In this paper, we examine a Copernican Revolution in American economics. Much of the old economic orthodoxy will have to be discarded and replaced by new ideas – some already being tried – if our country is going to survive and prosper. We demonstrate that the new theory is based on a model of systemic interaction between the financial sector and the “real” economy, perhaps representing best today what Keynes was aiming at in his General Theory. We understand this as an attempt to move toward a unified framework of economic analysis.
The two major components of this Copernican Revolution are 1) Microeconomics should be modeled on Keynes’ “income-expenditure” framework, and 2) Macroeconomics must be built on the nexus between finance and industry, which in turn is mediated by currency.
Instead of laying out this new Copernican Model in detail here (we do so elsewhere), we shall simply provide a few hints to whet the appetite of the reader. Consider the following seven points:
It is widely acknowledged that Keynes’ “income-expenditure” paradigm can be used to describe how economies behave over time. It describes a multi-period economy in which all the future benefits derived from production are distributed (immediately or eventually) to owners of productive assets as income. The flow of (present and future) income influences the extent to which those same assets are employed in the “real” economy at any point in time.
Keynes’ model is very different from the Walrasian model, where equilibrium occurs over a single time period and all prices and quantities adjust simultaneously to achieve that equilibrium (which may be unstable). The two models are also different from the neoclassical marginalist paradigm, where equilibria between supply and demand occur at each point in time as a direct result of optimizing behaviour.
In contrast to these other approaches, Keynes’ model is intended as a flexible generalization of “ordinary” microeconomics. This is appropriate, because Keynes’ life work was on the connection between saving and investment. Thus his model of the economy is intended to represent both microeconomic decisions (decisions about saving, consumption, working time) and macroeconomic outcomes (investment over time).
His new model showed that an increase in savings leads to lower interest rates (with a lag) as the markets for securities adjust. The lower interest rates encourage entrepreneurs to invest more and lead to an increase in income and employment over time – that is “the multiplier effect.” This came to be known as Keynes’ “General Theory” because of his efforts to link macroeconomics and microeconomics together, and because of its transformative impact on economics after 1936.
Keynes’ income-expenditure model has been the main theme of post-World War Two economic theory and of macroeconomic policy. It has been taught in graduate schools of business and economics and applied everywhere in the world where more than trivial amounts of money matter to decision makers. Despite its enormous success, however, the Keynesian model has a number of well known limitations that have become more and more troublesome over time.
One limitation is that the multiplier effect does not work in reverse – a reduction in income leads to a downward spiral as sales decline and layoffs occur. A second limitation is that an increase in savings does not necessarily lead to an increase in investment, and even if it does lead to lower interest rates this is not sufficient to ensure an increase in investment. A third limitation (discussed most recently by Minsky) is that the ability of income earners to service their debts depends at least partly on the level of income they receive. If incomes decline, debt defaults increase and financial crises may occur.
This last limitation is particularly troublesome, because a decline in income does not necessarily lead to a decline in spending – a decline in debt servicing reduces spending and causes an additional decline in income. These three limitations have led some economists over the past few decades to suggest that the employment level should be managed by fiscal policy (changing taxes and/or spending) or by monetary policy (changing interest rates or the money supply).
This approach has had some success, but it is far from satisfactory because of the unusual nature of the link between macroeconomic outcomes and microeconomic decisions. At a detailed level it is relatively easy to see how changes in spending lead to changes in output and employment. But it is not clear how to explain increases or decreases in overall levels of spending and output, and the factors that influence these changes. Nor is it clear how aggregate outcomes (interest rates, inflation, money supply growth) relate to microeconomic decisions.
The current structure of macroeconomics has been called a “black box” because its internal workings are not clear. This is generally considered a serious shortcoming by academic economists because it prevents testing and eliminates the possibility of falsification that characterizes science. However, given the limitations in Keynes’ model and Krugman’s extension while keeping its basic framework intact, it is tempting to suggest that there might be an alternative approach – one which allows for self-reinforcing cycles in financial markets and does not rely on the multiplier effect.