International Economic Policy Institute IEPI

Institut International d’Economie Politique IIEP

International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International TEconomic
HE POST-KEYNESIAN Policy
APPROACHInstitute
: IEPI
Institut International d’Economie Politique
AN INTRODUCTION IIEP
International Economic Policy Institute
Nicolas Zorn
IEPI
Institut International d’Economie Politique IIEP
International Economic WP-2016-01Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
International Economic Policy Institute IEPI
Institut International d’Economie Politique IIEP
MISSION STATEMENT

The International Economic Policy Institute is a bilingual, non-partisan, non-profit policy research group at
Laurentian University, Ontario (Canada), which seeks to offer critical thinking on the most relevant
economic and social policies in Canada and around the world. In particular, the institute’s mission is to
explore themes related to macroeconomic policies, globalization and development issues, and income
distribution and employment policies. Our overall concern is with the social and economic dignity of the
human being and his/her role within the larger global community.

We believe that everyone has a right to decent work, to a fair and equitable income and to equal
opportunities to pursue one’s self-fulfillment. We strongly believe that it is the role of policies and
institutions to guarantee these rights.

In accordance with its mission, the Institute is constantly seeking to create international research networks
by hosting conferences and seminars and inviting other thinkers around the globe to reflect on crucial
economic and social issues. The Institute offers ongoing, honest, and critical appraisal of current policies.

DIRECTOR
Louis-Philippe Rochon, Laurentian University

ASSOCIATE DIRECTOR
Hassan Bougrine, Laurentian University

SENIOR RESEACH ASSOCIATES

Amit Bhaduri, Jawaharlal Nehru University (India)
Paul Davidson, New School University (USA)
Robert Dimand, Brock University (Canada)
Roberto Frenkel, University of Buenos Aires (Argentina)
Robert Guttmann, Hofstra University (USA)
Claude Gnos, Université de Bourgogne (France)
Marc Lavoie, University of Ottawa (Canada)
Noemi Levy, Universidad Nacional Autonoma (Mexico)
Brian MacLean, Senior Researcher, Laurentian University (Canada)
Philip A. O'Hara, Curtin University (Australia)
Alain Parguez, Université de Franche Comté, (France)
Sergio Rossi, University of Fribourg (Switzerland)
Claudio Sardoni, University La Sapienza (Italy)
Mario Seccareccia, University of Ottawa (Canada)
Mark Setterfield, Trinity College (USA)
John Smithin, York University (Canada)

RESEACH ASSOCIATES
Mehdi Ben Guirat, The College of Wooster (USA)
Fadhel Kaboub, Drew University (USA)
Dany Lang, National University of Ireland, Galway (Ireland)
Joelle Leclaire, Buffalo State University (USA)
Jairo Parada, Universidad del Norte (Colombia)
Martha Tepepa, El Colegio de Mexico (Mexico)
Zdravka Todorova, Wright State University (USA)

2
 THE POST-KEYNESIAN APPROACH: AN
INTRODUCTION

NICOLAS ZORN
Policy Analyst, Institut du Nouveau Monde, Canada
___________________________________________________________

Summary

The Great Recession of 2009 and the current economic stagnation calls into question the
validity and usefulness of Mainstream economic theories. The post-Keynesian approach
provides a rich and relevant alternative, far better able to explain modern and complex
economic phenomena. This article is intended as an overview of their main micro and
macroeconomic contributions, as well as the significant limitations of their mainstream
counterparts. Will be addressed the epistemological, ontological and methodological
post-Keynesians principles and their theories of prices, firm, consumers, economic
growth, money and international trade.

The author thanks Louis-Philippe Rochon, Marc Lavoie, Jean-Claude Cloutier, Charles
Carrier, Jean-Pierre Proulx and Mario Jodoin for helpful comments and suggestions on a
previous version of this text. All remaining errors isn’t their fault.

3
1. Introduction
Mainstream economics, namely the neoclassical and neo-Keynesian schools of thought,
asserted until the last economic crisis that the growth path followed by the developed
economies in recent decades was sustainable. Despite its flaws, pre-crisis economic
growth and macroeconomic stability seemed to prove them right. The Great Recession of
2009 and the current economic instability left serious doubt on the validity of these
precepts.
The post-Keynesian approach has repeatedly underlined the unsustainability of this
approach (Godley and Zezza, 2006; Palley, 2006). This school of thought brings more
realistic and credible explanations to these issues but above all, it offers a complete
alternative to mainstream economics. Its array of theoretical tools and empirical
contributions are rich but less known by economists and the wider public. It deserves an
important place in the economics curriculum as well as public debates on economic
policies.
The post-Keynesian approach is a heterodox school of thought that evidently draws on
Keynes’s contributions, but also those of Michał Kalecki, Wassily Leontief, Piero Sraffa,
Thorstein Veblen, John Kenneth Galbraith, Nicolas Kaldor, Joan Robinson and Nicholas
Georgescu-Roegen, among others. Several disciplines contribute to its development, such
as sociology, history, political science and psychology (Lavoie, 2004, p. 22).
This article is an overview of the main contributions of post-Keynesian economics, as
well as the significant limitations of their mainstream counterparts. Section 2 deals with
the epistemological, ontological and methodological assumptions and principles of post-
Keynesians economics. Section 3 deals with their theories of price formation and the role
of firms. Section 4 discusses the consumer in all its complexity. Section 5 shows how
growth is primarily determined by demand rather than supply factors. Section 6 deals
with the role and mechanisms of money, which is endogenous in its nature. Section 7
deals with international trade and section 8 concludes.

2. Epistemological, ontological and methodological assumptions and

principles
The post-Keynesian approach starts with the fact that market economies are inherently
imperfect and inefficient. They do not tend to correct themselves automatically, and have
a tendency to underutilize and sometimes misuse the productive capacity of the economy.
Firms rarely operate at their full potential. They underutilize their utilization capacity and
produce involuntary unemployment. Central postulate of post-Keynesian theories, the
economy crucially depends on effective demand, regardless of the level of wages, in both
the short term and long term. It is rather the entrepreneur’s expectations of future demand
(and thus their investments) which determine the level of effective demand.
According to Keynes, firms will hire the number of workers that will allow them
to produce expected sales, which in turn depend on demand. The single most
important variable determining effective demand is investment expenditures,
4
 which depend on business sentiment ('animal spirits') or expectations not
reducible to optimizing behaviour. (Stockhammer, 2012, p. 167)

Large firms, the dominant oligopolies of our modern economies, have the ability to
determine prices, invalidating the presupposed benefits of free competition. In addition to
producing instability, the latter does not produce a situation of equilibrium which
coincides with the full employment of resources (capital and labor). Markets do not
automatically adjust, whereby calling for the intervention of the State to regulate them.
Mainly concerned with macroeconomic issues, the post-Keynesian analytical framework
distinguishes itself from the dominant theories in economics in several aspects (Lavoie,
2004, p. 12-16). To understand the economy, one has to ‘take reality as it is, with its main
stylized facts, and not as a hypothesized ideal’ (ibid., loose translation). The hypothesis
of absolute rationality of agents is abandoned; consumers instead use simple rule-of-
thumb and emulation to determine their consumption and behavior.
A holistic approach is preferred to the individualistic approach because ‘individuals are
social being, powerfully influenced by their environment, their social class and the
culture from which they have been impregnated’ (ibid., loose translation). To understand
the functioning of the economy, exchange and scarcity have to be downgraded in favor of
growth and production. Post-Keynesians give particular attention to institutions and
power relations, as well as the distribution of income and wealth, which is one of the
main determinants of demand and growth.
However, heterodox schools of thought all share some or all of these assumptions.
Among the more specific characteristics of post-Keynesian analysis, fundamental
uncertainty1 and the principle of effective demand are essential elements. Since economic
agents act in a monetary production economy, post-Keynesians reject Say's law and argue
that investment determines savings, not the other way around.
Although having fully developed theories of the firm, prices and consumers, post-
Keynesians focus most of their analyses at the macroeconomic level. Avoiding fallacy of
composition traps, they believe that aggregates better explain the interworking of the
economy, because individuals cannot be taken apart from of their social, historical and
institutional context. Social classes (workers, capitalists and rentiers), as well as firms
and banks, are preferred to the representative agent. This approach rejects the need for
microfoudations of macroeconomics, a mainstream principle that require utility-
maximizing individuals making rational choices to explain macroeconomic phenomena.
As the Sonnenscheinn theorem demonstrates, interactions become extremely complex
when different individuals are involved. This approach ignores the issue of coordination
between individuals. However, the representative agents of their models have no reason
to trade between them, which calls into question the idea of market where transactions
would take place. Assuming that this is the case, the issue of coordination arises.

1
The future is necessarily different from the past and cannot serve as a reliable guide to anticipate the
future, a major characteristic of mainstream models.
5
The number of agents in mainstream models are reduced to the bare minimum (one or
two), but representative agents being collective entities, they cannot adequately aggregate
the very different objectives and unequal resources of the individuals they represent
without falling in a fallacy of composition trap. Assuming the rationality of agents also
presupposes that they consistently have access to the same information, that markets are
efficient and that there is no fundamental uncertainty (so that every outcome can be given
a probability). If some mainstream models do address some of these issues, they never
address all of them in a consistent manner.
Omitting the transition between equilibrium points
The assumption that the economy is moving towards equilibrium doesn’t address how it
moves from points A to B. However, historical time is irreversible and the future is
uncertain. Mainstream approaches favor logical time in their models, failing to consider
this important issue. In those models, all the decisions of agents are taken at time zero
and the effects of these decisions are simply added up. In this situation, the order in
which the transitions take place are of no importance. However, the period of transition
from one equilibrium to another neglects the effects of the path between these two points
(the traverse). This transition can have a considerable effect on the new equilibrium, or
even generate many equilibriums. If there are several points of equilibrium, the supposed
optimization effects of markets no longer hold.
As demonstrated by Nicolas Kaldor (1985), because the real economy is dynamic (rather
than static), the adjustment process to reach a new equilibrium point directly affects it.
Cumulative causation and path dependency do not guarantee that the same operation in
the opposite direction would produce the same result. The adjustment process can
produce different equilibrium points, via hysteresis effects (Henry, 2012, p. 530).

3. Are prices determined by competition or established by firms?

Central concept of mainstream economics, the principle of supply and demand is but one
element among others to understand how prices are determined in the goods and services
markets. The strategies and behavior of firms play a decisive role.
Some issues with the marginalist theory of prices
The marginalist theory of prices is quite simple: entrepreneurship, strategy, decision, and
even risks are unnecessary to consider for firms because prices dictate their behavior.
Competing firms determine the quantities of goods and services to produce according to
their marginal costs and market prices. For the oligopolistic firm, two simple rules dictate
its actions: equate marginal revenue to marginal costs and sell products as long as there is
demand. In both cases, prices are fixed in an optimal manner by the market. Everything
that is produced is bought and prices reflect their scarcity. An increase in the production
generates an increase in the marginal cost, hence higher prices. Since prices rise when
demand increases, yields are decreasing. (Lavoie, 2001, p. 21)
The mainstream (marginalist) price theory hypothesizes that the marginal costs of
production of a firm are positive in the short term (their cost per unit of output increase
for each additional unit) because the amount of capital (and land) is limited. This uniform
6
treatment of capital carries several problems. For example, if four people use four axes to
cut trees, the use of a fifth person would transform these four axes in five smaller and less
effective axes. However, employed capital must usually be increased if the number of
workers increases, forcing the use of unused capital or the purchase of additional capital
(in our example, the purchase and use of an additional ax).
This assumption is problematic when an economy has several different industries (i.e.
capital which is not interchangeable from one industry to another); capital is not putty,
although this approach is tempting to model its use. Workers and capital are more often
than not used together; a cook without an oven or a taxi cab without a driver is of little
use. This is why firms generally keep a surplus production capacity if they to increase
production in the short term, an essential flexibility allowing a firm to survive in a
modern economy. Capacity utilization of productive resources is never fully utilized,
whereby suboptimal. Thus, firms have constant or increasing, rather than diminishing,
returns.
Constant or declining production costs
Assuming constant or increasing returns finds important support in the literature. Keen
(2011) lists 150 empirical surveys where firms reported mostly constant or declining
costs of production. Blinder et al. (1998) conducted a similar survey of 200 firms in the
United States, representative of the American industrial structure. The study reported that
89% of respondents indicated that their average variable costs had either declined or
remained constant when production increased. Only 2% of the firms surveyed reported a
combination of elastic demand curves and increasing marginal costs, two central
premises to marginalist theories of prices.
Moreover, more than 50% of respondents indicated that they did not increase their prices
when demand increased, for fear of losing customers. These firms therefore do not
maximize their profits because they have other objectives than maximizing short-term
profits. According to Downward and Lee (2001), these empirical findings confirm post-
Keynesians theories of prices.
Alternative theories of price and the firm
In a world marked by complexity and uncertainty, firms adopt simple rules based on
accessible data to manage their strategic and financial goals. Even if firms wish to
maximize their profits, their knowledge of the demand curve is at best an approximation.
As to their knowledge of consumers, their preferences (which cannot be simply summed
up with market prices) are uncertain, sometimes irrational, expensive to obtain, and
subject to sudden change. In addition, firms evolve in a context of oligopolistic
competition and monopolies, which considerably alters their strategies and objectives:
The environment is one of interdependencies; at any time rivals, actual or
potential, may change their behavior and employ new strategies. In such an
environment, short-run profit maximisation is not possible to achieve. Moreover,
profit maximisation is an inappropriate goal for firms that strive to survive and
want some market power over their economic environment. Finally, the goals of
firms and of their managers are multidimensional; as circumstances change, the
weight given to various goals is revised and some goals need to be modified.
(Lavoie, 2001, p. 21)
7
Rather than resort to marginalist considerations, most firms use the method of cost plus,
or markup, pricing; they add an extra cost (the target profit rate) to the average price of
their products. They adopt rule-of-thumb and trial-and-error approaches to set their
prices: ‘Cost plus pricing means that firms fix prices based on some measure of costs,
rather than as a response to demand fluctuation.’ (ibid.) Markup pricing is present in most
industries. The only exceptions are those where production is manufactured by lot (such
as agriculture), those where production is limited by access to some limited resources
(such as natural resources or land) or those where production is not easily reproducible
(such as art).
Firms adopt this method because it is easy to apply and control. It has several advantages,
notably because it is simple to calculate and therefore inexpensive to implement (most
firms do not have an economist at their disposal). These prices are not determined on
markets but established by firms at the stage of production. Central concept for post-
Keynesians, fundamental uncertainty is an important issue:
In an uncertain world, prices are set in advance of trade. [...] A markup is added
to direct average costs, as a manifestation of an organizational process of coping
with uncertainty, to cover both overheads and profit. [...] Prices are more likely to
change from cost changes than demand changes. (Downward and Lee, op. cit., p.
474)

These conventions allow prices to adjust to changes in the cost of production rather than
to changes in demand.
Post Keynesian pricing theory accepts that average total costs will decline and
that both overhead and direct costs will affect pricing decisions. As calculations
of average fixed costs – for example, to determine overhead recovery rates – will
involve planning over pricing periods, then individual transactions may not affect
prices, other than in a preplanned way through, for example, discounts. (ibid., p.
475)

The cost-plus method depends on several variables such as conventions, shareholders’

expectations, the firm’s history and its market power. The markup may even be set
arbitrarily (for example, by choosing a round number). In addition, it guarantees a profit
margin (useful for forecasting and long term planning). Knowledge of the marginal cost
and future income are difficult, if not impossible to know, particularly because markets
constantly change.
However, contrarily to flex-prices (set in the market), fix-prices (prices set by firms) are
not fully rigid, as they change according to the conditions of the pricing process. Thus,
the firm cannot necessarily set the price that it wants and it should not be too high:
The pricing power of the enterprise is a matter of degree. It is limited by the
competition in the market for the product, and while the firm can mark up the
product’s price, the mark-up on the product’s cost cannot be too high. The firm
has to consider the sales effects of the mark-up’s level, for higher mark-ups
8
 means higher prices; and when the firm’s price is above that of its competitors,
sales are lost, and the revenue from the product can drop. (Shapiro and Mott,
1995, p. 38)

Firms adjust to demand by the quantities put up for sale and by marketing strategies
rather than prices, driven by costs and therefore by supply factors. Because of their
market power, firms set prices that suit them; they are not 'price follower'. If they do not
have sufficient market power, they will follow market prices, driven by large firms. Thus,
prices can be rigid not because of market failures or psychological barriers, but rather
because firms prefer to reduce the fundamental uncertainty of markets, ensuring to obtain
the desired level of income they yearn. Imperfect competition is the norm, not the
exception.
The result of the market’s discipline will not be the improvement of the enterprise
but its demise. Survival in the market requires market power; the enterprises that
survive the market are the ones that can affect its outcomes. They are the firms
with the size and financial strength needed to wait out the market and stabilize its
results. (ibid.)

Prices rarely have the capacity to attain equilibrium (market clearing), but that is not their
primary function; markup profits obtained by firms provide them with the degree of
flexibility necessary to respond to changes in demand and to ensure their survival in the
longer term. The objective of the firm is not the maximization of profits, but the
maximization of growth ‘and the requisites of firm growth determined the mark-up on the
product.’ The maximization of the company's growth requires investment, which can be
guaranteed by a level of adequate profit: ‘While profit is needed for the expansion of the
enterprise, growth is needed for survival’.
If prices are similar or identical in a market, unit costs are not; firms therefore do not
have the same cost-plus or the same return on investment for similar products, which
depends on market power and the size of the firm: ‘There must be some price leader, or a
group of leading firms, that set the prices of the industry. [...] The price set by an
individual firm depends both on its unit costs and on the prices of other firms. [F]oreign
firms fix their prices based on the prices set by domestic firms’. (Lavoie, 2001, p. 22).
However, the financialization of the economy has somewhat partly limited these
principles, shareholders imposing when they can the maximization of short-term profits.
The priority given by some firms to share buybacks instead of investment in the
productive capacities of the firm testify of this growing trend.

4. Are consumers simple optimizer?

Are consumers omniscient and welfare-optimizing agents? Are their purchases calculated
with an internalized super computer taking into account all available information, as
implied by mainstream economics? Post-Keynesians consider this theory disconnected

9
from reality and of little use for economic analysis. They have developed a more realistic
alternative theory, based on empirically-observed behavior.
The consumer, a rational and omniscient optimizer?
Mainstream economics portray the consumer as a rational optimizer that maximizes its
well-being through his choices and purchases, a concept that is modeled by a utility
function. He makes his choices at the margin, in a logic of substitution, as there would
always be a price at which a good will be substituted for another. This approach
presupposes that all choices are comparable (as measured by the same unit of measure,
i.e. utility), without allowing neither indecision nor complexity for the decision-making
process.
In addition to being impossible to empirically calculate, this approach is static, leaving no
room for changes in preferences. However, consumers (sometimes rapidly) change ideas
about what constitutes their constellation of preferences. This approach makes it difficult
to predict the behavior of consumers since several other factors come into account. For
example, the manner and the order in which choices are presented have a significant
impact on their decisions.
The post-Keynesian theory of the consumer
Rather than calculating the optimal value of a basket of goods (which is impossible to
estimate and even less to aggregate), post-Keynesians conceive the consumer as an
individual who will use rule-of-thumb and emulation to determine its consumption and
behavior. He will confine his decisions to a limited number of choices, mostly
determined by social norms and routines.
The post-Keynesian approach is inspired by several schools of thought and contributions,
including the work of institutionalists, psychologists, sociologists, marketing specialists
and heterodox economists such as Nicholas Georgescu-Roegen and Herbert Simon. Post-
Keynesian theory presents the consumer as a human with limited capacity and patience:
It has been shown that the vast majority of consumer decisions are spontaneous
and arise out of routines and choices weighted on the basis of one or two criteria.
For example, when buying a chair, the choice of colors could be offset by the
quality of leather he desires. Households do not weigh all possible options, except
for significant purchases. This allows them to take the necessary decisions of
everyday life. (Lavoie, 2004, p. 29, loose translation)

This approach allows the consumer to simplify his daily decisions. He doesn’t optimize,
he practices satisficing. This neologism of the words satisfy and suffice is a concept
developed by the behavioral economist Herbert Simon. As explained by Lavoie:
‘individuals set aspirational levels, so that the search for alternatives is brought to an
end when the aspiration level is achieved’ (2014, p. 90). In defining what is acceptable
and what is not, the consumer avoids considering all possible options, juggling only with
those considered suitable.

10
Hierarchical needs
Contrarily to mainstream theories of the consumer, post-Keynesians make the distinction
between a need and a desire. For example, eating is a need; the choice between a pizza
and a filet mignon is a choice. Also, the consumer’s decision-making process should be
simple and fast, because his cognitive abilities and his time are limited. In real life, he has
no time to make the precise calculations necessary to determine what are the optimum
choices of shampoos or biscuits. The possibilities become much more limited, whereby
manageable:
If the consumer attempted to allocate his income by taking into account all prices
and all possible goods, the task would be impossible. To alleviate this
complexity, consumers take a series of decisions that simplify and subdivide the
task. They allocate different budgets to various items of expenditure (food,
clothing, services, entertainment, accommodation, transport), and within each
expense item and every need, they evaluate different subcategories or their
desires, regardless of the other items of expenditure. (Lavoie, 2004, p. 30, loose
translation)

The consumer will allocate his available income by dividing his needs according to
specific categories of goods and services. His choice will be relatively isolated and
hierarchical, an obvious parallel with Maslow’s pyramid. Basic necessities (housing,
food) will be probably be determined first. When a category of need is satisfied, he will
pass on to the next category. This hierarchy of preferences indicates that income effects
prevail over substitution effects. The level and the type of demand will outweigh relative
prices. Macroeconomic effects become more decisive than microeconomic effects. This
observation is consistent with post-Keynesian macroeconomics, economic growth being
determined by demand, which is composed mainly of wages. Unlike mainstream theories,
consumers empirically behave as predicted by the post-Keynesian perspective:
Only an increase in the overall cost of goods can have an impact on the allocation
to other major items of expenditure (a global increase of the cost of food can lead
to a drop in food expenditures). Indeed, empirical studies clearly demonstrate that
the major items of expenditure have [...] extremely low price elasticities and
cross-price elasticities close to zero. [...] In other words, effects of substitution
between major items of expenditure are almost zero [and] are useless when
similar products are implicated (in the case of fruit juices and soft drinks, for
example). (ibid., emphasis in original, loose translation)

In this perspective, largely influenced by the social environment, advertising takes on its
full meaning. Needs can be created before the consumer is 'aware' that he 'needs' an iPad.
For a consumer, acquiring needs is mostly a social phenomenon, determined by its
environment. Consumers adapt. Social consumption relative to that of others is better
explained in this perspective. In addition, past choices have an influence on the current
decisions of the consumer; the purchase of an Apple computer can be motivated by the
possession of software and habits inherited from the possession of a similar computer in
an earlier period. Table 1 lists the seven principles of the post-Keynesian theory of the
consumer.
11
 Table 1: The seven principles of the post-Keynesian theory of the consumer

Lavoie, 2004, p. 28, loose translation.

Evidently, this theory is more complex to model than a utility function. It has the
advantage of being much more representative of the real world, the complexity of the
latter being rather difficult to reduce to its simplest expression. Economic theory has to
adapt to the real world, rather than the other way around.

5. Demand, main determinant of economic growth

Economic growth is a recurring issue in public debates. Why has it been so low since the
Great Recession? How can we generate more (for all)? Modern societies depend (too
much?) on growth to function and strive. How is it determined? The post-Keynesian
school of thought provides relevant and empirically-grounded theories, based on the
central role of aggregate demand, rather than supply factors, main components of
mainstream growth theories.
Mainstream theories of growth
For heterodox macroeconomists, Solow’s canonical model (1956) and the theory of
endogenous growth developed in the 1980s fail to convincingly explain the formation and
changes of economic growth2. For Solow’s model, the evolution of savings and labor are
exogenously given. The only remaining explanatory factor is the growth of productivity
(total-factor productivity), which is measured as what remains when subtracting the
effects of savings and the labor force.
Thus, the sole determinant of growth is a residual (what we fail to explain). In the words
of Stanford economist Moses Abramovitz, it is a measure of our ignorance. According to

2
The assumptions of diminishing marginal returns, the neutrality of money, the use of logical time rather
than historical time, the substitutability between capital and labor, the production function, the absence of
uncertainty and the causal relationship implying that savings produce investment (Say’s law) are strongly
disputed by post-Keynesians.
12
Schlefer: ‘Productivity growth does tend to parallel economic growth, but economic
growth often seems to be the horse, and productivity growth, the cart.’ (2012, p. 177)
As for endogenous growth models, they have a number of significant shortcomings,
including a large number of ad hoc assumptions added ex post, the search for empirical
validation rather than theoretical falsification, the idea that technological innovation
comes almost exclusively from the competitive process of markets (evacuating non-
market institutions from the analysis), the failure to take into account the distribution of
income, as well as the Cambridge critic, whereby capital cannot be aggregated.
Also, an important shortcoming is the hypothesis that Say’s law holds, even in the long
run because savings would generate investment and money would be neutral (the subject
of the next section). Of course, saving does equal investment, but this is only an
accounting identity and unsold goods are recorded as inventory at the end of a period,
which is classified as an investment. For post-Keynesians, savings does not determine
investment: ‘there is no reason why an increase, say, in the saving rate should lead to the
adoption of more capital intensive techniques, thus casting doubt on the mere theoretical
existence of a stable neoclassical growth path.’ (Cesaratto, 2010) According to Lavoie,
[there] are an infinity of possible long-term equilibria, which depend on constraints
imposed by demand and institutions. Supply side factors will adjust to demand.
(2004, p. 17, loose translation)

Growth is demand-driven
For Post-Keynesians, the principle of effective demand is the main determinant of
economic growth: ‘in a situation of unused capacities and unemployment, an increase in
aggregate demand will increase output and employment without changing the price
level.’ (Herr, 2013, p. 12) Supply factors determine the maximum productive capacity of
the economy but effective demand rarely reaches this limit, beyond which only inflation
is produced. The economy only rarely reaches full capacity of physical capital and full
employment of workers available on the labor market. For example, the rate of capacity
utilization3 of firms in Canada ranged between 70% and 90% from 1987 to 2014, rather
than being close to 100% (Statistics Canada, 2015). When it comes close to full
utilization, firms will simply acquire new productive capacity to preserve the flexibility
necessary to adapt to rapidly changing markets.
According to post-Keynesians, overall demand is driven by autonomous demand 4, mainly
investment, which depends on a multitude of factors, ‘including the state of present and
prospective demand, profitability and 'animal spirits' and technological factors.’ (Arestis
and Sawyer, 2009, p. 22) Investment and net exports determine the current level of
production and the employment rate since firms base their decisions on the value of
goods and services that they think they can sell (expectations), in a context of

3
Defined by Statistics Canada as being ‘the ratio between the actual production and theoretical production’.
4
Non-autonomous demand refers to consumer spending, which vary depending on the distribution of
income, i.e. the marginal propensity to consume, which declines when an individual’s income increases.
Savings are a residual (what remains after consumption), rather than a consciously predetermined level. It
should be noted that a large portion of the population does not save because their income is too low.
13
fundamental uncertainty. Firms invest and take risks according to the state of effective
demand and future expectations. This is why post-Keynesian models usually have an
independent investment function.
Unlike the neoclassical, neo-Keynesian and Marxist postulates, post-Keynesians argue
that supply factors (productivity, technological innovation, size of the labor force) are
largely determined by effective demand, even in the long term, via its effects on the
structure of the economy (the distribution between sectors, i.e. manufacturing, services,
etc), immigration and the participation rate of the labor force.
It is a serious defect in mainstream economics to have reduced all long-term issues
to matters of the supply side. Lack of demand destroys capacity and technology,
and conversely demand is a key stimulus for innovation and investment in Post
Keynesian theory. (Hayes, 2010, p. 2)

Investments determine savings, due to its multiplier effect on growth:

The analogy between the individual (or household) and the economy does not hold,
due to the circular flow between expenditure and income in the macroeconomy,
where, in a double-entry national accounting format, my expenditure becomes your
income. As a result, expenditure injected into the circular flow (as autonomous
investment) can generate a matching amount of saving by raising income via the
multiplier effect. In this framework, higher saving is the consequence of higher
investment, and the maximizing principle of the individual agent deciding between
present and future consumption (or saving) is, to say the least, an inessential detail.
(Bhaduri, 2014, p. 4)

This short demonstration casts serious doubts on the analytical priority granted to supply
side factors by mainstream economics and reaffirms the importance of demand as the
main driver of growth.

6. Money, created by commercial banks

Unlike most mainstream schools of thought, post-Keynesians consider money to be
endogenously determined, even in the long term. The evolution of the money supply is
the product of the economic system, the decisions of agents and economic growth.
Liquidity preference in the context of fundamental uncertainty plays a vital role. The
creation and the fluctuations of money are therefore not an exogenously given neutral
phenomena. The central bank only has a peripheral influence on the quantity of money.
The post-Keynesian theory of endogenous money
Credit is a central component of our modern economies. For post-Keynesians,
commercial banks play an important role that goes beyond the allocation of savings; they
create money; not bank notes per se but the money supply in circulation. Monetary
policies only exert an indirect influence on the money supply, by the use of interest rates
and by fixing the level of reserves required to guarantee deposits. But these factors do not

14
limit the capacity of banks to create deposits, and thereby money, almost literally out of
thin air.
For commercial banks to grant credit and create deposits, no prior reserves are
necessary. The creation of credit and of bank deposits (money) in based solely on
the basis of the credibility of the borrower and the guarantees he offers. (Lavoie,
2004, p. 55, loose translation)

According to post-Keynesians, the demand for money is the leading constraint for the
amount of money in circulation. Speculation and an inflationary spiral (driven by a
conflict between wages and prices) are among the factors that influence the demand for
money, but the main factor is the increase in aggregate income, i.e. GDP growth, via the
Keynesian multiplier. It is investment decided by firms and the interest rate fixed by the
central bank that determines the amount of savings, via economic growth.
Conversely, if all households wish to save more, they will fail at this task; the aggregate
result of a decline in consumption will be an equivalent loss of income for the firms that
employ them, which will affect the level of investment and in the end, their own salaries.
Higher desired savings leads to lower aggregate income, not higher savings. This is the
paradox of thrift.
Whenever they grant loans, commercial banks create money by crediting the account of
the borrower. Credits make deposits, not vice versa. The money supply is determined
endogenously by the demand for loans (and the willingness of banks to lend): ‘banks
create credit and deposits, and they then procure the bank notes issued by the central bank
when requested by their customers, as well as minimum reserves required by law.’ (ibid.,
loose translation) In a closed economy, the scarcity of funding is conventional: ‘as long
as only the resources of a national economy are mobilized, financing economic activity
depends only on the credibility of the borrower and the existing financial standards.’
By using double-entry bookkeeping, banks create money in the form of credit and most
transactions simply transfer money between the accounts of their customers. When a loan
is granted, M1 grows, and when it is repaid, M1 shrinks at an equivalent level. This
means that the money supply is adjusted to the level of economic activity. Empirically,
M1 is procyclical.
The preference for liquidity
John Maynard Keynes advanced the idea of liquidity preference to illustrate the motives
for demanding money. It is preferred to other types of less mobile assets, satisfying the
need for available and liquid funds to attain the preferred level of flexibility of agents in a
context of fundamental uncertainty, an essential characteristic of the real economy.
The preference for liquidity can be found in three distinct motives. First, transactions
require a quantity of money to meet anticipated expenditure. Also, to respond to
unanticipated needs, consumers and firms will keep in reserve a determined quantity of
money in a precautionary fashion because revenues could not be available at the
appropriate time. In both cases, the demand for money increases when income increases.
Finally, speculation requires flexibility of financial resources that allows liquidity of

15
assets, a flexibility that is granted by the possession of money in a situation of
fundamental uncertainty. However, unlike the transactional and precautionary motives,
an individual’s desire to hold money to satisfy the speculative motive is a
function of anticipated movements in a range of asset prices rather than changes
in the level of income. [...] The money balances that are held to satisfy these
motives reflect the individual’s degree of liquidity preference. (Kelton, 2012, p.
373)

According to Keynes, the interest rate is the price to depart from liquidity. Thus,
commercial banks offer credit according to their own preference for liquidity, and
borrowers demand credit according their own preference. This is reflected by the
composition of their portfolio of assets, determined by their state of confidence in the
prices of all financial and non-financial assets, according to their anticipations:
Money is created and made available to nonbank agents as a result of the
portfolio decisions of banks. The responsiveness of banks to demands from the
public depends on the preferences that orient those portfolio decisions. (Dow,
1995, p. 1)

If uncertainty or pessimism about economic perspectives in the short or medium term

increases, liquidity preference will be higher: ‘Shifting liquidity preference influences the
supply of and demand for credit, as well as output and employment’ (ibid.) By hoarding
money, individuals and firms withdraw money from circulation, which would otherwise
be dedicated to consumption or investment. A higher preference for liquidity will
increase the rate of interest at too high a level, undermining the investment potential, and
thereby economic growth and unemployment: ‘When liquidity is high, there may be no
preference rate of interest that will induce investment in illiquid capital - and even if the
overnight interest falls, this may not lower the long-term rate.’ (Wray, 2012, p. 408)
If investors and borrowers do not have access to all information and are not perfectly
rational, they cannot allocate the 'correct' price, i.e. the exact price of risk (notably
because they do not know the future), with the exception of the guaranteed rate of interest
offered by the central bank. Due to the preference for liquidity, uncertain expectations
and emotional factors prevail. The real economy has a real influence on monetary factors.
Table 2 identifies the fundamental characteristics of money for post-Keynesian and
neoclassical schools of thought.

16
Table 2: Characteristics of money for post-Keynesian and neoclassical schools of
thought

Source: Lavoie, 2004, p. 54, loose translation.

This approach may seem counter-intuitive, especially if the theories learned at the
undergraduate and graduate levels advocate mainly (if not only) an exogenous approach
to money. Yet the facts remain.

7. An alternative approach to international trade

Based on comparative advantages, mainstream economic theories of international trade
assume that the production of a country will be determined by supply-side factors, such
as technology, consumer preferences and availability of 'substitutable' productive
resources (capital, labor). If there are no constraints to trade, the prices of resources and
products will adjust to an optimal situation of full employment in the long term. The
previous sections addressing mainstream approaches of the firm, growth and prices have
shown the limits of these assumptions.
Effective demand and trade equilibrium
In a world characterized by involuntary unemployment and insufficient effective demand,
countries often try to obtain a surplus of their current account to increase their economic
growth and their employment rate. Their comparative advantages (low currency and low
costs) basically allow them to 'import demand'. Since all countries cannot be in a situation
of surplus at the same time, this surplus is gained at the expense of their trading partners,
producing a deficit in their current account, whereby reducing their economic growth and
increasing their unemployment rate. This export-based policy was described by Joan
Robinson as a 'beggar-thy-neighbor policy'. This phenomenon was and still is largely
overlooked by mainstream economists: ‘in the 1980s mainstream economists waxed
enthusiastic about the export-led economic miracle of Japan, Germany and the Pacific
rim NICs, without noting that these miraculous performance were at the expense of the
rest of the world.’ (Davidson, 1999, p. 10). Demand constraints must therefore be
considered.
Important post-Keynesian contribution, the balance of payment growth theory argues that
in the long term, a trade equilibrium deficit is not indefinitely sustainable and affected
countries will need to balance their current account. In other words, national economies
17
could grow faster if they were not constrained by their balance of trade. This necessity to
adjust in the long run must be made through changes of the quantities produced (level of
income) or changes to the growth rate, rather than by changes in the level of relative
prices (real exchange rates). This external constraint limits the growth of supply and
demand factors. Here is how Thirlwall describes the process:
If a country gets into balance of payment difficulties as it expands demand before
the short term capacity growth rate is reached, then demand must be curtailed;
supply is never fully utilised; investment is discouraged; technological progress is
slowed down, and a country’s goods compared to foreign goods become less
desirable so worsening the balance of payments still further, and so on. A vicious
circle is started. By contrast, if a country is able to expand demand up to the level
of existing productive capacity, without balance of payment difficulties arising,
the pressure of demand upon capacity may well raise the capacity growth rate.
(Thirlwall, 2011, p. 430)

Balance constrained growth is defined as the growth rate of domestic exports divided by
the rate of elasticity of income relative to the demand for imports. In other words, a
country will have significant economic growth by exporting goods and services with a
high elasticity relatively to global demand, while importing goods which have a low
elasticity: ‘The key to long-run growth is to make one's exports more attractive to the rest
of the world relative to import, in the non-price dimensions.’ (Razmi, 2012, p. 197)
Obviously, trade deficits can be ‘offset by the influx of foreign capital, but for all
countries except the United States, whose dollar is the international currency, this
situation cannot be temporary, because interests and dividends must be paid on
accumulated debt and investments from abroad.’ (Lavoie, 2004, p. 110, loose translation)
Capital flows, essential determinant of international trade
Since the 1970s, deregulation and the amplification of capital flows have caused many
problems to countries engaged in international trade, in terms of trade imbalances,
volatility and instability:
It has changed the very nature of the market and provides an excellent example of
the folly of what Keynes called the ‘fetish of liquidity’. In addition to the
payments imbalances, resource misallocations, and trade and investment
diversion this may cause, it reduces government policy autonomy and represents
a waste of entrepreneurial talent. This is a problem in all market-based
economies, but is even more problematic in the developing world. (ibid., p 210)

Central element of the post-Keynesian theory of international trade, capital flows finance
trade deficits: ‘As long as countries with trade surpluses run offsetting capital account
deficits (that is, become net lenders) and countries with trade deficits run offsetting
capital account surpluses (that is, become net borrower), overall balance-of-payments
equilibrium can be sustained without eliminating trade imbalances.’ (ibid., p. 306) Net
capital flows determine the balance of trade. The implications of this phenomenon are
sometimes misunderstood. Some may support that low real wages, superior technology or
similar factors are responsible for surplus or trade deficits of a monetary regions.
18
However, a deficit account in the national accounts must be identical to net capital
inflow, as well as a current account surplus with net capital outflow. The causal link
clearly flows from capital imports to current account imbalances. Productivity, the
preferences of consumers, the availability of natural resources, tariffs, monopoly
situations in certain sectors of production, and so forth only determine the structure of
international trade (McCombie and Thirlwall, 1999, p. 41).
Developing countries in particular benefit in the short term of an influx of foreign direct
investment, which most often take the form of credit (loans). These debts are generally
contracted in foreign currencies by firms and local governments. When countries
(especially developing countries) undergo a rapid depreciation of their national currency,
a high level of debt marked in foreign currency leads to serious problems of liquidity and
solvency. These additional investments, initially bringing growth and jobs, can quickly
become cumbersome, destabilizing their economies and fuelling financial crises, like
those experienced by Asian countries, Mexico and Russia during the 1990s. Short term
gains do not compensate for these problems in the long term. Unfortunately, there is no
automatic correction mechanism to bring these countries to equilibrium:
Debt, once contracted, cannot be dealt with through deflation and
‘decumulation’, as in neoclassical and Austrian business cycle theory – that is by
‘getting prices right’ internally – since the underlying problem is not one of a
temporary inefficient allocation of existing resources, or even of the endogenous
instabilities of self-sustaining capitalist accumulation paths, but one of structural
socio-economic obstacles to industrialization. (Blankenburg and Palma, op. cit.,
p. 139)

Without a mechanism to force countries with trade surpluses to increase their domestic
demand (excluding international political pressures), the adjustment process lay on
countries with current account deficits. Without capital controls that ensures this
objective, countries with high levels of demand must restrict their growth. Global
aggregate demand is therefore pulled down, reducing the potential economic growth and
unnecessarily increasing unemployment.
The free movement of large capital flows can create serious balance of payment problems
for countries that would otherwise have an approximately balanced current account.
Unfortunately, in a system of deregulated capital markets, fund being invested to develop
the planet’s resources are indistinguishable from money laundering of flows of illegal
funds, speculative capital flows continually in search for short-term profits, funds that are
kept for precautionary motives or simply hiding from the tax collector. According to
Davidson, these capital movements can be dangerous:
The international movement of speculative, precautionary, or illegal funds (hot
money), if it becomes significantly large, can be so disruptive to the global
economy as to impoverish most, if not all, nations who organise production and
exchange processes on an entrepreneurial basis. Keynes warned: ‘Loose funds
may sweep round the world disorganizing all steady business. Nothing is more
certain than that the movement of capital funds must be regulated’. (op. cit., p.
13)

19
Without control of capital flows or binding mechanism for countries with export-led
policies based on high trade surpluses (like Germany and Japan), the current global
trading system will keep its deflationary bias, limiting the opportunities for employment
and growth.

Exchange rates as adjustment variable?

Mainstream trade economics argue that flexible exchange rates will correct these
imbalances of international trade; a country’s currency is expected to increase when it
accumulates surpluses, while those with deficits should see their currency depreciate,
restoring the trade equilibrium. However, trade imbalances have greatly increased since
the Bretton Woods fixed exchange rate system (under which the world has known few
financial and economic crises) gave way to the current flexible exchange rate system.
Post-Keynesians consider that flexible exchange rates
are driven primarily by financial capital flows and asset market speculation, and
hence need not move in the ‘right’ direction for balancing trade and, even when
they do adjust, exchange rate changes may not generate the desired improvement
in the trade balance due to low price elasticities or offsetting price changes. [The]
implication that imbalanced trade will not follow comparative advantages is
emphasized only by Post Keynesians. (Blecker, 2012, p. 306)

Since the 1970s, the deregulation of capital flows and the adoption of flexible exchange
rates resulted in a large increase of capital flows across countries, representing up to 50
times the amounts exchanged strictly for commercial purposes. Such changes produced a
surge of exchange-rate volatility, a significant increase in current account imbalances and
financial crises (mainly in developing countries). This fueled fundamental uncertainty,
thereby reducing potential economic growth.
In a system with multiple currencies, flexible exchange rate markets function like stock
markets, i.e. based on the expectations of agents and financial speculation. Without any
reality-based anchor (markets can be quite irrational), this phenomenon does not allow
foreign exchange markets to benefit from the mainstream-attributed tendency to
equilibrium by the price mechanism.
Since prices are not a reliable measure of true economic scarcity and economic
agents do not act solely as choice-theoretic automatons but also as members of
social groups, comparative advantage is not a reliable driver of international
integration. (Blankenburg and Palma, 2012, p. 139)

Flexible exchange rates are thus determined by the expectations of exchange rates. They
are driven by financial investors, which explains their volatility since the end of the
Bretton Woods fixed exchange rate system. Why do these expectations change so
quickly? Post-Keynesians identifies six causes:

20
 the speculative nature of the currency market; the lack of a true anchor to
currency values; the subculture of foreign currency dealers; the particular manner
in which people make decisions; the environment of uncertainty in which
decisions are made; and bandwagon effects. (Harvey, 1999, p. 206)

Capital flows are crucial to understand international trade. Absolute advantages, rather
than comparative advantages, determine international exchanges.

Relative versus absolute advantage

For a country playing the game of free trade and who has a lower productivity than its
trading partners, it will simply suffer a decline of its domestic demand. There will be no
automatic adjustment mechanism in the long term to correct it’s current account
imbalances. Capital flows, rather than the flow of goods and services, determine
international trade. These capital flows, most often of speculative origin, seek higher
yields. The absolute benefit of a country will therefore be decisive, rather than it’s
comparative advantage. ‘The law of comparative advantage is only applicable after all
nations have domestic demand management policies assuring full employment.’
(Davidson, op. cit., p. 11) Trade equilibrium will not automatically adjust.
If capital flows, rather than the current account, dominate the development of the
balance of payment, then there is no reason to believe that the balance of payment
is self-adjusting. This implies that the imposition of capital controls is essential
for full employment policies to be sustainable. (Vernengo, 2001, p. 182)

Post-Keynesians reject the assumption of the neutrality of money and the preeminence
accorded to 'real' trade instead of financial factors. Absolute advantages outweigh
comparative advantages. The argument that free trade benefits all countries falls flat as
soon as are discarded the unrealistic assumptions on which it is based:
The conventional argument for mutual benefits to all countries from free trade,
based on the theory of comparative advantages, is rooted in the 'pure' trade
models that assume balanced trade and full employment as well as capital
immobility. If any of these assumptions are dropped, the theory of comparative
advantage breaks down, and it can no longer be presumed that free trade policies
are always in a nation’s best interest. (Blecker, op. cit., p. 305)

8. Conclusion
Modern economies that leave markets unchecked are unstable, produce economic and
financial crises, as well as a chronic underutilization of resources, resulting in rising
inequality and high unemployment. Firms and individuals undergo high levels of
detrimental uncertainty and only a minority benefits from unfettered markets.
The post-Keynesian school of thought provides realistic and empirically grounded
theoretical tools, as well as effective policies. The regulation of finance, proactive
macroeconomic and industrial policies to support demand and economic growth, the
21
reconstruction of an international regime based on cooperation and the establishment of a
mechanism to reduce current account imbalances by recycling trade surpluses, the
rebalancing of market power in favor of all workers by an active role of the State, trade
unions and civil society; all these viable and necessary policies can reduce inequality and
achieve stable, truly sustainable economic growth.

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