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1.7 Theoretical Schizophrenia and the Neoclassical Synthesis

We can only speculate on what Keynes would have made of the Keynesian

policies carried out in his name. What we can see more clearly, with the benefit

of hindsight and experience, is that at the theoretical level Keynesian economics

created schizophrenia in the way that economics was taught, with courses in

microeconomics typically concentrating on issues relating to allocation, production

and distribution (questions of efficiency and equity) and courses in

macroeconomics focusing on problems associated with the level and the longterm

trend of aggregate output and employment, and the rate of inflation

(questions of growth and stability). The Keynesian propositions of market

failure and involuntary unemployment expounded within macroeconomics did

not rest easily alongside the Walrasian theory of general competitive equilibrium,

where the actions of rational optimizing individuals ensure that all markets,

including the labour market, are cleared by flexible prices. In the Walrasian

model, which dominated microeconomics, lapses from full employment cannot

occur. Although Paul Samuelson and others attempted to reconcile these two

strands of economics, producing a ‘neoclassical synthesis’, Keynesian macroeconomics

and orthodox neoclassical microeconomics integrated about as

well as oil and water. During the ‘Golden Age’ this problem could be ignored.

By 1973, with accelerating inflation, it could not. As Greenwald and Stiglitz

(1987) have argued, from this point there were two ways in which the two subdisciplines

could be reconciled. Either macro theory could be adapted to orthodox

neoclassical micro theory (the new classical approach) or micro theory could

be adapted to macro theory (the new Keynesian approach). As we shall see,

these attempts at reconciliation have been a dominating influence on macroeconomic

theorizing during the past three decades.

Keynes himself had contributed to this dichotomy because he saw ‘no

reason to suppose that the existing system seriously misemploys the factors

of production which are in use … It is in determining the volume, not the

direction, of actual employment that the existing system has broken down’

(Keynes, 1936, p. 379). In other words, the apparent inability of the capitalist

system to provide for full employment was the main blemish on an economic

system which Keynes otherwise held in high regard. Once this major defect

was remedied and full employment restored, ‘the classical theory comes into

its own again from this point onwards’ and there ‘is no objection to be raised

against 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’ (Keynes, 1936, pp. 378–9). Thus

Keynes can be viewed as attempting to reconcile two opposing views of a

capitalist market economy. First, we have the classical–neoclassical view

which extols the efficiency of the price mechanism in solving the fundamental

allocation and production problems which arise from the scarcity of

resources. Second, we have Keynes’s iconoclastic vision which highlights the

shortcomings of the invisible hand, at least with respect to the general level

of output and employment. Keynes was optimistic that this later problem

could be solved with limited government intervention, and capitalism could

be saved from itself.

The synthesis of the ideas of the classical economists with those of Keynes

dominated mainstream economics at least until the early 1970s. The standard

textbook approach to macroeconomics from the period following the Second

World War until the early 1970s relied heavily on the interpretation of the

General Theory provided by Hicks (1937) and modified by the contributions

of Modigliani (1944), Patinkin (1956) and Tobin (1958). Samuelson’s bestselling

textbook popularized the synthesis of Keynesian and classical ideas,

making them accessible to a wide readership and successive generations of

students. It was Samuelson who introduced the label ‘neoclassical synthesis’

into the literature in the third edition of Economics, in 1955. This synthesis of

classical and Keynesian ideas became the standard approach to macroeconomic

analysis, both in textbooks and in professional discussion (see Chapter

3). The orthodox Keynesian model provided the foundation for the largescale

macroeconometric models developed by Lawrence Klein and also those

associated with the Cowles Commission. Such models were used for forecasting

purposes and to enable economists to assess the likely impact on the

economy of alternative economic policies. Lucas and Sargent (1978) have

attributed the ‘dominant scientific position’ that orthodox Keynesian economics

attained by 1960 to the fact that it ‘lent itself so readily to the formulation

of explicit econometric models’. As far as macroeconomics was concerned,

for the majority of researchers in the 1960s, the ‘Keynesian model was the

only game in town’ (Barro, 1989a).

The orthodox Keynesian argument that government intervention, in the

form of activist monetary and fiscal policies, could correct the aggregate

instability exhibited by market economies also influenced political decision

makers. At least up until the mid-1970s both Labour and Conservative parties

in the UK adhered to orthodox Keynesian principles. In the USA it was not

until the early 1960s that the Keynesian approach (known as the ‘New Economics’)

was adopted with any real enthusiasm (Tobin, 1987; Perry and

Tobin, 2000). The Council of Economic Advisers (CEA) appointed by President

Kennedy was dominated by Keynesian economists. Chaired by Walter

Heller, the CEA also included James Tobin and Robert Solow while Paul

Samuelson served as an unofficial adviser (see Snowdon and Vane, 2002a). In

1971 even President Nixon had declared that ‘we are all Keynesians now!’

However, by the 1980s, US economic policy was very different from that

prevailing during the Kennedy–Johnson era (see Feldstein, 1992).

Before the 1970s the Keynesian approach gave emphasis to demand-side

factors. Keynes had reversed Say’s Law, and Keynesianism, based on the IS–

LM interpretation of Keynes, was the established orthodoxy in macroeconomics

(see Chapter 3 and Patinkin, 1990a, for a discussion of the IS–LM interpretation

of Keynes). Initially Keynesianism was associated with fiscalism but by

the late 1960s the importance of monetary factors was widely recognized by

Keynesians (see Tobin, 1987, 1996; Buiter, 2003a). The most important

Keynesian development during this period was the incorporation of the Phillips

curve into the prevailing macroeconomic model (see Phillips, 1958; Lipsey,

1978; Chapter 3). By the early 1960s the IS–LM model was being used to

explain the determination of output and employment, while the Phillips curve

enabled the policy maker to predict the rate of inflation which would result

from different target levels of unemployment. The simultaneous increase in

both unemployment and inflation (shown in Tables 1.4 and 1.5) in the major

industrial economies in the early 1970s proved fatal to the more simplistic

versions of ‘hydraulic’ Keynesianism and prepared the way for the monetarist

and new classical counter-revolutions (see Johnson, 1971; Bleaney, 1985; Colander,

1988). The 1970s witnessed a significant renaissance of the pre-Keynesian

belief that the market economy is capable of achieving macroeconomic stability

and rapid growth providing the visible (and palsied) hand of government is

prevented from conducting activist discretionary fiscal and monetary policies.

The stagflation of the 1970s gave increasing credibility and influence to those

economists who had for many years warned that Keynesian macroeconomic

policies were both over-ambitious and, more importantly, predicated on theories

that were fundamentally flawed (see Friedman, 1968a; Hayek, 1978;

Buchanan et al., 1978; Lucas and Sargent, 1978; Romer and Romer, 1997).

The demise of the neoclassical synthesis mainstream position signalled the

beginning of a period when the dominance of Keynesian macroeconomics

came to an end and, as we have seen, the breakdown of this consensus

position was due to both empirical and theoretical flaws (see Mankiw, 1990).

For the more extreme critics of Keynesianism the task facing the new generation

of macroeconomic theorists was to ‘sort through the wreckage determining

which features of that remarkable intellectual event called the Keynesian

revolution can be salvaged and put to good use and which others must be

discarded’ (Lucas and Sargent, 1978).