Equilibrium, Expectations and Information

A Study of the General Theory and Modern Classical Economics

Christopher Torr

• Publisher: Taylor & Francis
• Year: 2019
• Print ISBN: 9780367007041
• eBook ISBN: 9780429718526
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

This book attempts to elucidate the views of Keynes's General Theory as far as equilibrium, expectations and information are concerned, and compares them with those of modern classical economists of the Chicago and Ricardian persuasion.

1
Equilibrium in the General Theory

A parable of planets I

A watchmaker once flew into Venus to repair a clock. While inspecting the gears he came across a spanner in the works which he duly removed. To the delight of the local inhabitants the clock started ticking again. He then flew off to Pluto accompanied by an apprentice anxious to learn the trade.

On Pluto the watchmaker did not appear particularly interested in inspecting the clocks. In fact he spent most of his time making sure that nobody else was tinkering with them. The apprentice kept himself occupied by looking for hidden spanners but after a few days began to tire of the exercise, and he wondered if he had chosen the right trade. He mentioned his misgivings to the watchmaker who told him that in the rarefied atmosphere on Pluto the clocks always functioned perfectly. On hearing this the apprentice retired to his hotel room and spent the next few days staring at the ceiling.

Their next port of call was Mars. Upon their arrival, the watchmaker announced that he was going to take a quick walk before getting down to business. He advised the apprentice to become acquainted with Martian clocks in the meantime. After a stroll alongside the canals, the watchmaker returned to find an agitated apprentice with his head and a spanner in his hands. The apprentice could not understand why the clock refused to tick even though he had removed the spanner. The watchmaker reminded him that they were on Mars, not Venus, and replaced the spanner. He pointed out that on Mars clocks ran on batteries and that the battery (containing animal spirits) was dead. When the battery was recharged the clock started ticking.

Moral: A spanner in the works may not be a spanner in the works. What on Earth you see depends in theory upon your telescope.

The opening chapter of the General Theory contains Keynes’s claim that his approach constitutes a general theory which subsumes (what he refers to as) classical theory as a special case. In the past 50 years much time has been spent in investigating Keynes’s claim. The conclusions drawn depend largely on the theoretical framework chosen for the demonstration.

In a neoclassical environment the equilibrium position is determined by supply and demand forces. Since the self-adjusting properties of an economic system are conventionally viewed in the light of events on the labour market, the system is regarded as self-adjusting, because supply and demand forces operate in the labour market, just as in any other market. A situation of less than full employment may nevertheless be explained by drawing attention to the presence of some or other spanner in the works of a supply and demand mechanism. In the absence of such a spanner, the system moves to a state of rest which is one of full employment. One might wish to argue, therefore, that Keynes’s General Theory is a special case of the neoclassical synthesis.

Within the framework of the General Theory, the equilibrium position is determined by the principle of effective demand. The equilibrium position is not necessarily one of full employment although it may be. The system is therefore not regarded as self-adjusting, since events in the labour market do not ensure a movement towards full employment. One can accordingly argue that Keynes’s claim to generality is substantiated.

The above two paragraphs illustrate a distinction between neoclassical theory and the General Theory. Supply and demand theory is being distinguished from the principle of effective demand. But what kind of environment is required for a supply and demand framework to be appropriate? And on what parade ground must the principle of effective demand be put through its paces?

For a supply and demand framework to be appropriate, suppliers and demanders must be on an equal footing as far as the possibility of bringing about change is concerned. A neoclassical system is inhabited by entrepreneurs and workers. Both entrepreneurs and workers must therefore be in a position to change matters which do not suit them. In a supply and demand environment the equilibrium level of employment is one in which the expectations of the entrepreneurs and the workers are realized. Some spanners in the works such as rigid wages may prevent such a mutually acceptable position from being reached. In the absence of a spanner in the works, involuntary unemployment is a theoretical impossibility.

The imposition of rational expectations upon a neoclassical framework may be viewed as the logical extension of the neoclassical argument. In such a rational expectations environment the agents in the model are required to know that the world revolves on supply and demand wheels, or behave as if they do.

The General Theory is also inhabited by entrepreneurs and workers. But here employment decisions appear to be in the hands of the entrepreneurs. In the General Theory the equilibrium level of employment is one in which the expectations of the entrepreneurs are realized. Workers are unemployed unless it suits entrepreneurs to hire them. Involuntary unemployment is therefore a theoretical possibility.

Entrepreneurs and workers appear in the General Theory and in the neoclassical approach. A distinguishing feature of Keynes’s approach is that employment decisions are not in the hands of the workers, whereas entrepreneurs as well as workers determine the level of employment in the neoclassical framework. (Whether one can safely say that employment decisions are in the hands of entrepreneurs in an entrepreneur economy is something that will be considered in chapter 2.) This distinction, while necessary, is not sufficient. While the framework depicts the environment in which the action is to take place, it does not constitute an explanation for the level of employment beyond saying that it is what it is because the decisions of the entrepreneurs (or the entrepreneurs as well as the workers) make it so. In the General Theory, for example, the employment decisions are allegedly in the hands of the entrepreneurs, but this says nothing about the forces bringing the system to a state of rest. And while in the neoclassical approach employers and employees together determine the level of employment, such environmental economics provides no explanation for the state of rest. A theory is necessary for this purpose.

We are distinguishing, therefore, between two levels of discourse. On the one hand there is the playground on which the theoretical action is to take place. On the other hand there is the theory itself. The playground itself provides no explanation for the level of employment. That is for the theory to explain. However, the choice of playground will to a large extent dictate the type of theory to be used. For example, one would not necessarily want a theory explaining feudal behaviour to be put through its paces in an environment in which production is arranged on factory lines. (Perhaps one would like to do so in Japan.) The theory reflects (or should reflect) the type of economic environment the economist has in mind.

If this is obvious, then the reason the neoclassical synthesis has displayed the General Theory in a supply and demand framework must be that the world is presumed to run on supply and demand wheels. There is, however, nothing in the General Theory to suggest that supply and demand forces in the labour market bring the system to a state of rest.

In the neoclassical approach, the system moves automatically to a state of rest dictated by the principle of supply and demand, unless there is a spanner in the works. In Keynes’s approach, the system moves automatically to a state of rest determined by the principle of effective demand.

Self-adjusting or self-regulating tendencies should be distinguished from automatic tendencies (Eatwell and Milgate, 1983a). Automatic tendencies are associated with those forces bringing the system to the state of rest. Self-adjusting tendencies, on the other hand, are traditionally associated with those forces which move the system to a position of full employment. Thus to argue that an economic system is self-adjusting is to argue that it moves of its own accord to a state of full employment. The converse is not necessarily true, because an economy may move to a situation of full employment and yet not be self-adjusting. The economy is led as if by an invisible hand to the state of rest. This does not mean that this hand points down the road towards full employment.

Thus if we regard those forces which propel a system to a state of rest as automatic forces, automatic forces need not be self-adjusting forces. In the supply and demand view of the labour market, the automatic forces are the self-adjusting forces. A spanner in the works is then something that prevents the automatic (self-adjusting) forces from operating. In the General Theory automatic forces move the system to a state of rest which need not be at full employment. In this view the system is not self-adjusting.

The framework chosen for analysis reflects the economist’s views on the self-adjusting tendencies of the economic system. Leijonhufvud (1981, p. 104) has argued that the central issue in macroeconomic theory is the question of whether the economic system can be regarded as self-regulating or not, and it is instructive to examine Keynes’s views on the matter.

[W]e fall into two main groups. … On the one side are those who believe that the existing economic system is, in the long run, a self-adjusting system, though with creaks and groans and jerks, and interrupted by time lags, outside interference and mistakes. … On the other side of the gulf are those [heretics] who reject the idea that the existing economic system is, in any significant sense, self-adjusting. …Now I range myself with the heretics. … The system is not self-adjusting, and, without purposive direction, it is incapable of translating our actual poverty into our potential plenty. (CW, vol. 13, pp. 486–7, 489, 491)

As noted, the self-adjusting tendencies of an economic system are judged in the light of events on the labour front. The employment of a supply-demand framework in the labour market presupposes that the system is self-adjusting – albeit with creaks and groans – since the automatic forces are the self-adjusting forces. Of course, to employ a supply-demand framework is not tantamount to saying that unemployment cannot exist. If, however, the world revolves on supply and demand wheels, persistent unemployment must be attributed to something that prevents the wheels from spinning smoothly.

Those interpreters of the General Theory who insist that involuntary unemployment does not require a spanner-in-the-works argument have a different framework in mind. They deny the existence of self-adjusting forces, but do not deny the presence of automatic forces.

Modern classical economists who employ rational expectations have taken the argument a step further. Uncomfortable with reasoning which cannot be reduced to maximizing behaviour, Lucas and his followers speak of a system in which markets are always in equilibrium. In the rational expectations vernacular this amounts to saying that supply is always equal to demand. Those who do not agree that equilibrium is necessarily a situation in which supply is equal to demand would no doubt object – this simply illustrates that the framework is of critical importance. If supply is always equal to demand, there is no spanner in the spinning works.

As we shall subsequently see, the market participants on the rational expectations planet can be regarded as self-employed artisans. The absence of involuntary unemployment is therefore scarcely surprising. Fifty years ago Robinson remarked that:

An economy consisting of self-supporting families each working their own land must always enjoy full employment, since each individual is free to work as long as he considers the real reward he obtains a sufficient inducement for his efforts. (Robinson, 1936, p. 225)

In the new classical environment inhabited by self-employed artisans, all unemployment is voluntary. This line of reasoning will be discussed in chapter 4.

Within the pro-Keynesian-anti-neoclassical camp there are differences of opinion as to whether Keynes’s approach should be seen in the light of the long or the short period (Milgate, 1983). Those who accept Keynes’s principle of effective demand do not necessarily accept Keynes’s views on the dark forces of ignorance and time. We have in mind here the modern Ricardian view which will be discussed in chapter 5.

Although the General Theory constitutes a denial that supply and demand forces in the labour market determine the state of rest for an economy, Keynes’s approach is hardly devoid of supply and demand apparatus – witness for example his analysis of the money market, or his approach to international currency and commodity markets. Moreover, to argue that supply and demand forces do not bring about a state of rest in the labour market does not necessarily mean that such forces are nonexistent – they may simply be overshadowed by other automatic forces. For example, while Keynes notes that wages do play an allocative role (GT, p. 270), the level of real wages is determined by other forces (GT, p. 13).

Important as it might be for other purposes, we are going to sidestep the issue of whether a particular theory constitutes a general approach or not, largely because the issue depends on whether a neoclassical, modern classical or Keynesian environment is chosen for the demonstration. If the General Theory is displayed on a neoclassical playground, it is hard to escape the conclusion that Keynes’s approach amounts to a special case. If equilibrium is regarded as a state of rest dictated by the principle of effective demand, the neoclassical synthesis can be regarded as a special case.

Instead of trying to establish whether a particular theory constitutes a general or a special case, different theories will be compared by employing a definition of equilibrium in which neither supply-demand equality nor the principle of effective demand constitutes the defining characteristic of equilibrium. The definition of equilibrium will also help to identify the type of economic society in question.

We do not wish to pursue the matter of whether a theory constitutes a special case or a general case for another reason. As time goes by, a society which consists largely of self-employed peasants may change into one in which the factory system plays a dominant role. The process may take several hundred years. A theory of peasant behaviour may not be applicable to an industrial society and vice versa. Much time can be spent in trying to decide whether the peasant theory or the industrial theory is the general case. We prefer to divert attention to the question of whether we are living in a peasant economy or an industrial economy. Some intimate, however, that the peasant/industrial distinction makes no difference (Lucas, 1977, p. 17).

In what follows, equilibrium will be regarded as a state of rest. (See Chick, 1983, p. 21; Davidson, 1967; and compare with Chipman, 1971, p. 342.) The state of rest may or may not be brought about by supply and demand forces. It may or may not be brought about by the principle of effective demand. The neoclassical synthesis is an example of a system in which the principle of effective demand is overshadowed by supply and demand forces in the labour market. The General Theory is an example of a system in which supply and demand forces in the labour market are overshadowed by the principle of effective demand.

To regard equilibrium as a state of rest is to leave open the question of whether the equilibrium position is one of full employment or not, i.e., whether the equilibrating forces are self-adjusting or not. In the minds of many economists, of course, equilibrium is considered to be synonymous with full employment. For example, Hayek (1935, p. 34) notes that in economics, ‘… we have no means available but to build on the foundations given by the concept of a tendency towards equilibrium.’ On the next page he adds that ‘… the only situation which satisfies this criterion is the situation in which all available resources are employed.’ If the central issue in economic theory is whether an economic system is self-adjusting or not, we should not employ a definition of equilibrium which prejudges the issue. If equilibrium is associated with full employment, the presence of persistent unemployment will require a spanner-in-the-works explanation.

The reader may be led to believe that the term spanner in the works is being used in a derogatory sense. This is not our intention. Rather, our aim is to identify spanner-in-the-works arguments. We have given a rather intuitive account of what such an argument entails – it is now time to be more formal. In developing a theory, an economist will identify certain automatic (i.e., equilibrating) forces. These are the forces that bring the system to...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Contents
• Preface
• Introduction
• 1 Equilibrium in the General Theory
• 2 Expectations in the General Theory
• 3 Information in the General Theory
• 4 Information, Equilibrium and Rational Expectations
• 5 Equilibrium and Expectations in Modern Ricardian Economics
• Conclusion
• Bibliography
• Index