What is Post-Keynesian economics?

Post Keynesians went back to basics and decided to interpret John Maynard Keynes’s “The General Theory of Employment, Interest and Money.” They felt that mainstream macroeconomics was not focusing or even applying some of the things Keynes was truly trying to say.  They disagree with Keynesian, New Keynesian, Classical and New Classical economics, basically all mainstream macroeconomics.  Their focus is primarily financial markets and their implications on the economy, which they feel as been ignored in entirety.

Post Keynesian economics is broken up into two groups, the Americans and the Europeans.  The European group includes famous economists such as Geoff Harcourt, Richard Kahn, Nicholas Kaldor, Michal Kalecki, Piero Sraffa and the most famous Joan Robinson.  Joan Robinson does not classify herself as a Post Keynesian, like most economists who do not like to “pigeon-hole” themselves, but she is known as the woman who started the school of Post Keynesian economics.  Robinson believed there was a misinterpretation of Keynes’s main insights by leading mainstream Keynesian thinkers, but the American group felt the Europeans did not expand enough on the true interpretation of Keynes. The Europeans focused on behavior and functioning of the real economy and downplayed monetary and financial implications.

The American group consists of Victoria Chick, Alfred Eichner, Jan Kregel, Basil Moore, George Shackle, Sidney Weintraub, Paul Davidson and Hyman Minsky.  Hyman Minsky is the economist most famously attached to Post Keynesian economics.  The Americans focused on uncertainty, monetary and financial influences.  This is what Post Keynesian economists are most known for.  Hyman Minsky wrote the book Stabilizing an Unstable Economy back in the late 1970’s; it was not until the financial crisis that the book became wildly popular with copies selling for $10,000 on eBay.  Minsky’s book concentrated highly on financial implications which made for a perfect summary of how to understand what happened to the economy a couple of years ago.  The American group saw the importance of the financial market within the economy and as Paul Davidson said “The true legacy of Keynes cannot be found within any branch of mainstream Keynesianism.”

Post Keynesian economics has many theories but one of the foundations is effective demand, and that it matters in both the long run and the short run. Effective demand is when the demand for a good but are constrained in a different market, but it also means that a competitive market economy has no natural or automatic tendency towards full employment.  This contradicts New Keynesian theory working in the Neo-Classical tradition.  Post Keynesians do not accept that market failure to provide full employment is caused by sticky wages or prices.  They also reject the IS/LM model.  Contributions of Post Keynesians include theories of income distribution, growth, trade and development where money demand is very important when it comes to aggregate employment, unlike neoclassical economics which believe in theories of technology, endowment and preferences.

Post Keynesians were one of the first to emphasize that the money supply reacts to bank credit demand.  This means that the central bank can only influence the quantity of money or the interest rate but not both.  This theory has been incorporated into monetary policy and Minsky put forward a theory of financial crisis based on financial fragility.

Rejection of Say’s Law

Post Keynesians rejects Say’s law, which they claim is not a true law when we model an economy that has real-world characteristics.  They overthrow the classical dichotomy by stating, money matters in the long run and short run, money and liquidity preference are not neutral and they affect real decision making.  They reject the idea that the economic system moves through time from the past to an uncertain future.  Important decisions involving production, investment and consumption activities are taken in an uncertain environment.  They also reject forward contracts, in money terms, are a human institution developed to efficiently organize time-consuming production and exchange precesses.  The money wage contract is the most ubiquitous of these contracts and modern production economies are on a money wage contract-based system.  Most importantly, Post-Keynesians assert that unemployment, rather than full employment, is a common laissez-faire situation.

Post Keynesian economists went back to the General Theory to try and truly interpret what Keynes was saying. One of the reasons they reject Say’s Law is because Keynes himself had an issue with the taxonomy of Say’s Law.  Keynes stated that people are using the same words to describe things with different meanings and created new definitions in order to explain why Say’s Law is not the true law relating the AD and AS functions.  He SG: Who? required Keynes needed to demonstrate that a change in relative prices by a substitution effect could not resurrect Say’s Law.  Keynes said time preference determines how much of current income is spend on currently produced consumption goods and how much is not spent on consumption goods but is instead saved by purchasing liquid assets.  Liquidity preference is where the income earner determines in what type of liquid assets are saved income to be stored in order to be used to transfer purchasing power of saving to a future time period.  Since all liquid assets have certain essential properties, the demand for liquid assets does not exactly create a demand for the products.

Hyman Minsky

“The interpretation of Keynes was assimilated into traditional economics without emphasis upon finance and debt was lost.  Today, an abstract non-financial economy is analyzed and theorems about this economy are applied to complex economies with financial and monetary institutions.  Policy advice based upon the neoclassical synthesis rests upon this act of faith so this cannot be a basis for a serious approach to economic policy.  Keynes advanced an investment theory of why our economy is susceptible to fluctuations and a financial theory of investment that is especially relevant for our economy.  The panics, debt deflations and deep depressions that historically followed a speculative boom as well as the recovery from depressions are of lesser importance in the analysis of instability than the developments over a period characterized by sustained growth that lead to the emergence of fragile and unstable financial structures.”  (Minsky, Stabilizing an Unstable Economy)

Minsky developed his financial instability hypothesis which states that in a capitalist economy, market mechanisms cannot lead to a sustained, stable-price, full-employment equilibrium. Financial behavior essential to capitalism will lead to serious business cycles.

This contrasts to neoclassical economics. Neoclassical economics states that unless disturbed by an exogenous event, a decentralized market economy will lead to full employment equilibrium. Because Minsky’s theory is derived from the behavior and incentives of a capitalist economy, it’s important to know the characteristics of such an economy. The means of production are privately owned and the income of the owners of capital assets is the difference between the revenue and labor costs associated with that capital. In addition, capital assets can be both traded and used as collateral and the financial instruments that enable pledging capital assets can also be traded. And because they can be traded, they have a market price. So what happens is that, the future income derived from capital assets is transformed into current prices.

The prices of capital and financial assets depend upon the future cash flows that they are expected to generate and the capitalization rate. Since investment creates the profits of production and distribution of output, today’s investment determines the cash flows available to fulfill financial obligations of the past. So if a capitalist economy is to function normally, capital income and implicitly investment needs to sustain a level of capital asset income that validates past debts. If this doesn’t happen, the prices of capital assets and debts fall, and such a decline adversely affects investment demand.

In Minsky’s view, investment is the essential determinant of the path of a capitalist economy. So it’s important to know how investment works. The demand for capital assets is determined by their expected profit. This demand can be augmented by debt financing of capital and financial assets. The extent of debt-financing and the financial instruments used in creating such demand reflects the willingness of businessmen and bankers to speculate on future cash flows.

The main idea Minsky promotes is that when full employment is achieved, businessmen and bankers tend to accept larger levels of debt-financing because there are confident that they’ll succeed. During periods of tranquil expansion (it’s important to note that Minsky doesn’t believe in equilibrium, but in periods of tranquility, a term borrowed from Joan Robinson), profit-seeking financial institutions invent new forms of money or substitutes for money in portfolios. Financial innovation is a characteristic of an expansionary economy.

These financial innovations enable the financing of more demand for capital and financial assets or of more investment. Financial innovation thus tends to increase capital gains, investment and profits. This results in an economy expanding beyond the tranquil full-employment state. What Minsky concludes is that the temporary full employment state leads through financial innovation to an expansion of debt-financing and moves the economy beyond full employment.

During a tranquil expansion, the price of capital assets relative to the price of current output increases, consumption and investment increase. The subsequent increase in profits lowers the value of the liquidity of money. So, in the eyes of businessmen and bankers the value of insurance or liquidity that money offers decreases. The value of liquidity will continue to decrease as the period of expansionary tranquility extends. The debt to equity ratios increases even as the value of the equity increases.

View on Elasticity and Money Contracts

The essential properties of interest and money are what differentiate Post-Keynesian economics from old classical, new classical, old and new Keynesian theory, so basically all mainstream macroeconomic theory.  The essential properties are that the elasticity of productivity of all liquid assets including money was zero or negligible and the elasticity of substitution between liquid assets (including money) are reproducible goods was zero or negligible.

The zero elasticity of productivity of money means that when the demand for money increases, entrepreneurs cannot hire labor to produce more money to meet this change in demand for non-reproducible goods.  Zero elasticity of substitution means that the portion of income that is not spent on consumption will find ‘resting places’ in the demand for non-producible goods, a good man can not make.

Hahn- “Say’s law is violated and involuntary unemployment occurs whenever there are ‘resting places for savings in other than reproducible assets.’ The existence of non-reproducible goods (all liquid assets) that would be demanded for stores of new savings means that all income earned by engaging in the production of goods is not, in the short or long run, necessarily spend on products producible by labor.  An increased demand for ‘savings’, even if it raises the relative price of non-producibles, will not spill over into a demand for producible goods. So deny gross substitution axiom.”

The economy today utilizes money contracts to seal production and exchange agreements and binding nominal contractual commitments are a sensible method for dealing with true uncertainty regarding future outcomes whenever economic activities span a long durations.

Risk and Uncertainty

Risk can be quantified; uncertainty cannot be quantified. Risk is not knowing what is going to happen next; it’s a calculation of the distribution of observable/observed past events, and based on that distribution it assumes the likelihood of an event contained happening in the future. Uncertainty is not knowing what will happen and not knowing the possible distribution.  A statistical and quantifiable approach can clarify between the two.  The future is unknown but sometimes there are options available that can be chosen.  A dice is a perfect example of risk, the outcome is unknown but the options are clear, 1 through 6 with each digit having a 1 in 6 chance of facing up.

Minsky’s Financial Theory

Minsky provides an alternative analysis of Keynes’s theory. The two key building blocks of his financial theory of investment and investment theory of the cycle are the two price systems and the difference between lender’s risk and borrower’s risk.

Minsky distinguishes between a price system for current output and one for asset princes.

  1. The price system for current output is determined by the cost plus mark-up, set at a level that will generate profits. This price system covers consumer goods and services, investment goods and goods and services purchased by government. When purchases of capital are financed from internal funds, the current output price of investment goods is effectively a supply price of capital – the price sufficient to induce a supplier to provide new capital assets. If the firm must borrow external funds, then the supply price of capital also includes finance cost (i.e. the interest rate payments and other finance fees). The supply price will increase, as it also has to cover lender’s risk.


  1. The second price system covers assets that are expected to generate a stream of income and possibly capital gains. The income stream derived from such assets cannot be known with certainty, and their value depends on subjective expectations. How much would one pay for the expected revenue that it can generate? But their value is again augmented by borrower’s risk since the price one is willing to pay depends on the amount of external finance required.

Investment can only proceed if the demand price exceeds the supply price of capital assets. Because these prices include margins of safety (lenders and borrower’s risk), they are affected by expectations concerning unknowable outcomes. In a recovery from a severe downturn, margins are large as expectations are muted.

Over time, if an expansion exceeds pessimistic projections these margins prove to be larger than necessary. Thus, margins will be reduced to the degree that projects are generally successful. Over the course of an expansion, the financial stances (hedge, speculative, ponzi) evolve from largely hedge to include ever rising proportions of speculative and even Ponzi positions.  The hedge stage occurs after a financial crisis when banks and borrowers are cautious and borrowers are able to play both the interest and the principal. The speculative stage of financial stances occurs when confidence rises and borrowers are be awarded loans for which they only afford to pay the interest. In the last stage, Ponzi finance implies that banks offer loans that cannot be repaid at all. Neither the principal nor the interest is repaid.

Aggregate demand includes expenditures on goods and services, including financial assets and services. While neoclassical economics attempts to analyze the economy, while ignoring the financial system, post-Keynesians believe that the economy is intimately linked to finance. Thus, post-Keynesians identify three main sources of aggregate demand. One is the demand derived from income earned by selling goods and services, which primarily drive consumption of goods and services. The second is demand originating from entrepreneurial debt which forms the bulk of investment. Lastly, the third major source of aggregate demand is the one rising from Ponzi debt, which funds the acquisition of current assets.

New Keynesians and Monetarists consider that banks can raise demand by lending the savings of those with a low propensity to spend to those with a higher propensity to spend. They don’t really create higher purchasing power, but simply redistribute the power to those willing to use it.

The Endogenous Theory of Money states that banks can create money “out of thin air”. They do not lend out savings and their lending ability is not limited by deposits or reserves. All economic agents (households, firms, financial institutions, governments) can be labeled as banks since they all take positions in assets by issuing liabilities, with margins of safety maintained for protection.

1. One margin of safety is the excess of income expected to be generated by the ownership of assets over the payment commitments entailed in the liabilities.

2. Another is net worth. For a given expected income stream, the greater value of assets relative to liabilities, the greater the margin of safety.

3. Another margin of safety is the liquidity of the position: if assets can be sold quickly or pledged as collateral in a loan, the margin of safety is bigger.

If a disruption occurs, economic agents that rely on a continual stream of refinancing will try to sell assets to meet cash commitments.  What will occur is what Irving Fisher calls a debt deflation: a generalized sell-off is going to drive asset prices toward zero, since financial assets and liabilities net to zero.

Specialized financial institutions can protect markets from debt deflation by standing ready to purchase or lend against assets, preventing prices from falling. However they might be overwhelmed by the contagion and refuse to provide finance.  Central banks have to intervene as a lender of last resort by temporarily providing finance and stopping debt deflation with their ability to purchase or lend assets without limit.

Financial institutions are special because they are very highly leveraged: for every dollar they might issue 95 cents of liability. Their positions in assets are really financed positions. Traditional commercial banks make short term loans that are collateralized by goods in production and distribution. The loans are made good as soon as the goods are sold. The bank’s position is financed by issuing short-term liabilities such as demand and savings deposits. Essentially, a firm borrows to pay wages and raw materials (the costs of production), with the bank advancing demand deposits received by workers and suppliers. When the finished goods are sold, firms are able to repay the loans. Banks charge higher interest on loans than they pay on deposits – with the net interest margin supplying bank profits.

From this process we observe that banks do not sit and wait for deposits in order to lend. Rather the process is precisely the reverse: banks accept the IOU from the firm that needs to pay for wages and raw materials, and then create a deposit that the firm uses for its purchases. The Endogenous Money Theory states that loans create deposits, in the sense that bank buys the IOU from the firm by issuing its own deposit IOUs.

If deposits are to maintain parity, losses on assets must be very small because the commercial bank’s equity (what it makes from the difference in interest rates) must absorb all asset value reduction. Thus, it is the duty of the banker to be skeptical. Bankers hold the key to the business cycle, because not only do entrepreneurs have to be sufficiently optimistic to invest, they must also find a banker willing to advance the wage bill to produce investment output. By financing the wage bill of workers in the investment goods sector, commercial banks are promoting the capital development of the economy even if they do not actually provide finance for position taking in investment foods.

Once the firm finishes production and sells the output, it receives deposits and uses these to retire the short-term loan. Repaying the loan clears the banks’ balance sheet because the payment on the firm’s IOU brings back to the bank its own IOUs.

Post-Keynesians consider that in a modern, developed, capitalist economy money should be viewed as credit money, an IOU of the issuer and an asset of the holder. Even the state’s own money i.e. the dollar, the RON (The Romanian Leu) etc. is an IOU, which is redeemed in tax payments or other payments owed to the state. Thus, the state’s money is not simply “fiat” currency e.g. “let it be” currency. Rather, its use is driven by the state’s ability to impose tax liabilities on the population, which are subsequently validated when tax payments are made in the state’s IOU. Using the context provided by this definition of money, post-Keynesians consider private money as “pyramiding” or leveraging the state’s money, which is further used for the ultimate net clearing of private balance accounts, as well as for making payments to the state.

There is no fixed leverage ratio between the quantity of private IOUs issued and the stock of state money existing. (hence, the lack of meaning for the concept of money multiplier in post-Keynesian economics). Most creation of state money occurs when the state spends, and most destruction occurs when the state recovers the population’s tax liabilities. The central bank also creates and destroys state money as it increases or decreases banking system reserves through the repo rate at the discount window (an instrument used by central banks to allow financial institutions to meet temporary shortages of liquidity) and through open market operations such as the current Large Scale Asset Purchases.

In this context, the supply of money is not exogenously determined and money multiplier effect devoid of meaning. What constrains banks from lending is the point beyond which it would be unprofitable to expand its balance further. The central bank may not be trying to target a particular quantity of currency or of the monetary base, but it can target a price level by varying its lending rate or by taking steps to vary the interbank overnight rate on bank reserves i.e. the federal funds rate, the discount rate. The central bank hasn’t the ability to quantitatively constrain the private sector’s creation of money through quantitative measures of controlling the money supply. Rather, the central bank has the ability to set the overnight interest rate, which has an indirect impact on the quantity of reserves and the quality of privately created money. Post-Keynesians view the supply of reserves as horizontal at the central bank’s target rate. The financial sector has ability to perpetually seek innovation that can reduce the quantity of reserves they need to hold or innovation that increases the return on equity within regulatory constraints. This gives raise to the structuralist post-Keynesian concern regarding the financial sector and the economy, in general. Minsky `was greatly focused on the institutional environment in order to solve the unstable nature of capitalism.

While the central bank is viewed as a lender of last resort, the post-Keynesian establishment views government as an employer of last resort. Instead of reducing poverty through welfare programs and creating a welfare-dependent, marginalized class, the government should offer one full-employment job per low income household. The result of such a policy would be fewer families below the poverty line and an increase in consumption and GDP by a multiple of the extra wages. In Minsky’s view, this is the only situation in which a minimum wage is effective, since if the government is not employer of last resort, the minimum wage is actually zero for all those unemployed. Just as the central bank’s lender of last resort responsibilities create a floor for asset prices by stopping the process of debt-deflation, the government sets a wage floor and subsequently a floor to aggregate demand and consumption.

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