Keynes
Rethinking economics
Bachelor thesis
Author: Ridwan Shadid
Student number: 10765360
Supervisor: Dr. D.F Damsma January 2018
Amsterdam School of economics University of Amsterdam
Statement of Originality
This document is written by Student Ridwan Shadid who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Contents List 1. Foreword….………..3 2. Introduction………..4 3. Keynes………...………..………...5 4. Neo-Keynesian economics…………....…………..………..7 5. New-Keynesian economics..……….………..10 6. Post-Keynesian economics..…………...…………...………..16
7. Discussion and Conclusion………20
8. Biography………22
Foreword
My fascination with economics began with the financial crisis of 2008. As I was watching the news, I could not understand much of what the news anchor or prominent economists were explaining about the most significant economic downturn since the Great Depression. Many of the public did not understand the financial crisis, though everyone felt the consequences of
the economic downturn. The nationalization of large banks, the lossof millions mostly
middle-class jobs, the Euro Crisis as a successor of the 2008 crash, and the fear of a total breakup of the European Union were all topics that dominated the newsfeed when I was in high school. Inspired by these issues I decided to choose an economics major at UVA. However, from the beginning I noticed some discrepancy between the theories I had to study and the economic reality I read in the newspapers. Many courses remained unchanged and the disadvantages of the capitalistic system we live in, such as external effects like climate
change, were not part of the curriculum. During my time at UVA, I attended several lectures at Room for Discussion, Rethinking economics and several meet-ups from the TV Program
Tegenlicht, about the faults in our economic thought. For this reason, choosing a topic for my
bachelor thesis was an easy one. I want to thank Dr. Damsma who assisted me while writing this thesis and who often offered me great articles from economists with remarkable
innovative views about the financial crisis. Writing this paper gave me even a deeper insight into the alternative of the "mainstream economic thought". I hope that my fellow students from all kinds of disciplines are going to read my thesis. Since economics is one of the most influential social sciences, it must, therefore, be discussed by all academic disciplines. Which is often difficult since economic papers mainly used algebra to calculate the obvious or to divert attention from the common sense. For this reason I have written a paper that is
therefore easy to read for people with no economic background. I hope you enjoy reading this thesis!
Kind regards, Ridwan Shadid
Introduction
The financial crisis had a tremendous effect on the world economy. Many governments were forced to spend billions of tax dollars to prevent a financial meltdown, and millions lost their jobs during the next recession. National debt levels increased, governments had to cut
spending, and the lives of many citizens changed. As the effects of the financial crisis were so severe, many countries entered an era of low economic growth for a long time. Until this day many economists argue that Europe experienced a lost decade that is in many ways
comparable to the lost decade of Japan in the 1990s. Although many countries have shown economic recovery, all face the inheritance of the extensive effects of the recession. Millions of middle-class jobs were lost and later replaced by low paying flexible jobs when economic recovery started, national debt levels are far higher than before the crisis, and the public still feels the many cutbacks on government spending to this day. Although policymakers are celebrating the economic upturn of the past few years, the state of the economy is on many fronts not on pre-crisis levels, especially for southern European countries.
As the 1970s economic downturn caused a crisis in the mainstream economic thought of the Keynesians, so did the 2008 financial crisis, in which the "mainstream economic thought'' inspired mainly by the neoclassical school was faced with its shortcomings. Up to the 2008 crash, many economists saw no dangers in our financial system and claimed that the market is an efficient functional machine that always depicts the right prices. After the 1970s economic recession, the neoclassical thought gained more attention, and the Reagan administration started with economic legislation that was supported by the neoclassical methodology. This economic theory spread around the globe, and many countries, especially in Western Europe, followed the neoliberal laws, first in Great Britain with Margaret
Thatcher, and later in other countries.
As the world experienced one of the worst financial crises in history, many economists regained an interest in the theories of John Maynard Keynes; this attention was later called the Keynesian Resurgence. The critique of the mainstream economic thought resulted in the launch of several new institutions that urged for new economic theories, such as The Institute of New Economic Thinking, founded in New York by prominent economist George Soros. The mission its states are "to nurture a global community of next-generation economic leaders, to provoke new economic thinking, and to inspire the economics profession to engage the challenges of the 21st century". Many other organizations around the globe followed.
The Keynesian Resurgence gave me the idea to write a thesis about the Keynesian school and its developments throughout time. This paper will give you an historical overview of the Keynesian School and its developments throughout the 20th and beginning of the 21th century. The central question I like to answer at the end of this paper is how the Keynesian school and its sub theories have developed over time and how its current sub theories should interpret the financial crisis of 2008.
Keynes
After Roosevelt took office during the Great Depression, he introduced in many ways revolutionary stimulus packages that were summed up as the New Deal. The now famous governmental projects for infrastructure, the introduction of social security, unemployment programs, etc., made the American Government an essential factor in the U.S economy. Roosevelt radically changed the economic policies from his predecessor, Herbert Hoover who was convinced that the government should never intervene in the market economy. Roosevelt's policies made the American Government a demand creator during the Great
Depression. Roosevelt also set up various rules, in an attempt to gain more control over the 1
financial system. On March 1933 after a period of multiple bank runs, the newly elected President Roosevelt declared a national banking holiday that shut down the entire banking system. During the Bank Holiday, the U.S. government took action and past the Emergency Banking Act, to reform and restore the trust in the financial sector. In Roosevelt's first Fireside Chat, Roosevelt convinced the public to trust the financial system and to re-deposit their savings. Within two weeks the public re-deposited more than half of all the currencies at the banks. The Banking Act later that year, introduced legislation to prevent any future banking crises. The most effective part of this Banking Act was the Glass Steagall Act, that
separated commercial and investment banks.2
The Government's vision on to what extent the market must be regulated, the importance of a welfare state, and the level of taxes each have significant implications on how the economy will develop. Most industrial countries are mixed economies, which is an economic system that features both capitalistic and socialistic elements. In a mixed economy, the government protects private property, unlike a communist regime, and legislation allows a certain level of economic freedom. The government has the function in the mixed economy to interfere in economic activities and to achieve social goals. Thanks to the ideology of Keynes and the democratic adaptation of his ideas, every western country has some modern welfare state in
which the government plays a prominent role in the economy. Keynes as one of the most 3
influential economists to this day fundamentally changed the theory and practice of economics and the economic policymaking of governments worldwide.
Keynes’ most substantial counterpart is the neoclassical theory. This approach argues that the government should be as small as possible to pursue the highest economic growth. The two economic schools are both not only academically discussed, but also on the societal level:
Republicans support the neoclassical theories of free markets and Democratsbelieve in the
Keynesian view of an interventionist government. The methods of Keynes are also a debate between the right and left of the political spectrum. Since the 1980s, the neoclassical theory gained its way into the mainstream economic theory. Today, mainstream economics is inspired mainly by the neoclassical approach in which the neoclassical assumptions such as
1
Rauchway, Eric. The Great Depression and the New Deal: A Very Short Introduction. Oxford University Press, 2008. 2
William L. Silber, ‘’Why Did FDR’s Bank holiday Succeed? ‘’, Economic Policy Review, July (2009)
rational decision making and optimizing utility are part of that. The neoclassical approach 4 regained its interest after the Keynesian theories dominated the economic thought of the post-war western world, which will be explained in more detail later.
Keynesgained international fame for his masterpiece, The General Theory of Employment,
Interest, and Money. In this book, Keynes called for a revolution in economic thinking. The
leading academic and political consensus of president Hoover was that government
intervention would not help the economy to recover, since the economy would soon or later recover to its natural equilibrium. Hoover's economic theory did not meet with the economic reality during the Great Depression in which the economic output lowered even further and further. Unemployment remained high, and production was kept low. The events of the Great
Depression inspired Keynes to rethink the dominant economic theories. Keynes rejected the 5
idea of the neoclassical economists that output would return to its equilibrium point. Keynes instead saw the economy as a natural cycle that could turn into periods of boom and bust. To naturalize this economic cycle, Keynes called for a countercyclical fiscal policy from the government, which meant that the government would create demand during recessions by
increased spending or lower taxes and do the reverse during economic booms. Keynes even 6
praised Roosevelt's new policies in an open letter, quoting:
"With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World but in comfort to men's minds through a restoration of their faith in the wisdom and the power of Government!" 7
After World War II, the Keynesian framework became popular amongacademics as well as
policymakers. The fast economic growth directly after WWII is not yet truly understood by economists. Many Keynesian economists argue that in this long period of rapid economic growth often cited as "The Golden Ages of Capitalism'', or the period of the “Keynesian Consensus’’ both left and right of the political spectrum had the same basic ideas about how
the economy functioned. 8
In short, the New Deal and the theories of Keynes helped the public and the economy during the Great Depression. The New Deal helped the US government to set up a modern welfare system. The post-war economic expansion was helped even further by Keynesian economic policies that helped both the US and Europe to reach standards of living that pre-war
generations could only dream off. As the economic reality of post-war America was 9
fundamentally different, the economic theories of Keynes had to be altered to stay relevant. A new generation of Keynesians developed theories that would match the new economic reality of Post-war America, the topic described in the next chapter.
4
Dequech, David. "Neoclassical, mainstream, orthodox, and heterodox economics." Journal of Post Keynesian Economics 30, no. 2 (2007): 279-302.
5
Skidelsky, Robert. ‘’Keynes: A very short introduction.’’ Vol. 248. Oxford University Press, 2010. 6
Skidelsky, Robert. ‘’Keynes: A very short introduction.’’ Vol. 248. Oxford University Press, 2010. 7
Excerpts from Keynes's Letter To Roosevelt: "On Spending Our Way To Prosperity" The New York Times, on 31 December 1933 8
Singer, Hans W. "The golden age of the Keynesian consensus—the pendulum swings back." World Development 25, no. 3 (1997): 293-295. 9Van Rossem, Maarten. ‘’
Neo-Keynesian economics
Neo-Keynesian economics is a macroeconomic thought that developed after World War II and the dominated mainstream economic idea in the 1950s, 1960s, and 1970s. The original framework of Neo-Keynesian economics was to use the theories of Keynes in the
neoclassical models of economics. The Neo-Keynesian School was dominant in the era of post-war economic expansion. In this period, western capitalist countries enjoyed high economic growth, low and stable unemployment in combination with rising wages, and low
inflation. 10Many Keynesian economists often look back with nostalgia to this economic era.
Theories of Hicks, Modigliani, and Samuelson are still being lectured at universities. The IS/LM model, which is in the first year Macroeconomics, was Hicks’ contribution to the Neo-Keynesian framework and is nearly as influential as Keynes original framework. The IS-LM model, which stands for investment-savings, IS-curve and liquidity-money,
LM-curve, is a Keynesian macroeconomic model that shows how the market for goods (IS) interacts with the money market (LM), the two curves intersect to show the short-run
equilibrium between interest rates and output. As this theory is seen today as too simplified, it
founds its main ideas in numerous economic models introduced laterby New-Keynesian
economists.
The Phillips Curve, also developed during the Golden Ages of Capitalism, showed that
inflation and unemployment have a stable and inverse relationship.11 This model was
criticized after the first oil embargoes and stagflation at the end of the 1970s that did no longer prove the Phillips Curve model.
Along with the oil crisis, other historical developments played a role in the dismantling of neo-Keynesian theories. The postwar economic expansion came with high wage increases in the late 1960s. The wage increases along with the up rise of the low-wage countries saw a shift of production facilities from the west to the east, especially for the labor-intensive industries. Unemployment rates tripled in the 1970s. The once dominant industrial cities like Detroit and Pittsburgh lost their manufacturing jobs and population. The surrounding era later got the nickname "Rust Belt."12This "Rust Belt'' is politically a fascinating region, since
many working-class Democrats (blue collar) that lost their jobs during the deindustrialization shifted to the Republican side. With the 1980 presidential election these blue collar democrats
were called the Reagan Democrats. 13
Due to the post-war economic expansion of the United States and Europe, policymakers loosened several parts of the Glass Steagall Act, since they saw no danger in repealing some parts of the bill. And for good reasons, the US economy was in a long-term economic expansion with growth rates that were historically high. Bankers, therefore, saw many
10
Vonyó, Tamás. "Post-war reconstruction and the Golden Age of economic growth." European Review of Economic History 12, no. 2 (2008): 221-241.
11
Fisher, Irving. "I Discovered the Phillips Curve:" A Statistical Relation between Unemployment and Price Changes." Journal of Political Economy 81, no. 2, Part 1 (1973): 496-502.
12
Alder, Simeon, David Lagakos, and Lee E. Ohanian. "The decline of the US Rust Belt: a macroeconomic analysis." (2014). 13Riddle, Richard David. "
government regulations as a burden to their business. In the early 1960s, Federal-banking regulators, therefore, loosened some legislation to meet with bankers’ preferences. The deindustrialization, oil embargo's, high wages, inflation, and unemployment were
socio-economic problems in which the Neo-Keynesian School had no answer too. During the Golden Ages of Capitalism, a small group of economists studied the neoclassical theories and tried to create an alternative thesis to the dominant Neo-Keynesian theory. One of these
economists who criticized the Neo-Keynesian models was Robert Lucas. The Lucas critique
stated that the effects of policy decisions could not be forecasted using historical data only.
Decisions rules, for example the consumption function, are in Keynesian models seen as
structural, structural in the way that they are not vulnerable to government policy changes. The Lucas critique, seen as revolutionary in the history of macroeconomic thought,
underwent a paradigm shift in the 1970s towards a new interest in establishing micro-foundations in macroeconomic theory.
The two most prominent economists of this neoclassical ideology were Friedrich Hayek and
Milton Friedman. Hayek got the Nobel Prize in economics in the year 1974 and Friedman in
1976, which was a sign of a changing academic consensus. The neoclassical economic
thought urged for a purer form of market capitalism instead of the preached Keynesian mixed
economy. Hayek saw the market as complex information driven system, in which no single
participant has all the available data. Because the government did not have all the market information, any government intervention would automatically lead to market distortion. Milton Friedman believed that citizens were rational economic agents. He compared the economic decision making of citizens with pool table players, who according to Friedman had no idea about the concepts of physics, but made the most efficient decisions anyway. This same principle must, therefore, hold for how the economy works, according to Friedman. Citizens are forward-looking individuals who act rationally to any market intervention of the government. If the government, for example, increases spending, the public would begin to save to cover any tax increases, due to higher expense now in the future. Friedman argued that for this reason, any market intervention would not be useful in
the long run. 14
Friedman's efficient market theory got extra support from the price fluctuations of stocks on
Wall Street. The price development of shares was called a ‘random walk’. The random walk
hypothesis states that stock market prices evolve according to a random walk, and for this reason cannot be predicted. The random walk theory is in line with the efficient market hypothesis, a theory that states that all asset prices fully reflect all available information. For
this reason, no investor can "beat the market'', since the market prices should only react to
new information or changes in interest rates. Critics claim that this theory is hard to prove. Stock prices tend to be over or undervalued in periods of time. Periods of overvaluation, such
as the Internet bubble, showed Internet stocks that were far beyond any reasonable price. 15
Others claim that there are obviously investors who outperform the stock exchange. The most
14 Friedman, Milton. ‘’Essays in positive economics.’’ University of Chicago Press, 1953. 15
famous investor Warren Buffett for example, who warned of the financial crash of 2008, by
calling CDO's "Weapons of mass destruction".16
To conclude, Keynesian theories were the dominant economic theories in the post-war era, as they later became obsolete in the 1970s due to changing economic circumstances. As Keynes provided an answer to the Great Depression, so did the neoclassical theory in the 1970s. The Keynesian theory therefore needed a new framework to stay relevant in the new economic reality. Although the Neo-Keynesian theories are still lectured in university courses, there are no current economists who ally themselves as Neo-Keynesians, as the Neo-Keynesian school stopped at the end of the 1970s, to converge to the New-Keynesian school, the subject of the next chapter.
16Wolf, Martin. "
New-Keynesian economics
When the neoliberal era of Reagan started, the neoclassical economic view was adopted under the Reagan administration in their economic policy. The Keynesian School needed new theories to stay relevant. The first waves of New-Keynesian argument came up in the late 1970s. The New-Keynesians mixed the theory of Keynes with the neoclassical approach, in which firms and households have rational expectations. New-Keynesians distance themselves because they believe that the market can show imperfections and that prices can be sticky, in the sense that prices do not adjust instantaneously during changing economic performances. Neoclassical economists do believe that markets are efficient and therefore the rates are
always adapted to all the information available. Wages too, according to New-Keynesians 17
have some stickiness, since there are labor unions, minimum wages and other factors that can alter salaries from their new equilibrium. The market failures as wage and price stickiness presented in the models of New-Keynesians imply that the economy may fail to reach full employment. New-Keynesians, therefore, argue that the government must use
macroeconomic stabilizers, for example using fiscal or monetary policy, to find the highest
possible macroeconomic outcome. 18
A new era of deregulation, privatization etc. gave the financial lobby more power to demand for the loosening of regulation. President Carter passed the Depository Institutions
Deregulation, and Monetary Control Act and Reagan signed the Garn-St. Germain
Depository Institutions Act, which deregulated the banking sector further. Still many banks that wanted to grow and diversify their business were on hold due to the Glass Steagall act. Under enormous pressure of the financial lobby, backed by neoclassical economists as Alan Greenspan, former chairman of the Fed, The Glass-Steagall act was repealed in 1999 and was
replaced by the Gramm–Leach–Bliley Act (GLBA). This Gramm-Leach Act made an end to
the difference between commercial and investment banks. As a consequence, many financial institutions merged. These mergers created so-called "system'' banks, which meant that they played a key role in the financial system. Insolvency in any of these banks would, therefore, create a threat to the whole system. During the financial crisis, these banks were called “too big to fail’’ which meant that the US. The government was forced to bail them out, to avoid a
financial meltdown.19
The financial deregulation came along with technological innovations in the financial sector. The technological changes made it possible for banks and trading firms to introduce more
complicated financial products. Financial derivatives, such as famously known CDO
(Collateralized Debt Obligations), were structured financial products backed by a pool of loans. When a commercial bank accepted loans, such as mortgages and sold these loans to an
17
Dixon, Huw. "Reflections on new Keynesian economics; the role of imperfect competition." Retrieved from http://finance5. net/Huw-Dixon-Reflections-on-New-Keynesian-Economics (1998).
18
Mankiw, N. Gregory, and David Romer, eds. ‘’New Keynesian Economics: Coordination failures and real rigidities.’’ Vol. 2. MIT press, 1991. 19
Grant, Joseph Karl. "What the financial services industry puts together let no person put asunder: How the Gramm-Leach-Bliley Act contributed
investment bank, the investment bank then bundled these loans into products, called a CDO, and sold them to investors. The loan and interest payments were then paid back to the
investors. The collateral, in this case, real estate, gave the CDO value. If the underlying loans went bad, the bank had to transfer much of the risks to the investor. For this reason, the CDO was cut in several tranches. With safest tranches called “senior” because this tranche had the first claim on assets and “junior” tranches that were riskier and offered, therefore, higher interest rates. Because mortgages were seen as debt with little risk and the complexity of the CDO, Credit Rating Agencies, such as S&P, Moody's, could not predict the real dangers CDO's had, therefore various CDO derivatives received the highest possible rating. The
so-called Triple-A rating. The introduction of financial derivatives was by many economists 20
seen as a positive development, since new financial products offered opportunities for markets to seek for a new rate of return. The policymakers of the United States, like the Federal Reserve, the Treasury, etc. initiated a study of the OTC derivatives market. Many prominent (neoclassical) economists like Alan Greenspan, helped convince Congress to pass the Commodity Futures Modernization Act of 2000, which excluded any regulation of
financial derivatives from the US. Government. 21
Few economists criticized the deregulation of the financial sector, or the possible dangers of financial innovations. Since the neoclassical economic consensus believed that markets
should operate without any governmental regulation, New-Keynesians adopted the
neoclassical approach in their academic framework. A good example of that is the
macroeconomic policy model, called the Dynamic Stochastic General Equilibrium Model (DSGE). The DSGE model, in short, is a model that attempts to explain business cycles, economic growth and the effects of fiscal and monetary policy. The New-Keynesians saw the micro-foundations as a proper groundwork, since this model based the preferences of the decision makers in the model, considering that at least the policymakers were rational agents. As in contrast to older models, the DSGE is a dynamic model since it studies new
technological changes and other factors that show how the economy evolves. After the 22
financial crash, the United States Congress hosted a hearing on macroeconomic modeling methods on July 20, 2010. Robert Solow, a prominent economist for his famous Solow Growth Model, said the following:
“I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way... The protagonists of this idea claim respectability by asserting that it is founded on what we know about
microeconomic behavior, but I think that this claim is phony. The advocates no doubt believe
20
Reinhart, C. M., & Rogoff, K. S. (2009). ‘’Is the 2007 US sub-prime financial crisis so different?: An international historical comparison.’’
Panoeconomicus, 56(3), 291-299.
21
Levine, R. (2012). ‘’The governance of financial regulation: reform lessons from the recent crisis.’’ International Review of Finance, 12(1), 39-56.
22
Colander, David, Peter Howitt, Alan Kirman, Axel Leijonhufvud, and Perry Mehrling. "Beyond DSGE models: toward an empirically based
what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether.23
New-Keynesians and neoclassical economists had previously agreed monetary policy was
sufficient for most downturns and the two schools debated only about the technicalities. Both New-Keynesians and neoclassical economists believed that monetary policy was the adequate policy tool to treat economic downturn. As history shows, monetary policy is never the only tool for accomplishing higher economic growth, since this device can create new bubbles
when it is too accommodative as the subprime crisis showed. 24
In the early 2000s events as the dot.com crash and 911 caused a recession. To aggregate economic growth, the Federal Reserve lowered its interest rates. From 2000 to 2003 the Fed
reduced its interest rate from 6.5% to as low as 1%. 25Many critics claimed that the FED kept
interest rates too low for too long and therefore stimulated another financial bubble. The 26
Fed defended their low-interest policy due the economic recovery was in fact jobless growth,
in which there is economic recovery but without job creation. Not only the low-interest rates 27
of the Federal Reserve created the credit boom, the economic up rise of Asia, and especially China, caused a new influx of cash flow to the United States. China, with world's most inhabitants, with an household saving rate of 38%, prospered on American spending. The massive buildup of savings depressed interest rates worldwide. These Chinese savings were invested in risk-free assets, like the US. Government bonds, causing interest rates to fall to historic low. By the time the Federal Reserve tried to higher the interest rates it was already too late, long-term interest rates remained low, fueled the housing bubble further since the
housing market used the long-term interest rate to finance mortgages. 28
Moreover, many economists saw no danger in the credit-lending boom for the real estate market. This is because the United States is in many ways a complicated country. Social and economic differences are more significant than the average European might think. For
example, the average income in Connecticut is twice that of the average salary in Mississippi. It is, therefore, no wonder that the United States does not have one single housing market. Therefore, residential property in good performing economic regions like New York is more expensive than in less performing areas like Missouri. Thus predicting the US Housing market is very difficult since it's such a fragmented market. Although there are vast regional differences, an economist could have seen a housing bubble coming by observing the price increase of the typical American home as an average of the total market, as it increased by 124% from 1998 to 2006. A consequence of the housing bubble was that many homeowners refinanced their homes at lower interest rates, or took out a second mortgage for a consumer. The credit boom continued, and new kind of mortgages was introduced, with the NINJA loan
23Solow, R. "Prepared Statement Robert Solow Professor Emeritus, House Committee on Science and Technology Subcommittee on Investigations and Oversight." Building a Science of Economics for the Real World” July 20 (2010): 2010.
24
Reinhart, C. M., & Rogoff, K. S. (2009). ‘’Is the 2007 US sub-prime financial crisis so different?’’: An international historical comparison.
Panoeconomicus, 56(3), 291-299.
25
Reinhart, C. M., & Rogoff, K. S. (2009). ‘’Is the 2007 US sub-prime financial crisis so different?’’: An international historical comparison.
Panoeconomicus, 56(3), 291-299.
26
Crotty, James. “Structural causes of the global financial crisis: a critical assessment of the new financial architecture’’ Cambridge journal of
economics 33, no.4 (2009): 563-580 27
Schweitzer, Mark Edward. Another jobless recovery?. Federal Reserve Bank of Cleveland, Research Department, 2003.
28Mees, Heleen.
(no income no job mortgage) as its most extreme example.29 Although many argue that the
subprime-mortgage crisis was mainly due to low-income households that took these subprime loans, a new finding in a 2017 research showed that the buy-to-let mortgage during the
housing boom also played a significant role in the subprime mortgage crisis. In this type of loan, the mortgage taker takes an extra mortgage to buy property to use it as a new kind of income stream from renting the place. The idea is that the mortgage is lower than the monthly
income from rent. This type of lending accelerated the housing prices even further. As in 30
2006, the housing prices stopped growing, interest rates were rising again, and many homeowners came into trouble with paying off their mortgage.
After the bubble burst, the world economy experienced a recession. The United States soon recovered thanks to the Keynesian economic policy that introduced various stimulus
packages. Europe, on the other hand, got the Euro Crisis as a successor of the 2008 financial crisis. In combination with the strict budget policies, known as the "Maastricht Treaty", the Euro Crisis caused a second recession called the ‘'second dip''. As the United States was less strict in their fiscal budget policies, the United States experienced a faster recovery, whereas
Europe experienced a more prolonged recession.31This shows that the Keynesian theory is
still useful, although many neoclassical economists were convinced that higher debt levels
would in the long-term damage the economy. 32
Many economists saw no dangers in the housing boom, since they believed that the United States would not show an overall decline in housing prices, with the argument that this never
had happened in history. To illustrate this belief, Ben Bernanke, former chairman, who
dedicated his academic life to the study of the Great Depression, could not predict any future bubble and stated:
“We’ve never had a decline in house prices on a nationwide basis. So, what I think what is
more likely is that house prices will slow, maybe stabilize, might slow consumption spending
a bit. I don’t think it’s gonna drive the economy too far from its full employment path,
through.” 33
When the first signs of a bubble on the housing market were observed in 2005 Bernanke
wrote, “largely reflect strong economic fundamentals.”34
The New-Keynesian and neoclassical economists largely ignored all these developments in the World economy. To see how the New-Keynesian school has developed since the financial crash of 2008, we have a look at a few papers from the most prominent
New-Keynesian economists, such as Krugman, Blanchard and Bernanke, to come up with some consensus from the New-Keynesians. It is therefore attractive to look at their work and to find out in which way New-Keynesians changed their economic view. It is of course hard
29
Goodchild, Philip. "What is wrong with the global financial system?." Journal of interdisciplinary economics 24, no. 1 (2012): 7-28. 30
Albanesi, Stefania, Giacomo De Giorgi, and Jaromir Nosal. ‘’Credit growth and the financial crisis: A new narrative’’. No. w23740. National Bureau of Economic Research, 2017.
31
Heimberger, Philipp. "Did fiscal consolidation cause the double-dip recession in the euro area?." Review of Keynesian Economics 5, no. 3 (2017): 439-458.
32
Reinhart, Carmen M., and Kenneth S. Rogoff. ‘’Growth in a Time of Debt’’. No. w15639. National Bureau of Economic Research, 2010.
33
Leonhardt, David. "The Fed Missed This Bubble: Will It See a New One?." New York Times (2010).
to generalize how the academic framework of the New-Keynesians has changed, but looking at the papers of a prominent New-Keynesian as Blanchard gives a better insight into a changing academic shift. Olivier Blanchard, head of the IMF, declared in March 2008 that
“The state of macro is going through a process of great progress and excitement.” 35
Blanchard later published the article ‘Where the danger lurks’ in which he criticizes the 36
mainstream economic models. These models, based on Rational Expectations Theory, simply cannot be used when the market is acting unpredictably. Blanchard then criticizes the
New-Keynesian look at the central bank monetary policy, considering this as sufficient to prevent economic downturns. During the Great Moderation (period of low economic
volatility in the US since the 1980s), Blanchard described Alan Greenspan as some Chief
Economic Architect, providing the public a false sense of control over the economy. Blanchard here criticizes the academic consensus under neoclassical and New-Keynesians that every financial downturn is entirely manageable by the central bank. Blanchard further states that the financial system must be more robust and transparent. Even though the bank capital ratios went up, banks are part of a much more complex network of financial markets and institutions. Calculating risks is therefore much more complex and therefore risks are far
from gone.37All in all, Blanchard changed his view on economics drastically since the
outbreak of the financial crisis. Another prominent New-Keynesian, Krugman, pointed out that New-Keynesians tried to keep their deviations from the dominant neoclassical theory as limited as possible. This meant that there was no room for bubbles or bank-collapses in their models. The events like the Asia crisis of 1997 and the bankruptcy of Argentina of 2002 were not used as study cases for new economic modeling. Again the economic theory lost its connection with the economic reality.
As was previously mentioned, New-Keynesians came to believe that every crisis was solvable by monetary policy. As former chairman of the FED, Ben Bernanke once declared about the Great Depression: “You're right. We did it. We're very sorry. But thanks to you, it
won't happen again” He implied that the only thing the economy needs during an economic 38
downturn is an influential Federal Reserve. Krugman declares at the end of his article that it will take a long time before new theories and approaches of economics will be developed, that will offer the same kind of completeness and clarity as the neoclassical approach did.
This is why according to Krugman, so many economists cling to the neoclassical approach. 39
In general, we can argue that the New-Keynesian theories were just a product of its time. The academic sentiment got a renewed interest in the neoclassical economic approach. New- Keynesians had to adopt many neoclassical methods to keep Keynesian theories relevant. Without the New-Keynesians, Keynes’ theories about the vital role of government would be ignored by the neoclassicals who viewed the market as a correctly functioning machine, and the government as an inefficient, dangerous entity. The fact that the New-Keynesians ignored the crisis of Asia and Argentina also showed how western-oriented economic science is. It is also remarkable to read from several New-Keynesians that they are not sure what the next
35Blanchard, Olivier. "
The state of macro." Annu. Rev. Econ. 1, no. 1 (2009): 209-228.
36
Blanchard, Olivier. "Where danger lurks." Finance & Development 51, no. 3 (2014): 28-31.
37
Blanchard, Olivier. "Where danger lurks." Finance & Development 51, no. 3 (2014): 28-31. 38
Krugman, Paul. "How did economists get it so wrong?." New York Times 2, no. 9 (2009): 2009. 39Krugman, Paul. "
step must be to find a better economic paradigm. To quote Krugman in the conclusion of this article,
"What we need is a change in the destructive social dynamics that brought us to this point. And I wish I knew how to do that. But my problem is obvious: I'm an economist, and it
seems that we need some kind of sociologist to solve our profession's problems.'' 40
Post-Keynesians
The term ‘Post-Keynesian economics’ refers to the collection of emerging schools within
macroeconomics that are attempting “to go back to the basics", that is the work of John Maynard Keynes. As described in the previous chapters, other Keynesian theories such as the Neo- and New-Keynesians tried to mix macroeconomics with microeconomic theories of the neoclassical School. The financial crisis caused a re-interest in Keynesian theories because many economists wanted to study the alternative of the dominant neoclassical theory. This interest in Keynes was later called the "Keynesian Resurgence." This process reminded many of the academic shift of the 1970s in which neoclassical theories replaced Keynesian theories. Although Post-Keynesians try to ‘go back to the basics' of Keynes, Post-Keynesians also came up with new theories which gain influence from a much broader variety of disciplines, like history, sociology, political science, psychology, and anthropology. As the group of Post-Keynesians is very diverse, this paper will use the main findings of one of the most prominent Post-Keynesians of this day, Steve Keen. In his paper published in 2013, Keen describes the main assumptions of the Post-Keynesian School. Foremost, the Post-Keynesian theory is in contrast to the New-Keynesian theory, and not part of the academic consensus. It
is therefore needed to explain the basic assumptions the Post-Keynesians have. One of the
main assumptions that Post-Keynesians reject is the idea that macroeconomics must be derived from microeconomics. Using microeconomic assumptions in macroeconomic models showed its shortcomings during the financial crash, and for this reason, Post-Keynesians reject this assumption. Keen uses a quote from physicist and Nobel Prize winner Anderson to support his Post-Keynesian argument further:
"The behavior of large and complex aggregates of elementary particles, it turns out, is not to be understood concerning a simple extrapolation of the properties of a few particles. Instead, at each level of complexity entirely new properties appear, and the understanding of the new
behaviors requires research which I think is as fundamental as any other …'' 41
As New-Keynesians acknowledge the shortcomings of microeconomics, they still see no
better alternative yet. Post-Keynesians disagree with the neoclassical economists, who
believe that markets always move to a natural equilibrium. Post-Keynesians, on the other hand, think that the market is an ever-changing and therefore dynamic system that is rarely in
balance. In contrast to the neoclassical models?, Post-Keynesian models do not have a long
run equilibrium point to which the economy is assumed to grow to. In line with this theory,
Post-Keynesians also reject the idea of a natural rate of unemployment. Markets, therefore,
might be below or above the equilibrium in specific periods of time. New-Keynesians share
this point of view since New-Keynesians believe that markets can be affected by "sticky prices." In our modern economy, inefficient markets are easily found, from agriculture, technology to the automotive industry: all face some market distortions. The agriculture market, for example, receives government subsidies, while the technology sector is often remarked as a duo/ monopolies. Examples of the dominance of Microsoft’s operating
software and Google for its dominance of the web-browsing industry are evident. 42
41 Keen, Steve. "Predicting the ‘Global Financial Crisis’’: Post-Keynesian Macroeconomics." Economic Record 89, no. 285 (2013): 228-254. 42 Boyd, Connor. "How has the Monopoly of the Web affected the economy, society & industry?." Ph.D. diss., Cardiff Metropolitan University, 2017.
Post-Keynesians reject the Rational Expectations theory of the neoclassical school. The neoclassical school saw the rational expectation theory as a way to develop economic models. For example, when the government increased spending, agents would be smart enough to save to pay for the increased taxes in the future. Post-Keynesians reject this homo
economicus idea and emphasize dynamics and disequilibrium in their models.
Post-Keynesians used Keynes’ original theory about expectations. As Keynes once wrote:
"One of these pretty, polite techniques which try to deal with the present by abstracting from
the fact that we know very little about the future." 43
The neoclassical theory changed this to the "Rational Expectations Revolution" in which the future could be anticipated by agents that used rational expectations. As the subprime
mortgage crisis showed, very few agents make good economic decisions that are rational and forward-looking. Post-Keynesians see money as endogenous. Endogenous money is created as other economic variables interact, rather than exogenously created by an external authority
such as a central bank. Money is created by the increase in credit demand by agents. This
leads to an increase in the money supply by the financial system that creates a part of this
money by financial innovation. As already described in previous chapters, neoclassical
economists see the economy as self-equilibrating. For this reason, the neoclassical school has a critical view on the role of the government in the economy.
Keynes and the Post-Keynesians, on the other hand, view the market economy as a system that can generate insufficient output. Post-Keynesians, therefore, agree that the government has a responsibility to boost aggregate demand during recessions. Post-Keynesians see the importance of the credit cycle as part of the business cycle, mostly modeled off of the Minsky's financial instability hypothesis. Minsky’s research attempted to provide an understanding of financial bubbles and crises. This research is remarkable since most
economists, especially before the financial crisis, saw Keynesian economic theory as inferior since Keynesians did not mathematically underline their theories as much as neoclassical economists did. Minsky's hypothesis shows that economists can introduce complex mathematics to prove their Keynesian models. Minsky's theories were largely ignored for decades, until the subprime mortgage crisis of 2008 in which they gained renewed interest. In short Minsky's financial instability hypothesis states that the key mechanism that pushes an economy towards a crisis is the rapid growth of debt by the non-governmental sector. The main argument in Minsky theory is that capitalism by itself is an unstable regulation must. Therefore, it focuses on the fact that capitalism is unstable. The market is not efficient, and the market is not always right. Another key feature in Minsky's theory is that it sees financial variables as interdependent, so anything that goes bad in the financial sector will have
consequences for the real economy. The financial crisis of 2008 showed that any problems in the financial sector had devastating effects on the real economy. By the time investors forget the last financial crisis, they believe there is a new economic reality in which all conditions are fundamentally different.The New York Times bestseller This time is different, eight
centuries of financial folly, by44 economist Reinhart, and Rogoff perfectly describes this
process by giving the reader a historical overview. The longer an economy experiences a period of growth, the less likely it is that it will grow for even a longer time. Minsky stated: "each state nurtures forces that lead to its destruction''. Minsky uses psychological 45
43 Keynes, John Maynard. "The general theory of employment." The quarterly journal of economics 51, no. 2 (1937): 209-223. 44 Reinhart, Carmen M., and Kenneth S. Rogoff. ‘’This time is different: Eight centuries of financial folly.’’ princeton university press, 2009. 45 Keen, Steve. "Predicting the ‘Global Financial Crisis’: Post-Keynesian Macroeconomics." Economic Record 89, no. 285 (2013): 228-254.
arguments that are very similar to Galbraith economic theory. In a market economy,
speculation is always there, financial agents like speculators and bankers ride the economic cycle by lending out more money. This is possible because our modern financial system allows money to be created out of nothing. For that, there is no limit on the amounts of credit that banks can write out. Credit is, therefore, an immaterial service, which can be granted by punching a keynote on a computer. In sharp contrast with the real sector, in which
overproduction quickly becomes visible when unsold products start to pile up, and must then be sold at a huge discount. For this reason, the banking sector purely relies on trust. 46
In his book The Global Minotaur Varoufakis perfectly describes a Minsky moment in the
metaphor of an always-improving car. As cars technically enhance over time, cars get safer and drivers tend to spend more. Minor accidents on the roads make drivers more careful, but for every improvement like better brakes, abs, and airbags our safety is improved. These features are used to increase our average speed on the road. Traffic accidents become more rare; big ones can hit hard. This is in many ways a remarkable example how a financial crash of 1929 and 2008 could have happened. In both periods, new financial instruments fueled rapid growth and made investments seem safer than ever before. When the economic boom ends and the debt levels are too high, asset prices fall, and uncertainty over financial
institutions increase, such that debt cannot easily accumulate which will default, triggering a financial crisis and recession, as seen in the 2008 financial crash.47
Post-Keynesian economists were the first economists to emphasize that money supply responds to the demand for bank credit. Although not lectured at universities, banks can create money out of nothing. The modern financial system is purely based on trust. Economic growth is therefore for a large part dependent on how much bankers are willing to create loans to individuals, companies, etc. Commercial banks create money in the form of bank deposits by making new loans. When a bank writes out a mortgage, it credits their bank
account with a bank deposit of the size of the mortgage. This is how new money is created.48
Therefore according to the Post-Keynesians, the money supply responds to the demand for bank credit. If the public does not want to borrow money, or the banks are risk averse during economic recessions, no money is created.
Since the second half of the 1970s, labor productivity and wages did not grow at the same rate. Since most western economies are strongly depended on wages, these economies will in the long term suffer from economic growth. The growing inequality costs economic growth, since lower income groups have a more substantial marginal propensity to consume than high-income groups. Income inequality can lead to an economic crisis as a result of consumer demand shortages. Both Marxist as Post-Keynesians use this argument in their terminology. In the period before the 2008 financial crash, we saw that lower income groups in society were able to increase their debt levels due to higher availability of finance. This in
combination with rising asset prices, such as the housing boom and the public will believe that they are better off, since higher asset prices create a wealth effect. The urge for keeping wages at the same level came due to the uprise of Asia with especially China has led to some regional economic downturn. Factory Workers that in the beginning earned a living wage saw their jobs being outsourced to low-wage countries like China. Unions had to their best to keep specific jobs in the US and western countries. In this case, demanding wage increases were not to their advantage. Many economic reports urged governments to introduce labor legislation for a more flexible labor market, in which employees were not that much
46Keen, Steve. "
Predicting the ‘Global Financial Crisis ": Post-Keynesian Macroeconomics." Economic Record 89, no. 285 (2013): 228-254. 47Varoufakis, Yanis. "
The global minotaur ": America, Europe and the future of the global economy. Zed Books Ltd., 2015. 48McLeay, Michael, Amar Radia, and Ryland Thomas. "
protected against layoffs and therefore were not in the position for demanding higher salaries. This flexibilization of the labor market happened in all countries, and since the financial crisis the devastating effects are being seen. The number of people classed as the "working poor" exploded, home ownership is harder to accomplish by some groups, and it costs economic growth since it keeps workers in an uncertain social/economic situation. If the poorer segments of the population can accumulate debt due to greater availability of finance and because of rising asset prices (wealth-effect). Rising debt, in the beginning, ensures stable or growing demand for consumption but will become a burden to low incomes when the interest rates increase, and income is lost. In the long run, income will, therefore, be distributed from poorer to richer households and therefore the low-income groups
consumption will be constrained, eventually most likely lead to a recession, like the 2008 financial crash. 49
Discussion &. Conclusion
Economics is, like it or not, one of the most influential social science. Decision making over societal problems, ranging from healthcare, the labor market, education, etc. are all mainly based on economic advice. Decision makers look at economic models that manage to wrap entire concepts in beautifully mathematical graphs. One of the best metaphors to show how influential economists and their models can be is the moment when Ronald Reagan and economist Robert Laffer have dinner and Laffer draws a model in which he quickly shows to Reagan that higher taxes do not automatically lead to higher incomes. Therefore urging Reagan to lower taxes. As it turned out, the model that Laffer used was not accurate. It was obviously too simplified to tackle something as complex as taxes. This metaphor of Reagan and economist Robert Laffer shows how problematic it is when we attempt to take these economic models as facts and fall into the trap of thinking that the real world should work as the model suggest.
In this thesis, I have shown you how the Keynesian School has developed in the past decades. It is interesting to see how each school is in this way a product of its own time. The
Keynesian school that emerged as a reaction to the Great Depression and the re-interest in the neoclassical school that appeared after the Keynesians had no answers to the economic problems of the 1970s. The New-Keynesians developed new assumptions in which they used neoclassical theories to keep the Keynesian methods relevant to the new economic reality. When the 2008 financial crisis broke out, economists regained an interest in the theories of Keynes. A small group of unorthodox economists, called the Post-Keynesians showed new observations and theories about the economic reality. They criticized the "mainstream economics'' which by then was dominated by the neoclassical School.
The New-Keynesians share some of the critiques the Post-Keynesians have but at the same time are convinced that there is yet no better alternatives to use. The 2008 crash is in this way different from the 1970s. As in the 1970s, economics experienced an academic shift to the neoclassical theory. As with 2008, this was not the case. Although Post-Keynesians came up with some remarkable methods that in my opinion gives an economist a better insight into how economics work, I urge every economist to read the Minsky hypothesis and the
endogenous money theory. The Post-Keynesian School remains a relatively small academic field, which is a missed chance for the academic debate.
As the crisis showed, some economic assumptions must be changed. Or at least more
discussion about the economic assumptions is needed. In my opinion economic models must be used more as a tool or framework, not as the only way to approach an economic issue. Economic models are often interpreted as how things should work in the real world instead of describing the real world. As the Post-Keynesians focused their research on the economic reality, they came up with various theories, or forgotten theories like the Minsky moment, the endogeneity theory and income inequality theory that showed that the economy is in many
ways functioning in a different way than what was previously thought. Introducing Post-Keynesian theory to the mainstream will lead to a better academic debate.
Unfortunately, mainstream economics have not changed that much as many economists hoped. I therefore ask my fellow economists to study the Post-Keynesian theories and to question the mainstream economic thought.
Bibliography
Albanesi, Stefania, Giacomo De Giorgi, and Jaromir Nosal. "Credit growth and the financial
crisis: A new narrative." No. w23740. National Bureau of Economic Research, 2017.
Alder, Simeon, David Lagakos, and Lee Ohanian. "The decline of the US Rust Belt: a
macroeconomic analysis." (2014).
Backhouse, Roger E., and Bradley W. Bateman. "Keynes and the Welfare State." History of Economic Thought and Policy (2012).
Blanchard, Olivier. "The state of macro." Annu. Rev. Econ. 1, no. 1 (2009): 209-228 Blanchard, Olivier. "Where danger lurks." Finance & Development 51, no. 3 (2014): 28-31 Boyd, Connor. "How has the Monopoly of the Web affected the economy, society &
industry?." PhD diss., Cardiff Metropolitan University, 2017.
Crotty, James. "Structural causes of the global financial crisis: a critical assessment of the
‘new financial architecture." Cambridge journal of economics 33, no. 4 (2009): 563-580.
Excerpts from Keynes's Letter To Roosevelt: "On Spending Our Way To Prosperity" The
New York Times, on 31 December 1933
Fisher, Irving. "I Discovered the Phillips Curve:" A Statistical Relation between
Unemployment and Price Changes." Journal of Political Economy 81, no. 2, Part 1 (1973):
496-502.
Goodchild, Philip. "What is wrong with the global financial system?." Journal of interdisciplinary economics 24, no. 1 (2012): 7-28.
Grant, Joseph Karl. "What the financial services industry puts together let no person put asunder: How the Gramm-Leach-Bliley Act contributed to the 2008-2009 American capital markets crisis." Alb. L. Rev. 73 (2009): 371.
Heimberger, Philipp. "Did fiscal consolidation cause the double-dip recession in the euro
area?." Review of Keynesian Economics 5, no. 3 (2017): 439-458.
Keen, Steve. "Predicting the Global Financial Crisis: Post-Keynesian Macroeconomics." Economic Record 89, no. 285 (2013): 228-254.
Levine, Ross. "The governance of financial regulation: reform lessons from the recent
Krugman, Paul. "How did economists get it so wrong?." New York Times 2, no. 9 (2009): 2009.
Krugman, Paul. "The profession and the crisis." Eastern Economic Journal 37, no. 3 (2011): 307-312.
Mees, Heleen. Changing Fortunes: "How China’s Boom Caused the Financial Crisis". No. EPS-2012-266-MKT. 2012.
McLeay, Michael, and Radia, Amar and Thomas, Ryland, "Money Creation in the Modern
Economy." (March 14, 2014). Bank of England Quarterly Bulletin 2014 Q1.
Rauchway, Eric. The Great Depression and the New Deal: A Very Short Introduction. Oxford
University Press, 2008.
Robert Solow Prepared Statement, Professor Emeritus, MIT, to the House Committee on Science and Technology, Subcommittee on Investigations and Oversight: "Building a Science of Economics for the Real World," July 2010
Schweitzer, Mark Edward. "Another jobless recovery?". Federal Reserve Bank of Cleveland, Research Department, 2003.
Singer, Hans W. "The golden age of the Keynesian consensus—the pendulum swings back."
World Development 25, no. 3 (1997): 293-295.
Skidelsky, Robert. "Keynes: a very short introduction." Vol. 248. Oxford University Press, 2010.
Varoufakis, Yanis. "The global minotaur." London: Zed books, 2013.
William L. Silber, ‘’Why Did FDR’s Bank holiday Succeed? ‘’, Economic Policy Review, July (2009)
Afterword
As I enjoy my late night coffee, I am thinking about all the things I have learned while writing this thesis. Before I started writing, I had some clues about the different economic schools. I understood the difference between the Keynesians and neoclassicals that were part of some classes. When you are studying economics you are focused on learning mathematics, statistics and economic models. The bachelor thesis was for me the first time to ignore the mathematical side of economics and to focus me on the ideologies behind these models I had to study. It surprised me how the Keynesian School evolved and which theories from other economic approaches it adopted. The idea that an ideology of an economist from the 1930s would still be relevant today is fascinating. The historical part in which I described the evolution of the world economy over time was exciting, since it gave me better historical perspective. The neoclassical School and its influence on economics and politics are
remarkable. The way a generation of politicians adopted the free market ideology is in many ways fascinating. Altogether I am glad that I found a subject that combined my interest in the fields of economics, history, and politics.
Kind regards, Ridwan Shadid January 18, 2018
