A classic case of economic ignorance

I am in the midst of finishing off a book on classical economic theory from which, and only from which, you can discover just how fatal to economic health modern economic theory is. The Australian economy is not far from disaster, real growth is falling as are real wages. But this we find at the top of the front page of The Oz.

PUBLIC SPENDING KEEPS NATION AFLOAT

Here are the opening paras.

Surging federal and state government spending has insulated the economy from a dramatic plunge in growth, as business investment and household spending shrank, raising questions about the health of the economy.

The latest national accounts show annual economic growth fell to 1.4 per cent — the slowest since 2009 — as rapid increases in public spending and global demand for the nation’s coal, LNG and iron ore papered over weak or falling household spending and business investment.

That it is the public spending that is taking the economy to death’s door occurs to no one. Let me therefore take you to a bit from the introduction to my forthcoming book.

The chapter goes to some length in discussing the advent of Keynesian theory, which was summarised by Paul Krugman in his introduction to The General Theory which was published in 2006, seventy years after Keynes’s original publication in 1936.

“Stripped down, the conclusions of The General Theory might be expressed as four bullet points:

1. Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment
2. The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully
3. Government policies to increase demand, by contrast, can reduce unemployment quickly
4. Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach.

“To a modern practitioner of economic policy, none of this – except, possibly, the last point – sounds startling or even especially controversial. But these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable. And the great achievement of The General Theory was precisely to make them thinkable.”

There is no question that Keynes did indeed make each of these more than just thinkable. He was able to turn these propositions into the mainstream where they have been accepted by virtually every economist ever since. It is classical economic theory that has now become unthinkable. The result of the Keynesian Revolution has left things so that the classical alternative is not just no longer contemplated by anyone within the mainstream of economic theory, but that no one within the mainstream even knows what that alternative is.

I stumbled onto classical theory by accident but it has been so accurate in allowing me to understand what’s going on that I can never understand why others don’t sicken of this Keynesian trash. It has never ever in a single instance brought an economy from recession into recovery. It’s all set out in my Free Market Economics. How we ended up in this dismal place we are now in is what my next book will go into chapter and verse.

The power of classical economic thought

Here is a story picked up just today which had a bit in it I found quite striking since it presents a real-world economic event straight out of classical economic theory. It’s from an article titled, New recession warning: The rich aren’t spending. There we find:

The savings of the rich has also exploded, more than doubling over the past two years, suggesting that the wealthy are hoarding cash. The middle earners, or those in the 40% to 89.9% of the income distribution, have largely picked up the spending slack from the rich….

The middle-class consumer, however, is being buoyed up by strong employment and a relatively stable housing market. A U.S. economy that for over a decade has been defined by the rich reaping the gains and fueling the spending, has now flipped. Now, it’s Main Street that is prospering, while the investor class is signaling a consumer recession.

Which made me think of this from Mill’s Principles:

The proposition for which I am contending is in reality equivalent to the following, which to some minds will appear a truism, though to others it is a paradox: that a person does good to labourers, not by what he consumes on himself, but solely by what he does not so consume.

Clear as a bell to anyone versed in classical thought but to anyone else, specially to a student of modern macro, a statement near impossible to comprehend.

Told ya so

Here’s the front page story in The Oz today: Aussies no better off since GFC: household incomes stagnant for past decade. From which:

“Over the eight-year period from 2009 to 2017, average household income grew by only $3156, or 3.5 per cent, while the median in 2017 was $542 lower than 2009,” the report, which has tracked the circumstances of more than 17,500 Australians since 2001, finds.

The share of households in relative poverty — living on less than half the median income — rose to 10.4 per cent, according to analysis released today by the Melbourne Institute that will add to the controversy about the adequacy­ of Newstart, the govern­ment’s jobless payment.

All as obvious as the morning sun, if you can do away with modern macroeconomic trash and return to pre-Keynesian theory. From my tenth anniversary warning on the stimulus published in Quadrant:

Just as the causes of this downturn cannot be charted through a Keynesian demand deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.

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.

— Steven Kates, Quadrant, March 2009

Why have the IMF, the OECD, the ILO, the treasuries of every advanced economy, the Treasury in Australia, the business economists around the world, why have they got it so wrong and yet you in your ivory tower at RMIT have got it so right?

— Question to Steven Kates from Senator Doug Cameron,
Senate Economic References Committee, September 21, 2009

I caught on to classical economic theory in 1980 and have spent the years since watching in every circumstance how accurate the economics of John Stuart Mill actually is, from the failure of every single “stimulus” put in place to stimulate through to watching the recovery that followed the massive cuts to public spending brought on by Peter Costello’s budget in 1996 and the return, not just to balanced budgets but zero debt. Modern Keynesian economics is junk science and has never worked on a single occasion during the entire period since The General Theory was published in 1936.

Read my text if you are interested: Free Market Economics, now in its third edition. And here is the endorsement from Art Laffer, the genius behind the Reagan recovery and now also complicit in the recovery in the United States:

‘This book presents the very embodiment of supply-side economics. At its very core is the entrepreneur trying to work out what to do in a world of deep uncertainty in which the future cannot be known. Crucially, the book is entirely un-Keynesian, restoring Say’s Law to the centre of economic theory, with its focus on value-adding production as the source of demand. If you would like to understand how an economy actually works, this is one of the few places I know of where you can find out.’

Classical economic theory presents perennial truths that economists once knew but have completely forgotten

The perfect statement of classical economic theory, from David Uren in The Australian today: Get used to the new normal – booming rates of growth are gone.

Over the year to December, growth was only 2.3 per cent and, short of massive revisions by the Australian Bureau of Statistics, Treasury’s forecast of 2.7 per cent growth this financial year looks unattainable

It is time Treasury let go of its vision of an extended burst of rapid growth around the corner.

After a decade in the slow lane, this may be as good as it gets.

It is not such a bad place to be — employment growth has been strong.

It was a staple within classical economic theory that economic growth is unrelated to employment. And there we see it before our eyes, low rates of economic growth and high levels of employment growth. All that is discussed in my Quadrant article this month: The Dangerous Persistence of Keynesian Economics. There at the very end of the article we find the then-Treasurer of the UK, Winston Churchill, discussing the futility of public spending to add to employment in the wake of their attempt in the 1920s to stimulate employment through high levels of public works:

“For the purposes of curing unemployment the results have certainly been disappointing. They are, in fact, so meagre as to lend considerable colour to the orthodox Treasury doctrine which has been steadfastly held that, whatever might be the political or social advantages, very little additional employment and no permanent additional employment can in fact and as a general rule be created by State borrowing and State expenditure.”

Ninety years later we demonstrate once again what once upon a time every economist knew which now no one knows. Read the Quadrant article if for no other reason than to get another perspective.

The bang-your-head-against-a-wall theory of economic policy

I’m in the middle of writing a paper on Classical Economic Theory which has as its central theme how near impossible for someone educated within one school of economic thought to understand another. My own belief is that one can only understand an economic theory if one actually has at some stage thought it was valid.

But on the larger question whether economic theory can help us understand what to do, it is an unambiguous yes, if it’s classical economic theory, and for the most part if it’s Austrian. Otherwise, forget it. Modern economics is basically a bang-your-head-against-a-wall-theory because it feels so good when you stop.

This book has just come to my attention. I have highlighted two bits from the ad which make me very suspicious that she might really be able to help out any of us with much of anything at all.

Questions:

(1) What do the ideas of Karl Marx tell us about the likely future for the Chinese economy?

(2) With globalization in trouble, what can we learn about handling Brexit and Trumpism?

Answers:

(1) The more they pay attention to Marx, the worse their economic outcomes will be.

(2) If you are wondering how to “handle” Brexit and the economics of Donald Trump, you are already demonstrably incapable of understanding their natures or how and why they will improve things.

Anyway, here is the ad for the book. History of Economics is always worth a look, and you have to start somewhere, although if you want my advice, where to start is with this one. Meanwhile, there is this:

Front Cover

Since the days of Adam Smith, economists have grappled with a series of familiar problems – but often their ideas are hard to digest, even before we try to apply them to today’s issues. Linda Yueh is renowned for her combination of erudition, as an accomplished economist herself, and accessibility, as a leading writer and broadcaster in this field. In The Great Economists she explains the key thoughts of history’s greatest economists, how our lives have been influenced by their ideas and how they could help us with the policy challenges that we face today.

In the light of current economic problems, and in particular growth, Yueh explores the thoughts of economists from Adam Smith and David Ricardo to recent academics Douglass North and Robert Solow. She asks, for example, what do the ideas of Karl Marx tell us about the likely future for the Chinese economy? How do the ideas of John Maynard Keynes, who argued for government spending to create full employment, help us think about state intervention? And with globalization in trouble, what can we learn about handling Brexit and Trumpism?

The economic role of saving

There are two ways to understand the word “saving”. It is either:

(1) deferring the use of one’s purchasing power to a later date

OR

(2) that part of the capital, labour and other existing resources of a community that are used to maintain and extend the productive apparatus of an economy.

If you confuse (1) with (2) you will never understand how an economy works. (1) is of course modern and Keynesian, while (2) is classical and Austrian.

But these things are very very difficult to keep straight in the midst of analysis unless you really have the distinction absolutely clear.

Let me therefore take you to a sad example of how these issues became muddled in the midst of an interview with an Austrian economist who was trying to explain (2) to someone who thinks only in terms of (1). This is the title, Our Obsession with Consumption — while Ignoring Saving and Investment — Is a Big Problem. I have adopted his explanation from his Austrian treatment and translated into how things would be looked at from a classical perspective.

In economics today very little attention is given to the role of savings. This is a very curious situation.

There can be no production without prior saving.

Nature on its own provides us with only very few consumer goods eg apples on a tree.

For anything more, we must first produce the goods that we then afterwards can consume.

But to produce these goods we must first devise and construct tools, instruments or machines.

But to devise and construct tools, instruments or machines we already need a stock of already existing tools, instruments or machines. This stock is what is meant by “saving”.

Without prior savings no increase of future consumption is possible.

But then the interviewer asks this question, which transfers the issue from (2) to (1).

Do the current saving systems for retirement in the West work? If not, with what should they be replaced?

Suddenly the issue is about the future real potential purchasing power that lies behind money saving in the present. And from there the conversation never gets back to the need to widen and deepen our productive capabilities. They do go on to discuss who should make the decisions on what capital to build but by then it is too late.

The real problem for me is that even the interviewer, who was trying to provide soft questions so that the issues could be explained clearly, was too muddled himself and never allowed the interview to go where it needed to go, so another opportunity to make things clear disappeared.

Marginal analysis as it ought to be done

This is my own version of the marginal revenue and marginal cost diagram with the traditional version a complete waste of time. The traditional version has a series of lines many of which can never be drawn (such as the demand curve) with the ultimate point to show the price-quantity configuration for the sale of a single product. The conclusion is that if a firm wishes to maximise profitability on the sale of some good or service, it will price the product just exactly where a lower or higher price would lead to a lower return over cost. Fatuous and useless, with various bits of the real world left out, such as the actual ability to work out the effect on revenue of changing a price. Modern micro truly is as useless as modern macro.

The above diagram – discussed fully in my Free Market Economics – brings in a number of crucial factors:

  • it is about whether some decision should be made rather than deciding on what price to charge
  • it is about trying to make a decision in the face of a future that can never be foretold but is filled with endless uncertainties
  • it recognises that there are costs that almost invariably must be borne before there is a return [Area A]
  • costs continue even after revenues commence and only eventually, in a profitable venture, will revenues exceed costs [when B = A]
  • the point of origin is the present moment when some decision must be made – all of the lines drawn are the expectations of the decision maker
  • reality may turn out to be much different, with losses instead of a net positive return
  • only when total revenue and total costs are equal – that is, when the expected addition to revenues is equal to the expected addition to costs (when MR=MC at the moment the decision is made) does the decision become profitable

This is the way a business, or anyone else for that matter, makes a decision: in the present with only one’s own conjectures as a guide.

I will lastly mention a very nice note I received the other day:

Steve

Just finished reading your book Free Market Economics and wanted to congratulate you.

I have read plenty of economic texts, but yours is the best by far and helped crystalize a number of things that have been swirling around in my mind.

Great work.

It was truly appreciated. You can get a copy for yourself here. I didn’t make any of it up myself. It is just a distillation of classical theory, the economics of John Stuart Mill and his contemporaries.

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.

Classical economic theory and the American recovery

UPDATE ABOVE: Birthday pressies from the family who seem to know me quite well.

Modern economics explains to governments how they and their crony capitalist mates can steal from you while pretending they are doing you good. And before we go any farther, here is something you should know before you listen to another word from anyone in government: Government spending never creates a net increase in employment. Government spending only creates jobs in one place at the expense of jobs somewhere else, and does it by giving money to the government’s best friends to run projects no firm, based on profit and loss, would ever undertake. And if the project is loss making, which government projects almost invariably are, it has taken the economy backwards – that is, people in general invariably become less well off than they otherwise would have been had these projects not gone ahead – even if those to whom the government has paid money are better off, which they almost invariably are. Government spending, unless there is a genuine and calculated return above the cost, is a ripoff, and it is you who are being ripped off. They pick your pockets and pretend they are doing you good.

Let us look at the alternative. The turnaround in the American economy over the past year is astonishing and almost unprecedented; you might have to go back to Harding in 1921 to find a parallel. No modern macroeconomist can explain it. The supply-side of the economy is not only invisible to almost every economist miseducated today, but so far as their demented demand-side models go, is irrelevant to raising growth and employment. Here is what I wrote in November 2016, with the only bit I got wrong being how quickly things have turned around.

Getting a recovery from here, from within the mess that Obama has left behind, will be a task of such Herculean difficulty that only because Trump is president do I think it is even possible. And one of the most important virtues he may have is not listening to economists such as this one discussed in the article at the link: The brilliant economist who designed the failed 2009 stimulus plan tells us that Donald Trump’s economic plans are going to fail. Here we are dealing with Harvard economist, i.e. Keynesian economist, Lawrence Summers, about whom the article states:

At this point, we have to note that the esteemed Dr Summers was the architect of President Obama’s 2009 stimulus program, the American Recovery and Reinvestment Act of 2009, an $831 billion boondoggle which was promised to hold unemployment to a maximum of 8%; it reached 10.0% in October of 2009, and stood at 9.2% in June of 2011, when it was projected to be below 7%. There are many economists who still justify the stimulus bill by saying that while the effects of the recession were worse than estimated, they’d have been worse yet without the ARRA. That, of course, is unprovable, but when the designer of such a huge, failed program tells me that someone else’s economic plans won’t work, I have to look at his statements with a jaundiced eye.

Trump has spending plans of his own that aside from The Wall, which if it significantly reduces the size of the American welfare bill may pay for itself many times over, will also add to the burdens on the economy. But he also intends to cut energy costs, improve decaying infrastructure, free up the regulatory framework that suppresses industry, renegotiate trade deals that are intended to work for American industry, and lower government outlays generally. He will also remove Obamacare, which has raised the cost of full-time employees, while lowering the cost of health insurance. Interest rates will also start to rise which should assist in the shifting of resources into more productive areas of the economy, and will also add to the willingness of many to save.

I definitely do not say it’s easy, and no one can guarantee things will turn round rapidly enough to show results soon enough to work politically, specially in the midst of the hostile media circus Trump will have to deal with. But at least I feel that for the most part the changes that will be introduced will generally shift things in the right direction. Here is the alternative Summers has in mind:

I have long been a strong advocate of debt-financed public investment in the context of low interest rates and a decaying U.S. infrastructure, so I was glad to see Trump emphasize it. Unfortunately, the plan presented by his advisers, Peter Navarro and Wilbur Ross, suggests an approach based on tax credits for equity investment and total private-sector participation that will not cover the most important projects, not reach many of the most important investors and involve substantial mis-targeting of public resources.

There is no learning from history other than that economists never learn from history. You also know that Congress will fight like cats to maintain expenditure since that is almost entirely what they have to maintain their support. Whether there is a constituency for re-building the private sector is still to be discovered, but at least with Trump you know he will want to try.

You really do have to wonder whether economists will learn a thing from what they’ve just seen. Given the experience of the past, there is not the most remote chance in the world that they will. But what you’ve seen has been the result of following classical economic policy – the economics of John Stuart Mill – in just the way it would have been done before Keynes published his General Theory, a book that has destroyed the coherence of economic theory for three generations of economists and counting.

Macro Follies returns

The only movie that has ever been made from a book I wrote. The movie was put together by that genius, John Papola, producer of the greatest economic video ever, The Keynes-Hayek Rap. And as noted in the credits for Macro Follies, there I am found in truly stellar company:

Special Thanks to Russ Roberts, Steven Kates, Larry White, Steve Horwitz, James Adams and Steve Fritzinger

As for the book, if you are looking for a Christmas present, let me recommend my Free Market Economics which is the book from which the movie was made. It is the only economics book written in approximately the last 150 years that is built on classical economic principles. As it says at the Book Depository website

“In this thoroughly updated third edition of Free Market Economics, Steven Kates assesses economic principles based on classical economic theory. Rejecting mainstream Keynesian and neoclassical approaches even though they are thoroughly covered in the text, Kates instead looks at economics from the perspective of an entrepreneur making decisions in a world where the future is unknown, innovation is a continuous process and the future is being created before it can be understood. Key Features include: * analysis derived from the theories of pre-Keynesian classical economists, as this is the only source available today that explains the classical pre-Keynesian theory of the business cycle * a focus on the entrepreneur as the driving force in economic activity rather than on anonymous `forces’ as found in most economic theory today * introduces a powerful though simplified model to explain the difference between modern theory of recession and classical theory of the business cycle * great emphasis is placed on the consequences of decision making under uncertainty * offers an introductory understanding, accessible to the non-specialist reader. The aim of this book is to redirect the attention of economists and policy makers towards the economic theories that prevailed in earlier times. Their problems were little different from ours but their way of understanding the operation of an economy and dealing with those problems was completely different. Free Market Economics, Third Edition will help students and general readers understand classical economic theory, written by someone who believes that this now-discarded approach to economic thought was superior to what is found in most of our textbooks today.”

You can order a copy here. For anyone who wants to get a sense of how an economy works, and also why government intervention beyond a minimum creates harm, this is the place to go. Of course, you might instead decide to save your money and have an even better Christmas next year, but you might also instead just think of it as helping to build your own human capital, as well as helping you to contain your rage watching Malcolm and Co butcher economic policy before Bill and Co are allowed to take over who will do even worse.