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Leijonhufvud on New Keynesian Economics and the Economics of Keynes

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Leijonhufvud on New Keynesian Economics and the Economics of Keynes Hans-Michael Trautwein1 Leijonhufvud on New Keynesian Economics and the Economics of Keynes 1 Introduction In a famously unpublished paper on The Uses of the Past, which Axel Leijonhufvud presented at the ESHET 2006 conference in Porto and on other occasions, he has compared the evolution of economic thinking to the growth of a decision tree (Leijonhufvud 2006). The basic understanding is that currently predominant theories have developed out of earlier decisions about modelling standards that, at the time of their making, appeared plausible and feasible for reducing complexity. However, those modelling conventions may create blind spots that critically limit their scope. In his semi-centennial classic On Keynesian Economics and the Economics of Keynes (1968) and in many of his later writings, Leijonhufvud has amply demonstrated that it is possible to detect the blind spots by looking at research questions in theories that branched off at lower forks of the Econ tree. Moreover, climbing out on those older branches by way of analytical reconstruction or other methods may lead to new ideas. The theme that Leijonhufvud has extracted from the Economics of Keynes and other writers in the inter-war period is the incompleteness of information in large, complex economic systems that may lead to failures in the intertemporal coordination of activities. Fifty years ago, Leijonhufvud attacked post-war Keynesian Economics (the old Neoclassical Synthesis) for its adherence to a frictions view that reduces macroeconomic pathologies to deviations from optimal general equilibrium, which are caused by nominal rigidities and other spanners in the works of the price mechanism. With the rise of New Keynesian Economics as an integral part of the New Neoclassical Synthesis, based on dynamic stochastic general equilibrium (DSGE) modelling, Leijonhufvud has pointed out time and again, that standard macroeconomics may have made much technical progress since the 1960s, but is still stuck in the frictions view. Referring to the global financial crisis of recent vintage, he considers DSGE modelling conventions to be fundamentally obstructive to analysing core problems of 1 FK II-VWL, Carl von Ossietzky Universität Oldenburg, 26111 Oldenburg, Germany; [email protected]. Draft prepared for the 22nd ESHET conference at the Universidad Complutense de Madrid, 7-9 June 2018. 2 macroeconomic coordination and instability. However, some New Keynesians – and even the occasional Post Keynesian – claim that they have now found ways to deal with those problems within their DSGE frameworks. The aim of this paper is to describe continuity and change in Leijonhufvud’s critique of Old and New Keynesians, and to assess some contrary claims of progress made in the DSGE world. Section 2 summarizes Leijonhufvud’s reinterpretation of Keynes in critique of (Old) Keynesian Economics. Section 3 provides an account of his criticism of New Keynesian Economics which, in comparison with his systematic assessments of older Keynesianism, he has made in more scattered remarks; here these will be directly related to the representative DSGE model of pre- crisis New Keynesianism. Section 4 describes some recent attempts to deal with macro- economic instability within DSGE frameworks. Section 5 takes stock of the progress made or forgone in the light of Leijonhufvud’s interpretation of Keynes. For the sake of simplicity, his first name Axel (a trademark of its own among the literati) will serve as substitute for his complicated surname (old Swedish spelling for Lionhead) throughout the text of the following sections, while Leijonhufvud will mostly be encaged in parentheses for referencing. 2 Keynes and the Keynesians: Axel’s suggested interpretation Leijonhufvud’s 1968 treatise On Keynesian Economics and the Economics of Keynes was based on the dissertation that had earned him a doctoral degree at Northwestern University the year before.2 His original intention for that project had been the construction of a debt deflation theory that would explain the difference between ordinary recessions and great depressions (Leijonhufvud 1998: 174, Snowdon 2004: 123). The 1960s were the time, when it was commonly claimed that ‘we are all Keynesians now’, on the belief that Keynesian economics had managed to eliminate the threat of economic depression once and for all. Yet, Axel found it unacceptable that standard Keynesian economics was lacking a convincing framework for analysing the emergence and dynamics of grave system failures such as the Great Depression. Learning that Irving Fisher had already developed a debt-deflation theory in a (then half-forgotten) contribution to the first volume of Econometrica (Fisher 1933), he gave up on the original intention. Yet, still wondering why debt deflation could not be accommodated in standard macroeconomics, he took his time for a close reading of John Maynard Keynes’s Treatise on Money (1930) and General Theory of Employment, Interest and Money (1936). This resulted in an accumulation of notes and unfinished manuscripts that would not make a coherent PhD thesis 2 This section is based on Trautwein (2018) and Axel’s interviews with Snowdon (2004) and Jayadev and Mason (2015) for biographical information. 3 before time was up for Axel’s acting assistant professorship at the UCLA (University of California, Los Angeles). To avoid going home to Sweden without a PhD degree, Axel reorganized his writings into an admissible thesis, in a way that is certainly not taught as standard fare in PhD courses: As he would jokingly put it ex post, he made the footnotes of his unfinished manuscripts into text and the text into footnotes. The more general theory The result was an interpretation of Keynes that differed substantially from the conventional understanding. This had already become apparent in a preview article, published in the American Economic Review under the title ‘Keynes and the Keynesians: A Suggested Interpretation’ (Leijonhufvud 1967). The title echoed John Hicks’s famous 1937 essay on ‘Mr Keynes and the “Classics”; A Suggested Interpretation’, the birthplace of IS-LM analysis. Axel’s interpretation was diametrically opposed to Hicks’s downgrading of Keynes’s General Theory to a special case, characterized as ‘Economics of Depression’ (Hicks 1937: 155). ‘To be a Keynesian, one need only realize the difficulties of finding the market- clearing vector [of prices]... The only thing which Keynes “removed” from the foundations of classical theory was the deus ex machina – the auctioneer which is assumed to furnish, without charge, all the information needed to obtain the perfect coordination of the activities of all traders in the present and through the future. Which, then, is the more “general theory” and which the “special case”? Must one not grant Keynes his claim to having tackled the more general problem?’ (Leijonhufvud 1967: 404, 410 – italics in the original) The positive answer to the last question became the leitmotif of the dissertation, which earned Axel international recognition and, as collateral benefit, tenure at the UCLA. The removal of the Walrasian auctioneer assumption was a key point, since his critique of Keynesian economics centred on the latter’s implicit use of neo-Walrasian logic.3 By the mid-1960s, macroeconomists had come to regard the IS/LM model in the tradition of Hicks (1937) and Hansen (1949: ch. 5) as a framework that accommodated both Walrasian general equilibrium and Keynesian underemployment. It represented the workhorse model of 3 Later on, Axel (Leijonhufvud 1998: 177) admitted that ‘ “getting rid of the auctioneer” was… a big part of [his] own ‘struggle to escape’ from the neo-Walrasians,’ while ‘it cannot have been a problem that Keynes had with his own classical mentor, Marshall.’ In the corresponding footnote, he explained: ‘I’m afraid that I may be the one responsible for this “anthropomorphication” of Walras’s hypothetical market process. In my 1967 article, “Keynes and the Keynesians”, I wanted to dramatize the contention that (modern) general equilibrium theory was cheating on the obligation to explain how the information required for the orderly coordination of activities was generated and communicated. Clerk Maxwell’s famous thought-experiment in physics carne to mind and I introduced Walras’s auctioneer as my counterpart to Maxwell’s demon.’ (1998: 186 fn. 12) 4 the Neoclassical Synthesis. Although the Walrasian auctioneer was not explicitly invoked in standard IS/LM analysis, general equilibrium defined the benchmark position, in which all intertemporal plans for consumption and production are fully coordinated. Keynes’s general theory of unemployment was confined to three special cases: liquidity traps, investment traps, and nominal wage rigidities. The first two looked indeed like belonging within the special category of depression economics, in which inscrutable market psychology did the trick. After Modigliani (1944), more general explanations of Keynesian underemployment had therefore been reduced to nominal wage rigidities, to frictions in the price mechanism. For Axel, the trouble with the rigidities approach of the Neoclassical Synthesis is its tacit assumption of system stability. Absent such impediments, the price mechanism would automatically return the economy to full employment with perfect coordination of all plans, ‘as if’ the Walrasian auctioneer or some other contrivance of costless recontracting had matched them before any sales and purchases would take place. As indicated by the
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