Crisis Watch (3) - Friedman versus Romer - Post-Keynesians versus "the Classicals"

Image credit. Edward William Cooke (1811 - 80)

Gerald Friedman, whose article on "Different Models, Different Politics" I discuss below, has been attacked by influential economists for estimating that the economic policies proposed by Presidential candidate Bernie Sanders to reinvigorate the US economy are likely to have a substantial positive impact. I am hardly acquainted with the controversy and do not intend to occupy myself much with it. The reason why I turn to Gerald Friedman's (above referenced) reply to his critics is that it addresses directly the difference between two basic economic philosophies - one that seems to be prevalent today, and the Post-Keynesian alternative, in which latter I have recently become very interested.

Writes Friedman:

Economic models matter because they guide policy. For a time after World War II, we had effective economic policy [along Keynesian lines] which reduced unemployment and raised growth rates. We turned our backs on this success at the suggestion of economists who adopted older, Classical models premised on assumptions of full employment and exogenously determined growth.

In the quotes contained in this article, all insertions and emphases are mine.

1.

Let me try to compose an outline of the two competing models. Unlike Gerald Friedman in his article, I shall first discuss the features of the Post-Keynesian approach, and then look at "the Classicals," as Keynes called them.

Instead of the static Classical model, I would use that developed by John Maynard Keynes for periods of slow economic growth in the 1920s (in the United Kingdom) and the 1930s (throughout the world), models extended by him and by his students and colleagues, including Nicholas Kaldor, Joan Robinson and Michael Kalecki, into a general theory of growth. Having observed a period of slow growth similar to what we have experienced in the last six years, and a period of severe recession, Keynes rejected the Classical view ... Instead, he argued that an economy can have a low-employment equilibrium where a lack of effective demand constrains demand, and policy can increase growth by encouraging increased consumption and investment to increase output and employment to full employment.

What does the last sentence, in particular the part in bold letters, tell us? A "lack of effective demand constrains demand"? What is the difference between "effective demand" and "demand"? I suppose, the former refers to what people actually buy, thus expressing manifest, realised or "effective demand," while "demand" stands for the spectrum of possible levels of demand, including levels of demand exceeding effective demand.

By stimulating economic policies, government can provide people with more money, enabling them to engage in increased consumption/spending which lifts demand that, in turn, encourages investment geared to higher output and requiring more employment, a process to be continued until full employment is reached.

Argues Friedman:

... faster growth promotes faster growth by encouraging investment, greater labor force participation, and more technological innovation with higher productivity growth. Drawing on these theories, I would argue that in the United States today, productivity and the growth rate of capacity can be raised by policies that push the economy, drawing more into the labor force and by increasing investment and productivity.

The bone of contention between him and "the Classicals" seems to pertain to the question whether a fiscal stimulus can be transformed into an enduring episode of high quality, full employment economic growth.

We agree that [in a recession] people leave the labor force, investments are deferred, and productivity growth falls because of slow growth. Why not then the contrary? Why not have a period where high employment raises output by drawing more into the labor force, and by upgrading skills, promoting investment, and raising productivity through learning-by-doing? If recession induces a decline in productivity, could a boom raise productivity growth through induced investment in equipment and facilities, and when employers seek to increase the efficiency of their operations to reap profits from expanding sales opportunities?

In Gerald Friedman's vision:

An economic stimulus not only reduces involuntary unemployment caused by the previous shortfall in effective demand, but it can lead to a higher level of employment, investment, and productivity growth, increasing economic capacity and raising the trend growth rate of income

In a situation, where an economy languishes in a low-employment equilibrium, "discouraged workers have abandoned the labor market and firms have had little incentive to innovate or to raise productivity,"

additional stimulus not only raises output temporarily, but by priming the pump and encouraging additional private spending and investment, it can push the economy upwards towards capacity. And, capacity itself will grow more quickly when higher levels of employment lead more people to look for work, more businesses to invest, and businesses to find new ways to raise productivity to match growing demand. All this will push up the growth rate in capacity. That is why I see lasting effects from a government stimulus.

2.

Now, why would one be opposed to Friedman's proposal? Well, the Classicals espoused a theory that simply would not accommodate the idea that it is possible to trigger the chain of causation suggested in Friedman's policy proposal, for

... the Classicists believed that the economy always operates at full employment equilibrium except to the extent that price rigidities or failures in the financial system might cause temporary unemployment. For this classical view, the level of output, therefore, is determined exogenously with respect to employment levels [the italicised phrase is not entirely clear to me - is he saying: if we manage to increase employment, we may be able to also lift output to a higher level, thanks to higher spending (by the employed), and thanks to greater productivity growth incentivised by a more optimistic businesses outlook?]; it is set by the supply of factor inputs and technology under the assumptions that the economy will always operate more-or-less at full employment and growth rates are determined exogenously by an exogenous rate of technological progress and an exogenously determined rate of savings and investment. 

Setting aside dislocations owing to price rigidities and financial failures, employment is determined by technological progress, savings and investment, all three factors being exogenous - meaning presumably, they cannot be influenced at will by government.

Under these "Classical" assumptions, policy can do little. It can mildly speed recovery from a shock, but recovery would occur in any case even without government policy, perhaps a little slower. Policy can do little or nothing to raise the long-run growth rate. Because the economy moves naturally towards its full-employment equilibrium, persistently low output must be due to a shock to technology [what does that mean?] or to the supply of factor inputs [what does that mean?] rather than to a failure of policy or to a shortfall in demand. Thus, in the Classical view, the appropriate response by policy makers is to adjust downward expectations for economic capacity rather than seek to raise output to a higher level of income and employment.

I would tend to think, the way Friedman presents his case, he seems to have a point. The most interesting part of his argument is this - I repeat the quote:

... additional stimulus not only raises output temporarily, but by priming the pump and encouraging additional private spending and investment, it can push the economy upwards towards capacity. And, capacity itself will grow more quickly when higher levels of employment lead more people to look for work, more businesses to invest, and businesses to find new ways to raise productivity to match growing demand. All this will push up the growth rate in capacity. That is why I see lasting effects from a government stimulus.

My attention was drawn to Friedman's article via here.