Farewell, Paul Davidson
John E. King
Emeritus Professor of Economics
La Trobe University, Melbourne, Australia
Monetary Policy Institute Blog #143
“At the level of international economic policy, Davidson urged the implementation of Keynes’s plan for an International Clearing Union, in which fixed rather than floating exchange rates would prevail and all international payments would be made by governments through an International Clearing Union.
This would eliminate private sector transactions in foreign exchange and would involve a huge reduction in both the volume and the influence of global finance. Davidson made the case for such a system in International Money and the Real World (1982) and, in response to the global financial crisis of 2008, in his last book, The Keynes Solution: the Path to Global Economic Prosperity (2009).”
The American economist Paul Davidson, who recently died at the age of 93, was the most prominent member of the ‘fundamentalist Keynesian’ school of Post Keynesian economists, which maintained that the core of a correct macroeconomic theory can be found in Keynes’s General Theory, suitably interpreted. The fundamentalist Keynesians were persistent critics of the ‘neoclassical synthesis’ and its IS-LM model, which they believed to be a fundamental misinterpretation of the General Theory. Davidson set out the arguments in Money and the Real World (1972), a difficult book which is however summarized very clearly in a short article in the Economic Journal (March 1972, pp. 101–15).
The neoclassical synthesis, Davidson maintained, was inconsistent with Keynes’s basic principle that output and employment were demand-determined, and it had resulted in the restoration of Say’s Law as being always true in the long run. This, he argued, was inconsistent with the capitalist economy in which we all live, and applied only to barter economies in which money played no role. It followed, according to Davidson, that in capitalism money is not neutral, even in the long run, as demonstrated by the importance of the ‘finance motive’ for holding money, in which firms hold money in order to ensure that they will be able to carry out their investment plans in an economy characterised by fundamental uncertainty with regard to the profitability of new investment projects.
This entailed that the ‘classical dichotomy’ could not be sustained, so that any effort to partition the economy into separate ‘real’ and ‘monetary’ sectors was mistaken. For Davidson, changes in monetary conditions led to changes in output and employment, while changes in the price level often resulted from changes in the ‘real’ economy, especially in wage-fixing in the labour market. And so neoclassical models of general equilibrium, which depended on the assumption of monetary neutrality, could be applied only to non-capitalist barter economies. Davidson argued that it was crucial to distinguish risk from uncertainty, as Keynes had insisted in the General Theory. Risk is quantifiable and predictable, while uncertainty is neither. In a world of certainty-equivalence, there would be no need to make contracts in monetary terms. But this was not the world in which we actually live. According to Davidson our world is ‘non-ergodic’, by which he meant that the future cannot be reliably inferred from the past. In an ergodic world it would be safe to assume the existence of ‘complete financial markets’, so that all future eventualities could be insured against and those who offered such insurance would never default (or perhaps that the probability of such defaults could be calculated in advance).
The other two critical propositions that distinguish Keynes’s theory from that of the mainstream, Davidson believed, were the non-neutrality of money and the absence of gross substitutability between money and all other goods. There were significant implications for economic policy. Downward wage flexibility was neither a necessary nor a sufficient condition for the achievement of full employment, which required government intervention to prevent aggregate demand from being either inadequate or excessive. At the level of international economic policy, Davidson urged the implementation of Keynes’s plan for an International Clearing Union, in which fixed rather than floating exchange rates would prevail and all international payments would be made by governments through an International Clearing Union. This would eliminate private sector transactions in foreign exchange and would involve a huge reduction in both the volume and the influence of global finance. Davidson made the case for such a system in International Money and the Real World (1982) and, in response to the global financial crisis of 2008, in his last book, The Keynes Solution: the Path to Global Economic Prosperity (2009).
Davidson’s approach to macroeconomic theory has drawn criticism from some Post Keynesians, for example from Kaleckians, who argue that it ignores the theoretical and policy implications of the growth of market power and cannot be applied to the oligopolistic system in which we actually live. In a rather different vein, Sheila Dow has suggested that Davidson’s reliance on non-ergodicity has been taken too far. There are significant parts of the economic system, she maintains, which are sufficiently stable for us to be able to treat them as if they actually were ergodic. Keynes’s own epistemology, Dow suggests, leads to the important conclusion that in a variety of context economic actors develop conventions and habits that deal with uncertainty and do away with the problems posed by non-ergodicity. Some very large methodological issues arise here, with potentially significant implications for the Post Keynesian theories of money and monetary policy.
To end on a personal note: I only met Paul once, but I was very impressed. This was in 1993, when I undertook a global tour financed by the Australian Research Council interviewing prominent Post Keynesians in Europe and North America. This took me to Nashville, Tennessee, where Paul gave me a substantial amount of his time, even though he knew nothing of me and my research into the history of Post Keynesianism had barely begun. The interview was published in my Conversations with Post Keynesians (1995), from which readers can see just how frank, forthcoming and understanding Paul was with me. It was a good experience.
Read the conversation here: “Paul Davison”, in John E. King (ed.), Conversations with Post Keynesians, London, Palgrave, pp. 15–34.
