The Post-Keynesian Critique of the Mainstream Theory of the State and the PostKeynesian Approaches to Economic Policy
Richard P.F. Holt
Southern Oregon University
Introduction
One very important area where Post-Keynesian economics differs from neoclassical
economics is in public policy. Neoclassical economists believe in the efficacy of markets
in most situations. As a result, they tend to oppose government interference in market
economies. On the other hand, from a Post-Keynesian perspective, it is not unusual for
markets to fail. In such instances, government actions are necessary to improve
economic performance and social welfare. This leads not only to different approaches to
economic and social policies, but also to a different view of the state and its
responsibilities in providing economic stability and overall well-being for its citizens. It
is also important to emphasize that for Post-Keynesians the purpose of an economy is to
serve the needs of people, not the other way around. Economic development and public
policy should be based on improving the overall standard of living, and should reflect the
values and goals of equity and social justice as well as efficiency.
This chapter provides a critique of the mainstream theory of the state by looking
at the Post-Keynesian responses to neoclassical economics and their approaches to public
policy starting with the Great Depression. In mainstream economics the state plays a
minimal role. In contrast, Post-Keynesians look at the state as playing an integral and
vital role for the development and stability of markets and achieving sustainable
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economic growth. Besides providing a critique of the mainstream view of the state, the
chapter shows the development of Post-Keynesian approaches to public policy. The final
section discusses some tensions that exist today between Post-Keynesians and their
approaches to public policy.
The Mainstream View of the State and Public Policy
Building on the writings of Adam Smith, neoclassical economists believe that a laissezfaire economy of competitive markets will channel all self-seeking and profit-oriented
behavior into a socially beneficial outcome that will support the “natural liberty” of
individuals (Smith, 1937, p. 14). The consequence is that the state’s role should be quite
limited. Government interventions, taxes, subsidies and regulations all misdirect capital
and diminish the contributions of individuals. In addition, government action usually
restricts markets, which reduces the rate of capital accumulation and the division of labor
and the level of social production. Smith believed that the state should be given only
three duties:
First, the duty of protecting the society from violence and invasion of other
independent societies; secondly, the duty of protecting, as far as possible, every
member of the society from the injustice or oppression of every other member of
it, or the duty of establishing an exact administration of justice; and, thirdly, the
duty of erecting and maintaining certain public works and certain institutions,
which it can never be for the interest of any individual, or small number of
individuals, to erect and maintain; because the profit would never be repay or
expense to any individual or small number of individuals, though it may
frequently do much more than repay it to a great society ( Smith, 1937, p. 651).
This has been interpreted today by mainstream economists as meaning that the state has
four legitimate roles in the economy: 1) government needs to make sure that there is
competition and that no firm is able to exert monopoly power in the market. This
prevents firms from acquiring both economic and political power; 2) government
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intervention is needed in cases of externalities and for producing public goods; 3)
government intervention is necessary when consumers and firms do not have sufficient
information to make informed decisions; 4) the government needs to protect by laws
private property and contracts.
The main policy conclusion of neoclassical analysis, both in macroeconomics and
microeconomics, is that in the absence of imperfections market economies will move
towards an equilibrium position that is stable and optimum. Equilibrium prices always
clear the market for consumer goods and factors of production. This equilibrium cannot
be improved upon by government intervention in the economy. Whenever some outside
force like changes in consumer preferences affects the market it is assumed that the
economy will move to a new equilibrium point. There is never a problem with the real
world transition from an equilibrium point to another, except for the possibility of some
transaction costs, which are usually minimal. Efficiency for mainstream economics
comes through substitution effects working through the “invisible hand”. When market
imperfections do exist, the neoclassical solution is to remove the imperfection. In cases
like this the government can play a role of removing the imperfection.
Neoclassical economics uses the criteria standard of Pareto optimality. This
implies that government policies to redistribute income either directly or indirectly by
raising taxes on some people to provide goods and services to others should be very
limited. Under the assumptions of utilitarianism we can never know that any
redistribution will improve total utility, yet we do know that some people are made worse
off because their taxes have gone up. In the neoclassical framework, these higher taxes
will have undesirable substitution effects – since taxes reduce the rewards for working
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and producing (Whereas for Post Keynesians the income effects of taxes would actually
encourage work and savings). Another example from the neoclassical paradigm is deficit
expenditures, which are assumed in the neoclassical model to create a “crowding out”
effect. Higher government expenditures will be offset by less private expenditures and
vice versa. The conclusion of mainstream economics is that free markets with minimal
government intervention provide maximum benefits to all, which creates the greatest
possible good for its people and the economy.
We are now able to draw a number of key characteristics that define the
neoclassical approaches to public policy and their theory of the state:

Individuals make choices and decisions independent of others and are primarily
concerned with their own self-interest and are generally in a better position to
judge what is in their interest than their government.

Individuals act rationally and can calculate the probable outcomes of every
decision needed to maximize the expected utility of all possible outcomes. Even if
this might not be true in all cases, it averages out over time to be true.

Markets are generally competitive, which increase the overall social welfare
measured by economic growth. Government intervention, except for some
exceptional cases, limits the social benefits of competitive markets.

Equilibrium analysis leads to optimum market outcomes and allows factors of
production, such as wages and profits, to equal their marginal productivity.

State involvement can reduce individual liberty. Laissez-faire policy prescriptions
generally provide the best approach for maximizing both personal freedom and
prosperity.
A Post-Keynesian Critique of Mainstream Theory of the State and Public Policy
In contrast to the neoclassical view, Post-Keynesians see the state role as integral and
vital for economic growth and increasing the overall standard of living. They reject the
view that capitalism operating solely under market forces is a self-adjusting economy that
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inevitably leads to full-employment and low rates of inflation. Due to the precarious
nature of advanced capitalism, the state has a responsibility for the overall performance
of the macro economy and to develop policies that will mitigate economic problems and
lead to social justice. The Post-Keynesian critique of the mainstream theory of the state
starts with questioning the basic beliefs of neoclassical economics and replacing them
with what they see as more realistic assumptions of how people and a capitalist economy
actually functions in the real world. Here are six major tenets in which Post-Keynesians
differ from neoclassical economics:
 A recognition that the future is uncertain, rather than being known or known with
some probability distribution. This makes acting “rational” as defined by
neoclassical economics not possible in many cases.
 Individual decision-making is dependent on social factors, such as human
relations, conventions and habits, rather than on individual rational choice.

Economic analysis should focus on economies moving through historical time
rather than economies that effortlessly reach some equilibrium point.

Most markets are imperfectly competitive in the real world, and their results
deviate substantially from the competitive world.

Economic public policy should focus on growth rather than the efficient
allocation of resources as the most important economic issue, and recognize that
income effects are more important than substitution effects in many instances.

A theory of the state should be concerned with distribution issues both at a macro
and micro level for achieving economic stability and social justice. Market forces
by themselves will not achieve these goals.
Several key policy conclusions follow from the Post-Keynesian world-view. For
Post-Keynesians, the state may need to take a larger role to provide what the private
sector cannot or will not provide (Pressman 2006). At the aggregate or macroeconomic
level, the state needs to assure full employment and stable prices. But state action is also
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needed at a microeconomic level. This is especially true for merit goods like social
security, health care, and education. Besides helping to bring social justice, these goods
also stabilize and grow the economy. To see the development of Post-Keynesians
approaches to public policy and their critique of the mainstream theory of the state we
need to turn to John Maynard Keynes for our starting point. In The General Theory
(1964) he challenged the foundations of neoclassical economics by explaining how and
why Great Depressions are possible within an advanced capitalist system that is driven by
finance.
Changes in Keynes’s Approach to Public Policy and the State
It can be argued that up to the 1930s Keynes followed a more traditional path toward
public policy, but with The General Theory he exhibited a new “vision” of economic
theory that would have significant public policy ramifications, besides changing the
direction of economic theory (Davidson, 1994, p. 4). Robert Skidelsky suggests that the
Great Depression of 1929-32 had a dramatic impact on Keynes and his way of looking at
the world. He states: “Keynes abandoned for good the belief that markets were
automatically self-correcting. In a notable shift in moral perspective, he started to place
less emphasis on efficiency, more on duty” (Skidelsky, 2009, p. 65). In the 1930s Keynes
was entering a period where inaction was unacceptable to deal with the world-wide
economic crisis. He believed that economists needed to be more engaged with public
policy. Keynes in his earlier writingsi started to question the stability and predictability of
market outcomes, but it is during the Great Depression that we see him coupling his
doubts about free markets with new economic polices. Peter Clarke points this out in his
biography on Keynes (2009, p. 103):
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“…he had no doctrinaire reason to advocate state intervention; his whole education as an
economist taught him that it was generally best to leave things to be sorted out by the free
play of market forces. But what if the market seemed to be failing to perform as the
textbooks prescribed? What was the best option under such conditions? The orthodox
answer was to show patience. Keynes’s answer was to opt for second-best expedients”.
Responding to his critics on the type of public policy needed to deal with the
economic crisis, Keynes bluntly stated: “We do not know what will be the outcome. We
are – all of us, I expect – about to make many mistakes.” (1963, XXI, p. 239). He
recognized that with uncertainty and the magnitude of the different economic problems
the world was facing in the 1930s that new and bold policies were needed and that some
would work and others would fail. But he had no doubt that action was required to deal
with the human misery that was apparent and new policies were needed to create stability
in an economic system that was on the verge of collapse. He came to recognize the
importance of state intervention.
We can get a glimpse of how Keynes looked at the role of government and state
intervention during the Great Depression from his comments praising Roosevelt’s
method of working “within the framework of the existing system” (Shesol, 2010, pp. 2021). Roosevelt was not interested (nor was Keynes) in destroying capitalism and looked
to government policies as a way to “restore, secure, stabilize, and save” the market
system. According to Frances Perkins, his Secretary of Labor : “Roosevelt took the status
quo in our economic system…[But] he felt that it ought to be humane, fair, and honest,
and that adjustments ought to be made so that the people would not suffer from poverty
and neglect, and so that all would share” (Shesol, 2010, pp. 20-21). This in many ways
sums up Keynes’s economic philosophy on state and public policy goals during the Great
Depression.
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Keynes’s Policy Recommendations
Keynes saw the achievement of full employment and dealing with the distribution of
market power to provide economic growth, stability and increase the overall standard of
living as the primary job of economic policy. As he stated in The General Theory, “The
outstanding faults of the economic society in which we live are its failure to provide for
full employment and its arbitrary and inequitable distribution of wealth and incomes”
(Keynes, 1964, p. 372). Keynes came to realize that it is aggregate demand that drives the
overall economy, and that there would continue to be problems of involuntary
unemployment unless there were increases in real expenditures to guarantee full
employment.
In The General Theory Keynes shifts from the Marshallian use of market supply
and demand as “his basic tools” of analysis to aggregate functions in a world of
uncertainty for understanding the economy and the type of policy recommendations
needed for economic stability (Harcourt, 2007, p. 60). This pivotal shift is crucial to
understanding a Post-Keynesian approach to micro as well as macro policy and the
relationship between the two. Keynes recognized that total demand is affected by income
distribution, uncertainty, the psychological habits of investors and consumers (“animal
spirits”) and government policies. Keynes was able to see the “big” picture and how
aggregate demand determines levels of employment and inflation, but also how supply
factors affect demand. He understood the impact of total demand on the distribution of
income and government budgets and national trade deficits. The importance of aggregate
demand drove his policy views in the 1930s – both domestically and later with
international economics.
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In sum, Keynes came to believe that the foundation of economic policy should be
based on generating full employment and stabilize the economy. He questioned classical
and neoclassical theory and the belief that endogenous market forces would create full
employment with stable and fair outcomes, even in the long run. The constraint of the
economy was on the demand side and not supply. State action was necessary.
The Role of the State
Besides recognizing that in a decentralized monetary economy the market itself would
not guarantee levels of aggregate demand sufficient to achieve full employment, Keynes
came to believe that the state must step in and provide what private markets cannot. At
the aggregate or macroeconomic level, the state should assure full employment and stable
prices. But it also needs to deal with coordination problems between aggregate demand
and aggregate supply related to such factors as uncertainty and imperfect market
structures (Chick, 1983; Davidson, 1994). This leads policy makers to be concerned not
only with macro policies of providing a sufficient level of aggregate demand for full
employment, but also with the social and equitable consequences of having factors of
production unemployed.
Keynes came to understand the significant impact that aggregate demand has on
supply side factors (labor, resources, entrepreneurship and capital). With low levels of
demand more people become unemployed and entrepreneurship lays fallow. For Keynes,
inflation’s most corrosive impact comes from price uncertainty, although the adverse
effects of anticipated inflation can be compensated by thoughtful and creative
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institutional structures like income policies. Unemployment, on the other hand, causes an
unambiguous loss to society. Output lost from under utilization of capacity
is gone forever. Skills and talents may be lost. Long term unemployment can create
social problems such as poverty, disease, homelessness, racial antagonism, crime and in
extreme cases social unrest and revolution. Keynes argued that the state must carry out
economic policies to deal with these economic problems. He looked primarily to macro
policies of deficit spending to expand aggregate demand during times of recession to get
people back to work. Any attempts to increase taxes or lower government expenditures
would make any economic down turn worse by reducing aggregate demand. Keynes’s
overall view of the state has been summarized by Pressman (2001, p. 109):
Keynes saw the state as a set of institutions working for the public good. It
provides public goods and benefits. In particular, the state must make sure that the
requisite amount of spending takes place, leading to full employment and robust
economic growth. The state must also control the national currency and back it.
These are the key policy recommendations of the General Theory.
The Classical Response
The classical response to unemployment is that it is primarily caused by factors that do
not allow markets to be competitive i.e. government intervention, unions, etc. The answer
is not more state intervention but less to allow for competition and substitution effects.
This position is still held in neoclassical policies today with “New Keynesians” and
rational expectations on the assumption that most markets are competitive. Keynes
questioned laissez-faire economics. He came to believe it is not the rigidities in markets
that created involuntary unemployment. Instead it is the inherent nature and dynamics of
laissez-faire markets within industrial economies that are prone to periods of instability
and crisis. What was needed to achieve full employment and reasonable levels of
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economic growth were government policies and an institutional framework that
supported high levels of demand with coordinated efforts to deal with supply side
efficiency and equity issues. By seriously questioning the assumptions of classical
economics, Keynes was able to develop a much richer understanding of how markets
work.
Some have argued that the short fall in Keynes analysis was in not providing a
new microeconomics foundation to his macro analysis. This left the door open for
neoclassical economists to interpret his views on unemployment as being caused by wage
inflexibility. It was Post-Keynesians such as Joan Robinson, Piero Sraffa and Michal
Kalecki that started to address these issues and the relationship of microeconomics to
macroeconomics by looking at monopolistic market structures and their effects on
business cycles, prices and distribution. Their new approaches to microeconomic allowed
Post-Keynesians to provide an alternative theoretical model to neoclassical welfare
economics to deal with policy issues such as poverty, discrimination and consumer
welfare.
Another critique comes from Barro (1974) with rational expectations who argues
that Post Keynesian policies will be ineffective. A tax cut and increase government
spending might increase demand, but it will also increase the government’s deficit.
Individuals will recognize this and save more for expected future increases in taxes to pay
for the deficit spending. Besides not increasing aggregate demand the policy has a
crowding out effect.
The main problem with this argument is that it relies on the assumptions of having
rational acting agents in a world of perfect market predictability, which is the foundation
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of the mainstream theory of the state. Keynes in The General Theory questioned these
assumptions, particularly the view that economic agents – consumers and firms – have
near-perfect knowledge of economic situations and act “rational”. He came to believe
that “people simply lacked the logical ability or rationality to see what was there
(Bateman, 1996, p. 56).
Besides questioning the rationality principle, Post-Keynesians also question the
assumption of certainty. If there is no sound evidence or ability to be able to make
rational choices because of uncertainty, then government policies become even more
important for they can provide long-term government guarantees and commitments that
can influence economic behavior and outcomes in a positive way. (Keynes, 1964 ;
Pressman, 2006). Post-Keynesians see the potential of the state to work for the public
good. If the state policies guarantee full employment with stable prices, then this is the
expectation that will be developed. The state can do this by setting up institutional
structures that support these policy goals. Two primary ways are through public
investment spending and by converting uncertainty into risk through social programs like
unemployment insurance.
Macro and Micro Public Investments
Keynes recognized the need of public investments as a way of achieving full employment
and to guarantee the full utilization of resources for economic growth, particularly during
times of recessions (1964, p. 378). Public investments should be designed not just for the
increase of aggregate spending, but to increase spending in areas where the private sector
is not doing enough for the public good. At the end of The General Theory, Keynes
talked about the public investment of education, building hospitals, etc. To this we can
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add spending to improve the environment, promote greater health, reduce poverty, create
jobs with decent wages and working conditions, security in retirement, crime prevention
and improve public safety. These policies have a number of different positive effects.
They help stabilize the macro economy and reduce uncertainty as well as improving the
overall well-being of individuals and increase their productivity while creating a better
and more just society.
Public Policy and Uncertainty
To understand Post-Keynesian approaches to public policy and why state intervention is
needed for economic growth and stability it is important to point out the distinction
between uncertainty and risk in the real world. This distinction is absolutely essential for
a comprehensive understanding of Post-Keynesians’ policy views. In the 1920s, along
with Frank Knight (1971 [1921]), Keynes (1973 [1921]) was seriously concerned with
the question of risk and uncertainty and the implications for economic decisions. Keynes
accepted Knight’s argument of the distinction between risk and uncertainty where risk
involves measurable probabilities whereas uncertainty involves unknowable probabilities.
Knight pointed out that we could estimate and calculate risk and so insure against it. For
example, an insurance company can calculate the risk of a middle age man passing away
suddenly as compared to predicting the price of a barrel of oil or wine 20 years from now,
which carries with it uncalculated or uncertain probabilities. For Keynes this distinction
has major ramifications in the real world of personal and economic decisions. Keynes
links the difference between risk and uncertainty to economics in Chapter 12 of The
General Theory (1964 [1936]) where uncertainty means that investment cannot depend
on some objective assessment of probable outcomes. Instead we are forced to rely on
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“animal spirits” of the average state of confidence as the driving force behind business
investments. Given the importance of investments – both private and public – to
achieving full employment, economic growth and overall well-being, the government can
turn uncertain outcomes into marketable risk investments that have some assessment
value. This will increase the level and stability of investments leading to higher economic
growth and employment.
There are many ways that governments can and does accomplish this. For
example, product liability laws place risk on manufacturers. Workers’ compensation
laws shift the risk of workplace accidents from employees to employers. Deposit
insurance safeguards individual depositors during a financial crisis. Federal disaster
relief helps victims of natural catastrophes. Consumer product safety laws, banking
standards, workplace safety regulations are among other policies that reduce risk for
average citizens. Large firms have been helped in raising financial capital through limits
on the liability of passive investors. If the firm collapses, creditors have no claim on
assets of those who simply owned shares of stock in the firm.
Keynes’s uncertainty is also related to the unidirectional nature of time (brought
out in more detail by Joan Robinson (1974)) where we cannot go back and change our
decisions (1937, p. 113). This means that past evidence is not a reliable guide when
events happen infrequently or when we are dealing with situations far into the future. Past
evidence is also no guide for situations with no prior history. In these cases, expectations
are bound to be volatile and uncertain, unless public policy develops rules, conventions
or routines to set guidelines for future economic and social decisions. Let’s us turn to the
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environment as an example to show the Post-Keynesian approach to public policy under
conditions of uncertainty.
Environmental Policy
Many long-term consequences of environmental damage cannot be known because the
probability of environmental damage is not attainable without repeated action and the
passage of time. We cannot perform controlled experiments with the earth and a parallel
earth to see how pollution affects one but not the other, keeping everything else constant.
We cannot do the second best thing and use a large sample of past experience to make
probability judgments. We are currently experiencing the worldwide consequences of
many kinds of pollution for the first time in history. The Post-Keynesian approach to
policy recommendations and decisions is very different from the neoclassical. First, they
hold onto a form of organicism or holism that recognizes the interdependency and
connection between the environment, society and the economy as compared with the
mechanical and methodological individualism of neoclassical economics (Dow, 2001).
Second, Post Keynesians do not rely on neoclassical marginal analysis since they rely
more on notions of path dependency and irreversibility, which plays an important part in
understanding the dynamics of environmental and sustainable development (Holt, 2005).
Because of the uncertainty of environmental outcomes the work of Post-Keynesians on
institutions, knowledge, procedural rationality (Rosser, 2004), all of which look at
complex dynamics and the lack of predictability about the future, compels policy-makers
to concern themselves with non-market factors and to adopt a more cautionary approach
when assessing the environment. By developing policies that deal with complexities in a
global ecologic-economic system we can put into place a series of cautionary principles
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like the Lisbon Principles (Constanza et at., 1999) that establish guidelines and
institutional structure to deal with environmental uncertainties that could lead to
catastrophic outcomes.
As the above example shows, uncertainty has microeconomic policy implications
as well as macroeconomic. Post-Keynesians do not see people as being isolated
individuals. Rather, they see the interdependence of humans with their society and the
environment. This approach has public policy consequences very different from the
neoclassical view of looking at individuals as being independent of others, their society
and environment. This also provides a very different role for the state as compared to the
mainstream theory of the state. Post Keynesians take a pragmatic approach to the role of
the state. While they believe in relying on markets where they can achieve a socially
desired outcome, there are cases like with the environment where public protection and
investments in natural capital are needed. An ideology that values small government
above all else may mean foregoing these vital protections and investments. In addition,
the recent work of Nobel Prize winners Williamson (2002) and Ostrom (1990) highlights
the important role of social cooperation outside of formal governments and markets, as
does the work of Bowles and Gintis (2002). This brings home that there are other ways
of achieving efficiency and well-being outside of government intervention and the use of
market forces. For Post Keynesians results are more important than ideology and take an
“open systems approach” that shows an appreciation for pluralism in its methodological
approach to public policy analysis (Greenwood and Holt, 2010; Dow 2001).
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Social Rationality
In addition, Post-Keynesians have questioned whether the notion of individual rationality
yields optimal outcomes in the real world, or whether there is a social rationality makes
everyone better off. The difference between social rationality and individual rationality is
clearest in the prisoner’s dilemma, which shows how two individuals pursuing their own
best interests wind up in a less than optimal situation. Prisoner’s dilemma situations are
common in everyday life. They are the heart of the free rider problem. Like the prisoner
who confesses, the free rider does not pay to support public goods that everyone regards
as desirable, such as public schools and safe neighborhoods. The free rider assumes that
others will contribute and the marginal effect of one less contribution will make no
difference to how safe our communities are or how clean our environment will be. But
the aggregate outcome of free riding may be a lack of public goods that everyone desires.
To get to an outcome that provides a higher optimal outcome might mean moving from
what makes individual rational sense to a social rationality where individuals give
something up, but society sees an increase in its welfare. This opens the door to
government policy—for example, taxes to support public goods.
One result of replacing individual rationality with social rationality in Post
Keynesian analysis is that macroeconomics has primacy over microeconomics. The
behavior of the economic system as a whole is not reducible to the sum of individual
parts. Post-Keynesians point out that there are fallacies of composition such as the
famous paradox of thrift in The General Theory that undermine the implications of
microfoundations in neoclassical economics. Another example is Kaleckian paradox of
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costs. As Kalecki (1971, p. 26) pointed out, “one of the main features of the capitalist
system is the fact that what is to the advantage of a single entrepreneur does not
necessarily benefit all entrepreneurs as a class.” While one firm benefits from cutting the
wages and benefits of its employees, gaining more in profits, when all firms do this, there
is a negative effect on aggregate demand and all firms lose sales and income. What is true
of the individual is not always true of the whole.
Public Policy and Imperfect Markets
Galbraith (1967) was most responsible for pointing out the benefits of imperfect
competition, and for exploring the causes and consequences of the dominance of large
firms in our economic system today. He argued that the large firm is a consequence of
the natural evolution of advanced industrial economies (1967) by taking advantage of
economies of scale. Size has advantages, according to Galbraith, “as a means of
facilitating technological change by emancipating it from the uncertainties of the market”
(Dunn & Pressman 2005. p. 171). Galbraith sees technological change as a main
characteristic of the world and a main challenge facing all firms. Technology requires
more capital and specialized manpower, and entails a need for planning. Moreover, as
production becomes more complex due to technical change, one person can no longer be
familiar with all aspects of production reinforcing the development and importance of
social over individual rationality.
Galbraith’s insights become important in a number of policy areas. For example,
the neoclassical policy solution of eliminating government monopolies in providing
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health care is less convincing when one sees the economic world as dominated by large
oligopolies or megacorporations. The question becomes which system is more
efficient—government monopoly or private oligopoly with the need of government
regulation. Similar issues arise in the policy debate over privatizing social security and
education.
Post-Keynesian Public Policy Method Compared to the Mainstream
In addition to differing on economic theory, Keynes and Post Keynesians share a very
different methodological approach to public policy than neoclassical economics.
The origin of Keynes’s approach can be found in his father’s writings. In The Scope and
Method of Political Economy (1891, p. 83) John Neville Keynes argued that theory and
policy have different methodologies. This is because economic science is a branch of
logic that relies on theorems that are based on self-evident assumptions. But policy
requires much more than just the use logic, it requires a knowledge of history,
institutions, politics, and common sense. For Keynes it wasn’t that economic science was
irrelevant to policy but that the focus of economic science is by its nature abstract and
limited, so the driving interest behind those that do economic theory is different from
what policy makers should be focusing on: the role of institutions, political economy, and
history. Turning to Keynes (1938) himself:
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. The object of a
model is to segregate the semi-permanent or relatively constant factors from those
which are transitory or fluctuating so as to develop a logical way of thinking
about the latter, and of understanding the time sequences to which they give rise
in particular cases. Good economists are scarce because the gift for using
“vigilant observation” to choose good models, although it does not require a
highly specialized intellectual, appears to be a very rare one.
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This approach to public policy was similar to the tradition of classical economists like
Adam Smith, John Stuart Mill and Karl Marx. This method recognized the limitations of
theory, the importance of empirical work and the need to have an intuitive and historical
sense of the institutional dynamics of the economy at a particular time. Keynes did not
disagree so much with classical economists method of public policy as with their
theoretical assumptions of a long run equilibrium model with central tendencies. In other
words, he made a distinction between pubic policy and economic theory and both should
use different methods of analysis. This distinction is important for understanding PostKeynesians approaches to public policy (Colander, 2009).
Keynes’s earlier words on public policy, also give us a sense of the limitations he
saw in economic theory. First, one gets a sense of the complexity of economics, the
importance of relying on more than one model, the “art to choosing” from a variety of
models to understand the real world at any one time in history. Keynes seems to suggest
the Babylonian mode of thought advocated by such Post Keynesians as Sheila Dow
(2001) for economic pluralism. Second, what can be learned from abstract economic
theory is limited. We need an awareness of the role of institutions, politics, intuition and
normative values in order to come up with good and solid policy recommendations.
Public policy for Keynes was an art and not a science that required professionals trained
in more than economic theory. He believed state actions chosen by dedicated individuals
with high professional standards could help to stabilize capitalism, support economic
growth and increase overall well-being.
This is in contrast to the view of public policy that logically derives from the
neoclassical model and its’ assumptions that economies naturally tend to efficiency and
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optimum outcomes. This neoclassical approach to public policy is derived primarily from
the logic of its theoretical models. Any deviation by looking at historical or political
factors for example can be considered as moving away from the “objective” analysis that
economics can provide to policy recommendations. Keynes stated his concern with this
approach in Chapter 1 of The General Theory: “… the characteristics … 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 facts of
experience” (Keynes, 1963 [1936], p.3). Unfortunately Keynes’s message began to
disappear with the rise of neoclassical Keynesianism in the 1940s and 1950s when
economists directly related theory to economic policy, blurring the methodological
difference between them. The consequence is having economic policy that has not been
able to address chronic unemployment, financial instability and world-wide recessions.
Policy outcomes can be devastating when driven by incorrect theory. We saw this in the
1970s with stagflation and more recently with the global financial crisis of 2008.
Neoclassical Keynesians and Public Policy
The classical theory to which Keynes refers in his work provides the foundation for
neoclassical thought today and its theory of the state. It is represented in the neoclassical
synthesis and the new classical critique of Keynesian economics. Because neoclassical
Keynesians never abandoned classical theory, they made it easy for a new generation of
economists to go back to classical theory. As Gregory Mankiw stated: “ “General Theory
is an obscure book…We are in a much better position than Keynes was to figure out how
the economy works… Classical economics is right in the long run. Moreover, economists
today are more interested in the long-run equilibrium” (Mankiw, 1992, pp. 560-561).
21
Starting in the late 1930s and into the 1950s economics started to move more in
the direction of developing highly mathematical economic models and attempts to derive
policy from those models -- much of this in the name of Keynes. Many people accept the
version of Keynes produced by neoclassical Keynesian economists such as Paul
Samuelson, Robert Solow, James Tobin and John Hicks. They were all wedded to general
equilibrium analysis, the neutrality of money and the belief that the economy is governed
by a natural long-run central tendency, in contrast to the writing of Keynes outlined
above. They emphasized a commitment to “economic science” which meant analytic
techniques based on cutting edge work in mathematics and statistics. Because of this
emphasis, mathematics sometime drove model building, affecting conclusions about what
appropriate policy is needed. For example, in macroeconomics the IS/LM model made it
very convenient to determine macro policies from neoclassical theory. In
microeconomics, the development of welfare economics, also was used to draw policy
recommendations directly from theory without sufficient attention to history, institutions,
and present conditions.
The consequence was that macro policy began to look like a cookbook in the
1960s and 1970s: change a fiscal policy here and a monetary there and helped by the
power of market forces the economy would automatically return to full employment with
low inflation. Microeconomic public policy was not any better. It started with the
assumption of perfect competition and that any government intervention could only be
justified under the limited conditions of market failure. Any other type of policy action
would interfere with private choice and lead to an inefficient outcome that was not Pareto
optimal. When market imperfections did exist, such as externalities or natural
22
monopolies, polices that allow markets to work freely again or internalize the externality
were all that was required. This assumed of course that conditions of perfect competition
will actually deliver the outcomes that it promises, and that the assumptions made by
neoclassical economics concerning the rationality of human behavior, the structure of
markets and general equilibrium are correct.
However, these big assumptions made by neoclassicals were questioned by
Keynes and have been since by Post-Keynesians. If consumers and firms face a world of
radical uncertainty, monopoly market structures where cumulative causation effects (in
contrast to forces of equilibrium) determine economic outcomes, then public policy must
go beyond fixing a “market failure” to achieve the goals of a “good society.” Government
intervention is called for to improve opportunity, maintain floors of consumption and
improve fairness (Sen, 1999). Post-Keynesian approaches to public policy and the role of
the state incorporate a broader range of market failures than those dealing with efficiency,
and thus have a larger role for government.
The Evolution of Post-Keynesian Economics and Policy
Keynes’s work laid the foundation, but it is important to recognize and appreciate the
significant contributions of others to Post-Keynesian economics and public policy.
It is fair to say that Keynes never completely threw off the vision of the working of
economies in terms of an equilibrium framework. He did, of course, argue that
government intervention was needed to help attain a satisfactory full employment
equilibrium (internal balance) in each economy…One of the major changes in vision
since Keynes’s death about how markets, economies, even whole systems work,
associated with Keynes’s followers, especially Kaldor and Robinson, is the concept of
cumulative causation. (Harcourt, 2007, p. 64).
Nicholas Kaldor and Joan Robinson’s contributions to cumulative causation is just one
example of expanding the alternative “vision” for economic theory and approaches to
23
public policy that build on Keynes’ insights. Other influential thinkers include Michal
Kalecki, Richard Kahn, and Richard Goodwin. Their work explored the relationships
between theory, empirical work and policy based in Keynes’s writings, but they went
beyond his insights in many ways. There are also many contemporary Post-Keynesians
like Paul Davidson, Hyman Minsky, Geoff Harcourt, and John K. Galbraith who had
substantial impact. Among Post-Keynesians there seems to be a general consensus that
the primary focus of Post-Keynesian economic policy should be on demand-side
management to furnish long-term full employment and stability that allows for economic
growth. There is the rejection of scarcity analysis of neoclassical economics and
recognition of the importance and implications of income distribution and imperfect
market competition on economic growth and social justice. But there are also major
differences among Post-Keynesians as to what are the best approaches in various areas of
public policy.
Public Policy Tensions in Post Keynesian Economics Today
As has been shown Post Keynesian approaches to public policy have evolved, but there
are some tensions in their approaches, which is captured in a debate that has significant
public policy implications. Should policy be based on equilibrium analysis or
accumulation cyclical processes that lead to bouts of instability? For Paul Davidson
(1994) we should do the former and for others like Hyman Minsky (1975) and Richard
Goodwin (1947) we should do more of the latter. It is an important debate for public
policy.
Minsky (1974) argues that Davidson insists on integrating Keynes’s The General
Theory with his earlier book A Treatise on Money. In Minsky’s view, the Treatise
24
adopted a Marshallian equilibrium, approach which is inconsistent with the cyclical
nature of The General Theory. According to Minsky: “…[Davidson] still is wedded to the
idea that the economic process can be characterized by sustainable equilibriums. His
emphasis is upon growth and accumulation as steady rather than cyclical processes and
the essential destabilizing impact of evolving financial and cost relations which take
place during each temporary equilibrium is neglected” (1974, p. 11).
Minsky goes on to say, “uncertainty is of central importance in decision-making
because the economy is inherently cyclical” (p.13). More generally, Minsky along with
other institutional Post-Keynesians maintain that theory must take account of custom,
usages, rules of thumb, conventional beliefs and “transitory and temporary system state”
as the economy cycles between boom and bust. These institutional economists argue that
the use of equilibrium and marginal analysis ignore the importance of the evolution of
institutions in understanding the dynamics of modern capitalism.
Another area of controversy concerns the endogeneity of money. Some PostKeynesians have adopted the endogenous approach to money, but emphasize that money
can be introduced to the economy through two distinct processes, the portfolio-change
process and the income-generating finance process (Davidson, 1994). The first of these
processes is more similar to the orthodox money approach: the central bank increases
reserves, which changes interest rates and induces subsequent portfolio adjustments.
Other Post-Keynesians like Basil Moore have adopted a different approach called
“Horizontalist” approach alleging that central banks cannot determine the quantity of
reserves, but can only determine the priced at which reserves will be supplied (Moore,
1988). Banks then set retail loan and deposit interest rates relative to the central bank’s
25
target rate and then accommodate the demand for loans and accept the supply of deposits
at those administered rates. The money supply is said to be ‘horizontal’ at the loan rate of
interest. Some have criticized Moore’s work for downplaying the importance of portfolio
changes as well as the influence that this might have on loan interest rate and the
willingness to lend (Davidson, 1994).
Post-Keynesians also differ on policy approaches to inflation. Davidson has
stated that the “existence of continuing inflation in any society involves some
redistribution of real income from the weaker to the more powerful groups in an economy
and/or its trading partners” (Davidson, 1991, pp. 89,91). The appropriate policies are
Tax-based Incomes Policy (TIP) to fight domestic inflation and indexing of the
International Monetary Clearing Unit (IMCU) to fight exported inflation. Other Post Keynesians attribute inflation to a variety of causes and would recommend a basket of
policies to reduce inflationary pressures should they arise. For Minsky “prices in our
accumulating economy are the carriers of profits and vehicles by which a surplus is
forced” (1986, p. 254). In a big government, big firms, big labor economy “there are a
variety of inflations,” with inflation “mainly determined by the way the economy is run
(1986, pp. 265, 260). He attributed inflation primarily to the markup over wages rather
than to wage pressure, arguing “the behavior of money wages once the inflation barrier is
pierced is more a defensive reaction than a cause” (1986, p.261). Thus, an incomes policy
would treat only the symptom but not the primary cause of inflation. Instead a policy that
would increase the production of consumer goods would reduce pressures to increase the
markup. Minsky believed that TIP was impractical and would interfere with the ability of
private firms to set prices that would allow them to service the debt issued to financed
26
positions in assets. This overview of the debate among Post Keynesians cannot be
resolved here, but it does show some of the challenges that Post Keynesians must deal
with in the future in developing consistent public policy approaches.
Conclusion
This chapter has identified several key differences between the Post Keynesian and the
neoclassical approach to policy issues and a theory of the state. Neoclassical analysis
begins with the assumption that individuals are rational and confront a simple world of
risk, instead of a messy and complex world of uncertainty. In addition, for neoclassical
economists, history is not important; instead all economic analysis is couched in terms of
equilibrium outcomes. In contrast Post-Keynesians see individuals living in a world
uncertainty where history does matter. In this world the state can play an important role
of reducing uncertainty and create an environment that improves economic decisionmaking and performance. Moreover individual rationality and free choice as assumed in
the neoclassical paradigm do not always lead to optimal equilibrium outcomes for PostKeynesians.
Post Keynesians also adhere to the principle of effective demand. In the
macroeconomic world this means that unemployment is a function of the level of demand
in the economy. This principle plays an important role in Post-Keynesians approaches to
public policy. The essence of the Post Keynesian approach is a set of public investments
to provide merit goods and to deal with economic and social problems. Public
investments are designed to not just increase spending, but to increase spending in areas
where the private sector is not doing enough. These investments may be for public goods
such as quality education and health care for all, public safety (including national defense
27
and crime prevention), jobs with decent levels of income and working conditions,
security in retirement, and a clean environment. These policies also have a number of
different positive effects. They help stabilize the macroeconomy and improve
microeconomic performance as well as helping to increase the satisfaction of individuals
who live in a nation.
28
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Like Keynes’s Treatise on Probability ((1973) [1921]) .To classical economists who believed in a handsoff approach to state intervention in the economy, Keynes made his famous remark though before the Great
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i
34