Classical Macroeconomics: Some Modern Variations and Distortions

Published by EH.NET (December 2005)

James C. W. Ahiakpor, Classical Macroeconomics: Some Modern Variations and Distortions. New York: Routledge, 2003. xvii + 256 pp. $120 (cloth), ISBN: 0-415-15332-8.

Reviewed for EH.NET by Marin Muzhani, Department of Economics, University of Florence, Italy.

James Ahiakpor has written a fascinating book which readers will find difficult to put down. Students of macroeconomics should not deprive themselves of the opportunity to study this rich volume on classical macroeconomics.

The broad range of the book presents difficulties to the reviewer since it is difficult to cover it adequately in a few pages. Ahiakpor may have had this difficulty, too, since his treatment is sometimes (but not often) cursory, wordy and not very helpful. I have chosen a few topics to show both the range of the book and the shortcomings of the treatment.

About half the chapters were published in journals from the mid-1980s and to the late 1990s. The preface describes the difficulties encountered from referees when Ahiakpor submitted papers on Keynes’s misinterpretation of “capital” in the classical theory of interest. Indeed, his goal is to explain the confusions and misinterpretations of classical macroeconomics – especially the theory of capital and interest –contained in textbooks covering the works of B?hm-Bawerk, Fisher, Wicksell and Hayek.

The second chapter looks directly at the theory of value, which is one of the foundations of macroeconomic analysis. This chapter restates the theory of value in Smith, Ricardo, Malthus and Mill and interprets it in a straightforward way without variations and distortions. The main point is that the classical theory of exchange value is not about the utilities of commodities but the ratio in which different units of goods are exchanged for one another. Ahiakpor emphasizes that the misinterpretation of the classical theory of value by Austrians, Marxists and other economists influenced several writers including Alfred Marshall. Later this theory was distorted by Paul Douglas (1928) and Emil Kauder (1953) who influenced other modern writers, and attempts to restate it have not been wholly successful. The correct interpretation of the classical theory of value is based on the cost of production measured in terms of the quantity of labor. The concept of utility is essential but should not be considered as a measure of exchangeable value. Valuable quotations from classical works are given to support this argument.

A rich but pithy chapter three tackles the difficult task of establishing the definition of money. The classical economists defined money as a particular commodity (such as gold and silver) used to measure the value of other commodities and which, most important, serves as a medium of exchange. They held a clear distinction between money credit and capital. Ahiakpor emphasizes the idea that a correct understanding of classical theories requires a very careful distinction of money from credit, and credit from “capital” and capital goods. Capital is supposed to arise from savings or loans. According to the author, the classical distinction between money and savings or “capital” is more helpful than the modern definition of money. A high-powered currency in the classical definition is supposed to explain better the changes in the price level or the value of money from the supply and demand for money. The latter determines the rate of interest. This statement is completely different from Keynes’s argument that the quantity of money determines the supply of liquid resources and therefore the rate of interest. In fact, during the Great Depression it was the change in high-powered currency or in the quantity of money that caused the fall in savings as the public increased its demand for cash balances. Because of this, the increase in the reserve-deposit ratio of banks, the money supply multiplier was reduced and the currency stock declined rapidly. So the classical savings theory of growth confirms that the significant decline in GDP during the Great Depression came as a result of considerable contraction in savings.

In chapter four reexamines of the classical theory of interest, the price level, and inflation. In the classics the theory of the price level is almost a direct application of the theory of value. The price level is determined by the supply and demand for money. In the same way interest is established as by the supply and demand for capital. It is the borrowed “capital” that is offered and taken in loan on the basis of the borrower’s ability to pay back the credit. In this context interest is described as the cost of credit. Thus the classical theory of interest is more logical on the meaning of “capital.” Robertson and Friedman are the two modern economists that, remarkably, have included the classical credit theory or the loanable-funds theory in their works. In effect, “the classical version is superior because it avoids the confusion between money and credit which Friedman correctly notes as plaguing the Keynesian monetary or liquidity preference theory of interest” (p. 77). Hence the application of the classical theory of value to “capital” better explains the determination of interest rates than the traditional Keynesian money supply and demand theory of interest. Keynes misinterpreted the classical theory of interest. He incorrectly included hoarding in the classical definition of saving and his contemporaries were not able to persuade him of his erroneous criticism of the classical theory of capital.

Chapters six, seven and eight deal with the Austrian theory of capital and interest, Wicksell’s monetary theory and Fisher’s macroeconomic analysis. The Austrian school and predominantly Eugen B?hm-Bawerk interpreted capital-goods as “capital” only in the classical theory of interest and proceeded incorrectly to criticize it. B?hm-Bawerk introduced the theory of time-preference in place of the classical theory of capital. He observed that interest is a premium borrowers are willing to pay for their impatience for present consumption. The production process is affected by variations in the rate of interest and more roundabout methods are adopted when the rate of interest falls.

Wicksell reacted to the classical theory of interest. He believed that observed high interest rates with high rate of inflation and low interest rates with low rates of inflation contradict the classical theory of interest. He developed the “cumulative process” by which deviations between the market and “natural” rates of interest cause the price level to change continually. According to chapter seven, Wicksell repeated almost the same theory of price dynamics as in classics, except that in his model the process starts from banks lowering their rates of interest without any new injection of money.

Irving Fisher rejected the classical “capital” supply and demand theory of interest and adopted the Austrian time-preference theory. In conflict with his time-preference theory of interest, Fisher defined “capital” as an asset that yields a flow of income over time, which is quite different from the classical flow-of-funds concept. Fisher associated the “stock of goods” with a fixed quantity existing at an instant of time and “capital” as capital goods only. His principal differences with classical monetary analysis include the notion of circulating currency to include money and bank deposits. But the inclusion of bank deposits in his analysis is inconsistent with the process of inflation.

Chapter ten is all about Kyenes’s full-employment argument. Keynes attributed erroneously to the classics the forced-saving doctrine where increases in the money supply may boost real output and employment in the short run while lowering the rate of interest and raising the price level. Keynes’s misinterpretation of the classics was based on his presumption that Say’s Law of Markets must be founded on the assumption of full employment. He criticized the classics for not recognizing the existence of hoarding while arguing the Law of Markets. His contemporaries including Pigou and Robertson, despite their attempts to correct his assumptions, did not give a clear interpretation of Keynes’s inaccuracy. “Rather, they attempted to sketch their own versions of classical economics, much to their disadvantage” (p. 175). Although some may agree with this statement, I must disagree. Rather than sketching their versions of classical economics, they developed new assumptions in the classical tradition regarding full employment — about which the classics were not comprehensible at all.

Chapter eleven explains the success of the IS-LM model created by Hicks in spreading Keynesian macroeconomics and at the same time Keynes’s distortion of classical macroeconomics. The IS-LM model based on changes in the supply and demand for money to explain interest rates does not take into consideration the determination of the price level from supply and demand for money as in the classical quantity theory. This model implies that the price level rises from increases in the quantity of money only after an economy has reached its full productivity capacity or full employment reaching the position of equilibrium (for a static state). However a real monetary economy is much more complex than the IS-LM model represents. The IS-LM model is inconsistent with economies experiencing high rates of unemployment, high rates of inflation and continuous economic fluctuations and hardly can be applied in modern realities. Despite distortions and variations claimed by the author, the IS-LM model still remains the basis for every undergraduate textbook in macroeconomics. It is the first and the most simple, well-known macroeconomic model combining real and monetary factors, making it easy for anyone with some basic notions in economics to understand the dimensions and the complexity of a national economy. This model merely shows the daily macroeconomic problems but certainly does not resolve them.

The mythology of Keynesian multiplier is developed in chapter twelve. The concept of the multiplier is based on consumption spending and on incomes that derive from expenditure. People normally consume a portion of their income and such purchases for consumption are incomes for producers who in turn make investments. The consumption spending is a means by which aggregate demand is raised and the growth of output and employment is promoted. Saving in Keynes’s view, as opposed to the classics, has no special effect on supplying the funds for investment. Ahiakpor states that the Keynesian multiplier is nothing more than a misinterpretation of the classical definition of saving to include the hoarding cash. It is founded on a misconception of the role of consumption rather than production in the income determination process. The question raised in the Keynesian multiplier is: “From where do people find the means to make their consumption purchases?” Keynes rejected the classical concept that production is the source of income and, therefore, comes from savings supply. Increased output in one sector, by increasing the demand for the output in other sectors causes an increase in their production also. This process is described as a “multiplier effect” (quite different from the Keynesian multiplier) and is supposed to affect major sectors of an economy. Ahiakpor argues that: “Keynes’s argument that saving is not needed to finance investment spending because the multiplier process makes it possible for investments to pay themselves through additional savings out of newly created income may have given confidence to supporters of public works program, but it is simply fallacious” (p. 209).

The Keynesian revolution (or the Keynesian event) can be summarized in a few words. The Keynesian theoretical event can be expressed in terms of the combination of his multiplier theory with his liquidity preference theory. For many governments it is a primary duty to control the level of total effective demand for goods and services. If demand is insufficient to provide full employment, it is government’s duty to raise it by stimulating the injections (investment, and government expenditure) and by reducing the proportions of income saved (or paid in taxes). If demand is excessive, then it is the government’s duty to restrain the injections. This general task of controlling the level of total effective demand throughout the economy was not recognized to be a duty of government before the Second World War (and especially during the nineteenth century); it has at least been generally so recognized since the war.

This duty, unfortunately, was not a major concern for classics. Despite their efforts, the classics were not able to set up a consistent macroeconomic model in which the economic system adjusted itself to full employment. The legacy of Keynes can be recapitulated in Pigou’s remarks: ” Nobody before him, so far as I know, had brought all the relevant factors, real and monetary at once, together in a single formal scheme, through which their interplay could be coherently investigated” (p. 175).

As Ahiakpor suggests, it is true that by a very “careful reading” we may find more consistency in the classics than is generally believed, but it is also true that by using the same method of study we may find a lot of anomalies and contradictions which enable us to appreciate the classical explanation today.

The greatest value of the book is to professional economists, chiefly because of some of the penetrating suggestions, and its coverage of an immense range of subjects bearing on development. The inherent importance of the principal theme, the forceful reasoning with which it is developed, the excellent style and the wealth of topics covered will ensure that this book will be read by all seriously interested in the subject.

Marin Muzhani is Associate Researcher in Economics at the University of Florence, Italy. His book From the Path of “Warranted Growth” to Technological Progress and Endogenous Growth: The Evolution of the Theory of Growth in the Post-war Period, Six Decades of Controversies in the Theory of Economic Growth will be published soon in English. Other papers and publications are related to modern monetary theories such as optimum currency areas, endogenous money and monetary unions.