What is the neoclassical synthesis? How did it give rise to “theoretical schizophrenia” in post-war mainstream macroeconomics and how was this inconsistency resolved in subsequent contributions to mainstream macroeconomics?
An introduction of the neoclassical synthesis
The Neoclassical Synthesis formed the mainstream of macroeconomic thought after World War II, up until the early 1970’s. The macroeconomics was based on models formed around from an interpretation of John Maynard Keynes’s ideas in The General Theory of Employment, Interest, and Money (1936), starting with the IS-LL model introduced by John Hicks in Mr Keynes and the Classics: a suggested interpretation (1937). This model provided a starting point for a development for various extensions of Keynes’s analysis (Dixon and Gerrard, 2000), and was subsequently elaborated on by Modigliani (1944) and later modified and popularised in the United States by Hansen (1949, 1953) to produce the IS-LM system familiar to generations of economics students (Fletcher, 2002), and Paul Samuelson through his Principles textbook.
The Neoclassical synthesis was concerned with to what extent the principle innovations introduced by Keynes in The General Theory could be reconciled with the existing framework of neoclassical economics. Through its development, the Neoclassical Synthesis confirmed the validity of orthodox theory and subsumed Keynesian economics as a special case of the classical one; one relevant to policy making in a slowly, imperfectly adjusting real world. In the macroeconomic theory of the Neoclassical Synthesis, automatic adjustment to achieve full employment was apparent if money and prices are flexible, through the IS-LM and Pigou effect (Patinkin,1948).
In this essay, in chronological fashion, I will discuss a short history of the neoclassical synthesis, the popularity it gained through the ‘golden age of capitalism’, the theoretical schizophrenia that arose from the synthesis, its ultimate demise within the political context of the 1970’s, and subsequent contributions to mainstream economics resolving the inconsistencies within the synthesis, both in theory and what has come to be influential within mainstream economics/policy making. I will then discuss the legacy and the influence the synthesis has on today.
Origins of the Keynesian Revolution
To understand what the Neoclassical Synthesis was, it is of importance to first revisit the developments within mainstream economics preceding its materialisation. Disagreement in methodology has been a prevalent characteristic of the study of economics, with some theories lying dormant as they become irrelevant in analysing the economic phenomena or crisis of that given time. Therefore, it is of importance to draw attention to the fact that Macroeconomics is prone to ‘revolutions’; episodes of rapid change in majority opinion about how the economy functions, what policy can do about it, and, more fundamentally, about what analytic and empirical methods should be used to address these questions (Laidler, 2015).
In the General Theory, Keynes addressed the central issue of his generation (mass unemployment), and was based on an insight that saw a workable resolution of the problem, which had reached crisis proportions during the Great Depression (Dillard, 1978, p.712). Keynes’s General Theory started an avalanche within the macroeconomic discussion. By rejecting the money neutrality doctrine (the quantity theory of money), and substituting this with his liquidity preference theory of interest rates, and the arguing for an unemployment equilibrium (understood as the absence of the self-regulating forces), he captured the interest of younger economists (Jepersen, 2009, p.27).
Given that most of the theoretical advances which distinguish the Neoclassical from the classical period had been in microeconomic analysis, Keynes perhaps felt justified in regarding the macroeconomic ideas of the 1776-1936 period as being relatively homogeneous in terms of their broad message (Snowdon et al., 1994, pp.42). By lumping the Classicals and Neoclassicals together calling them all Classicals, he suggested that it was a term to be contrasted with Keynesianism (Colander, 2000). His General Theory of Employment, Interest, and Money (1936) both critiqued the orthodox school of the time, and offered a competing, more ‘general’ theory of the macro-economy (Solomon, 2010).
However, Keynes’ relation to Neoclassical theory in terms of microeconomics is more ambiguous. Keynes’s micro economic analysis, as with the mainstream economists who came before him based their theory on rationality, individually acting agents. On one hand, Keynes accepted the Marshallian single market partial equilibrium price mechanism. On the other hand, he rejected the capacity of the price system to deliver full employment equilibrium in the economy as a whole (Palley, 2017), breaking away from Walrasian general equilibrium theory.
Classical economic theory, as with most economic theories within the Anglo-Saxon tradition, is based on the philosophies of Adam Smith (Palley, 2017), dubbed the father of laissez-faire economics. The revolution of Smith was against mercantile restrictions, his aim being to abolish barriers impeding on the efficient allocation of resources (Dillard, 1978, p.707). The significance of Say’s Law of markets, that supply creates its own demand, rests with its contradiction of the mercantilist case against free trade. This came to epitomize classical economics, for the simple reason that it was selected by Keynes for sacrifice to his new principle of effective demand (Steele, 1998). The Classical model of markets is self-adjusting, void of the need of outside influence or government intervention. Price levels and quantities are set at equilibrium, where all participants can satisfy their incentive driven goals through voluntary exchange within the free market is driven by the self-interest of agents.
Not all classical economists accepted Say’s Law and its implications. Robert Thomas Malthus, in ‘underconsumptionist’ tradition, argued that a general glut of commodities (demand deficit) was possible. This is in contrast to the Ricardian position of full employment as the normal condition, which became a standard assumption of classical economics. Keynes believed this was a wrong turn for economics (Palley, 2017), and claimed Malthus as his predecessor in appreciating the possibility of underemployment equilibrium (Dorfman, 1989). For this reason, Keynes gave high praise to Malthus for anticipating his own ideas with respect to a general deficiency of aggregate demand (Snowdon et al., 1994, pp.55). Ricardo concerned with the long run, whereas Malthus, like Keynes, was more concerned with the short run. This can be demonstrated in one of Keynes’s most quoted aphorisms; ‘in the long run we are all dead’. Keynes argued that there was no long run; only a constant succession of short runs (Foley, 2006, p.199).
The methodology of classical macroeconomics is the theory of behaviour of the economy as a whole by the aggregation of the behaviour of the individual agents. In Keynes’s observation, the aggregate does not behave in the same way as the economic agent, illustrating a fallacy of composition. In somewhat ‘underconsumptionalist’ fashion, this was observed famously in what is known as the paradox of thrift. This is seen as a critique of methodological individualism, which is at the core of neoclassical/classical method. Methodological individualism is based on the rational, optimising behaviour of individuals, extending their pursuit of self-interest to the formulation and use of expectations in the context of perfectly working markets only disturbed by exogenous shocks. His central contribution to economics was his critique of orthodoxy, particularly the notion that markets were self-correcting (Solomon, 2010).
Developments of orthodox Keynesianism
In a relatively Classical interpretation of Keynes, John Hicks’s Mr Keynes and the Classics undertook a construction of Keynes’s message in The General Theory (Rima, 2009, p.520), laying the groundwork for the Neoclassical Synthesis. Hicks’s model shows how the market for economic goods, expressing the principle of effective demand, represented by the IS curve, interacts with the money market (equilibrium between liquidity preference and the money supply), LL (now commonly referred to as the LM curve). While the Hicksian model provided an interpretation of the ‘analytical core’ of the General Theory, it was not intended to capture all that was contained within the book. This is emphasised by post Keynesians and disequilibrum models. Hicks mentions himself in IS-LM: an explanation (1980) that he grew dissatisfied over time with the model.
Modigliani’s 1944 Liquidity Preference and the Theory of Interest and Money article is considered one of the most important efforts to reconcile Keynes with classical economic thinking. By integrating Pigou’s argument that only rigidity in real wages could explain persistent unemployment (Jespersen, 2009, p.27) into the Keynesian model, he suggested that the only difference between the opposing systems were that in Keynes’ system, money wages did not fall as unemployment rose, as would happen in classical economic theory. The Pigou effect states that an increase in the real money supply, brought about through a decrease in the price level, implies an increase in real wealth and hence an increased demand for commodities. Assuming the existence of a liquidity trap, the literature argues that the Pigou effect could get the economy out of the trap (Rabin and Keilany, 1986). Therefore, in theory through the IS-LM and Pigou effect, the classical dichotomy is restored, and underemployment equilibrium is dependent on wage rigidity. Therefore, involuntary unemployment, in Modigliani’s interpretation of Keynes, was still consistent with classical theory; it was simply brought about by workers who were unwilling to accept pay cuts in order to remain employed (Rancan, 2017).
Popularisation of orthodox Keynesianism
The impact of the IS-LM framework was delayed temporarily by a general equilibrium interpretation of Keynes’s system that Samuelson has dubbed the Keynesian cross (Rima, 2009, p.520). However, Professor Alvin Hansen made the IS-LM framework the basis of his work detailing policy prescriptions for the United States in the period just before and immediately after World War II, resulting in its popularisation and led to this approach often being referred to as the Hicks-Hansen model (Minsky, 2008).
The Neoclassical Synthesis version of Keynesianism took rigidity as a given, subsequently arguing for aggregate demand stimulus as the practical solution to unemployment (Dequeech, 2018). The notion of ‘fine-tuning’ was popularised, in which fiscal and monetary policy would be used to adjust the level of aggregate spending until a full employment, noninflationary economy was achieved. Through the synthesis’s interpretation of the IS-LM model, the role of fiscal policy was emphasised. This was later contested by the Monetarists, led by Milton Friedman.
In the third edition of his Principles textbook, Paul Samuelson (1955) built on Keynes’s classification and turned it around on Keynes by developing the Neoclassical Synthesis, where Keynes’s dispute with Classical economists was resolved (Colander, 2000). Led by Samuelson, many post-war economists believed the complementarity of Keynesian macroeconomics and Neoclassical microeconomics through the Neoclassical Synthesis, and that both doctrines could coexist peacefully.