Three Important Interpretations of Keynes
In the vast literature relating to Keynes’s contribution since 1936 we can
identify three distinct interpretations which command varying degrees of
support (see Snowdon and Vane, 1997a). Coddington (1983) identifies three
interpretations, namely: (i) the ‘hydraulic’ interpretation, (ii) the ‘fundamentalist’
interpretation, and (iii) the modified general equilibrium approach.
The ‘hydraulic’ interpretation
This is the orthodox interpretation of Keynes initiated and inspired by Hicks
(1937), Modigliani (1944), Klein (1947), Samuelson (1948) and Hansen
(1953). The IS–LM model formed the backbone of theorizing within this
approach and it dominated thinking in the emerging neoclassical synthesis
during the 1950s and 1960s. Samuelson’s famous textbook, Economics, first
published in 1948, played a very important role here, popularizing Keynes
with the aid of the 45° Keynesian cross diagram. Following Modigliani’s
contribution, Keynesian economics was seen to be the economics of wage
and price rigidities. The destabilizing impact of unstable expectations was
played down in this approach. Although Keynesians such as Modigliani and
Tobin worked on improving the microfoundations of Keynes’s model, a major
weakness of hydraulic Keynesianism was the lack of a convincing reason
for wage and price rigidities based on rational behaviour. The ideas associated
with this hydraulic variety of Keynesianism are developed in Chapter 3,
while the more recent attempts by new Keynesian theorists to rectify the
theoretical shortcomings of the neoclassical synthesis model are examined in
Chapter 7.
The ‘fundamentalist’ interpretation
This interpretation of the General Theory regards Keynes’s work as a frontal
assault on neoclassical orthodoxy. Fundamentalists regard the influence of
unstable expectations due to uncertainty as a key feature of Keynes’s work,
particularly as expressed in Chapters 12 and 17 of the General Theory, where
he discusses ‘The State of Long-Term Expectations’ and ‘The Essential Properties
of Interest and Money’. Fundamentalists also point to Keynes’s (1937)
Quarterly Journal of Economics article entitled ‘The General Theory of
Employment’, which Keynes wrote in response to his critics, as evidence that
the problems of decision making under conditions of uncertainty lay at the
heart of his system. The key figures in this school include George Shackle
(1967, 1974) and Joan Robinson (1962), although a very early statement can
be found in Townshend (1937). Fundamentalists reject the hydraulic interpretation
as a ‘bastardization’ of Keynes’s contribution. The ideas and development
of this Post Keynesian school are explored in Chapter 8.
The modified general equilibrium approach
Coddington (1983) refers to this view as ‘reconstituted reductionism’
(reductionists are those economists whose method of analysis consists of
‘analysing markets on the basis of the choices made by individual traders’;
see Coddington, 1983, p. 92). This approach initially received stimulus from
Patinkin’s (1956) suggestion that Keynesian economics is the economics of
unemployment disequilibrium and that involuntary unemployment should be
viewed as a problem of dynamic disequilibrium. In Patinkin’s analysis, involuntary
unemployment can exist in a perfectly competitive economy with
flexible wages and prices. The emphasis given by Patinkin to the speed with
which markets are able to absorb and rectify shocks shifted attention away
from the degree of price and wage flexibility to the issue of coordination.
This line of enquiry was followed by Clower (1965) and Leijonhufvud (1968),
who developed a modified general equilibrium approach along Walrasian
lines in order to make sense of coordination problems which inevitably
emerge in a market economy operating without the fictional ‘auctioneer’. If
the hydraulic interpretation played down Keynes’s contribution as a theorist,
the reconstituted, reductionist approach attempts to rehabilitate the General
Theory as a pioneering exercise in disequilibrium dynamics.
Clower’s reinterpretation of the General Theory suggests that Keynes’s
revolt was against the Walrasian general equilibrium tradition within neoclassical
economics. In the Walrasian paradigm all markets continuously clear
thanks to the work of the fictional auctioneer. Building on the insights of
Patinkin (1956), Clower’s work emphasizes the dynamic disequilibrium nature
of Keynes’s work. Clower argues that Keynes’s objective was to kill off
the auctioneer myth in order to raise the profile of information and
intertemporal coordination difficulties within real economies. The cumulative
declines in output in Keynes’s General Theory result from massive coordination
failures as agents respond to wrong (false) price signals. Once the
assumption of instantaneously adjusted prices is abandoned there is no longer
any guarantee that a decentralized price system will coordinate economic
activity at full employment. Once again the classical model is shown to be a
‘special case’, and Keynes’s theory the more ‘general’ theory. Clower has
continued to be highly critical of all the mainstream macro schools for not
taking market processes seriously. To do so involves recognizing that markets
and monetary institutions are created by firms, individuals and governments.
In Clower’s view, in order to really understand market processes economists
need to create a ‘Post Walrasian Macroeconomics’ based on Marshallian
rather than Walrasian microfoundations (Clower and Howitt, 1996; Colander,
1996). While Keynes had a profound influence on the development of macroeconomics,
his anti-formalist approach was swept away by the ‘Walrasian
formalism’ of mainstream theorists in the post-1945 period (Backhouse,
1997a).
In the 1970s several economists inspired by Clower’s insights went on to
develop neo-Keynesian quantity-constrained models (Barro and Grossman,
1976; Malinvaud, 1977). This work served to remind economists that conventional
Keynesian models lacked solid microfoundations (Barro, 1979). This
was a theme the new classical economists were to exploit throughout the
1970s but in a very different way from that favoured by Clower. During the
1970s the new classical approach prospered while the neo-Keynesian models
gradually fell out of favour, not least because high inflation made fix-price
models appear ‘unrealistic’ (Backhouse, 1995).
In the mid to late 1960s, Axel Leijonhufvud also provided an influential
and provocative interpretation of Keynes’s General Theory. His dissertation
thesis, On Keynesian Economics and the Economics of Keynes, was an instantaneous
success when published in 1968 and became the subject of
Keynes v. the ‘old’ classical model 73
intense debate and controversy given its novel analysis of Keynes’s most
influential contribution. Leijonhufvud elaborates upon the Clower theme by
building an ‘economics of Keynes’ that is distinct from the Walrasian
Keynesianism that characterizes the mainstream neoclassical synthesis interpretation.
Leijonhufvud, following Patinkin (1948), provides a neo-Walrasian
interpretation of Keynes which focuses on the process and implications of
disequilibrium trading and coordination failure. In doing so, Leijonhufvud
shows how Keynes’s (1936, p. 15) concept of ‘involuntary unemployment’
emerges as a dynamic disequilibrium phenomenon. In Leijonhufvud’s reinterpretation
of the General Theory, Keynes’s main innovation is seen to be
his attempt at providing a coherent and systematic analysis of how a predominantly
private enterprise market economy reacts, responds and adjusts in
the short run to aggregate demand shocks when price and wage adjustments
are less than perfectly flexible. The Walrasian assumptions of instantaneous
price and wage flexibility and complete information are nothing more than a
fiction. Leijonhufvud therefore argues that Keynes provided a more General
Theory where the incomplete information of agents prevents the economic
system from moving quickly and smoothly to a new equilibrium following an
aggregate demand shock. Leijonhufvud’s reinterpretation of Keynes attempts
to show that the content of the General Theory is consistent with a choicetheoretic
framework providing the key assumption, that agents have complete
information when trading, is abandoned. There is no need to resort to imposing
institutional rigidities (such as rigid nominal wages) on the price
mechanism to generate Keynesian outcomes. This is a direct refutation of the
‘Keynesian Gospel According to Modigliani’ (2003). The late Nobel Memorial
Laureate Franco Modigliani (2003) continued to maintain that ‘the essence
of Keynesian economics is wage rigidity. That is Keynes’ (see the interview
with Modigliani in Snowdon and Vane, 1999b, and Chapter 3).
Leijonhufvud suggests that the neoclassical synthesis interpretation of
Keynes provides an incoherent theoretical basis for a Keynesian revolution.
He argues that Keynes recognized the difficulties experienced, within decentralized
market economies, of finding the appropriate market-clearing price
vector. In Keynes’s vision, the initial response to shocks on the system is via
quantity adjustment rather than price adjustment, with the relative speed of
adjustment of the latter tending to lag behind the former (a reversal of the
Walrasian approach). In the absence of the fictional ‘Walrasian auctioneer’,
the key issue focuses on the control mechanisms and relates to the generation
and dissemination of information. According to Leijonhufvud, the information
and coordination deficiencies lead to deviation-amplifying (positive
feedback) processes, such as the multiplier, which were played down by the
Walrasian synthesis which highlighted the deviation-counteracting (negative
feedback) mechanisms.
Leijonhufvud argues that the neoclassical synthesis totally misunderstands
and misinterprets Keynes (Leijonhufvud, 1981; Snowdon, 2004a). The orthodox
Keynesian story highlights elements that play no real part in the argument
of the General Theory (but a significant part in the work of the Keynesians) –
such as the claims that wages are rigid; that the liquidity trap exists in
actuality; and that investment is interest-inelastic. Leijonhufvud controversially
maintains that none of these essential Keynesian building blocks is to
be found in the economics of Keynes (see Chapter 3).
After the initial enthusiasm and wide interest that Leijonhufvud’s interpretation
of Keynes aroused during the 1970s, the younger generation of
economists were soon caught up in the excitement created by the ‘rational
expectations’ revolution inspired by Robert Lucas (see Chapter 5). Interest in
Keynes and Keynesian economics began to wane. By his own admission
Leijonhufvud (1993) ‘drifted out of the professional mainstream from the
mid-1970s onwards, as intertemporal optimisation became all the rage’. As
Leijonhufvud (1998a) recalls, ‘macroeconomics seemed to have taken a turn
very similar to the movies: more and more simple-minded plots but ever
more mind-boggling special effects. One would like to look forward to a
macroeconomics whose plots will give more insight into the human condition.’
While the younger generation of new classical economists was
everywhere pronouncing the end of the Keynesian era and embracing rational
expectations and equilibrium theories of the business cycle, Leijonhufvud
has continued to argue that Keynesian economics has a future. Leijonhufvud
(1992) suggests two main reasons for such optimism. First, the coordination
problem is too important an issue to be kept indefinitely off economists’
research agenda. ‘Will the market system “automatically” coordinate economic
activities? Always? Never? Sometimes very well, but sometimes pretty
badly? If the latter, under what conditions, and with what institutional structures,
will it do well or do badly?’ Leijonhufvud regards these questions as
the central ones in macroeconomics. Second, Leijonhufvud believes that
sooner or later economists must open up their theoretical structures to allow
results from other behavioural sciences to be utilized in economic analysis.
When that happens, ‘the “unbounded rationality” postulate will have to go’.
In his Nobel Memorial Lecture, George Akerlof (2002) also presents a
strong case for strengthening macroeconomic theory by incorporating assumptions
that take account of behaviour such as ‘cognitive bias, reciprocity,
fairness, herding and social status’. By doing so Akerlof argues that macroeconomics
will ‘no longer suffer from the “ad hockery” of the neoclassical
synthesis which had overridden the emphasis in the General Theory on the
role of psychological and sociological factors’. Since in Akerlof’s view
Keynes’s General Theory ‘was the greatest contribution to behavioural economics
before the present era’, it would seem that economists need to
rediscover the ‘wild side’ of macroeconomic behaviour in order to begin the
construction of ‘a not too rational macroeconomics’ (Leijonhufvud, 1993).
The interested reader is referred to Chapter 3, section 3.5 (and references
therein) of Snowdon, et al. (1994), for a more detailed discussion of the work
of Clower, Leijonhufvud and Malinvaud.
In the vast literature relating to Keynes’s contribution since 1936 we can
identify three distinct interpretations which command varying degrees of
support (see Snowdon and Vane, 1997a). Coddington (1983) identifies three
interpretations, namely: (i) the ‘hydraulic’ interpretation, (ii) the ‘fundamentalist’
interpretation, and (iii) the modified general equilibrium approach.
The ‘hydraulic’ interpretation
This is the orthodox interpretation of Keynes initiated and inspired by Hicks
(1937), Modigliani (1944), Klein (1947), Samuelson (1948) and Hansen
(1953). The IS–LM model formed the backbone of theorizing within this
approach and it dominated thinking in the emerging neoclassical synthesis
during the 1950s and 1960s. Samuelson’s famous textbook, Economics, first
published in 1948, played a very important role here, popularizing Keynes
with the aid of the 45° Keynesian cross diagram. Following Modigliani’s
contribution, Keynesian economics was seen to be the economics of wage
and price rigidities. The destabilizing impact of unstable expectations was
played down in this approach. Although Keynesians such as Modigliani and
Tobin worked on improving the microfoundations of Keynes’s model, a major
weakness of hydraulic Keynesianism was the lack of a convincing reason
for wage and price rigidities based on rational behaviour. The ideas associated
with this hydraulic variety of Keynesianism are developed in Chapter 3,
while the more recent attempts by new Keynesian theorists to rectify the
theoretical shortcomings of the neoclassical synthesis model are examined in
Chapter 7.
The ‘fundamentalist’ interpretation
This interpretation of the General Theory regards Keynes’s work as a frontal
assault on neoclassical orthodoxy. Fundamentalists regard the influence of
unstable expectations due to uncertainty as a key feature of Keynes’s work,
particularly as expressed in Chapters 12 and 17 of the General Theory, where
he discusses ‘The State of Long-Term Expectations’ and ‘The Essential Properties
of Interest and Money’. Fundamentalists also point to Keynes’s (1937)
Quarterly Journal of Economics article entitled ‘The General Theory of
Employment’, which Keynes wrote in response to his critics, as evidence that
the problems of decision making under conditions of uncertainty lay at the
heart of his system. The key figures in this school include George Shackle
(1967, 1974) and Joan Robinson (1962), although a very early statement can
be found in Townshend (1937). Fundamentalists reject the hydraulic interpretation
as a ‘bastardization’ of Keynes’s contribution. The ideas and development
of this Post Keynesian school are explored in Chapter 8.
The modified general equilibrium approach
Coddington (1983) refers to this view as ‘reconstituted reductionism’
(reductionists are those economists whose method of analysis consists of
‘analysing markets on the basis of the choices made by individual traders’;
see Coddington, 1983, p. 92). This approach initially received stimulus from
Patinkin’s (1956) suggestion that Keynesian economics is the economics of
unemployment disequilibrium and that involuntary unemployment should be
viewed as a problem of dynamic disequilibrium. In Patinkin’s analysis, involuntary
unemployment can exist in a perfectly competitive economy with
flexible wages and prices. The emphasis given by Patinkin to the speed with
which markets are able to absorb and rectify shocks shifted attention away
from the degree of price and wage flexibility to the issue of coordination.
This line of enquiry was followed by Clower (1965) and Leijonhufvud (1968),
who developed a modified general equilibrium approach along Walrasian
lines in order to make sense of coordination problems which inevitably
emerge in a market economy operating without the fictional ‘auctioneer’. If
the hydraulic interpretation played down Keynes’s contribution as a theorist,
the reconstituted, reductionist approach attempts to rehabilitate the General
Theory as a pioneering exercise in disequilibrium dynamics.
Clower’s reinterpretation of the General Theory suggests that Keynes’s
revolt was against the Walrasian general equilibrium tradition within neoclassical
economics. In the Walrasian paradigm all markets continuously clear
thanks to the work of the fictional auctioneer. Building on the insights of
Patinkin (1956), Clower’s work emphasizes the dynamic disequilibrium nature
of Keynes’s work. Clower argues that Keynes’s objective was to kill off
the auctioneer myth in order to raise the profile of information and
intertemporal coordination difficulties within real economies. The cumulative
declines in output in Keynes’s General Theory result from massive coordination
failures as agents respond to wrong (false) price signals. Once the
assumption of instantaneously adjusted prices is abandoned there is no longer
any guarantee that a decentralized price system will coordinate economic
activity at full employment. Once again the classical model is shown to be a
‘special case’, and Keynes’s theory the more ‘general’ theory. Clower has
continued to be highly critical of all the mainstream macro schools for not
taking market processes seriously. To do so involves recognizing that markets
and monetary institutions are created by firms, individuals and governments.
In Clower’s view, in order to really understand market processes economists
need to create a ‘Post Walrasian Macroeconomics’ based on Marshallian
rather than Walrasian microfoundations (Clower and Howitt, 1996; Colander,
1996). While Keynes had a profound influence on the development of macroeconomics,
his anti-formalist approach was swept away by the ‘Walrasian
formalism’ of mainstream theorists in the post-1945 period (Backhouse,
1997a).
In the 1970s several economists inspired by Clower’s insights went on to
develop neo-Keynesian quantity-constrained models (Barro and Grossman,
1976; Malinvaud, 1977). This work served to remind economists that conventional
Keynesian models lacked solid microfoundations (Barro, 1979). This
was a theme the new classical economists were to exploit throughout the
1970s but in a very different way from that favoured by Clower. During the
1970s the new classical approach prospered while the neo-Keynesian models
gradually fell out of favour, not least because high inflation made fix-price
models appear ‘unrealistic’ (Backhouse, 1995).
In the mid to late 1960s, Axel Leijonhufvud also provided an influential
and provocative interpretation of Keynes’s General Theory. His dissertation
thesis, On Keynesian Economics and the Economics of Keynes, was an instantaneous
success when published in 1968 and became the subject of
Keynes v. the ‘old’ classical model 73
intense debate and controversy given its novel analysis of Keynes’s most
influential contribution. Leijonhufvud elaborates upon the Clower theme by
building an ‘economics of Keynes’ that is distinct from the Walrasian
Keynesianism that characterizes the mainstream neoclassical synthesis interpretation.
Leijonhufvud, following Patinkin (1948), provides a neo-Walrasian
interpretation of Keynes which focuses on the process and implications of
disequilibrium trading and coordination failure. In doing so, Leijonhufvud
shows how Keynes’s (1936, p. 15) concept of ‘involuntary unemployment’
emerges as a dynamic disequilibrium phenomenon. In Leijonhufvud’s reinterpretation
of the General Theory, Keynes’s main innovation is seen to be
his attempt at providing a coherent and systematic analysis of how a predominantly
private enterprise market economy reacts, responds and adjusts in
the short run to aggregate demand shocks when price and wage adjustments
are less than perfectly flexible. The Walrasian assumptions of instantaneous
price and wage flexibility and complete information are nothing more than a
fiction. Leijonhufvud therefore argues that Keynes provided a more General
Theory where the incomplete information of agents prevents the economic
system from moving quickly and smoothly to a new equilibrium following an
aggregate demand shock. Leijonhufvud’s reinterpretation of Keynes attempts
to show that the content of the General Theory is consistent with a choicetheoretic
framework providing the key assumption, that agents have complete
information when trading, is abandoned. There is no need to resort to imposing
institutional rigidities (such as rigid nominal wages) on the price
mechanism to generate Keynesian outcomes. This is a direct refutation of the
‘Keynesian Gospel According to Modigliani’ (2003). The late Nobel Memorial
Laureate Franco Modigliani (2003) continued to maintain that ‘the essence
of Keynesian economics is wage rigidity. That is Keynes’ (see the interview
with Modigliani in Snowdon and Vane, 1999b, and Chapter 3).
Leijonhufvud suggests that the neoclassical synthesis interpretation of
Keynes provides an incoherent theoretical basis for a Keynesian revolution.
He argues that Keynes recognized the difficulties experienced, within decentralized
market economies, of finding the appropriate market-clearing price
vector. In Keynes’s vision, the initial response to shocks on the system is via
quantity adjustment rather than price adjustment, with the relative speed of
adjustment of the latter tending to lag behind the former (a reversal of the
Walrasian approach). In the absence of the fictional ‘Walrasian auctioneer’,
the key issue focuses on the control mechanisms and relates to the generation
and dissemination of information. According to Leijonhufvud, the information
and coordination deficiencies lead to deviation-amplifying (positive
feedback) processes, such as the multiplier, which were played down by the
Walrasian synthesis which highlighted the deviation-counteracting (negative
feedback) mechanisms.
Leijonhufvud argues that the neoclassical synthesis totally misunderstands
and misinterprets Keynes (Leijonhufvud, 1981; Snowdon, 2004a). The orthodox
Keynesian story highlights elements that play no real part in the argument
of the General Theory (but a significant part in the work of the Keynesians) –
such as the claims that wages are rigid; that the liquidity trap exists in
actuality; and that investment is interest-inelastic. Leijonhufvud controversially
maintains that none of these essential Keynesian building blocks is to
be found in the economics of Keynes (see Chapter 3).
After the initial enthusiasm and wide interest that Leijonhufvud’s interpretation
of Keynes aroused during the 1970s, the younger generation of
economists were soon caught up in the excitement created by the ‘rational
expectations’ revolution inspired by Robert Lucas (see Chapter 5). Interest in
Keynes and Keynesian economics began to wane. By his own admission
Leijonhufvud (1993) ‘drifted out of the professional mainstream from the
mid-1970s onwards, as intertemporal optimisation became all the rage’. As
Leijonhufvud (1998a) recalls, ‘macroeconomics seemed to have taken a turn
very similar to the movies: more and more simple-minded plots but ever
more mind-boggling special effects. One would like to look forward to a
macroeconomics whose plots will give more insight into the human condition.’
While the younger generation of new classical economists was
everywhere pronouncing the end of the Keynesian era and embracing rational
expectations and equilibrium theories of the business cycle, Leijonhufvud
has continued to argue that Keynesian economics has a future. Leijonhufvud
(1992) suggests two main reasons for such optimism. First, the coordination
problem is too important an issue to be kept indefinitely off economists’
research agenda. ‘Will the market system “automatically” coordinate economic
activities? Always? Never? Sometimes very well, but sometimes pretty
badly? If the latter, under what conditions, and with what institutional structures,
will it do well or do badly?’ Leijonhufvud regards these questions as
the central ones in macroeconomics. Second, Leijonhufvud believes that
sooner or later economists must open up their theoretical structures to allow
results from other behavioural sciences to be utilized in economic analysis.
When that happens, ‘the “unbounded rationality” postulate will have to go’.
In his Nobel Memorial Lecture, George Akerlof (2002) also presents a
strong case for strengthening macroeconomic theory by incorporating assumptions
that take account of behaviour such as ‘cognitive bias, reciprocity,
fairness, herding and social status’. By doing so Akerlof argues that macroeconomics
will ‘no longer suffer from the “ad hockery” of the neoclassical
synthesis which had overridden the emphasis in the General Theory on the
role of psychological and sociological factors’. Since in Akerlof’s view
Keynes’s General Theory ‘was the greatest contribution to behavioural economics
before the present era’, it would seem that economists need to
rediscover the ‘wild side’ of macroeconomic behaviour in order to begin the
construction of ‘a not too rational macroeconomics’ (Leijonhufvud, 1993).
The interested reader is referred to Chapter 3, section 3.5 (and references
therein) of Snowdon, et al. (1994), for a more detailed discussion of the work
of Clower, Leijonhufvud and Malinvaud.
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