May 19, 2016

What Keynes really meant but could not really prove

Comment Lars Syll on ‘Krugman and “what Keynes really meant”’

Blog-Reference and Blog-Reference

Keynes clearly saw that economics of his time was just a matter of belief: “On the one side were those who believed that the existing economic system is in the long run self-adjusting, though with creaks and groans and jerks, ... Those on the other side of the gulf, however, rejected the idea that the existing economic system is, in any significant sense, self-adjusting.” (See intro)

Belief is the very opposite of science. Science is about knowledge. And scientific knowledge is clearly defined by material and formal consistency. What Keynes meant is that there are two beliefs about the economy and that neither side could prove their case. From this follows: “Thus, if the heretics on the other side of the gulf are to demolish the forces of nineteenth-century orthodoxy ... they must attack them in their citadel ... There is, I am convinced, a fatal flaw in that part of the orthodox reasoning that deals with the theory of what determines the level of effective demand and the volume of aggregate employment ...”

Neither Keynes nor the After-Keynesians, though, delivered anything that came close to a scientific proof. All controversy remained on the level of opinion and belief. So let us now PROVE that the market economy is NOT self-adjusting as Orthodoxy claims.

Keynes formulated the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

This formal core, a.k.a. axiom set, is false, just as the Walrasian axiom set, a.k.a. citadel, is false. Consequently, what has to be done is to fully replace Keynes’s formal starting point. This is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

For the graphical representation of the ABSOLUTE formal MINIMUM see link #1. A1 to A3 asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the ADDED preliminary conditions of (i) budget balancing, i.e. C=Yw, and (ii), market clearing, i.e. X=O.

Under the conditions (i)|(ii) the price is derived in each period as P=W/R (1), i.e. the market clearing price is in the most elementary case equal to unit wage costs. This is the simplest form of the Law of Supply and Demand. It holds for the economy as a WHOLE.

The first point to notice is that the real wage W/P is invariably equal to the productivity R according to (1). So, for the economy as a whole the marginal principle does NOT hold. This is the first blow for the citadel.

The second point to notice is that monetary profit, i.e. Qm=C-Yw, in the most elementary case of the pure consumption economy is zero because of (i). For profit/loss to emerge this condition has to be lifted.

Note that the product market is cleared due to condition (ii), and it has been left open so far HOW this is done in practical detail. These details are not needed at the moment.

It is assumed now that actual employment L is below full employment Lf. There is no need to define Lf at this stage in greater detail.

Now, the orthodox behavioral assumption is added that the wage rate W falls as long as there is unemployment, i.e. as long as L-Lf is less than 0. What happens then? From (1) follows that the price falls and that the real wage is invariably equal to the productivity R. The profit of the business sector is again zero. Hence, the wage reduction does NOT increase profit.

For the firm/business sector there is no motive to move in any direction. All employment levels are INDIFFERENT with regard to profit. There is NO such thing as equilibrium/ disequilibrium. The wage reduction can be repeated for an arbitrary number of periods, the only result is deflation. The flexible fall of the wage rate cannot clear the labor market. This is the second blow for the citadel.

Up to this point we have dealt with the pure consumption economy. Perhaps things change when the business sector is differentiated? So, in the next step the investment economy has to be investigated.

To cut the meticulous formal derivation short (2012; 2014a; 2014b), the most elementary version of the employment equation for the economy as a whole is given with link #2. From this equation follows:
(i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio).
(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.

The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export. Employment is now the dependent variable, the price is among the independent variables.

Item (i) and (ii) cover Keynes’s arguments about effective demand. What is missing in the Keynesian employment multiplier, though, is the ratio rhoF as defined in (iii). This variable embodies the price mechanism. It works such that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa.

This is the very OPPOSITE of what economics teaches. “We economists have all learned, and many of us teach, that the remedy for excess supply in any market is a reduction in price. If this is prevented by combinations in restraint of trade or by government regulations, then those impediments to competition should be removed. Applied to economy-wide unemployment, this doctrine places the blame on trade unions and governments, not on any failure of competitive markets.” (Tobin, 1997, p. 11)

The orthodox adaption rule for competitive markets DESTABILIZES the system. The system is NOT self-adjusting. This is the third and lethal blow for the citadel. Note that all this is no longer a matter of belief and wish-wash but of proof. The employment equation is formally consistent and because it consists of measurable variables its material consistency can be readily established through testing. This settles the matter once and for all according to the immutable scientific criteria of true/false.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014a). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2014b). Towards Full Employment Through Applied Algebra and Counter-Intuitive Behavior. SSRN Working Paper Series, 2456184: 1–25. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money.. London, Basingstoke: Macmillan.
Tobin, J. (1997). An Overview of the General Theory. In G. C. Harcourt, and P. A. Riach (Eds.), The ’Second Edition’ of The General Theory, volume 2, pages 3–27. Oxon: Routledge.

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REPLY to Paul Davidson 'Yes or No: Is the economy self-adjusting?' on May 23

Thank you for the reference to your INET article.* It covers the whole range of controversies between Keynes and what he called the citadel or Orthodoxy. The stated purpose of my post, though, is just the opposite, it is to focus exclusively on ONE point, the key point.

My understanding is the same as Keynes’s: “We are ... at one of those uncommon junctures of human affairs where we can be saved by the solution of an intellectual problem, and in no other way.”**

The only way the key question can be solved is by scientific proof. Proof has two dimensions: formal AND material consistency. Roughly speaking the procedure is as follows: (i) state your premises with utmost clarity, (ii) do NOT take outcomes into the premises (e.g. equilibrium = petitio principii), (iii) do NOT take nonentities into the premises (e.g. optimization, ergodicity, rational expectations), (iv) start with the MINIMUM of premises (= Occam’s razor), (v) derive the conclusions consistently from the premises, (vi) test the conclusions.

So, the key question is ‘Is the economy self-adjusting?’ and NOT how Keynes’s ideas have been perverted from Samuelson onward to Krugman. This is a legitimate question in itself, of course, but does not bear upon the key question which is about the working of the economy and NOT about the working of academic discourse.

What is needed are the objective determinants of employment/unemployment and NOT the accustomed silly second-guessing of human nature/behavior. The most elementary version of the employment equation for the economy as a whole which satisfies the methodological requirements (i) to (v) is given with link #1 (2012).

This equation embodies the price mechanism and the interaction between TWO markets, the product and the labor market. It works such that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa. This means that the orthodox rule, i.e. the remedy for excess supply is a reduction in price, does NOT apply to the labor market. This means in turn that Orthodoxy got the interaction of the two pivotal markets wrong. The Walrasian/Hayekian/Lucasian/ Krugmanian story of market coordination is provable false.

The structural instability is a feature, not a bug. So, the filibuster about flexibility/ stickiness or short run/long run is way beside the point.

All this follows from the correct employment equation, which in turn follows from three elementary structural premises. After having established formal consistency the only thing that has to be done by Heterodoxy is to establish material consistency, that is, to empirically test the equation. To continue the discussion about what Keynes or Krugman meant or means is practical idiocy.

The market economy is NOT self-adjusting. Q.E.D.

Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL

* Article
** See Keynes’s 1934 BBC radio address at Econospeak
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