Through the ‘golden age of capitalism’, with Paul Samuelson’s influence, and publication of his vastly popular Economics (1955), the Neoclassical Synthesis seemingly triumphed the mainstream of economic thought. In the way of the synthesis, students of economics were introduced to Adam Smith’s invisible hand and the fundamental theorems of welfare economics in microeconomics, followed by macroeconomic courses focusing on the failures of the market economy and the role of government in correcting them (Greenwald and Stiglitz, 1987). However, these inconsistencies between the micro and macro, referred to as theoretical schizophrenia, ultimately led to the Neoclassical Synthesis’s demise. I will now discuss the sources of these inconsistencies, and how they have subsequently been resolved within the body of mainstream macroeconomics.
To look at this, we must first revisit the notion of methodological individualism and fallacy of composition. In theory, the macro economy as suggested by the synthesis, should be aggregation of agents/individuals. In the dominant microeconomic approach (from neoclassical), Walrasian general equilibrium theory is employed where all markets clear, relying on the price mechanism, rationality, perfect information, competition, money being neutral (allow for temporary money illusion). In the macroeconomic approach (from orthodox Keynesianism) the market clears at a very slow pace and may not clear without government intervention, and therefore the market is not always in equilibrium. mention disequilibrium models – rejection of walrasian auctioneer The microeconomic model of the neoclassical synthesis did not allow for their macroeconomic model (Snowdon et al., 1994, pp.110).
Keynes gained influence at a time where mathematical models in mainstream economics was becoming increasingly prevalent. While the Neoclassical Synthesis captured orthodox Keynesian macroeconomic analysis with the Hicks-Hansen model, this can be attributed to the heavy influence of the formalist revolution of the 1950’s in microeconomics (Blaug, 2003). The neoclassical emelents of the IS-LM may have increased the acceptability of Keynes’s theory. This interpretation however, removed some the more radical elements of Keynes’s theory attached to the nature of the financial system, for example by the reduction of the liquidity trap by the synthesis as a special case of failure of Walrasian adjustment, and the role of uncertainty, which was reduced to risk (Fine, 2016). It has been noted by Hyman Minsky (2008) that in The General Theory, Keynes limits his use of mathematical models, and asks if this could be due to Keynes’s scepticism about whether phenomena as uncertain as economic activity could ever be adequately captured in a mathematical model.
The Neoclassical Synthesis failed to recognise that the logic of Keynes’s case based upon a rejection of the key Walrasian coordinating mechanism, namely, the auctioneer. To an extent, however theoretical schizophrenia in the Neoclassical Synthesis potentially originated from Keynes himself, who kept not only kept some ambiguous relation and retention Neoclassical elements within his theoretical scheme, but also expressed his highly complex ideas in a form that did not readily lend itself to modern notions of economic analysis.
In 1958, William Phillips published a paper entitled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. The interpretation of what is known as the Philips curve contained an observation of a historical inverse relationship between employment and inflation. The Phillips curve, imported to the US by Samuelson and Solow in 1960, was both a blessing and a curse for the neoclassical synthesis. It seemingly gave strong empirical support to a relationship between the rate of change of nominal wages and the level of unemployment, but it also made less urgent the need for better microeconomic underpinnings of market adjustment. Given the existence of a reliable empirical relation and the perceived difficulty of the theoretical task, it made good sense to work on other and more urgent topics, where the marginal return was higher (Blanchard, 1991, p.505). the adoption of the phillips curve contributed to orthodox keynesianism’s theoretical vunerability.
The state of macroeconomics after the golden age of capitalism, and the resolution of the theoretical schizophrenia
While prominent economists such as Milton Friedman and Friedrich Hayek had long contested the legitimacy of the synthesis, perhaps lending to the economic performance of the golden age of capitalism in the western world, and the popular formality of models such as the IS-LM, the theoretical divergence between mainstream macro and microeconomics had been overlooked. During the 1960s the synthesis became increasingly associated with an acceptance of a stable long-run trade-off between inflation and unemployment.
However, in the wake of the crisis in the macro-economy that followed, the Neoclassical Synthesis gave way to monetarist and rational expectations models which seemed better able to explain these events. With the breakdown of the Phillips curve in the late 1960s/early 1970s it became apparent that the microeconomic under-pinnings of the supply side of Orthodox Keynesian models were fundamentally flawed (Snowdon and Vane, 1995). Stagflation in the 1970’s generated dissatisfaction with the policy regime of the preceding decades and opened the way for alternatives that defended a stronger role for the market (Dequech, 2018).
Keynesian demand management no longer seemed to work, which raised questions about the theories and methods of the Neoclassical Synthesis, and Keynes’s critics started to attract greater attention. Drawing on the classical school of thought, the Monetarist school called into question the post-war Neoclassical Synthesis. The monetarists claimed policy makers had been led astray by their Keynesian beliefs, and argued that the inflation was to do with the growth in the money supply. By the early 1980’s, many governments in the western world had adopted Monetarist techniques, emphasising the dominant role of the money supply as opposed traditional Orthodox Keynesian methods which emphasised the control of fluctuations in effective demand (Palley, 1993). The post-World War II history of macroeconomic policy has been aptly characterised as a parallel rise and fall of fiscal policy and fall and rise of monetary policy – with the transition between stages dates in the second half of the 1960’s (Campbell, 1975, pp. 27-28).
New classical approach
The New Classical school agreed with the monetarists in the sense that in their theory, the market was self-adjusting. In the New Classical theory, Friedman’s conviction that money is neutral in the medium term is held to apply to the short run also (Trevithick, 1992, p.144). However, it was almost as hostile to monetarism as it has to Keynesianism, since it maintains that money supply fluctuations have no long-run effect on real output, and any short-run effect is restricted to the unanticipated component due to rational expectations (Palley, 1993). The New Classical approach was developed by emphasising Neoclassical microeconomic foundations to analyse macroeconomic models, and can be seen theoretically, as a real attempt to solve theoretical schizophrenia arising from the Neoclassical Synthesis. Led by Robert Lucas, the New Classical school, for a while, became the dominant school in Macroeconomics. This was a sharp turn away from Keynesianism and returned back to classical theory, where the goals of agents are assumed to be the maximisation of utility and profits, that each (intended) supply must be matched by an (intended) demand and so the aggregate of all supplies and demands must sum to zero (Fine, 2016), leading to definitive market clearing.
The New Classical counter revolution was both methodological and ideological in nature. With all markets clearing continuously in the New Classical world, the existence of unemployment in denied. Lucas’s redefined notion of constant market clearing reduced the unemployment of the Great Depression as a case of mass voluntary unemployment.
It became an established requirement of neoclassical macroeconomic models that an explicit, microeconomic foundation should be specified so that macroeconomic theory could be acknowledged as being anchored in rational, forward looking economic behaviour. This led to the rational expectations revolution (Jespersen, 2009, p.29). Robert Emerson Lucas is well known for his investigations into the implications of the assumption of the rational expectations theory. Freidman’s challenge to Keynes is also attributed as being part of the push for the rational expectations revolution. Both the new classicists and monetarists conclude with similar, free market advocating policy solutions.
Lucas critique, which showed that many of the parameters in the Keynesian macroeconomic models will be affected by changes in macroeconomic policy, as agents learn and anticipate these (McCombie and Negru, 2014). Expectation formation, within monetarism and the neoclassical synthesis, was subject to criticism from the new classical economists. In the “Lucas critique”, it was argued quite generally that, as any policy regime changed, private sector agents would take note and adapt their behaviour to the new environment, thus causing apparently stable empirical relationships among economic variables to shift (Laidler, 2015). This is a demonstration of the ‘forward looking’ nature of Lucas’s rational expectations theory, as opposed to..
New Keynesian approach
In the late 1970s, in response to Robert Lucas and the New Classical School, the New Keynesian School began its development. Like the New Classical economics, it sees a single theory, but unlike to the New Classical economics, it sought to explain unemployment, rather than deny its existence. Unemployment is shown to be just one manifestation of a much wider set of market failures (Greenwald and Stiglitz, 1987). In contrast to the New Classics, the New Keynesian approach was set about building new micro-foundations for Keynesian macroeconomics; Its aim was to develop a microeconomic theory that can account for the phenomena of unemployment, credit rationing and business cycles, which are inconsistent with standard microeconomic theory (Greenwald and Stiglitz, 1987)
New Keynesian analysis assumes variety of market failures and imperfect competition, in both the micro and macro level. Full employment cannot be achieved in the short run New Keynesian model due to price rigidity (sticky prices), but full employment is automatically achieved in the long run, contrasted to the New Classical model where the market is constantly clearing.
The New Neoclassical Synthesis currently forms the mainstream of macroeconomic theory. This is sometimes seen paradoxically, as a synthesis of New Keynesian and New Classical economics (McCombie and Negru, 2014), inheriting the ‘spirit’ of the old synthesis (Goodfriend and King, 1997). Until the financial crisis of 2008, is had generally been agreed for some decades by the majority of economists in the mainstream that monetary policy was sufficient to regulate the economy. The 2008 financial crisis saw a resurgence of Keynesian policy prescriptions in the form of fiscal stimulus
Although the Neoclassical Synthesis was theoretically inconsistent in many ways, this is not to say that it’s legacy should be disregarded. A significant aspect of the neoclassical synthesis was its translation of all economic theory, macro as well as micro, into a more precise mathematical language (Eichner, 1983). In the period that the neoclassical synthesis reigned, major advances in both theoretical and applied economics were observed.