I recently came across a very interesting paper by Costas Lapavitsas on the systemic euro crisis which, among various observations on the Euro area crisis, also made some quite insightful comments on the basic propositions of neo-classical macroeconomic theory.

At its core, the neo-classical model (when considering a perfectly functioning economy with no rigidities and perfect foresight) assumes that profits are stationary with very small movements around the mean. The economy adjusts through the price level, both of wages and goods prices and of inter-temporal prices (the interest rate reflects the relative price of future vs current goods). In such a setting, investment will equal savings with the former being financed through debt (thus profits will be earned by lenders in the form of debt repayments). Real profits will be rather constant, and firms will face a steady expansion path, hit by random productivity shocks which will induce changes to the current and future price level.

The Keynesian view on the other hand will be structurally different. Adjustment is not done through prices but through quantities, making profits (which can be treated as a residual since companies can only really decide on the level of inventories they will hold in each period) a non-stationary variable. Since in reality investment is mainly financed through retained profits, a change in profits will generally have an impact on investment. In the classical Kaleckian sense, profits will actually be Π = I – S and the I=S identity will just be an ex-post confirmation of the change in profits.

While a change in the interest rate can change the NPV of retained profits, it cannot close a gap of lower profits because of the existence of the ZLB. Only other autonomous factors (government and the foreign sector) or a fall in savings will raise profits and induce companies to expand their production capacity. Savings are treated as a leak on income, not as the driving force of investment. If one also adds endogenous money in the picture (with banks creating new purchasing power when they extend a loan), the picture is totally different, especially since in this case, creditors are not households with large savings but banks, which use retained profits not for investment but to increase their capital base in order to be able to further increase their balance sheets.

Obviously, each ‘world view’ will suggest a completely different solution for the current Euro crisis. The neo-classical view will push for ‘structural reforms’ which are envisioned to be able to increase the speed and depth of price adjustments. If only adjustments were quicker, the crisis would end quite swiftly. On the other hand, the Keynesian view will point to the fact that real liabilities will increase (without inducing ‘creditors’ to increase their consumption) thus making economic agents favor an increase in their savings. Whether they achieve it or not is another story, but the mere act of it will drive profits (and consequently investment) lower and income further downwards. The way out will be to increase quantities and lower the real debt burden.