Transmogrifying Keynes

by
Lars Pålsson Syll
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The other day, on the way home after having attended an economics conference, yours truly tried to beguile the way by listening to a podcast of EconTalk where Garett Jones of George Mason University talked with EconTalk host Russ Roberts about the ideas of Irving Fisher on debt and deflation.

Jones’s thoughts on Fisher were thought-provoking and interesting, but in the middle of the discussion Roberts started to ask questions on the relation between Fisher’s ideas and those of Keynes, saying more or less something like “Keynes generated a lot of interest in his idea that the labour market doesn’t clear … because the price for labour does not adjust, i. e. wages are ‘sticky’ or ‘inflexible’.”

This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage rigidities, he certainly did not hold the view that wage rigidity was the reason behind high unemployment and other macroeconomic problems. To Keynes, recessions, depressions and faltering labour markets were not basically a problem of “sticky wages.”

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers, in general, could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes, it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions were not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labour market.

To mainstream neoclassical theory, the kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility. Keynes, on the other hand, writes in General Theory:

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur … Writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

Unfortunately, Roberts’s statement is not the only example of this kind of utter nonsense on Keynes. Similar distortions of Keynes’s views can be found in, e. g., the economics textbooks of the “New Keynesian” – a grotesque misnomer – Greg Mankiw. How is this possible? Probably because these economists have but a very superficial acquaintance with Keynes’s own works, and rather depend on second-hand sources like Hansen, Samuelson, Hicks and the likes.

Fortunately, there is a solution to the problem. Keynes books are still in print. Read them!!