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Introducing Post-Keynesian Economics

Introducing Post-Keynesian Economics

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A common charge directed at heterodox economics is that it is defined as a negative and has little to offer in the way of an alternative to mainstream economics (at least, if we ignore the 'extremes' of Austrianism and Marxism). It's true that heterodox economists, including myself, often spend more time criticising mainstream economics than we do offering alternative theories. Yet there is in fact a large amount of work on alternative theories of pricing, distribution, finance and trade. Below I will sketch out what is known as the 'Post-Keynesian' (PK) approach to economic theory. Note that this post is largely uncritical as it only hopes to introduce the theories, rather than defend them.

Consumer Theory

Although there is not a great deal of work on PK consumer theory - it is generally more focused on macroeconomic issues - there still exists a consensus around a particular theoretical framework. The primary expositor of this framework is Marc Lavoie, who has synthesised the available work and found a great deal of coherence: between different PK authors; between PK consumer and macro theories; and, tentatively, between post-Keynesian theories and established psychological/behavioural traits. 

In PK theory, instead of calculating the optimal utility from a bundle of goods - which is computationally impossible - consumers follows simple rules of thumb, copy others and make decisions based on a highly (self-)restricted choice set. People's consumption is largely routine and rarely involves making 'decisions' in the neoclassical sense of the word. Consumers aren't really 'opimitising' anything; they are at best 'satisficing'.

Consumers first split their consumption between specific categories of goods and services. They choose between these categories in a hierarchical manner: basic needs such as food and shelter are more likely to be fulfilled first, and as the consumer becomes satiated in one category, they will move onto another. This hierarchical ordering of preferences means that 'income effects' are dominant over 'substitution effects', so income is a more important determinant of both the level and type of demand than relative prices. This is consistent with post-Keynesian macro, where the economy is generally demand driven, wages being a key component of this demand. 

In this model, unlike a neoclassical utility function - where it is presumed that there is always a price at which one good will be substituted for another - the consumer will consider different categories largely in isolation: no price for scarves would make the consumer prefer them to rent. However, once basic 'needs' are met, subsequent 'wants' - which are largely socially created - are more readily substitutable, for example clothes and iPod speakers. 

Producer Theory

Post-Keynesians have much to say about the flaws in neoclassical producer theory, particularly since most firms seem utterly bewildered by marginalist theories of pricing. The PK approach is therefore far simpler and more in keeping with observed business practices. (As I've noted previously, the marginalist perspective may be more applicable to agriculture, but it is pretty far off for industry).

Studies show that firms tend to use a 'cost-plus' rule for pricing, where they add some percentage mark up to the average cost of their product(s). This mark up can depend on any number of things: market power; norms and the firm's history; the demands of shareholders, and can even be somewhat arbitrary (eg in many cases it is a round number). Firms use this approach for a few reasons: it is simple, saving calculation costs; knowledge of marginal costs and revenues is difficult or impossible to know; it guarantees a particular rate of profit, which is useful for creating business plans and forecasts. (If firms are not big enough they will generally follow the market price, but this usually has less to do with a perfect competition-esque scenario and more to do with a dominant firm setting certain prices and costs - think of newsagents and Coke/Pepsi).

This means that prices are not "sticky" due to some psychological barrier or market failure; they are sticky because firms want to be sure about the flow of revenue they will receive for a substantial time into the future. Prices rarely clear markets and indeed are not intended to do so, as firms wish to have a degree of flexibility and spare capacity to respond to changes in demand. Furthermore, firms generally face at least constant - in fact, probably increasing - returns to scale, so quantity is varied more readily than price (consumers also dislike frequent price changes). Finally, as Cameron Murray has theorised, firms generally chase returns (profit/cost) rather than squeezing every last drop of profit out of an investment. Overall, understanding the internal mechanics and administrative decisions of firms is often more important than studying 'demand-supply' mechanics.

Endogenous Money

Endogenous money is not new ground for those in blogosphere, so I will not spend too much time on it. The leading principle is that modern capitalist economies are, first and foremost, credit-based. Through double-entry bookkeeping, banks create money as credit, and most transactions are simply made by transferring money between people's accounts. When a loan is made, M1 expands, and as it is paid back M1 contracts by the same amount. This means that the money supply adjusts to the level of economic activity, rather than the other way around (or the 'hot potato' effect).

Since banks expand credit before they look for reserves, the monetary causality goes 'backwards' compared to mainstream economics: broader measures of the money supply increase before narrower ones. The role of the central bank is largely passive: it can influence the price of reserves through open market operations, but it has limited control over the quantity, as being too restrictive will cause massive problems for the banking system and the economy as a whole. Though the central bank can, theoretically, increase the amount of reserves as much as it likes, this is largely pointless exercise as it cannot control broader measures of the money supply (or income).

International Trade

Post-Keynesian theories of trade, true to their namesake, draw heavily on Keynes' own work on effective demand and trade. According to the mainstream theory comparative advantage, the conditions of production are determined by innate 'supply side' factors such as technology, preferences and resource endowments, so in absence of any 'barriers to trade' prices will adjust to create full employment. On the other hand, Keynes saw the level of employment and production as determined by effective demand or the level of autonomous expenditure. 

In Keynes' framework, any reduction in nominal wages and/or prices is not guaranteed to lead to a reduction in real wages, as relative prices and wages are decided separately. Furthermore, any reduction in real wages can reduce demand as workers have a higher Marginal Propensity to Consume (MPC) than capitalists. Lastly, general deflation will increase the value of cash and cause people to hoard instead of spending. This means that a 'free trading' country with lower productivity than its trading partner will simply experience a lower volume of demand. Workers displaced from the unproductive industry will generally face unemployment rather than shift to a new sector, and there will be no long term tendency to 'correct' this imbalance. In fact, following Verdoorn's Law, the long run rate of growth of productivity is deemed to be a function of the growth of output.

In the post-Keynesian view, capital flows - often speculative - dominate 'real' trade. Capital will flow according to absolute, not comparative, advantage, as investors will want the highest return possible. Therefore, in the absence of capital controls, monetary authorities do not have complete control over interest rates due to continual disruption from foreign inflows and outflows. What's more, central banks will generally have to set level of interest higher than the 'full employment'  level, else the country will experience capital flight. (On a quick inspection of the past 50 years, this seems somewhat true: if we compare the Bretton Woods (BW) era of capital controls and exchange rate management with the post-BW era of 'liberalisation', the former has lower rates of interest and unemployment than the latter).

In summary

There are some notable similarities between all of these approaches. First, post-Keynesians tend to emphasise that key variables (wages, the rate of interest) are monetary, not real phenomena. This doesn't mean the notion of the real is unimportant - far from it - but it does mean that it is often a poor starting point for analysis. Second, there is generally no special status accorded to particular variables. Consumers and producers are not 'optimising'; trade between countries can be imbalanced for long periods of time; the economy can remain in a state of depressed demand and no adjustment of prices will save it. Third, there is a lot of emphasis on institutional considerations. Since prices, demand and trade depend somewhat on social norms and agreements, and since agents tend to fix their decisions for long periods of time to maintain a degree of certainty, different economic trends can persist based on historical path dependence, and there is no 'one size fits all' model.


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oh, looks like my html links did not work.

UE

okay, point taken about "thin" - I should have written something like "weak" or "vulnerable", meaning that if one sets out to pick these ideas apart (as you do with mainstream econ), one can easily do so.

right, yes revenues=prices*quantity, so if you keep price fixed but quantity varies as circumstances change, how does keeping prices fixed help you be sure about future revenues when quantities are changing? (in the absence of knowledge about how quantities will vary, i.e. knowledge of how the demand curve has shifted).

"price changes are actually not very common" (this is how often prices change)

yes we know prices are sticky, we are discussing the merits of PK explanations of that fact. You have stated this explanation is: because firms want to be sure about the flow of revenue they will receive for a substantial time into the future. And I am trying to show this makes little sense, or is at least as weak as mainstream explanations (menu costs, information frictions etc. - I don't know where you got "psychological barrier or market failure" from).

I am just looking to pick holes in your arguments, just like you look to pick holes in mainstream econ. If you'd prefer that I had a more generous attitude, well maybe you need to reconsider your modus operandi too.

are you claiming that firm value predictability or stability? [not the same thing: you can know for certain something will change]. Why do firms prefer revenue predictability to profit maximization? let's accept that keeping prices fixed allows them to be sure about future revenues flows. So let's say AD falls, and firms keeps prices fixed, because that makes them "sure" of future revenues (they are sure revenues will fall as quantity sold falls). Why wouldn't firms change their prices if they thought that would boost profits, even if it makes revenues harder to predict (especially as you claim they have spare capacity to adjust production if demand surprises them)?

Remember in mainstream macro if changing a price won't boost profits, then prices wouldn't change even if prices were completely flexible. So we are talking about prices being held fixed when changing prices would boost profits.

On the utility function thing, I think you are repeating your favourite claim about standard U-max being circular in a context where that point makes no sense. Of course standard approaches allow for some things (food, accommodation) to be more important than others, and can hence naturally incorporate the idea that people will prioritize certain items, so in sense they only think about buying scarves once basic needs are taken care of. That's all I'm saying.

But you seem to be saying something stronger, "There is a portion of income spent on rent that will be largely untouched by prices changes in scarves" [I don't know what you're on about re: the maths - "single functions" may have vector arguments]

I spend a certain proportion of my income upon rent. Suppose the relative price of consumer goods increases sharply, so the opportunity cost of my rent is much larger in terms of sacrificed consumer goodies. I might respond by moving to cheaper accommodation in an effort to decrease the proportion of my income I spend on rent and free up some to buy consumer goods. Or if the relative price of consumer goods falls, I might move to a bigger flat. That's the mainstream position, ain't it? That paragraph you describe as arguing from incredulity was trying to show you that people can still vary the quantity of rented accommodation they purchase.

And you think people won't adjust spending on rent if relative prices change? (obv there are some costs of moving, prices would have to change a lot). I am trying to show that's not a very credible claim.

now as I said, I'm sure there's a lot of truth in the "mental accounting" idea, and I see you were also thinking of Thaler but I had not thought of him as post-Keynesian, but I'm pretty sure I could dig out empirical evidence that spending on different categories of good (rent, food, savings, consumer goodies) does respond to relative price changes (here is one example from a quick google). Hence your claim "consumer will consider different categories largely in isolation: no price for scarves would make the consumer prefer them to rent." is absurdly over stated, and on the face of it as ridiculous as anything you could find in mainstream econ.

Unlearning Economics

@luis

Yes, it is an *introduction* to PK economics, which is why it looks "thin". If you want something "thicker" do some research, like heterodox economists do for mainstream economics.

" Suppose you did keep prices fixed as AD changes - how are you going to be "sure" about how your revenues will change, unless you know what your demand curve looks like?"

Because the quantity sold is what varies, and firms have spare capacity to adapt to changing AD. Price changes are actually not very common outside finance/raw commodities.

"you know nothing stops you writing down a mainstream utility function (preferences) in which you will prioritise your rent because you'd much rather have a roof over your head than have nice clothes. "

Yes, you can fit basically any behaviour into a utility function. Of course, the entire process is circular: assume people follow a utility function then modify it to include whatever they do. I am instead proposing a more general rule about human behaviour which is more open to falsification.

You're really missing the point about this rent/scarves thing, and your first paragraph on it is verging on an argument from personal incredulity. The idea is that people will first look to fulfill their rent needs, then move onto less important "wants" like scarves. There is a portion of income spent on rent that will be largely untouched by prices changes in scarves, and mathematically this would be represented by a vector rather than a single function. In fact, people's budgeting decisions do often seem to resemble this process (Thaler discusses it in Nudge): they have a food budget, a bill budget etc.

Frances Coppola

If you know that you cannot be evicted even if you don't pay your rent, or that even if you are evicted the local council will be obliged to find you accommodation, you might not give a higher priority to paying your rent than buying clothes or a new iPad.

if you applied the same "look for flaws" approach you have with mainstream macro to this rather thin collection of claims, you'd tear it to pieces in minutes.

where to start?

"This means that prices are not "sticky" due to some psychological barrier or market failure; they are sticky because firms want to be sure about the flow of revenue they will receive for a substantial time into the future."

In mainstream macro, price stickiness means firms don't change prices when something happens that would change the "flow of revenue" they will receive, if they were to keep prices (or price plans) unchanged. For example, if nominal aggregate demand rises (or falls) keeping nominal prices unchanged would cause nominal revenues to rise (or fall). Suppose you did keep prices fixed as AD changes - how are you going to be "sure" about how your revenues will change, unless you know what your demand curve looks like?

I think you might mean that firms primarily worry about their prices relative to competitors (and suppliers), and are therefore worried about changing prices in response to some macro shock (say, monetary policy) because they cannot easily coordinate with competitors - and if they changed prices whilst their competitors did not, that would result in an undesirable change in relative prices. I actually like this story, and whilst it is not exactly mainstream (other explanations being more popular) I don't think of it as post-keynesian - just google the words "sticky price coordination"

you know nothing stops you writing down a mainstream utility function (preferences) in which you will prioritise your rent because you'd much rather have a roof over your head than have nice clothes.

I'm sure there's some truth in the idea that people tend to think in categories. Afaik, this is called "mental accounting" by mainstream / behavioural economists - Richard Thaler writes about it. But the claim "no price for scarves would make the consumer prefer them to rent" is just absurd. Think about this for a minute. What are you going to rent - some space in a shared bedroom, your own room in a shared flat, your own bedsit, your own flat, your own house ...? You have a certain income, now how are you going to respond if the relative price of rental accommodation to consumer goods (scarves) changes? We agree that preferences are such that no matter how cheap consumer goods get, you are still going to want a roof over your head, but are you really claiming that as relative prices (price_accommodation / price_consumergoods) change, people won't substitute between the two? Don't be daft.

Suppose you are poor and already in the cheapest possible rented accommodation, and relative prices are 1 - so one unit of "the cheapest possible rented accommodation" costs one unit of "consumer goods" To fix ideas say your monthly income is 10 and you spend 5 on one minimal unit of rented accommodation and 5 on one unit of consumer goods. Now say relative price change - either rent becomes a lot cheaper relative to consumer goods or vice versa. Mainstream econ says you will adjust the quantities of accommodation/consumer goods you purchase, although I have started in a "corner solution" with the minimum feasible quantity of accommodation, so no matter what happens to price you will not buy less accommodation. (If I'd started you off in a rented house, clearly you could choose to move to cheaper accommodation). So far, so compatible with U-max.

So what exactly would a PK economist say happens if the relative price of accommodation changes, that a mainstream economist would not?

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Robert Flood and Miles Kimball on the Status of the Efficient Markets Theory - by @mileskimball http://t.co/cEY5SjDZ1r

Another bid for global expansion suggests M&S has not learned past lessons - http://t.co/ZvOR41sHKU