Neoclassical economists and the financial crisis: an interview with the distinguished Keynes biographer, Robert Skidelsky.
Robert Skidelsky is the author of a definitive three-volume biography of the economist John Maynard Keynes and a professor emeritus of economics at the University of Warwick. Skidelsky’s most recent book, Keynes: The Return of the Master, draws upon his earlier work to address the renewed interest in Keynes’s ideas the economic crisis has sparked, and updates Keynes’s status in the intellectual history of economics.
In The Return of the Master, Skidelsky lays out the argument that neoclassical economics, ascendant since the early 1980s under the leadership of economists at the University of Chicago, bears most of the responsibility for the financial crash and economic recession. He pinpoints three neoclassical concepts that led academics and policymakers astray: the rational expectations hypothesis, the real business cycle theory, and the efficient financial market theory. The misguided conclusion yielded from these premises is that “all risk can be correctly priced and that therefore financial markets are optimally self-regulating,” Skidelsky writes. He believes that Keynes, on the other hand, adequately incorporated the effects of uncertainty into his models.
The Return of the Master bookends an August 1981 Spectator essay by Skidelsky that noted the decline of Keynesian ideas in economics and lamented the academy’s loss of Keynes’s most important contributions to economic knowledge. To understand the full circle of his historical narrative, I asked Prof. Skidelsky a few questions about his new book and his thoughts on the current state of macroeconomics, and he graciously fielded them.
JL: In your August 1981 Spectator article, you wrote that Keynes’s original, narrow prescriptions were “turned into a pseudo-Keynesian pseudo-solution to the much more fundamental problems of governing divided societies, thereby bringing the inevitable crisis and reaction.” Do you see hope for a Keynesianism that is more politically sensible and modest in its approach? Also, if the Washington Consensus has now reached its own “inevitable crisis,” do you worry that economists will similarly forget lessons about technical economics learned from the neoclassicists?
RS: What I really meant by “pseudo-Keynesian pseudo-solution” was the attempt to prop up demand-management by controls over wages and prices. Keynes would not have approved of this extension of his ideas. What was needed — and lacking — in the Keynesian tool kit of the 1960s was any notion of the “natural rate of unemployment.” This was supplied by Milton Friedman, and is his greatest contribution to economics. Naturally we should learn from Friedman. I don’t think, on the other hand, there is much to learn from Robert Lucas and the new classical economists.
JL: In your book, you favorably contrast the “Keynesian” regime era in the United States, from the postwar period to the mid- to late-'70s, with the “Washington Consensus” years that followed. If you count the late-'70s stagflation era as under the Keynesian regime, however, that comparison might not reflect as well on Keynes. What is the logic behind absolving Keynes from those bad economic policies but crediting him with the growth of the 1950s and '60s?
RS: As I write in chapter 5, most comparisons between the Keynesian and the new classical era simply compare pre- and post-1973 — the time of the first OPEC shock — so in a sense I’m being more lenient in favour of the latter period than convention. The Keynesian era effectively ended in the early 1970s with the breakdown of the Bretton Woods system and the OPEC oil shock. Government failure to secure a coordinated reaction to the oil shock of 1973 meant, as one commentator — Stuart Holland — has said, that “within months it was hard to find an avowed Keynesian in any Chancellery or Treasury.” I’m not denying that the Keynesian regime was deteriorating by the end of the 1960s, but the two main triggers of “stagflation” — the Vietnam War and OPEC — can’t be blamed on Keynesian policy advisers. The mid-and late-1970s were tumultuous both theoretically and empirically and are therefore better not lumped together with any broad school of policy.
JL: In closing your narrative, you make the unusual proposal that students of economics should be required to master different and complementary fields, such as history or political science, when pursuing economics doctorates. But so far economics departments seem entirely unrepentant in their ways, despite the recent failures of their profession. Do you see your suggestion gaining traction in any schools or with any other economic thinkers?
RS: I don’t think that we can expect this kind of structural change to occur quickly. Remember that only a bit more than a year ago most people still did not see the end of the boom. Commodity prices had peaked and there was definitely a sense of anxiety amongst those who followed the movements of asset prices but the night before Lehman collapsed most economists were sleeping blissfully ignorant. It was not until the 24th of October — roughly six weeks later — that Alan Greenspan admitted to a “flaw” in the “intellectual edifice” and that the economic crisis became accepted as a crisis for economics. There has only been one academic year in between then and now. Universities move slowly. We have yet to see the full impact of the current crisis on the way economics is done. But there are many straws in the wind. Even if my specific suggestions are not acted on, there is agreement among many economists that economics is over-burdened with maths, and that realism is sacrificed for the sake of mathematical tractability. In his review of my new book, Paul Krugman supported the general idea of restructuring economics although he might have thought my actual proposal too extreme. However, I maintain that the seemingly extreme attraction of false perfection offered by microeconomic mathematisation requires “extreme” countermeasures.
JL: The name of Paul Davidson, a relatively unheard-of heterodox economist in the Post Keynesian school, comes up a lot in your book. Do you see Post Keynesians as having a better grasp of the uses and limitations of Keynes’s theories? In an interview, Davidson told me that Keynes’s current prescription for the U.S. would be a much larger stimulus than we currently have, lasting until well after panic has subsided, the Fed rate is back above the zero lower-bound, and the economy is back to steady growth (this interview was in the spring, so his opinion might have changed). Is that what you would have expected?
RS: I agree with Paul. Keynes would have been pleased to see that our current governments had learnt something from the mistakes of the governments during the Great Depression. Rather than letting the last energies of a collapsing economy disappear into the abyss of depression, governments worldwide have shouldered the responsibility to provide stimulus. However, as the first so-called “green shoots” have appeared conservative economists spread alarm stories about the costs of continuing the stimulus. They seem to assume that now the banks have been rescued the economy will roar ahead as though nothing has happened. This strikes me as very dangerous. Recovery is still far too fragile for economies to be taken off their life-support systems. The talk about losing investor confidence is exactly what actually makes investors lose confidence in governments. Keynes would probably have pointed to the output gap numbers in America and elsewhere. The IMF expects the U.S. output gap — that is, the difference between what America can produce and what America does produce — to be around $600bn in 2009 and more than $800bn in 2010. That is because Americans are spending much less than they did when the economy was at full employment.
Keynes would have said that given the current state of expectations, aggregate spending would not recover spontaneously to fill the gap. Unless the government plugs the spending deficit, we will be stuck with high unemployment figures for a very long time to come. The U.S. stimulus plan amounts to roughly $680 billion and would therefore seem to match the 2009 gap rather well. However, those $680 billion are distributed over three years! This is the reason why Davidson, Krugman and [Martin] Wolf among others have advocated larger stimulus packages. And I agree. The sums required are huge, but the cost of letting the economy slip is much larger. The whole point of stimulus is to raise confidence in order to increase demand and investment. Thus, with more demanded and more produced tax revenue increases and the cost of social security decreases. In this sense, I believe that post-Keynesians like Davidson understand what Keynes’s take on our crisis would have been rather well.
JL: In the U.S., Keynes’s cause is being championed by Paul Krugman, most notably in a recent New York Times Magazine article that I’m sure you’ve seen. Do you have any thoughts on his argument regarding the neoclassical school’s ignorance of Keynes? Are there significant ways in which your thesis differs from his?
RS: Paul is not convinced that uncertainty lies at the heart of Keynes’s explanation why economies are not self-correcting following a disturbance. Indeed, he believes (I think) that Keynes never did provide a satisfactory explanation of this. He and other economists like [Nobel laureate Joseph] Stiglitz are “sticky price Keynesians.” Output adjusts to a shock because wages and prices are if not rigid, insufficiently flexible. This lack of flexibility is explained by information problems of one kind or another — either the information is too costly to acquire, or some economic agents have more information than others. Paul admits, though, that this type of theorising, which takes place within a rational expectations framework, doesn’t get to the heart of the problem of sticky prices. I believe that Keynes put it much more directly: wages and prices don’t adjust when the economy has started to slide because no one knows what the correct wages and prices are. Economic theory needs to start from the assumption of uncertainty, not of perfect information.
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