was sufficient to fuel the case
for frequent stimulation of aggregate demand and also led to the neglect of
important supply-side considerations (see DeLong, 1998). While Keynes
(1936, p. 16) was well aware that there were other sources of unemployment
than demand deficiency, he understandably paid little attention to these in the
General Theory. While Keynes understood that much of interwar British
unemployment had a large structural component, to try to explain the simultaneous
international outbreak of increasing rates of unemployment across
the major capitalist economies after 1929 in terms of changing structural or
frictional factors seemed completely implausible to him. The expected secular
stagnation via a lack of investment opportunities also failed to materialize.
As Abramovitz (1986, 1990) notes, a large backlog of unexploited technological
opportunities arising from the interwar stagnation and failure of Western
European industrialized countries to adopt the American system of mass
production manufacturing, provided enormous scope for ‘catch-up’. As a
result capital investment had a high marginal productivity and the West
experienced a long boom during the Golden Age.
Jeffrey Sachs (1999) has also argued that the impression given by the more
extreme enthusiasts of demand management, that the Great Depression might
somehow represent the normal functioning of market economies, turned out
to be wrong. As discussed in section 2.14, we now know that the Great
Depression was exceptional and largely the result of a perverse policy response.
Sachs writes:
The importance of the Great Depression in economic history is probably on a par
with the First World War in political history. The Great Depression taught many
lessons, most of them wrong. Keynes, the greatest political economist of the
century, made a grave mistake when he titled his text The General Theory of
Employment, Interest and Money. He left the impression that the Great Depression
was a ‘general’ situation of market economies, not a one-time fluke of grotesque
proportions. He failed to make clear that it occurred because of the international
gold standard, a monetary arrangement that Keynes had heatedly attacked and
abhorred, but strangely under-emphasised in the General Theory. In any event, the
Great Depression left the world deeply sceptical about the self-organising market
system. It took decades to revive robust confidence in market economies.
So, from this perspective, Keynes’s General Theory was ‘not quite as general
as he believed’ (Skidelsky, 2000, p. 499).
Throughout the period after 1936 there have been numerous developments
and contributions which reflect a hostile response to Keynes’s General Theory
and have ultimately contributed to a classical revival. The influence of Friedman
and the monetarist counter-revolution represented a major challenge to
the more simplistic versions and policy conclusions associated with hydraulic
Keynesianism. In Friedman’s (1983) opinion, ‘While the General Theory is a
great book, I do not regard it as his best … I have been led to reject it …
because I believe that it has been contradicted by the evidence.’
In Chapter 4 we examine the important challenge to the Keynesian orthodoxy
posed by monetarist analysis. Following this we examine the emergence
of the new classical school, which launched a much more fundamental attack
against Keynesianism during the 1970s. To many, this critique represents the
most important challenge to date for the Keynesian conventional wisdom. For
Lucas and Sargent, it is a simple matter of ‘fact’ that the predictions of
Keynesian models were ‘wildly incorrect’ and based on a doctrine which is
‘fundamentally flawed’. The ‘spectacular failure’ of Keynesian models in the
1970s has led to more attention and respect being accorded to ‘the theoretical
casualties of the Keynesian revolution, to the ideas of Keynes’s contemporaries
and of earlier economists whose thinking has been regarded for years as
outmoded’ (Lucas and Sargent, 1978, emphasis added).
Charles Plosser, a leading advocate of the new classical real business cycle
approach to macroeconomic fluctuations, is also of the view that the Keynesian
model is fundamentally flawed. In his opinion, ‘the underpinnings of our
understanding of economic fluctuations are likely to be found somewhere
other than a suitably modified version of the Keynesian model’ (Plosser,
1989). Minford and Peel (1983), in commenting on the impact of rational
expectations on macroeconomics, feel that ‘It has turned a body of knowledge
– macroeconomics based on the neo-Keynesian or neo-classical systems
of the late 1960s – upside down; virtually every topic … has been found to be
in need of rethinking’. In Chapters 5 and 6 we examine the development of
the new classical ideas particularly associated with Lucas, Sargent, Barro,
Prescott, Kydland and Plosser.
From the Austrian viewpoint, Friedrich von Hayek throughout his life
remained a stern critic of Keynes and Keynesians. In Hayek’s own words,
Keynes was ‘wholly wrong in the scientific work for which he is chiefly
known’ (Hayek, 1983). The powerful Austrian critique associated with the
work of Hayek and his followers is reviewed in Chapter 9.
Although we do not deal with the ‘public choice’ perspective as a specific
school, the perspective offered by Buchanan and Wagner (1978) is worth
noting, given the influence such ideas have had on popular opinion. Buchanan
and Wagner accuse Keynes of ‘Intellectual error of monumental proportions’
and assert that Keynesian economics ‘has turned politicians loose; it has
destroyed the effective constraint on politicians’ ordinary appetites to spend
and spend without the apparent necessity to tax’ (see Chapter 10).
Only a great economist could stir up such reactions. In writing to Roy
Harrod in 1935, Keynes made it clear that his attack on the classical economists
in his forthcoming book was quite deliberate because he wanted ‘to
force the classicals to make a rejoiner’. His objective was, ‘so to speak, to
raise a dust’ (see Skidelsky, 1992, p. 534). We can only conclude that in this
objective Keynes was spectacularly successful!
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