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Luke’s reign failed to dethrone Keynesian economics

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John Maynard Keynes (1883-1946) is undoubtedly the most influential and eminent economist of the past century. His ideas have had a lasting influence on policymakers around the world, who to this day swear by his concepts of fiscal stimulus and monetary policy as measures to revive the economy. This seems intuitive and logical. Most of the ideas were developed during the Great Depression of the 1930s. His magnum opus The General Theory of Employment, Interest and Money was published in 1936, in the midst of two world wars and at the bottom of a deep global recession. His approach was abstract, yet his precepts seemed practical. He introduced many new concepts to macroeconomics, one of which was the prevalence of widespread involuntary unemployment to explain chronic unemployment. The word ‘involuntary’ may seem superfluous, because no one chooses to remain unemployed in a recession, right? He also posited the concept of downward sticky wages that do not fall despite high unemployment. Keynes’s advice was followed by governments, but the flaws in his model caused some unease among economists, especially those with laissez-faire tendencies. They were accustomed to the idea of ​​supremacy of supply and demand and could not easily accept ad hoc deviations from free market principles. But if the market functioned, why didn’t wages fall to zero to accommodate the hordes of the unemployed during a recession? Keynes was right about the facts, but his theory lacked a sufficiently rigorous mathematical model to explain sticky wages. And how can macroeconomic outcomes be explained by optimizing and maximizing behaviour? A policy implication of Keynesian theory was that there was a trade-off between unemployment and inflation, and that it was possible to reduce unemployment by tolerating higher inflation. This was the famous Phillips curve.

This was the basis of the revolution against Keynesian theory, beginning with Milton Friedman and culminating in the work of Robert Lucas in the early 1970s. Friedman said that in the face of policy-induced inflation, workers would simply demand higher wages, and ultimately there would be no gains in employment, rendering the Phillips tradeoff useless. Friedman was proved right by the emergence of a new phenomenon called stagflation, which demonstrated the coexistence of high inflation and high unemployment. This was the beginning of the “rational expectations” revolution, which Robert Lucas, who passed away this week (1937-2023), elevated to a paradigm shift away from Keynesianism. Lucas almost single-handedly steered the economics profession in a radically new direction, paving the way for a whole movement called “microfoundations” of macroeconomics. One of his main insights was that public policy cannot be based on ad hoc models that do not explicitly take into account how people will behave in anticipation of that same policy. The macro policy should be based on the micro modeling of the behavior of an individual striving for maximum self-interest. A policy that changes behavior and does not explicitly account for that response is suspect in its effectiveness. The rational school of expectation led to the emphasis on the futility of government macro-policy, based on discretion, because sooner or later people will get wind of it and negate the effects. So it is better for policy makers to follow rules rather than discretion. This could be the emergence of monetary fundamentalists sticking to a target of 2% inflation regardless of the employment rate. One of the implications of Lucas’s theory was that business cycles were purely a supply-side phenomenon caused by technological shifts or productivity changes. Any attempt to control aggregate demand through fiscal spending was doomed to failure, and there was no such thing as a ‘demand shock’ as market prices and wages would always adjust. Keynesian economics was in decline. In 1979 Lucas gave a lecture on ‘The Death of Keynesian Economics’. He led a revival of neoclassical economics in which Keyensian thinking was kaput. Lucas’s students were even more devoted as fighters on the front lines of the Chicago school. After the so-called pervasive insights and irrelevance of Keynesian ad hoc policies, the phenomenon of deep recessions was relegated to the past. Rules-based monetary policy was sufficient to deal with minor deviations in economic growth cycles. Lucas himself had moved from the study of business cycles to a larger academic question of how to sustain economic growth. He has a famous quote referring to “what must India do to have passed high economic growth”.

In his 2003 presidential address to the American Economic Association, Lucas stated that the “central problem of depression prevention has been solved for all practical purposes”. But just five years later, the Great Recession hit. This was clearly not a technology or productivity issue. shock. It was an old-fashioned Keynesian-style aggregate demand collapse. A huge pump was needed on a global scale. Monetary policy had failed again, for despite zero interest rates neither investment nor employment rose, a classic Keynesian case of a “finance trap”.

We are all solidly Keynesian now. Lucas cast a long shadow over the profession of macroeconomics and enabled a more analytical approach to the study of macroeconomics. But despite all the hand-waving and ad hoc assumptions, Keynes remains firmly on the throne. For he himself told us that in the end it is the ideas and not the vested interests that survive in the long run.


Joanna Swanson

Joanna Swanson is Europe correspondent at the Thomson Reuters Foundation based in Brussels covering politics, culture, business, climate change, society, economies and inclusive tech. With specific focus in breaking news, she has covered some of the world's most significant stories.