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In view of the ongoing, and fraught, discussion about austerity measures and their effect, I thought I would present the theories underlying the two sides of debate.

Basically we are going through a rehash of the Orthodox versus Keynes argument that has been an episodic moment for decades. That it remains unresolved is testimony to the depth of the differences between the two sides.

First and foremost: Keynesian economics is radically different from what we read in standard textbooks. Plus even Keynes did not fully appreciate the differences, nor did he explain himself well. I came across a quote this morning by Paul Samuelson who, more than anyone, set the standard for the content of today’s textbooks with his own text back in 1948. Referring to Keynes masterpiece “The General Theory” he said:

“[The General Theory] is a badly written book, poorly organized … it is not well suited for classroom use. It is arrogant, bad-tempered, polemical, and not overly-generous in its acknowledgements … In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties … When it is finally mastered, we find its analysis to be obvious and at the same time new. In short, it is a work of genius.”

Anyone who has tried to read The General Theory will agree. It is devilishly difficult to get to grips with. No wonder it remains controversial.

But the true source of controversy is not Keynes’ theory, it is that he overturns much of the prior well accepted theory. His contemporaries were faced either with embracing his ideas, or rejecting them out of hand. He was called a heretic by most of the establishment, and it wasn’t until his theory was re-cast in more orthodox terms by Hicks that it found its way into the curriculum. Indeed anyone who studied Keynes in the post war years was most likely studying the Hicksian rendition rather than pure Keynes.

Why is this important?

Because Hicks adapted Keynes to the classical framework and in so doing cut out much of the heretical work. In essence he sanitized Keynes for widespread consumption. Any of you familiar with those IS/LM curves of macroeconomic analysis are familiar with Hicks, not Keynes. One consequence of this was that when the big fight erupted over policy back ion the 1970’s, the ‘new wave’ represented by the likes of Milton Friedman and Robert Lucas were trying to eradicate Hicks, not Keynes. So their triumph, and the apparent overthrow of Keynesian economics, was an illusion: Keynes’ central ideas, and especially his emphasis on the role of uncertainty, were not attacked substantially. This left a hard core of Keynesians – now called “Post Keynesians” after the name adopted by the great Joan Robinson of Cambridge UK – festering on the outside of policy making. In effect economics splintered as a subject even more so than it had in the past.

There have always been great schools of thought in economics, each with an emphasis as to the purpose of the subject, but since the 1930’s the orthodox view has been that economics should focus on the allocation of wealth, with sociology being the discipline concerned with the consequences of that allocation and any social problems that it may cause. Once on that track Friedman and his ilk tried to make economics ‘positive’, by which he meant apolitical. They concentrated on key features such as rational behavior, efficient markets, and general equilibrium, each of which are antithetical to the Keynesian view. Especially his understanding of uncertainty.

So what?

Well, the clash spills over into today’s policy fight.

If you believe the Friedman/Lucas paradigm is correct then government deficit spending is not just bad policy it is expensive and counter-productive. This is because Lucasian theory tells us that consumers and businesses will look at the deficit and automatically set aside enough cash to offset the taxes they expect to have to pay in the future in order to extinguish the new debt. In other words the demand created by the deficit will be exactly offset by the savings set aside to pay for it. GDP won’t budge. So in the Lucasian view government spending can never stimulate the economy. It is simply a burden on the private sector because it diverts resources temporarily to ineffective uses.

Moreover, as the only effective policy then would be monetary policy – mucking around with interest rates – the inflationary impact of all that deficit spending, the government prints money to raise debt, screws up the money markets and hinders the efficient workings of the market place. This, in turn, leads to underinvestment by business and harms GDP.

Nothing could be more diametrically opposed to the Keynesian view.

For Keynes a recession was a loss of demand, not a loss of investment. In fact during a recession, or a depression, there is a glut of spare capacity which means that businesses have no incentive to invest no matter how low interest rates go. Keynesian theory has a very high behavioral aspect to it. In particular people’s expectations are not entirely rational in the way orthodoxy assumes: they can, and do, act intuitively in response to poor or incomplete information. The obvious implication – to Keynes – was that demand needed to be pumped up. And in the absence of private demand being sufficient, it fell to the government to fill the breach. Since he was not wedded to the tenets of rationality and efficiency, and was clear about the role of money as a method of hedging against uncertainty – people tend to hoard cash in tough times – he did not believe that cash was being set aside to pay for future taxes. It was simply being set aside as a hedge. Were demand to be primed by governments spending, the need to hoard cash would be ameliorated, people would start to spend again, and the economy would return to its historic growth pattern.

To Keynes austerity is adding to the problem by sucking out demand. To the orthodox, people like Lucas and Friedman, austerity is a way of getting government out of the private sector’s way and of creating good business conditions for investment.

One last major difference: orthodox theorists place no special emphasis on banking. They ignore banking as a factor in their models. Instead they ‘see through’ money and look only at the goods and services of the ‘real’ economy. In contrast, Keynes placed a huge emphasis on finance, but it was his follower, Minsky, who articulated a proper ‘Keynesian’ theory of finance and its destabilizing potential in a business cycle.

Chalk and cheese. Oil and water. They simply don’t mix.

To make matters worse: since the Japanese disaster of the 1990’s a middle ground theoretical group has appeared. These are the “New Keynesians” such as Paul Krugman. In times of crisis the New And Post Keynesians are very similar. Both advocate stimulus. The difference is that people like Krugman do not advocate Keynesian theory when the economy is humming along with anything like the same fervor. They see it as a theory for certain circumstances. As in today when we have become stuck in a ‘liquidity trap’. This is when the economy is awash with cash, business conditions militate against investment, and yet monetary policy is highly expansive. In other words Krugman supports Keynes mostly – perhaps only – when all else is ineffective, whereas a more purist Keynesian would advocate Keynes throughout the entire business cycle.

So these are the camps. Open warfare has broken out. The name calling is intense.

Up until now the Obama administration has used a watered down Keynesian approach. It’s as if they didn’t really believe in Keynes, but had no alternative. They certainly ignored Minsky in their financial reform thinking, and they trimmed very closely towards orthodoxy in their mix of programs in the stimulus package of 2009. Yet their modeling includes all sorts of Keynesian ideas, such as the multiplier effect of fiscal stimulus.

Like most hybrids the Obama approach is scorned by all purists. It looks muddled and half hearted. And by being thus it opens the door for debate about its efficacy. The stimulus was too small to offset the shortfall in demand, so the Keynesians attack it for weakness. Orthodox theorists attack it for being there in the first place, and look at the way in which GDP seems to be fading as the stimulus wears off: they see that decline as proof that it didn’t work at all.

It is largely because of the muddle at the center of current policy that the austerity versus more stimulus debate has taken on such a vitriolic tone. Neither side supports the administration. Both want to see a clean set of policies.

We won’t get that purist solution. American politics is so fractured right now that no one has the power to adopt anything remotely strong. Everything has to be watered down for consensus building purposes. We appear doomed to keep on muddling in the hope that things work out without politicians having to take a stand on anything. That tells me that we are headed down the Japanese path and a lost decade of jobless anemic growth.

Maybe we need a new and better theory? Perhaps a synthesis?

Stay tuned.