Category Archives: Economic theory and policy

When do you suppose we will see the likes of that again?

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Janet Albrechtsen discusses austerity in The Australian today. A nice column and well timed to coincide with the budget. If actual economic outcomes counted for anything, this Keynesian theory would have been flushed out to sea years ago, but there it is, stronger than ever. So you have to sympathise with Angela Merkel as she tries to battle with people with real money to lose if these balanced budgets ever catch on again. From Janet’s column:

Happily, the ‘austerity thing’ is not pretty much debunked everywhere. While the word may have lost appeal (let the Left enjoy that hollow victory), the need for fiscal discipline is more certain than ever. ‘I call it balancing the budget,’ German Chancellor Angela Merkel said last month. ‘Everyone else is using this term austerity. That makes it sounds like something truly evil.’ A week earlier Merkel repeated her oft-repeated theme that Europe was living beyond its means. It has 8 per cent of the world’s population, 25 per cent of its gross domestic product and 50 per cent of its social spending. ‘That money has to be earned,’ she said.

It’s not even as if Merkel hasn’t got the runs on the board. The German economy is practically supporting the entire southern half of Europe but mendicants, whatever they may lack in honour and scruple, never lack the hunger for the wealth of others. The mentality of the indolent is that the hard working and provident owe them a tribute for being so capable of earning incomes on their own, in contrast with they themselves who can do no more than plead for a cut of the wealth produced by those who are somehow, through hard work and foresight, able to produce the flood of goods and services the mendicant class are so desirous of.

It is all luck in their minds, completely unjust and in no way related to merit.

But I fear Merkel and the rest will never be able to overcome the Keynesian monster until they have a theoretical explanation of how things work that refutes the belief that spending is itself the cause of growth. It’s obviously untrue, but what is even more obvious is that it is not in the interest of those who love parceling the booty out or of those who are on the receiving end, to admit that, just perhaps, this Keynesian economics is utterly mistaken from stem to stern and is the actual source of many of the economic problems we have.

Every fact has a thousand explanations. I used to say during the Costello years that when it is finally over no one would have learned a thing. And it’s true. There is not one economist in a hundred who could give you a coherent theoretical explanation why the Australian economy took off after public spending was cut in 1996 and 1997 just as the Asian Financial Crisis got under way. Zero deficits, zero debt and a strong economy. Sounds good to me. When do you suppose we will see the likes of that again?

“Adhering to the outdated ideas of thinkers such as Mises, Hayek and Friedman”

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Having looked at Ben Eltham’s uninformed analysis of my article which was published in the Australian Financial Review in 2010, in which he had stated that I was “adhering to the outdated ideas of thinkers such as Mises, Hayek and Friedman”, I thought I might also put up the article I wrote then. I still think the RBA is far and away the best central bank in the world and I say this even though they have brought official interest rates to their lowest level since 1959 (or so I think I read). It is a reflection of their judgment on how dead in the water the Australian economy is. My AFR article was however published in November 2010, a more hopeful time for the economy when government plundering was at its height. And for you Keynesians out there, the analysis I use in this article is the same Wicksellian analysis Keynes used in his Treatise on Money.

It was pleasing to see the RBA raise interest rates, and the economy will be all the better for it as well.

The trouble with all that free stuff governments like to give out is that it isn’t really free after all. The true cost of government spending comes out of our collective wealth in a process almost invisible to the naked eye, with the frequent aim of governments to keep it as invisible as possible.

Australia is amongst the few economies where official interest rates have been rising. Nor is it a coincidence that the Australian economy has been amongst the better performing economies of the world. Raising rates has been an essential part of the reason why the economy has performed as well as it has. It is a cause as well as a consequence of our relative economic success.

The rate of interest is the price paid for resources made available for investment. When people save, they may think what they are saving is money but this is in many ways an illusion. They have produced goods and services, received an income for their efforts but chose not to buy everything their income would have allowed them to buy. Unspent income is saving, and to the individual saver these savings come in the form of money.

But that is to look at things from the perspective of the individual saver. From the economy’s perspective what savers do is leave for others the goods and services they had produced but did not themselves consume.

They have transferred to others, for a price, the right to use the output that has been made available by their decisions not to immediately buy as much as their incomes would have enabled them to.

They have postponed their own purchases until a later date but in doing so have provided an opportunity for others to make use of those unused resources to build productive assets through investment programs of their own.

Without saving there can be no investment. All investment is the product of saving and however much or little there is, you cannot invest more than what you have saved.

But it is not just private firms who seek access to these savings. Governments, too, absorb huge amounts, taking these in as tax revenues and then borrowing more to finance projects of their own.

Rising rates are a reflection of the supply and demand conditions for private savings. What’s left after the government has taken what resources it has decided to use up is what’s left for the private sector to divide amongst itself.

The advantage the government has in getting its hands on the savings of a nation is that when it borrows lenders know they will get their money back, governments get to print money when they cannot borrow all they want, and they can run deficits without immediate concerns about where the money to repay their debts will be coming from.

But here is the trick. Borrowing almost invariably comes in the form of money. A nation’s real savings, on the other hand, come in the form of actual resources which can be applied in building investment projects.

Of money there is an almost endless supply. There is as much as a government is prepared to create.

As to the availability of underlying real resources, the supply is finite and strictly limited. The core task for a central bank is to make sure the flow of dollars entering an economy is matched by an available flow of real resources the money can be used to buy.

Too much money relative to the resource base of an economy and we have inflation. It is this the RBA is determined to stop.

Interest rates are rising because the government is using resources even before they reach the private sector. The government may be able to provide school halls, install insulation and now the NBN. But if you think you are getting all this for free, you should think again.

The RBA is continuing to raise rates because the government is taking up domestic savings more rapidly than we are able to generate those savings through productive activity.

In this economy at this time it is the government that is the single most important cause of rising rates. The RBA is only doing what it can to ensure the resources available for investment are properly priced.

The pressure on rates therefore remains upwards and will continue to remain upwards so long as the government continues its relentless take up of our productive resources.

But if you don’t like higher interest rates, there is no point in blaming the RBA or for that matter the private banks. It is the government that is absorbing our national savings and raising the cost of capital. So long as it continues to do so, the pressure on rates will remain.

As a side note, The Age this morning ran a front page splash on how the banks are gouging their customers based on the economically illiterate notion that the central bank sets the rates for everyone else.

Why you should study economics at RMIT

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As it happens, I teach one of the finest introductory economics courses you will find anywhere in the world. Not standard by any means, it is based around my text, Free Market Economics: an Introduction for the General Reader. If you would truly like to understand how an economy works, you could not do better, in my view, than to read my book and if you can, to take my course. The reality is that you could not do better than to study economics at RMIT.

For all that there is a wildly absurd blog post by Ben Eltham, a self-confessed Keynesian and economic know-nothing, that comes first up if you google my name that goes under the heading, “Don’t Study Economics at RMIT”. Mr Eltham, it seems, wrote this in 2010. Must have been expecting a wondrous recovery although I must say he was a very optimistic soul to have still harboured such confident beliefs as late as the 6th November that year.

The kind of certainty found in Skidelsky (and Eltham) has drifted out to sea in the last few years. There are a few diehards of the Krugman variety but with economic matters getting worse just about everywhere, it will be a while before we again hear about the return of the master in relation to Keynes. I am told my students do read this post but interestingly they have never brought it up with me. What I describe to them in theoretical terms is exactly what they can see for themselves everywhere they look.

The notion that Keynesian policies have worked anywhere at all since the stimulus programs at the end of the GFC can not be sustained for a moment. They have been a disaster everywhere they were tried with the American economy amongst the most disastrous. The likelihood of any kind of serious recovery even now is remote. And it’s not because of some financial crisis years ago but because of the stimulus and the deficits and the debt that are a direct result of Keynesian theory. Mr Eltham, a self-confessed non-economist, totally without formal training in economics, is in absolutely no position to comment on any economic matter other than as a matter of wishing things were true that are not. You would think that by now he would have the decency to apologise but the possibility is as remote as his ever understanding the first thing about how an economy works.

Austerity and Keynesian economics

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Oddly, could the real beginning of the Keynesian counter-revolution begin here in Australia? It’s one thing to stop spending because you have run out of other people’s money. It’s quite another to understand the problem of valueless public spending which will lead to a very focused attack on public waste.

Adam Creighton has a wonderful article in today’s Australian, Nothing austere about Europe’s fiscal policies which truly goes to the heart of the problem. He begins:

IN 1946 George Orwell famously pointed out how politics degraded and abused the English language for the sake of political ends. The same is true in economics. The word austerity, used to describe European and even US fiscal policy, has been a clever ruse by opponents of measures that may cause any reduction in the size of government.

No objective, sane person could describe, in a relative or absolute sense, fiscal policy in Europe or the US as austere, a word stemming from the Greek meaning harsh or severe.

‘The word austerity entered into the conversation once it became clear what a disaster the debt-financed stimulus was going to be,’ says Steven Kates, an economics lecturer at RMIT University, referring to the failure of repeated and colossal budget deficits to resurrect economic growth across advanced countries, almost five years after the end of the global financial crisis.

‘Those who support public spending and deficits prefer to characterise those who oppose them as wearing a hair shirt, rather than wanting to reduce public waste and have governments live within their means,’ he adds.

Government budget deficits in Europe are still up to twice as large as they were before the GFC – when no one described them as austere – and are contributing to already vast public debt burdens. Far from the ‘savage cuts’ of Wayne Swan’s imagination, European governments have reduced only the rate of growth of public spending. Even in Greece, a country with little population or economic growth in recent years, spending is still greater than it was five years ago.

Yet ‘mindless austerity’ has become a favourite phrase of the Treasurer since he dumped his promise to restore the budget to surplus this financial year. With a tsunami of costly spending promises on the horizon across disability, health, the environment and parental leave, it appears unlikely the budget will return to surplus soon – and without a change in attitude, ever.

OK, obviously I was one of the people he spoke to when he put this article together. But I speak to lots of people who never seem to get it. This is different. He sees the point and explains it exactly right which I don’t think you can do unless you understand it. And while it has felt somewhat strange to discover what I have discovered ploughing this furrow since the 1980s, I would still make the statement that there is no other way to find our way out of the economic problems we are in without a return to pre-Keynesian economic theory. First let me get back to the article and then let me continue:

Adam Smith’s dictum that what is prudent for households is never folly for governments infuriates economists who remain deeply wedded to the theory of John Maynard Keynes, who said public borrowing and spending, however wasteful, could revive moribund economies.

The giants of economic history before then – Jean Baptiste Say, John Stuart Mill and Alfred Marshall, for instance – all railed against the idea, which for Mill was an absurdity: ‘The usual effects of the attempts of government to encourage consumption is merely to prevent saving; that is, to promote unproductive consumption at the expense of the reproductive (investment).’

You won’t find the problem explained in any modern text based on the idea that aggregate demand drives an economy forward, which as it happens constitutes virtually all modern texts at the macro level. You certainly cannot make sense of the economic problems we have in the absence of a focus on value adding activity (i.e. the supply side of the economy) as the actual driver of economic growth. These concepts were, however, the foundational principles of the economics of Smith, Mill and Marshall, and indeed for all economists of the classical school prior to Keynes. But with the publication of The General Theory, which argued that public spending on anything at all will prime the pump and get an economy moving again, the notion that spending to create growth and jobs had to be value adding evaporated from the curriculum.

For me, schooled in the classics as I am, it was as obvious as a cloudless day that the stimulus could never achieve its ends. For virtually the rest of the profession it was not. Why the difference? I base my understanding on the classical theory of the cycle; they base their understanding on Keynes. That’s it. Nothing else. Anyone can do it. So why don’t they? Because the grip of Keynesian demand management has since the 1930s had the profession locked into the most destructive form of economic analysis, a form of analysis every classical economist understood as fallacious to its very roots. So all I can do is direct you to the pre-Keynesians. Here is a primer on the classics.

After that read either the first edition of Haberler’s 1937 Prosperity and Depression or if that doesn’t appeal to you, you can try my own Free Market Economics. But unless we can get out of this Keynesian death grip, our economies may never fully recover. We’ll just get used to slow rates of growth and limited improvements in our standard of living, in just the same sort of way the Japanese have done since their own Keynesian stimulus of the 1990s wrecked the world’s fastest most vibrant economy of the time.

Dangerous economic ideas

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Niall Ferguson, historian, buys in on the anti-Keynesian debate with the totally superfluous comment that Keynes developed his theory of the short run because of his absence of children and etc. And what about all those fathers of six who thought that Keynesian theory was the answer to our economic problems? I just wish people would concentrate on the theory and leave the rest alone. Ferguson has apologised but so what. One more distraction away from what really needs a bit of discussion: the harm that Keynesian theory is doing and the reason why his theories are so economically unsound. The rest is trash.

Here is an article on Ferguson’s claim, “Sex, Economics, and Austerity“. The one useful bit that I did pick up was this:

As Mark Blyth has shown in his new book Austerity: The History of a Dangerous Idea, the power of arguments for austerity come from the fact that they invoke the traditional moral system of the West, a way of thinking that is rarely questioned because it seems like common sense. Implicit in austerity are all sorts of moral adages: no pain, no gain; suffering builds character; thrift is virtue.

Austerity: The History of a Dangerous Idea! I fear life is too short but I suspect that if I run across it on a shelf I will pick it up just because. We are ruining our economies before our eyes by this madcap spending but it’s austerity that’s the dangerous idea. Well so far as dangerous economic theories are concerned, I came first with my Dangerous Return of Keynesian Economics in Quadrant in March 2009. Four years later and I wouldn’t add a word or change a comma.

What’s missing here?

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The Australian Conference of Economists has listed a number of areas of interest for special examination at this year’s meeting in Perth. Notice anything missing?

Researchers are invited to submit original papers that examine factors that influence ‘Beyond the Frontiers: New Directions in Economics’. We welcome the submission of papers that further develop this theme. We believe the theme offers considerable flexibility and could be used to report research findings or discuss issues related to areas such as:

  • GFC / Euro / Banking Crisis
  • Resources Boom (Energy Crisis)
  • Federal / State Financial Relations
  • Chinese Economy and Impact on WA / Australia
  • Experimental and Behavioural Economics
  • Climate Change / Environment
  • Monetary Policy / World Bank

Of interest to me, but to few others apparently, is the dismal policy failure of Keynesian economic theory. And as long as the belief remains that the world’s economies are suffering from the after effects of the financial crisis rather than the Keynesian stimulus that followed, the longer it will be before we start dealing with the actual nature of the problems we have.

The anti-capitalist mentality

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I spoke at Latrobe University today on the anti-globalisation movement about which I had hardly ever given a thought. But to start off I began with this letter to the editor from yesterday’s Australian:

QUITE simply the rich get richer and the poor get poorer – and fewer people on the fringes seem to care about suffering, just so long as the next piece of fleeting fashion or new technology is available at an affordable price (“Rags, riches and rubble”, 6/5).

History does repeat itself. Think back to the industrial revolution. But this time around the phenomenon can be described in one word: globalisation. Unlike the industrial revolution , it is easier for most people to forget the true origin of the goods that enable them to live comfortable lives. For many of us, Bangladesh may as well be on a different planet. Out of sight, out of mind. So much for the level playing field that we are force-fed by our political leaders as being the answer to all our future problems.

The usual lefty stuff. Something happens in some business somewhere and a label is attached to the process which can be used to demonstrate that capitalism is an intrinsic problem that must be suppressed. So to match the story of the horror of the building collapse in Bangladesh I discussed the Triangle Shirtwaste Factory fire in New York in 1911. Industrial accidents are a tragic reality but to use it as a reason to end the slow slow progress of material development in the third world is a specialty of the comfortable who will never be afflicted by the sudden disappearance of the market system. Its deterioration will affect them over time, just not right away.

But of all the sanctimonious nonsense, the Colombian girl who told us of the good that was being done in her home country by the Marxist guerillas and how Colombians peasants were the happiest people in the world struck me as sensationally inane but merely proved my point since all I did was discuss the anti-capitalist mentality that remains so prevalent.

Post 350

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I am not only surprised that I got to 350 posts, but am surprised at how quickly it happened. There have been periods when I am away, and sometimes I am just too busy. And while I cannot say the traffic has been immense, it still astonishes me the number of hits this gets and the places that people are in. This is the list of places where people had had a look yesterday from highest to lowest:

United States
South Africa
Turkey
Australia
Norway
United Kingdom
Brazil

My interest remains government economic management by public spending. It is just too bizarre that no one has learned from the dismal outcome. Recoveries eventually happen because people hate being in recession. There is a will to act even in the face of such idiotic government regulation. But there are so many unnecessary obstacles that it is unlikely ever to be full throated and there will be a deterioration in living standards at least for a time.

Zingales on Keynes

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This is Luigi Zingales’ opening statement in The Economist‘s 2009 debate. It is Say’s Law in all its ramifications without the actual name applied. It is my bolding in the article below:

What does “being Keynesian” mean? Simply believing in the role of demand-side factors in the determination of aggregate output is an insufficient characterisation. A true Keynesian differs, in so much as he also believes that: 1) monetary policy is not the most effective tool for stabilising the economy and it may be completely ineffective in some circumstances (liquidity trap); 2) fiscal policy is effective and government spending is the preferred tool; 3) government intervention works and short-run consequences are more important than long-run ones.

With this definition in mind, there could be four ways in which the statement “we are all Keynesians now” can be interpreted. I propose that the statement is false in three out of four of these interpretations.

The first interpretation is that the economic profession has reached a consensus on Keynesian positions. This statement is definitely false. If you browse through the articles published in the leading journal of the American Economic Association in 2008, you would find that only one of the 12 articles that deal with macroeconomic issues (JEL Code E) supports (albeit very indirectly) the idea of a fiscal policy expansion as a policy tool. An even stronger imbalance is present at the pinnacle of our profession. Among the 37 Economics Nobel prize winners in the last 20 years, four received the prize for their contributions to macroeconomics. None of these could be considered Keynesian. In fact, it is hard to find academic papers supporting the idea of a fiscal stimulus.

The second possible interpretation is that there exists a consensus among economists that the causes of the current crisis are Keynesian. Even under this interpretation the statement is patently false. I do not think that any economist would dare to say that the current US economic crisis has been caused by underconsumption. With zero personal saving and a large budget deficit the Bush administration has run one of the most aggressive Keynesian policies in history. Not only has adherence to Keynes’s principles not averted the current economic disaster, it has greatly contributed to causing it. The Keynesian desire to manage aggregate demand, ignoring the long-run costs, pushed Alan Greenspan and Ben Bernanke to keep interest rates extremely low in 2002, fuelling excessive consumption by the household sector and excessive risk-taking by the financial sector. Most importantly, it has been the Keynesian training of our policy-makers that has led them to ignore the role that incentives play in economic decisions. The main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economics base all their analysis on incentives. In 1998, when the Fed co-ordinated the bail-out of Long Term Capital Management, it did not care about the impact this decision would have on the incentives to take risk and price liquidity appropriately. When Mr Bernanke engineered the bail-out of Bear Stearns, he did not care about the impact this decision would have on the other investment banks’ incentives to raise equity capital at rock-bottom prices. When he changed his position twice in the space of two days, letting Lehman fail, but bailing out AIG, he did not care about the impact it would have on investors’ confidence and incentives to invest. It is this erratic behaviour that has spooked the market and created the current economic crisis: in a recent survey 80% of Americans declare that they are less confident of investing in the market as a result of the way the government has intervened.

If Keynesian principles and education are the cause of the current depression, it is hard to imagine they can be the solution. Thus, even the third interpretation of the house statement—that we should follow Keynesian prescriptions to combat the current economic crisis—is false. I am not disputing the idea that some government intervention can alleviate the current economic conditions, I am disputing that a Keynesian economic policy can do it. With a current-account deficit that in 2008 was $614 billion, a budget deficit that was $455 billion and military expenditures of $731 billion, it is hard to argue that the government is not stimulating demand sufficiently. The current crisis is not a demand crisis, it is a trust crisis. Bad corporate governance coupled with bad government policies has destroyed the financial sector, scaring investors and freezing lending. It is as if a nuclear bomb had destroyed all roads in America and we claimed that to alleviate the economic impact of such an event we should invest in banks. It is possible that eventually the effect will trickle down. But if the problem is the roads, you want to rebuild roads, not subsidise the financial sector. And if the problem is the financial sector, you want to fix this and not build roads.

The only interpretation under which the house statement is true is that “we”—the English/American people and their elective representatives—are all Keynesians now. Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behaviour. Medical science has established that one or two glasses of wine per day are good for your long-term health, but no doctor would recommend a recovering alcoholic to follow this prescription. Unfortunately, Keynesian economists do exactly this. They tell politicians, who are addicted to spending our money, that government expenditures are good. And they tell consumers, who are affected by severe spending problems, that consuming is good, while saving is bad. In medicine, such behaviour would get you expelled from the medical profession; in economics, it gives you a job in Washington.

I just don’t think the major dividing line is over incentives. It is, in my view, about the need for value adding activity which public spending never provides.