Theoretical Schizophrenia and the Neoclassical Synthesis
We can only speculate on what Keynes would have made of the Keynesian
policies carried out in his name. What we can see more clearly, with the benefit
of hindsight and experience, is that at the theoretical level Keynesian economics
created schizophrenia in the way that economics was taught, with courses in
microeconomics typically concentrating on issues relating to allocation, production
and distribution (questions of efficiency and equity) and courses in
macroeconomics focusing on problems associated with the level and the longterm
trend of aggregate output and employment, and the rate of inflation
(questions of growth and stability). The Keynesian propositions of market
failure and involuntary unemployment expounded within macroeconomics did
not rest easily alongside the Walrasian theory of general competitive equilibrium,
where the actions of rational optimizing individuals ensure that all markets,
including the labour market, are cleared by flexible prices. In the Walrasian
model, which dominated microeconomics, lapses from full employment cannot
occur. Although Paul Samuelson and others attempted to reconcile these two
strands of economics, producing a ‘neoclassical synthesis’, Keynesian macroeconomics
and orthodox neoclassical microeconomics integrated about as
well as oil and water. During the ‘Golden Age’ this problem could be ignored.
By 1973, with accelerating inflation, it could not. As Greenwald and Stiglitz
(1987) have argued, from this point there were two ways in which the two subdisciplines
could be reconciled. Either macro theory could be adapted to orthodox
neoclassical micro theory (the new classical approach) or micro theory could
be adapted to macro theory (the new Keynesian approach). As we shall see,
these attempts at reconciliation have been a dominating influence on macroeconomic
theorizing during the past three decades.
Keynes himself had contributed to this dichotomy because he saw ‘no
reason to suppose that the existing system seriously misemploys the factors
of production which are in use … It is in determining the volume, not the
direction, of actual employment that the existing system has broken down’
(Keynes, 1936, p. 379). In other words, the apparent inability of the capitalist
system to provide for full employment was the main blemish on an economic
system which Keynes otherwise held in high regard. Once this major defect
was remedied and full employment restored, ‘the classical theory comes into
its own again from this point onwards’ and there ‘is no objection to be raised
against classical analysis of the manner in which private self-interest will
determine what in particular is produced, in what proportions the factors of
production will be combined to produce it, and how the value of the final
product will be distributed between them’ (Keynes, 1936, pp. 378–9). Thus
Keynes can be viewed as attempting to reconcile two opposing views of a
capitalist market economy. First, we have the classical–neoclassical view
which extols the efficiency of the price mechanism in solving the fundamental
allocation and production problems which arise from the scarcity of
resources. Second, we have Keynes’s iconoclastic vision which highlights the
shortcomings of the invisible hand, at least with respect to the general level
of output and employment. Keynes was optimistic that this later problem
could be solved with limited government intervention, and capitalism could
be saved from itself.
The synthesis of the ideas of the classical economists with those of Keynes
dominated mainstream economics at least until the early 1970s. The standard
textbook approach to macroeconomics from the period following the Second
World War until the early 1970s relied heavily on the interpretation of the
General Theory provided by Hicks (1937) and modified by the contributions
of Modigliani (1944), Patinkin (1956) and Tobin (1958). Samuelson’s bestselling
textbook popularized the synthesis of Keynesian and classical ideas,
making them accessible to a wide readership and successive generations of
students. It was Samuelson who introduced the label ‘neoclassical synthesis’
into the literature in the third edition of Economics, in 1955. This synthesis of
classical and Keynesian ideas became the standard approach to macroeconomic
analysis, both in textbooks and in professional discussion (see Chapter
3). The orthodox Keynesian model provided the foundation for the largescale
macroeconometric models developed by Lawrence Klein and also those
associated with the Cowles Commission. Such models were used for forecasting
purposes and to enable economists to assess the likely impact on the
economy of alternative economic policies. Lucas and Sargent (1978) have
attributed the ‘dominant scientific position’ that orthodox Keynesian economics
attained by 1960 to the fact that it ‘lent itself so readily to the formulation
of explicit econometric models’. As far as macroeconomics was concerned,
for the majority of researchers in the 1960s, the ‘Keynesian model was the
only game in town’ (Barro, 1989a).
The orthodox Keynesian argument that government intervention, in the
form of activist monetary and fiscal policies, could correct the aggregate
instability exhibited by market economies also influenced political decision
makers. At least up until the mid-1970s both Labour and Conservative parties
in the UK adhered to orthodox Keynesian principles. In the USA it was not
until the early 1960s that the Keynesian approach (known as the ‘New Economics’)
was adopted with any real enthusiasm (Tobin, 1987; Perry and
Tobin, 2000). The Council of Economic Advisers (CEA) appointed by President
Kennedy was dominated by Keynesian economists. Chaired by Walter
Heller, the CEA also included James Tobin and Robert Solow while Paul
Samuelson served as an unofficial adviser (see Snowdon and Vane, 2002a). In
1971 even President Nixon had declared that ‘we are all Keynesians now!’
However, by the 1980s, US economic policy was very different from that
prevailing during the Kennedy–Johnson era (see Feldstein, 1992).
Before the 1970s the Keynesian approach gave emphasis to demand-side
factors. Keynes had reversed Say’s Law, and Keynesianism, based on the IS–
LM interpretation of Keynes, was the established orthodoxy in macroeconomics
(see Chapter 3 and Patinkin, 1990a, for a discussion of the IS–LM interpretation
of Keynes). Initially Keynesianism was associated with fiscalism but by
the late 1960s the importance of monetary factors was widely recognized by
Keynesians (see Tobin, 1987, 1996; Buiter, 2003a). The most important
Keynesian development during this period was the incorporation of the Phillips
curve into the prevailing macroeconomic model (see Phillips, 1958; Lipsey,
1978; Chapter 3). By the early 1960s the IS–LM model was being used to
explain the determination of output and employment, while the Phillips curve
enabled the policy maker to predict the rate of inflation which would result
from different target levels of unemployment. The simultaneous increase in
both unemployment and inflation (shown in Tables 1.4 and 1.5) in the major
industrial economies in the early 1970s proved fatal to the more simplistic
versions of ‘hydraulic’ Keynesianism and prepared the way for the monetarist
and new classical counter-revolutions (see Johnson, 1971; Bleaney, 1985; Colander,
1988). The 1970s witnessed a significant renaissance of the pre-Keynesian
belief that the market economy is capable of achieving macroeconomic stability
and rapid growth providing the visible (and palsied) hand of government is
prevented from conducting activist discretionary fiscal and monetary policies.
The stagflation of the 1970s gave increasing credibility and influence to those
economists who had for many years warned that Keynesian macroeconomic
policies were both over-ambitious and, more importantly, predicated on theories
that were fundamentally flawed (see Friedman, 1968a; Hayek, 1978;
Buchanan et al., 1978; Lucas and Sargent, 1978; Romer and Romer, 1997).
The demise of the neoclassical synthesis mainstream position signalled the
beginning of a period when the dominance of Keynesian macroeconomics
came to an end and, as we have seen, the breakdown of this consensus
position was due to both empirical and theoretical flaws (see Mankiw, 1990).
For the more extreme critics of Keynesianism the task facing the new generation
of macroeconomic theorists was to ‘sort through the wreckage determining
which features of that remarkable intellectual event called the Keynesian
revolution can be salvaged and put to good use and which others must be
discarded’ (Lucas and Sargent, 1978).
We can only speculate on what Keynes would have made of the Keynesian
policies carried out in his name. What we can see more clearly, with the benefit
of hindsight and experience, is that at the theoretical level Keynesian economics
created schizophrenia in the way that economics was taught, with courses in
microeconomics typically concentrating on issues relating to allocation, production
and distribution (questions of efficiency and equity) and courses in
macroeconomics focusing on problems associated with the level and the longterm
trend of aggregate output and employment, and the rate of inflation
(questions of growth and stability). The Keynesian propositions of market
failure and involuntary unemployment expounded within macroeconomics did
not rest easily alongside the Walrasian theory of general competitive equilibrium,
where the actions of rational optimizing individuals ensure that all markets,
including the labour market, are cleared by flexible prices. In the Walrasian
model, which dominated microeconomics, lapses from full employment cannot
occur. Although Paul Samuelson and others attempted to reconcile these two
strands of economics, producing a ‘neoclassical synthesis’, Keynesian macroeconomics
and orthodox neoclassical microeconomics integrated about as
well as oil and water. During the ‘Golden Age’ this problem could be ignored.
By 1973, with accelerating inflation, it could not. As Greenwald and Stiglitz
(1987) have argued, from this point there were two ways in which the two subdisciplines
could be reconciled. Either macro theory could be adapted to orthodox
neoclassical micro theory (the new classical approach) or micro theory could
be adapted to macro theory (the new Keynesian approach). As we shall see,
these attempts at reconciliation have been a dominating influence on macroeconomic
theorizing during the past three decades.
Keynes himself had contributed to this dichotomy because he saw ‘no
reason to suppose that the existing system seriously misemploys the factors
of production which are in use … It is in determining the volume, not the
direction, of actual employment that the existing system has broken down’
(Keynes, 1936, p. 379). In other words, the apparent inability of the capitalist
system to provide for full employment was the main blemish on an economic
system which Keynes otherwise held in high regard. Once this major defect
was remedied and full employment restored, ‘the classical theory comes into
its own again from this point onwards’ and there ‘is no objection to be raised
against classical analysis of the manner in which private self-interest will
determine what in particular is produced, in what proportions the factors of
production will be combined to produce it, and how the value of the final
product will be distributed between them’ (Keynes, 1936, pp. 378–9). Thus
Keynes can be viewed as attempting to reconcile two opposing views of a
capitalist market economy. First, we have the classical–neoclassical view
which extols the efficiency of the price mechanism in solving the fundamental
allocation and production problems which arise from the scarcity of
resources. Second, we have Keynes’s iconoclastic vision which highlights the
shortcomings of the invisible hand, at least with respect to the general level
of output and employment. Keynes was optimistic that this later problem
could be solved with limited government intervention, and capitalism could
be saved from itself.
The synthesis of the ideas of the classical economists with those of Keynes
dominated mainstream economics at least until the early 1970s. The standard
textbook approach to macroeconomics from the period following the Second
World War until the early 1970s relied heavily on the interpretation of the
General Theory provided by Hicks (1937) and modified by the contributions
of Modigliani (1944), Patinkin (1956) and Tobin (1958). Samuelson’s bestselling
textbook popularized the synthesis of Keynesian and classical ideas,
making them accessible to a wide readership and successive generations of
students. It was Samuelson who introduced the label ‘neoclassical synthesis’
into the literature in the third edition of Economics, in 1955. This synthesis of
classical and Keynesian ideas became the standard approach to macroeconomic
analysis, both in textbooks and in professional discussion (see Chapter
3). The orthodox Keynesian model provided the foundation for the largescale
macroeconometric models developed by Lawrence Klein and also those
associated with the Cowles Commission. Such models were used for forecasting
purposes and to enable economists to assess the likely impact on the
economy of alternative economic policies. Lucas and Sargent (1978) have
attributed the ‘dominant scientific position’ that orthodox Keynesian economics
attained by 1960 to the fact that it ‘lent itself so readily to the formulation
of explicit econometric models’. As far as macroeconomics was concerned,
for the majority of researchers in the 1960s, the ‘Keynesian model was the
only game in town’ (Barro, 1989a).
The orthodox Keynesian argument that government intervention, in the
form of activist monetary and fiscal policies, could correct the aggregate
instability exhibited by market economies also influenced political decision
makers. At least up until the mid-1970s both Labour and Conservative parties
in the UK adhered to orthodox Keynesian principles. In the USA it was not
until the early 1960s that the Keynesian approach (known as the ‘New Economics’)
was adopted with any real enthusiasm (Tobin, 1987; Perry and
Tobin, 2000). The Council of Economic Advisers (CEA) appointed by President
Kennedy was dominated by Keynesian economists. Chaired by Walter
Heller, the CEA also included James Tobin and Robert Solow while Paul
Samuelson served as an unofficial adviser (see Snowdon and Vane, 2002a). In
1971 even President Nixon had declared that ‘we are all Keynesians now!’
However, by the 1980s, US economic policy was very different from that
prevailing during the Kennedy–Johnson era (see Feldstein, 1992).
Before the 1970s the Keynesian approach gave emphasis to demand-side
factors. Keynes had reversed Say’s Law, and Keynesianism, based on the IS–
LM interpretation of Keynes, was the established orthodoxy in macroeconomics
(see Chapter 3 and Patinkin, 1990a, for a discussion of the IS–LM interpretation
of Keynes). Initially Keynesianism was associated with fiscalism but by
the late 1960s the importance of monetary factors was widely recognized by
Keynesians (see Tobin, 1987, 1996; Buiter, 2003a). The most important
Keynesian development during this period was the incorporation of the Phillips
curve into the prevailing macroeconomic model (see Phillips, 1958; Lipsey,
1978; Chapter 3). By the early 1960s the IS–LM model was being used to
explain the determination of output and employment, while the Phillips curve
enabled the policy maker to predict the rate of inflation which would result
from different target levels of unemployment. The simultaneous increase in
both unemployment and inflation (shown in Tables 1.4 and 1.5) in the major
industrial economies in the early 1970s proved fatal to the more simplistic
versions of ‘hydraulic’ Keynesianism and prepared the way for the monetarist
and new classical counter-revolutions (see Johnson, 1971; Bleaney, 1985; Colander,
1988). The 1970s witnessed a significant renaissance of the pre-Keynesian
belief that the market economy is capable of achieving macroeconomic stability
and rapid growth providing the visible (and palsied) hand of government is
prevented from conducting activist discretionary fiscal and monetary policies.
The stagflation of the 1970s gave increasing credibility and influence to those
economists who had for many years warned that Keynesian macroeconomic
policies were both over-ambitious and, more importantly, predicated on theories
that were fundamentally flawed (see Friedman, 1968a; Hayek, 1978;
Buchanan et al., 1978; Lucas and Sargent, 1978; Romer and Romer, 1997).
The demise of the neoclassical synthesis mainstream position signalled the
beginning of a period when the dominance of Keynesian macroeconomics
came to an end and, as we have seen, the breakdown of this consensus
position was due to both empirical and theoretical flaws (see Mankiw, 1990).
For the more extreme critics of Keynesianism the task facing the new generation
of macroeconomic theorists was to ‘sort through the wreckage determining
which features of that remarkable intellectual event called the Keynesian
revolution can be salvaged and put to good use and which others must be
discarded’ (Lucas and Sargent, 1978).
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