Confidence, Crashes and Animal Spirits

Abstract

This article is an attempt to reformulate what I take to be two key insights from Keyness General Theory (Keynes, 1936). The first is that there is something profoundly different about the labour market from most other markets in the economy. The second is that the beliefs of participants in the asset markets have an independent influence on economic activity. In the language of modern dynamic general equilibrium theory, we would say that there is a continuum of labour market equilibria and that beliefs about the value of the stock market select an equilibrium. The General Theory contains many ideas, some of which are internally inconsistent, and Keynes did not try to reconcile his theory with Walrasian economics. That task was carried out by a group of interpreters, including Hansen (1936) and Hicks (1937). The current dominant paradigm, new-Keynesian economics, originated with the third edition of Samuelson’s (1955) undergraduate textbook in which he introduced the idea of the neoclassical synthesis. According to this doctrine, the economy is Keynesian in the short run but classical in the long run. The short run is defined as the period over which not all prices have had time to adjust to their Walrasian levels. This article introduces a different interpretation of the key ideas from the General Theory. 1 Although my work is inspired by Keynesian economics, this article is not about the history of thought. I offer a way of formulating the idea that market economies are not inherently self-stabilising without assuming that prices or wages are prevented from adjusting to their equilibrium levels by some kind of friction. Instead, I claim that high, persistent unemployment is a potentially permanent feature of a market economy in a steady-state equilibrium.