The difference between Keynesian and classical economics

Just posted on Quora in answer to the question: What is the difference between Keynesian and classical economics? There are 13 other replies which not much more than prove to me that no one without a truly specialist knowledge of classical theory would have the slightest idea what an economist between the late eighteenth and nineteenth centuries would have understood about anything in relation to the operation of an economy. Their ignorance of what classical economists believed is matched by their ignorance of how an economy actually works. Anyway, this is what I wrote.

The differences between classical and Keynesian economics are so vast that to accept one version of how an economy works means you must reject the other. Classical economic theory is the theory that was developed between let us say 1776 and the 1870s, almost entirely by philosophers and business people who were actually looking at the economy. Modern economic theory has almost entirely been developed within universities by people who have neither a philosophical training nor have ever run a business as their primary mode of earning a living.

Here’s the difference. Classical economic theory begins from the existence of a market economy in which, on one side of the equation, there is a mass of people who would like to buy goods and services, and on the other side there are people who would like to earn their living by producing and selling things to others. The producers continually try to work out what to produce that others will buy, and do it by trying to decide what buyers will pay enough for in total to cover their production costs. These producers hire employees and the combined incomes of producers and wage earners become the purchasing power of the community.

Classical economic theory is thus entirely supply-side driven. And what is particularly interesting about reading the classical literature is that government regulation was an important part of how the economic system worked. The very first Factory Act in Great Britain was introduced in 1802, and there were many others that came after. The notion that classical economics was simply leave everything to the market is 100% wrong. If you look at the greatest economics text of the era, John Stuart Mill’s 1848 Principles of Political Economy, the final 200 pages are devoted to discussing the role of government in ensuring that economic activity was carried out in a morally acceptable way to the benefit of the entire community.

But crucially, classical theory assumes the role of the independent entrepreneur as the linchpin in making an economy work. Try to find a modern economic text that starts from there. Other than my own – Free Market Economics, Third Edition – none of the major mainstream texts starts from the supply side and none – as in zero – feature the role of the entrepreneur.

Keynesian economics assumes economies are driven from the demand side. That is, it is buying goods and services that makes an economy grow and employ, not their production. It is based on the total confusion between the demand for a single product – the greater the demand for shoes the greater the production of shoes will be along with the greater the level of employment for shoemakers. Demand affects individual products; demand in aggregate does not affect the level of output in total. The more that is produced, the higher the level of demand, for the obvious reason that the more that is produced, the more there is that buyers are able to demand. But if you are a Keynesian, you will go on believing that the cause of higher output is higher demand, whereas the reason more can be demanded is that more output is being produced. Public spending may have many benefits, but increasing the level of income and speeding up the rate of economic growth is not one of them. If anything, higher levels of public spending slow things down and lower real incomes below levels that otherwise would have been reached.

Keynesian economics is based on the fallacious belief that buyers will not buy as much as an economy can produce, and therefore demand must be stimulated to ensure everything produced is bought and that everyone who wants to work is employed. A great theory if you are in government and need a justification for taking as much money as you can get away with from income-earning citizens and spending it yourself. But a pernicious theory if you are interested in raising living standards as rapidly as possible.

A lesson in trade theory

“Every economic answer is a political question.”

Here then is a question for all you experts on international trade, taken directly from my Free Market Economics [pp. 248-249]. Picture two countries, A and C.

Suppose in Country A, in one hour it can produce either one car or 1000 shirts. [It’s also the same answer if Country A can produce ten cars and 10,000 shirts per hour!]

Meanwhile in Country C, in two hours it can produce either one car or 500 shirts.

According to the economic theory of comparative advantage, how many cars will Country A produce? OK, once you’ve worked that out, now tell me if you get the same answer using common sense. As chrisl said, “economic theory is all right in theory”. Personally, I’m not even sure of that, but you get the idea.

So here’s the thing. It is entirely possible that the US is tired of carrying most of the burden for the defence of the West and would like a bit of sharing the burden. It might also find some respite for itself in strengthening those parts of its economy which are more closely associated with its defence industries. And it might even wish for some kind of gratitude from others, supposedly on the same side, in trying to assist the US in resurrecting its strength. And then there are the straightforward economic issues, which are not the same as the political. So let us go to these.

And of course the issue economically is comparative advantage, and not pure let the most efficient producer produce each product. With comparative advantage, it is not always the most efficient low-cost producers who produce. If you don’t even understand that, you should keep right out of this debate.

Why encourage free trade:

  • competition is what drives improvement and growth – without competition most businesses would just coast along to the fullest extent they could
  • innovation is driven by competition – the way to take on an established business is to find a better way to do something
  • all other things being equal, free trade is best

Why “free trade” is not working for the US:

  • cheating is rife – try to sell an American car in Japan – not possible for all kinds of products in all kinds of countries
  • many countries subsidise exports while imposing non-tariff barriers to trade on imports along with tariffs themselves
  • currency manipulation – artificially holding exchange rate lower to discourage imports and encourage exports is not unknown
  • $US is world reserve currency it is unable to adjust to repair a balance of payments deficit
  • there are many forms of approved trade restrictions everywhere you look – the EU for example – such as:

Trading blocs

A regional trading bloc is a group of countries within a geographical region that protect themselves from imports from non-members. Trading blocs are a form of economic integration, and increasingly shape the pattern of world trade. There are several types of trading bloc:

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a geographical region agree to reduce or eliminate tariff barriers on selected goods imported from other members of the area. This is often the first small step towards the creation of a trading bloc.

Free Trade Area

Free Trade Areas (FTAs) are created when two or more countries in a region agree to reduce or eliminate barriers to trade on all goods coming from other members.

Customs Union

A customs union involves the removal of tariff barriers between members, plus the acceptance of a common (unified) external tariff against non-members. This means that members may negotiate as a single bloc with 3rd parties, such as with other trading blocs, or with the WTO.

World Trade Organisation

There are then the WTO rules of trade engagement which are not designed to create a world where free trade is on the only answer. The rules were devised when the US economy was a lot more robust than it now is, and when the US was both willing and able to make sacrifices of all kinds to help others withstand the spread of communism. None of this is applicable today. The US is therefore no longer willing to watch others cheat their way into a stronger trade position, at the cost of its own national security, economic strength and domestic employment. Here is part of what the WTO is up to.

WTO Rules

1. Most-favoured-nation (MFN): treating other people equally Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favour (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members.

2. National treatment: Treating foreigners and locals equally Imported and locally-produced goods should be treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

3. Developing countries have transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions — particularly so for the poorest, “least-developed” countries – so these basket case economies are allowed to whittle away at the economic strength of the developed world.

Meanwhile, economic ministers around the world increase unproductive public spending every chance they get, add new regulations on top of old, and increase business taxes at every turn, and then job on their chairs screaming, “Eek, a tariff!’

The quote at the top, by the way, is from Joan Robinson, who has quite a lot to say about free trade that ought to be read by the economic illiterates who populate the world, who are now found speaking on behalf of the status quo, as harmful as the status quo is to most of the lower half of the income distribution. Robinson was not just a Keynesian but also a big supporter of Mao, so I’d be very careful, but the above quote seems as accurate as anything else you are likely to hear about economics.

There are Keynesians in even the most unlikely places

This is from, of all places, Maurice Newman’s article in The Oz today on Trump’s news might be bad for his forgotten flock. So which is the absolutely wrong word in this passage?

Despite a decade of easy money, continued fiscal stimulus and a personal savings rate that has tumbled from 6.6 per cent to 2.4 per cent in just 12 years, the US economy during calendar 2017 grew at 2.5 per cent, hardly a number to write home about. Indeed, adjusted for the once-off hurricane rebuild effect, it managed just 1.5 per cent in the last quarter.

It is, of course, the first word, “despite”. If he had said instead, “because of …” then all would be clear. Artificially low rates of interest, high levels of unproductive public spending and falling savings are the very recipe for stagnation.

Ho hum; trillion dollar deficit

us fed debt

Here’s the US debt story with a bit of historical perspective. Here we find an example of Change You Can Believe In care of the blessedly departed Barack Obama. Consequences include slower growth, limited if not actually negligible increases in the real wage, additional upwards pressure on the price level and some additional increases in rates of interest. But really, where’s the constituency to do anything else? How many non-Keynesians are there, never mind anti-Keynesians?

Remember this? Remember how it ends?

What’s changed and how you gonna change it? Still, there are  regulations going and public spending is being better targeted. Large numbers are being peeled from the welfare rolls. Not good, but if the deficit is rising and you’re a Keynesian, what’s the problem? And if you’re not, what are you going to say to convince them otherwise?

Of course, there is then this from Drudge yesterday:

Then there’s this from today:

But then there’s this also from today.

Really, you only wish people knew how things worked, as in some business comes up with an idea, borrows some money to buy in some capital and labour, and then produces that are sold on the market for a profit. There is endless entrepreneurial drive in the US. With a President who is an entrepreneur, who knows what’s possible.

This is classical economic theory

No one can really see it yet but classical economic theory is coming back. This post at Instapundit by Mark Tapscott is presented and discussed in exactly the way economics would have been discussed by the great classical economists between 1776 and 1936. The issue is not about demand. It is about the redeployment of actual physical resources – capital goods – from less productive and even non-productive uses into more productive and positively productive uses. You may think you have heard this said before, because you think that is how economic theory and policy should be discussed, but I keep an eye out for it and this is the first time I have come across anything discussed in that way.

I have posted this paper before – Making Sense of Classical Theory – which is a pre-print of a paper that will appear in the April 2018 edition of the Journal of the History of Economic Thought. If you are at all interested in understanding how pre-Keynesian economists thought about the structure of an economy and what made it grow and flourish, you should read that paper. It describes in theoretical terms how Mark Tapscott explains the sudden flourishing of the American economy. This is exactly how classical economists looked at things.

TRUMP’S FIRST-YEAR BOOM IS LARGELY DUE TO DEREGULATION BUT THINK ABOUT THIS: Merely cancelling an expensive federal regulation doesn’t immediately convert the compliance cost into a potentially productive new investment. The capital has to be reallocated and some time is required for the new investment to produce sufficient return to offset the former compliance costs. Huh?

In other words: “It takes time for the economy to recover the costs of excessive regulatory compliance and to redirect capital to productive uses, so the gains seen during Trump’s first year are likely attributable in significant part to the expectations generated by his slashing the red tape. The full impact of the deregulation is still to be felt.”

And remember, the Trump tax cuts aren’t in effect until February. Wayne Crews of the Competitive Enterprise Institute estimates regulatory compliance cost the U.S. economy $1.9 trillion. Trump can’t repeal all federal regulations but what if his tax cuts and the continuing positive impact of deregulation in coming years produces an economic boom that far exceeds the Reagan era? Ponder that one a bit!

The value of tax cuts is in their ability to divert resource use away from consumer goods and governments into the hands of productive business who are then able to invest. Cuts to regulation play their role by reducing wasted efforts within business in complying with government directions and instead use the resources at their disposal to create value. It works like magic, because to a modern macroeconomist it is magic since they have no means of explaining what was once perfectly well understood by everyone.

C’mon, who’s really clueless about trade?

From Forbes, the kind of thing you find in among Chamber of Commerce types: Trump’s Tariffs Are A Reminder He’s Clueless About Trade. Sure he is, and the evidence keeps piling up day by day. If we lived in a crony-capitalist-free world, and no one ever cheated in their trade relations,* maybe such blanket statements would make sense. But truly lacking in any penetration is the manipulation of arithmetical statistical identities as if they were actual theoretical constructs where a change in one variable is the cause of a change in another. In reality, with such identities, these are accounting balancing items which have no effect on actualities in the real world, but are only a record of what took place.

Now here is where the simple analytics of the trade deficit can be used to prove the cluelessness of the Trump trade team on “trade,” of all things, and the utter futility of its policy prescriptions having any impact on America’s aggregate trade deficit. In economics, identities play an important role. These identities are obtained by equating two different breakdowns of a single aggregate. Identities are interesting, and usually important, by definition. In national income accounting, the following identity can be derived. Indeed, it is the key to understanding the trade deficit.

(Imports – Exports ) ≡ (Investment – Savings) + (Government Spending – Taxes)

Given this identify, which must hold, the trade deficit is equal to the excess of private sector investment over savings, plus the excess of government spending over tax revenue. So the counterpart of the trade deficit is the sum of the private sector deficit and the government deficit (federal + state and local). The U.S. trade deficit, therefore, is just the mirror image of what is happening in the U.S. domestic economy. If expenditures in the U.S. exceed the incomes produced in the U.S., which they do, the excess expenditures will be met by an excess of imports over exports (read: a trade deficit).

This is the same as fiddling with Y=C+I+G and pretending that an increase in G can cause an increase in Y. Complete sophistry. There is much more to say about free trade and I have been meaning to say it for a while. This might therefore be what finally stirs me to spell it out in more detail, but this will have to do for now.

* See, for example, Australia takes Canada to WTO over rules on selling wine. My dual nationality obviously makes it impossible for me to see the rights and wrongs of this, but let me say that no Australian will ever understand the liquor laws of Canada, which were introduced as temporary measures during World War I. There’s a lesson in there as well.

If you want to understand how an economy works you need to understand classical economic theory

So long as Keynesian economics remains the mainstream, there is no possibility of taking down the crony capitalist system of economic management. Because Keynesian theory is the mainstream which everyone learns, economists are taught from their very first days in class, that routinely syphoning our wealth into the hands of governments and their friends will create a net increase in the number of jobs while making everyone better off. It isn’t true, and ought to be seen as obviously untrue, but since the pretence makes governments and their crony capitalist friends immensely rich, it just goes on. So more fool you for accepting Keynesian theory.

The argument that an economy is driven by the level of demand, irrespective of what is being demanded, works very well for those receiving handouts from governments, but harms everyone else. All production uses up resources while only a small proportion adds anything back in. It is now invisible in the way economics is currently taught why all of that matters. In writing as I do I am doing nothing more than repeating what was obvious to every great economist before The Keynesian Revolution but is utterly unknown other than to a handful of economists who have actually studied the classics.

At the link may be found a pre-print of an article of mine that will appear in the June 2018 issue of the Journal of the History of Economic Thought: Making Sense of Classical Theory. This is the description of its contents.

The fundamental problem discussed is the shifts in the conceptual base of economic theory that followed the publication of The General Theory, along with various technical terms being given different meanings, which have made it almost impossible for modern economists to comprehend classical theory. Yet it is in the classical theory of the cycle where the most profound understanding of the nature of recession and cyclical unemployment is found.

The paper’s not long but it takes you into the heart of the differences between modern economics and the classical theory that had existed prior to the publication of The General Theory in 1936. This is now the sixth paper in a series that began with the publication of my article on Mill’s Fourth Proposition on Capital in 2015. That earlier paper was criticised by an economist in the UK by name of Roy Grieve, whose criticism of my paper attracted a series of comments by an American economist, James Ahiakpor.

I can only hope that the core point found in the attached paper, explaining why classical theory works and Keynesian economics does not, will be clear. But as this brief paper points out, there have been so many changes in the terminology and presuppositions within economic theory since classical times that it remains almost impossible for a modern economist to follow what the great economists of the past had said. But not only can it be done, but you will only understand how an economy works if you do.

Productive and unproductive spending

A very classical distinction that is lost on most economists today.

There is this grand distinction between an individual borrower and a borrowing government, that, in general, the former borrows capital for the purpose of beneficial employment, the latter for the purpose of barren consumption and expenditure.

— J. B. Say

From his Treatise on Political Economy dealing with “Of the Consumption of Wealth”.

Two letters on Say’s Law

Once someone gets Say’s Law, the reality of what is going on in an economy becomes so obvious that it is impossible to go back to the pallid and utterly inadquate nonsense that passes for modern theory. The following is a letter I received the other day from someone I have been corresponding with for a while, and after that is my reply to him.

Hope you are well. Yes I read (and watched) all you have given me. [I even read (and bought) your conversation with Gregoire Canlorbe ‘Say’s Law, between Classical, Keynesian and Austrian Interpretations (2016)’ (from De Gruyter)].

I read your ‘200 years of Say’s Law (2003)’. Another thought provoking gem.

Back in the early 2000s I undertook 3 and a half years of bible college. I learnt the importance of hermeneutics and exegesis. Today, I am not surprised Economics scholars also struggle with proper interpretation of another author and can fall into eisegesis. The four scholars, arguing against Say’s Law, could only attack the many straw men (eg. ‘supply creates its own demand’, or Say’s economy is barter-only economy, or Say’s Equality, or change Savings’ definition) and reduce its meaning, or, read something of Say’s Law which wasn’t really there and added their own meaning (eisegesis). Misinterpreting is common, unfortunately, across disciplines as you well know. Let me illustrate my two theological favourites, however. If you can you find anywhere in the bible where it says “Money is the root of all evil” or “The truth will set you free” I will happily give you/anyone $15,000 cash and clean one’s house for a year! The point is: if we omit the few words before these popular phrases then the originator’s point is changed and COMPLETELY lost. Sound familiar?

In the tradition of Hayek’s name calling of some scholars to be ‘quasi-scientific’ (p 20) I thought I could respectively/humbly/comically generally refer to those ‘against’ Say’s Law as:

1. ‘One-side of the ledger Economists’: Aggregate Demand (and full employment) is their God, and ignoring the complexity of the supply side is welcome by their herd. Not sure why some Economists think they can ignore one side of a transaction when professional Accountants get fired for it.
2. ‘Unsustainable-loving Economists’: They are at peace to see government spending on unproductive consumption even if it alters the dynamics of the economy and reduces its viability to stand on its own feet.
3. ‘Second-rate Economists’: It is written “All things are [permissible], but not all things are beneficial” Amplified version. Maybe most complacently see policies in action and gravitate to think that must be the best option. Just because a policy is enacted doesn’t mean it is the most beneficial. Most don’t stand for a strong economic view- so they fall for any.
4. ‘Ignore the opportunity-cost-type of Economists’
5. ‘Short term-ism Economists’
6. ‘I missed school that day they taught ‘the cause-and-effect principle’ Economists’ (or ‘Symptom-is-a-cause Economists’)
7. ‘Blinker Economists’: They focus on only that scope of economic activity which supports their limited explanation.
8. ‘Soft-love loving Economists’… as opposed to hard-love=real love (but you get the idea).

I asked my successful business owner brother-in-law how much he has in idle cash (hoard). He answered it was a lot less than 1% because “you try to put all your money to the best use in every way”. I’m sure if I asked my trader friends what makes them buy and sell a specific trade I am sure they would respond “there is always a reason” rather than Littleboy’s reference of Keynes’ “…people, typically investors, spontaneously change their mind…” (p 160). Ask any banker what they do with savings deposits and they definitely do not lay waste any dime above the ratio reserve law. And I remember asking a wealthy person once as to what keeps him going? The context was why he wants to keep making more and more money. I will never forget his response. “Choices! I can choose to work when I want, or not work when I want” was his reply. Not sure why Keen says capitalists build up money for the sake of it. There is always a reason and it eventually comes back to enriching their lifestyle in some way – whether buying larger home, braces on kids’ teeth, buy another business, securing their wealth/freedom more concretely etc. Lifestyle is the end- not money. Finally, I have been working in the financial sector for the last 4 years. Not sure why this sector is the leakage from the expenditure/circular flow model. We are all charging fees and employed and spending our incomes… maybe we can add ‘Different planet Economists’ to the above list.

Recently I threw a simple question at my demand-worshipping colleagues: “Name one thing you can spend money on that hasn’t been produced?”. They could only resort to the usual retorts: “you have weird economic ideas” preceded by “spending will always be the driver of the economy”.

I am now off to read your 3rd edition Free Market Economics. I only read about half of the 2nd edition nearly a year ago preparing for my anti-Keynesian essay. I have read a quarter of Smith’s Wealth of Nations, but, you are right, these can be difficult to read- I need a break.

All the best Steve and thanks for a wonderful discourse. I am still totally addicted to this issue. Chat soon.


This was my reply.

That is the most original and possibly insightful non-strictly-economic explanation of Say’s Law I have ever come across. Looking at Say’s Law within the framework of the theory of knowledge is something I do not think I have come across before and may never have been previously done. Also not having come across eisegesis before (and neither has my spell check apparently) I can only emphasise that it is a very useful conceptual distinction that really does help get to the heart of the issue. I, of course, share your frustrations in trying to make others even become aware of the problem. When you ask them to name a product they have bought that had not already been produced (which naturally implies a very lengthy structure of production that must go back a considerable distance in both time and space) the only reaction you are likely to get is that even if they don’t know the answer themselves, someone else does because how could it be possible that you have asked something so penetrating that the entire company of modern economists have no answer for. But they don’t have an answer other than to say that buying something will mean that a replacement item will have to be produced to put on the shelf so it will encourage more production. Except that this new order, if there is a new order, can only be filled if the producer had already made the decision to produce this additional replacement item long before you bought what you bought. But for them to go there would mean they had already seen the problem and understood that it is not demand that causes the supply, but that supply is created in anticipation of some future demand. So you will just have to keep teasing them just for your own satisfaction but do not be surprised if the scales fail to fall from their eyes anytime soon (I hope I have not mis-used the metaphor).

I also found your classification system astonishing and accurate. It is also funny but finding it so on the money, its ironical intent seems more serious than anything. The list truly does begin with the implied words, “Look stupid . . .” but where you go from there I do not know. Well actually, where you go is you write this up in some more polished form and try to get it published. There is no Journal of Irony and Economics but I would not want you to mess with the vision you have shown here or try to diminish your satirical intent. You should just expand what you have written and see what follows.

Anyway, we can discuss when you come to visit which you MUST do if you have the time. I will also pass on a copy of my Economics for Infants discussed here on my blog:

As I mention, it is the only children’s book that incorporates Say’s Law, which is indeed an actual feature of the text and the fantastic picture that comes with it.

I do look forward to catching up, but as a kind of cautionary note before we meet I will just say that we had a School retreat the other day where at the dinner we were asked to come as our favourite literary character and I came as the much maligned and mis-understood Edward Casaubon.

With kindest best wishes

The book no child should be without

If you are looking for Christmas ideas, you might consider Economics for Infants, the only book of its kind.

A perfect book to read to your children and grandchildren! How do you explain the complexities of the economic order to a child? This retro-inspired illustrated book attempts this task in storybook form. A basic primer on economics for the youngest of readers.

For myself, what I like best about the book are its pictures which illustrate the points with an astonishing clarity. There is no children’s book anywhere, past or present, that has illustrated Say’s Law so incredibly well along with so much more. In a recent pee’er reviewed study, 97% chose Economics for Infants as their favourite book (astonishingly, the same as the proportion of climate scientists who believe global warming is caused by humans!). The above photo was taken during that study and is conclusive proof that if your child is to succeed in getting into the best kindergartens and play groups, this is the book you will need to ensure they have read and its contents absorbed. You can see how the other books were ignored while Economics for Infants held the attention of this particularly bright child not entirely chosen at random.

And let me also say this. There may be parents of young children whom you may feel need a refresher course in the economics of the market. Give a copy to their children and contemplate the pleasure it will give in reading about how the capitalist system works for the betterment of all, that is, the pleasure it will give you contemplating their parents vetting the book while deciding whether to pass it along.

Here’s where you may order the book and have it still arrive in time for Christmas.