If the economy does recover from the global financial crisis — without private debt levels again rising relative to GDP — then my approach to economics will be proven wrong.

But this won’t prove conventional neoclassical economic theory right, because, for very different reasons to those that I put forward, modern neoclassical economics argues that the government policy to improve the economy is ineffective. The success of a government rescue would thus contradict neoclassical economics just as much — or maybe even more — than it would contradict my analysis.

The actual reasons for this belief are arcane, but this choice quote from leading neoclassicals Thomas Sargent and Neil Wallace puts the dominant neoclassical case in a nutshell:

In this system, there is no sense in which the authority has the option to conduct countercyclical policy. To exploit the Phillips Curve [a relationship between unemployment and inflation], it must somehow trick the public. But by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. Thus, combining the natural rate hypothesis with the assumption that expectations are rational transforms the former from a curiosity with perhaps remote policy implications into an hypothesis with immediate and drastic implications about the feasibility of pursuing countercyclical policy.’ (“Rational Expectations And The Theory Of Economic Policy”, Journal of Monetary Economics, Vol. 2 (1976) pp. 177-78; emphases added)

The neoclassical confidence that the government can’t beneficially affect the economy is thus based on the insane assumption of “rational agents” who live in a world that is permanently in equilibrium, and whose expectations about the future are accurate—something that Ross Gittins’s recent column did a good job of critiquing. The real world is inhabited by real, fallible human beings, who are prone to bouts of irrational exuberance, susceptible to Ponzi Schemes disguised as investment, and who live in a world in permanent disequilibrium and with an uncertain future, in which their expectations are almost always wrong. They are therefore incapable of predicting and therefore neutralizing the impact of government policy, as neoclassical theory assumes that “rational agents” do.

There are other strands in neoclassical theory that argue there is some role for the government in controlling the economy — notably the so-called Taylor Rule which argues that the Central Bank can control the economy by fine tuning the interest rate. Taylor himself is arguing that deviation from his rule — when the Federal Reserve under Greenspan held interest rates at near zero after the burst of the DotCom bubble in 2000 — is what caused the crisis. I disagree, but that’s a topic for a later day.

The general proposition remains that in its overall bias, neoclassical theory argues that the government can’t beneficially influence the economy — and therefore that if there is a genuine, sustainable recovery as a consequence of the government stimulus packages, that contradicts neoclassical economics even more than it would contradict my approach.

That means that if there is a “winning” economic theory out there, then it must be one that argues that government action alone can help an economy recover from a crisis, and indeed maintain output growth at a level that will maintain full employment.

There is one “neoclassical” theory that argues this, which most economists—reflecting their non-existent training in the history of their own discipline — actually think is Keynesian. This is the so-called “IS-LM” model, which argues that the government can manipulate employment via fiscal policy. Neoclassicals are likely to retreat to this model — and declare themselves “Born Again Keynesians” in the process—without realizing that the originator of this model, John Hicks, rejected it on very sound grounds almost 30 years ago.

Hicks realized that his model attempts to represent the economy using just two markets — goods and money — when there is of course another important market: that for labour. He omitted the labour market from his model on the basis of what neoclassical economists call “Walras’ Law“. This is the proposition that, if all but one market in an economy are in equilibrium, then that final market must also be in equilibrium.

Writing in 1979 in the non-orthodox Journal of Post Keynesian Economics, Hicks realized this flaw (and several others) in this logic: it can apply only when the economy is in equilibrium—when both the goods market AND the money market are in balance. That, in terms of the model, is where the two curves cross. But the model is used to simulate what is supposed to happen when one or both markets are not in equilibrium, or when one curve—normally the IS curve—is shifted by deliberate government policy, such as running a deficit during an economic crisis. Therefore it is used to try to describe what happens in disequilibrium.

But in disequilibrium — anywhere on the diagram apart from where the two curves cross — Walras’ Law can’t be used to ignore what’s happening in the labour market. So even working from Hicks’s model, neoclassical economists would need to consider disequilibrium dynamics of 3 or more markets. Hicks damningly concluded that:

the only way in which IS-LM analysis usefully survives – as anything more than a classroom gadget, to be superseded, later on, by something better – is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. (Hicks, J. 1981, ‘IS-LM: An Explanation’, Journal of Post Keynesian Economics, vol. 3, no. 2, p. 152; my emphasis)

Yet as Gittins pointed out, and as Paul Krugman himself recently confirmed, neoclassical economists are so obsessed with equilibrium methods that they will shy away from thinking in disequilibrium terms. As Krugman put it, right after critiquing neoclassical economics for being braindead, “I, for one, am not going to banish maximization-and-equilibrium from my toolbox”.

I’m sorry Paul, but stick with those tools and you’ll never come to grips with Minsky’s Financial Instability Hypothesis, let alone the actual disequilibrium dynamics of the real economy.

So there is no coherent neoclassical theory that can take solace from the success of the government stimulus packages, should they avert a deep recession and cause a sustained recovery without a rise in the private debt to GDP ratio. If there is to be a winner in this debate, it has to be a non-neoclassical school of thought.

There is such a school of thought which has developed in Post Keynesian literature recently. Known as Chartalism, it argues that the government can and should maintain deficits to ensure full employment.

Chartalism rejects neoclassical economics, as I do. However it takes a very different approach to analyzing the monetary system, putting the emphasis upon government money creation whereas I focus upon private credit creation. It is therefore in one sense a rival approach to the “Circuitist” School which I see myself as part of. But it could also be that both groups are right, as in the parable of the blind men and the elephant: we’ve got hold of the same animal, but since one of us has a leg and the other a trunk, we think we’re holding on to vastly different creatures.

That said, I do have numerous issues with the Chartalist approach, but I haven’t studied its literature closely enough yet to write a critique. I also could have distorted their arguments if I had attempted a summary of their views. So what I decided instead to do is to ask a leading Chartalist, Professor Bill Mitchell from the University of Newcastle, to write a précis of the Chartalist argument (Bill also has a blog on this approach to economics).

This précis follows. I emphasise in closing my own comments that, if there is a genuine recovery not involving rising private debt to GDP levels, then Chartalism is the only theory left standing. Neoclassical economics is dead.

Peter Fray

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