The Modigliani controversy – the break with Keynesian thinking

I have been continuing the research for my next book (hopefully to be finished by May 2016) on the way in which the neo-liberals convinced policy makers including those in progressive social democratic political parties that the globalisation of finance and capital flows meant that the currency-issuing state was no longer capable of maintaining full employment through appropriate use of fiscal policies. The tenet we are entertaining is that the state never went away, it was just co-opted by capital to serve its interests. This will be a two-part blog and centres on a critical period in economic history in the mid-1970s, which marked the break with the full employment system which had moderated the excesses of capitalism. This was the period when the neo-liberal period dawned, and which steadily, opened the way for these excesses to reemerge, in all their indecent indulgence and destruction. It is also the period in which a series of economic myths crystallised into the mainstream narrative we know today, which opposes government deficits and allows unemployment to remain elevated at excessive levels. It is really important to understand what went on then because we are living with the legacy of the falsehoods introduced during this period.

This part of the story begins in 1977 with the publication of a academic article in the Italian journal Moneta e Credito by Franco Modigliani and Tommaso Padoa-Schioppa – La politica economica in una economia con salari indicizzati al 100% o più.

[Full Reference: Modigliani F. and Padoa-Schioppa, T. (1977) ‘La politica economica in una economia con salari indicizzati al 100% o più’, Moneta e Credito, 117, 3-53.

An extensive revision came out in English in 1978 – The Management of an Open Economy with ‘100% Plus’ Wage Indexation, Essays in International Finance, Princeton University, 130, 221-259].

According to Italian academic, Francesco Cattabrini, this paper began a vigourous debate in Italy at the time, which was dubbed the “Modigliani controversy”.

[Reference: Cattabrini, F. (2012) ‘Franco Modigliani and the Italian Left-Wing: the Debate over Labor Cost (1975-1978)’, History of Economic Sword and Policy, 75-95].

It should be said that the arguments presented in the Modigliani and Padoa-Schioppa paper were not unique to Italy but were echoed in several other academic papers at the time which examined the distribution of income and its impacts on economic growth and inflation in many other advanced nations.

Remember also that Modigliani along with his co-author and then Phd student Lucas Papademos, introduced the notion of an invariant Non-accelerating-inflation-rate-of-unemployment (NAIRU) into the literature in 1975.

The NAIRU became the full employment unemployment rate despite elevated levels of unemployment persisting.

This concept was part of a series of myths that allowed mainstream economists to allege that the currency-issuing government could not reduce unemployment below the NAIRU and if it tried it would generate accelerating inflation. The concept lacked precision in theory and was impossible to measure accurately.

But still policy makers adopted the concept as a policy reference point – claiming at various times that 5, 6 or even 8 per cent unemployment represented the current NAIRU estimate and that any remaining unemployment, no matter how large the pool was, had to be the voluntary choice of the unemployed.

According to the underpinning mainstream assumptions about rational choice, such unemployment was an optimal outcome.

Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

Papademos later became the governor of the Bank of Greece was the so-called caretaker Prime Minister of Greece after the had pushed out George Papandreou in November 2011. Recall that Papandreou had threatened as a political ploy to call a popular vote on one of the early bailouts. The Troika got rid of him a few weeks later.

Modigliani has always been considered a Keynesian economist but it is clear from analysing the way he developed his arguments that is roots did not lie in the work of Keynes (General Theory 1936 version) but the earlier Walrasian theory that Keynes had outrightly rejected.

Italian academic Luigi Pasinetti in 2005 wrote (p.31) that Modigliani was “quite convinced and proud of arriving … at Keynes’s major results without giving up orthodox economic theory”.

Pasinetti concluded that:

If the foundations kept unshaken are those of orthodox Walrasian theory, what grounds are there to claim to be following Keynes’s sharp break-away from traditional ‘Classical’ theory? More specifically, how could one continue to talk – or at least in what sense or to what extent could one continue to talk – of a Keynesian ‘revolution’?

[Reference: Pasinetti, L (2005) ‘How much of John Maynard Keynes can we find in Franco Modigliani?’ BNL Quarterly Review, LVIII(233-234), June-September, 21-39].

In this 2009 blog – Those bad Keynesians are to blame – I explain that using the term ‘Keynesian’ to describe a unified theoretical position with associated policy understandings is quite misleading, without further context.

You might also like to refresh your understanding of what the Keynes and the Classics debate was about in the 1930s, which still resonates today:

1. Keynes and the Classics – Part 1

2. Keynes and the Classics – Part 2

3. Keynes and the Classics – Part 3

4. Keynes and the Classics – Part 4

5. Keynes and the Classics – Part 5

6. Keynes and the Classics – Part 6

7. Keynes and the Classics – Part 7

8. Keynes and the Classics – Part 8

9. Keynes and the Classics – Part 9

The publication of Keynes’ 1936 The General Theory of Employment, Interest and Money – representated a major challenge of the neo-classical thought that dominated until the Great Depression.

In his Collected Works (Volume XXVIII), a letter Keynes had written to George Bernard Shaw on January 1, 1935 stated that:

I believe myself to be writing a book on economic theory which will largely revolutionize – not, I suppose, at once but in the course of the next ten years – the way the world thinks about economic problems … I can’t expect you, or anyone else, to believe this at the present stage. But for myself I don’t merely hope what I say, – in my own mind, I’m quite sure.

So it is clear that Keynes conceded, in his inimitable modesty (not!), that his 1936 work was offering a paradigms break from the extant neo-classical theory that was based on Walrasian general equilibrium theory, which had alleged that the only thing preventing full employment was rigid prices and wages – that is, the inability of the real wage to adjust to the so-called full employment marginal productivity level.

Whichever way the neo-classical approach is presented, mass unemployment can only exist if prices are unable to adjust to their free market, full employment equilibrium levels.

The free market rules unless … the government or trade unions interfered with its working (by setting minimum wages, providing income support or demanding ‘excessive’ wages).

There can be no question that Keynes rejected the claim that mass unemployment arose and persisted as a result of rigid prices, principally nominal wage levels, which prevented the real wage (that is, the purchasing power equivalent of nominal wages) from adjusting to this hypothesised equilibrium level.

For Keynes, mass unemployment (which he termed ‘involuntary unemployment’) was always a problem of deficient effective demand (spending). He demonstrated that it would still occur, even if prices were flexible in both directions, if there was deficient demand.

The solution to mass unemployment was therefore to increase aggregate spending so as to stimulate firms into expecting higher future sales, which in turn, would lead them to increase output and hire more workers to support the higher expected output levels.

The problem that Keynes identified was that the capitalist economy could easily become mired in what he considered to be an under-full employment equilibrium state.

This state occurs when workers would not increase consumption spending for fear of further unemployment, and firms were pessimistic about future sales and therefore had no incentive to increase their investment spending because they could satisfy the existing level of spending with the current productive capacity in place.

In this context, the equilibrium means that there were no forces in the non-government sector to disturb the current state of affairs.

Keynes clearly considered that government intervention was necessary to ensure that under-full employment stalemates didn’t arise – due to lack of aggregate demand.

The idea that you could have a steady-state situation with mass unemployment was anathema to neo-classical thought, which paraded models that essentially always assumed full employment.

The neo-classical models all hypothesised that if there were temporary situations where labour in some area of the economy found itself in excess supply (perhaps because consumer spending has shifted away from the goods and services that these workers were producing), then the excess supply would drive prices down and real wages would adjust accordingly.

The point was that if prices were truly flexible then all markets would adjust so that demand equalled supply at all times (with minimal adjustment periods during which prices might adjust as noted in the previous paragraph). In other words, the labour market would also be more or less, continuously, in a state of full employment (demand for labour equalled the supply of labour).

Keynes rejected this reasoning and concluded that even if wages and prices were flexible, a monetary economy could become mired in one of these under-full employment states, which would need external (that is, government) intervention to push it out of this malaise.

The problem is that Keynes, himself, did not clearly break away from neo-classical propositions. In the famous Chapter 2 – The Postulates of the Classical Economics, he examined the demand for and supply of labour, which he summarised with “two fundamental postulates”:

I. The wage is equal to the marginal product of labour

II. The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment.

Postulate I related to the neo-classical demand for labour theory and Postulate II described its labour supply theory.

His subsequent analysis in that chapter was a comprehensive and convincing attack on Postulate II, which established that a monetary economy could easily generate mass unemployment even if wages and prices were flexible.

This allowed him to introduce the idea of ‘involuntary unemployment’, which was the product of deficient spending rather than excessive and rigid real wages.

At that point, Keynes made the classic remark:

The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight-as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

The problem was that to simplify his argument, Keynes chose to maintain Postulate I. That is, he chose to focus on how examining just one significant departure from the neo-classical framework (abandoning Postulate II) could radically alter its results – that is, establish that mass unemployment could occur and persist such that workers were powerless to alter their situations.

Keynes wrote (Chapter 2, Section V):

In emphasising our point of departure from the classical system, we must not overlook an important point of agreement. For we shall maintain the first postulate as heretofore, subject only to the same qualifications as in the classical theory …

This acceptance of Postulate I meant that Keynes accepted the idea of diminishing marginal productivity (that is, that as employment rose each additional worker would be less productive than the last), a fundamental neo-classical proposition.

In turn, this meant that he accepted the neo-classical proposition that “any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product”.

In other words, he accepted that there was an inverse relationship between real wages and employment.

The causation that Keynes invoked to explain that association between employment and the real wage was different to the Classical theory. But in the General Theory, Keynes considered that the firms were always “on” their demand curve (Postulate I) and aggregate demand fluctuations shifted employment up and down that curve.

For Keynes, it was that aggregate spending determined employment, but with fixed money wages, as output rose, prices rose (he also assumed competitive prices) because unit costs rose as firms it diminishing marginal productivity. As a result, the real wage also fell (higher prices deflating fixed money wages), which established the inverse relationship between employment and the real wage.

But he understood that cutting the wage as a remedy to unemployment would not work because it would likely reduce spending and at any rate would reduce unit costs and prices would fall accordingly, probably leaving the real wage unchanged.

For the Classics, the relationship between employment and the real wage was more direct – the real wage had to be equal to the marginal product of the last worker employed if firms were to maximise profits. So unemployment would occur if the current real wage was in excess of the marginal productivity that would result if the last worker employed constituted ‘full’ employment.

Two separate studies subsequently persuaded Keynes that his earlier views on marginal productivity theory were unsupportable by the evidence. One was published in 1939 by the American economist John Dunlop and the other, a yaer later, by Canadian economist Lorie Tarshis.

[References: Dunlop, J. (1939) The Movement of Real and Money Wage Rates, The Economic Journal, 48(191), September, 413-434.

Tarshis, L. (1939) Changes in Real and Money Wages, The Economic Journal, 49(193), March, 150-154].

What these articles demonstrated was that there was no definitive inverse relationship between real wages and employment, which meant that the idea that an reduction in unemployment could be accomplished by driving up the general price level to deflate a fixed money wage was unsustainable.

Keynes responded to these articles in his own 1939 Economic Journal article and accepted that his adoption of Postulate I was unsustainable.

He said (p.34) that the research presented:

… clearly indicate that a common belief to which I acceded in my “General Theory of Employment” … needs to be reconsidered.

He also agreed (p.40) it was likely that “the falling tendency of real wages in periods of rising demand” is contrary to the real world evidence and suggested that made the argument about effective demand being the crucial determinant of employment rather than real wages more easy to make.

[Reference: Keynes, J.M. (1939) ‘Relative movements of real wages and output’, The Economic Journal, 49(193), March, 34-51 – Download].

But the damage had already been done – his accceptance of the Postulate I – allowed a ‘bastardised’ version of Keynes’s approach to emerge within a year of the General Theory being published.

After all, the neo-classical economists highlighted the fact that for employment to increase, Keynes had said the real wage must fall. This was exactly the same conclusion that the orthodox models to that date also reached.

As a result, the causality whereby increased aggregate spending would stimulate employment, but also push up prices (Keynes had mistakingly assumed a perfectly competitive world with increasing unit costs – driven by diminishing marginal productivity) and drive down real wages was pushed into the background and the traditional neo-classical causality was once again promoted.

That is, that with diminishing productivity, firms would only hire less productive workers if the product wage (the amount the marginal worker produced) fell.

As a result, mass unemployment must be due to excessive real wages relative to the productivity that would be consistent with all workers being employed (bar those moving between jobs).

This reconstruction of Keynes became known as the Neo-classical-Keynesian Synthesis (or simply, the Neo-classical Synthesis), whereby the fundamental and revolutionary message contained in Keynes was lost and his insights rendered relatively barren.

Within a year of the General Theory being released, the English economist J.R. Hicks proposed the so-called IS-LM model of joint product and money market equilibrium, which became one of the centrepieces of the Neo-classical Synthesis.

The model was not consistent with Keynes’ vision at all and eliminated, among other things, the importance of expectations and investment behaviour – a key idea in the theory of effective demand and the tendency of monetary economies operating under conditions of endemic uncertainty to generate mass (involuntary) unemployment.

Robert Skidelsky’s biography of Keynes suggests that the acolytes of Keynes at the time were not vehement enough in opposition when the IS-LM model was floated in September 1936, at the Sixth European meeting of the Econometric Society (held at Oxford University).

Skidelsky wrote (p.538) that in the context of the “desperate urgency” to cure the mass unemployment arising from the Great Depression:

… it was not surprising that the earliest ‘Keynesians’ saw his book as a machine for policy, and interpreted it primarily as providing a rationale for public spending … [But] … Hicks, Harrod, Meade and Hansen in America, the leading constructors of the ‘IS-LM’ Keynesianism, had a clear motive: to reconcile Keynesians and non-Keynesians, so that the ground for policy could be quickly cleared. These early theoretical models incorporated features which were not at all evident in the magnum opus, but which conformed more closely to orthodox theory. The constructors of these models also thought they were improving the original building. Joan Robinson, no slouch with insults, would later label the result ‘bastard Keynesianism’. But Keynes was the bastard’s father (Emphasis in original)

[Reference: Skidelsky, R. (1992) John Maynard Keynes – The Economist as a Saviour, 1920-1937, Macmillan].

This hi-jacking of the General Theory, ultimately, led to the so-called ‘Keynesian’ approach being discredited during the 1970s, even though the discredited approach was a pale reflection of what Keynes had developed in 1936.

It is in this context that we can appreciate Luigi Pasinetti’s conclusion that Franco Modigliani was firmly in the ‘bastard Keynesian’ camp.

Pasinetti explains that there is a lot of Keynes that is missing from the ‘Keynesian’ work of Modigliani, the latter being representative of the formalised (mathematical) IS-LM versions of the General Theory.

Among the many elements, Pasinetti notes that:

… the concept of effective demand plays an absolutely central role in Keynes’s work … Keynes would never consider – not even as a particular hypothesis – the case of a wage cut leading to an increase in the demand for labour. This might appear to be the case when considering an isolated single entrepreneur, for whom it would seem rational to react in the same way as to any other reduction of costs. But this ‘partial equilibrium’ argument falls to ground as soon as the analysis is expanded to consider the entire economic system. The sum of all hypothetical wage cuts for all producers would simply lead to a fall in overall effective demand, and thus to a macro-economic slump.

Modigliani’s ‘Keynesian’ results (in his PhD thesis and subsequent articles) “follow almost exclusively from his assumption of an exogenously given fixed nominal wage”, which means that if that rigidity was relaxed we would, according to Modigliani, be back in a neo-classical world of full employment delivered by the free market (that is, through price flexibility).

We are now in a better position to understand what the ‘Modigliani controversy’ was aboutin the 1970s as the academic world turned away from ‘Keynesiam’ and adopted Monetarism as the dominant macroeconomic approach.

This shift was extremely significant because it became part of a broader rejection of fiscal intervention by governments, in the rise of neo-liberalism and the perversion of Leftist political movements.

It also marked the return of the flawed neo-classical thinking, which had been so thoroughly rejected by Keynes in the 1930s as being an untenable approach to understanding monetary capitalist economies.

Monetarism rears its ugly head!

In the article cited above, Francesco Cattabrini quotes Modigliani as saying:

I want to be even more brutally frank and explicit: we need to lower the level of real wages …

The context was the major recession and resulting stagflation (the simultaneous incidents of high unemployment and accelerating inflation) that beset the advanced economies after the first oil shock in 1973.

The outbreak of hostilities in the Middle East in October 1973 (the 1973 Arab Israeli War) was accompanied by the oil embargo imposed by the Organization of the Petroleum Exporting Countries (OPEC).

A few days later, on October 16, the Arab nations increased the price of oil by 17 per cent and indicated they would cut production by 25 per cent as part of a leveraged retaliation against the US President’s decision to provide arms to Israel.

The price of oil rose by around three times within eight months.

The reaction of financial markets was excessive and significant instability emerged in world currency markets, which impacted more severely on the fixed exchange rate regime in Europe than it did elsewhere.

There were multiple real effects of a varied nature across different economies. Suffice to say that real GDP growth fell significantly in many countries at the same time as the imported oil price rises and subsequent distributional struggles (between labour and capital as to who would bear the costs of the rising import prices) triggered accelerating inflation.

The conventional ‘Keynesian’ wisdom (that bastard version) was that policy had to be relaxed to counter the rising unemployment but that would exacerbate the rising inflation.

It was clear, however, that the inflation was a ‘cost’ or supply event rather than being induced by excessive spending relative to available productive capacity.

Economists wedded in the institutional tradition clearly understood that the remedy for cost push inflation was quite different to the remedy that would be invoked to deal with a demand pull (excessive spending) inflation episode.

In fact, the institutionalists were closer to the Keynes of the General Theory than the ‘Keynesians’ who dominated the macroeconomic policy debate.

However, these insights were lost somewhere in the public debate and the emerging Monetarist adherents in the US academy (mostly, at first) took full advantage of the confusion.

Thus, the claims that fiscal policy (adjusting spending and tax rates) could not deal with the stagflationary situation and that this impotence represented a failure of the Keynesian economic approach, was based upon a series of false premises that were been promoted by the emerging Monetarism of Milton Friedman.

The Monetarists responded to the stagflation in 1973 and 1974 with accusations that government intervention, in particular, accommodative monetary policy to help reduce unemployment, had created the inflation and failed to reduce unemployment.

Indeed, the inflation was blamed on lax fiscal and monetary policy and the resulting unemployment as policy was tightened was blamed on the excessive power that trade unions were alleged to have built up over the full employment years.

Even well-known ‘Keynesians’ started writing books about the inflationary biases of full employment with big trade unions. Talk about conceding the ground to the enemy without a shot.

To exploit the observed stagflation, Friedman and others emphasised that there was only one unique unemployment rate that was consistent with price stability and if governments tried to reduce the actual rate below this level to garner political popularity, then accelerating inflation would result and the unemployment rate would sooner or later adjust back to the higher, so-called ‘natural rate of unemployment’.

Accordingly, the rising unemployment and inflation was the direct result of policymakers trying to reduce the unemployment below this hypothesised ‘natural rate’.

It escaped the attention of economists who, like lemmings, were abandoning their ‘Keynesian’ calling cards as fast as they could, and reinventing themselves as Monetarists, that the actual growth of the US money supply in 1973 and 1974 was well below the levels required by the Monetarist theoretical models to generate the actual inflation rates that were observed.

There was no reasonable way in which one could interpret the behaviour of monetary policy in the US during this period as being responsible for the inflation that occurred.

In fact, the rising unemployment in the US was more the result of a massive hike in the Federal Funds rate in 1974. In February 1974, the effective funds rate was 8.97 per cent and by July 1974, the Federal reserve had pushed it up to 12.92 per cent.

There were also claims that fiscal policy had failed. It is typically pointed out that US federal government spending rose in nominal terms in 1975 by 23.1 per cent. The Monetarists claimed that as spending was rising real activity was falling and unemployment was rising, which ‘proved’ that government spending was bad for the economy.

In fact, the unemployment rate rose from 5.1 per cent in January 1974 to 8.1 per cent in January 1975 but had fallen back to 7.9 per cent 12 months later and hovered around that rate before falling rather quickly in mid-1977.

The other fact to note is that the US Federal fiscal deficit was contracting from 1971 through to the end of 1974. The fiscal contraction in 1974 was substantial at a time that world demand was falling and the impacts of the oil shocks were seeing unemployment rising sharply.

The expansion in the fiscal deficit in 1975 was only of the order of 2.9 percentage points of GDP and that stabilised the rise in unemployment and delivered a downward trajectory by the end of that year.

It is hard to claim that the increased net public spending was not effective. The fact is, that it was insufficient given the collapse in world demand – real US exports fell by 16.3 per cent between the June-quarter 1974 and the September-quarter 1975) and total real US investment spending fell by 23 per cent between the March-quarter 1974 and the June-quarter 1975.

In that period, real growth in household consumption expenditure was largely flat.

In that context, the fiscal response of the US government was very effective but insufficient.

But the events that occurred in the world economy at that time painted a picture of chaos and policy failure and that was exploited by the mainstream of the economics profession (particularly in the US).

It abandoned the idea that counter-cyclical macroeconomic policy could stabilise real GDP growth in the face of a collapse in non-government spending.

There were three elements to this rejection:

1. The broad acceptance of the notion of a ‘natural rate of unemployment’, which meant that policymakers would only cause accelerating inflation if they tried to use fiscal and monetary policy to reduce unemployment.

2. The broad acceptance of the notion that fiscal policy was dangerous due to lags implementation and impact and that deficits were corrosive to incentives and undermined private sector investment spending. As a corollary, it was broadly accepted, as central Monetarist doctrine, that economic stability required the growth of money to be stable and free from manipulation by government in a alleged vain attempt to reduce unemployment.

3. That the mass unemployment was the result of excessive real wages rather and an elevated ‘natural rate of unemployment’ which reflected subsidies to unemployment arising from income support policies and excessive minimum wages – both of which prevented the ‘free’ market from operating as the textbooks suggested.

Conclusion

In Part II, I will study the Modigliani intervention and its impact. We will see how he introduces the balance of payments bogey ‘person’ to supplement his belief that real wages were excessive.

This was a critical period in economic history because it marked the break with the full employment system which had moderated the excesses of capitalism.

The rejection of ‘Keynesian’ thought signalled the dawning of the neo-liberal period and a return to the indulgence of lightly regulated capital excess.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.