At the very start of the GFC and the stimulus there was a debate at The Economist Online about what should or should not be done, revolving around Keynesian theory and policy. We now, of course, know who won the debate so far as policy is concerned but I still wonder whether it was not also won so far as theory goes as well. The arguments against were from John Cochrane of the University of Chicago who wrote:

Nobody is Keynesian now, really. Keynes distrusted investment and did not think about growth. Now, we all understand that growth, fuelled by higher productivity, is the key to prosperity. Keynes and his followers famously did not understand inflation, leading to the stagflation of the 1970s. We now understand the links between money and inflation, and the natural rate of unemployment below which inflation will rise. A few months before his death in 1946 Keynes declared:1 “I find myself more and more relying for a solution of our problems on the invisible hand [of the market] which I tried to eject from economics twenty years ago.” His ejection attempt failed. We all now understand the inescapable need for markets and price signals, and the sclerosis induced by high marginal tax rates, especially on investment. Keynes recommended that Britain pay for the second world war with taxes. We now understand that it is best to finance wars by borrowing, so as to spread the disincentive effects of taxes more broadly over time.

Really, the only remaining Keynesian question is a resurrection of fiscal stimulus, the idea that governments should borrow trillions of dollars and spend them quickly to address our current economic problems. We professional economists are certainly not all in favour. For example, several hundred economists quickly signed the CATO Institute’s letter2 opposing fiscal stimulus.

Why not? Most of all, modern economics gives very little reason to believe that fiscal stimulus will do much to raise output or lower unemployment. How can borrowing money from A and giving it to B do anything? Every dollar that B spends is a dollar that A does not spend.3 The basic Keynesian analysis of this question is simply wrong. Professional economists abandoned it 30 years ago when Bob Lucas, Tom Sargent and Ed Prescott pointed out its logical inconsistencies. It has not appeared in graduate programmes or professional journals since. Policy simulations from Keynesian models disappeared as well, and even authors who call themselves Keynesian authors do not believe explicit models enough to use them. New Keynesian economics produces an interesting analysis of monetary policy focused on interest rate rules, not a resurrection of fiscal stimulus.

Our situation is remarkable. Imagine that an august group of Nobel-prize-winning scientists and government advisers on climate change were to say: “Yes, global warming has been all the rage for 30 years, but all these whippersnappers with their fancy computer models, satellite measurements and stacks of publications in unintelligible academic journals have lost touch with the real world. We still believe the world is headed for an ice age, just as we were taught as undergraduates back in the 1960s.” Who would seem out of touch in that debate? Yet this is exactly where we stand with fiscal stimulus.

Robert Barro’s Ricardian equivalence theorem was one nail in the coffin. This theorem says that stimulus cannot work because people know their taxes must rise in the future. Now, one can argue with that result. Perhaps more people ignore the fact that taxes will go up than overestimate those tax increases. But once enlightened, we cannot ignore this central question. We cannot return to mechanically adding up today’s consumption, investment and export demands, and prescribe the government demand necessary to attain some desired level of output. Every economist now knows that to get stimulus to work, at a minimum, government must fool people into forgetting about future taxes, an issue Keynes and Keynesians never thought of. It also raises the fascinating question of why our Keynesian government is so loudly announcing large and distortionary tax increases if it wants stimulus to work.

There is little empirical evidence to suggest that stimulus will work either. Empirical work without a plausible mechanism is always suspect, and work here suffers desperately from the correlation problem. Quack medicine seems to work, because people take it when they are sick. We do know three things. First, countries that borrow a lot and spend a lot do not grow quickly. Second, we have had credit crunches periodically for centuries, and most have passed quickly without stimulus. Whether the long duration of the great depression was caused or helped by stimulus is still hotly debated. Third, many crises have been precipitated by too much government borrowing.

Neither fiscal stimulus nor conventional monetary policy (exchanging government debt for more cash) diagnoses or addresses the central problem: frozen credit markets. Policy needs first of all to focus on the credit crunch. Rebuilding credit markets does not lend itself to quick fixes that sound sexy in a short op-ed or a speech, but that is the problem, so that is what we should focus on fixing.

The government can also help by not causing more harm. The credit markets are partly paralysed by the fear of what great plan will come next. Why buy bank stock knowing that the next rescue plan will surely wipe you out, and all the legal rights that defend the value of your investment could easily be trampled on? And the government needs to keep its fiscal powder dry. When the crisis passes, our governments will have to try to soak up vast quantities of debt without causing inflation. The more debt there is, the harder that will be.

Of course we are not all Keynesians now. Economics is, or at least tries to be, a science, not a religion. Economic understanding does not lie in a return to eternal verities written down in long , convoluted old books, or in the wisdom of fondly remembered sages, whether Keynes, Friedman or even Smith himself. Economics is a live and active discipline, and it is no disrespect to Keynes to say that we have learned a lot in 70 years. Let us stop talking about labels and appealing to long dead authorities. Let us instead apply the best of modern economics to talk about what has a chance of working in the present situation and why.

Here is some Keynesian wisdom I think we should accept.

“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”

“How can I accept the doctrine, which sets up as its bible, above and beyond criticism, an obsolete textbook which I know not only to be scientifically erroneous but without interest or application to the modern world?”

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

Not much of an argument. It merely did the usual macro trick of saying that the spending will shift from the private sector to the public. What doesn’t get said is why that might be a problem for both growth or employment. Leaving out value added leaves out everything that matters. But since it is a measure that cannot be captured in statistical series – how do you tell if an expenditure will repay all of its costs which can only be known at some future date – there is no means to measure. And if Barro is the height of the anti-Keynesian theoretical argument, there really is no argument worth the name at all. Without Say’s Law the anti-Keynesian case is all nonsense.

John Papola – the producer of the Keynes-Hayek Rap – has posted a further article on Say’s Law at the PBS website. You should read the lot, but this at the start gets right to the heart of the matter:

Ironically, none of the foundational greats in the history of economic thought could get into Harvard University’s Ph.D. economics program today.

This is not because of radical advances in our understanding of economics. To paraphrase Milton Friedman, we have only advanced one step beyond David Hume in our understanding of economics. Rather than advance real understanding, the economics profession, bewitched by a century-long envy of the physical sciences, has collapsed into an esoteric and pointlessly hyper-mathematized maze of confusion. The result is an economic mainstream so disconnected from reality that we must resurrect 1800s debates over whether consumption, which by definition uses up our wealth, can somehow increase society’s supply of wealth as a result.

We are living in a dark age of economic understanding.

I was given a copy of John Kenneth Galbraith’s 1975 junk science treatise which goes by the name of Money: Whence it Came, Where it Went. And there on pages 218-19 we find this:

Until Keynes, Say’s Law had ruled in economics for more than a century. And the rule was no casual thing; to a remarkable degree acceptance of Say’s Law was the test by which reputable economists were distinguished from the crackpots. Until late in the ’30s no candidate for a Ph.D. at a major American university who spoke seriously about a shortage of purchasing power as a cause of recession could be passed. He saw only the surface of things, was unworthy of the company of scholars. Say’s Law stands as the most distinguished example of the stability of economic ideas, including when they are wrong.

Well let me say three things about this. The first is that the initial statement is absolutely right. Before the Keynesian Revolution, denial of the validity of Say’s Law placed an economist amongst the crackpots, people with no idea whatsoever about how an economy works. That the vast majority of the economics profession today would have been classified as crackpots in the 1930s and before is just how it is.

Second, Galbraith not only doesn’t understand the meaning of Say’s Law, he doesn’t even understand Keynes. The one thing that both the classical side and Keynes agreed on was that a shortage of purchasing power is never the cause of recession. It is not whether people have the purchasing power that is at issue, but whether they spend it. That is why saving is such a major issue in the Keynesian model. People could spend their money but choose not to. It is never argued that they never had the money in the first place which was not the issue of Say’s Law either. How disgraceful it is that one of the leading Keynesians has no idea of one of the fundamental ideas behind The General Theory.

Third, if we are looking for some crackpot notion that stands as a truly distinguished example of the stability of economic ideas, including when they are wrong, there is virtually nothing in the history of ideas quite as incredible as Keynesian economics itself. Inane to the point of vacuity, destructive of prosperity on every occasion it has been applied, utterly useless as a guide to policy, Keynesian economics is the ultimate in crackpot ideas that stay long past their welcome in spite of every form of evidence that it is entirely mistaken about how an economy works and what needs to be done when recessions occur.

[My thanks to Peter S for Galbraith’s tome.]