July 2, 2016

The other half plus the hitherto missing true foundations of macroeconomics

Comment on Richard Koo on ‘The other half of macroeconomics and the three stages of economic development’


Richard Koo’s paper about macroeconomic development is descriptively accurate and historically rich in detail. It is far above the low level of familiar orthodox and heterodox economics. What is lacking, though, is a sound theoretical foundation. This cannot be otherwise because economics as a whole lacks sound foundations. There is no longer anything to dispute, BOTH microeconomics and macroeconomics is a scientific failure.

Koo puts it thus: “Macroeconomics is still a very young science compared to such disciplines as physics and chemistry. It started when Keynes began talking about the concept of aggregate demand in the 1930s, only 85 years ago. As a very young science, it has achieved only limited coverage of the broad range of economic phenomena and remains prone to fads and influences.”

Reality is far worse, indeed. Keynes based macroeconomics on logically and conceptually defective foundations and neither Post Keynesians nor New Keynesians nor Anti-Keynesians have realized Keynes’ foundational blunder in 85 years (2011b; 2014).

Keynes defined 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 two-liner is defective because Keynes never came to grips with profit: “His Collected Writings show that he wrestled to solve the Profit Puzzle up till the semi-final versions of his GT but in the end he gave up and discarded the draft chapter dealing with it.” (Tómasson et al., 2010, p. 12)

Let this sink in, Keynes had NO idea of the fundamental concepts of economics, viz. profit and income. Because profit is ill-defined the whole theoretical superstructure of macroeconomics is false, in particular, ALL I=S/IS-LM models (2011a; 2013b).

Koo starts his analysis as follows: “One person’s expenditure is another person’s income. It is this unalterable linkage between the expenditures and incomes of millions of thinking households and businesses that makes the study of the economy both interesting and unique.”

Note that Koo’s first sentence is identical to Keynes’. For every economist, this proposition is pure common sense ― a mere accounting identity. As a matter of fact, it is provably false and this explodes the whole of macroeconomics. Economists do not grasp the elementary mathematics of accounting (2012a) and this goes a long way to explain why economics has never risen above the proto-scientific level.

To get out of failed economic theory requires nothing less than a full-blown paradigm shift from accustomed microfoundations and Keynes’ flawed macrofoundations to entirely new macrofoundations. In other words, the faulty axiomatic foundations of standard economics have to be replaced.

In the following, a sketch* of the formally and empirically correct price, employment, and profit theory is given. The most elementary version of the objective structural Employment Law (2012b) is shown on Wikimedia AXEC62

From this equation follows:
(i) An increase in the expenditure ratio ρE leads to higher employment (the Greek letter ρ stands for ratio). An expenditure ratio ρE greater than 1 indicates credit expansion, a ratio ρE less than 1 indicates credit contraction.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete and testable Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.

Item (i) and (ii) cover Keynes’ and Koo’s arguments about aggregate demand. What is missing in the Keynesian multiplier is the factor cost ratio ρF 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.

For the relationship between real wage, productivity, profit, and real shares see (2015, Sec. 10)

The correct macroeconomic Profit Law reads Qm ≡ Yd+I−Sm (2014, p. 8, eq. (18)). Legend: Qm monetary profit, Yd distributed profit, Sm monetary saving, I investment expenditure. The interaction of I and Sm underlies Koo’s description of economic expansion and balance sheet recession (2013a). What is entirely missing in Koo’s description is the interaction of Qm and Yd.

The profit equation gets a bit longer when import/export and government are included.

Note that OVERALL profit and by consequence the income distribution has NOTHING to do with productivity or low wages or market power. These and other factors affect only the DISTRIBUTION of overall profit BETWEEN firms. What holds on the firms’ level does NOT hold for the economy as a WHOLE. Not to realize this is the fatal insufficiency of economists’ feeble-minded ruminations about the relationship between (average) wage rate, price, productivity, and employment.

Keynes’ approach is macrofounded but incomplete because he had no deeper understanding of the profit, the credit- and the price mechanism. Koo’s approach is a clear improvement with regard to the credit mechanism but shares the fundamental conceptual error which is embodied in this simple proposition: Income = value of output. It is as commonsensical and scientifically false as the sun goes up.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011a). Squaring the Investment Cycle. SSRN Working Paper Series, 1911796: 1–25. URL
Kakarot-Handtke, E. (2011b). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL
Kakarot-Handtke, E. (2012a). The Common Error of Common Sense: An Essential Rectification of the Accounting Approach. SSRN Working Paper Series, 2124415: 1–23. URL
Kakarot-Handtke, E. (2012b). Keynes’ Employment Function and the Gratuitous Phillips Curve Disaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2013a). Redemption and Depression. SSRN Working Paper Series, 2343561: 1–28. URL
Kakarot-Handtke, E. (2013b). Settling the Theory of Saving. SSRN Working Paper Series, 2220651: 1–23. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

* Students are referred to the working papers on SSRN for all details and the consistent formal underpinning of all assertions