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Macrofoundations of Microeconomics

By James H. Nolt

During my lifetime I witnessed the largely successful counterattack against John Maynard Keynes within neoclassical (standard textbook) economic theory. This neoclassical intellectual current has been one of the most influential ideologies of our era. Modern conservatism and its faith in free markets is largely beholden to it. In fact, contemporary liberalism’s analysis of the proper role and limits of government is also strongly shaped by the same intellectual agenda. Increasingly, even decisions made by courts of law reference this intellectual foundation.

Discerning the “microfoundations of macroeconomics” has been a prominent slogan of the counterattack against Keynes. In this blog, I wish to argue for the opposite. Before Keynes the separate fields of micro- and macroeconomics did not really exist. That is, neoclassical economics was so focused on equilibrium of supply and demand in individual markets that macro problems that did not fit this micro equilibrium framework were impossible to conceive.

Keynes subverted the standard equilibrium framework by illustrating conditions under which disequilibria could endure, as was most obviously the case during the Great Depression of the 1930s. The Great Depression meant that there were tens of millions of people eager, indeed desperate, to work, and yet thousands of factories locked their doors and shut down. Idle workers and idle capital are never supposed to exist according to equilibrium economics. There should be some equilibrium wage at which the workers could be hired to produce useful and desired goods. Free markets should be brilliant at discovering equilibrium wages and prices, the textbooks said. Instead, millions starved, drifted, and shivered in the winter cold.

While multitudes of workers in capital-rich countries became jobless and went hungry, the Soviet Union of the 1930s was booming under a planned socialist system that for a time seemed better able to keep workers employed and factories humming along. Consequently, communist and socialist criticisms of the gross failures of capitalism looked increasingly plausible to millions worldwide.

Keynes, himself a rather successful investor and stock speculator, proposed not to abolish capitalism, but to save it from its own excesses by active governmental macroeconomic management. His idea was that aggregate demand and supply were not necessarily in equilibrium because of time. In other words, capitalists make decisions at one point in time to purchase capital goods and hire workers with the expectation that when all this labor and capital is set to work, it will produce output in the future that is salable at prices that satisfy the capitalist’s expectation of profit.

But the future is never perfectly knowable, so capitalists may make mistakes. They may bullishly overinvest in one period (say, the Roaring Twenties) and then find themselves unable to sell the resulting output at prices that cover their costs and debts incurred to purchase the means of production, while simultaneously reaping a “reasonable” profit.

If actual sales results are more disappointing than capitalists’ original expectations, they have two options: cut prices or cut output. Neoclassical economists argue for “Walrasian equilibrium” (after Leon Walras), which requires cutting price rather than output in the face of excess demand. Keynes knew that capitalists in reality may choose the second option and cut output instead, perhaps even ceasing production entirely. This is “Marshallian” dynamic theory, named for Keynes’ famous teacher Alfred Marshall. Neoclassical economists assume one or the other not according to empirical evidence, but according to the convenience of a particular model.

Walrasian dynamics promise a stable equilibrium result. But the sad reality often involves a vicious cycle resulting from the output cuts predicted by Marshallian theory: As each individual capitalist cuts output in the face of falling sales, more and more workers are laid off, so aggregate demand falls further as ever more become jobless. It is often said that they “lose their jobs.” I have always found this language too euphemistic and tame. They do not “lose” their job, the way you might lose your keys or cell phone. The factory or place of their former employment still exists. It is not lost. Rather, jobs are terminated by capitalists that have ownership rights and can decide whether to produce, not according to social need but their own strategic interests. Capitalists have the Marshallian choice; they are not bound by the Walrasian textbook prescription.

I witnessed a tragic situation like this in the Philippines during the 1980s. During that time, the price of sugar in world markets was rather low. Vast areas that used to produce sugar cane were overgrown with weeds because the landlords were bearish on sugar. They believed the price they would get producing sugar would not cover their costs adequately, so they preferred to keep the land idle until world market demand picked up again and they could sell at an acceptable profit.

Meanwhile, the children of former sugar workers were starving. I saw firsthand their listless eyes and swollen bellies. The sugar workers’ union made a reasonable and humanitarian demand to the landlords: Let the workers plant rice on the idle land until the sugar price rebounds. Indeed, textbook economics would expect rational landlords to accede to this demand because idle productive resources produce no profit, whereas finding something else profitable to produce would make economic sense.

The landlords, however, were acting strategically, contrary to the non-strategic logic of textbooks. If allowed to plant food crops, the workers might become successful enough to feed themselves better than they could with the paltry wages they received to cut cane. When the price of sugar eventually recovered, the landlords might have found their former workers unwilling to revert to their old lives as property-less cane cutters. The landlords made a strategic decision to starve them instead, relying on the local militia, the Philippine Constabulary, to repress the resulting protests. Textbook economics does not let you imagine this.

Involuntary unemployment is the result of a strategic decision by capitalists who are at that moment bearish on the prospects of producing. They might choose to cut wages and prices instead, as textbooks insist they would, but their strategic sense, their desire to persevere as capitalist owners, may argue instead for withdrawing their capital from the marketplace until such time as they may deem it profitable to employ it (and the workers) again. This is known as a “capital strike.”

Connecting this with last week’s blog: this is a case where capitalists become bullish on cash and bearish on almost everything else, so they prefer to hold their capital idle until prices move in their favor. Keynes called this “liquidity preference,” but he did not explain it very well strategically. This happens often enough in history so that you might think textbooks would have a way to account for it. They do not. They ignore it instead, because they tend to ignore nearly every exercise of private power.

The counterattack against Keynes ignores the strategic uses of liquidity in the contest between bears and bulls, and instead reduces it to yet another equilibrium market (the “market” for cash) in an effort to reduce macroeconomics to the same static equilibrium methods employed in microeconomics. Nearly all the important insights of Keynes have thus been obliterated ever since the Nobel Prize-winning economists John Hicks and Paul Samuelson “tamed” Keynes in this way. “Post-Keynesians,” like British economist Joan Robinson, tried to develop the disequilibrium elements of Keynes, but have been largely ignored within the overwhelming mainstream consensus for equilibrium theory. Modern establishment “Keynesians” mostly accept the effort to transform macroeconomics into an application of microeconomics. More on this next week.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of James Gagen]

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