The intra-Keynesian fight over correct macroeconomic policy is a good lesson in the importance of epistemology in economics.  A good overview of the current debate is presented here.  Basically, mainstream Keynesians like Paul Samuelson and Paul Krugman are accused of  combining Keynes’ ideas with neoclassical thought and producing a watered down version which is devoid of the insights which made the Keynesian theory valuable in the first place. These modern Keynesians, according to the true believers, incorrectly believe that the market system is basically efficient and only needs tweaking by government action to remedy such features as sticky wages in order to fix a recession, which should be done by government deficit spending and easy credit, in that order.

Paul Davidson, leading Post Keynesian, in his book “The Keynes Solution: The Path to Global Economic Prosperity”, says that the crucial insight in Keynes’ General Theory is that uncertainty causes people to hold cash at a level that causes demand to fall, resulting in an equilibrium with unemployment, described here.  Unlike Samuelson and Krugman, who believe markets to be for the most part efficient, Davidson follows Keynes in seeing uncertainty as a permanent negative force on an economy.  Keynes also alleges that financial markets and investing are less based on rational analysis than they are on emotion or “animal spirits”.  These two factors are the reasons investment should be socialized.

Now we reach the epistemology.  The modern Keynesians and neo-classicals believe that accurate spot and futures markets exist, and that the past and present can be used to predict the future, what they call the ergodic principle.  The beginning of the Wikipedia article on ergodicity says all we need to know about the problems with current macroeconomic epistemology:

“In mathematics, the term ergodic is used to describe a dynamical system which, broadly speaking, has the same behavior averaged over time as averaged over space. In physics the term is used to imply that a system satisfies the ergodic hypothesis of thermodynamics.”

Human beings’ economic behavior is assumed to behave like inanimate particles, which obey known statistical properties.  Unfortunately, humans act in accordance with no known statistical distributions and with no fixed correlations or magnitudes, making predictive models impossible and any policy prescriptions based on those models suspect.  Modern Keynesians like Samuelson believed in ergodicity, a mild, understandable randomness with known parameters.

Keynes disagreed with this and saw uncertainty everywhere.  People sensed their inability to predict the future and this kept them from investing in long term projects.  Demand falls, conditions worsen, people hold even more cash to guard against uncertainty, and the economy spirals down.  At this point, the government must start making up for the lost demand by deficit spending.  As demand picks up, investment will increase and the economy will improve.  So sticky wages or the money illusion are not the main problems in this higher level of Keynesian analysis.  It is the uncertainty and fear of investors which is at the root of low demand.  Constant government pressure must be maintained against the under-investment due to uncertainty, which is lost on the modern Keynesians who advocate action only in the face of recession.