Macroeconomics in the Twenty-First Century: Keynes Vis-à-Vis the Others

1. Introduction

This paper intends to provide a journey of macroeconomics from the time of Keynes in the 1930s to the present day in the twenty-first century. Before Keynes, as we all know, the discipline of economics was guided by the microeconomic principles which saw the economy as some free market-led harmonious equilibrium state with perfect competition in vogue. Any unemployment, so to say, was regarded as something voluntary. However, during the time of Great Depressions in the 1930s, these microeconomic principles could not provide the answer and solutions to the depression-induced all-around unemployment, loss of jobs and steep economic downturns, especially in the citadel of the then capitalist countries like the United States, United Kingdom, and France and like. With the publication of The General Theory in 1936, Keynes [1] posed a challenge to the existing neoclassical or classical doctrine, where the equilibrium of the economy was always held at the full-employment level. Keynesian theory showed it otherwise. With his analysis of the whole economy of his time, i.e., macroeconomy, Keynes indicated the existence of under-employment equilibrium which is the General case with full-employment equilibrium remained to him just one of the chances or accidental. That is how a capitalist free entrepreneurship market economy works, according to him. His policy prescriptions suggested intervention in the so-called invisible hand-led markets by the state or government whereby government directly had to spend money to augment employment in the economy. It is to be noted here that the Keynesian prescription for the economy was a short-run one, as in the long run, we are all dead. This is forgotten today while writing about Keynes and his policy imperatives. The point to be remembered here is that unemployment in Keynes is now involuntary, meaning people in the labour force are looking for jobs at the existing wage rates but are not finding one. Probably little has changed in this regard today since the time of Keynes.

Keynes and his policy imperatives dominated the macroeconomic theory and state policy till the early 1960s from the time of the Great Depression in the 1930s—the period which also witnessed the devastating World War II. From the 1950s, changes in the macroeconomic thinking at the level of theory began when the Monetarist school started offering new ideas regarding the operation of a free market capitalist economy—diametrically opposite to Keynes. With the breakdown of the Bretton Woods system and the beginning of the flexible exchange rate regime, the dimensions and nature of the macroeconomic problem changed thoroughly with the co-existence of massive unemployment and inflation for the first time in the history of the capitalist economy—dubbed as the situation of stagflation. So, both at the theoretical level and the policy level, Keynes was replaced by monetarist ideas. In the 1970s, the New Classical School started their journey which emphasized the microfoundations of macroeconomy [2] and where the causality of economic operation runs from supply to demand which was just opposite to the Keynesian causality running from aggregate or effective demand to aggregate supply.

The economic problems in the twenty-first century have been transformed with the emergence of the financial sector and financialization (which saw interest of finance only in every sphere of the macroeconomy) as the dominant sites or process over the real sector and the inflation and unemployment remaining the recurring problems coupled with fluctuating exchange rates as one of the major macroeconomic variables. The pertinent question today is to find some solution to these recurring problems both at the theoretical and policy levels in this twenty-first century all over the globe. Which theory suits you best today? Or is there any single theory which can provide panacea to the above-mentioned problems of the day? To understand that, one first needs to look at the historical journey of Macroeconomics from the time of Keynes which we try to offer in the first section of this paper. Next, it is important to look at the macroeconomic problems of the day and how they are different from the problems in the past. We will try to offer some ideas regarding this in the following section of the paper. Finally, we will try to offer or provide some ideas regarding the macroeconomic policy regime in the twenty-first century in the third section of this paper, in which we will deal with the issue of macroeconomic resilience in the present-day context. The concluding section will sum up the major findings of this paper. At the onset, it must be admitted we probably cannot offer a definitive picture of the capitalist economy and the policy regime, but we will throw open some “relevant” questions to the existing economic theories and concomitant policy regimes which in turn may garner some light towards the solutions to the present-day problems.

2. Historical journey of macroeconomics from the days of Keynes

Macroeconomics encounters important and complex methodological issues, which is probably not the case with microeconomics. Before the publication of The General Theory of Employment, Interest and Money (henceforth, GT) in 1936 [1], the mainstream economic theories were dominated by the neoclassical microeconomic theories which are offshoots of the classical political economy in some sense from the days of Adam Smith in 1776 followed by David Ricardo, Malthus, Mill, Walras, Jevons and like to name a few. In these theories, the ideal capitalist economy is one which Smith described as invisible hand-led free market economy with free market with its automatic harmonious operations remaining at the centre stage of these theories. A great belief was placed in Say’s Law of the market, i.e., supply creates its own demand. Hence, there was no need to analyze anything about unemployment which in the 1930s became the most significant macroeconomic problem, and as per Keynes, the classical or neoclassical theories of his time failed to understand this (involuntary) unemployment phenomenon. And this is the entry point of Keynes’s journey. First, Keynes showed theoretically that the equilibrium in the economy which classicalists before him indicated at the full-employment level, always need not be the case in general. Rather, through the (effective) demand deficiency, periodic crises are recurrent in capitalist economy, and the equilibrium is far below the full-employment level which is dubbed as under-employment equilibrium. Unemployment is not voluntary, but rather involuntary. Policy imperatives that followed from the Keynesian analysis were state intervention in the free market and an increase in government expenditure to create employment in the short run when such involuntary unemployment becomes a burning issue politically as well as economically. Let us now see the basic propositions of the Keynesian economics as follows:

1. The free market capitalist economy is subject to periodic crises which recur (as per business cycles) on a regular periodic intervals which are characterized by costly recessions leading to departures from full employment and giving rise to severe involuntary unemployment problem in general. These crises are owing to the deficiency of aggregate (effective) demand. So, here, it completely negates Say’s Law of market and runs quite contrary to the real business cycle theory in which supply constraint paves the way for economic downturn.

2. The economy can be in two different regimes—in one regime economy is demand-constrained a la Keynes, and in the other regime, the economy is supply-constrained as per Say’s Law, with supply becoming the source of causality of economic evils.

3. In Keynes, as already pointed out, unemployment is involuntary, and this is in sharp contrast with the viewpoints of the other schools, such as monetarists, new classical, and real business cycle believers.

4. As the market economy is always subject to fluctuations (sometimes wildly), this can be corrected by prudent use of mix of fiscal and monetary policy with greater emphasis being laid upon fiscal policy by Keynes. But the goal of such mix of policies—particularly fiscal policy—is to augment employment in the immediate short run to enhance aggregate (effective) demand in the economy.

5. Prices and wages may not be perfectly flexible, and thereby, changes in effective demand may have greater adverse effects on real output, employment immediately before affecting the nominal or monetary variables.

6. In the modern free market economy, business cycles are caused by lack of effective demand (unlike the real business cycle school), and there are frequent departures from full-employment equilibrium which is not at all coveted. Hence, Keynes called for the reform of the capitalist economy with state intervention in the free market, which was not supported by the other schools of macroeconomics—those that came after Keynes.

7. There is a trade-off between inflation and unemployment which is non-linear according to the Philips Curve in the short run. After all, Keynesian analysis is short-run analysis as long run, according to him, consists of sum of different short-run periods.

8. Lastly, as has been reported here already, Keynesian analysis is short-run one as Keynes envisaged the instability in the system as a short-run phenomenon, and his analysis is not applicable to the long run (especially the issues pertaining to economic growth and development in the long run). This must be admitted.

Keynes and his policy imperatives remained in vogue till the mid-1960s. After that, the nature and dimensions of the macroeconomic problems underwent several changes that probably did not fit fully into the orthodox Keynesian frame.

There was thus a change in the macroeconomic regime in the early seventies.

During 1950s and 1960s Monetarist School of Macroeconomic Thought started coming to the stage at the theoretical level (not at the policy level) when Milton Friedman revived the traditional quantity theory of money which was refuted by Keynes. The quantity theory of money is the focus of the monetarist school. Rather, it is the specific theory on which the doctrine of Monetarism stands [3]. It thus revived the quantity theory of money and offered a monetary explanation for the happenings of the Great Depression in 1930s as opposed to Keynes. The explanations were purely monetary in nature, and it is the happenings in the nominal sectors in the 1930s which included the financial system as well that triggered undesirable Great Depressions as per monetarist view. The key features of the monetary school, as led by Milton Friedman, were the following:

1. It is the change in the money stock which only explains change in money income.

2. The instability in the money using capitalist economy is owing to fluctuations in money supply (stock) as determined by the monetary authority despite the fact there may be stable demand for money. In this sense, monetarist school is supply side one quite opposite to the Keynesian demand-side arguments for the instability.

3. In the case of exogenous change in money supply by the monetary authority, the trend of the money income may also change which may not be the case when money supply is endogenous.

4. The attempt to control the economy in the desired path of the policymakers may be destabilizing owing to the lag between change in money stock and change in money income which is generally quite long.

5. The long-run price stability will hinge upon the fact whether the money supply has been permitted to grow at a fixed rate that is concomitant with the output growth. This is clearly derivable from the propositions of the quantity theory of money which Friedman revived.

In 1970 Friedman published his seminal work “Theoretical Framework for Monetary Analysis” [3], where the theoretical framework employed is a generalized IS-LM model which was an endeavor to accommodate monetarist arguments, i.e., to view every economic phenomenon in nominal terms and conditions, in mainstream position which was by then dominated by the Keynesians. So, we moved from demand-side approach to supply-side approach with the advent of the Monetarist School. This, to our understanding, had affected the macroeconomic policy regime in the West; as we have mentioned already, by the early seventies, there was a regime change which significantly differed from the regime from the 1930s to 1960s in which Keynesian prescription fitted most well.

However, the advent of the rational expectations school [4] and new classical economics did away with both the Keynesian and Monetarist dominance in the mainstream macroeconomic theoretical plane. In the early 1970s a change in the belief system came which held that a free market economy using money can achieve much coveted harmonious stability if the state or the government remains invisible (no government intervention), and with it came two major changes in the belief system as far as mainstream macroeconomic theories are concerned:

1. Restoration of classical model of equilibrium analysis which paved the way for showing what is termed as policy irrelevance in the presence of rational expectations made by individual economic agents.

2. Lucas critique which indicates micro foundation of macroeconomics and macro variables which completely negated the Keynesian proposition regarding what was “macro”.

The salient features of the new classical school are the following:

1. Macroeconomic theorizing based on neoclassical choice theoretic microfoundations in terms of Walrasian general equilibrium framework.

2. Postulate that all economic agents are rational (homo-economicus), implying that each agent in the economy is continuously optimizing.

3. There is no money illusion and hence, only real variables matter for optimizing decision-making.

4. Perfect wage-price flexibility automatically ensures the clearance of each market, and markets are always in equilibrium state through the optimizing behavior of the economic agents, who are all rational.

Therefore, the historical journey of macroeconomic theories from the days of Keynes in the 1930s to the end of the twentieth century earmarked a 180-degree departure from the sided approach of Keynes to a supply-sided approach based on neoclassical tools as opposed to Keynes. The policy regimes also underwent changes commensurate with the changes in the macroeconomic theories for a 70-year period starting in the 1930s. Now, it is time to ponder the macroeconomic problems and changes therein in this 70-year period, which we will discuss in the next section.

3. Changes in the macroeconomic problems in the twentieth century since 1930s

Keynes was induced to write his GT under some specific macroeconomic problems which came into being owing to the upsurge of the Great Depression in the 1930s. It was not inflation but rather severe involuntary unemployment that caused the uncoveted Great Depression to happen. So, the GT analyzed the particular macro problem and came up with a solution that was quite the opposite of the mainstream economic arguments. Keynesian policy prescriptions remained predominant till the mid-1960s, and most of the governments of that time, following Keynesian prescription, adopted fiscal deficit-inducing fiscal policies to prevent unemployment and to constitute what is known as a welfare state. Many Keynesians of that time termed the period as the Golden Age of Capitalism in the United States and Western Europe.

But from the mid-1960s, the situation turned out to be becoming different, with burgeoning fiscal deficits resulting due to Keynesian policy prescriptions and gradually, along with unemployment, inflation turned out to be a major economic problem at the centre stage of the macro level. The governments after governments of that time started leaving the Keynesian policy packages and started viewing inflation as a monetary phenomenon, thereby following a restrictive monetary policy. So, the emphasis shifted from fiscal to monetary. This was also the time that monetarism was becoming the major macro theory opposing the Keynesian one.

With the breakdown of the Bretton Woods system in 1973 and with the simultaneous emergence of massive inflation and unemployment (dubbed as stagflation), neither Keynesian nor the Monetarist thinkers of the time could provide any palatable solution to the impending problems of the day. Another variable at the macro level became significant at this time with the coming of a flexible exchange rate regime which is the exchange rate, and policymakers tried to find ways to stabilize exchange rate fluctuations. So, the imperative was to augment employment and real output growth and stabilizing prices and exchange rates. No single theory could provide a justified solution to these three objectives of macroeconomic policies of the time.

In the decade of 1980s, the world witnessed a gradual shift from a government-based interventionist kind of policy regime to an intervention policy regime as by then, the new classical school and also the rational expectations hypothesis surmised what is known in the economic literature as policy irrelevance. Thus came the age of neoliberalism – the basic tenet of which is minimal governance and free market as the economic agents in their optimizing decisions are rational and, hence, homo-economicus and thus do not require government intervention. The slogan was minimum governance is the better governance. The end of the twentieth century was thus beset with a neoliberal policy agenda whose main features were the following:

1. State to be replaced by the private.

2. Private investment to replace public investment.

3. Opening up the economy to foreign capital and investment.

4. Markets to be liberalized from all sorts of state interventions.

It was a belief that neoliberal economic order which is much based on the premises of new classical and rational expectations school of thought, would make all the markets free, and there would be a level playing field for all the economic agents as the markets sans any outside intervention are bound to become perfectly competitive where all economic agents would be at the Pareto optimal states. This is how the twentieth century ended, but the facts remained that periodic crises, as are supposed to occur in a capitalist economy, did occur, like the Third World Debt Crisis in the Eighties and the Asian Crisis at the end of the Nineties. However, the collapse of the Soviet Union and the East European Block in the early nineties and their beginning journey following the path of neoliberalism gave a further boost to the then-existing macroeconomic belief system of no government intervention and minimal governance as propagated by the neoliberal thinkers (who were mainly belonging to the new classical and rational expectations school of thought).

4. Macroeconomic policy regime in the twenty-first century: in the search for a new order

The most significant lesson that we learnt from our study of the historical journey of macroeconomic theories in the twentieth century and the macro problems that emerged from time to time in the twentieth century is the fact that quite a number of alternative macro regimes were attempted at various points of time. But no single theory became superior for all times and spaces. Actually, different regimes are suited to different macro circumstances and problems. We have to keep in mind that the appropriateness or suitability of a particular macro regime also crucially depends upon the political and social institutions of a particular space at a particular time. Time does change, and so do macro problems and the surrounding socio-political environment.

The beginning decade of the twenty-first century was marked by the recurrent occurrence of crises at the global level—the most notable among them is the crisis that engulfed the entire world in 2007–2008 with the beginning of a devastating financial crisis in the United States which later spread all over the globe.

There may be inter-dependence of the macro regime with the socio-political ambience of the time. Also, it is possible to have total independence from the macro regime in that ambience. A macro regime may lead to a supportive ambience and thus may fructify in terms of its ultimate objectives, which are price stability, employment augmentation, and exchange rate stability. However, a macro regime does not always lead to a supportive ambience, and then it fails to deliver. The other way round is also possible. Today, it is known in terms of the impossible trinity that a single policy regime cannot fulfill all three objectives: price and exchange rate stability and employment generation. One can attain two at the most, but not three.

Also, this century may best be described as the Age of Finance, where finance and, hence, nominal parameters of the economy dominate over the real output growth and employment generation. Financial growth need not necessarily be accompanied by real output growth as the facts of the time dictate all over the world [5]. Should we then regulate finance to benefit the real?—An idea which is quite contrary to the belief system of neoliberal synthesis. Then, what is to be done? That remains today the biggest challenge. In mainstream macroeconomic theories, we find two extreme poles today as Keynes vis-à-vis Others. At one extreme are the belief system and the concomitant neoclassical economics-induced policy prescriptions of no intervention (as is propounded by the makers of neo-liberalization) when the macro environment is at its normal with the economy remaining in the upswing mode. On the other extreme lies the Keynesian policy imperatives in the immediate short run when the economic crisis upsurges with the economy (particularly the real sector) remaining in the downswing mode.

So, the new macro order that is to be followed is not very easy to find. Regimes rotate from one extreme to another extreme as the economic business cycles rotate.

5. Conclusion

Summing up our main arguments in this paper, it can be asserted that different macro regimes as well as different macro schools of thought, have emerged from time to time as the macro ambience of the time and space underwent transformation. No single theory is applicable or suitable for all types of macro regimes and problems.

The macro problems of the twenty-first century are much more complex than those in the twentieth century, as now one has to keep a close eye on the following at the same time:

1. Price stability

2. Exchange Rate Stability

3. Employment generation

4. Real output growth

5. Containing speculative finance

The question thus remains, as has already been hinted by the impossible trinity, whether Keynes, Monetarist, or New Classicalists alone can answer this. Probably not. So, no macroeconomic theory is regime-independent or path-independent. In the short run as well as the long run, the ideal has to be found in prioritizing the macro problems listed above in this conclusion, and today, no policy would be perhaps fruitful without addressing the issues of finance (the classical role of which is to intermediate between ultimate lenders and ultimate borrowers in the system which is blurred with the advent of financialization as a major process in every single money using free market economy). Between Keynes and New Classical, the optimum has to be determined in terms of the socio-political institutions and environment of a particular space at a particular time as nothing is permanent in this world; everything—a process or a regime—is dynamic, i.e., is subject to continuous change.

The most pertinent question at the present moment is the real stagnation with financial growth at a very high level. Financialization as a process has engulfed almost all the money using free market economies of the world [6]. Thus, it is quite obvious that with continuing stagnation as well as recurrent instability—especially in the North, a convincing analysis is needed of the hour. The macroeconomic regime had undergone an extreme transformation from what it was either in 1930s or 1970s or even 1990s. In Keynes, there is probably no answer to all the problems of the present time from a long-run perspective—particularly the differing financial growth and real output growth. While financial growth continues to be unabated with the introduction of new instruments like derivatives almost frequently, real sector stagnation in terms of output and employment growth also continues. Can we therefore offer a new theory to address all these questions of the day? That is a challenge for macroeconomic theorists and present-day policymakers. When Keynes wrote GT, the money supply was a policy variable; thus, the LM curve discovered later was constructed, taking the money supply as exogenous. Today, as inflation has become a major policy challenge, the monetary policy targets the nominal interest rate, not the money supply. So, it is the rate of interest that is the policy variable today, not the money supply, and thus, the traditional notion of the LM curve is at stake [7]. This is just one example in today’s context, which lays great stress on the urge for macroeconomic theory and policy change to suit the current macro regime.