The Central Propositions of Orthodox Keynesian Economics
Finally in this chapter we draw together the discussion contained in sections
3.2–3.6 and summarize the central propositions of orthodox Keynesian economics
as they were in the mid- to late 1960s.
First Proposition: Modern industrial capitalist economies are subject to an
endemic flaw in that they are prone to costly recessions, sometimes severe,
which are primarily caused by a deficiency of aggregate (effective) demand.
Recessions should be viewed as undesirable departures from full employment
equilibrium that are generally caused by demand shocks from a variety of
possible sources, both real and monetary. As we will discuss in Chapter 6, this
view stands in marked contrast to the conclusions of real business cycle theory,
which emphasizes supply shocks as the major cause of aggregate instability.
Second Proposition: Orthodox Keynesians believe that an economy can be in
either of two regimes. In the Keynesian regime aggregate economic activity
is demand-constrained. In the classical regime output is supply constrained
and in this situation supply creates its own demand (Say’s Law). The ‘old’
Keynesian view is that the economy can be in either regime at different points
in time. In contrast, new classical economists, such as Robert Lucas and
Edward Prescott, model the economy as if it were always in a supplyconstrained
regime. In the Keynesian demand-constrained regime employment
and output will respond positively to additional real demand from whatever
source.
Third Proposition: Unemployment of labour is a major feature of the Keynesian
regime and a major part of that unemployment is involuntary in that it
consists of people without work who are prepared to work at wages that
employed workers of comparable skills are currently earning (see for example,
Solow, 1980; Blinder, 1988a). As we will discuss in subsequent chapters,
this contrasts sharply with the view of many monetarist, new classical and
real business cycle economists who view unemployment as a voluntary phenomenon
(Lucas, 1978a).
Fourth Proposition: ‘A market economy is subject to fluctuations in aggregate
output, unemployment and prices, which need to be corrected, can be
corrected, and therefore should be corrected’ (Modigliani, 1977, 1986). The
discretionary and coordinated use of both fiscal and monetary policy has an
important role to play in stabilizing the economy. These macroeconomic
instruments should be dedicated to real economic goals such as real output
and employment. By the mid-1960s the early ‘hydraulic’ Keynesian emphasis
on fiscal policy had been considerably modified among Keynesian thinkers,
particularly Modigliani and Tobin in the USA (see Snowdon and Vane, 1999b).
However, supporters of the ‘New Economics’ in the USA were labelled as
‘fiscalists’ to distinguish them from ‘monetarists’. But, as Solow and Tobin
(1988) point out, ‘The dichotomy was quite inaccurate. Long before 1960 the
neo-Keynesian neoclassical synthesis recognised monetary measures as coequal
to fiscal measures in stabilisation of aggregate demand’ (see Buiter,
2003a).
Fifth Proposition: In modern industrial economies prices and wages are not
perfectly flexible and therefore changes in aggregate demand, anticipated or
unanticipated, will have their greatest impact in the short run on real output and
employment rather than on nominal variables. Given nominal price rigidities
the short-run aggregate supply curve has a positive slope, at least until the
economy reaches the supply-constrained full employment equilibrium.
Sixth Proposition: Business cycles represent fluctuations in output, which are
undesirable deviations below the full employment equilibrium trend path of
output. Business cycles are not symmetrical fluctuations around the trend.
Seventh Proposition: The policy makers who control fiscal and monetary
policy face a non-linear trade-off between inflation and unemployment in the
short run. Initially, in the 1960s, many Keynesians thought that this trade-off
relationship was relatively stable and Solow and Tobin (1988) admit that in
the early 1960s they ‘may have banked too heavily on the stability of the
Phillips curve indicated by post-war data through 1961’ (see Leeson, 1999).
Eighth Proposition: More controversial and less unanimous, some Keynesians,
including Tobin, did on occasions support the temporary use of incomes
policies (‘Guideposts’) as an additional policy instrument necessary to obtain
the simultaneous achievement of full employment and price stability (Solow,
1966; Tobin, 1977). The enthusiasm for such policies has always been much
greater among European Keynesians than their US counterparts, especially in
the 1960s and early 1970s.
Ninth Proposition: Keynesian macroeconomics is concerned with the shortrun
problems of instability and does not pretend to apply to the long-run
issues of growth and development. The separation of short-run demand fluctuations
from long-run supply trends is a key feature of the neoclassical
synthesis. However, stabilization policy that combines tight fiscal policy with
easy monetary policy will ‘bring about an output mix heavier on investment
and capital formation, and lighter on consumption’. This mix will therefore
be more conducive to the growth of an economy’s long-run growth of potential
output (see Tobin, 1987, pp. 142–67, Tobin, 2001). ‘Taming the business
cycle and maintaining full employment were the first priorities of macroeconomic
policy. But this should be done in ways that promote more rapid
growth in the economy’s capacity to produce’ (Tobin, 1996, p. 45).
The orthodox Keynesians reached the peak of their influence in the mid-
1960s. In the UK Frank Paish (1968) concluded that on the basis of Phillips’s
data, if unemployment were held at around 2.5 per cent, then there would be
a good chance of achieving price stability. In the USA, reflecting on the
experience of 20 years of the Employment Act of 1946, the 1966 Annual
Report of the Council of Economic Advisers concluded on the following
optimistic note with respect to the effectiveness of Keynesian demand management
policies (emphasis added):
Twenty years of experience have demonstrated our ability to avoid ruinous inflations
and severe depressions. It is now within our capabilities to set more ambitious
goals. We strive to avoid recurrent recessions, to keep unemployment far below
rates of the past decade, to maintain essential price stability at full employment,
to move toward the Great Society, and, indeed, to make full prosperity the normal
state of the American economy. It is a tribute to our success under the Employment
Act that we now have not only the economic understanding but also the will
and determination to use economic policy as an effective tool for progress.
As we now know, this statement turned out to be far too optimistic with
respect to the knowledge that economists had about macroeconomics and the
ability to target the economy toward increasingly lower unemployment targets
(see DeLong, 1996, 1997, 1998).
Does this mean that Keynesian economics is dead (Tobin, 1977)? Certainly
not. Paul Krugman (1999) has warned economists that the 1990s have witnessed
‘The Return of Depression Economics’. Krugman’s argument is that
‘for the first time in two generations, failures on the demand side of the
economy – insufficient private spending to make use of available productive
capacity – have become the clear and present limitation on prosperity for a
large part of the world’. Krugman sets out to remind economists not to be
complacent about the possibility of economic depression and deflation, particularly
in view of what happened in the Japanese, Asian Tiger and several
European economies during the 1990s. DeLong (1999a, 1999b, 1999c) has
also emphasized that the business cycle and threat of deflation are far from
dead. Several economists have argued that the Japanese economy appears to
be caught in a ‘liquidity trap’ (Krugman, 1998). Krugman (1999) writes:
Even now, many economists still think of recessions as a minor issue, their study
as a faintly disreputable subject; the trendy work has all been concerned with
technological progress and long-run growth. These are fine important questions,
and in the long run they are what really matters … Meanwhile, in the short run the
world is lurching from crisis to crisis, all of them crucially involving the problem
of generating sufficient demand … Once again, the question of how to keep
demand adequate to make use of the economy’s capacity has become crucial.
Depression economics is back.
So even given that there were significant deficiencies in the orthodox Keynesian
framework that required new thinking, the issues that concerned Keynes have
not disappeared.
In the next chapter we discuss the development of the orthodox monetarist
school which, over the period of the mid-1950s to the early 1970s, highlighted
a number of weaknesses both at the theoretical and empirical levels of
the then-prevailing orthodox Keynesian framework.
Finally in this chapter we draw together the discussion contained in sections
3.2–3.6 and summarize the central propositions of orthodox Keynesian economics
as they were in the mid- to late 1960s.
First Proposition: Modern industrial capitalist economies are subject to an
endemic flaw in that they are prone to costly recessions, sometimes severe,
which are primarily caused by a deficiency of aggregate (effective) demand.
Recessions should be viewed as undesirable departures from full employment
equilibrium that are generally caused by demand shocks from a variety of
possible sources, both real and monetary. As we will discuss in Chapter 6, this
view stands in marked contrast to the conclusions of real business cycle theory,
which emphasizes supply shocks as the major cause of aggregate instability.
Second Proposition: Orthodox Keynesians believe that an economy can be in
either of two regimes. In the Keynesian regime aggregate economic activity
is demand-constrained. In the classical regime output is supply constrained
and in this situation supply creates its own demand (Say’s Law). The ‘old’
Keynesian view is that the economy can be in either regime at different points
in time. In contrast, new classical economists, such as Robert Lucas and
Edward Prescott, model the economy as if it were always in a supplyconstrained
regime. In the Keynesian demand-constrained regime employment
and output will respond positively to additional real demand from whatever
source.
Third Proposition: Unemployment of labour is a major feature of the Keynesian
regime and a major part of that unemployment is involuntary in that it
consists of people without work who are prepared to work at wages that
employed workers of comparable skills are currently earning (see for example,
Solow, 1980; Blinder, 1988a). As we will discuss in subsequent chapters,
this contrasts sharply with the view of many monetarist, new classical and
real business cycle economists who view unemployment as a voluntary phenomenon
(Lucas, 1978a).
Fourth Proposition: ‘A market economy is subject to fluctuations in aggregate
output, unemployment and prices, which need to be corrected, can be
corrected, and therefore should be corrected’ (Modigliani, 1977, 1986). The
discretionary and coordinated use of both fiscal and monetary policy has an
important role to play in stabilizing the economy. These macroeconomic
instruments should be dedicated to real economic goals such as real output
and employment. By the mid-1960s the early ‘hydraulic’ Keynesian emphasis
on fiscal policy had been considerably modified among Keynesian thinkers,
particularly Modigliani and Tobin in the USA (see Snowdon and Vane, 1999b).
However, supporters of the ‘New Economics’ in the USA were labelled as
‘fiscalists’ to distinguish them from ‘monetarists’. But, as Solow and Tobin
(1988) point out, ‘The dichotomy was quite inaccurate. Long before 1960 the
neo-Keynesian neoclassical synthesis recognised monetary measures as coequal
to fiscal measures in stabilisation of aggregate demand’ (see Buiter,
2003a).
Fifth Proposition: In modern industrial economies prices and wages are not
perfectly flexible and therefore changes in aggregate demand, anticipated or
unanticipated, will have their greatest impact in the short run on real output and
employment rather than on nominal variables. Given nominal price rigidities
the short-run aggregate supply curve has a positive slope, at least until the
economy reaches the supply-constrained full employment equilibrium.
Sixth Proposition: Business cycles represent fluctuations in output, which are
undesirable deviations below the full employment equilibrium trend path of
output. Business cycles are not symmetrical fluctuations around the trend.
Seventh Proposition: The policy makers who control fiscal and monetary
policy face a non-linear trade-off between inflation and unemployment in the
short run. Initially, in the 1960s, many Keynesians thought that this trade-off
relationship was relatively stable and Solow and Tobin (1988) admit that in
the early 1960s they ‘may have banked too heavily on the stability of the
Phillips curve indicated by post-war data through 1961’ (see Leeson, 1999).
Eighth Proposition: More controversial and less unanimous, some Keynesians,
including Tobin, did on occasions support the temporary use of incomes
policies (‘Guideposts’) as an additional policy instrument necessary to obtain
the simultaneous achievement of full employment and price stability (Solow,
1966; Tobin, 1977). The enthusiasm for such policies has always been much
greater among European Keynesians than their US counterparts, especially in
the 1960s and early 1970s.
Ninth Proposition: Keynesian macroeconomics is concerned with the shortrun
problems of instability and does not pretend to apply to the long-run
issues of growth and development. The separation of short-run demand fluctuations
from long-run supply trends is a key feature of the neoclassical
synthesis. However, stabilization policy that combines tight fiscal policy with
easy monetary policy will ‘bring about an output mix heavier on investment
and capital formation, and lighter on consumption’. This mix will therefore
be more conducive to the growth of an economy’s long-run growth of potential
output (see Tobin, 1987, pp. 142–67, Tobin, 2001). ‘Taming the business
cycle and maintaining full employment were the first priorities of macroeconomic
policy. But this should be done in ways that promote more rapid
growth in the economy’s capacity to produce’ (Tobin, 1996, p. 45).
The orthodox Keynesians reached the peak of their influence in the mid-
1960s. In the UK Frank Paish (1968) concluded that on the basis of Phillips’s
data, if unemployment were held at around 2.5 per cent, then there would be
a good chance of achieving price stability. In the USA, reflecting on the
experience of 20 years of the Employment Act of 1946, the 1966 Annual
Report of the Council of Economic Advisers concluded on the following
optimistic note with respect to the effectiveness of Keynesian demand management
policies (emphasis added):
Twenty years of experience have demonstrated our ability to avoid ruinous inflations
and severe depressions. It is now within our capabilities to set more ambitious
goals. We strive to avoid recurrent recessions, to keep unemployment far below
rates of the past decade, to maintain essential price stability at full employment,
to move toward the Great Society, and, indeed, to make full prosperity the normal
state of the American economy. It is a tribute to our success under the Employment
Act that we now have not only the economic understanding but also the will
and determination to use economic policy as an effective tool for progress.
As we now know, this statement turned out to be far too optimistic with
respect to the knowledge that economists had about macroeconomics and the
ability to target the economy toward increasingly lower unemployment targets
(see DeLong, 1996, 1997, 1998).
Does this mean that Keynesian economics is dead (Tobin, 1977)? Certainly
not. Paul Krugman (1999) has warned economists that the 1990s have witnessed
‘The Return of Depression Economics’. Krugman’s argument is that
‘for the first time in two generations, failures on the demand side of the
economy – insufficient private spending to make use of available productive
capacity – have become the clear and present limitation on prosperity for a
large part of the world’. Krugman sets out to remind economists not to be
complacent about the possibility of economic depression and deflation, particularly
in view of what happened in the Japanese, Asian Tiger and several
European economies during the 1990s. DeLong (1999a, 1999b, 1999c) has
also emphasized that the business cycle and threat of deflation are far from
dead. Several economists have argued that the Japanese economy appears to
be caught in a ‘liquidity trap’ (Krugman, 1998). Krugman (1999) writes:
Even now, many economists still think of recessions as a minor issue, their study
as a faintly disreputable subject; the trendy work has all been concerned with
technological progress and long-run growth. These are fine important questions,
and in the long run they are what really matters … Meanwhile, in the short run the
world is lurching from crisis to crisis, all of them crucially involving the problem
of generating sufficient demand … Once again, the question of how to keep
demand adequate to make use of the economy’s capacity has become crucial.
Depression economics is back.
So even given that there were significant deficiencies in the orthodox Keynesian
framework that required new thinking, the issues that concerned Keynes have
not disappeared.
In the next chapter we discuss the development of the orthodox monetarist
school which, over the period of the mid-1950s to the early 1970s, highlighted
a number of weaknesses both at the theoretical and empirical levels of
the then-prevailing orthodox Keynesian framework.
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