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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