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Keynes

Historical background

The outbreak of the First World War ushered in what Hobsbawm rightly called the “age of catastrophes.” The world had not yet recovered from the trauma of the war when on October 29, 1929, the stock market crash on Wall Street, known hereinafter as “Black Thursday”, became the reference for the beginning of the longest depression of the world history of modern capitalism, which is renamed, in its own right, the “Great Depression.” In the eight years from 1930 to 1938, the unemployment rate in the United States averaged 26%, in Germany 22%, and in the United Kingdom 15%. Strictly speaking, the recovery of production and employment would come much later and in circumstances that were not too pleasant, linked to the gigantic process of rearmament of the powers. Thus, the Second World War that broke out in 1939 and claimed more than 60 million lives was one of the main sources for industrial reactivation after the crisis of the 1930s. 

In the field of economic theory, the Marginalist school in its Marshallian version, the Neoclassics, achieved hegemony, with the help of the so-called second generation of a legion of economists whose presence was felt in the major centres of world powers. The period during which John Maynard Keynes (1883-1946) developed his theoretical production was plagued, as can be seen, with great novelties in the field of economic debates, which lagged behind historical events. One of the major debates was  associated with the problem of massive and prolonged unemployment during the Great Depression. 

Thus, during the interwar period, a considerable number of economists expressed their dissatisfaction with the traditional theory since the Neoclassical theoretical system failed to account for the causes of inflation, deflation and unemployment, that is, it did not have answers to the dilemmas of the time. Keynes was part of this broad movement, but among all the theoretical efforts that were made, it was his General Theory of Occupation, Interest and Money of 1936, the work that managed to break with orthodox thought in the most influential way. In short, Keynes’ claims pointed to the historical assumptions and premises on which the theoretical edifice of Neoclassics had been erected, which no longer corresponded to the new economic reality due to the profound transformations that had taken place at the beginning of the 20th century.

 

Keynes’ critics to the (neo)classics

It is necessary to make a clarification, apparently purely terminological, which is in fact loaded with a deep theoretical content. Keynes intends to escape the old and anachronistic theories, but to which economists is his criticism specifically directed? In The General Theory he uses various expressions to designate his opponents: “orthodoxy”, “traditional theory” or also, especially, “classical theory” or “classical economists”. We already know that Keynes was opposed, first of all, to Marshall who was Keynes’ professor and mentor. More specifically, Keynes calls “classics” a group of economists made up of both the classics and the Marshallian-Marginalists. 

What are the main criticisms that Keynes addresses to Marshall and “the Classics”? 

Synthetically, his argument is as follows: the classical system has lost its prestige, fallen into disgrace, so that it must be replaced by a different one. Keynes argued that the most important errors are in the field of the premises, mainly: 

  1. the separation between the theory of value and the theory of money, a separation that carries strong conceptual contradictions; 
  2. the postulate according to which the economy is always in conditions of full employment;
  3. unconditional adherence to Say’s law, which through the labour market, the capital market and the goods market ensures that the economic system moves towards equilibrium in all markets and, therefore, towards full use of available resources.

As we have seen, classical theory presupposes that the economy is always in a state of equilibrium and full occupation, that is, that all the goods and resources that are offered can be placed on the market. For classical theory, then, unemployment is synonymous with disequilibrium. Unemployment should simply be considered an “excess supply of labour”, an imbalance that occurs every time the real wage is above the level corresponding to equilibrium. The causes of unemployment are inexorably associated with the obstacles and difficulties that occur in any market that cause “rigidities” in the adjustment of wages; obstacles outside of economic reign, such as labour unions, laws, and the State. Unemployment is, for the (neo)classics, eminently “voluntary”.

Keynes’ General Theory, in contrast, tries to show that the system has multiple possible positions of equilibrium and not a single one that coincides with full employment. In other words, unemployment could also be a situation of equilibrium that could be stable in time. Keynes offers two strong criticisms to Marshall’s labour market theory and its corresponding theory of wages and employment, one empirical in nature and the other theoretical. Both directed to the assumptions that are implicit in the construction of the labour supply curve. For this, Keynes introduced in his analysis the difference between nominal wages (wage measured in money) and real wages (defined as the nominal wage divided by the general price level). 

Empirically, if it were true that the real wage is always determined by the supply of labour, each time there is an increase in prices, it should be observed that a portion of the employed workers abandon their work positions, since the new real wages reduced by the increase in prices, should not now be enough to compensate for the marginal disutility of their work. But this is not the answer that is typically verified in practice since, as a general rule, workers do not leave their jobs en masse when prices rise (in the face of inflation). 

Theoretically, the critique of the labour market is of greater importance, since it aims to disrupt the adjustment mechanism towards equilibrium (and full employment) that takes place in the Marginalist conceptual framework. Based on the Marshallian theory of prices, in the face of a labour supply excess in which workers would effectively agree to cut their nominal wages in order to achieve full employment, for example a 10% reduction in all wages in the economy represents a fall in the marginal prime cost of all goods that will be approximately the same proportion. This is, according to the classical (Marshallian) theory of value (we explained above), a proportional reduction in all prices should be expected. Thus, a reduction in the nominal wage is accompanied by a reduction in prices of approximately the same percentage magnitude, for which it follows that the real wage remains fixed at approximately the same level as before the nominal wage reduction by the workers. If the real wage is the same, the supply excess, that is, the volume of unemployment, also remains the same. In Keynes’s words:

“If nominal wages change, the classical school should be expected to hold that prices would change in almost the same proportion, leaving the level of real wages and unemployment practically the same as before” (Keynes [ 1936] 2005: 31).

The conclusion is lapidary: workers can reduce their nominal wages but cannot, even if they wanted to do so, cause a decrease in real wages through these consented reductions in money wages. This argument not only obliges us to reject the accusatory attitude of the marginalists towards the workers, but also entails, in addition, very profound theoretical consequences. Following the Marshallian theory of prices, it must be accepted that it is not in the power of the workers to reduce real wages to the equilibrium level with full employment. Then, it must be concluded that the labour market simply does not have an automatic way to reach a full employment equilibrium. 

The conceptual consequences that accompany Keynes’ criticism of Marshall’s labour market turn out to be devastating, since the labour market is one of the pillars of the Neoclassical theory of distribution and also of the theory of value, as Marshall founded his theory of price on the production costs. 



Keynesian new theories  

As we have seen, Keynes attacked the idea that unemployment was only voluntary and approached the problem of wages from another point of view that was diametrically opposed. He considered, on the one hand, that nominal wages should be the ones taken into account and not, as the neoclassical model did, the real wages because, according to him, workers act under monetary illusion. And, on the other hand, that in no way could it be considered that wages had the degree of flexibility required by the neoclassical model in order to achieve equilibrium situations of full employment.

After rolling out the classical labour market, Keynes was forced to offer new theories about wages and the level of employment, since these two variables had remained without explanation after his criticism. He starts by the analysis of the aggregate demand. In his The General Theory, aggregate demand is not “subordinated” to the volume of supply (as the classic state under the Say’s law), but rather other factors govern its behaviour. Aggregate demand is a completely different function that depends on other factors that can be modified in the short term to determine the equilibrium occupancy level. First, Keynes identified two components into which global demand is divided: consumer demand and investment demand. It is necessary to differentiate them because the laws that govern consumption and investment are different, and therefore must be studied separately.

Precisely, one of the main theoretical disruptions in Keynes’ theory was understanding of the forces that govern demand dynamics. In his vision, the variations in consumption caused by the increase in income are always less than proportional to the changes in income, since there is a “psychological law” according to which “when income increases, consumption grows, but not as much as income ”. Keynes calls this psychological law that governs consumer spending propensity to consume. By stating this, the transmission mechanism that was ensured by Say’s law is again broken. According to Say’s law, any increase in employment and production produced a rise in income and this in turn was channelled to demand. Now, according to Keynes, any time employment, production and therefore income grows, it can only be assured that consumer demand will increase less than the original increase in income.

Keynes’ reasoning is simple: consumption demand is not enough to exhaust the increases in output, so, to reach equilibrium it will be always necessary a certain volume of investment demand that covers the difference. However, investment demand does not depend on changes in production; so such an increase is not assured. Therefore, two fundamental consequences can be deduced in Keynes’s system: 

  1. the magnitude of investment demand is the one that “rules the game”, because once its level is determined, the corresponding equilibrium level of employment can be obtained; 
  2. if investment demand is small and insufficient, the equilibrium occupation volume may well be below that required to guarantee full employment. Hence, full employment is not the only state of equilibrium and towards which the economic system necessarily tends, as the classical system used to say. 

The full employment situation is a special case that is only realised when the propensity to consume and the incentive to invest are in a mutual relationship. Investment must always “fill the gap” between the cost of any level of production (global supply) and consumer demand, always lower. As can be seen, unemployment could be then a situation of equilibrium. The global supply is determined by the technical conditions of production (the costs associated with each level of employment) and, in the short term, must be considered fixed.

It can also be concluded that from this explanation there is a shift with respect to the classical interpretation of unemployment, the identification of its “responsible” and the appropriate remedies to get the economy out of that state. Indeed, for Marshall unemployment was mainly due to the resistance of the workers (generally protected by a permissive state), who refused to reduce their real wages until reaching equilibrium with full employment. The image projected by Keynes’s system is very different. Now, the main cause of unemployment becomes weak demand; more precisely, weak investment demand. Very far from the spirit of orthodoxy, the responsibility for unemployment falls on the backs of those who establish the volume of investment, that is, of the businessmen. The State, for its part, instead of appearing in the dock by preventing the proper functioning of the markets, now becomes an alternative source of demand, which comes to complement or replace the declining impulse of the entrepreneurs who invest less than enough to provide full employment. It can now be understood why The General Theory became an antidote to the stale medicine of classical orthodoxy that, in the face of unemployment, recommends reducing wages, reducing public spending, and making labour legislation more flexible.

To sum up, the political consequences of Keynes’s thesis clearly differ from the Neoclassical and are well known:

  1. a) There may be equilibrium situations that imply unemployment.
  2. b) Unemployment could be involuntary due to downward wage rigidity 
  3. c) Increasing employment in unemployed situations can be achieved by increasing induced incentives in investment demand, which means that exogenous market interventions are not negative, but are essential to achieve full employment.
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