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Keynes and Keynesian Economics

You began your study of economics at Harvard the very year that the General

Theory was published. What attracted you to economics?

It was an unbelievably happy combination of a subject that promised to save

the world and was fascinating from an intellectual puzzle-solving point of

view. I was also very much worried about the Great Depression and had every

reason to think that the massive failure of our economies was the key to many

other of the world’s ills, political as well as economic.

The General Theory is a very difficult book and reflects Keynes’s ‘long

struggle to escape’ previous ideas. What were your first impressions of the

General Theory?

I didn’t know enough to know it was a difficult book, which I had no business

reading. I was 19 years old. My tutor at Harvard, who had been in England

for a year, just said at our first one-on-one tutorial meeting ‘Why don’t you

and I read this new book I’ve heard about for our tutorial this year?’ I didn’t

know any better so I read it, and I didn’t feel it was that difficult. One of the

exciting things, of course, for a 19-year-old was the sense of intellectual

revolution, overturning the obsolete wisdom encrusted in the past, especially

when the new theory was on the side of promising to do something constructive

about the main problems that concerned me and people of my generation.

Skidelsky [1992] in his biography of Keynes [Volume 2] has argued that

‘Keynes’s inspiration was radical but his purpose conservative’. How did

Keynes reconcile these two opposing forces?

I think that what Skidelsky says is essentially right. Compare Keynes’s remedies

for the problems of the world at the time to those of Marxians and

Spengler’s Decline of the West – all those apocalyptic warnings of the death

of capitalism, because capitalism can’t ever succeed. Keynes comes along

and says that the basic problem is not really the organization of the economy

but rather the way that aggregate demand is controlled. Keynes had no great

complaint about the way the economy allocates the resources that it does

employ, just that it doesn’t employ them all.

It only took about twelve years for the General Theory to capture the hearts

and minds of the vast majority of the economics profession. Why did Keynes’s

ideas spread so quickly?

Well, because it did look as if they would work to remedy the problems of the

Great Depression. There was a lot of anxiety in all countries that after the

Second World War we would revert to the depression conditions of the prewar

period. Keynes’s ideas looked like a pretty good way to avoid that

possibility. In the USA, consider the spending for mobilization even before

we got in the war, and what it did to GNP and employment. That was a

dramatic living vindication of Keynes’s ideas.

You are widely recognized as being America’s most distinguished Keynesian

economist. Are you happy with the label Keynesian and what does being a

Keynesian mean to you?

If you’d asked me that, let’s say 25 years ago, I would have said that I don’t

like any label and that I’m just an economist working on problems that I

happen to be interested in; macroeconomic problems, monetary–fiscal policy

and all those things. There appeared to be a considerable practical consensus

about these matters. A lot of my work had been fixing up Keynes in various

ways where I found theoretical problems or a lack of ‘micro foundations’. In

fact the first thing I wrote and got published [in 1941] was a piece of anti-

Keynesian theory on his problem of the relation of money wage and

employment. So at that time I would have said let’s not label people, let’s just

do our work. After the counter-revolutions, when all these schools and labels

arose, I certainly would be proud to be regarded as a Keynesian, considering

the alternatives [laughter].

What are the fundamental propositions which Keynesians adhere to?

One way to put it is to say that there is a two-regime model of the economy.

Sometimes the economy is in a classical situation where markets are clearing

 (demand equals supply) and the economy’s ability to produce output is supply-

constrained. You can’t produce any more because there are essentially no

idle resources (I exaggerate to simplify). Therefore the constraint on output is

capacity. That capacity constraint results in a price and income structure that

equalizes demand and supply at those prices. At other times the economy is

in a Keynesian situation in which the constraint on actual output is demand –

aggregate spending. Extra output would be produced if there were extra

aggregate real demand, and the inputs to make it are available at real returns

which won’t exceed what the factors of production could earn by their productivity

if they were employed. That situation obtains lots of the time, not

always, and there are then demand-increasing policies that will eliminate the

social waste involved. That I think is the distinction. Whereas for the real

business cycle theorists (like Ed Prescott) and new classical guys (like Robert

Barro) you are always supply-constrained. There is just one regime, and the

observed cyclical fluctuations are fluctuations in voluntary willingness to be


Some interpretations of the neoclassical synthesis which emerged in the late

1950s and early 1960s suggest that the General Theory represents a special

case of a more general classical model. What is your view on that particular


I wouldn’t interpret it that way. Rather there was a consensus on the tworegime

model just mentioned. I thought there was also a normative consensus,

in the sense that you shouldn’t regard any output that you get from putting

unemployed resources to work as free, because you have alternative ways of

putting unemployed resources to work. The same classical opportunity cost

considerations that determine allocation of resources in a classical equilibrium

determine the allocation of resources as among different ways of returning

to that supply-constrained regime. So I think in that sense there is no excuse

for wasteful projects to increase employment, like digging holes in the ground,

because you can arrange to employ people by investments or other projects

that are socially beneficial. In that sense the classical opportunity cost considerations

apply in either regime. But that’s only if you’re prepared to do

something to get out of the wasteful situation that you’re in.

Has too much been made of the Pigou effect as a way of diminishing Keynes’s

contribution to economic theory?

Of course. I’ve said that all the time in print. It’s a very slender reed on which

to assert the efficacy of self-adjusting mechanisms. For one thing the accounting

aggregation of credits and debts doesn’t necessarily imply behavioural

netting out of credits and debts. I believe that the effects of deflation on

aggregate demand can be perverse if debtors have a bigger propensity to

spend from wealth than creditors do – a reasonable expectation. Then there’s

the whole issue of how you get to the lower price level from where you are.

The immaculate conception effect of getting there suggests there’s no real

time involved – it’s just the static comparison of one price level to another

price level. As Keynes himself observed, although he didn’t make of it a point

of theoretical principle, the process of deflation – or disinflation for that

matter – involves an increase in the real interest rate and certainly produces

perverse effects.

Do you think that if Keynes had still been alive in 1969 (aged 86) he would

have been awarded the first Nobel Prize in economics?

Very likely. He would have got my vote. As for Keynes versus Tinbergen and

Frisch, the actual recipients, I don’t know. The prize says for economic

science. In some senses they might have been considered to have made

identifiable innovations more similar to those of Nobel-winning natural scientists.

But JMK would have been an early award-winner.

How do you feel about your award of the Nobel Prize in 1981? What do you

consider to be your most important contributions to macroeconomics?

I never thought I was going to get it. I was interested in straightening out

macroeconomics and the neoclassical synthesis as I understood them, in

generalizing monetary models to take account of the variety of assets, in

portfolio theory and its macroeconomic implications – that’s what I was

trying to do.

Why do you think there are so many conflicting interpretations of the General


Well, I suppose one reason is that the book is ambiguous in many ways and

has a number of strands that could be cited to support different messages.

They allow people a variety of views about the world, in particular, on the

one hand, since people interpret the General Theory as a kind of general

equilibrium model of the determination of output, employment and interest

rates that could be used in both of the two regimes I referred to above. That’s

what J.R. Hicks was doing in his famous article. On the other hand you have

Chapter 12 on long-run expectations, which suggests that maybe there is not

an investment function at all. In the Hicks general equilibrium model you

have got to have an investment function. The second approach, stressing the

conventionality of expectations and animal spirits, may be seen as opening

the way to a different kind of model. This would be supported by Keynes’s

own tentative advocacy of the socialization of investment, his suspicion that

maybe investment wouldn’t be adequately stabilized by monetary and fiscal

policy, his feeling that you need some central planning to get it right. I guess

those ambiguities allow us to interpret it one way or the other. Of course,

some people hoped to extract from Keynes a much more radical position with

regard to the social and political institutions than he had explicitly expressed.

I have in mind Mrs Robinson and others who claim to be the true heirs of

Keynes. I never could get that excited about this kind of battle over Keynes’s

mantle, so to speak. The central part of the book, the central core of the

modelling, is on the other side, Hicks’s side, in my opinion. Certainly that’s

in practice the model that has been taught and has influenced policy making

and macroeconomic theorizing for more than 50 years.

Do you think teaching the IS–LM model is still an important part of an

undergraduate’s understanding of the macro economy given the criticisms of

the IS–LM model by people like Robinson, Clower and Leijonhufvud?

Yes I think the IS–LM model is the tool of first resort. If you’re faced with a

problem of interpretation of the economy – policy or events – probably the

most useful first thing you can do is to try to see how to look at it in these

terms. Since students are in that position, yes they need to know it. It’s not

the end of the matter by any means. I don’t say that it’s enough. I doubt if

Keynes or Hicks would have thought it enough. But it’s a start and lots of

times it’s exactly right.

Critiques of Keynesianism

Would you accept that many of the theoretical changes made in the 1970s,

and inspired by people like Lucas, were the inevitable consequence of defects

in the Keynesian model?

No I wouldn’t accept that. I do think the idea of model-consistent expectations

is a good idea. It would be a bad feature of any equilibrium model that

people chronically perpetuate mistaken expectations about variables, mistaken

in the sense that they are different from those that the model persistently

creates itself. But I think that applying that idea to dynamic situations where

learning is going on and people can have a lot of different opinions about the

world is carrying it too far.

How important do you think it is for macroeconomics to have neoclassical

choice-theoretic foundations?

Well, I think it’s important for the behavioural equations of a macroeconomic

model not to contradict choice-theoretic considerations, to be in principle

consistent with them. But I think the stronger version of ‘micro foundations’

is a methodological mistake, one that has produced a tremendous amount of

mischief. I refer to the now orthodox requirement of postulating representative

agents whose optimizations generate ‘macroeconomic’ behavioural

equations. That is a considerable sacrifice of the essence of much of macroeconomics.

Suppose you have a lot of different types of agents, who are all

maximizing. Then it’s their aggregation into a behavioural equation that you

want for a macro model. That aggregation won’t necessarily be the solution

for any single agent. To insist that it must be seems to me very wrong-headed.

It has put us on the wrong track in macroeconomics or what passes for


In the late 1960s you had a considerable debate with Friedman who at one

stage argued that the main differences between macroeconomists were over

empirical matters. Surely the 1970s demonstrated that there were some fundamental

theoretical differences between macroeconomists?

What Friedman was saying was disingenuous. He had a theory of the demand

for money which put a lot of variables in the demand function including

various interest rates, and yet his monetary policy propositions were based on

the assumption that interest rates were not in the function. He asserted empirical

results that he was unique in finding – that the interest elasticity of the

demand for money was negligible. When he was really stuck by the weight of

evidence, he then wrote that the question of the size of interest elasticity of

the demand for money had nothing to do with anything. The only way one

could make sense of that particular proposition was that you were going to be

at full employment anyway, no matter what the stock of money was, and so

the interest rate would have to be what was consistent with the demand and

supply of savings at full employment. But that was a complete evasion of the

original issues of our debate. He had never before said that monetary policy

would have no effects on real variables. He said they have a lot of effects on

real variables. He had some kind of Phillips curve (although he didn’t call it

that) in his mind, and even when he invented the natural rate he still did. He

didn’t deny that monetary policy would have some effects on real output

during cyclical fluctuations – so he was caught between being a true new

classical economist, in which case he was going to have to say that money

doesn’t ever matter, or being a pragmatic monetarist, where he didn’t have a

good theoretical or empirical basis for what he had been saying.

What exactly is the difference between Friedman’s concept of the natural rate

of unemployment and NAIRU – the non-accelerating inflation rate of unemployment?

Is there some important difference between these two concepts?

I don’t think there is a big practical difference. Maybe what was in the mind

of Modigliani when he started that acronym was that Friedman said that the

natural rate was the amount of unemployment that was the solution to Walrasian

general equilibrium equations – a proposition that neither he nor anybody

else ever proved as far as I know – complete speculation. I mean, why would

Walrasian equations have any unemployment at all in their solution? [laughter].

That identification of the natural rate doesn’t make any sense, and it’s

certainly not true. When Modigliani and others started talking about NAIRU,

they were talking more about a pragmatic empirical idea.

At the end of the day politicians make economic policy. The public choice

school, as well as the work of your colleague William Nordhaus on political

business cycles, suggests that politicians may actually use economic policy

for their own gain. Do you think that Keynes was perhaps naive in thinking

that we could hand over policy making to politicians and they would follow

the advice of economists?

I won’t quote the last paragraph of the General Theory, which says that in the

long run ideas matter. I think that’s true, but I think my point would be a little

different. If we are advising government officials, politicians, voters, it’s not

for us economists to play games with them. It’s not for Keynes to say, I am

not going to suppress the General Theory and not tell the House of Commons,

the Labour Party, the Tories, whomever, that it would be possible to

reduce unemployment by public works expenditure. If I am giving advice to

them about war finance – or whatever else my advice will be not to do bad

things – I am not going to decide myself that they are so evil and irresponsible

that I don’t give them advice about what actions will do what. I don’t

think that Jim Buchanan has, or I have, the right to withhold advice from

Presidents of the United States or Members of Congress or the electorate on

the grounds that if they knew what we know, they would misuse it. I don’t

think that is for us to decide.

You have said that good papers in economics contain surprises and stimulate

further work. On this criterion the 1970s contributions of people like Lucas,

Sargent, Wallace and Barro were good. Do you feel that new classical macroeconomics

has changed macroeconomics for the better?

In some respects I think Lucas’s ideas about policies being anticipated by

actors, so you can’t be sure that behaviour will stay put when you change

policy, is an important idea, one we have to worry about. I don’t think it is as

important an idea as he seemed to think it was. I thought his ingenious

explanation of how you can have observations that look like Phillips curves

yet have none of the operational policy implications of the curve – that was

neat. However, I think it turned out not to be a good idea. It didn’t survive

because of the implausible notion that people are confused about what the

money supply is. If they’re confused, why don’t we publish the money supply

data every Friday afternoon – which in the USA we do of course and have

been doing for a long time. I observe that the new classicals no longer pay

any attention to this misperception story. They have become much more

extreme. Barro’s [1974] paper was provocative and stimulated a lot of theoretical

and empirical work. I had a paper in my Jahnsson lectures [Tobin,

1980a] that gave, I don’t know, say 15 reasons why Barro’s neutrality proposition

doesn’t work, and I think there have been numerous articles since on

each of them.

We have seen a lot of contributions recently from what are called new

Keynesian economists. What is the central difference between your view of

Keynesian economics and the new Keynesian contributions? Is it that they

accept rational expectations and a lot of monetarist ideas?

Yes, they accept rational expectations. Moreover they accept the methodology

of choice-theoretic foundations and representative agents, much more

than I would. They accept market clearing, except as it is modified by imperfect

competition, much more than I would. They regard their task as to give a

rationale for the alleged rigidity of money wages and money prices, a rationale

that allows nominal shocks to create real consequences. I think that was

not Keynes’s idea. Keynes was primarily concerned not with nominal demand

shocks but real demand shocks, which would create problems even if

prices were flexible. They have said that all they are going to do is show how

it is rational for nominal prices to be inflexible and derive unemployment

results from that. I don’t find it extremely convincing – and I’m sure Keynes

wouldn’t have – that the whole effective demand problem is that there are

real costs of changing nominal prices on the menu at the restaurant. I think

Keynes would have laughed at the idea that menu costs are a big enough

resource-using problem to cause the Great Depression or any other substantial

losses of economic activity. It’s not credible. If I had a copyright on who

could use the term Keynesian I wouldn’t allow them to use it [laughter].

What do you think of the real business cycle approach?

That’s really the enemy at the other extreme of macroeconomics. Real business

cycle theory suggests that society is a moving equilibrium responding

continuously to technological–productivity–supply shocks all the time, and

that the economy is doing the best job possible in responding to them. It’s

those benign responses that generate the fluctuations we call business cycles.

There isn’t any unemployment in the Keynesian sense. There are simply

intertemporal substitutions of employment now and employment later, which

are rational responses to the stochastic environment in which people live. I

don’t see any credibility to the idea that people are doing a lot of intertemporal

substitution as to how much they want to work. To interpret the rise in

unemployment in this country from 5.7 per cent in 1978 to 11 per cent in

1982 as a desire on the part of workers to take leisure in preparation for

working when real wages will be higher – that is ridiculous (laughter).

Should we take Lucas’s [1978a] advice and abandon the concept of involuntary


Certainly not. Any time that you don’t have supply and demand equal at

existing prices then there is involuntary something. Some people would like

to supply more, or some people might like to demand more, at those prices

but are not able to do so. The only way you can say that everything must be

voluntary is to assume market clearing all the time – that at every moment in

time the economy is in market-clearing equilibrium.

In new classical models full employment is equated with actual unemployment.

How should we define full employment?

I would define it, as Keynes did, in a classical way at the point where people

are on the supply curve for labour, getting all the work they are willing to

accept at real wages that employers can and will pay for them. Keynes

himself allows for intersectoral flux and frictional unemployment, but essentially

I wouldn’t define equilibrium full employment any differently from a

classical model.

There seems to be more consensus amongst economists on microeconomic

issues than macroeconomic issues. Why do you think this is the case?

Let’s go back to what Keynes said. He didn’t have any big reservations about

the way the market economy allocates the resources it does employ. I think

myself, and many microeconomists and economists in general would say,

that Keynes gave away too much. He should have recognized more externalities

in the ordinary market allocation of resources, and he should have worried

more about the possible social wastes of monopolistic competition than he

did. In many areas of microeconomics like rent control and minimum wages,

choice-theoretic opportunity-cost methodology is being used the way we are

trained to use it. That’s the secret that we know, and sociologists and other

social scientists don’t know. We are a more scientific discipline, but I don’t

think that all is well in those respects. What rational expectations has done to

macroeconomics is what game theory has been doing to microeconomics.

Game theory has the problem that it leads to multiple solutions all the time,

so it doesn’t seem to get results. It’s got the same fascination for people

looking for ways to use their mathematical and puzzle-solving prowess as

rational expectations has, and that comes at the expense of more pragmatic,

and empirical, and institutional industrial organization studies. So, I am not

so sure that all is well in microeconomics either. A lot of good policy work

continues in more applied areas.

Do you see any signs of an emerging consensus in macroeconomics?

It may be coming, but I don’t see it. There is still great conflict.