Classics versus Keynes

Image credit. Continued from here and here.

The clash of the classical and the Keynesian economists is interesting along a number of lines. The first aspect under which I like to look into the controversy is freedom, of course. Do we have grounds to favour one of the two approaches and reject the other thanks to compelling reasons inherent in our conception of freedom, as many advocates of liberty ardently propose? To put it more directly: which of the two conceptions is compatible or incompatible with a free society?

I surmise that the answer is complex and multi-layered. On one layer both theories are compatible with freedom in that they are legitimate contenders in an open debate of pour et contre. On another layer both still qualify as legitimate parts of a free regime: if large numbers of people subscribe to the respective approaches, that is: if each have a solid basis of acceptance, they are entitled to being, in fact, they must be, accommodated in a divisively disputatious yet peaceable political order. Then there are layers on which dissension demands exclusion: either subjectively and emotionally asserted, or subjectively and empirically asserted - meaning some people will have a strong enough emotional attachment to consider one of the two simply true to the exclusion of the rival theory. Others are confident of their interpretation and the empirical evidence they have marshalled to feel they are in possession of the truth, while adherents to the competing school are therefore thought to be in objective error.

It is certainly interesting to trace the history of persuasion, alteration, compromise, assent and eclipse of these schools in reality. Why do we not fight a civil war over such an important question?

See my Economics and the Indeterminacy of Freedom (1).

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According to the classic economists, unemployment would tend to be quickly eliminated, so long as prices and wages remained perfectly flexible. Keynes countered that even if this was the case, unemployment could still ensure when aggregate demand slackens, i.e. the willingness and the ability of the population of spend retracted to a sufficient degree for a sufficiently long period of time.

Keynes spearheaded

a paradigms break from the extant neo-classical theory that was based on Walrasian general equilibrium theory, which had alleged that the only thing preventing full employment was rigid prices and wages – that is, the inability of the real wage to adjust to the so-called full employment marginal productivity level.

[...]

For Keynes, mass unemployment (which he termed ‘involuntary unemployment’) was always a problem of deficient effective demand (spending). He demonstrated that it would still occur, even if prices were flexible in both directions, if there was deficient demand.

The solution to mass unemployment was therefore to increase aggregate spending so as to stimulate firms into expecting higher future sales, which in turn, would lead them to increase output and hire more workers to support the higher expected output levels.

The problem that Keynes identified was that the capitalist economy could easily become mired in what he considered to be an under-full employment equilibrium state.

This state occurs when workers would not increase consumption spending for fear of further unemployment, and firms were pessimistic about future sales and therefore had no incentive to increase their investment spending because they could satisfy the existing level of spending with the current productive capacity in place.

In this context, the equilibrium means that there were no forces in the non-government sector to disturb the current state of affairs.

Keynes clearly considered that government intervention was necessary to ensure that under-full employment stalemates didn’t arise – due to lack of aggregate demand.

The idea that you could have a steady-state situation with mass unemployment was anathema to neo-classical thought, which paraded models that essentially always assumed full employment.

The neo-classical models all hypothesised that if there were temporary situations where labour in some area of the economy found itself in excess supply (perhaps because consumer spending has shifted away from the goods and services that these workers were producing), then the excess supply would drive prices down and real wages would adjust accordingly.

The point was that if prices were truly flexible then all markets would adjust so that demand equalled supply at all times (with minimal adjustment periods during which prices might adjust as noted in the previous paragraph). In other words, the labour market would also be more or less, continuously, in a state of full employment (demand for labour equalled the supply of labour).

Keynes rejected this reasoning and concluded that even if wages and prices were flexible, a monetary economy could become mired in one of these under-full employment states, which would need external (that is, government) intervention to push it out of this malaise.

The source.