1 Classical Political Economy Smith; Ricardo; Mill Marx Historical School NeoClassical Economics Jevons – Walras – Menger Marshall Keynes 1870 1940Institutional Ecs. – Veblen •builds on; ↔opposes Emergence of theoretical strands within economic science 1800-1940 1800 History of Economic Theory 2010/11 Geert Reuten Lecture Notes 6ORTHODOX ECONOMICS AFTER 1945 Neoclassical Economics: from the Neoclassical Synthesis to Monetarism and from General Equilibrium Theory to New Classical and New Keynesian Economics General Introduction This lecture provides a schematic overview of the developments in orthodox economic theory after 1945. The objective is merely to set out wherefrom the other economics courses start theo- retically (macroeconomics, microeconomics, money & banking, international economics, public sector economics). The scheme below summarizes the interconnecti on of the strands in economic theo ry as treated in Lectures 2-5. Structure of this lecture A. Neoclassical Synthesis (NCS) B. Monetarism (MON) C. Neoclassical Microeconomics: General Equilibrium Theory (GET) and after D. New Classical Economics (NwC) E. New Keynesian Economics (NwK) F. On the gradual falling apart of the Neoclassical Economics mainstream G. Schematic summary Appendix: Debates – the case of the Cambridge–Cambridge Capital Controversy (CCCC)
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8/7/2019 6 HET 2010 Extended Lecture Notes 6, Orthodox Ecs
With the discussion of the strands that emerged between about 1945 and 1980 we get to the cur-
rent Orthodox Economics (until recently indicated by the term Neoclassical broadly). In their
diversity these strands may be considered to constitute the ‘mainstream’ of economics. The pur-
pose of this lecture is to indicate their interconnection – matters of content are restricted to that
purpose. (In the first part of Lecture 7 this orthodox mainstream will briefly be contrasted with
current heterodox strands.)
• Both the “Neoclassical Synthesis” (A) and the neoclassical “General Equilibrium Theory” (C)
emerge in the 1950s. However the Neoclassical Synthesis reaches dominancy before General
Equilibrium Theory.
• The period 1950-1980 can be characterised as the highlight of Neoclassical theory as a sys-
tematic whole. At the same time however, it gets contested, not only from the side of the het-
erodox streams (as one might expect) but increasingly also from inside.
o On the exact periodisation of these matters opinions diverge. Landreth & Colander
mostly emphasise the precursors and the ‘beginning of the end’ (1950s ?). I rather em-
phasise ‘dominance’ so that the falling apart for Neoclassical microeconomics emerges
not before 1980, and that for macroeconomics not before the end of the 1990s – L&Cshare this last view:
“In the late 1990s and early 2000s, there was no generally accepted approach to macro-
economics. It was a field in chaos.” (page 386)
o See also the remarks about periodisation in Lecture 3. L&C agree that for the teaching
programmes at especially the bachelor level the neoclassical dominance reaches till to-
day.
(A) THE NEOCLASSICAL SYNTHESIS (NCS)
1. Introduction
Around 1945, most economists believed that the economy would lapse back into a depressionsoon after the restoration (continuation of the Great Depression of the late 19th century and the
Depression of the 1920s and 30s).1
→ Climate right for active steering of the economy by the government (i.e. steering rather
than just legislation and provision of infrastructure).
This provides the background for the “Neoclassical Synthesis” (NCS) and the corresponding
economic policy. (The full name is: Neoclassical-Keynesian Synthesis; however, it is also called
“Neo-Keynesian economics”).
Principal economist: Paul Samuelson. He was both a prominent researcher – 2nd Nobel Prize
1970 – but also the author of the standard textbook Economics. This book was used all over the
world from ±1950-1980; 1st edition 1948. In the 1955 edition he baptises the name: “grand neo-
classical synthesis”.The years 1950-1980 were not only the heyday of Neoclassical Economics in general, but
particularly also of the NCS. Nevertheless the theoretical infringement starts by the 1970s. In
terms of economic policy the microeconomic turn to deregulation and the roling back of the State
starts by 1980 (also called neoliberalism). However, the macroeconomic policy influence lasts
much longer – in a way even till today, be it rarely in terms of an active discretionary steering but
rather in terms of automatic stabilizers.2 (‘Rarely’: the financial-economic crisis that developed
from 2008 provided an impetus to renewed active steering.)
1
The problem formulation in Sweezy's underconsumption theory – see lecture 7 – fell in line with this idea.2 The current theoretical basis for it is in the so called ‘New Keynesian Economics” – see E. Unfortunately economists
are not very original in their name givings.
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Along with it went the development of ‘large’ macro-econometric models – cf. Keynes' criticism
of such models: these cannot account for uncertainty. In his Economics, 10th ed. 1976 Samuelson
writes:
“The business cycle has been tamed, even if not completely made a thing of the past.
Although democratic mixed economies are unlikely to experience old-fashioned, prolonged
depressions once again, recessions and periods of relative stagnation will no doubt stilloccur even though fiscal and monetary policies can moderate their frequency, intensity, and
duration.” (p. 267)
3. Macro and micro theory The NCS leaves the micro-economic edifice of the NCE intact (hence, e.g., the macroeconomic
dichotomy and the eclectic savings function, that is, as including the interest rate). From this
stems the NCS thesis that NCE is adequate, nevertheless in the short run a "Keynesian" (i.e. Neo-
Keynesian) macro-economic government intervention is convenient. Nonetheless, full
employment and equilibrium is also possible without it, namely through:
“a policy of price flexibility; but the length of time that might be necessary for the
adjustment makes the policy impractical” (Patinkin, 1951)
The NCS coincided with the emergence of the separate fields of micro and macroeconomics.
A mathematical formalisation of (orthodox) economics emerged in micro economics, especially
General EquilibriumTheory (GET). Important founders: Hicks [1939, Value and Capital],
Samuelson [1947, Foundations of Economic Analysis] and Arrow & Debreu [1954, Existence of
an Equilibrium for a Competitive Economy, in Econometrica]. On the latter see section C.
4. Growth theory During this period, the NCE micro theory was primarily an allocation theory. Although this was
also a long run theory, there was no growth theory initially. For a long time (in teaching until at
least the early 1980th), the Harrod-Domar ‘knife edge’ model of economic growth (see Lecture 7)
was added as a ‘Fremdkörper ’ (an uneasy fitting addendum) to the NCE macro-theory. (This is
remarkable because – as we will see in Lecture 7 – this model aimed to show that equilibrium
growth is unlikely. Nevertheless, within NCS it was interpreted as an equilibrium theory!)
Around 1960 there emerges (in research) the first ‘true’ Neoclassical macro equilibrium theory of
economic growth (a.o. Solow) with capital–labour substitution. This theory, and the capital
theory behind it, gave rise to a hot debate in the main economics journals between its defenders
and Post-Keynesian inclined researchers, in which the consistency of the Neoclassical concept of
capital was at stake (called the “Cambridge–Cambridge capital controversy”, discussed in the
Appendix).
8/7/2019 6 HET 2010 Extended Lecture Notes 6, Orthodox Ecs
• There is no claim that GE also really exists (Hahn p. 125);
• There is no effective indication of how equilibrium prices evolve (p.133);
• There is no claim that GE is socially optimal (Hahn p. 125).
d. Specific Limitations
There are/is:
• no money and monetary matters (p. 130);
• no stock markets (p. 130);
• no uncertainty (p. 130);
• no asymmetric information (p. 130);
• time: “collapsing the future into the present” (p.132);
• no oligopoly and other forms of imperfect competition (p. 130);
• no coalitions (p. 130);
• in general no `power' (p.132);
• applies (with the limitations above) only to large economies (p.130) (there must be `many'enterprises) (p.131);
With regard to the limitations of expectations and “time”, there are two possible solutions:
1) Exogenous expectations→ successions of short-term equilibriums, which are not Pareto-
efficient (p.133);
2) Assuming “Rational Expectations” (RATEX) (i.e. every agent correctly predicts the
equilibrium prices associated with every possible ‘state of nature’). This solution is also not
Pareto-efficient. RATEX theory must also assume that everything that can be learned comes to
be learned (p. 133).
If and when there are no Arrow-Debreu markets, it is unclear exactly what it is that firms do
maximise or should maximise (p.133-34).
3. “Modern” microeconomics: “eclectic formalist modelling”Hahn’s text (1981) appeared in a book with the telling title: The Crisis in Economic Theory. This
illustrates that by this time the GET programme had reached its internal limits. (L&C, page 384,
date this earlier.)
In the mean time much of neoclassical microeconomics is returning to a partial equilibrium
approach, though not necessarily a Marshallian.
Modern microeconomics (research) is an “eclectic formalistic modeling approach” (L&C
405). Even so its approach may – for the time being – best be characterised as one ‘in divergence’
from the neoclassical principles. See L&C’s list on pp. 403-4:
1. The focus on allocation of resources at a point in time is no longer central (there has been
more focus on growth – but this is rather a macro issue).
2. Utility theory is rarely used today.
3. Mathematically calculus is gradually being dropped (though not in undergraduate teaching)
in favour of game theory (this, however, is a matter of technical instruments rather than
content – nevertheless game theory seems to go along with a gradual shift in content).
4. Instead of ‘rationality’, there is a movement towards ‘bounded rationality, norm-based
rationality ... and empirically determined rationality’.
5. Individualism ‘still reigns’ but it is under attack.
6. Even if the (possible) existence of general equilibrium is still a dominant view, the
development of research is rather along the lines of ‘multiple equilibria’.
The list applies especially also to the very recent approach of “behavioural economics”. Withinthis approach fundamental Neoclassical assumptions are (at least experimentally) being dropped
8/7/2019 6 HET 2010 Extended Lecture Notes 6, Orthodox Ecs
Monetarists are optimistic about the outcome of free markets. The recent branch of the Chicago
School, The New Classical Economics is even more optimistic about that.
Precursors of this approach are (a.o.) Muth {1961} and Lucas {1972; 1981}. From the early
1980s onwards can we discern it as a new branch of neoclassical economics. (A new branch: itmight also be argued that given the falling apart, or even the state of disarray, of NCE, the New
Classicals are the true heirs of NCE.)
Note: Notwithstanding the suggestion by the name “New Classical” the term has – like the
term Neoclassical – few to do with Classical Political Economy.
Key to this branch, in brief, is its movement back to the “macroeconomics” of before Keynes –
just as the Monetarists did – yet for them on the basis of General Equilibrium Theory (not the
Marshallian partial equilibrium theory, which is the basis for the Monetarists).
This movement is based on their idea of a requirement of “microeconomic foundations of macro-
economics”. (Note that for quite some economists this implies the giving up of macroeconomics– which might perhaps be part of the agenda: macroeconomic policy at least is inevitably
associated with state intervention.)
In the NwC view individual behaviour is dependent on the ‘rational expectations’ of individuals;
in particular also on their expectations about economic policy. Individuals adapt their behaviour
to (expected) economic policy. Therefore the predictions on basis of econometric models fail
(these predictions are based on past behaviour).
According to the NwC the economy is continuously in a state of ‘competitive equilibrium’, i.e. all
markets cleare. In as much as the Monetarists they postulate that for the labour market the actual
unemployment is in effect not a disequilibrium unemployment, but rather a ‘natural
unemployment’, an equilibrium unemployment.
This poses of course the problem of how business cycles should be explained. (This has been a
problem for all of the Neoclassical tradition, though perhaps one somewhat less pressing when
equilibrium was conceived to be a “long run” entity.) The NwC indeed undertook this
explanation. “Expectational errors” might perhaps seem to be causative for business cycles. This
was rejected however, because NwC see expectational errors as short lived (whereas cyclical
‘deviations’ are rather enduring for some period). Lucas saw – in line with the Monetarists – the
money supply as the cause of cycles. Instead the NwC developed a so-called “real business
cycle” theory, which conceptualises their cause in exogenous technological shocks.6
6
Interestingly the theme of a technical impetus to the business cycle seems to correspond with that of one branch withinmodern Marxian Political Economy. The important difference is that the latter is no equilibrium theory, and also that for
the latter this technical development is endogenous,
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We have seen before (Lecture 4) that business cycles had been a terrain researched by heterodox
economists only. In whatever way one might want to assess the NwC business cycle theory, it is
important that now (in 1980) 90 years after the emergence of NCE, the New Classicals finally
undertook research in business cycle theory.
As a final note it may be remarked that whereas the NwC theory of the business cycle is based on
exogenous technological shocks, they developed an “endogenous growth theory” in terms of
endogenous technical development. Further, demand plays no role in this theory: it is a pure
“supply-side economics”.
(E) NEW KEYNESIANS
In terms of research the Neoclassical Synthesis is over. Roughly, however, the so-called “New
Keynesians” (NwK) can be seen as the successors of the NKS (i.e. the Neo-Keynesians).
The term New Keynesian is misleading. As for the Neo-Keynesians these economists havelittle to do with Keynes; they have also little to do with the Post-Keynesians (Lecture 7).
However, relevant for them is the theory of – what was misleadingly called – keynesian
economic policy, that is Neo-Keynesian policy.
• The New Keynesians accept the New Classical idea of rational expectations. However, they
hold that these rational expectations lead to (Neo-)keynesian conclusions, provided that one
does not assume at forehand a unique equilibrium of all markets (as the New Classicals do).
All individuals could take ‘rational’ decisions; the result, however, can be socially ‘irrational’.
• New Keynesians argue for macroeconomic foundations of microeconomics (the reverse of the
New Classicals).
• According to the New Keynesians a “keynesian” policy is theoretically effective, though often politically ineffective (for example because it is often politically difficult to cut back
government expenditure in boom periods – whereas this might be required for making
financial room for expansions in times of recession).
Comment on L&C Chapter 15
L&C 410 : All of the first paragraph after the first sentence is better deleted (Ricardo did analyse
economic growth ; he did present a macroeconomic theory ; on the other hand the problem of
allocation plays a role only with the emergence of the Neoclassicals after 1870).
The following scheme presents the interconnection of the Neoclassical branches presented in
Sections C, D and E.
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(F) THE GRADUAL FALLING APART OF NEOCLASSICAL ECONOMICS
I have suggested several times (also in Lecture 4) that neoclassical economics is (being) falling
apart. This is not just so because we have now three or four main branches of within NCE. It is
also the case because within those branches the theoretical problems accumulate.
By using the term “orthodoxy”, instead of neoclassical, I leave somewhat open to what extent
exactly the current ‘mainstream’ is in fact neoclassical. Landreth & Colander argue thatNeoclassical Economics has fallen apart. Perhaps it is too early for a definitive assessment of
this. (Note again the research, teaching and policy distinction – Lecture 4.) The issue depends
also on what exactly one understands by ‘Neoclassical’. The current orthodoxy has the
following main characteristics:
• individualism;
• (bounded) rationality;
• priority of micro over macro (except for the New Keynesians);
• equilibrium (for the disequilibrium approach of the New Keynesians, equilibrium seems
nevertheless the reference point for the disequilibrium);
• some concept of ‘natural unemployment’;
• neutrality of money;• capital as a factor of production: productivity of capital;
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DEBATES: THE CASE OF THE CAMBRIDGE–CAMBRIDGE CAPITAL CONTROVERSY (CCCC)
Introduction
As indicated in the main text, around 1960 there emerges (in research) the first ‘true’
Neoclassical macro equilibrium theory of economic growth (a.o. Solow) – as it is one with
capital–labour substitution. In fact, the capital theory behind it had for long been a matter of
controversy (see Landreth & Colander 259-270). In 1953 Joan Robinson revived the discussion.
The neoclassical capital theory together with the growth theory gave next rise to a hot debate in
the main economics journals between its defenders and Post-Keynesian inclined researchers, in
which the consistency of the Neoclassical concept of capital was at stake. (The Post-Keynesian
strand will be introduced in Lecture 7.) The debate came to a provisional close with an article by
Samuelson in 1966.
The discussion was led by Neoclassical Cambridge U.S.A. economists on the one side (a.o.
Samuelson, Solow, Arrow) and by Post-Keynesian economists from Cambridge England on the
other side (a.o. Robinson, Pasinetti, Kaldor). Therefore the debate became baptised as the
“Cambridge–Cambridge capital controversy”. Note that the Cambridge England critique is animmanent critique of Neoclassical economics, thus the neoclassical concepts are accepted (that is
to the extent that these are clear and consistent).
This Appendix provides a summary of one of the key points of the controversy.7
A1. The problem of capital aggregation in general: circularity The following figure indicates in simplified terms the problem of the NCE marginal physical
productivity theory (MPP theory). Prices are explained by the MPP of labour and capital. But in
order to make a coherent statement about a physical quantity of labour or capital, one requires
that what is to be explained (prices, including the distribution of income w and r ):
i = current (or expected!) rate of interest/profit
NB: in the Neoclassical Equilibrium Theory, the rate of profit (r) and the rate of interest (i) are
identical.
For the sake of simplicity imagine just 2 periods with R=100; and two different i’s: 5% and 2%
K' = 100 / (1+5%) + 100 / (1+5%)2 = 95 + 90 = 185
K'' = 100 / (1+2%) + 100 / (1+2%)2
= 98 + 96 = 194
So when i↓ the present value of the expected R's increases – so the value of capital goods rises
too. K is thus dependent on the distribution of income.
A3. Distribution of income and changes in technique [Post-Keynesians establish] K 's dependence on the distribution of income has far-reaching consequences for the NCE Growth
Theory (generally the theory of long-run equilibrium) which is based on wage flexibility and
factor-substituting changes of technique. This also affects Neoclassical economic policy tenets.
Note that because equation (1) is about the macroeconomic production of (supposedly) one
homogeneous good, that equation is proportionally equivalent to the price equation for that good,
i.e.
p = wL + (1+r)pk where pk = K.
A5. The perverse case: heterogeneity and reswitching
[implications of the NCE theory, as shown by Cambr. Eng. (PKE)]Cambridge Eng. introduces a small complication to the framework presented in the previous
section: two types of commodities are produced: capital stock (subscript k) and consumption
commodities (subscript c). We thus have a two-sector macro model. For each sector we have a
different K/L ratio and thus different price equations:9
pk = wLk + pk k k (1+r) (4)
pc = wLc + pk k c(1+r) (5)
pc
= 1 (6)
(pc is the numéraire: the as if “money'”commodity)
define p'k = pk /pc and w' = w/pc
then rewrite (4) and (5) as:
p'k = w'Lk + p'k k k (1+r) (7)
1 = w'Lc + p'k k c(1+r) (8)
Thus:
w = [1–k k (1+r)] / [Lc(Lk k c – Lck k )(1+r) (9)
This relation between w and r indicates the wage-profit frontier for each technique (WPF).
If we now regard the economy as a whole, then the form of the WPF (linear, concave or convex)
depends on the K/L ratios in the sectors (see Figure 3).
Figure 3: Possible forms of the Wage-profit
frontier
9 Remember that K=pk (section 4); now Kk =pk k k .
• Let the wage rate be w1. Firms will then choose technique A (yields the highest rate of profit).
• If wages increases to w2, then they will switch to technique B. According to Neoclassical theory this technique B is more capital-intensive than A: we
have substitution of capital for labour.
• If wages increase further to w3, then we have a reswitching to technique A.
According to Neoclassical theory this technique A is more capital-intensive than B: we
have substitution of capital for labour.
• ? ? ? This is of course inconsistent.
One way to explain this inconsistency is that the distribution of income (w, r) affects the
“value” of capital. This would be in line with sections A1 and A2 above. However, this
would also be rather fatal for the Marginal Productivity theory (which is in terms of
physical productivity) – and its explanation of the distribution of income generally.
A6. Result of the debate The result of the debate is that, on closer examination, the earlier general conclusions of the
Neoclassical Marginal Productivity Theory are not tenable.10 Or: the Neoclassical definition of
capital is problematic (which was Robinson's point of departure in 1953). Strangely enough, this
discussion has not permeated through to the Neoclassical textbooks to a significant extent (if at
all).
10. The original fundamental argumentation of the problems, elaborated on by the Cambridge (Eng.) side of the debate, can
be found in Sraffa, Production of Commodities by Means of Commodities; Prelude to a Critique of Economic Theory (1960).
Also refer to Harcourt's summary, `Some Cambridge Controversies in the Theory of Capital', Journal of Economic
Literature, June 1969 (on reswitching especially §4 `A Child's Guide [not exactly that!] to the Double-Switching Debate', pp.386-395). As indicated, the main texts produced in the debate can be found in the collection by Harcourt & Laing (eds.)
Capital & Growth, 1971.
AB
w
r
r1
r2
r3
w1
w2
w3
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