An email on Say’s Law

On Friday, I received the following email.

Dear Professor Kates,

As perhaps the only lay person in the United States to have read the two books by Sowell and Hutt, as well as Anderson’s book and some of the articles you cited in your book, I consider myself pretty knowledgeable about the logic and rationale behind Law of Markets and I must say, yours is the best I have seen on the subject.

Your classical views pretty much line up with Austrian theory, especially in their criticism of the “lack of aggregate demand” theory accepted today as being the root cause of recessions, although it would not appear that you are totally sold on their link of recessions with “expansion of money supply” and consequential “malinvestment” in production– leading to the proverbial “cluster of errors” referred to by Robbins. You seem to believe that the malinvestment can occur without the expansion of the money supply. Austrians would agree, but they would maintain that malinvestment would not cause anything but micro level adjustments or perhaps a mild slowdown and not an outright macro-recessionary period. Dispute seems to be more about degree and semantics on how to define recessions rather than serious dispute on substance. Clearly, you and Austrians do not buy the general glut argument.

Your book was excellent overview of history of economic thought, at least from early 19th C. onward. It points out how wrong Keynes was on history of economic thought, either by ignorance, or as I believe, by design. He set up a false historical narrative in developing his straw man to make it easier to take down.

Your point that the acceptance of the “lack of aggregate demand” theory by economists since 1936 has set the science of economics on a terrible path cannot be understated. Failure to understand cause will almost always result in bad policy, as can be seen by measures taken in recent years by the “policy makers”. J.B. Say: “Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption”. Contrast that with:

“Simply put, we live in a world in which there is too much supply and too little demand,” star economist Nouriel Roubini of New York University …

Ugh! That is the media’s “star”. How far the profession has fallen. Unfortunately, guys like Roubini, Stiglitz and Krugman now rule the day.

I have been working on a book for several years challenging most all of modern day macroeconomic theory, with one of the first fallacies being the lack of aggregate demand theory. (The deflation bogeyman is another.) I also bought your “Free Market Economics” and just started it last night. It looks like you beat me to the punch. Keep up the good work.

Kind Regards

So today, I wrote back.

Thank you very much for your kind and encouraging letter. We are so obviously on the same wave length that it is uncanny. I had thought that once the failure of the stimulus had become perfectly clear to everyone, there would be a groundswell of some kind to think through what had gone wrong, and that, perhaps, there would be a closer re-examination of the Keynesian macro that has ruined economic theory along with most of our economies. I must therefore confess to no little astonishment to discover that Keynesian economics is even more embedded within economics than ever. I suppose that to confess to such a massive error, as would need to be done if economists rose up and said, “come to think of it, Say’s Law seems to have been right after all and Keynesian economics wrong”, would have been a gigantic step too far. But even if not that, some kind of re-thinking about how an economy works, and whether valueless public spending really can generate growth, might have been in order. Such is not how it’s been. It is therefore not a little frightening that the cures continue to be administered from the demand side.

About the way I look at the cycle, “mal-investment” gives the impression that if entrepreneurs had been more clear-eyed about the future, that the downturn would never have occurred. For me, the recession that I grew up on was the downturn that followed the OPEC oil boycott of the 1970s which was followed by a massive inflationary pulse that led to an international wage explosion. The dislocations that rolled across the world were neither caused by nor could have been cured by monetary policy. Certain categories of investment – such as those that depended on low-cost energy – were left high and dry by these major changes in the economic environment in ways that no one could have foreseen. I also think that it helps me see these things because I live in one of the more remote provinces, where domestic monetary policy will seldom be the cause of a downturn. I therefore see recessions as a consequence of government policy generally and the effects of major international instability. The GFC started in the US, and while I think we in Australia should for the most part have ignored it so far as policy went, there was never any chance we were not going to be affected irrespective of the monetary policies we might have run, either before or after. My main point is that recessions are structural and not caused by too much saving (or supply!). My chapter 14 on the cycle is a summary of the classical view, which I have synthesised from Haberler. Chapter 15 looks at the role of government, which was not a classical perspective but it is mine.

I do hope you write your own book. The one thing I know from having written what I have is that you only truly understand what you think yourself by trying to write it all down. The things that end up on the page often surprise even you. Please let me know how you go. And if I may, I will attach a paper I did on the origins of the Keynesian Revolution. Just to be able to mention Fred Manville Taylor and Harlan McCracken is often a showstopper for someone trying to argue with a Keynesian. Try it out and see how you go.

With kind regards and many thanks again.

Anyone who invokes aggregate demand as part of an economic argument is wrong

A market economy in recession, left more or less to itself to adjust to circumstances, will find its way back to growth and full employment within a year, a year and a half at the outside. That same economy, under the administration of managers unsympathetic to the market, may travel in the desert for a very long time before coming good, assuming it comes good. I would like to come back to a post put up yesterday, The Next Phase of Economic Stagnation, which contains the transcript of a debate between a defender of Quantitative Easing in Europe and someone who thinks it is a very bad idea. But what I particularly wanted to comment on was this, stated in defence of QE:

If you’re in a situation where aggregate demand is very weak and that’s a position I think the eurozone is in and you are in danger of slipping into the sort of deflation which I at least and some other judges think is pretty damaging, then this is a mechanism for fending that danger off. And I have to say, I don’t think that there will be much impact from quantitative easing within the Eurozone, apart from through the exchange rate. In driving the exchange rate lower that’s going to help to boost eurozone net exports. It will boost aggregate demand. It will tend to keep up the price level. On balance I think those are pretty good things to be aiming at.

Anyone who invokes aggregate demand as part of an economic argument is wrong. Once universally understood, now universally disregarded, there is no independent force in an economy called aggregate demand. You can shift who gets to do the spending – and in every case where aggregate demand is invoked it is the government that gets to do the extra spending – but you cannot increase the rate of growth or employment. In fact, over time, it weakens an economy’s structure so profoundly that you are frequently worse off than when you began.

Recessions are inevitable, and there are actions a government can take, but increased public spending and higher levels of public debt are not amongst them. The sad part is that economists have so comprehensively invested in this nonsense theory, governments find it perfectly in tune with their basest political desires, and the public cannot understand why it shouldn’t work and like to see more spent on them by government. So here we are, a perfectly constructed downwards spiral based on the latest most up-to-date theories, in which no one can ever quite see the way out again.

The next phase of economic stagnation

The disastrous consequences of Keynesian thinking never seems to subside, the next catastrophe being the introduction of Quantitative Easing by the ECB. The following is an exchange of views under the heading, Eurozone prepares for QE. Bootle is your Keynesian, and when it comes down to it, can only think in terms of aggregate demand. The Europeans, like the Americans and the Japanese, and I guess pretty well everyone else, generally cannot think outside of macro aggregates. They seem to have no understanding of how a market economy slowly, but ever-so surely, knits itself back together, if the government would only stop messing with the parameters under which businesses must operate. The following is a bit long-winded, but since we are heading into the next phase of economic stagnation, it is worth understanding the kind of macro thinking behind it.

The ECB is preparing to announce a huge stimulus programme. We hear diverging views from the chief economist at one of Germany’s largest banks Commerzbank Joerg Kraemer and leading British economist Roger Bootle.

KRAEMER: I think that deflation is one of the most abused terms in economic policy discussions. Because there is no real threat from deflation. The Bank for International Settlement made it clear over a study of 150 years that a mild decline in prices is no problem for real GDP growth, and especially in the eurozone. The only reason why we have a negative inflation rate is the decline in oil price, but the decline in oil price is good for the economy. And if you strip out oil and look at the underlying core inflation at 0.8% is also low, but this is primarily caused by the fact that in some peripheral countries such as Spain, Portugal and Ireland, firms have cut their unit labour costs, they regained their price competitiveness and now they pass on a part of the cost reduction onto their customers in the form of slightly falling consumer prices, but again this is GOOD deflation because it goes hand-in-hand with an increase in profit margins and this is nothing to worry about, but nevertheless the negative inflation rate is used by the doves on the ECB council as an argument to go for QE which – in the end – will not change the picture of low inflation and low growth, but will primarily help the finance ministers of the highly indebted countries and their banks, which had bought a lot of government bonds, for example Spanish banks have bought roughly one-third of the outstanding volumes of Spanish government bonds.

BOOTLE: I think this is a dramatic misjudgment and it’s one that people coming from Germany are rather inclined to make with German history behind them because of course, the great fear in Germany – understandably – is inflation. Other countries have suffered significantly from deflation. As to the idea that the BIS concluded that over the last 150 years, deflation has been a good thing, well I wonder where they’ve been all that time. I mean, it all depends quite frankly on what the circumstances are.

Now, when you’ve got an economy that isn’t that heavily indebted, that isn’t super-sensitive to every little jot and tittle of the latest CPI figures, that isn’t very financially sophisticated, then yes, probably falling prices no one notices frankly and even know what’s going on. But when you move to the sort of economy we’ve got in today, where you have very heavy levels of debt, both government and private sector, we’ve got the markets all agog to see what’s happening to the CPI, I think is potentially quite dangerous to have a situation where prices are falling and are likely to fall year after year. Now we are not quite there yet really because at the moment all I think that’s happened in Europe is really the effect of a one-off drop in oil prices, which isn’t really if you like genuine deflation. But the danger is we might move to that.

KRAEMER: The Bank for International Settlements also showed that the slight decline in the Japanese consumer price index over the past 14 years did not change the picture that per capita GDP in Japan has grown roughly by the same amount than per capita GDP in the U.S. As long as consumer prices decline only mildly, this is not a big problem. We had this, for example, in the second half of the 19th century, during the gold standard, we had several periods of mild deflation, which had no negative impact on real GDP. I think the point is when you try to fight, when you try to avoid the inevitable, low inflation, low growth environment, after the burst of a debt bubble, then you only fuel asset price inflation.

BOOTLE: Let me be clear. I am not the greatest fan of quantitative easing in the sense that I don’t think it’s going to cure the European malaise, much of which has real rather than monetary foundations. It’s not the answer to a maiden’s prayers. It’s not a magic wand and moreover, the evidence of its effectiveness in other countries is not settled. In Japan it didn’t do very much good for a long time. In the United States and the UK it appears to have done some good quite how much we don’t know. The point is there is not much else in the locker. There is not much else you can do. If you’re in a situation where aggregate demand is very weak and that’s a position I think the eurozone is in and you are in danger of slipping into the sort of deflation which I at least and some other judges think is pretty damaging, then this is a mechanism for fending that danger off. And I have to say, I don’t think that there will be much impact from quantitative easing within the Eurozone, apart from through the exchange rate. In driving the exchange rate lower that’s going to help to boost eurozone net exports. It will boost aggregate demand. It will tend to keep up the price level. On balance I think those are pretty good things to be aiming at.

No one ever mentions markets, profits or entrepreneurs in any discussion of the economy. Economic theory has become junk science.

Debating Keynesian economics – the posts in order of publication

debate format jean-leon-gerome-a-collaboration-corneille-and-moliere

I began with this in the form of a letter to Louis-Philippe Rochon, the editor of The Review of Keynesian Economics amongst other accomplishments.

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader</em>. There is literally nothing else like it anywhere.

Best wishes,

Steve

This was the reply:

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

This then was my reply:

Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction.

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least we can agree, that the world’s economies are in a mess: consumers deep in debt, savings eaten away by low productivity, government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things worse. You describe what I see, but I expected things to end like this from the start.

You only began to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, that the problem is not enough government spending.

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding production. You must do more than build brick walls, you must build where what is built actually contributes to prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And if we were looking to make matters worse, it’s hard to go past items 1-3 of your program for recovery:

First, we must replace private debt with public debt.

Second, we must put job creation above all other goals.

Third, we must deal head on with the problem of income inequality.

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Kind regards

Steve Kates

And now Louis-Philippe’s reply to my second letter.

My dear Steven,

I read with much interest your most recent letter and I will confess I agree with you … we are indeed far apart! But surely this is not surprising as we both defend not only a very different vision of economic theory, but also a different vision of markets and society. At the core of our disagreement lies an understanding of markets, which you see as self-regulating, whereas I claim they are not. I view markets as chaotic and prone to instability and, quite honesty, capable of exploding (or rather deteriorating) into crises, with unimaginable consequences. Perhaps you are OK with that, but I am not. So when I said that the ‘worst infliction’ is to leave us exposed to the ‘tyranny of markets’, I meant precisely that: because of periodic crises, but also because of oft-occurring recessions, we cannot place our complete faith in free-markets. I see unregulated markets and unfettered capitalism as a scourge that must be tamed. To deny or ignore this would be a grave mistake, which would condemn us all to misery, and worse. How else would you characterize the massive inequality of income and wealth around the world and in particular in the United States, which is one of the most unequal developed economies? Is the fact that 40% of the wealth in the US rests within 1% of the population not a tyranny? Does this not shock you? It shocks me, and I will say it again: unless we address this calamity, we are bound to relive a crisis – and soon. Mark my words: another crisis is coming.

You seem to view markets as “the single most liberating institution in possibly the entire history of the human race.” Well, I can see where we disagree indeed. Markets are where goods are produced and sold, where incomes are determined. But they are not efficient, in the way that they do not always produce an optimum result; that is why we need some regulator and some other institution to intervene when markets fail. I would go further, I would argue that markets never allocate efficiently, and never perform optimally, so that there is a permanent and on-going need for the State to precisely regulate the cycles and minimize the pains that recessions and crises can inflict upon us, and to reduce the injustice of inequality. You say this is socialising our economies. I assume you say this in a derogatory way. I am by no means a socialist; like Keynes, I want to save capitalism from itself. But I will wear that label proudly if you meant it as somehow to denigrate. Rather, I see it as the only way of making capitalism work for mankind. In that sense, I stand proudly on the shoulders of Keynes and others who have defended that very notion. I will proudly stand and argue, supported by a vast literature of empirical research that the State is in a unique position, given its power to spend, to create wealth and prosperity for all.

You then suggest that my claim that economies grow from demand, both in the short and long term, is a mere statement devoid of a theory. Of course, you will pardon me if I did not, in less than 1,500 words, write a complete theoretical treatise on the economics of aggregate demand. But there is a vast literature on this topic, with which you are familiar I am sure, and well-developed theories, with considerable empirical support to buttress the argument.

But why are you so dismissive of Keynesian policies? The problem here, I believe, is your interpretation of what consists of Keynesian aggregate demand policies. Twice now you mention Keynes’s assertion that we should bury bottles full of banknotes as representative of Keynesian policy. My dear Steven, Keynesian economics is much more than that, and to isolate that sentence as representative of Keynes is both misleading and, well, dishonest. Keynes of course said much, much more, and Keynes was being more sarcastic than anything.

In fact, Keynes was clear, a bit later in the same often-quoted passage, that “It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing” (GT, p. 129). Did you not read that part of the General Theory?

Keynes’s message was that ideally, it would be better to build houses, or roads and bridges than to do nothing, the latter condemning us to misery and, yes, the tyranny of the markets. Keynes’s point about the bottles is that even something as silly as that would be better than doing nothing.

I suspect your insistence of that quote as an example of Keynesian economics is perhaps more sinister, knowing full well of course that the population would instantly be opposed to the silliness of that policy. So you must admit, there is some treachery afoot in your argument. If we are to have a dialogue, you cannot reduce the Keynesian edifice to ‘wasteful projects’. I know that you know that Keynesian economics is more than digging holes: there are large infrastructure projects and public investment. I suspect if we explained to the masses that Keynesian policy is about infrastructure, investing in the future, social justice and building civilizations, then I am convinced that they would see the wisdom residing within it.

Now regarding that ‘piece of arithmetic’, which you call the Y = C + I + G + (X – M), I am afraid that is simple national accounting, no more no less. But more than that, for me it is a point of pure logic: when consumers, private firms or governments spend, that increases the demand for goods, which firms must produce. Please, tell me where the flaw in that logic is? And when the private sector is incapable or unwilling to spend, governments must above all step in to sustain that level of demand, which will be hopefully met by the private sector producing.

I was struck at how different we interpret history, and recent history at that. I must admit I am at a loss for words. Keynes once famously said, “When the facts change, I change my mind. What do you do, sir?”, but I fear that no matter what I say, or in fact anything you read anywhere by anyone won’t change your mind. I think perhaps if you got away from digging holes as representative Keynesian policies would be a good start.

In closing, let me address what I consider the biggest lie in economics at the moment: the idea that reductions in government spending will lead to higher economics growth. This is pure theoretical poppycock. For instance, in Europe, it has proven to be disastrous. Austerity never works. After a few years of austerity, Europe is no closer to sustained economic growth as before. For instance, in France, after imposing several fiscal cutbacks, the government expected deficits of 2.2%. Austerity now translated into deficits running at double that, at 4.4%. This is because of that piece of arithmetic: austerity leads to depressed demand and economic activity that then deflates the entire system, more proof that demand is what matters. Policies based on supply do not work, never work, and never shall work. It is pure fantasy to believe that anything but demand is the driving force of economic activity. So we may not all be Keynesians now, but the real world is, and it operates along lines described by Keynes and Keynesians. And the General Theory, while written over 75 years ago, like you point out, remains to this day the best guide to successful macroeconomic policy we have. Granted, it needs updating, but the basic logic of the book is as relevant and as important today as it was back when it was published.

You say that what we need is value-adding production, and not just building brick walls as you put it. I completely agree. But, my dear Steven, that is what Keynesian spending does: by contributing to infrastructure building, by contributing to crowding-in, it value-adds to society.

In conclusion, the empirical evidence is squarely on the side of Keynesian economics and the importance and vital role of aggregate demand and the State. To advocate for free markets under the illusion of the efficiency dogma is pure nonsense and self-delusional. As Keynes said, that would be disastrous if we tried to apply it to the facts of experience. The real world is government by Keynesian laws, and any attempt to deny and interfere with those laws can only result in more hardship.

Finally, let me leave you with this wonderful quote by Keynes: “the man who regards all this [public expenditures] as a senseless extravagance which will impoverish the nation, as compared with doing nothing and leaving millions unemployed, should be recognized for a lunatic.” (Collected Writing, Volume XXI, p. 338).

Best wishes,

Louis-Philippe

——

The endless supply of Keynesian nonsense

I have now received Louis-Philippe Rochon’s reply to my critique of Keynesian economics which was the lead comment in an exchange we are having on Keynesian economics. His reply comes under the heading, How to Promote a Global Economic Recovery? “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets”.

Thus, from the very heading I can see how far apart we are. There are an astonishing number of techniques and approaches that can be used to manage an economy with public spending to get an economy out of recession only one amongst this vast array of possibilities. If you are going to start with the assumption that not trying to spend your wasteful way to recovery is the same as laissez-faire then there is no possibility of ever understanding how badly our economies are now being mismanaged. But perhaps that is just the title. What more does his letter say? Let me pick up his argument point by point, starting with this misbegotten piece of theory.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

Nothing to lift an economy like public investment! Every business like the post office. Every investment another Solyndra. All subsidised with nothing self-sustaining through the revenues it earns. Dig a hole and get fill it in again. Don’t worry about earning a greater return than the funds outlayed. Just close your eyes and spend. Don’t worry, it will all work out once that magic multiplier cuts in. If this is all there is to the theory, there is nothing there but wishes and wind. But there is also your recollection of those magic Keynesian moments at the end of World War II.

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers.

First, the General Theory was published in 1936, three years after the Depression had come to an end in every economy but the United States, where it dragged on until the coming of the war to the US in 1941. And, of course, those three wonderful post-war decades were preceded by the decision of the United States in 1945-46 to balance its budget immediately. The massive wartimes deficits were instantaneously brought to an end and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit but Truman turned them down.

How does a Keynesian explain that, I wonder? We are instead reminded of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

It is a contrast, of course, but the contrast of importance is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. The catastrophic stagflation of the 1970s, where deficits and spending only led to high unemployment and a blowout in inflation that could only ultimately be controlled by a fierce monetary policy that finally did regenerate a period of prosperity that continued for another two decades. But what about the period after the GFC when governments were spending hand over fist on one stimulus after another.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

A one-year stimulus, was it? The US is the paradigm example. Despite Congressional attempts to slow the growth in the deficit, the attempt to contain public spending in the US only seriously began with the sequester in 2013!
And indeed, the White House specifically dates the commencement of the sequestration from the first of March that year. If ever a stimulus was given time to work itself out, that was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own argument. The very belief that conditions were improving up until the sequestration began can only mean we are living in a parallel universe.

But how much we differ on the timing when restraint finally began, we can certainly agree on the current disaster. He may think it’s because the stimulus was brought to an end too soon. I think of it as the inevitable consequence of a Keynesian policy.

When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth.

On this much we can agree, that the world’s economies are in a mess. Consumers deep in debt, savings eaten away by low productivity government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things much much worse. You describe what I see, but I expected things to end like this from the start. You could only start to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had become much worse. You nevertheless continue to believe that the problem is not enough government spending.

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

I understand that the principle of cause and effect never applies to Keynesian theory. The plain fact is that there has never been a single instance in the whole of the period since the General Theory was written that a public sector stimulus has been able to bring a recession to an end. There is not one single solitary example, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding aggregate supply. You must do more than build brick walls, you must build where what is built actually contributes to future prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And for true economic illiteracy, it’s hard to go past your program for recovery:

First, we must replace private debt with public debt.

Second, we must put job creation above all other goals.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand.

Fourth, with respect to Europe . . . they must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together.

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into us deep recession that it is almost impossible to understand how this is not perfectly obvious to you.

If such a program appeals to you merely because of this aggregate demand incantation of yours, I’m afraid, your program would be part of the problem and in no way part of any solution. I fear, however, that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect good sense, even as every attempt to do what you have suggested would make things worse than they already are.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what had to happen to turn desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any understanding that for everyone to buy from each other, they first have to produce what each other wish to buy. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Debating Keynesian economics with a Keynesian

We are slowly but ever so surely finding our standard of living slipping away. In spite of all that public spending and the deficits and mounting debt – well actually because of all these things – we are slowing going under. Most of us find we are doing without some things we took for granted not that long ago. Whether you look to the US, the UK, Europe, Japan or Australia, a return to rising real incomes and full employment continues to look ever more remote.

And it’s not for lack of public sector “stimulus”. Those deficits continue and even so the money market geniuses keep worrying about deflation. What are we to do? More QE? More debt? More government subsidies for projects that cannot be funded through the revenues they are expected to earn? These are the textbook answers from the textbooks provided to every economic student in the world.

It is all the same Keynesian rot that has not only never worked on any occasion that it has been tried, it has always with no exception made economic conditions worse. If you know of some example where public spending led to recovery, please let me know. For myself, I can give you chapter and verse on all of the failures, and yet nothing seems to be more everlasting than a textbook theory that is simple, plausible and wrong.

I am now in the midst of an online debate with Louis-Philippe Rochon, an Associate Professor of economics, founding co-editor of the Review of Keynesian Economics and co-editor of New Directions in Post-Keynesian Economics. It has been organised by Edward Elgar between two of its authors, and I have just had my first go in an exchange of letters. I have also discussed this debate at Quadrant Online.

The problem remains for me remains as it always was:

What I can tell you from personal experience is that the notion of aggregate demand as a driver of economic activity is now so universally believed that it is nearly impossible to get anyone even to see that it might possibly be wrong, that there is another way of thinking about things. But before Keynes came on the scene, no economist, other than a handful of cranks, ever thought that economies were driven from the demand side.

To deny the independent existence of aggregate demand is so conceptually disorienting to an economist educated any time over the past half century that it is near impossible to get them even to see what you mean. But I have had my go and I expect Louis-Phillipe to answer in the next day or so. I am pleased that he has taken this on, but I remain curious how he will respond. I can only say that no one has ever been brave enough to take this on before. I have had plenty of slanging and ignorant comment. But if it is possible to show that aggregate demand for anything however wasteful can ever promote economic growth and higher employment – NBN, mothballed desal plants, bridges to nowhere – I hope to hear it now.

First use of aggregate demand and aggregate supply

Robin Neill put the following question up on the Societies for the History of Economics (SHOE) list last night:

Colleagues:

Who and when was the terms “aggregate demand” and “aggregate supply” first used?

I have now written both to the list and to Robin. Here is what I wrote to Robin:

Dear Robin

You have put the cat amongst the pigeons with your question, if only they knew. Using superhuman restraint, I did not point out that the use of aggregate demand was forbidden amongst economists precisely because they had all absorbed Say’s Law. If you understand that demand is constituted by supply, then so far as aggregates go, there is no aggregate demand separate from aggregate supply, and anyways, it is the structure of production, i.e. the structure of supply, that matters and not the aggregate. Not that the classics ignored such aggregates. John Stuart Mill was pretty straightforward, but on behalf of the classical view, to wit, “[aggregate] demand for commodities is not demand for labour”. Again a complete contradiction of modern macro. I don’t know if you’ve seen either, but I discuss AD in both my Say’s Law and the Keynesian Revolution and my Free Market Economics. The 2nd ed of FME will be coming out in a few months so if you haven’t seen it yet, I’d wait for that. But in short form, I have argued in every place I can that the introduction of AD was Keynes’s big contribution which has ruined economic theory, macroecvonomics and the theory of the cycle ever since.

And this is what I wrote to SHOE:

The question really is who can take us back before Keynes? So here, from The General Theory page 25:

“Let Z be the aggregate supply price of the output from employing N men, the relationship between Z and N being written Z = φ(N), which can be called the Aggregate Supply Function. Similarly, let D be the proceeds which entrepreneurs expect to receive from the employment of N men, the relationship between D and N being written D = f(N), which can be called the Aggregate Demand Function.”

And then there is this from page 32:

“The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas.”

I have seen the phrase aggregate demand used before that but in a kind of aimless way. But I am interested in its use prior to 1936 as well.

The examples others have come up have been just as I described, random uses in an aimless way. But now we use AD as the basis for stimulating our economies and are then astonished that the real world does not follow textbook theory. The real world actually does follow textbook theory, but of course you have to use the right textbook.

Why focus on Say’s Law?

This was not written to me but I was copied in on the reply that was sent to Michael:

Michael

You asked about the article in the latest Quadrant by Steve Kates on “The Dangerous Return of Keynesian Economics – Five Years On”. On the use of “Keynesian” stimulatory policies, I think he is right to draw attention to their failures and the idea that budgetary action to stimulate demand works. This is apparent from recent and past experience, such as the failed Roosevelt policies in the 1930s cf to the Premiers plan of budgetary cuts, which helped get Australia out of the recession much more quickly than the US (I think I have written to you about this before). However, don’t forget that Keynes himself said at the time not to risk budget deficits and that he also changed his advice to Roosevelt ie Keynes did not in practice necessarily stick to his textbook (published I think in 1936, half way through the recession). It is amazing that Australia’s experience in the 1930’s is still said to reflect Keynesian “stimulatory” action: Rudd ran that line when he became PM and used it to justify his stimulatory policies during the GFC.

I prefer not to get involved in the Say’s law argument like Kates does [my bolding]. It is simpler, I think, to focus on what is the likely response of the private sector to budgetary stimulus action. As suggested, recent experience supports the view that it is not likely to result in any sustained increase in spending (ie there may be a temporary surge but not a lasting one). Treasury had to publish a correction to the budget papers about the claimed success. [But why didn’t it work?]

What about “stimulation” through monetary policy? The recent experience in the US and some other countries again suggests this doesn’t work. It may be claimed that it has worked in the sense that Bernanke may have prevented the US from going into recession. But what would have happened to interest rates if there had been no abnormal increase in the supply of money and the market had been allowed to determine interest rates without central bank intervention? My guess is that they would still have fallen to similar low levels because the private sector would not have been invited to finance additional spending by borrowing, just as it wasn’t under the Bernanke policy.

I have also written to you about what caused the GFC. I won’t venture further on that here other than to say that central banks allowed the supply of credit to increase at far too rapid a rate.

In his article Kates also includes a graph on the US unemployment rate calculated by including in it labour force drop outs since 2009 and showing that (on this basis) the rate has not fallen at all from the 11% reached in 2010. Kates uses this as one indication that the stimulatory policy in the US hasn’t worked. With press releases and letters I have been trying (unsuccessfully) to get across a similar message here and that the unemployment rate is not on its own an effective measure of the state of the labour market and the regulations thereof ie including drop outs our unemployment rate in Australia is much higher than the published one.

So my reply.

I much appreciate Des’ comments but if I might, would like to add my own perspective. And what is most important here is why I do dwell on Say’s Law which I do not just because it is the most accurate way of thinking about macroeconomic issues which I will come to in a moment. But why Say’s Law.

First, Say’s Law was Keynes’s own issue. The General Theory is written as a book-length refutation of Say’s Law which Keynes is at pains to show. The key passage in the General Theory so far as explaining Keynes’s intentions are found on page 32:

The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas. [My bolding again]

The one innovation of The General Theory that remains embedded in all macroeconomics today is aggregate demand. The existence of aggregate demand as an independent force in economics was absolutely denied by pre-Keynesian economists. The denial was summarised in the propositions “demand is constituted by supply” and “overproduction is impossible” which were the specific meanings associated with Say’s Law, along with there is no such thing as a general glut. Demand deficiency, so far as classical economic theory is concerned, is never a realistic explanation for recession and therefore demand stimulation is never a solution for recessions when they come.

If you use aggregate demand in any context to explain anything about the state of the economy, in my view you have sold the pass. You can never recover since you have accepted Keynes’s basic premise to argue against Keynesian theory. And once you have done this, you really have no firm foundation that will allow you to turn back the Keynesian tide. In fact, if you think of aggregate demand as actually independent from aggregate supply, and therefore a force for raising the level of economic activity and employment, there is no reason not to apply a stimulus of some kind during recessions. It is only if you understand that such a stimulus cannot possibly work that you would oppose a stimulus as a set of actions that will certainty harm our economic prospects whatever brief relief it might do over the initial one or two quarters.

But there are other reasons for bringing Say’s Law into it. Because when I do, I am invoking the conclusions reached by all of the great economists of the past: David Ricardo, John Stuart Mill, William Stanley Jevons, Alfred Marshall, Henry Clay and Allyn Young. This takes me across a period from 1820 through to 1928 and thus encompasses economists from the first days of economic theory through until almost the very day of publication of The General Theory. No economist of any stature denied the validity of Say’s Law until it was swept away by Keynes. Please see my Say’s Law and the Keynesian Revolution if you would like to go through the entire sordid story how Say’s Law disappeared from economic discourse.

But the theory is what’s important, and for this you would need to go to my Free Market Economics. Very hard to summarise but the two elements that make this kind of economic theory different are firstly the essential role of the entrepreneur and secondly the embedding of value adding into the very core of economic thinking.

The order in which everything occurs within an economy is that entrepreneurs come to conclusions about what they might produce and sell at a profit, then go through the many stages of setting up their businesses which requires a tremendous amount of outlay before they earn a single cent of positive return, and then, when the goods or services are brought to market, buyers may or may not choose to buy enough to repay all of the previous costs. Demand, to be strictly technical about it, is the relationship between price and quantity demanded for an existing product that is already on the market. All production, however, is future orientated and while past sales may provide some clues about what might sell in the future, it is hardly the most important consideration in the minds of entrepreneurs in trying to decide what they will do next. Governments wasting a tonne of money on pink batts and school halls is great in the short term for pink batt and school hall producers but distorts your economy away from productive activities, raises input costs across the economy and provides no clear direction about the nature of demand say eighteen months ahead. And because such activities were non-value-adding, the effect on employment at the going wage was certain to be negative as time went by.

As for Say’s Law here’s a brief outline.

1) If you pay some people to dig a hole and then pay other people to fill them in again nothing of value has been created so no matter how much money you pay them thinking only of this group there is nothing for them to buy.

2) Every form of economic activity uses up resources. All economic activity draws down on the available productivity of the economy. Keynesian economic theory thinks of the drawing down as in and of itself stimulatory. No classical economist would have been so stupid. Drawing down on resources – even in some activity that will eventually provide you with a positive return – makes you worse off. You have used up resources and are less wealthy than you had previously been.

3) The need for economic activity to be value adding is essential. Production is value subtracting. It uses up resources. When whatever is being produced finally becomes available, it is either just consumed or it becomes part of the productive apparatus of the economy. It is those additions to the productive parts of the economy that are the essential for growth and prosperity. Only if the value of what these newly produced capital assets is greater than the value of the resources that have been used up can the activity be counted as value adding. And only if the net effect of such investment has left behind an economy capable of producing more than it previous could do can one say that the economy has grown.

4) Only value adding activities create growth and employment over anything other than the short term. Timing is everything, but the flow of new productive assets coming on stream (and it may take years of value subtracting investment for any particular project to become productive) is the only thing that can make an economy more productive, raise living standards, add to employment at the going real wage and then, thereafter, increase the real wage.

5) Why Say’s Law? Amongst the many lessons that Say’s Law provides, and this is from the classics, is that “demand is constituted by supply”. Because of the low state of economic theory today, I now make it explicit what classical economists had meant, “demand is constituted by value adding supply”. Unless what is produced is value adding – that is, it adds more to output than the resources that have been used up in their production – then it cannot add to employment at the going real wage.

6) No stimulus program in the world was value adding and was ever likely to be. Virtually no government activity, other than some roads and a few infrastructure projects, is value adding. All draw down on resources but do not provide a net addition either in the short term or in the long. NBN is such a prime example, as is the Desal plant in Victoria. We are not better off for spending the money and using up the resources because there is no return above the costs. That the construction workers went out and bought goods and services with the money they were paid do not make those projects in any way beneficial to the economy. They are pure waste.

7) Private sector activity often misfires on an individual basis which is what bankruptcy is about. But a properly structured free enterprise economy, where financial institutions lend to the most promising projects for which funds (ie resources) are sought, provides you with the only structure that will provide an overall net rate of growth and an accumulation of capital assets across an economy that will build prosperity.

8) You want to understand what’s wrong with Keynesian economics, it offends against Say’s Law which makes it absolutely clear that only value adding activity adds to growth – demand is constituted by supply.

The art and science of debate

Let me start by taking up a couple of issue as examples of the lack of reasoned debate in our society.

The first of these is global warming. There has been an across-the-world debate on whether the planet is in the midst of unsustainable warming due to increased greenhouse gases. Even though I have had my doubts from the start, what you do is examine the arguments others bring up to see what truth content there is and you look at the evidence that’s presented along with the theoretical explanations. And OK, for a while, the temperatures were going up, which was a correlation but not proof. I, like others, therefore kept an open mind and watching brief. But then, around fifteen years ago, temperatures stopped rising even while atmospheric carbon continued to increase. As a result, my scepticism has been maintained and I think of such scepticism as fully justified. Yet I do not know of a single person of the green persuasion who has come to the conclusion that perhaps they might have been wrong?

Or take another of my areas of interest, Keynesian economics. I have, for theoretical reasons, strong doubts about modern macroeconomics and its focus on aggregate demand. In my view, Say’s Law is valid while the whole of modern macro is built on a well known classical fallacy. And what is the the fallacy: that increases in public spending will increase aggregate demand and therefore return an economy to low unemployment and faster growth. OK, comes the stimulus, I set down in print my expectation that it would fail on a grand scale, that it would make economic conditions far worse than they were, and would not return our economies to strong growth and full employment. And had our economies, contrary to my expectation, recovered I would have had to give up my opinions, not least because everyone would have reminded me of what I had written. But instead, the world’s economies have unfolded almost exactly as I expected they would. But has any Keynesian actually said that, well, you know, perhaps modern macroeconomics is wrong after all. If there is, I have not heard of a single instance.

This brings me to a very high level and interesting discussion on why arguing with people on the left is not the same as debating, more like talking to a wall. Beyond that, as Captain Capitalism, the name he calls himself, points out, a proper debate is about advancing the truth, whereas dealing with the left merely ends up with abuse but little advance of knowledge. A long post on the art and science of debate but here is one part of which the whole is well worth the effort:

Aurini . . . delves into detail explaining the “debate” structure of grammar, logic, and rhetoric. Grammar basically meaning you all have to agree on the definitions and meanings of words. Logic meaning you have to be intellectually honest and adhere to associative rules and other logical concepts that ensure integrity. And rhetoric meaning you apply it in the real world or test one another’s arguments with anecdotes from reality. If both parties in a debate or even a discussion have these three things, then the conversation/debate is much more productive and progresses towards an inevitable “conclusion,” “reality” or agreement.

What’s funny though is for the longest time I never viewed debate as a cooperative effort, but rather an adversarial one. One of competition. One where you had an enemy that needed to be defeated. Of course, this was the sad consequence of growing up with the mentally deficient people that populated my generation. Parties I attended in my 20’s I was regularly attacked and berated for being a conservative. Debates in college (or even post college) were filled with emotion and vitriol. And in nearly 100% of the cases my opponents degraded into name calling, ad hominem attacks, accusations of “ism,” or being a nazi, etc.

And then a little later in his article there is this:

The majority of people are weak-minded. They are also lazy. However, they are also egotistical . . . and so their mind reaches for something that will not only allow them to claim some kind of intellectual “superiority” or “achievement,” but also allow them to do so with no work.

Going green
Protesting
Claiming they’re a caring liberal
Joining a religion
Going vegan
Becoming a professor
etc.

This not only results in them living in a delusional, non-real world, but also makes them emotionally and egotistically invested in keeping up their ideological facade. Thus, when you make impassionate, logical, stoic arguments of fact, math, and statistics you (consciously or not) pierce their ego, expose their charade, and therefore trigger a visceral, emotional, and often hate-laden response from them.

The left tend to deal in feelings rather than facts and proof. It actually seems that facts and proof are no part of anything they propose. They believe what they wish to believe because it makes them feel better, not because it is actually valid or demonstrable to reason and common sense.

The Keynesian walking dead

keynesian walking dead

Megan McArdle has an article on Bloomberg they’ve titled, Why It’s So Hard to Kill Keynesianism. And in spite of the arguments you find in the article which are from a rather diverse crew of supposedly anti-Keynesian economists, it’s straightforward why Keynesian theory continues to lurch forward.

  • It is taught in virtually every introductory economics textbook in the world.
  • No economist would even consider giving up on aggregate demand as the driver of economic activity.

So we have John Cochrane quoted as saying:

Since about 1980, if you send a paper with this model to any half respectable journal, they will reject it instantly.

I don’t know what “this model” consists of but if he is saying that employing aggregate demand is instant death for any article, I would have my doubts. But it’s not the articles supporting Keynes that interest me. Where are the ones that point out that Keynesian theory and policy are nonsense? Articles along those lines would be a radical departure but where are they? And let me add, as a personal experience, that it is not all that easy to get them published if you write them.

But then, what would be the exact point of these articles so far as policy is concerned? As McArdle says herself:

New Keynesian models do predict stimulative effects from government spending. But they do so through a completely different channel from the old Keynesian models that are still popular with most of the public intellectuals who support stimulus.

No one at the political level, trying to work out what to do as recession comes crashing through the wall, is going to be interested in the channels that cause a stimulus to work. They just want an answer, and if the answer is a stimulus then off they go. And off they did go. They have now spent in haste and are repenting in leisure but it was some variant version of Keynesian theory that drove them to take the actions that they took. But where are the post mortems on what went wrong? Plenty on what caused the Global Financial Crisis. Almost nothing on why the stimulus that followed has been such a disaster.

And for McArdle to say that Keynesian theory represents “an economic model with zero percent mindshare among professional macroeconomists” just cannot be true. The reality is that economists know virtually nothing else. I have scoured the article for the alternative theory the people she spoke to have in mind and can find nothing. The most you hear is that we should abandon macro and leave everything to micro which is as nonsensical an idea as the Keynesian theory it would replace. I would merely point out that The Wealth of Nations was entirely macro, classical macro. That is where the action is and the answers begin. Economic theory around 1916 say, would be something like the high point and a good place to start over from.

McArdle does, however, go into “supply side economics” but restricts it to the notion of tax cuts. She unfortunately goes nowhere near the underlying theory or discusses any of the wider implications. And there is nothing on the absolute necessity found within supply-side theory which explicitly requires starting over from classical presuppositions and a return to Say’s Law.

And while the efficient market hypothesis is fine as far as it goes, what it does not do and cannot do is rule out recessions. In my view, there is nothing in the EMH that is not fully discussed in classical business cycle theory (and who amongst the entire history-deprived economics profession could tell me whether I am right or wrong on this). Just because you believe that information gets fully used as soon as it is available is no reason to think recessions cannot happen. There are the known unknowns and the unknown unknowns that will get you every time. Even the known knowns can sometimes put an economy into recession. No one can prepare for everything.

The Keynesian walking dead are anyone who uses aggregate demand to explain how an economy works. If that’s not 100% of the profession, it’s near enough.

[My thanks to I.D. for bringing this article to my attention.]