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1 Introduction

I define a classic in economics as a book everyone cites but practically no one reads. Thus, Keynes’s General Theory of Employment Interest and Money is truly an economic classic. I should add that even among those few who claim to have read Keynes’s book, it is obvious that most of these readers have not comprehended Keynes’s message.

Keynes (1936) stated that “The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of income and wealth ” (p. 372). Some 70 years after Keynes wrote this, the Great Recession, beginning in August 2007, has demonstrated that these ‘faults’ are still plaguing the developed nations around the globe. This chapter will demonstrate that the persistence of these economic faults of the economic system in which we live are due in large part to the fact that what passes for Keynes’s theory in mainstream professional journals, textbooks, and so on is not the theory that Keynes specified in his General Theory (1936).

Modern macroeconomic theory has flourished professionally in its pursuit of the secrets of long-run economic growth, but has completely neglected the short-run economic problem of unemployment. Modern macroeconomics assumes that in the long run, prices are flexible and the growth of the economy is determined primarily by the growth in the ability to supply goods and services. Thus, increases in technology which produces increases in labor productivity are often cited as the basis for economic growth and prosperity.

But in the short run, it is assumed that we live in an economy where prices and/or money wages are not perfectly flexible . Consequently, growth and full-employment prosperity can be held back because prices and/or money wages are too high, and as a result, market demand is too low to absorb all that can be produced at full employment . Samuelson’s mainstream Neoclassical Synthesis Keynesian theory and the next generation of New Keynesian theorists, as well as most widely sold Principles of Economics textbooks, claim that Keynes’s general theory associates any short -run unemployment problem as being caused by the stickiness or even rigidity of money wages and/or administered prices.

This claim that Keynes’s analysis required short -run wage and/or price rigidity, such as a sticky, money wage rate and administered product prices, is, however, exactly what classical theory specified to explain the causes of unemployment. This rigidity of money wages presumption is also the fundamental basis of Samuelson’s neoclassical synthesis interpretation of Keynes’s General Theory. But this presumption of rigidity is in direct conflict with Keynes’s own words about what he believed was the basis of his General Theory of Employment, Interest and Money.

As Keynes (1936) put it:

For the classical theory has been so accustomed to rest the supposedly self-adjusting character of the economic system on the assumed fluidity of money wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment ..... My difference from this theory is primarily a difference of analysis. (p. 257)

To understand the difference between Keynes’s analysis of the cause of involuntary unemployment and the rigidity of the money wage rate presumption of Samuelson and modern Neoclassical Synthesis, Keynesian theorists and New Keynesian theorists, and in terms of the causes of unemployment, requires an explanation of how Keynes’s macroeconomic analysis was perverted by Samuelson’s neoclassical synthesis interpretation of Keynes.Footnote 1 We will then be able to provide the explanation of how Keynes’s liquidity serious monetary theory and its specification of the essential properties of money and all other liquid assets is, as Keynes noted (1936, p. 257), ‘primarily a difference of analysis’ of the cause of involuntary unemployment from the classical theory that presumes wage and price rigidity or stickiness is the basic cause of unemployment in the short run—or even in the long run. Once the reader is made aware of what Keynes specified as ‘the essential properties’ of money and all other liquid assets , then the reader will be able to understand the principles of why international payments imbalances and the financial crisis of 2007–8 has created the worst global economic recessionary period since the Great Depression .

2 Samuelson’s Abortion of Keynes’s General Theory

In 1941, Samuelson’s PhD dissertation won the Wells prize for the best PhD dissertation in economics at Harvard. This dissertation was polished by Samuelson and finally published as Foundations of Economic Analysis (1947). Neoclassical Synthesis Keynesianism and New Keynesianism theories are both based on what Samuelson’s Foundations of Economic Analysis asserts as the necessary Walrasian classical microfoundation of all valid economic theories. If the microfoundations of any macroeconomic analysis are not Walrasian, then, according to Samuelson, this non-Walrasian micro-based macroeconomics is neither a valid theory of economics nor what Keynes meant in his General Theory.

Nevertheless, Keynes (1936, pp. 176–177) stated that Walras “is strictly in the classical tradition”—a tradition that Keynes’s General Theory was attempting to replace. Moreover, as already noted on p. 257 of the General Theory, Keynes explicitly denied that his theory of unemployment required the classical theory presumption of rigid money wages.

After reading Keynes’s General Theory of Employment, Interest and Money in 1936, Samuelson stated that he found Keynes’s General Theory analysis ‘unpalatable’ and not comprehensible (Colander and Landreth 1996, p. 159). Samuelson then explicitly stated that “The way I finally convinced myself was to just stop worrying about it (about understanding Keynes’s analysis). I asked myself: why do I refuse a paradigm that enables me to understand the Roosevelt upturn from 1933 till 1937? … I was content to assume that there was enough rigidity in relative prices and wages to make the Keynesian alternative to Walras operative ” (Colander and Landreth 1996, pp. 159–160, emphasis added).

In the Preface to the German language edition of The General Theory, however, the following sentences appear: “One of the reasons for justifying my calling my theory a General theory. Since it is based on fewer restrictive assumptions (“weniger enge Vorasusstezungen Stutz”) than the orthodox (classical) theory. It is also more easily adopted to a large area of different circumstances”.Footnote 2 In other words, Keynes’s general theory is a classical theory from which some restrictive axioms fundamental to classical theory have been removed.

On the other hand, Samuelson has claimed that the Walrasian general equilibrium analysis is the fundamental foundation of any general theory of economics and Keynes’s analysis was a special case where an additional restrictive assumption of rigidity of money wages and/or product prices was added to the Walrasian microfoundation to develop an analysis where the gross substitution effect (which require freely flexible prices and wages) cannot work to assure full employment in the short run.

Samuelson (as in Colander and Landreth 1996, p. 163) explicitly stated that in his view Keynes’s analysis is merely a “very slowly adjusting disequilibrium …. [where] the full Walrasian equilibrium was not realized” in the short run because prices and money wages do not adjust rapidly enough to an exogenous shock. Nevertheless, the economic system would, if left alone, achieve full employment in the long run as all prices and wages are variable. It therefore follows that Samuelson as a ‘Keynesian’ has urged additional government spending to achieve full employment before there was at the long run Walrasian adjustment to flexible wages and prices, merely because he is too impatient to wait to leave it to the market to permit the slowly adjusting Walrasian system to achieve this longer-run goal of full employment.

It is worth noting that Samuelson’s slowly adjusting Walrasian microfoundation interpretation of Keynes apparently convinced all mainstream ‘Keynesian’ economists after the Second World War to treat Keynes’s theory as a ‘special case’ of the general classical (Walrasian) theory where full employment is inevitable if all money wages and money prices are freely flexible. In the Samuelson and mainstream Keynesian economists’ post-Second World War view, the classical Walrasian general theory involved freely flexible wages and prices, while Keynes’s theory was merely a special case of the Walrasian system , where this special case presumed an additional restrictive assumption of sticky or rigid money wages and/or prices is added to the general Walrasian theory. Following Samuelson’s insistence that the foundation of all economic theories explaining the economic system in which we live is a Walrasian slowly adjusting process, mainstream Keynesian theorists after the Second World War always taught their students that Keynes’s explanation of involuntary unemployment required the fact that money wages and prices were not freely flexible.

Since Samuelson claimed he read The General Theory of Employment, Interest and Money and found it ‘unpalatable’, most economists after the war were convinced by Samuelson’s use of mathematics in economics that reading exactly what Keynes wrote would not be very productive. Instead they merely adopted Samuelson’s interpretation of Keynes’s book as a classic in economics and they apparently never even tried to read Keynes’s book. Thus, all mainstream Keynesian theories ignored Chap. 19 in the General Theory, entitled ‘Changes in Money Wages’.

In this chapter, Keynes explicitly denies the validity of this rigidity of wages and prices assertion as a basis for his theory of involuntary unemployment. Using the Marshallian micro theory—instead of the Walrasian micro theory—as the microfoundation of his general theory, Keynes is able to demonstrate in Chap. 19 that even if the economy possessed freely flexible money wages and prices, involuntary unemployment equilibrium can still occur and persist.

Samuelson never tried to comprehend Keynes’s use of Marshallian micro analytical foundation and framework for his General Theory. For in 1986 Samuelson was still claiming that “we [Keynesians] always assumed that the Keynesian underemployment equilibrium floated on a substructure of administered prices and imperfect competition” (Colander and Landreth 1996, p. 160). When pushed by Colander and Landreth as to whether this requirement of rigidity was ever formalized in his work, Samuelson’s response was: “There was no need to” (Colander and Landreth 1996, p. 161). Clearly had Samuelson and any of his Keynesian followers read and understood Chap. 19 of Keynes’s classic in economic theory, Samuelson would have to have noted that there was at least one ‘Keynesian’ named John Maynard Keynes, who had not assumed that the “Keynesian underemployment equilibrium floated on a substructure of administered prices and imperfect competition”.

Specifically in Chap. 19 of the General Theory, and even more directly in Keynes’s published response to Dunlop (1938) criticism of Keynes’s analysis, Keynes (1939) had already responded in the negative to this question of whether his analysis of less than full-employment equilibrium required imperfect competition, administered prices, and/or rigid wages. Dunlop (1938) had argued that the purely competitive model was not empirically justified; therefore, it was monopolistic price and wage fixities that must be the realistic basis of Keynes’s involuntary unemployment equilibrium analysis. Keynes’s (1939) reply to Dunlop was simply: “I complain a little that I in particular should be criticised for conceding a little to the other view” (p. 411).

In Chaps. 17–19 of his General Theory, Keynes explicitly demonstrated that even if a purely competitive economy with perfectly flexible money wages and prices existed (‘conceding a little to the other side’), there was no automatic competitive market mechanism that could restore the full-employment level of effective demand in his theory if some involuntary unemployment existed. In other words, Keynes’s general theory, using Marshallian microfoundations , could show that, as a matter of logic, less than full-employment equilibrium could exist in a purely competitive economy with freely flexible wages and freely competitive product prices.

Obviously Samuelson, who became the premier American ‘Keynesian’ of his time, had either not read or not comprehended (1) Keynes’s response to Dunlop or even (2) Chap. 19 of the General Theory.

Keynes (1936) indicated that to assume that wage rigidity was the sole cause of the existence of an unemployment equilibrium implied accepting the argument that the Marshallian micro-demand functions “can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and fixity as to the amount of aggregate effective demand. It is invalid, therefore to transfer the argument to industry as a whole unless we also transfer the argument that the aggregate effective demand is fixed. Yet this assumption reduces the argument to an ignoratio elenchi” (p. 259).

An ignoratio elenchi is a fallacy in logic of offering a proof irrelevant to the proposition in question. Unfortunately Samuelson invoked the same classical ignoratio elenchi when he argued that Keynes’s general theory was simply a slowly adjusting Walrasian general equilibrium system where if there is insufficient aggregate effective demand to produce full employment , then rigid wages and prices created a temporary disequilibrium that prevented full-employment equilibrium from being restored in the short run.

As Keynes (1936) went on to explain,

whilst no one would wish to deny the proposition that a reduction in money wages accompanied by the same aggregate effective demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money wages will or will not be accompanied by the same aggregate effective demand as before measured in term of money, or, at any rate, by an aggregate effective demand which is not reduced in full proportion to the reduction in money -wages. (pp. 259–260)

Keynes (1936) then spent the rest of Chap. 19 analyzing the question that if the economy was not initially at full employment, how any reduction in the money wage rate would affect both the aggregate supply function and the aggregate demand function. A reduction in money wage rate reduced money costs of production at every level of employment and therefore would shift downward the aggregate supply curve function ‘in terms of money’. The money wage reduction implies a reduction in aggregate money wage income at every possible level of employment. This reduction in wage earners’ money income would reduce their aggregate money spending on consumption by wage earners at each level of employment. The result is to also shift downward the aggregate demand function ‘in terms of money’.

Does the downward shift in both the aggregate demand curve and the aggregate supply curve in money terms result in their intersection at the same initial level of unemployment or will a new point of intersection of these aggregate supply and aggregate demand curves after their shifts be at full employment, or at least a higher level of employment? Keynes’s Marshallian microfoundation answer was there was no reason to believe that the two downward-shifting curves’ intersection would produce a higher equilibrium level of employment.

This question of where the point of effective demand would be if all prices and wages were flexible, by assumption, is not relevant to a Walrasian system or Samuelson’s Neoclassical Synthesis Keynesianism which assumes a slowly adjusting Walrasian system . A Walrasian system is built on the assumption that with flexible wages and prices, there will always be a sufficient market demand to purchase all that is produced by a fully employed economy at profitable prices for the entrepreneurs . There can never be a lack of aggregate effective demand if all wages and prices are flexible.

At the same time that Samuelson was developing his Neoclassical Synthesis Keynesianism, he was working on cleaning up his masterful Foundations of Economic Analysis (1947) in which Samuelson ‘demonstrates’ that the Walrasian system is the foundation for all economic theory. In this 1947 book, Samuelson asserted certain specific classical axioms are necessary for the foundation of all economic analysis. For example, Samuelson (1947) noted that “in a purely competitive world it would be foolish to hold money as a store of value as long as other assets had a positive yield” (pp. 122–124). This statement implies that (1) producible capital goods (plant and equipment) that provide a positive yield of output are preferable to money (or any other liquid asset ) as a substitute form in which to hold one’s store of value savings and therefore (2) money is neutral in the sense that changes in the quantity of money per se cannot affect the level of employment and output.

Keynes (1935), however, rejected the neutral money axiom when he wrote:

the theory which I desiderate would deal…with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted either the long period or in the short, without a knowledge of the behavior of money between the first state and the last. And it is this which we mean when we speak of a monetary economy….Booms and depressions are peculiar to an economy in which …money is not neutral. (pp. 408–409)

Furthermore, in Chap. 17 of the General Theory, Keynes (1936, p. 231) explicitly stated that in his liquidity theory , real producible capital goods are not gross substitutes for money or any liquid asset as a form for holding one’s savings. Accordingly, Keynes explicitly rejected the ubiquitous use of the gross substitution and the neutral money presumption of classical economic theory as a foundation of his macroeconomic theory. Consequently, by rejecting the ubiquitous use of the gross substitution and neutral money axioms (which is a specific requisite of the Walrasian classical theory), Keynes is providing a more general theory (because it is based on fewer assumptions) than the classical Walrasian theory.

Furthermore, Samuelson (1969) argued that the “ergodic hypothesis (axiom )” (p. 184) is a necessary foundation if economics is to be a hard science. But as we have also explained in detail elsewhere (Davidson 1982–1983, 2007, 2011, 2015), Keynes’s concept of an uncertain future requires the rejection of this ergodic axiom .

Since a general theory is one that has fewer restrictive axioms than another theory, Keynes’s theory, which rejects three restrictive classical presumptions, namely, the neutral money axiom , the ubiquity of the gross substitution axiom , and the ergodic axiom , is, by definition, a more general theory than the foundations of the Neoclassical Synthesis Keynesian macroeconomic theory developed from the Walrasian classical equilibrium theory by Samuelson. These three classical restrictive axioms are “the postulates of the classical theory …applicable to a special case only and not to the general case….Moreover the characteristics of the special case assumed by classical [Walrasian] theory happen not to be those of the economic society in which we actually live, with the result its teaching is misleading and disastrous if we attempt to apply it to the fact of experience” (Keynes 1936, p. 3).

3 Keynes’s Theory Is Primarily a Difference of Analysis

As Keynes’s developed his theory of liquidity preference, he recognized that his explanation of the existence of involuntary unemployment required specifying ‘The Essential Properties of Interest and Money’ (1936, Chap. 17) that differentiated his analytical results from classical theory. These ‘essential properties’ assured that money and all other liquid assets are never neutral. Keynes (1936, pp. 230–231) specified these ‘essential properties’ as:

  1. 1.

    The elasticity of production of all liquid assets including money is zero or negligible; and

  2. 2.

    The elasticity of substitution between liquid assets (including money) and reproducible goods is zero or negligible.

“The attribute of ‘liquidity’ is by no means independent of the presence of these two characteristics” (Keynes 1936, p. 241n.1). In other words, all liquid assets have these two essential elasticity characteristics.

A zero elasticity of production means that money does not grow on trees and consequently workers cannot be hired to harvest money trees to provide people with more money when the demand for money increases. Or as Keynes put it: “money…cannot be readily reproduced; labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises” (Keynes 1936, p. 230).

Accordingly, when people save some portion of their current income instead of spending their entire current income on buying producible goods, then, ceteris paribus, the demand for producibles, is reduced, while the resulting savings out of income is used to demand money (and/or other liquid assets with the same essential elasticity properties). Since the market demand for producibles is reduced by any increase in savings out of current income, then employers will hire fewer workers as they face a decline in market demand, and there will be unemployment and less production of goods and services.

Since the production elasticity of money and liquid assets is zero, private sector entrepreneurs cannot hire the unemployed labor to produce more money (or other liquid assets ) to meet this increase in demand by savers for liquid nonreproducible (by the private sector) assets. In Keynes’s theory, liquidity is a concept where if one has sufficient liquidity , one has the ability to meet all money contractual obligations as they come due.

Friedman, in his permanent income theory, avoids this problem where we have specified that any additional positive aggregate savings will go to the demand for liquid assets and therefore, ceteris paribus, create less demand for producible goods and services, thereby reducing the demand for entrepreneurs to employ workers. For Keynes and most normal persons, savings is typically defined as being that part of current income that is not spent on producible goods and services. Savers store their savings in the form of liquid assets .

Friedman, however, defines savings differently. For Friedman savings is the utility stored in a producible durable goods that is not consumed in the current accounting period. Since the consumption of any good, in Friedman’s theory, produces utility for the consumer, the purchase price of a newly produced durable good at the moment of purchase is the value of all the utility that is stored in this produced durable good—the utility will be provided to the consumer over the useful life of this produced durable. Thus, at the moment of purchase of a newly produced durable, the total utility that the durable will produce is being saved for the future periods when the durable will be slowly consumed over its useful life.

According to Friedman’s definition of savings out of current income, savings are not stored in money or other liquid assets such as bonds , stocks , bank savings accounts, and so on. Instead savers are using current savings out of income to purchase newly produced durables; and therefore, spending on savings out of current income creates jobs in the producible durable goods industries just as much as consumption spending out of current income on nondurables produced goods and services creates jobs.

In classical Walrasian theory, however, money is a reproducible commodity. In many neoclassical textbook models of a Walrasian system , peanuts or some other easily reproducible product of industry is the money commodity or numeraire. Peanuts may not grow on trees, but they do grow on the roots of bushes. The supply of peanuts can easily be augmented by the hiring of additional workers by private sector entrepreneurs when the demand for peanut money (or any readily producible asset money) increases.

Keynes insisted that one essential property of money and all liquid assets is the elasticity of production is approximately zero. Accordingly, if the savings out of current income take the form of increasing the demand for nonproducibles money (or other liquid assets ), then the price of this demand for liquid assets rises relative to the price of producible durables. The zero elasticity of substitution assures that portion of income that is not spent on by the products of industry for consumption purposes, that is, savings, will, in Hahn’s (1977, p. 31) terminology, find ‘resting places’ in the demand for nonproducibles, that is, liquid assets . Producible real capital goods are not a gross substitute for liquid assets as places where savers will store their savings. Some 40 years after Keynes, Hahn (op, cit.) rediscovered Keynes’s point that a stable involuntary unemployment equilibrium could exist even in a purely competitive system with flexible wages and prices whenever there are “resting places for savings in other than reproducible assets” (p. 31).

Hahn (1977) rigorously demonstrated what may have been logically intuitive to Keynes. Hahn (op. cit.) showed that the view that with “flexible money wages there would be no unemployment has no convincing argument to recommend it …. Even in a pure tatonnement in traditional models convergence to [a general] equilibrium cannot be generally proved” (p. 37) if savings were held in the form of nonproducibles. Hahn (1977) also argued that “any non-reproducible asset allows for a choice between employment inducing and non-employment inducing demand” (p. 39).

Accordingly, given the ‘essential properties’ of money and other liquid assets specified by Keynes, the existence of a demand for any liquid nonreproducible assets (when the products of the capital goods -producing industries are not gross substitutes) as a store of ‘savings’ creates the potential for involuntary unemployment. Any saved income is not, in the short or long run, necessarily spent on the products of industry. Households that save (i.e., they do not spend a portion of their income on the products of industry) store that portion of their income that they do not consume in liquid assets are choosing, in Hahn’s (1977) words, “a non-employment inducing demand” (p. 39) for their savings.

However, if the gross substitution axiom was universally applicable, any new savings that would increase the demand for nonproducibles would therefore increase the price of nonproducibles (whose production supply curve is, by definition, perfectly inelastic). The resulting relative price rise in nonproducibles vis-à-vis the price of producibles would, if gross substitution was universally applicable, induce savers to increase their demand for reproducible durables as a substitute for nonproducibles for storing their savings holdings. Consequently, nonproducibles could not be the ultimate ‘resting places’ for savings for when the price of nonreproducible liquid assets rose, savers will substitute producibles and therefore their savings will spill over into a demand for producible goods.

Samuelson’s assumption of a Walrasian system where all demand curves are based on a ubiquitous gross substitution axiom implies that everything is a substitute for everything else. In Samuelson’s foundation for economic analysis, therefore, producibles must be good (or better) gross substitutes for any existing nonproducible liquid assets (including money) when the latter are used as stores of savings. Accordingly, Samuelson’s Foundations of Economic Analysis explicitly denies the logical possibility of involuntary unemployment as long as all prices are perfectly flexible. Samuelson’s brand of Keynesianism is merely a form of the classical special case analysis that is “misleading and disastrous” (Keynes 1936, p. 3) if applied to the real world. In Keyes’s general theory, any increase in the demand for ‘savings’ in liquid form over time raises the relative price of nonproducibles, but will not spill over into a demand for producible goods.

Accordingly, if at a full -employment level of income decision makers want to save a portion of their income in liquid nonproducibles, then they will have made a choice for ‘nonemployment-inducing demand’. To offset this nonemployment-induced demand and maintain full employment, other decision makers must spend more than their full-employment income in the marketplace on producibles. To spend in excess of their full -employment income, these decision makers must either spend a portion of their previous savings on producibles or borrow new money from the banking system to spend on producible goods and services.

In an international context, if any nation runs a persistent surplus in its balance of payments, then it is saving its excess of income earned from exports over its payment for imports, to obtain liquid foreign reserves, namely, an international noninducing employment demand. Thus, Keynes (1941) put forth as a principle that if any nation persistently runs international payments surpluses , it creates a significant shortage of international effective demand for its trading partners. Consequently, to remove the international sector from creating employment problems for any nation, Keynes (1941) required any persistent surplus creditor nation to spend down its saved accumulated liquid international reserves. Keynes (op. cit., p. 176) argued that the onus should be on the creditor saver nations to solve this accumulating noninducing employment demands for international liquid reserves and therefore to encourage the creditor nations to provide international expansionary economic forces. After all, this onus is not costly to the creditor nation for it has the international liquidity wherewithal to engage in such an activity. Thus, Keynes saw the necessity of creating an international institution where all trading nations agree to a ‘rule of the road’ that requires persistent creditor nations to spend down their excessive foreign reserves. This would solve any international payment imbalance problem by placing an expansionist pressure on world trade.

If, instead of relying on an international institution’s rule of the road and creating an expansionist pressure on global trade, the onus of reducing a nation’s deficit in its international payments was placed on the debtor nation to somehow obtain a devaluation in its exchange rate to improve its balance of payments position by making its industries ‘more competitive’, then the effect would not only reduce the standard of living for the residents of the debtor nation, but it would put ‘in place a contractionist pressure on world trade’ (Keynes 1941, p. 176).

Finally, Keynes (1941) argued that only in a money-using entrepreneur economy where the future is uncertain (and therefore could not be reliably predicted) would money (and all other liquid assets ) always be nonneutral as they are used as a store of value savings. In essence Keynes (op. cit.) viewed the economic system as moving through calendar time from an irrevocable past to an uncertain, not statistically predictable, ‘real’ future. This required Keynes to reject the ergodic axiom .

Samuelson’s slowly adjusting Walrasian system view of Keynes’s theory resulted in aborting Keynes’s revolutionary analysis from altering the foundation of mainstream macroeconomics from classical microeconomic theory. Consequently, what passes as conventional macroeconomic wisdom of mainstream economists, such as Krugman, Akerloff, and Temin, at the beginning of the twenty-first century, is nothing more than a high-tech and more mathematical version of the nineteenth-century classical theory.

Current economic policies, such as the need for ‘austerity’ and the fear of government deficit spending increasing the national debt, policies adopted in the United States, the United Kingdom, and the Euro zone, demonstrate the real-world economic damage that Samuelson’s proclamation that his ‘reconstructed’ Keynesianism provided the correct analytical foundations for understanding the economic world in which we live. Instead, had the correct explanation of Keynes’s General Theory been taken up by mainstream economists and politicians, the world we live in would have been a more prosperous and civilized economic society.Footnote 3

4 A Serious Monetary Theory

Arrow and Hahn in their book General Competitive Equilibrium (1971; emphasis added) explicitly state that even in a general equilibrium system “The terms in which contracts are made matter. In particular, if money is the goods in terms of which contracts are made, then the prices of goods in terms of money are of special significance. This is not the case if we consider an economy without a past or future…. If a serious monetary theory comes to be written, the fact that contracts are made in terms of money will be of considerable importance” (256–257).

Keynes wrote a ‘serious monetary theory’ since his theory of liquidity recognized that (1) the economy has a past and an uncertain future and (2) all market transactions are organized by the use of legal money-denominated contracts that specify money as the means of contractual settlement for all spot and forward contractual obligations. All market transactions are organized by the use of spot and/or forward money-denominated contracts. The essence of a capitalist economic system involves a legal money-denominated contract system. Hence, the need for liquidity to meet one’s market money contractual obligations must have an important impact on decision makers choosing what to buy and what to sell and when to take on these contractual obligations. This legal money contract analysis is absent from the works of Samuelson, and other mainstream ‘Keynesians’ and therefore their theory is not even a ‘serious monetary theory’.

This use of money to settle all market transaction contracts, including international transaction contracts, is ignored by mainstream economists when they discuss changing the exchange rate, where the latter, in fact, must alter the sum of the specified money that must be obtained to settle an international contractual obligation for the buyer or seller or both. Indeed, whenever any international forward contract spans the moment in calendar time when an exchange rate change occurs, this can create a liquidity problem in obtaining sufficient funds in terms of the money specified in the international contract—a problem which apparently is not important to today’s mainstream international macroeconomists! But it is important to Keynes in his international analysis and even important to entrepreneurs engaged in international contractual transactions in the world we live in.

Since Greece and the other southern Mediterranean Euro nations have the same currency as their Euro trading partners, it is not possible for these deficit nations to look to a monetary exchange rate devaluation to achieve a better trade balance. Accordingly ‘austerity’ is a policy designed to induce a more favorable trade balance for Greece since it is presumed that austerity depresses the income of Greek workers and Greek enterprises sufficiently so that a reduced Euro price of Greek products induces a gross substitution effect to reduce Greek imports from Germany (and the rest of the Euro-zone nations) and significantly increase Greek exports to the Euro-zone nations. The result will be socially distressing and divisive politically for all Greek residents but would supposedly end up with slower outflow of Euros, in which case the inflow of Euros on trade contractual obligations emerges. Would not an institutional rule such as the Keynes Plan of Bretton Woods, which would put the onus on the nations running a trade surplus to spend more Euros on the products of the balance of trade deficit nations be better? The answer is positive in that the result would be that the deficit balance of the trade nation could earn sufficient Euros to service its debt obligations to the surplus nations, while employment and income of the deficit nation’s population would rise and the nation would become more prosperous.

5 Concluding Remarks: The Role of Monetary Policy

Finally, it should be pointed out that the classical presumption of neutral money means that any increase in the money supply will immediately be spent to purchase newly produced goods and services, while none of the increase is used merely to store savings. Accordingly, the neutral money axiom provides a necessary condition for the quantity theory of money. This quantity theory states that any increases in the supply of money greater than any increase in total production by a fully employed labor force will directly increase the rate of price inflation. Nobel Laureate Milton Friedman (1970) stated his belief that money is neutral when he wrote: “We have accepted the quantity theory presumption…that changes in the quantity of money as such in the long run have a negligible effect on real income, so that nonmonetary forces are ‘all that matter’ for changes in real income [total production or GDP] over the decades and ‘money does not matter’. On the other hand, we have regarded the quantity of money …as all that matter for …the price level” (p. 27).

Oliver Blanchard (1990) characterized all the mainstream econometric models used by government agencies, central banks, and in academia, as follows: “All the models we have seen impose the neutrality of money as a maintained assumption. This is very much a matter of faith, based on theoretical considerations rather than on empirical evidence” (p. 828).

It follows that most mainstream economists and almost all politicians believe that the primary role of the central bank is to control the rate of expansion of the money supply in order to directly affect the rate of inflation. Since in Keynes’s theory, money is not neutral and therefore the role of monetary policy is not to directly affect the rate of price inflation but rather to assure orderliness in the operation of public financial markets by providing sufficient liquidity in order to avoid any financial crisis.

For the most part, central bankers such as Alan Greenspan or Janet Yellen tend to indicate to the public that easing or tightening of monetary policy depends on the rate of inflation that the economy is experiencing. In recent years, the Board of Governors of the Federal Reserve has indicated a 2 percent rate of price inflation is a target rate for monetary policy. Thus, when the rate of inflation is less than 2 percent, the public can expect an easy monetary policy, while if the rate of inflation exceeds 2 percent, one can expect that the Federal Reserve will engage in a tightening of monetary policy.

When the global financial crisis of 2007–8 occurred, however, the Federal Reserve engaged in a policy that was labeled quantitative easing or QE. In essence, a policy of quantitative easing was adopted because the Federal Reserve recognized that the disorderly price collapse of many derivative financial markets involved a rush by market participants to make a fast exit from holding these derivative securities in their portfolios. This set off fears of participants in many other financial markets of a possible spreading of price disorderliness. Such fears induced financial market participants to make a fast exist in order to substitute some global liquid money holdings as the safe financial asset harbor to protect the liquidity of their portfolio holdings.

Consequently, the Federal Reserve apparently saw the need for it to become the market maker in US government bonds and many derivative securities by entering these markets to directly purchase over $4 billion of US government bonds and derivative securities. By doing so, the Federal Reserve created significant additional liquidity and therefore the feeling of more security for participants in financial markets.

It is evidently clear that the quantitative easing policy of the Federal Reserve prevented the Great Recession which began in 2008 (and was a result of the global financial crisis of 2007–8) from developing into a Great Depression similar to the global economic collapse of the 1930s.