The Critics of Keynesianism: A Survey "He who knows only his own side of the case, knows little of that." --John Stuart Mill Bryan Caplan Econ 199 Dickens Spring, 1991 An Overview John Maynard Keynes' General Theory marks a turning point in intellectual history. In less than a decade since its publication, the numerous converts to Keynesianism attained dominance in both the academic and political realms. Their hold on these positions has, since the 1970's, weakened under the combined force of theoretical criticisms and practical failures. This theoretical criticism is not a coherent edifice; rather, this criticism consists of disparate strands of dissent from both the general principles and the specific applications of Keynesianism. This paper, then, will survey these criticisms of Keynesianism, describing them, classifying them, and tentatively evaluating them. One of the important barriers to a thorough study of anti- Keynesian doctrines is that Keynesianism is a broad tendency of thought rather than a rigid set of theorems. Still, there are certainly basic assumptions that all species of Keynesianism share. By stating them explicitly, it will be possible to see what portions of the Keynesian system the major schools of critics reject. Two fundamental postulates underlie Keynesian theories of all types: 1. Unemployment is caused by insufficient aggregate demand. 2. The proper means to eliminate unemployment is for the government to increase aggregate demand through discretionary monetary and fiscal policies. This definition is admittedly simple, but will prove its worth by both distinguishing Keynesians from non-Keynesians, and by allowing a clear way of classifying the many schools of Keynesianism's critics. Roughly speaking, there are those who criticise the first postulate, and those who criticise the second. The first group includes rational expectations, sectoral shifts, real business cycles, the more extreme forms of monetarism, Austrians, and, perhaps inadvertantly, Keynesians who concentrate on microfoundations. The second group adds moderate monetarists, public choicers, and advocates of free banking. The critics of the first postulate can be split into two main factions. The first approach, which focuses on the microeconomic assumptions of Keynesianism, spearheaded the modern wave of criticism but no longer part of cutting-edge discussion; the second and more popular approach emphasizes the influence of real variables such as supply shocks, sectoral shifts, and search. The early critics observed that Keynesians had not fully explained the microfoundations of their models, and that this sin of omission led to dangerous long-run consequences. Unemployment, Friedman and others explained, is not caused by insufficient aggregate demand per se; it is caused by excessive wage rates. Increasing aggregate demand only effects employment if, due to nominal wage rigidity, the real wage falls relative to prices. A Phillips' curve, then, does not describe a set of long-run equilibrium positions. It works only so long as the market does not anticipate what is going on. The widely varying pattern of inflation and employment combinations both between countries and within countries in different historical periods testifies to the power of this insight. Other modern critics of Keynesianism doubt that money illusion is possible or relevant; at least, it matters much less than Keynesians seem to think. Think of it this way: all economists, Keynesians included, agree that some positive amount of unemployment is the natural and inevitable result of freedom of contract, due to quits, dismissals, search and other frictions. Moreover, all economists agree that a change in real factors can affect the rates at which workers find and lose jobs; hence, there will always be some fluctuations in employment. Given this, is it possible that real factors have caused employment fluctations rather than aggregate demand fluctations? There are many variations on this theme. Robert Barro simply doubts that a "strong" correlation exists between real and nominal variables. David Lilien argues that sectoral shifts can account for about half of recent cyclical unemployment normally thought to be caused by fluctuations in aggregate demand. The radical divergence between this approach and Keynes' should be obvious. The second group of critics, whether or not they agree with the first group, have a decidedly different orientation. They argue that, even granted the Keynesian view that unemployment is caused by insufficient aggregate demand, that there are better means to cure unemployment than active fiscal and monetary policies. For example, they argue that active intervention makes the
unstable, since policy can change with the winds of opinions of politicians and the central bank. No one can know policy in advance, so they may make actions which, though reasonable given their ignorance of future policy, are foolish in light of the policy that actually happens. Such critics advocate rules to strictly delimit options the of monetary and fiscal authorities, such as a balanced budget amendment, or a constititionally fixed rate of money growth. This criticism is typical of both monetarists and rational expectationists. Other critics, especially with a public choice slant, doubt whether the government actually would choose to pursue the "optimal" policy even if it knew exactly how to achieve it. They think government actors are self-interested, not angelic servants of the public good. Put otherwise, they view government actions as endogenously determined by the motives of the officials and the incentives of the system, rather than exogenously determined by the wise advice of Keynesian economists. Some possible motives that would deter the quest for "optimal" policies are: the desire to win elections by subsidizing favored groups when expansionary fiscal policy is not needed, or to obtain seigniorage by economically unjustified expansionary monetary policy. A final notable band of theorists of the second group think that central banking is an ineffective way to maintain monetary equilibrium. Instead, they endorse "free banking," a system whose mildly unconventional characteristics will be described later. Free bankers argue that unregulated banks would expand or contract their liabilities by varying their reserve ratios in response to changes in the demand to hold money - and that they would do so automatically in response to profit-and-loss indicators. In their view, this compares favorably with a central bank, which cannot easily discover how to adjust the money supply in response to changes in demand to hold or currency-deposit ratios. Since both the workings of free banking (which has, incidentally, existed historically, and is not merely idle hypothesizing) and the reasons why its proponents think their system would improve upon central banking are relatively unknown, this essay will devote extra space to their critique. Monetarism's and Rational Expectations' Microeconomic Critique Monetarists and rational expectationists have, it is fair to say, completely destroyed naive
with their attacks on its microfoundations. In modern discussions Keynesians as well as anti- Keynesians agree that if wages were perfectly flexible, involuntary unemployment would be impossible. And, even if wages are not perfectly flexible in the short-run, almost everyone agrees that, first, wages are flexible in the long-run, and, second, that this implies that a permanent trade-off between inflation and unemployment is impossible. It is true that all participants to the macroeconomic debate now accept this microfoundational critique of Keynesianism. Still, the power of this attack is clear from the fact that Keynesian theories mitigate, and anti-Keynesian theories emphasize, the practical importance of this fact. Let us, therefore, investigate the classic statements of this critique, then examine the work that builds on it. The microfoundational criticism was forcefully expressed in 1962 by Murray Rothbard, just as the American government for the first time invited leading academic Keynesians to prescribe proper policy for the nation. Rothbard bluntly stated, "Keynesian and neo- Keynesian 'compensatory fiscal policy' advocates that government deflate during an 'inflationary' period and inflateÉto combat a depression. It is clear that government inflation can relieve unemployment and unsold stocks only if the process dupes the owners into accepting lower real prices or wages. This 'money illusion' relies on the owners' being too ignorant to realize when their real incomes have declined - a slender basis on which to ground a cure."1 Rothbard's thesis was ignored by the academic community at the time, but other critics, notably Milton Friedman and Robert Lucas, successfully advanced similar objections after America experienced rising unemployment and rising inflation simultaneously - a phenomenon inconsistent with Keynesianism in its naive form. Writing in 1968, Friedman criticized the Keynesian view that increased aggregate demand increases employment: "But it describes only the initial effects. Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of the factors of production, real wages received have gone down - though real wages anticipated by employees went up, since employees implicitly evaluated the wages offered at the earlier price level."2 Robert Barro is a leading advocate of replacing the Keynesian model with an alternate, "market-clearing" model. After defining the model, he summarizes its implications: "The theory predicts that changes in the monetary base are neutral. In particular, a one-time shift in the quantity of base money leads to proportional changes in nominal variables, but to no changes in the real variables."3 Barro then makes a novel move. Economic theory, he says, must explain the effect of nominal variables on real variables only to the extent that the effect exists. Surely no one would disagree with this. Barro then proceeds to examine the historical evidence of relationships between nominal and real variables. Barro's econometric methods have drawn fire from critics. We shall focus only on his conclusions. In the United Kingdom, he says, there is a negative relationship between wage inflation and unemployment for 1862-1913; no relationship from 1923-39; and a positive relationship for 1947-84. For
described in this paper as belated efforts to make a sober comparison between markets and government. The quality of these arguments, I admit, varies widely. But taken together, I think that they should raise serious doubts about the alleged necessity for the government to correct the macro failures of the market. Determined moral opponents of capitalism will likely aim to make government management work more efficiently rather than abandon it. This approach seems wrong to me. Do not many of the criticisms show that the inadequacies of goverment management are not mere coincidence, but something inherent in the very existence of state control as such? Only if the debaters recognize this can the crucial controversy, the dispute over the nature of the just society, be resolved. Notes 1. Rothbard, Murray. Man, Economy, and State, (Nash Publishing: Los Angeles, 1962), p.879. 2: Friedman, Milton. "The Role of Monetary Policy," American Economic Review, March 1968, p.10. 3: Barro, Robert. Macroeconomics, (John Wiley and Sons, 1987), p.453. 4: ibid, pp.458-63. 5: ibid, p.470. 6: Lilien, David. "Sectoral Shifts and Cyclical Unemployment," Journal of Political Economy, 1982, p.793. 7: Abraham, Katharine and Katz, Lawrence. "Cyclical Unemployment: Sectoral Shifts or Aggregate Disturbances?," Journal of Political Economy, 1986, pp.507-522. 8: Azariadis, Costas. "Implicit Contracts and Underemployment Equilibria," Journal of Political Economy, 1975, pp.1183-1202. 9: Akerlof, George and Miyazaki, Hajime. "The Implicit Contract Theory of Unemployment meets the Wage Bill Argument," Review of Economic Studies, 1980, pp.321-338. 10: Dornbusch, Rudiger and Fischer, Stanley. Macroeconomics, (Mc-Graw-Hill, 1990), p.699. 11: Yellen, Janet. "Efficiency Wage Models of Unemployment," American Economic Review, Vol. 74, No.2, pp.201-3. 12: For an illuminating exception, see Dickens, William, Katz, Lawrence, Lang, Kevin, and Summers, Lawrence. "Employer Crime and the Monitoring Puzzle," Journal of Labor Economics, July 1989, pp.331-347. 13: ibid, p.344. 14: Akerlof, George. "Gift Exchange and Efficiency-Wage Theory: Four Views," American Economic Review, Vol. 74, No.2, pp.79-83. 15: Mises, Ludwig von. Human Action, (Yale University Press, 1966), pp.777-8. 16: Lindbeck, Assar and Snower, Dennis. "Cooperation, Harassment, and Involuntary Unemployment: An Insider-Outsider Approach," American Economic Review, March 1988, pp.167-88. 17: Salop, J. and Salop, S., "Self-Selection and Turnover in the Labor Market," Quarterly Journal of Economics, November 1976, pp.619-628. 18: Friedman, Milton. A Program for Monetary Stability, (Fordham University Press, 1963), p.87. 19: ibid, p.95. 20: ibid, p.93. 21: Barro, op. cit., p.380. 22: Buchanan, James and Wagner, Richard. Democracy in Deficit: the Political Legacy of Lord Keynes, (Academic Press, 1977), p.96. 23: ibid, pp.96-97. 24: ibid, p.129. 25: ibid, p.99. 26: ibid, p.103. 27: ibid, p.63. 28: ibid. p.111. 29: ibid, pp.180-182. 30: Dye, Thomas and Zeigler, Harmon. The Irony of Democracy, (Brooks/Cole Publishing, 1987), p.205, and passim pp.204-229. 31: ibid, p.206. 32: Selgin, George. The Theory of Free Banking, (Rowman & Littlefield, 1988), pp.72-73. 33: ibid, p.76. 34: ibid, pp.64-85. 35: ibid, p.96. 36: Horwitz, Steven. "Keynes's Special Theory," Critical Review, Vol. 3, Nos.3-4, p.424. 37: Selgin, op. cit, pp.96-107. 38: ibid, p.12. 39: ibid, p.135-137. 40: Friedman, Milton. Essays in Positive Economics, (University of Chicago Press, 1953), p.5. 41: On the "Keynesian" anti-depression policies of Herbert Hoover, see Rothbard, Murray. America's Great Depression, (Sheed and Ward, Inc., 1975), especially pp.165-295; and Rothbard, Murray. "Herbert Hoover and the Myth of Laissez-Faire," in A New History of Leviathan, edited by Radosh, Ronald and Rothbard, Murray, (E.P Dutton & Co., 1972), pp.111-145.