Post-Keynesian Macroeconomic methodology

Cambridge, 26. January 2010

Jesper Jespersen

Roskilde UniversityE-mail: Jesperj@ruc.dk

1. Post-Keynesian methodology: a Critical Realist perspective

2. Post-Keynesian macroeconomic theory: making ‘uncertainty’ epistemological relevant:

a. the Principle of Effective Demand

b. liquidity preference theory

What is Post-Keynesian (macro)economics?

• A broad ranging approach on how to understand the dynamics of the real-world economy - considered as a whole:

1. Methodology – the (re)search for a relevant method to establish

2. Real-world related Theories and Models +

3. Empirical Tests of our Findings +

4. Reasonable judgements

(with inspiration from Keynes and many others)

Inspiration from Keynes’s view on real-world economics:

[Real-world]……’[E]conomics is essentially a moral

science and not a natural science... [I]t deals with introspection and values... and with

• Motives (incentives), • expectations, • psychological uncertainties.’ Microeconomic foundation

Keynes’s Methodology:• Economics is a science of thinking in terms of

models joined to the art of choosing models which are relevant to the contemporary world.

• It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time (CWK, XIV: 296)

• It seems to me … that you [Roy Harrod, jj] do not repel sufficiently firmly attempts ... to turn [economics] into a pseudo-Natural-science.....’

Two fundamentally different methods in macroeconomics:

• On the one side are those who believe that the existing economic system is, in the long run, a self-adjusting system, (CWK, XIII: 486)

• On the other side of the gulf are those that reject the idea that the existing economic system is, in any significant sense, self-adjusting (Ibid.: 487)

• The gulf between these two schools of thought is deeper, I believe, than most of those on either side of it are aware of.

• On which side does the essential truth lie? That is the vital question for us to solve. (Ibid.: 488)

Said by Keynes in 1934

Method has implication for theory!

• The strength of the self-adjusting school depends on it having behind it almost the whole body of organised economic thinking of the last hundred years (CWK, XIII: 488)

• There is, I am convinced, a fatal flaw in that part of orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment (Ibid.: 488)

Methodology (continued):• I shall argue that the postulates of classical

theory are only applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium.

• Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the fact of experience. (Keynes, 1936: 3, my highlighting).

Hence, Post-Keynesian economics have to deal with methodology:

• How to model the consequences of uncertainty?

• Does macroeconomics need a specific microeconomic foundation?

• How to avoid the fallacy of composition? (the outcome is different from the sum of the parts) – the economy as a whole

• Trend and cycles cannot be separated in an open and path-dependent system

• Context matters

Methodology is a major dividing line when these questions are answered

• Post-Keynesian economics is when uncertainty and money are taken seriously

• It penetrates economic decision making and behaviour at all levels – micro/macro and short or long run.

• Hence, uncertainty and money are inescapable phenomena in macroeconomics

• We know this from e.g.Liquidity preference theoryThe theory of effective demand

The post-Keynesian economists have to be conscious about

methodology!

Methodological requires thinking about:1. Ontology - object2. Epistemology - method3. Outcome - results

Three worlds of Popper

• World 1 – Reality: ontology

• World 2 – the analytical level, where method matters: epistemology

• World 3 – the strategic level, where analytical results are used for politics: judgements

Figure 2.1: Critical Realism methodology (Retroduction)

The real level:(Reality)

Ontology TendenciesHistory

The cognitive veil

Map

pin

g

Tests

The analytical level: Results Theory/ModelLandscape

WORLD 3The operational level: recommendations

WORLD 2

WORLD 1

Figure 2.2: Stratified reality grounded in Critical Realism

Empirical stratumData – Imprecise measurements

Factual stratumEvents and tendencies

The deep stratumCausal mechanisms, power structures and institutional relations

Reality divided into three strata

Figure 3.1: Macroeconomics is a sub-disciplin of social sciences

Frame of nature

Society as a whole

Macroeconomics Law Sociology Political science

clock-work

Market System

Power, structures, culture

agents actors

data

Jesper’s methodological ’iceberg’

reflexive organism

Predicting the marketsystem

Understand reality

Inspiration: Martin Hollis

World 1

World 2

World 3:

Post-Keynesian methodology – Critical Realism/retroduction

General equilibrium methodology – Hypothetical deduction

Reality(World 1)

Analysis (World 2)

Policy-recommendations (World 3)

Axioms(World 2)

Analysis (World 2)

Results = policy-recommendations (World 2)

Figure 2.3: Two different methodologies

Why Critical Realism(I)?

• There is an emerging consensus that the Post Keynesian approach is consistent with much of critical realism, with open-system theorizing applied to an economy understood as an organic, open system. Different forms of abstraction are relevant to different questions, and different economies; and indeed the study of actual economies required before abstraction can occur involves the application of different disciplines (Dow, 1996:79).

Why Critical Realism(II)?

• Finally, since Post Keynesian theory starts with observation, the position on empirical matters must be discussed. First, rejecting the subjective/objective dual…. 'Facts' can be observed with some degree of objectivity… Since the group of theories includes formal models which are susceptible to empirical application, Post Keynesians do not reject econometrics (ibid.: 80)

Why Critical Realisme (III)?

1. Understanding Reality2. Unescapable uncertainty, the future is

unknowable3. Individuels are context dependent and

interrelated because of uncertainty4. Hidden structures and powers matter5. Actual performance is path-dependent6. Hence, open system analysis without a

predetermined outcome is needed.

Open System Ceteris Paribus-Method

• The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems;

• and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then go back on ourselves and allow, as well as we can, for the probable interactions of the factors among themselves. This is the nature of economic thinking (Keynes, 1936: 297).

Post-Keynesian economics is a social science :

As Keynes remarked:

…’[E]conomics is essentially a moral science and not a natural science... [I]t deals with introspection and values... and with

• Motives (incentives),

• expectations,

• psychological uncertainties.’

• Keynes’s perception was that economies did not behave in the way economists said they did, that something vital had been left out of their accounts, and it was this missing element which explained their malfunctioning;

• Keynes accused economists of his day of abstracting from the existence of uncertainty – human beings take decisions in ignorance of the future. (Skidelsky, 1992: 538-9)

Macroeconomic implications of taking uncertainty seriously

• Here uncertainty makes a crucial difference, because any microeconomic decision or activity is characterized by lack of knowledge, but you have to act – so what do you do?

Look at Figure 1 – The structure of uncertainty

Figure 1: The anatomy of uncertain individual knowledge

Future

Consequence

Expectations

Actions

(un) known (un) likely

(un) known (un) likely

Uncertain knowledge

• Uncertainty makes macro-behaviour different from (n * individual micro), because:

• Households and firms don’t behave independently

• They follow conventions

• Or they act intuitively on new information (animal spirit)

• Or they learn from past experiences

Hence, there is no such thing as an atomistic market (theory)

I will now concentrate on Macroeconomic: Effective Demand

& Liquidity Preference

• There is, I am convinced, a fatal flaw in that part of orthodox reasoning which deals with the theory of what determines the level of effective demand and the volume of aggregate employment

Where has ‘macro-demand’ gone?

because ‘You will not find it [effective demand] mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment’. (Keynes, 1936: 32).

This really is a puzzle, because neoclassical micro theory is, if anything, about supply and demand,

Until you realize, that at the macro level there was no room for macro-demand, when uncertainty is squeezed out of the analysis.

Effective DemandMacrobehaviour of business

sector

D-curve: Expected proceeds from aggregate (macro)demand

Z-curve: Expected Aggregate costs (incl. Profit): imperfect competition, mark-up:

Aggregate credit facilities: the working of the banking system

Expected availability of supply factors: labour, capital, technology environmental conditions

Figure 2: Uncertainty explains the complexity of ’effective demand’

Instead we are looking for:

An open, integrated market system ruled by aggregate - macroeconomic behaviour:

Liquidity preference:

There is, however, a necessary condition failing which the existence of a liquidity preference for money as a means of holding Wealth could not exist.

This necessary condition is the existence of uncertainty as to the future of the rate of interest (Keynes,1936: 168)

So, what to do in practice?

• We make a macroeconomic landscape

• We have to make semi-closures, provisional stability (fixed expectations)

• Using the Open System Ceteris Paribus method developed by Mark Setterfield

Figure 3.2: The macroeconomic landscape

Exports

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Real in

vestm

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Gro

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Goods and services

Con

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Inco

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nsfe

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Market for goods and services(GDP)

Households

Firms

Central Bank

Tax

Financial savings

Housing- market

Foreign sector:Balance of payments:Current accountCapital accountExchange rates

Inte

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in cu

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Mortgages

Labour market:Employment---------------------------------Unemployment

Imports

Loan

Financial markets:Money, bonds and shares

Wag

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Public sector