\t\t\t\tI 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.
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This part of the story begins in 1977 with the publication of a academic article in the Italian journal Moneta e Credito<\/em> by Franco Modigliani and Tommaso Padoa-Schioppa – La politica economica in una economia con salari indicizzati al 100% o pi\u00f9<\/a>.<\/p>\n [Full Reference: Modigliani F. and Padoa-Schioppa, T. (1977) ‘La politica economica in una economia con salari indicizzati al 100% o pi\u00f9’, Moneta e Credito<\/em>, 117, 3-53.<\/p>\n An extensive revision came out in English in 1978 – The Management of an Open Economy with ‘100% Plus’ Wage Indexation<\/a>, Essays in International Finance<\/em>, Princeton University, 130, 221-259].<\/p>\n According to Italian academic, Francesco Cattabrini, this paper began a vigourous debate in Italy at the time, which was dubbed the “Modigliani controversy”.<\/p>\n [Reference: Cattabrini, F. (2012) ‘Franco Modigliani and the Italian Left-Wing: the Debate over Labor Cost (1975-1978)’, History of Economic Sword and Policy<\/em>, 75-95].<\/p>\n 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.<\/p>\n 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.<\/p>\n The NAIRU became the full employment unemployment rate despite elevated levels of unemployment persisting.<\/p>\n 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.<\/p>\n 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.<\/p>\n According to the underpinning mainstream assumptions about rational choice, such unemployment was an optimal outcome.<\/p>\n Please read my blog – The dreaded NAIRU is still about!<\/a> – for more discussion on this point.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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”.<\/p>\n Pasinetti concluded that:<\/p>\n \nIf 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’?\n<\/p><\/blockquote>\n [Reference: Pasinetti, L (2005) ‘How much of John Maynard Keynes can we find in Franco Modigliani?’ BNL Quarterly Review<\/em>, LVIII(233-234), June-September, 21-39].<\/p>\n In this 2009 blog – Those bad Keynesians are to blame<\/a> – I explain that using the term ‘Keynesian’ to describe a unified theoretical position with associated policy understandings is quite misleading, without further context.<\/p>\n 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:<\/p>\n 1. Keynes and the Classics – Part 1<\/a> <\/p>\n 2. Keynes and the Classics – Part 2<\/a> <\/p>\n 3. Keynes and the Classics – Part 3<\/a> <\/p>\n 4. Keynes and the Classics – Part 4<\/a> <\/p>\n 5. Keynes and the Classics – Part 5<\/a> <\/p>\n 6. Keynes and the Classics – Part 6<\/a> <\/p>\n 7. Keynes and the Classics – Part 7<\/a> <\/p>\n 8. Keynes and the Classics – Part 8<\/a> <\/p>\n 9. Keynes and the Classics – Part 9<\/a> <\/p>\n The publication of Keynes’ 1936 The General Theory of Employment, Interest and Money<\/a> – representated a major challenge of the neo-classical thought that dominated until the Great Depression.<\/p>\n In his Collected Works (Volume XXVIII), a letter Keynes had written to George Bernard Shaw on January 1, 1935 stated that:<\/p>\n \nI 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.\n<\/p><\/blockquote>\n So it is clear that Keynes conceded, in his inimitable modesty (not!), that his 1936 work was offering a paradigms break from the extant<\/em> 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.<\/p>\n 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.<\/p>\n 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).<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n In this context, the equilibrium means that there were no forces in the non-government sector to disturb the current state of affairs.<\/p>\n Keynes clearly considered that government intervention was necessary to ensure that under-full employment stalemates didn’t arise – due to lack of aggregate demand.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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). <\/p>\n 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.<\/p>\n 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”:<\/p>\n \nI. The wage is equal to the marginal product of labour<\/p>\n 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.\n<\/p><\/blockquote>\n Postulate I related to the neo-classical demand for labour theory and Postulate II described its labour supply theory.<\/p>\n 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.<\/p>\n This allowed him to introduce the idea of ‘involuntary unemployment’, which was the product of deficient spending rather than excessive and rigid real wages.<\/p>\n At that point, Keynes made the classic remark:<\/p>\n \nThe 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.\n<\/p><\/blockquote>\n 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<\/strong> 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.<\/p>\n Keynes wrote (Chapter 2, Section V):<\/p>\n \nIn 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 …\n<\/p><\/blockquote>\n 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.<\/p>\n 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”.<\/p>\n In other words, he accepted that there was an inverse relationship between real wages and employment.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n 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.<\/p>\n [References: Dunlop, J. (1939) The Movement of Real and Money Wage Rates<\/a>, The Economic Journal<\/em>, 48(191), September, 413-434.<\/p>\n