Home > Uncategorized > Larry Summers — ‘New Keynesian’ economics needs to be replaced

Larry Summers — ‘New Keynesian’ economics needs to be replaced

from Lars Syll

Standard new Keynesian macroeconomics essentially abstracts away from most of what is important in macroeconomics. To an even greater extent, this is true of the dynamic stochastic general equilibrium (DSGE) models that are the workhorse of central bank staffs and much practically oriented academic work.

kWhy? New Keynesian models imply that stabilization policies cannot affect the average level of output over time and that the only effect policy can have is on the amplitude of economic fluctuations, not on the level of output. This assumption is problematic at a number of levels …

The problem has always been that it is difficult to beat something with nothing. This may be changing as topics like hysteresis, secular stagnation, and multiple equilibrium are getting more and more attention …

As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world.

Maybe we can call it the Keynesian New Economics.

Lawrence Summers

Mainstream macroeconomics is stuck with crazy models — and ‘New Keynesian’ macroeconomics and DSGE models certainly, as Summers puts it, “essentially abstract away from most of what is important in macroeconomics. ”

Let me just give one example.

A lot of mainstream economists out there still think that price and wage rigidities are the prime movers behind unemployment. What is even worse — I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension — is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view.

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 was 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 labor market.

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …
The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemploy-ment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus 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.

J M Keynes General Theory

People calling themselves ‘New Keynesians’ ought to be rather embarrassed by the fact that the kind of microfounded dynamic stochastic general equilibrium models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with microfunded representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. 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. Maybe that’s also the reason prominent ‘New Keynesian’ macroeconomist Simon Wren-Lewis can write

I think the labour market is not central, which was what I was trying to say in my post. It matters in a [New Keynesian] model only in so far as it adds to any change to inflation, which matters only in so far as it influences central bank’s decisions on interest rates.

In the basic DSGE models used by most ‘New Keynesians’, the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its “equilibrium value,” the representative agent adjust her labour supply, so that when the real wage is higher than its “equilibrium value,” labour supply is increased, and when the real wage is below its “equilibrium value,” labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary. To be unemployed is something one optimally chooses to be.

In a blogpost discussing ‘New Keynesian’ macroeconomics and the definition of neoclassical economics, Paul Krugman writes:

So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players …

Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.

This is, not to put too fine a point on it, very much true of Keynesian economics as practiced … New Keynesian models are intertemporal maximization modified with sticky prices and a few other deviations …

Why do things this way? Simplicity and clarity. In the real world, people are fairly rational and more or less self-interested; the qualifiers are complicated to model, so it makes sense to see what you can learn by dropping them. And dynamics are hard, whereas looking at the presumed end state of a dynamic process — an equilibrium — may tell you much of what you want to know.

Being myself sorta-kinda Keynesian I find this analysis utterly unconvincing.

Maintaining that economics is a science in the “true knowledge” business, yours truly remains a skeptic of the pretences and aspirations of ‘New Keynesian’ macroeconomics. So far, I cannot really see that it has yielded very much in terms of realistic and relevant economic knowledge.

The marginal return on its ever higher technical sophistication in no way makes up for the lack of serious underlabouring of its deeper philosophical and methodological foundations. The rather one-sided emphasis of usefulness and its concomitant instrumentalist justification cannot hide that ‘New Keynesians’ cannot give supportive evidence for their considering it fruitful to analyze macroeconomic structures and events as the aggregated result of optimizing representative actors. After having analyzed some of its ontological and epistemological foundations, I cannot but conclude that ‘New Keynesian’ macroeconomics on the whole has not delivered anything else than “as if” unreal and irrelevant models.

Science should help us penetrate to “the true process of causation lying behind current events” and disclose “the causal forces behind the apparent facts” [Keynes 1971-89 vol XVII:427]. We should look out for causal relations. But models can never be more than a starting point in that endeavour. There is always the possibility that there are other variables – of vital importance and although perhaps unobservable and non-additive not necessarily epistemologically inaccessible – that were not considered for the model.

The kinds of laws and relations that economics has established, are laws and relations about entities in models that presuppose causal mechanisms being atomistic and additive. When causal mechanisms operate in the real world they only do it in ever-changing and unstable combinations where the whole is more than a mechanical sum of parts. If economic regularities obtain they do it (as a rule) only because we engineered them for that purpose. Outside man-made “nomological machines” they are rare, or even non-existant. Unfortunately that also makes most of the achievements of econometrics – as most of contemporary endeavours of economic theoretical modeling – rather useless.

Economic policies cannot presuppose that what has worked before, will continue to do so in the future. That macroeconomic models could get hold of correlations between different “variables” is not enough. If they could not get at the causal structure that generated the data, they are not really “identified”. Dynamic stochastic general euilibrium (DSGE) macroeconomists – including ‘New Keynesians’ — have drawn the conclusion that the problem with unstable relations is to construct models with clear microfoundations where forward-looking optimizing individuals and robust, deep, behavioural parameters are seen to be stable even to changes in economic policies.

Here we are getting close to the heart of darkness in ‘New Keynesian’ macroeconomics. Where ‘New Keynesian’ economists think that they can rigorously deduce the aggregate effects of (representative) actors with their reductionist microfoundational methodology, they have to put a blind eye on the emergent properties that characterize all open social systems – including the economic system. The interaction between animal spirits, trust, confidence, institutions etc., cannot be deduced or reduced to a question answerable on the idividual level. Macroeconomic structures and phenomena have to be analyzed also on their own terms. And although one may easily agree with Krugman’s emphasis on simple models, the simplifications used may have to be simplifications adequate for macroeconomics and not those adequate for microeconomics.

‘New Keynesian’ macromodels describe imaginary worlds using a combination of formal sign systems such as mathematics and ordinary language. The descriptions made are extremely thin and to a large degree disconnected to the specific contexts of the targeted system than one (usually) wants to (partially) represent. This is not by chance. These closed formalistic-mathematical theories and models are constructed for the purpose of being able to deliver purportedly rigorous deductions that may somehow by be exportable to the target system. By analyzing a few causal factors in their “macroeconomic laboratories” they hope they can perform “thought experiments” and observe how these factors operate on their own and without impediments or confounders.

Unfortunately, this is not so. The reason for this is that economic causes never act in a socio-economic vacuum. Causes have to be set in a contextual structure to be able to operate. This structure has to take some form or other, but instead of incorporating structures that are true to the target system, the settings made in these macroeconomic models are rather based on formalistic mathematical tractability. In the models they appear as unrealistic assumptions, usually playing a decisive role in getting the deductive machinery deliver “precise” and “rigorous” results. This, of course, makes exporting to real world target systems problematic, since these models – as part of a deductivist covering-law tradition in economics – are thought to deliver general and far-reaching conclusions that are externally valid. But how can we be sure the lessons learned in these theories and models have external validity, when based on highly specific unrealistic assumptions? As a rule, the more specific and concrete the structures, the less generalizable the results. Admitting that we in principle can move from (partial) falsehoods in theories and models to truth in real world target systems does not take us very far, unless a thorough explication of the relation between theory, model and the real world target system is made. If models assume representative actors, rational expectations, market clearing and equilibrium, and we know that real people and markets cannot be expected to obey these assumptions, the warrants for supposing that conclusions or hypothesis of causally relevant mechanisms or regularities can be bridged, are obviously non-justifiable. To have a deductive warrant for things happening in a closed model is no guarantee for them being preserved when applied to the real world.

In microeconomics we know that aggregation really presupposes homothetic an identical preferences, something that almost never exist in real economies. The results given by these assumptions are therefore not robust and do not capture the underlying mechanisms at work in any real economy. And models that are critically based on particular and odd assumptions – and are neither robust nor congruent to real world economies – are of questionable value.

Even if economies naturally presuppose individuals, it does not follow that we can infer or explain macroeconomic phenomena solely from knowledge of these individuals. Macroeconomics is to a large extent emergent and cannot be reduced to a simple summation of micro-phenomena. Moreover, as we have already argued, even these microfoundations aren’t immutable. The “deep parameters” of ‘New Keynesian’ DSGE models – “tastes” and “technology” – are not really the bedrock of constancy that they believe (pretend) them to be.

So I cannot concur with Krugman — and other sorta-kinda ‘New Keynesians’ — when they try to reduce Keynesian economics to “intertemporal maximization modified with sticky prices and a few other deviations.”

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

To Keynes this was self-evident. But obviously not so to ‘New Keynesians.’

Larry Summers is right — we certainly need “a new Keynesian economics that is more Keynesian and less new.”

  1. BC
    November 4, 2015 at 4:20 pm

    Not-so-New Newer Newest New Normal Keynesian eCONomics?

    What we’re being constrained by are the implied effects of the Schumpeterian depression and secular stagnation of the Long Wave Trough, which previously occurred in the 1930s-40s, 1890s, and 1830s-40s, and since the late 1990s in Japan.

    Factors coalescing to entrain the “new normal” of “secular stagnation” of the Long Wave Trough indefinitely hereafter:

    Peak Oil (increasing energy cost of energy extraction as a share of energy consumption to GDP and the resulting falling net energy per capita);

    population overshoot (too many people);

    resource depletion per capita (arable land, topsoil, water, forests, fisheries, rare earths, phosphorus, etc.);

    “Limits to Growth” (a function of the former three);

    deindustrialization and hyper-financialization resulting in unprecedented asset bubbles and private and public debt to wages and GDP, and disproportionate net flows to the financialized sectors, e.g., FIRE, “health” care, “education”, and gov’t;

    prohibitively costly so-called “health” care (for-profit dis-ease promotion and treatment rather than prevention, now at 19% of US GDP, $10,000 per capita, $26,000 per household, half equivalent of private wages, and 100% equivalent of US gov’t spending);

    Third World-like wealth and income concentration to the top 0.001-1% to 10% and resulting pernicious effects on growth, politics, and overall social well-being;

    record low for labor share of GDP (going back to the 1930s and 1890s);

    regressive taxation of labor and production, including self-employment;

    favorable tax treatment of non-productive rentier speculation at the expense of productive activity and labor share;

    the six foregoing factors are causing productivity to decelerate and exacerbating the effects of low labor share and inequality;

    fiscal constraints from high public debt to wages and GDP that will restrain/preclude fiscal “stimulus” hereafter, as virtually all incremental gov’t spending will go to no-multiplier income support (food stamps, unemployment payments, SSDI, SSI, Medicaid, and to cover shortfalls for SS and Medicare);

    Peak Oil, overshoot, and “Limits to Growth” causing increasing incidents of social instability, failed states, and human cross-border mass migration and the resulting economic, social, and political instability;

    increasing risk of a breakdown and eventual collapse of US-China trade and diplomatic relations, a geopolitical realignment, and the end of “globalization”, i.e., Anglo-American imperial trade regime; and

    the implied risk of a last-man-standing contest between the West and China for the remaining scarce resources of finite planet Earth.

    Tweaking the Keynesian canon against the foregoing converging factors is akin to pi$$ing into a raging tempest.

  2. November 4, 2015 at 7:11 pm

    THE BIG QUESTION: (I know why the 1940s are #1.) Why are the 1960s head and shoulders above every other decade in American history? About 40% more productive than the 1980s and about 70% more productive than the 1990s.

    GROWTH/PRODUCTIVITY RATES IN THE U.S.
    from 1820 to Present

    [Real GDP per capita, in 2009 $’s; factors out the effects of inflation and population growth.

    1. 1940s – 40% The Generations
    2. 1960s – 35% Greatest Generation
    3. 1870s – 28% Silent Generation
    4. 1980s – 25% Baby Boomers
    5. 1970s – 25% Generation X
    6. 1920s – 24% Millennials
    7. 1850s – 24%
    8. 1880s – 23%
    9. 1990s – 21%
    10. 1950s – 19%
    11. 1910s – 14%
    12. 1840s – 15%
    13. 1930s – 13%
    14. 1830s – 9.7%
    15. 1890s – 9.0%
    16. 1820s – 8.1%
    17. 1860s – 7.6%
    18. 2000s – 5.5%
    19. 1900s – 5.0%
    20. 2010s – 4.8% (for 5 years) 

    • Hepion
      November 4, 2015 at 10:23 pm

      I think much of the post-ww2 growth was based on leveraging public debt of ww2 which gave private sector very safe asset to build leverage on. Plus much of the growth those days consisted of people coming out agriculture to more productive sectors which this newfound wealth made possible. And Minskyan evolution of the credit cycle could explain why 60’s stand out especially.

    • November 4, 2015 at 11:37 pm

      Vic, well said. Below a table (not properly formatted here) first compiled by Stephen Bell all the way back in 1997. The neoliberal era has never matched the post-war social-democratic era.

      Pre 1974 1974-83 1983-93
      Australia
      GDP annual growth (from 1960), % 5.2 1.8 3.4
      Inflation (CPI annual increase, from 1953), % 3.3 11.4 5.6
      Unemployment (from 1953), % 1.3 5.6 8.4
      OECD
      GDP annual growth (from 1960), % 4.9 1.6 2.8
      Inflation (CPI annual increase, from 1960) , % 4.5 11.1 6.8
      Unemployment (from 1953) , % 3.2 6.4 8.4

      Bell, S., Ungoverning the Economy. 1997, Melbourne: Oxford University Press. 324 pp.

      • BC
        November 5, 2015 at 1:27 am

        After WW II, Europe and parts of Asia were flattened. Apart from the Soviet Union, the US’s competitors economic competitors were on their backs. The US had deleveraged private debt. The secular trend of real GDP per capita had decelerated to ~0-1%. There was large-scale pent-up private demand as a result of the Great Depression and rationing during WW II. The demographic cycle had bottomed and was turning up for the large GI Generation as a percent of total population (their children’s generation would be larger still).

        Moreover, the constant-dollar price of oil was $15 and the US was a net oil exporter (US oil production per capita is where it was in the late 1940s and down 45% since 1970) vs. an importer of 10Mbd (net importer of 5-6Mbd).

        The Long Wave Downwave’s Trough had resolved with rates where they are today but with private debt deleveraging (household credit to GDP was 2-3% vs. 18-19% today) and the onset of the Long Wave Upwave coincident with a new demographic cycle, including the Baby Boom birth cycle that lasted into the mid- to late 1950s.

        Total gov’t debt as a share of GDP was similar to where it is today but largely made up of $185B in War Bonds that were redeemed by the early to mid-1950s (equivalent to 80-85% of GDP during the war and 45-50% of GDP by the mid-1950s), but total gov’t spending as a percent of GDP is 36% today vs. 21% after WW II.

        Private productive capacity had been drawn down during the Great Depression with low labor share (as today) and the potential for large-scale infrastructure investment.

        However, today we have unprecedented private (minimal deleveraging by households but not by firms or gov’t) and public debt to GDP, total gov’t spending to GDP 50% higher than after WW II, oil at triple the constant-dollar price as in the late 1940s, and extreme wealth and income concentration and inequality like the 1920s, Gilded Age (1870s-1900), and Era of Good Feelings (1820s).

        The post-WW II era was a once-in-history period made possible by abundant supplies of cheap oil; low private debt at low interest rates; productive capacity drawdown and infrastructure replacement and expansion; increasing labor share because of capacity drawdown, low labor share, and capital deepening dramatically increasing labor productivity; and labor organization advocating for increasing labor share with capital deepening and increasing productivity.

        Without large-scale debt forgiveness/restructuring for households and restructuring of corporate debt AND an increase in labor share of GDP, most of the world’s economy will continue to stagnate with increasing public debt to GDP adding little, if anything, to productive capital stock, production, productivity, and growth of real GDP per capita.

        Another obstacle to increasing labor share and acceleration of growth of real GDP per capita hereafter is that the economy is now made up of 85-90% low-productivity services employment (gov’t, health care, education, financial services, and retail, 65-85% women employees in these sectors). Accelerating automation (robotics, Big Data analytics, bioinformatics, biometrics, nano-electronic sensors, telepresence, etc.) and large-scale elimination of paid employment in the services sector (including well-paid professionals in medical services, law, etc.) is underway, which will eliminate tens of millions of full-time, subsistence and middle- and upper-income jobs and after-tax purchasing power without net replacement over the coming generation. Women will be disproportionately affected.

        There is no existing school of economic thought acknowledging, discussing, analyzing, and devising policies to comprehensively address the short- and long-term effects of the foregoing, including Peak Oil, population overshoot, resource depletion, deindustrialization, financialization, excessive debt, inequality, demographic drag effects, hard fiscal constraints, and the likely large-scale economic, social, and political destabilization we are likely to face hereafter.

      • November 5, 2015 at 2:59 am

        1. No, it wasn’t due to the post-WWII where the European economies were devasted — that was true of our economy during the 1950s; by the 1960s the continental European economies were doing well and competitive with the U.S. By the late 1950s (1957) the European Common Market starts (with Germany, France, Itay, Belgium, the Netherlands, Luxembourg) and these nations are starting to come out with strong economies — Britain is much slower to recover.

        By the 1960s Germany will have two upgrades of the DM to the US$ (one in 1961 and one around 1968). In 1965 the French economy is doing so good that De Gaulle is exchanging dollars into gold. Italy is doing fine and the It Lira is holding up pretty good (I was over in Italy in the late 1960s).

        Even though the 1960s stand out for productivity compared to other decades, as you go through the 1960s the U.S. becomes less competitive and less productive.

        2. New orders for plant equipment during the 1950s and 1960s:
        Note how flat the curve is for the 1950s, where the U.S. doesn’t have much competition; and how the curve takes off in the 1960s when competition picks up.
        //research.stlouisfed.org/fred2/…

        3. Household debt and private debt started to increase in the U.S. relative to the GDP —https://en.wikipedia.org/wiki/Financial_position_of_the_United_States#/media/File:Components-of-total-US-debt.jpg.
        The total Fed Govt Debt (not just the debt held by the public)-to-GDP went from around 70% in 1960 to around 40% by 1969 — and this was after one budget deficit after another during the 1960s (the “balanced” budget of FY1969 still had a deficit in the operational budget).

        4. Total govt spending of 36% represents Fed, State, and Local govts — the Fed share has been pretty constant at 17% to 20%, it is only since the Great Recession that is has gone over that, to almost 25% (and coming down since).

      • November 5, 2015 at 3:03 am

        [Correction] FRED Chart for New Orders for Plant Equipment:

        //research.stlouisfed.org/fred2/graph/graph-landing.php?g=2kki

    • November 4, 2015 at 11:40 pm

      Oh and you can read more in my Sack the Economists http://sacktheeconomists.com

  3. November 4, 2015 at 9:37 pm

    One can’t really model network dynamics and distributional effects with representative agents and DSGE. This is why such models abstract away all the important challenges in macroeconomics. Homogeneous fixed preferences under bounded rationality? Really?

  4. November 4, 2015 at 10:43 pm

    A new more Keynesian employment theory
    Comment on Lars Syll on ‘Larry Summers — ‘New Keynesian’ economics needs to be replaced’

    Krugman comes directly to the core of the matter: “So, what is neoclassical economics? … I think we mean in practice economics based on maximization-with-equilibrium.” (See intro)

    And that is exactly why neoclassics is a failed approach: because it is based on two nonentities. For good methodological reasons, economics cannot take a behavioral assumption (constrained optimization or otherwise) and equilibrium into the premises. Economics is, to begin with, not a science of the behavior of humans but of the behavior of the economics system.* As a matter of principle, no way leads from the understanding of human behavior to the understanding of how the economic system works. Neoclassical economics is a casualty of the Science-of-Man fallacy.**

    So, the whole of economics has to be based on an entirely new set of foundational propositions. This operation is commonly known as paradigm shift. Keynes understood this very well: “The classical theorists resemble Euclidean geometers in a non-Euclidean world … Yet, in truth, there is no remedy except … to work out a non-Euclidean geometry. Something similar is required to-day in economics.” (1973, p. 16)

    Non-Euclidean means in this context: Krugman’s two nonentities have to be left out of the formal foundations. This, by the way, makes all of Lars Syll’s microfoundation critique of DSGE redundant.

    When we start from purely objective structural premises then the most elementary version of the correct employment equation reads as follows

    From this equation follows inter alia:
    (i) An increase of the expenditure ratio rhoE leads to higher employment. An expenditure ratio rhoE>1 indicates credit expansion, a ratio rhoE<1 indicates credit contraction/debt repayment of private households.
    (ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
    (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment. This implies that a higher average wage rate W leads to higher employment. This is, of course, contrary to conventional economic wisdom. It is, though, easy to prove that conventional wisdom is a mere fallacy of composition (2015).
    (iv) The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and the trade balance with the rest of the world.

    Point (i) and (ii) constitute a Keynesian multiplier. Let us focus here alone on the factor cost ratio rhoF as defined in (iii). This variable embodies the price mechanism which, however, does not work as the representative economist hallucinates. As a matter of fact, overall employment INCREASES if the average wage rate W increases relative to average price P and productivity R. The factor cost ratio is what is missing in Keynes’s original employment function (2012).

    The correct employment theory states that the average wage rate must rise in order to prevent unemployment and deflation. Until this day, the representative economist has not realized that the overall systemic interdependencies establish a POSITIVE feedback loop between ‘the’ product and ‘the’ labor market, that is, wage rate down – employment down – wage rate down – and so on. Vice versa with an increasing average wage rate. This is exactly what Keynes said in ‘The Great Slump of 1930.’

    The market system is NO equilibrium system (2015). And because of this, ALL equilibrium models are a priori false. This includes ALL variants of DSGE. Employment is determined according to the extended Keynesian employment equation in the most elementary case by the expenditure ratio, investment, and the factor cost ratio which in turn depends on (average) wage rate, price, and productivity. Interest is brought into the picture as soon as the relationships between investment and the lending rate and the expenditure ratio and the deposit rate (if rhoE<1) is formally established.

    The extended Keynesian employment equation sorta-kinda fully replaces the New Keynesian sorta-kinda maximization-with-equilibrium junk.

    Egmont Kakarot-Handtke

    References
    Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
    http://ssrn.com/abstract=2130421
    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working
    Paper Series, 2624350: 1–40. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2624350
    Keynes, J. M. (1973). The General Theory of Employment Interest and Money. The Collected Writings of John Maynard Keynes Vol. VII. London, Basingstoke: Macmillan.

    * See ‘From PsySoc to SysHum‘
    http://axecorg.blogspot.de/2015/05/from-psysoc-to-syshum.html
    ** See ‘The Science-of-Man fallacy‘
    http://axecorg.blogspot.de/2015/10/the-science-of-man-fallacy.html

    • November 6, 2015 at 8:45 am

      “Until this day, the representative economist has not realized that the overall systemic interdependencies establish a POSITIVE feedback loop between ‘the’ product and ‘the’ labor market, that is, wage rate down – employment down – wage rate down – and so on. Vice versa with an increasing average wage rate. This is exactly what Keynes said in ‘The Great Slump of 1930.’”

      I’m not a representative economist but a scientist who worked on control systems. What Egmont is saying is right, except that the term “positive feedback” hadn’t been invented in 1930, which is why I keep saying Keynes ANTICIPATED the development of PID control theory. I’m obliged to Egmont for spelling out how positive feedback applies in the wage-price subsystem, but surely that’s micro-economics, not macro? As I see it, at macro level it is positive feedback which persuades entrepreurs to change course, whereas negative feedbacks keep the system directionally and/or positionally on course: “on course” being in a flow system the mathematical equivalent of fluid equilibrium. On this interpretation Keynes was arguing for getting positionally back on course by upping the employment available in infrastructure maintenance.

      • November 6, 2015 at 11:21 am

        For the record, the term used for positive feedback (used to increase the amplification of low-gain thermionic valves) was ‘reaction’ in the Practical Wireless of the 1950’s. Norbert Weiner introduced the term ‘feedback’ in his “Cybernetics” of 1948: on p.114 “What we shall now on call the chain of feed-back” and on p.115 “examples of negative feedbacks” to stabilize velocity and position. On p.132 he sums this as “control by informative feedback”, and on p.133 to an anticipatory feedback, but the term “positive feedback” doesn’t occur: it is described only in mathematical terms on p.121, ending “a feedback with a multiplier L (lambda) [e.g. repayments with % interest] will certainly produce something catastrophic, and as a matter of fact the catastrophe will be that the system will go into unrestrained and increasing oscillation” [e..g. business cycles, experimentally modelled by upping the reaction causing the old type of radios to squeal.

        Reading this, and Shannon’s related book on information systems, I am once more astonished by economists never referring to them. As Egmont says, not just ‘orthodox’ economists but ‘heterodox’ ones too.

      • Larry Motuz
        November 6, 2015 at 7:31 pm

        Looking at this particular line, Dave Taylor, “I’m obliged to Egmont for spelling out how positive feedback applies in the wage-price subsystem, but surely that’s micro-economics, not macro?”, I find the second half puzzling. I’d say that lower wages lead to lower (and shifted) individual consumption that shows up as lower and shifted aggregate consumption. This ‘feedback’ will be perceived as positive — encouraging rises in output, prices, or both — in those areas where budgets shift towards; and, likewise ‘negative’ –slowing sales, rising inventories, reduced output…and eventually prices — by those in areas consumers are shifting out of.

        Egmont’s point, with which I agree, I that the very idea of equilibrium in markets is baseless; and, even more so, the idea of such a phenomenon as ‘general equilibrium’. That is also something Keynes himself argued very well.

      • November 6, 2015 at 11:40 pm

        No, Larry. Positive feedback encourages movement in the same direction, negative feedback reverses deviation. Assuming monetary profits in a particular line are falling, positive feedback may make them fall still further by redirecting motion/investment to a different line.

  5. Larry Motuz
    November 5, 2015 at 1:13 am

    It is very clear to me that the distribution of income, out of which budget formation occurs, can become so unbalanced that individuals, families, and households face an ever diminishing range of goods which they can afford to purchase while simultaneously meeting their basic needs. Withdrawing or reducing their spending from where they spent it leads to unemployment within nations and between them. Such unemployment leads to a race to the bottom where more and more have, or can purchase, less and less across the spectrum of their needs.

  6. Chris
    November 5, 2015 at 12:45 pm

    Why continue using the misnomer Keynesian New Economics? Wouldn’t something like Keynesian Revisionist Economics be more accurate and help the media and public at large (and lots of economists) understand what’s going on?

  7. November 5, 2015 at 8:09 pm

    What especially baffles me about the “(wage) deflation is the solution to unemployment” people is that they completely miss the whole *point* of capitalism, which is to make a profit. Lower wages mean less money to purchase stuff, which in turn implies lower prices — except it doesn’t. How can you make a profit by buying high and selling low? You can’t. What this implies is that some level of inflation is necessary in order for capitalism’s fundamental mechanism — the profit motive — to operate properly, because otherwise on an aggregate level businesses will refuse to take a loss and will accept lower outputs as a result, resulting in lower employment since they won’t need as many workers to produce those lower outputs. In short, lowering wages results in higher unemployment because workers have less money to buy goods and services from businesses that refuse to take a loss. It’s just a straightforward application of the Pigeonhole Theorem, one of the fundamental laws of finite mathematics, to arrive at the realization that the Austerians are totally bogus. Yet the Austerians still continue to peddle their hogwash to willing rubes. Huh.

    • Larry \Motuz
      November 5, 2015 at 9:42 pm

      Good comment.

      Since wage deflation implies lower demand for less essential goods and services, which also affects how and which ‘goods’ get to be consumed, the idea of lowering nominal or real wages to increase employment is obviously a falsity.

    • November 5, 2015 at 10:15 pm

      Comment on badtux99

      You say “What especially baffles me about the “(wage) deflation is the solution to unemployment” people is that they completely miss the whole *point* of capitalism, which is to make a profit.”

      This holds for the familiar approaches but not for the extended Keynesian employment equation discussed in my post of Nov 5.

      For details see the working paper ‘The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment’
      http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792

    • November 6, 2015 at 12:45 pm

      ” … they completely miss the whole *point* of capitalism, which is to make a profit.”

      I wholeheartedly agree with your argument here, Badtux, except that the term ‘profit’ is ambiguous as between goods (“real profit”) and non-goods (“monetary profit”: fool’s gold).

      May I suggest playing with the idea that the point of capitalism is to make more money to acquire more goods; the problem being that more goods require more investment in resources, work and looking after, whereas the printing of IOU’s purporting to be YOM’s appeals to the irresponsible because it has no such self-limiting factors. YOM’s can be “saved” just in case some day they could become useful, whereas IOU’s purporting to be YOM’s need to be written down or redeemed by worthwhile investment.

      • November 6, 2015 at 7:49 pm

        Dave, the term ‘profit’ is not ambiguous to anybody who has ever owned a small business. Attempting to parse the word’s meanings is irrelevant to understanding how businesses react to deflationary pressures in the real world. Any businessman who is a businessman knows that profit is the difference between the inputs needed to create or buy the widget, and the money you get from selling it. The goal is to sell it for more than you paid. That’s profit, for a businessman. Any additional quibblings about money profits versus real profits are irrelevant for understanding how businesses behave when there are deflationary pressures (i.e., by cutting production or accepting reduced sales, not by cutting prices below what they paid for the items, thus resulting in a need for fewer employees).

        Buy high, sell low is how you become a *former* businessman out here in the real world. Apparently this is a concept unknown to the Austerians…

      • November 6, 2015 at 11:31 pm

        Bear in mind that I agreed with your main argument. You are disagreeing with me on what I assume an economy to be, i.e. what it does (or should do) for everybody in any system, not just what it does for or requires of businessmen in our present system. Here’s another example of the ambiguity:

        “The goal is to sell it for more than you paid.”

        When an effectively monopolistic buyer is the price setter, its goal is actually “to buy it for less than it can be sold for”, which for small agricultural producers in particular is increasingly less than it costs them in money terms to produce, to say nothing of future costs arising from degradation of their real capital: their soil, tools and buildings.

      • November 6, 2015 at 11:56 pm

        I’m not disagreeing with you at all. I am just saying that your argument doesn’t have anything to do with business behavior in a capitalist economy, which is about the profit motive. Which is what dictates job losses when there is monetary deflation whereas the Austerians don’t factor into their models that this is how businessmen behave.

        Money is, of course, pieces of fancy toilet paper with pictures of dead people on it. Its only intrinsic value is in how well it can remove debris from your posterior post-excretion. However, as long as people trade goods and services for money, it has value beyond toilet duty, and businessmen treat it as a proxy for actual goods and services. What we’ve discovered is that the amount of money circulating (as versus stuffing possibly-virtual mattresses or otherwise unavailable to the economy) causes changes in how businessmen behave, which in turn causes job gains or losses. That is what I was focused on, not the nature of money in a capitalist society, where I assure you I’m quite aware that it’s what money buys that has intrinsic value, not the toilet paper itself.

      • November 7, 2015 at 10:10 am

        I am glad we agree, but you are both right and wrong about my argument having nothing to do with the profit motive. It was actually about the logic of perception, showing up in words like ‘ambiguity’ and ‘gestalt’; but to your point of behaviour in a capitalist “economy”. (As I tried to say, there are surely two ways of making a profit: by short-changing suppliers and undercutting competitors, or cooperating to make sure everyone gets a decent living out of business activities, e.g. by time-sharing rather than cutting necessary work, and/or learning from nature to live with only periodic harvests via seasonal care and maintenance activities).

        Does the sun go round the earth every day, as it appears to, or is what we are seeing due to the earth revolving on its axis? (as one can see from a perspective in outer space). Is the radio signal one can detect a chaotic mess (despite it conveying an intelligible message), or is that only the case if one is looking at its amplitude, not its frequency variations? Is economics a chaotic mess which cannot be captured in a theory, or does it appear that way because theory is presenting us with the equivalent of the negative of a photo, which only when printed in inverted form reveals clearly the realities we are intuitively aware of? That, anyway, is my theory. From a perspective outside economics I can see how it all fits together, which I wouldn’t have if my everyday job had been running a business rather than exploring dynamic logic. I can’t show you here what I can see; I can only invite you to try changing your own perspective.

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