Criticism
The strength of Keynesianism’s influence can be seen by the wave of economists who have based their analysis on a criticism of Keynesianism.
One school began in the late 1940s with Milton Friedman. Instead of rejecting macro-measurements and macro-models of the economy, the monetarist school embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, they regarded inflation as solely being due to the variations in the money supply, rather than as being a consequence of aggregate demand. They argued that the “crowding out” effects discussed above would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was largely ignored by early Keynesians.
Monetarism had an ideological as well as a practical appeal: monetary policy does not, at least on the surface, imply as much government intervention in the economy as other measures. The monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and inspired a wave of revisions to Keynesian theory.
Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and particularly emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted behavior from people, which totally contradicted the economic understanding of their behavior at a micro level. New classical economics introduced a set of macroeconomic theories which were based on optimising microeconomic behavior, for instance real business cycles.
Keynesian ideas were criticized by free market economist and philosopher Friedrich Hayek. Hayek’s most famous work The Road to Serfdom, was written in 1944. Hayek taught at the London School of Economics from 1931 to 1950. Hayek criticized Keynesian economic policies for what he called their fundamentally collectivist approach, arguing that such theories, no matter their presumptively utilitarian intentions, require centralized planning, which Hayek argued leads to totalitarian abuses. Keynes seems to have been aware of the potential pitfalls of his economy theory, since, in the foreword to the German version of the ‘The General Theory of Employment Interest and Money’, he declared that “the theory of aggregated production, which is the point of [‘The General Theory of Employment Interest and Money’], nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire.” [1] In other words, Keynesian economics ‘works’ better in a socialist or fascist society.
Another criticism leveled by Hayek against Keynes was that the study of the economy by the relations between aggregates is fallacious, and that recessions are caused by micro-economic factors. Hayek claimed that what start as temporary governmental fixes usually become permanent and expanding government programs, which stifle the private sector and civil society. Keynes himself described the critique as “deeply moving”, which was quoted on the cover of the Road to Serfdom.
James Buchanan followed the criticism by noting that, since Keynes had roots in the classically liberal or free market economic tradition, he was more concerned with what was good policy, not on how it would be executed. In the book Democracy in Deficit, he notes that Keynes never thought out how, say, deficit spending would give a blank check to politicians to run deficits even when orthodox Keynesian analysis didn’t find it proper.
[edit] Methodological Disagreement and Different Results that Emerge
Beginning in the late 1950s New Classical Macreconomists began to disagree with the methodology employed by Keynes and his successors. Keynesians emphasized the dependence of consumption on disposable income and, also, of investment on current profits and current cash flow. In addition Keynes posited a philips curve that tied nominal wage inflation to unemployment rate. To buttress these theories Keynesians typically traced the logical foundations of their model (using introspection) and buttressed their assumptions with statistical evidence. [2] New Classical theorists demanded that Macroeconomic be grounded on the same foundations as Microeconomic theory, profit-maximizing firms and utility maximizing consumers.[3]
The result of this shift in methodology produced several important divergences from Keynesian Macro economics: [4]
- Independence of Consumption and current Income (life-cycle permanent income hypothesis)
- Irrelevance of Current Profits to Investment (Modigliani-Miller theorem)
- Long run independence of inflation and unemployment (natural rate of unemployment)
- The inability of monetary policy to stabilize output (rational expectations)
- Irrelevance of Taxes and Budget Deficits to Consumption (Ricardian Equivalence)
