A Common Misconception Regarding Keynes and Neoclassical Economics

This editorial expresses a common misconception, that embracing Keynesian policy rejects the ideas of Adam Smith as expressed by neoclassical economics and therefore rejects individual liberty.  The editorial also says that intellectuals and politicians forget about Adam Smith, so let’s see what we can remember about Smith, Keynes, and neoclassical economists:

America benefits from the wisdom of Adam Smith, by Thomas Bray, The Detroit News: In 1971, seeking to justify the scrapping of the gold standard … Richard Nixon declared "we are all Keynesians now." He was referring to British economist John Maynard Keynes, who in the 1930s called the gold standard a "barbarous relic" ... Alas for Nixon, those policies were no more successful in the 1970s than they had been in combating the long Depression.  … President Bush responded to the bursting of the economic bubble of the late 1990s in quite a different fashion ... He cut tax rates and has generally supported Federal Reserve Board Chairman Alan Greenspan's efforts to keep prices on an even keel. ... As a result, the economy has responded with two years of uninterrupted, low-inflation growth, despite the phenomenal spike in oil prices. Bush might say we are all Adam Smithians now, referring to the British economist who argued for the market system and against unbridled government intervention. Indeed, last February, no less than Alan Greenspan paid a remarkable homage to Adam Smith in a lecture in Kirkaldy, Scotland, Smith's birthplace. … Nonetheless, intellectuals and politicians forgot about Smith. They rushed to embrace Keynesian theory, whose near-mystical complexities allowed them to believe government could stimulate the economy to even higher performance. Alas, most of their imagined improvements turned out to have counterproductive long-term effects. As a result, Smith is getting a fresh hearing, as the Greenspan lecture suggests…

First, note that Bray congratulates Greenspan and Bush for their use of tax and monetary policy to manage the economy, then states how faithful this is to the ideas of Adam Smith.  Sorry, but that’s not quite the laissez faire approach Smith had in mind.  But my main purpose is not this particular point so let’s move along. The editorial proceeds on an incorrect premise, one that is common so it’s worth dispelling.

Keynes did not intend to reject neoclassical economics.  The title of his book, which itself ignited controversy, started with the words “The General Theory ..” for a reason.  He was not rejecting the neoclassical paradigm, not at all, his intent as expressed in the title of his book was to improve upon the neoclassical model by generalizing it to give it the ability to explain short-run fluctuations in the economy, something missing from the neoclassical model with its insistence on Say’s law. His goal was to generalize neoclassical theory, not replace it.

When the General Theory appeared in manuscript form, some neoclassical economists expressed concern on this very issue.  Keynes, upon hearing this, wanted to counter this notion strongly and included the following statement in his book to express his solidarity with neoclassical economics.  While there was disagreement over the extent to which his model truly represented a generalization of the neoclassical model and not a special case, that Keynes believed it was a generalization of the neoclassical model rather than a replacement for it is not in doubt.  Also note his discussion of tax and interest rate policy in the first paragaph, precisely the type of Keynesian policy the editorial congratulates Bush and Greenspan for using:

The General Theory of Employment, Interest and Money, ch. 24: … the foregoing theory is moderately conservative in its implications. For whilst it indicates the vital importance of establishing certain central controls in matters which are now left in the main to individual initiative, there are wide fields of activity which are unaffected. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. ... But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary...

Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world. But if our central controls succeed in establishing an aggregate volume of output corresponding to full employment as nearly as is practicable, the classical theory comes into its own again from this point onwards. If we suppose the volume of output to be … determined by forces outside the classical scheme of thought, then there is no objection to be raised against the classical analysis of the manner in which private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them. …. Thus, apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest, there is no more reason to socialise economic life than there was before. …

Thus I agree with Gesell that the result of filling in the gaps in the classical theory is …to indicate the nature of the environment which the free play of economic forces requires if it is to realise the full potentialities of production. … the modern classical theory has itself called attention to various conditions in which the free play of economic forces may need to be curbed or guided. But there will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good.

Let us stop for a moment to remind ourselves what these advantages are. They are partly advantages of efficiency — the advantages of decentralisation and of the play of self-interest. ... But, above all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice. It is also the best safeguard of the variety of life, which emerges precisely from this extended field of personal choice, … it is the most powerful instrument to better the future.

Whilst, therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism. I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

Remember the conditions during the Great Depression.  Keynes believed he was stopping the capitalist system from destruction by the only “practicable means,” not replacing it with a new paradigm.  He wanted to restore the system to full employment where the wonders of the free market system can express themselves, not a State run economy. 

By embracing Keynes, neoclassical economics is not rejected, it is enhanced.  It allows a theory of the short-run to emerge within the classical structure.  Without such a theory our understanding of economic fluctuations is limited. There is currently a movement within the economics profession to do just this type of synthesis.  Real business cycle models, i.e. supply-side models, are adequate models of the long-run but do not explain demand side short-run economic fluctuations very well.  Because of this, they are limited in their applicability.  Models with wage and price rigidities, New Keynesian models, do have the ability to explain such short-run fluctuations but pay scant attention to long-run issues.  Combining these two models, a real business cycle model for the long-run and a New Keynesian model of wage and price rigidity for the short-run, is a promising avenue for explaining macroeconomic fluctuations.  Incorporating New Keynesian theory into these models does not undermine free market principles nor the belief in individual liberty.  Quite the contrary.  By having more realistic models of economic fluctuations, policy and institutions can be designed to enhance the performance of markets and thereby enhance economic well-being.