Classical Macroeconomics

James C.W. Ahiakpor

• Publisher: Routledge
• Year: 2003
• ISBN:
  9781134742035
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

John Maynard Keynes failed to correctly interpret classic economic concepts, and dismissed the classical explanations and conclusions as being irrelevant to the world in which we live. The trauma of the Great Depression and Keynes's changed definition of economic concepts, aided by Eugen Bhm-Bawerk, have made it difficult for modern economists to

1 Introduction

At least three reasons warrant a book focused on restating classical macroeconomics against its distortions in modern macroeconomics mainly through the work of John Maynard Keynes and the distorting influence of Eugen Böhm-Bawerk in spite of the numerous texts on the history of economics, including such general classics as Joseph Schumpeter’s History of Economic Analysis (1954) and Mark Blaug’s Economic Theory in Retrospect (1996), and more focused ones such as D.P.O’Brien’s The Classical Economists (1975) and Samuel Hollander’s Classical Economics (1987). The reasons include: (1) the discordant state of modern macroeconomics, as indicated by the multiplicity of textbooks competing with each other to explain more clearly the workings of the macroeconomy, but with rather limited success, (2) the increased number of camps in modern macroeconomics, reflecting different approaches to macroeconomic analysis and policy formulation since the 1970s, and (3) the rapid disappearance of courses in the history of economic thought from undergraduate and graduate instruction in economics. The general texts cover the life history and works of the principal contributors to the development of modern economics, from the pre-classical period to modern times—both micro and macro—but without the kind of focus needed to resolve the persistent theoretical disputes and misrepresentations of classical macroeconomics in modern macroeconomics. The texts on classical economics or the classical economists delve more into the motivations for their work and their contributions to economic theory and policy formulation, but not with the focus pursued in this book.

Indeed, Schumpeter’s text is hardly of much help in understanding the extent of Keynes’s misrepresentations of classical economics, being rather dismissive of the consistency of several classical arguments. In the specific chapter on “Keynes and Modern Macroeconomics,” Schumpeter describes Keynes’s “brilliance” in crafting his message in the style of the “Ricardian Vice” by the nature of its simplicity and how much Keynes promoted the development of macroeconomics, but hardly an acknowledgment of Keynes’s misrepresentations of classical macroeconomics (1954:1170–84).¹ In an earlier evaluation of Keynes’s treatment of the classical literature, Schumpeter in fact considers some of Keynes’s distortions as merely his having emphasized points most economists already had accepted or should have known, for example, “that the Turgot-Smith-J.S.Mill theory of the saving and investment mechanism was inadequate and that, in particular, saving and investment decisions were linked together too closely” (1951:285). Schumpeter also praises Keynes’s mistaken focus on consumption spending as a determinant of economic growth rather than savings in classical macroeconomics as his brilliance in the “skillful use…of Kahn’s multiplier” (287).²

Much of Hollander’s (1987) focus is to correct some of the interpretations of classical economics by Schumpeter as well as the so-called Cambridge school in the tradition of Piero Sraffa. Hollander does not address the distorting influence of Böhm-Bawerk, Irving Fisher, and Knut Wicksell on Keynes’s reading of classical macroeconomics. He notes that Keynes “had a totally distorted view of classical macroeconomics” (3), which he illustrates with Keynes’s misrepresentation of the classical law of markets (260, 275). But restating classical macroeconomics directly to counter its pervasive misrepresentations in modern macroeconomics is not Hollander’s principal focus as it is in this book. O’Brien’s text is hardly concerned with Keynes’s distortions of classical macroeconomics.

Blaug’s text is not much different from Schumpeter’s in terms of its contribution to understanding the classical literature against Keynes’s distortions. Several of his assessments of the classical literature are in conflict with conclusions reached in this book, including his accusing Adam Smith of having neglected “fixed capital” (1996:35), that Smith “had no consistent theory of wages and no theory of profit or pure interest at all” (38), and that the classics “saw no relationship between utility…and demand” (39). Blaug also tends to side with Keynes’s macroeconomic perspectives such as: (a) his praising Keynes’s mistaken defense of the mercantilist policy of hoarding gold as Keynes’s “intuitive recognition of the connection between plenty of money and low interest rates” (15), as if such intuition were helpful or always valid, (b) his judgment that “If Say’s Law is meant to be applicable to the real world…it states the impossibility of an excess demand for money” (144), just as Keynes claimed, and (c) his assertion that “The forced-saving doctrine [is] restricted…to the case of full employment” (159), again just as Keynes falsely claimed. Even when Blaug characterizes Keynes’s representations of some classical arguments as a “convenient straw man of Keynes’s invention” (674), he goes on to judge Keynes as having been “right!” in contrast with Keynes’s “orthodox contemporaries” (675). This because he accepts as correct, Keynes’s mistaken indictment of Say’s law, arguing: “The capitalist system is in fact a cornucopia that is forever tending to produce too much to be saleable at cost-covering prices. There is indeed in mature industrialised economies an everpresent danger of insufficient aggregate demand” (ibid.). Blaug (1997:235) repeats this claim, adding that such “insufficient effective demand…is indeed curable by standard [Keynesian] demand management.”

The failure of these works to restate classical macroeconomics against Keynes’s misrepresentations and Böhm-Bawerk’s distorting influence and thus assist the resolution of conflicts in modern macroeconomics derives from their failure to pay sufficient (in some cases, any) attention to the principal source of the confusion, namely, the changed meaning of economic concepts Keynes successfully introduced through his General Theory (1936). Significant among these concepts are: (a) saving to mean non-spending or hoarding rather than the purchase of interest- or dividend (profit)-earning assets, (b) “capital” to mean capital goods only rather than also savings or loanable funds, from the perspective of households, (c) investment to mean the purchase of producers’ or capital goods only rather than also the purchase of financial assets by households, and (d) money to mean currency in the hands of the public plus the public’s savings with depository institutions rather than only the currency supplied by a central bank.

The growth in the number of camps in modern macroeconomics from the principal two until the late 1970s, namely, Keynesians and Monetarists, to the current five,³ including the Keynesians, the Post-Keynesians, the New Keynesians, the Monetarists, and the New Classicals, pretty much results from the failure of texts in the history of economic thought to identify the conceptual confusions introduced by Keynes’s work. Thus, some of the schools overlap in their analytical perspectives and can be shown to belong still to two main camps: they are either (a) attempting to affirm Keynes’s views on how the macroeconomy works or (b) attempting to counter Keynes’s arguments. In their policy perspectives, the pro-Keynesians argue demand management through public sector spending and the manipulation of the quantity of money while the anti-Keynesians argue supply-side incentives and monetary stability as the most efficient means of promoting economic growth, trusting in the basic stabilizing forces inherent in a free-market economy. Yet the camps have the same basic trait, namely, their employment of the same definitions of economic variables introduced by Keynes in his successful overthrow of classical macroeconomics with his 1936 book.⁴ Thus none in the anti-Keynesian camp is successful in restating clearly the classical arguments Keynes undermined. This is the sense in which Keynes’s work constitutes a revolution in economic thought, contrary to the denial of such a revolution by Laidler (1999).⁵

The fast disappearance of the history of economic thought from the curriculum of economics education, by itself, may not be fatal to a correct understanding of classical macroeconomics, although it does constitute a hindrance. It may legitimately be argued that the existence of such courses in the past has made little difference to the persistence of the misrepresentations of classical macroeconomics. But the combination of the disappearance with the increasing tendency of textbooks in macroeconomics to treat an examination of the doctrinal disputes as wasteful “detours into the history of thought” (Frank and Bernanke 2002: xii), on the mistaken belief that the necessary resolution to such disputes has already been made, poses a problem for understanding classical macroeconomics. Indeed, Frank and Bernanke say nothing about classical economics or mention the classical economists, including David Hume, Adam Smith, David Ricardo, J.-B.Say, and John Stuart Mill, but they give a short biography of Keynes and teach the Keynesian model in the text.⁶

Bradord DeLong (2002) takes a similar position, arguing:

It is more than three-quarters of a century since John Maynard Keynes wrote his Tract on Monetary Reform, which first linked inflation, production, employment, exchange rates, and policy together in a pattern that we can recognize as “macroeconomics.” It is two-thirds of a century since John Hicks and Alvin Hansen drew their IS and LM curves. It is more than one-third of a century since Milton Friedman and Ned Phelps demolished the static Phillips curve, and since Robert Lucas, Thomas Sargent, and Robert Barro taught us what rational expectations could mean.

(DeLong 2002: vii)

He proceeds to lay out macroeconomic analysis as synthesized in the Keynesian IS–LM model, without correcting Keynes’s distortions of the classical concepts that allowed the Keynesian revolution to succeed.⁷ He also does not mention any of the major classical economists listed above, but gives the Keynesian version of “classical economics.”

The absence of any need for an historical context for understanding the confused state of modern macroeconomics also can be found among the presentations on a 1997 AEA panel discussing the “core of macroeconomics” to be believed or accepted.⁸ It thus would appear that, without a clear restatement of macroeconomics as the classical economists themselves laid it out, to be distinguished from Keynes’s distorted version, resolution of the confusion in modern macroeconomics may be long in coming, if at all.

The classical economists were concerned about explaining how an economy works and what are the determinants of economic growth. They did not assume that the economy was always in full employment equilibrium or that there were no obstacles to the attainment of full employment, contrary to Keynes’s misrepresentation of them. Their work also was not founded on any notion of market prices adjusting according to the modern assumptions of perfectly competitive markets (Marshall 1920:448–9). They also did not assume the neutrality of money in the short run or that changes in the quantity of money affected only the price level and never the level of real output and employment in the short run, and neither did they dichotomize the pricing process, as Keynes alleges.

The classical explanations accounted for the prices of goods and services in different markets, using their theory of value. They used the same theory of value to explain wage rates in different labor markets, the price (cost) of loanable “capital” or interest rates at different degrees of risk associated with borrowers, as well as the value of money (currency) itself or the price level. The classical economists also believed that a correct application of the theory of value in such contexts better informs the formulation of policies to promote economic growth. Thus, understanding that interest rates are determined by the supply and demand for savings or “capital” may encourage policymakers to keep taxation of income low in order to encourage more savings out of disposable income—increased supply of loanable funds. The same understanding would encourage policymakers to refrain from attempting to engineer low interest rates by inflating the volume of currency through the central bank, which ultimately would only lower the value of the currency or raise the price level.

To facilitate informed policy formulation to assist economic growth, the classical economists also clarified the nature of certain economic variables. They explained that saving is the investment of nonconsumed income in financial or income-earning assets. They carefully distinguished saving from the holding of income in cash or hoarding, which yields the security of cash as a ready means of purchasing goods and services, but not interest or dividends. Thus increased saving promotes economic growth because it releases the purchasing power of nonconsumed income to producers who borrow the funds, while hoarding withdraws the purchasing power of income from circulation.

Such an understanding of the role of saving in an economy also underlies the classical argument that, in the absence of increased hoarding, a mismatch or misalignment of supply and demand for goods in certain markets would soon be resolved by changes in relative prices and interest rates to clear the markets, and that there cannot be an over-supply of all goods, including money, at the same time—Say’s Law of Markets. Even in the face of an increased demand for cash or hoarding, which would create an excess supply of goods and services (to match the excess demand for money) and raise the value of money, a quick response by the monetary authorities in increasing the money supply would prevent a persistent glut of the goods and services in the marketplace.

Another of the important economic concepts the classical economists defined differently from modern macroeconomics is money. Money was specie or coined precious metals. Paper money issued by banks substituted for specie in circulation, and for as long as free convertibility of paper into specie prevailed, prudent banks would not issue more notes than they could redeem on demand. The classical economists clarified the financial intermediation function of banks—receiving savings in order to extend loans—differently from the “money supply” process as now perceived in modern macroeconomics. That way it was easier to apply the theory of value to loans in explaining interest rates and to money or its paper substitute to explain the price level. Furthermore, the classicals could explain longterm economic growth by increases in savings or loans and not by increases in the supply of money. Increases in the supply of money may increase real output and employment in the short run, while prices are yet to adapt fully to the increased supply, a process the classical economists called forced saving. But ultimately, only the price level and nominal wages would rise in response to the increased supply of money.

Such understanding of the role of money in an economy also informed what we may call classical monetary policy. Where money was specie, there was no need to regulate its quantity, since the production of specie or receipts of money through payments for net exports would take care of the supply. But in a fiat money system, its supply by a central bank would have to be regulated in order to maintain the price level, the same mechanism inherent in the commodity or specie money system.

The classical economists, with a few exceptions, also recognized consumption as the ultimate goal of all production. But they were quick to point out that production provides both the means and the objects of consumption, and that without increased production, made possible by increased savings to enhance productive capacity, there could not be increased consumption over time. This is why, instead of the modern Keynesian focus on consumption spending as the driving force of an economy’s growth, via the so-called expenditure multiplier, the classics focused on savings to provide the funds for increased production.

Keynes’s successful revolution overturned these classical insights, partly by changing the meaning of some key economic concepts under the influence of works by Böhm-Bawerk, Irving Fisher, and Knut Wicksell, and partly by attributing to the classical economists assumptions they did not make, such as full employment always, and no demand for money other than for transactions purposes.

Several of Keynes’s contemporaries, particularly A.C.Pigou, R.G.Hawtrey, D.H.Robertson, Jacob Viner, and Frank Knight, recognized the fundamental errors he had made in his criticisms of classical macroeconomics, and tried to point them out. Most of the corrections took the form of restatements of classical propositions, but without focusing on Keynes’s changed meaning of classical concepts. Few also made direct references to the classical literature Keynes had misrepresented. Keynes thus could not properly be directed to reread what he had misinterpreted. The younger generation at the time, being much less familiar with the classical literature, for example, J.R.Hicks, Richard Kahn, Joan Robinson, and Nicholas Kaldor, also could not appreciate the extent of Keynes’s misrepresentations of the classics. The creation of the IS-LM model as a device through which the disputes between Keynes and his contemporary neoclassical defenders of classical macroeconomics could be resolved also has helped to mask Keynes’s misrepresentations of classical concepts. In the end, the model has served only to convey Keynes’s arguments, to the disadvantage of the classical alternative.

The following chapters, six of which are based on previously published articles, elaborate the forementioned claims. The state of modern macroeconomics, which is mostly Keynes’s view of how a monetary economy works, very much dictates the approach I take in restating classical macroeconomics. I summarize the common themes that address the issues misrepresented in modern macroeconomics rather than discuss debates among the classical economists themselves, as typically done in texts on the history of economic thought or theory. I also rely very much on quotations from classical texts to make my points. Keynes’s distortions of classical concepts have become accepted definitions to such an extent that only direct quotations from the classics themselves may assist readers to recognize the extent of his distortions. The concluding chapter highlights some of the benefits to the different schools of thought in modern macroeconomics from their recognizing Keynes’s distortions of classical macroeconomics.

2 The classical theory of value

A foundation of macroeconomic analysis

Introduction

Classical macroeconomics involves applications of their theory of value—the determination of the exchange value of commodities by their supply and demand in the short run, and by their cost of production in the long run. Thus, to understand clearly classical macroeconomic analysis, it helps to understand their theory of value; getting their theory of value right is, in a sense, the modern equivalent of working out the “micro-foundations” of macroeconomics.

Value in the objective or measurable sense, according to the classics, is the quantity of other commodities that can be had in exchange for a unit of another. Where money is used as a generally accepted medium of exchange, the quantity of money given in exchange for a commodity, or its price, measures its value. Thus, although aggregation is involved when dealing with macroeconomic variables, it is with the application of the theory of value that the value of money (inverse of the price level), the rate of interest on loanable “capital,” the wage rate, and rentals on land or capital goods may be accurately explained. Many a confusion in modern macroeconomic analysis has resulted from the failure to apply correctly the principles of supply and demand or the theory of value to the issues being discussed. Sometimes it is because a disputant of some classical macroeconomic principle has failed to recognize the application of the theory of value in its context that the theory is claimed to be erroneous, as, for example, the proposition that the value of money (not the rate of interest) is determined by the supply and demand for money (currency) or that the rate of interest is determined by the supply and demand for “capital.” John Maynard Keynes (1936) had difficulties with both of these propositions while Eugen Böhm-Bawerk (1890) and Irving Fisher (1930) had difficulties with the latter. Subsequent chapters will elaborate, but Keynes’s complaint against classical macroeconomics for not having employed the supply and demand framework when explaining the price level and inflation is worth quoting as an example:

So long as economists are concerned with what is called the theory of value, they have been accustomed to teach that prices are governed by the conditions of supply and de...

Table of contents

• Cover Page
• Classical macroeconomics
• Routledge studies in the history of economics
• Title Page
• Copyright Page
• Preface
• Acknowledgments
• 1 Introduction
• 2 The classical theory of value
• 3 On the definition of money
• 4 The classical theories of interest, the price level, and inflation
• 5 Keynes’s misinterpretation of the classical theory of interest
• 6 The Austrians, “capital,” and the classical theory of interest
• 7 Wicksell on the classical theories of money, credit, interest, and the price level
• 8 Fisher, the classics, and modern macroeconomics
• 9 The classical theory of growth and Keynes’s paradox of thrift
• 10 Full employment
• 11 Hicks, the IS-LM model, and the success of Keynes’s distortions of classical macroeconomics
• 12 The mythology of the Keynesian multiplier
• 13 Conclusion
• Notes
• Bibliography