Brendan Sheehan

Has Reform of Global Finance been Misconceived? Policy Documents and the Volcker Rule

Abstract The focus from mainstream economics on the global financial crisis (GFC) has been relatively narrow, based on an underlying narrative and this focus has extended to and informed the majority of major institutionally commissioned reports, analyses, and pre-policy documents, which might collectively be termed an elite position. Specifically, there has been a focus on the role of neo-classically informed theory as a cause of the crisis. This has tended to reduce problems of economic theory to problems of neo-classical economics and this then has helped to shape the context of engagement with problems of the GFC. Much of the subsequent reform has been about preparing for failure rather than questioning why we have a system that fails and the issues here can be illustrated using the implementation of the Volcker Rule in the USA.

The Propensity to Consume and the Multiplier

From the time of Smith and Ricardo the classical school tends to view consumption in a negative light, even though it is by far the largest aggregate in total economic activity. From the classical perspective consumption spending is unproductive, acting as a fetter on the amount a community saves and invests, thereby retarding long-term economic growth. Having rejected Say’s law Keynes is able to properly appreciate the central role of aggregate consumption expenditure in determining aggregate effective demand and employment. Keynes is the first mainstream economist to treat consumption spending as an ultimate independent variable. For Keynes this represents a pivotal break with the classical frame of reference.

The Practical Theory of the Future

With Say’s law the classical school has little need for an explicit macroeconomic theory of investment. Moreover when the classical school does discuss investment demand, the calculus of probability means that they seriously underestimate the capricious nature of longterm profit expectations. Freed from such classical notions, Keynes’ task in the General Theory is to outline a rigorous theory of aggregate fixed investment spending.

The Classics, Keynes and the Keynesian Mainstream

This final chapter will assess the contention set out in Chapter 1 that an orthodox counter-revolution has effectively smothered Keynes’ more profound, but discomforting, insights. Consequently Keynes’ hope of revolutionising the way we think about economic problems and policies has failed. If true, this is a damning indictment of mainstream Keynesianism.

Consumption and Effective Demand

This chapter will explain how the consumption function underpins the derivation of aggregate effective demand in the General Theory model. The purpose is to make clear the connections between the materials in Chapters 3 and 4. Keynes alludes to these linkages in the General Theory but does not amplify them. The chapter will demonstrate that, given the level of aggregate investment spending, the value of the propensity to consume determines effective demand; it highlights the way in which changes in the propensity to consume influences the level of effective demand, and hence the volumes of employment, income and saving. The forces that determine investment spending and cause it to fluctuate are discussed in the forthcoming Chapters 6, 7 and 8.

The Inducement to Invest — A Theory of Investment

This chapter considers the theory of aggregate fixed investment spending that Keynes incorporates into his General Theory model. Having rejected Say’s law Keynes begins by formulating an analysis of investment demand from the viewpoint of entrepreneurs. He introduces the marginal efficiency of capital schedule (or investment demand curve) that sets out the terms on which entrepreneurs demand funds in order to initiate investment projects. The marginal efficiency is largely dependent on the state of long-term expectation which is derived in ways outlined in the previous chapter. As durable capital equipment links the economic present to the future, the marginal efficiency capital schedule is the primary channel by which expectations of the future influence present day spending decisions in the General Theory model.

Employment and Unemployment

This chapter brings together a range of themes about employment and unemployment in the General Theory model. First the chapter focuses directly on the relationship in the General Theory model between the key independent variable of aggregate effective demand and the main dependent variable of employment. This can be represented by what Keynes calls an employment function, which is strongly related to the aggregate supply function outlined in Chapter 3. The employment function allows Keynes to define different equilibrium volumes of employment generated by different levels of effective demand; it can additionally be used to define a full employment position free from reliance on the classical postulates.

Prices and Real Wages

The previous chapter examines the impact on employment of changes in money wages and prices that are not due in the first instance to changes in the level of effective demand. This chapter considers a separate issue: namely the changes in money wages, prices and real wages that are in response to variations in effective demand and output. The classical theory of money and prices is of little use in examining these responses, for it only applies to the special circumstances of a fully employed economy with effective demand assumed constant. In addition Keynes has severe reservations about the classical dichotomy between the theories of prices and value. In contrast Keynes’ General Theory model provides a generalised explanation of the response of money wages, prices and real wages to changes in effective demand. In doing this Keynes integrates the theories of value and prices, and this provides a springboard for his generalised analysis of prices and inflation.

Money Wages, Employment and Effective Demand

So far in this book the analysis has been conducted assuming the general level of money wages — and the wage unit — is given. Keynes however does allow money wages to change and this chapter will explain the implications of this for the General Theory model. In the process the chapter explodes the most erroneous myth perpetrated by mainstream Keynesians: that Keynes’ General Theory model assumes money wages are constant. Nothing is further from the truth. Indeed Keynes’ treatment of the impact that a cut in the general level of money wage has on total employment is a crucial part of his claim that his model is more generally applicable than the classical analysis.

Fluctuations in the Inducement to Invest

Keynes uses short-period changes in the state of long-term expectation working through the marginal efficiency of capital and the money rate of interest to explain fluctuations in the inducement to invest. This chapter completes the explanation of why the inducement to invest is inherently unstable in character in a capitalist economy. The chapter also highlights the impact that changes in the level of fixed investment spending have on effective demand and employment.