Evolutionary Keynesianism: A Synthesis of Institutionalist and Post Keynesian Macroeconomics

The dominant paradigm in mainstream macroeconomics is a synthesis of new Keynesian and new endogenous growth economics, which has modified the new classical and monetarist-based neoliberal macroeconomics known as the "Washington Consensus." The same model appears dominant in the United Kingdom and

perhaps in Euroland's European Central Bank and the EU countries as well. Evolutionary/institutionalist and Post Keynesian economics (IPK) offers a very different approach to policy making which could be characterized as "evolutionary Keynesianism."1 This paper compares and contrasts the two approaches to macroeconomics.2

Dominant (or hegemonic) in the mainstream means

1. The view of most policy advisors (Federal Reserve, Council of Economic Advisors, IMF, World Bank, Bank of England, European Central Bank).

2. Appearing in the most widely adopted textbooks and taught in the universities.

3. Taught and supported in the elite graduate schools.

4. Accepted by the majority of the profession.

The history of macroeconomics over the last fifty years can be interpreted as a dialectical struggle between two opposing visions of the economy (as in Schumpeter's "pre-analytic visions" with which economists begin their work):

1. Stable, tending toward short-run equilibrium at the natural rate of unemployment and potential output; tending toward a "steady state" long-run rate of growth determined by the rate of technological change and growth in inputs. Business cycles are caused by external disturbances or supply shocks. The role of the state should be limited to providing the necessary institutional infrastructure, especially property rights, money and competitive markets. This approach originated in classical economics and reappeared in new classical economics (NCE); it also underlies Solovian growth theory (see chaps. 5 and 11 in Snowden and Vane 2005 for good overviews of NCE and Solow-type growth model).

2. Inherently unstable, with unemployment usually greater than optimal, and capacity utilization lower than optimal. The actual growth rate is determined by short-run cycles in production as well as the factors cited in classical, NCE, and Solovian growth theory; the growth rate is usually lower than optimal. Demand is unstable and usually insufficient. Macro policy can improve performance greatly. Marx, Keynes, and institutionalist-Post Keynesian economists share this view of the economy.

3. New Keynesian economics (NKE) emerged in the 1980s; it occupies a third; intermediate position.

New Keynesian Economics

NKE accepts most of the NCE microeconomic core: flexible wages, prices, and interest rates lead the economy to the "natural rate" of unemployment (usually termed the NAIRU, or "non-accelerating rate of inflation unemployment rate"), which can be described as a Walrasian and Hicksian general equilibrium. But the adjustment process may take a long time due to "coordination failures" caused by inflexible wages and prices. The level of GDP fluctuates around the "potential" GDP, which is produced when unemployment is at the natural rate. Business cycles are temporary deviations from the long-run trend growth rate, caused by supply or demand shocks. The trend growth rate and the natural rate of unemployment are both "strong attractors" dominated by the rate of technological change and the institutional and historical factors which influence labor markets.

Large demand gaps can and should be offset by demand management policies, using monetary policy. Fiscal policy is too clumsy a tool because the political and implementation time lags are too long and the multiplier effects of fiscal policy are small. Therefore, fiscal policy is useful only for extreme crises and monetary policy should be used for normal stabilization situations; although "fine tuning" is impossible, "rough tuning" is possible. This represents a modification of the extreme laissez-faire/ nonintervention approach supported by NCE.

NKE recognizes the social costs of recessions and the importance of demand factors; it defends countercyclical monetary policy and advocates demand management using "constrained rules" such as (John) Taylor's rule. In most versions, the procedure is to estimate (or forecast) potential GDP and any demand gap and then adjust (nominal and real) interest rates to move actual GDP to its potential; monetary policy should target interest rates rather than the money stock since the velocity of money is unstable and the money supply is endogenous. Fiscal budgets should be balanced over the business cycle. (see Mankiw 1990 and Mankiw and Romer 1991 for descriptions of the NK approach.)

The principal contribution of NKE has been to provides microeconomic foundations that explain why wages and prices are sticky in modern economies (imperfect competition, management strategy, menu costs, information costs, contracts, and efficiency wages are often cited) and to model the implications of this market behavior for macroeconomics. NKE rationalizes state intervention to improve short-period macroeconomic performance. Reducing the natural rate of unemployment requires restructuring labor markets (increasing labor market "flexibility").

New Endogenous Growth Theory

Most NK economists also accept new endogenous growth theory (NEG), which first appeared in the late 1970s/early 1980s (Romer 1994 provides an account of the rise of NEG; see also chapter 11, Snowden and Vane 2005). NEG accepts the NCE/ NKE vision of the natural rate of unemployment and the Solow growth model equilibrium steady state growth rate (the latter determined primarily by technological change) as the normal states which the economy tends toward. NEG also accepts the NCE/ Solow argument that savings finances investment, so that an increase in the savings rate leads to more investment and at least temporarily a higher growth rate. But NEG rejects the NCE/Solow proposition that diminishing marginal returns to capital occurs as the capital/labor (K/L) ratio increases. Increasing returns are possible, so that the growth rate does not necessarily tend toward Solow's rate of technological change, the "steady state" growth rate for per capita real income.

Increasing or constant returns to capital are seen as possible due to phenomena such as

1. Effects of R&D, spillover effects, externalities, learning by doing, and the interrelationships between investment in fixed and human capital.

2. Economies of scale and scope across industries, technologies, and economies.

NEG implies that

1. Higher saving and investment rates can lead to permanently higher growth rates.

2. Conditional convergence of growth rates for countries with similar savings rates may not occur.

3. Poor countries will not automatically catch up to rich countries, even if they save a lot.

4. There exists a wide range of intelligent policy choices to promote growth, including public investment in fixed capital, human capital, research, and other forms of public infrastructure. Policy promoting high private investment (and saving) rates are growth promoting. Both NK and NEG support state intervention to promote the wealth of nations (full employment and higher growth rates); again, this is quite different from the "free market fundamentalism" and radical laissez-faire of new classical economics.

Institutionalist and Post Keynesian Economics: Evolutionary Keynesianism

Institutionalist and PK economists tell similar macro stories. The macroeconomics of first and second generation evolutionary or institutionalist economists such as John R. Commons, Thorstein Veblen, and Wesley Mitchell were similar to John Maynard Keynes' in many respects. Many of the recent contributors to institutionalist macroeconomics published in the JEI such as John Cornwall, Paul Davidson, Hyman Minsky, Basil Moore, and Randy Wray also contributed to Post Keynesian economics.3

Institutionalist and Post Keynesian economists argue that economic development is conditioned by and transforms economic institutions such as money, markets, and property rights: transformational growth leads to structural and institutional change (Nell 1992). Economies should be understood as complex systems with emerging properties that successively develop different laws of motion and pose different problems (Moore 1999). State intervention to create or change institutions is often necessary to promote the goals of full employment, economic growth, equity, social justice, and harmony. Given the emphases on institutional change, full employment, and demand management, "evolutionary Keynesianism or evolutionary macroeconomics" are appropriate terms for the IPK approach and models.

There are some similarities between IPK and NKE (the importance of aggregate demand is the chief common element), and IPK accepts much of NEG; there are, however, important distinctions between IPK and the orthodox consensus with respect to ultimate goals, assumptions, method, analysis, and policy.

Differences between IPK and NK/NEG

1. IPK-especially PK-emphasizes the importance of "fundamental" or "absolute uncertainty," Paul Davidson's "non-ergodicity," as a characteristic of the real world which has important implications for both theory and policy (2005). NCE and NKE economics both assume "probabilistic risk," which is more tractable but unrealistic.

2. The economy is inherently unstable because of this profound uncertainty-which implies great risk for many crucial decisions-and the resultant instability of expectations regarding profits from investment and the future price of assets. Financial instability and economic instability are dialectically interactive and must be constrained with appropriate institutions. Instability is not as important a concern in NKE economics, and financial markets are discussed largely as an afterthought. Financial markets and money are central to IPK macro (following Keynes' attempt to develop a "monetary theory of production." (see Davidson 2005, Niggle 2004, Rotheim 1998, and Setterfield 2002 for introductions to PK economics and contrasts between IPK and NKE/NEG.)

3. Economies are best understood as "complex systems" which are "self organizing" and exhibit "emerging properties" as they develop-using the insights and language of complexity analysis (Moore 1999). This proposition is a modern version of a core concept in original evolutionary economics: since institutions and economies evolve through historical time, theory must be institutionally specific if it is to be useful. Since the behavior of a complex system is not simply the outcome of the behavior of its components, the complexity proposition also means that we can't adequately understand an economy (a complex system) by observing the behavior of a component and extrapolating that behavior to the system as a whole (as Keynes observed in his "paradox of thrift" argument). Rather than the "microeconomic foundations of macroeconomics" (as in NCE and NKE) we need to understand the "macroeconomic foundations of microeconomics."

4. External shocks and inflexible wages and prices explain recessions and deviations from trend for NKE; IPK argues that even if wages and prices were flexible, full employment is not guaranteed. There is no unique natural rate or NAIRU which the economy gravitates toward and which acts as a strong attractor. IPK argues that flexible wages and prices would enhance instability since falling wages and prices in a recession would probably reduce profits, investment, and employment. Sticky wages, prices, and interest rates are a good thing; institutions which stabilize these are useful and should be developed (national collective bargaining; incomes policy).

5. IPK emphasizes insufficient aggregate demand as a cause for low growth as well as recessions (NKE only recessions). IPK advocates demand-enhancing policy, including inequality-educing tax, transfer and expenditure systems, low interest rates, and employer of last resort programs. Most IPK economists favor Lerner's "functional finance" theory of fiscal policy: the levels of taxation and government expenditure should be consistent with full employment and price stability (Nell and Forstater 2003).

6. Money is not neutral: changes in the price and availability of liquidity have powerful effects on the real economy; macroeconomics should begin with an analysis of the roles of liquidity in the economy, as in Keynes' "monetary theory of production." But IPK economists are skeptical regarding the power of monetary policy by itself and see fiscal policy as a more powerful tool for demand management. They are skeptical re "rules," in favor of "discretion" in policy.

7. IPK follows Keynes and Kalecki in arguing that savings do not finance or determine investment. Profit expectations, interest rates, and the availability and the cost of finance are the important influences on investment-not the flow of savings-since the former variables are largely independent of saving. Savings are determined by the level of income, itself determined by aggregate demand. The NK/NEG argument that policy should encourage higher saving is generally incorrect: high saving can mean low aggregate demand, capacity utilization, and investment.

8. IPK puts a higher priority on full employment than on low inflation; full employment is understood as the rate of unemployment that obtains when everyone who desires employment and is willing to work at the going wage rate for workers with comparable skills is employed. Inflation is seen as the result of distributional struggles between capital and labor which can lead to "cost push" inflation. Again, institutions which socially control wages, prices, and the distribution of income are necessary for full employment and price stability-some form of incomes policy. Many (but not all) IPK economists argue for government employer of last resort programs as necessary for full employment (Wray 1998).

9. IPK sees a strong reinforcing link between demand, cycles, and growth: high demand leads to high employment and capacity utilization, which leads to high investment, which leads to higher productivity in the next period (higher growth).

10. The distribution of income influences aggregate demand. More equality is demand, investment, profit, and growth enhancing.

11. IPK proposes "demand-led" growth economics; propositions 7, 8, 9, and 10 are not in NKE/NEG; IPK is richer and has more explanatory power and more usefulness in informing the design of macro policy. (See the essays in Cornwall and Cornwall 2001, Setterfield 2002, and Nell 1992.)

12. Most IPK economists favor some form of exchange rate regime which would reduce exchange rate instability; most NKE economists accept flexible ER systems (Davidson 2002).

13. IPK economists favor financial market regulation and see unregulated markets as instability enhancing (Isenberg 2000); most NK economists see financial instability and crises as occasional episodes which can be handled on an ad hoc basis.

What Do Economists Actually Believe about Macroeconomics?

Most macroeconomic textbooks and surveys of modern macroeconomics such as Brian Snowden and Howard R. Vane's Modern Macroeconomics (2005, chapter 12) argue that there is an emerging consensus among macroeconomists based upon a new Keynesian-new economic growth theory model. On the other hand, IPK economists argue against the validity of this consensus (for example, Arestis and Sawyer 2004, Nell and Forstater 2003, Lavoie and Seccareccia 2005, and the contributors to the JPKE Symposium cited in note 1).

Dan Fuller and Doris Geide-Stevenson (2003) surveyed a random sample of 1,000 AEA members; they report "fluidity" and not much consensus regarding macroeconomics among the (298) respondents to their survey. The reported views on eighteen macro propositions indicate as much support for propositions consistent with IPK as for NKE or NCE propositions, suggesting that IPK views are fairly widely accepted and that they might become more widely accepted in future.