Debating Keynesian Economics

During the war, Samuelson was repeatedly in contact with Oskar Lange, engag­ing with him both as a mathematical economist and as a business cycle theorist. The terms of their engagement are illustrated by a letter Samuelson wrote to Lange in April 1944.

Modigliani's dissertation, which formed the basis for “Liquidity Preference and the Theory of Interest and Money” published in Econometrica, sought to reconcile the Keynesian theory of interest with the classical theory, thereby assessing the interpretations of Keynes offered by John Hicks and Abba Lerner.²⁴ This article is notable for its explicit presentation of his aggrega­tive model, involving physical output, investment, and the price level, as a simplification of a Walrasian general equilibrium system in which every good is considered separately. Like Hicks, Modigliani analyzed this simpli­fied system in terms of two equations relating the rate of interest and national income—labeled an IS curve (on which investment equaled saving) and an L curve (on which demand for money, alias Liquidity preference, equals the money supply).^{[lxii] [lxiii] The diagram illustrated the stationary solution to an explic­itly stated dynamic model.}

Modigliani's conclusion challenged the Hansen-Samuelson-Klein view that there was a causal relationship between investment and national income. They did indeed move together, but this was because low invest­ment and low employment were “the effect of the same cause, namely a basic maladjustment between the quantity of money and the wage rate. It is the fact that money wages are too high relative to the quantity of money that explains why it is unprofitable to expand employment to the ‘full employment' level.”²⁵ In his letter to Lange, Samuelson said that he had read this letter with great interest. However, he thought Modigliani, in common with many economists discussing the Keynesian system, had not handled money and prices correctly.’ In Modigliani's system, a rise in the money supply and a fall in the wage rate both led to a fall in the rate of inter­est and a rise in the rate of investment. The exception was “the Keynesian case,” where there was a minimum below which the rate of interest could not be pushed because, at this rate, people would be willing to hold unlim­ited amounts of money. In contrast, Samuelson argued that in the classical system, there was full employment whatever the quantity of money, and that wage cuts (which would increase employment) were not equivalent to an increase in the money supply (which would not increase employment). Here, Samuelson was not challenging Modigliani's mathematics, but the economic assumptions on which his theory was based. He hoped Lange's forthcoming monograph would resolve the difficulties he was having, clos­ing by saying, “I hope that this letter is not too incoherent. It is written on the run in between other activities.”

Though Samuelson still taught Keynesian economics under the head­ing of the business cycle and had not changed his view that dynamics were important, the business cycle no longer framed his work on the economy as a whole in the way it had done in 1940. The demands of war production, which it clearly made sense to analyze as an exogenous shock to the system and not as part of some cyclical process, would have played a role.

Though Samuelson came to be identified with the Keynesian revolu­tion in America, his own identification with Keynes and the idea of a Keynesian revolution was slow. It is tempting to see his reluctance to identify himself as a Keynesian as political, for Hansen’s ideas on policy were already being attacked by conservatives who objected to any sugges­tion that governments should run deficits in peacetime.^k However, there were intellectual reasons for his distancing himself from Keynes. His reac­tion to the General Theory had been strongly influenced by Hansen, and though interwar American business cycle theory, represented by Hansen and Clark, became less prominent in his work, it flavored his interpreta­tion of Keynes. Whereas Modigliani, under Jacob Marschak’s influence, followed the mathematical logic of his general equilibrium system to conclude that frictions—wage rigidity—must underlie Keynesian results (except in special cases), Samuelson never went down that route. Cheap money had not stopped the Depression, and so it did not make sense to rely on any mechanism that involved investment responding to changes in the interest rate. He took for granted the belief, widespread in the 1930s, that markets were not competitive. The notion that there might be an insufficient level of investment to sustain full employment was a conclu­sion learned from Hansen that he never abandoned and which continued to color his interpretation of Keynesian economics. He was developing a Keynesianism that was distinct from the one that came to dominate post­war macroeconomic theory.