Another installment of my slowly-emerging book on Zombie Economics: Undead ideas that threaten the world economy. This is from the Beginnings section of the Chapter on Micro-based Macro. I’ve now posted drafts of the first three chapters (+Intro) at my wikidot site, so you can get some context. In particular, before commenting on omissions, take a quick look to see that the point hasn’t been covered elsewhere.
Macroeconomics began with Keynes. Before Keynes wrote The General Theory of Employment, Interest and Money, economic theory consisted almost entirely of what is now called microeconomics. The difference between the two is commonly put by saying that microeconomics is concerned with individual markets and macroeconomics with the economy as a whole, but that formulation implicitly assumes a view of the world that is at least partly Keynesian. Long before Keynes, neoclassical economists had both a theory of how prices are determined in individual markets so as to match supply and demand (‘partial equilibrium theory’) and a theory of how all the price in the economy are jointly determined to produce a ‘general equilibrium’ in which there are no unsold goods or unemployed workers.
The strongest possible version of this claim was presented as Say’s Law, named, somewhat misleadingly, for the classical economist Jean-Baptiste Say. Say’s Law, as developed by later economists such as James Mill, states, in essence, that recessions are impossible since ‘supply creates its own demand’. To spell this idea out, think of a new entrant to the labour force looking for a job, and therefore adding to the supply of labor. According to the classical view of Say’s Law, this new worker plans to spend the wages he or she earns on goods and service produced by others, so that demand is increased by an exactly equal amount. Similarly, any decision to forgo consumption and save money implies a plan to invest, so planned savings must equal planned investment and the sum of consumption and savings must always equal total income and therefore can’t be changed by policy. Say’s argument allows the possibility if prices are slow to adjust, there might be excess supply in some markets, but implies that, if so, there must be excess demand in some other market. It is this idea that is at the core of general equilibrium theory.
The first formal ‘general equilibrium’ theory was produced by the great French economist Leon Walras in the 1870s. Walras, like many of the pioneers of neoclassical economics, was inclined towards socialist views, but his general equilibrium theory was used by advocates of laissez-faire to promote the view that, even if subject to severe shocks, the economy would always return to full employment unless it was prevented from doing so by government mismanagement or by the actions of unions that might hold wages above the market price of labour.
The point of Keynes’ title was that “general equilibrium” was not general enough. A fully general theory of employment must give an account of equilibrium states where unemployment remains high, with no tendency to return to full employment.
In the simplest version of the Keynesian model, equilibrium can be consistent with sustained unemployment because, unlike in the classical account of Say, the demand associated with workers’ willingness to supply labour is not effective and does not actually influence the decisions of firms. So unsold goods and unemployed labour can co-exist. The second part of Keynes’ analysis shows that the standard monetary mechanism by which equilibrium should be restored, may not work in the extreme recession conditions referred to as a ‘liquidity trap’. This concept is illustrated by the experience of Japan in the 1990s and by most of the developed world in the recent crisis. Even with interest rates reduced to zero, banks were unwilling to lend, and businesses unwilling to invest.
Keynes General Theory provided a justification for policies such as public works programs that had long been advocated, and to a limited extent implemented, as a response to the unemployment created by recessions and depressions ( Jean-Baptiste Say himself supported such measures in the early 19th century). More generally, Keynes analysis gave rise to a system of macroeconomic management based primarily on the use of fiscal policy to stabilise aggregate demand. During periods of recession, Keynes analysis suggested that governments should increase spending and reduce taxes, so as to stimulate demand (the first approach being seen as more reliable since the recipients of tax cuts might just save the money). On the other hand, during booms, governments should run budget surpluses, both to restrain excess demand and to balance the deficits incurred during recessions.
At first, it seemed, both to Keynes’ opponents and to some of his supporters, that Keynesian economics was fundamentally inconsistent with traditional neoclassical economics. But the work of John Hicks and others produced what came to be called the Keynesian-neoclassical synthesis, in which individual markets were analyzed using the traditional approach (now christened ‘microeconomics’) while the determination of aggregate output and employment was the domain of Keynesian macroeconomics.
The synthesis was not particuarly satisfactory at a theoretical level, but it had the huge practical merit that it worked, or at least appeared to. In the postwar era, the mixed economy derived from the Keynesian-neoclassical synthesis provided an attractive alternative both to the failed system of laissez-faire reliance on free markets and to the alternative of comprehensive economic planning, represented by the (still rapidly growing) Soviet Union. Modified to include a theory of market failure, neoclassical microeconomics allowed for some (but only some!) government intervention in particular markets to combat monopolies, finance the provision of public goods and so on. Meanwhile, the tools of Keynesian macroeconomic management could be used to maintain stable full employment without requiring centralised economic planning or controls over individual markets.
 That is not to say that no-one paid attention to the economic issues with which macroeconomics is concerned: the business cycle, inflation and unemployment. On the contrary, the early 20th century saw the beginnings of serious empirical research into the business cycle, most notably by the National Bureau of Economic Research, established in the US. And there were some important theoretical contributions, from economists such as Irving Fisher. Most notably, the great economists of the Austrian School, FA von Hayek and Ludwig von Mises, produced an analysis of the business cycle based on fluctuations in credit markets that remains highly relevant today. But neither Fisher nor the Austrians took the final steps needed to create a theory of macroeconomics, and the Austrians in particular recoiled from the implications of their own ideas.