Macroeconomics for Monetary Policy: Differences between Keynes and Mainstream Economists.

Dr. Asad Zaman

Below I will summarize insights which have been gained from decades of study of a complex and
confusing subject. I believe that these insights are essential background for good decision making with
respect to monetary policy.

Following the lines of Keynes’ famous book: The General Theory of Employment, Interest and
Money”, Macroeconomics concerns the relationships between the three quantities mentioned.
Knowing these relationships is an essential pre-requisite to understanding how to conduct fiscal and
monetary policy. Unfortunately, there currently exists massive confusion on the fundamental principles
of Macroeconomics. Keynesian theory explained the Great Depression of 1929, which could not be
explained by classical economic theories (CET). There are three major principles on which Keynesian
theory was diametrically opposed to CET:

1. According to CET, unemployment cannot persist for a long time. If there is excess supply of
labor, the wage will go down, increasing demand for labor, which will lead to the elimination of
unemployment. However, Keynes argued that this was not true. The wage is fixed in nominal
terms, so it cannot go down. Alternatively, when wages go down, prices will also go down,
leaving real wage unchanged. This means that unemployment can persist for long periods – as
was observed to happen in the Great Depression. It follows the government must undertake
policies to ensure full employment.

This is the single most important conclusion of Keynesian theory. Just before the Great Depression, all
resources, including laborers, were fully employed. Thus the economy was capable of providing jobs for
all, and producing at full capacity. After the Great Depression, with no physical changes or damage to
productive capacities, suddenly there was massive unemployment. Production was way below the
potential of the economy, and vast numbers of people had miserable lives because they could not earn
a living. Why? And What could be done to fix the problem?

The Keynesian solution was that the government should undertake fiscal and monetary policy to
eliminate unemployment. This is the single most important target for the government, especially since
free markets cannot eliminate unemployment on their own. Basically this involves providing money
and/or jobs to the people, so that they can undertake actions, investments, projects on their own.
Money/credit is like the lifeblood of the economy, and having an insufficient supply makes it impossible
to have a healthy economy which provides jobs for all. Money can be provided by printing money, or
using fiscal policy to directly provide jobs to all, even if this involves running a deficit.

2. While the classical/neoclassical economists believe that money is neutral, meaning that it has no
effects on the real economy in the long run, Keynes argues that money had real effects both in
the short run and in the long run. In particular, too little money leads to unemployment, and too
much money leads to inflation. So money must be kept at exactly the right level to create full
employment and avoid inflation. This Keynesian prescription described the job of the Central
Banks for a long time, until changes in Macroeconomic thinking led to the current confusing
state of affairs now widely prevalent all over the globe. Even now, the mandate of the SBP
reflects Keynesian views, since SBP should ensure low inflation and full employment.
 3. The third important difference between Keynes and CET was that Keynes argued that the future
was basically unpredictable. For a more detailed explanation of the difference between Keynes
and the Classics, see The Ergodic Axiom, which the classics invoke to use past patterns to predict
the future. Because Keynes rejected this axiom, Keynesian investors do not have the knowledge
about the future required to make “rational” investment plans, which would maximize payoffs.
Investment in future capacity is the CRUCIAL and CENTRAL driver of future growth. If investors
are pessimistic, they will not invest enough, and economic growth will be choked off. One could
counteract this to some extent by providing loans at low interest rate, but this might not be
sufficient. In this case, the government had to do the investment itself, in order to create
economic growth. Again, this involves fiscal policy. Note the CET assumes, to the contrary, the
investors can foresee the future and therefore plan their investment in an optimal way to create
maximum growth. This means that there is no role for government investment. To create a
further barrier to government intervention, Chicago economists insist that if the government
invests, it will drive out an equivalent amount of private investment. This is called crowding out.
Keynes argued for crowding-in, under certain situations. In a recession, government investments
can create better expectations about the future, and thereby create additional private sector
investment.

When I was going to graduate school in the 1970’s, there was widespread consensus on Keynesian
Macroeconomics. The Monetarist school of thought, which was opposed to Keynesian ideas, was a small
minority, and our professors often dismissed them as eccentric ideologues, and joked about how
ridiculous their theories were. In effect, this meant that there was only one school of macroeconomic
thought.

To understand what
happened next, we must
switch to the political
economy view. Economic
theories are not neutral.
Each theory helps some
groups and hurts some
others. If powerful groups
are hurt by economic
theories, then they
manufacture and propagate
different types of theories.
Keynesian theory had
damaged the interests of
some very powerful groups
in the economy. This graph shows the picture of the damage done by Keynes to the rich and powerful.
After the Great Depression in 1929, strong banking regulations prevented banks from making arbitrary
expansions of credit, thereby strongly restricting the power of the top 0.1%. Keynesian policies which
led to full employment created a further boost for the bottom 90%. The combined effect of these is seen
in the rise of the blue line, reflecting a greater share of income for the bottom 90% from 1930 to 1985.
This is followed by a fall which started in 1985 and is continuing. At the same time, we see a fall in the
share of the top 0.1% from 1929 to 1980. Since 1980 the top 0.1% have been on an increasing uptrend,
and have recently overtaken the bottom 90% in 2010. From this graph it is clear that (1) Keynesian
theory empowered laborers and strengthened the bottom 90% from 1930 to 1980, and (2) Financial
Regulation following GD29 strongly restricted the financial powers of the top 0.1%. Chafing under these
restrictions, the top 0.1% planned a counter-attack, to de-regulate finance, and to discredit Keynes.

The opportunity for a counter-attack which had been planned for some time, came in the early 197o’s.
US support for Israel in the Yom-Kippur war led to the Arab Oil Embargo, which created oil shortages
and price increases in the USA in the 1970’s. Furthermore, unemployment also increased as a result of
structural changes in the economy in response to oil price shocks. This was contrary to simplified
Keynesian theory, which says that only one of the two can happen. When money is less than required,
there will be unemployment, and when it is greater there will be inflation. The two cannot both happen
at the same time. In fact, this conflict is superficial and can easily be fixed. Keynes was talking about
inflation driven by excess supply of money, which is now called demand-pull inflation. The rising oil
prices led to cost-push inflation which was not under consideration in the Keynesian scenario. So
“stagflation” is not in conflict with Keynesian theories, as many Keynesian of the times argued in the
1970’s. Indeed, these concepts of demand-pull and cost-push were invented to protect Keynesian
theories from the attack that was made upon them. However, the Chicago School took advantage of the
confusion and shock following the small economic crisis, to successfully argue that Keynesian economics
was wrong, and to replace it by pre-Keynesian ideas regarding Macro-economics. Paul Romer, who was
trained by Lucas and was a Chicago School Disciple for a long time, remarked recently that:

Sabena Alkire and Angus Ritchie, in their discussion paper entitled “Winning Ideas: Lessons from free
market economics” discuss the following question: “How did these [Chicago School, free market]
economists move from a marginalized position where they could not publish or receive tenure and
where their students were not hired at other leading universities, to a position of dominance?”. This is
an important study in how a revolution in thought was carried out, where Keynesian macroeconomics
went from being a dominant paradigm to a discredited theory, while free market economics did the
reverse. Alkire and Ritchie document how “free-market economists patiently developed a line of
thought and cultivating a community over more than 25 years, and waited for a crisis, to provide the
right timing for practical interventions. This conscious reshaping of the intellectual landscape has had a
huge impact on contemporary thought and practice.” The paper focuses on the strategies used to
achieve this revolution in thought. Three main strategies are identified: [1] Taking the high moral ground
– arguing in terms of freedom versus slavery, and similar morally grounded positions. [2] Leaders made
special efforts to reach ‘intellectuals’: journalists, novelists, entrepreneurs and filmmakers being prime
examples. The people who write op-eds in magazines and newspapers, and who direct documentaries,
comedies corporations and films determine which ideas become popular, which determines the future
trajectory of Society. [3] Develop an intellectual community – think tanks, societies etc. – Mt. Pelerin
Society, University of Chicago, IEA, Heritage Foundation, Hoover Institute. These were designed to
endure and to create influence, for this was a long run battle of ideas. [4] Foster Talent: attract bright
youngsters to the program and support them. [5] Choose Good Timing to introduce Change – that is,
after a crisis. It is the last point, the possibility of creating a change after a crisis, that is the focus of
Naomi Klein’s book: “The Shock Doctrine: The Rise of Disaster Capitalism”. Klein’s book is essential to
understanding economics in the 20th century, as it gives a global picture of how economic crises were
used to push capitalistic ideas all over the world, and how this has created disasters all over the world.

In particular, the Reagan-Thatcher era in USA and UK led to the ascent to power of the free market
economists all over the developed world. Keynesian and other schools of thought were marginalized.
The three doctrines that Keynes had disputed came back into fashion. Large numbers of Nobel Prizes
since then have been awarded to Chicago School economists. As an example, Hayek was so discredited
that he could not get a job in any economics department, but won a Nobel Prize in economics in 1974,
signaling the rise of the Chicago School. The Chicago School put forth exactly the same ideas that had
been discredited by Keynes:
1. In “A Re-Statement of the Quantity Theory of Money”, Milton Friedman put forth the same old
idea that money is neutral in the long run, contrary to Keynes. He also put forth several ideas as
to why Keynesian monetary policy was a bad idea, and should not be practiced. Instead, he
argued that Banks should announce a particular fixed rate of increase of the money stock, like
3% or so, and stick to this. This policy was tried briefly in the UK in the 1980’s and quickly
rejected because it led to very bad results. Nonetheless, Friedman’s ideas regarding money
became widely accepted
2. The “Natural Rate of Unemployment” was introduced, and the argument was again made that
government policies cannot influence unemployment. In opposition to Keynes, Nobel Laureate
Robert Lucas argued that the market does eliminate unemployment. Why do we observe large
unemployment? It is because people do not want to work at the going wage – that is
“voluntary” unemployment. The market provides jobs to all who want to work.
3. The theory of “Rational Expectations” says that, contrary to Keynes, people can forecast the
future accurately. The private sector uses these forecasts to make exactly the correct amount of
investment in the best areas to create maximal growth. Government fiscal policy can only have
harmful effects, since the government cannot choose the correct areas of investment. Also,the
“Crowding-Out” theory says that all government investment crowds out an equal amount of
private investment.

In this way, the dominant macroeconomic theories were completely reversed from Keynesian theories.
The rejection of Keynesian theories led to massive confusion in the field of macroeconomics. Several
textbooks list Seven Schools of Thought in Macroeconomics, all with different policy prescriptions. There
is similarly blooming confusion in the field of monetary theory, again with about seven different views
about the nature and role of money. Under the influence of the Chicago School, Central Banks all over
the world dropped the full employment target as being out of reach of monetary policy, and went back
to inflation targeting. However, the result of this policy neglect has been a rise in unemployment
globally, and “secular stagnation” – lower growth rates, because of unutilized labor resources.

After the global financial crisis (GFC) 2007, there has been a “Return to Keynesian Economics” as has
been recognized by many leading economists. Monetary policy does matter, both in the short and the
long run, and has dramatic effects on employment and growth. The key factor in producing growth is full
employment. This is also the key to prosperity and human welfare, since the ability to earn a living is a
key determinant of life satisfaction. Good monetary and fiscal policy can do a lot to promote this goal.
Unfortunately, development of macroeconomic theories completely out of sync with reality has put this
goal completely out of the vision of planners. As somebody pointed out, according to Robert Lucas, The
Great Depression was actually The Great Vacation, where everybody voluntarily took time off from
work. A signal of how widely the Chicago School ideas about natural rate have spread is that we have no
good measures of employment, and these numbers are not presented, either in our MPC meeting
deliberations or in the FPAS models. In fact, the employment numbers are the single most important
figure which need to be considered in monetary policy decisions.