May 24, 2016

Could we, please, all focus on the key question of economics?

Comment on Paul Davidson on ‘Krugman and “what Keynes really meant”’


Keynes characterized the situation as follows: “Though we all started out in the same direction, we soon parted company into two main groups. What made the cleavage that thus divided us?” (See intro)

The key question that divides Orthodoxy and Heterodoxy is, in Keynes’s own words: “... is the existing economic system in any significant sense self-adjusting.”

You say “the key question is what causes changes in employment and output in a capitalist market oriented economy?”

I have answered this question above with the elementary structural employment equation which is given here. From this equation follows:
(i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio).
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.

Item (i) and (ii) cover Keynes’s arguments about effective demand. So, the structural employment equation contains your argument about the determinants of employment: “The answer is changes in the market demand for the products of industry.”

Can we put this undisputed stuff now aside? The critical point is that the original Keynesian multiplier 1/1-c is incomplete, to put it mildly (2012). What is missing is the ratio rhoF as defined in (iii). This variable embodies the price mechanism. It works such that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa.

Now, every half-witted supply-demand-equilibrium economist fancies that the remedy for excess supply in any market is a reduction in price. From whence the claim comes that wage reductions will — in principle — restore full employment. This is the essence of the self-adjustment claim. The strong version, though, is regularly wish-washed by admitting practical hindrances, delays, and imperfections.

The structural employment equation says that wage reductions INCREASE unemployment which means that the market system is — in principle — self-destabilizing. The structural employment equation is composed of measurable variables and therefore readily testable. So, Keynes’s key question is unequivocally answerable.

What Post Keynesians have overlooked is that there are TWO ratios in the multiplier, the expenditure ratio rhoE and the factor cost ratio rhoF. For economic policy this means: an increase of the expenditure ratio can be counteracted at any time by a decrease of the factor cost ratio, that is, by a falling average wage rate or by a rising average price. The hitherto missing variable explains why Keynesian demand policies are sometimes effective and sometimes ineffective.

This, though, is an implication of the key point. The key point is that the price mechanism does NOT stabilize the market system, neither in the short nor in the long run. This systemic feature cannot be cured by Keynesian demand management.

The correct answer to Keynes’s question “is the existing economic system in any significant sense self-adjusting?” is NO because (i) aggregate demand is not self-adjusting, and (ii), the structural interrelation between (average) wage rate, price, productivity, and employment moves the system farther away from full employment (2014).

Post Keynesians have to be criticized for overlooking (ii) which proves that they have no idea about how (a) the price mechanism works, and (b), the profit mechanism works.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014). The Truly General Theory of Employment: How Keynes Could Have Succeeded. SSRN Working Paper Series, 2406891: 1–25. URL

Immediately preceding post 'What Keynes really meant but could not really prove'.