Tag Archives: classical economic theory

What does a modern economist think a classical economist believed?

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I am writing a paper in which I begin by setting down what a modern economist would believe about “classical” economics. In reality, of course, virtually no economist today would have the slightest clue how an economist prior to 1936 would have looked at the operation of an economy or dealt with the problems it might have. I have pulled together my own summary and am putting up it here so that others can tell me what they think. I would merely emphasise that what I have below is such a misbegotten caricature that economists ought to be thoroughly disgusted with their own discipline if they really think their ancestors believed anything like this caricature. Because if this really were what economists once believed, even Keynesian economics would have been an improvement.

The more one knows about the economics prior to the publication of The General Theory, the less dogmatic one can be about the teachings of “classical” theory, especially since in the Keynesian version it covers the entire period from 1776 to 1933. Nevertheless, here is a summary statement that more or less captures the modern version of the essential beliefs of economists prior to 1936.

The economy was seen as a world of more or less instantaneous adjustment due to the flexibility of prices and wages. Such rapid adjustments were expected to lead to an almost instantaneous economic reconfiguration in the face of new circumstances. Theory was almost entirely devoted to the long term with short-term fluctuations of little interest since downturns were so brief and government policy would anyway have been unable to alleviate any of the problems that might arise. The economy was, for all practical purposes, in equilibrium because of virtually instant adjustment made through changes both upwards or down in the price level. The key concept was Say’s Law, which stated that supply created its own demand, which in turn meant involuntary unemployment would never occur. Laissez-faire was the core policy setting. Market adjustment could not be improved on, with regulation of business and industry seen as almost never beneficial, but virtually certain to cause harm. Regulation was kept to a minimum as were welfare payments to the poor and unemployed.

A rare debate on Keynesian economics

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You cannot imagine how rare a moment it was last night to be debating Stimulus versus Austerity. No one takes these things on, from the austerity side because hardly anyone actually understands what’s wrong with Keynesian economics as a theoretical issue, and from the Keynesian side because it is almost impossible to defend based on its theory. From the nature of the discussion, Keynesian theory is now defended only on sentiment and reflex. People want to do something, and raising government spending is in all the textbooks so we keep on doing it. Raising demand just seems obvious, which is why economics once explained why it was a terrible mistake. It is not obvious why public spending is bad for growth and jobs. And of course, infrastructure is a good thing so we should have more of it and therefore government spending is essential, whether you can afford it or not.

As for my own presentation, when in a public forum, you basically say what comes into your head, and you hope that what actually comes to mind is appropriate to the mood of the room and the case you wish to make. The one thing I told myself before I began is not to argue in the way it used to be done by John Stuart Mill, which was to point out how absolutely ridiculous the position held by other side was. He was particularly scathing on anyone who actually thought Keynesian economics had any merit at all – the carrier in his day being Malthus who had argued that demand deficiency (a general glut) was the cause of recessions, therefore requiring a stimulus to bring them to an end. But alas, in the midst of it, I found I was no better than JSM. The notion that we can wilfully waste our productive potential and that this will create jobs is so ridiculous that I just had to point it out just like that. What kind of a profession is economics if such obvious nonsense can sit at its very core?

But it’s not just theory we are dealing with. I have been on about this since the start of the stimulus packages in 2009, not one of which has brought recovery, and every one of which has had to be abandoned. They are economic poison, so why doesn’t our economic theory explain why they don’t work, rather than encouraging governments to try these experiments which inevitably fail? For me, I have no answer; you would have to go to a social psychologist to work it out.

But as I said at the start, it seems partly reflex, since this is all we have taught for 70 years, and partly sentiment, since we think we should do something. If it comes to that, I think we should do something too, but since lowering taxes on our businesses is so contrary to the anti-capitalist ethos that pervades more than just the left (but the left almost root and branch), the cure to many such people is worse than the disease. Better people should live in poverty, remain unemployed and individuals remain dependent on the government than that business profits should go up.

Anyway, a very interesting night demonstrating just how completely empty Keynesian economics is. Since the defence of the stimulus as presented was to show how the Greek economy had collapsed after international support had been removed, and that in Australia, although the data show that consumer demand ought to be rising by four percent but is only rising by two and a half percent – demonstrating apparently that we are being overly cautious and saving too much. It was also argued that capital spending is lower than expected given what it ought to be, and that real growth in incomes is flat! I can only say, that these seemed to be the kinds of things I wanted to get across. How that amounts to a defence of the stimulus I have still not been able to work out. What I do understand is that you need a heavy dose of classical economic theory to see why the economy remains flat. What will continue, I expect, is that we will teach what we teach in our economics classes, and governments will keep doing other kinds of things which are described as austerity. I just say again, that you won’t make sense of what is going on if you still think that Y=C+I+G gives you any insight at all into how an economy works.

My thanks to Joe Dimasi and the Economic Society for setting this up and to Alan Oster for his presentation of the other side.

Keynes vs the classics

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A reminder that there will be a debate – more I suspect sequential talking points – between Alan Oster, the NAB’s Chief Economist, and myself on “Stimulus versus Austerity”. This is taking place on Wednesday August 19 @ 5:30 pm at the Imperial Hotel on the corner of Spring and Bourke Streets in Melbourne. If you are interested in coming, email joe.dimasi@monash.edu to let him know.

Of course, the reason I’m coming along is because I cannot actually think of how to defend the stimulus at this late stage. Back in 2008-09, even though a Keynesian stimulus had never worked anywhere else, not ever, we might have ended up lucky this time. It’s in all the texts, everyone learns Y=C+I+G, so how could every single economics text in the world have been wrong? But that was then. So I have been tossing around various thoughts on what Alan might say, what I might try to argue if I were defending the stimulus. This is kind of a Paul Krugman/Ken Henry version of all the lame things that might be part of such an argument. And I emphasise, the bailing out of financial institutions is not on the table. The financial crisis was over by May 2009. I am only interested in the public spending side of it. Here are my thoughts:

1) The stimulus worked a treat – we would have been back in the Great Depression if nothing had been done. As dismal as things seem, it is a better outcome than the alternative would have been had nothing at all been done.

2) The imperative was to use up those unused savings. No one was investing. The bottom was falling out of our economies. Savings were going to waste. This is still a problem as can be seen from all those unused bank accounts. People still aren’t spending so the government must do it for us.*

3) The theory was all right but the execution was badly done. A stimulus could have worked but the money was poured into the wrong kinds of activities.

4) We didn’t spend enough. A half-hearted stimulus would not only fail to solve the problem but would discredit the very idea of a stimulus.

5) The problems run even deeper than we originally thought. We are into a secular stagnation, not just a temporary fall off in demand.

6) Let me show you the stats to prove how fantastic things turned out relative to our forecasts at the time.

7) Fiscal policy might have been relatively weak but monetary policy has made a major difference by keeping rates low and encouraging investment.

Have I left anything out? Anyway, come along on Wednesday. For my part, I am going to present a short version of my Liberty Fund postings on “Reassessing the Political Economy of John Stuart Mill”, that is, real classical economics versus Keynesian inanities. We each get twenty minutes and then it is thrown open to the floor. And being Policy in the Pub, there is alcohol as well if that’s your sort of thing.

* Just today, in the AFR, Saul Eslake was arguing more spending is needed to put “idle” capital and labour back to work.

The Economist still thinks our economic problems are due to a shortfall of spending!

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economics hides its head

Like so many others, I have the answers to the dilemma economic theory is now in. My answers centre around the classical economics that was the core of theory before Keynes brought ruin to the heart of economics with his General Theory. Clear as a bell to me the havoc this has caused, but there are other views as well, some of whom, according to The Economist, are put forward by other economists as part of their blogs. Here’s how I can tell that most of the bloggers and economists they focus on are absolutely wrong:

America is suffering from a shortfall of spending. Both market monetarism and the neo-chartalists are right about that. They disagree about whether the best response is monetary or fiscal. The market monetarists argue that fiscal stimulus should be redundant, because a central bank can always revive spending—if it sets its mind to it. If the Fed’s efforts have disappointed, it is not because market monetarism is wrong, but because the Fed is not sufficiently committed to the cause. [my bolding]

Of course, both monetary and fiscal are important: the imperative is to raise interest rates and cut spending. But I don’t think that’s what they mean.

See how fortunate you are to be able to come to this blog and find out what is wrong and what to do. The problem is that both central banks and government spending are diverting our very scarce productive resources into a series of wasteful outcomes that are making us progressively less wealthy. The gross stupidity of thinking that the cause of our currently slow rates of activity and high levels of unemployment is a shortfall of spending shows that the curse of Keynes is going nowhere soon.

[An article from 2011 sent to me from a friend for comment. Economics is not about to change is my only answer.]

My book launch

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There will be few moments in my life as exquisite as Wednesday when Peter Costello* came up to the University to launch the second edition of my Free Market Economics: an Introduction for the General Reader. It was a rare moment when the political side of my life, the academic side and my recognition of the importance of classical economic theory were brought together all at once, and was a moment I could share with my friends and family.

I may sometimes give the impression that the book is mostly about Keynesian economics and macro which is not the case at all. That is why I started it out, but the oddest thing for me was to find that as I wrote each chapter, that I harboured views that are far outside the standard textbook treatment. This starts even before we get to supply and demand, but I promise you this, by the time you finish with supply and demand you will know you are in a different economic world. Of course, there are demand-side market forces that limit the price that can be charged for a product, and forces on the supply side that put some kind of lower limit on the price. But the notion that there is a single equilibrium price for a product where two lines cross on a two-dimensional plane is unsupportable by even the most casual empiricism. As I point out to my classes, the price of a cup of coffee, starting from the $1 at the 7-11, to prices four and five times higher that are charged, all within a mile of the front door of our building, ought to make you appreciate that there is something else. I do teach the traditional S and D analysis, but my students also are made to understand that prices are not set by these two curves, but by entrepreneurs who are making decisions about their optimal pricing strategy, given all of the forces of the market that surround them. And most importantly, I do not let them forget that the information in a demand curve can never be known by anyone, ever. It is strictly for teaching purposes. Entrepreneurs in the real world have to work these things out for themselves in real time.

But if I have a villain on the microeconomic side, it is the MR=MC analysis and diagram. If economics had gone out of its way to find some means to cloud minds about what goes on in markets, I don’t think they could have come up with anything worse.

mc equals mr

I teach Keynesian economics, of course, but I won’t teach that. You can find it discussed in my book, but it’s in an appendix. Over the years of teaching this diagram and the explanations that surround it, I found that after going through markets and then supply and demand, you would come to this and stop a class cold. Eventually some could draw the diagram and some might have seen the point, but there would not have been many. I do, of course, teach marginal analysis, but not like this. If you would like to see how I do it, as just part of the way this book is different from any economics book you know, Quadrant Online put up a few pages of the book under the heading Margin of Success.

As I said at the end of my presentation, there are three features of the book that I stress over and again: the role of the entrepreneur, value added and the crucial importance of uncertainty. Each is part of what must truly be understood by marginal analysis: entrepreneurial decision making in the face of the unknown future. And the point I make about the entrepreneur, as I said on the night, is that we now talk about market forces and the invisible hand, but the reality is that there is only one force that matters in a market economy, and that is the entrepreneur. And I don’t mean entrepreneur as in someone who innovates and causes change. I mean entrepreneur as in the captain of a ship in the midst of a storm a thousand miles from land.

_____

* For non-Australians, Peter Costello is the nearest equivalent we have to Ronald Reagan. He ran the economy for eleven of the best years economically this country ever had. Not only was the Asian Financial Crisis a non-event when every one of our major regional trading partners was in recession, but we ended up with 5-6% at the same time. And not only budget surpluses year after year, Australia was, until Labor took over, the only country in the world that had ZERO DEBT! The momentum given to the economy by Costello meant that we travelled through the GFC with hardly a ripple. Our problems have come since due to the debts and deficits Labor piled up. We will never see zero debt again in anyone’s lifetime, and will be lucky even to see our budget balanced any time this side of 2025.

The worst possible question in economic theory – where will the money come from?

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I went along to hear Joe Hockey talk about tax and the world in 2055, and while I understood the problem, I was underwhelmed by the analysis. It is one of the legacies of modern macroeconomic analysis, one of the absolute worst, to continually think in terms of money and not in terms of value added. This is one of the consequences of thinking in terms of aggregates which can only be denominated in money values. But once you sink into money as your mode of thought, you are almost never going to get your head around the problem, which is where will the capital stock come from, and how can we be sure that the capital we are building today is actually going to strengthen our economy over the longer term.

Money is all right as a means of thinking about accounting, which a budget basically is. It’s a balance sheet writ large. It is also why the central concern of those who don’t know any better is merely to try to balance the budget, as if money-in equals money-out is the issue.

The issue is resource use. All forms of production use up resources. Only some forms of production create more value than is used up. The only source of value adding production is the private sector. Governments virtually never create value, other than when they have a monopoly in the production of something, and even then it could inevitably be done better by the private sector. But if a government has a monopoly, they can create value, but the outcome is still far from being as productive as it might have been.

You need to divide all forms of production into three categories: wealth creating, welfare and waste. Only wealth creation makes you better off, and that is almost entirely the province of business. Welfare and waste are the province of government. And while I have no in-principle objection to welfare expenditure that doesn’t eat too deeply into the wealth-creation process, I have a large objection to welfare spending that does. Waste, of course, should be eliminated to the greatest extent possible. But if you are looking for a greater ability to spend on welfare, it is value creation that must come first.

As it happens, the only economics text in the entire world that truly examines and explains value added, outside of the typically useless discussions sometimes found in looking at the national accounts, is my Free Market Economics. If you know of another, feel free to let me know. If you don’t know of another, then you should read my book. It is only if policy makers understand value added properly, and are not muddling themselves up by thinking in terms of money, is there even a ghost of a chance they will get their policies right.

And if you don’t want to take my word for it, here is John Stuart Mill trying to say exactly the same, in Book I, Chapter V, Paragraph XVI of his Principles of Political Economy, the greatest book on economic theory ever written.

It is the intervention of money which obscures, to an unpractised apprehension, the true character of these phenomena. Almost all expenditure being carried on by means of money, the money comes to be looked upon as the main feature in the transaction; and since that does not perish, but only changes hands, people overlook the destruction which takes place in the case of unproductive expenditure. The money being merely transferred, they think the wealth also has only been handed over from the spendthrift to other people. But this is simply confounding money with wealth. The wealth which has been destroyed was not the money, but the wines, equipages, and furniture which the money purchased; and these having been destroyed without return, society collectively is poorer by the amount. It may be said, perhaps, that wines, equipages, and furniture, are not subsistence, tools, and materials, and could not in any case have been applied to the support of labour; that they are adapted for no other than unproductive consumption, and that the detriment to the wealth of the community was when they were produced, not when they were consumed. I am willing to allow this, as far as is necessary for the argument, and the remark would be very pertinent if these expensive luxuries were drawn from an existing stock, never to be replenished. But since, on the contrary, they continue to be produced as long as there are consumers for them, and are produced in increased quantity to meet an increased demand; the choice made by a consumer to expend five thousand a year in luxuries, keeps a corresponding number of labourers employed from year to year in producing things which can be of no use to production; their services being lost so far as regards the increase of the national wealth, and the tools, materials, and food which they annually consume being so much subtracted from the general stock of the community applicable to productive purposes. In proportion as any class is improvident or luxurious, the industry of the country takes the direction of producing luxuries for their use; while not only the employment for productive labourers is diminished, but the subsistence and instruments which are the means of such employment do actually exist in smaller quantity. [Bolding added.

I think my version is easier to understand, but this confusion of money with wealth causes endless damage. You may, of course, disagree with Mill and think that following the money is all there is to it. But it’s not, and if you wish to understand why, read Mill, or again let me suggest, the second edition of my Free Market Economics, especially Chapters 3 and 5.

A query on Keynesian economics

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I have received a brief email from one of my students:

Dear Dr Kates,

First let me thank you for the emails guiding us through the course.

On a personal note, I am curious as to how and why you believe that we should beware of the Keynesian approach (theories that we all have been taught at some point). Is there a book or some articles I could read to in order to understand why the pre-Keynesian era is more relevant to our current economy?

Thank you.

Kind regards

This I can tell you is not an every-day occurrence in the life of an academic. I have now replied:

You don’t know how much you have gladdened my heart in writing to me with your query. As I try to emphasise, I do not ask anyone in an introductory course to choose which side is right and I teach both. You have no doubt which side I think is valid, but I also teach Keynesian economics as accurately as anyone I know, all the more so since I understand it so well since I have studied it for so long. Nevertheless, you may be in the only classroom in the world that is taught the other side as comprehensively as you will find in this course.

But you ask where you might find some literature on the non-Keynesian classical side. I have, as it happens, just completed an 1800-page, two volume collection of every article critical of Keynesian economics written since the publication of The General Theory in 1936. But if you are looking for what I think of as the best criticism available, the best I can offer are two articles I wrote myself, the first one written at the end of 2008 and published at the beginning of 2009 just as the various stimulus packages were getting under way. The second was a five-year review of the first article written in 2014.

This is what was published in 2009 under the title, “The Dangerous Return to Keynesian Economics”.

This is what was published five years later under the title: “Keynesian Economics’ Dangerous Return – Five Years On”.

Both somewhat long, but both are straight to the point and were written so they could be understood without an economics training. Given how things are going, I am not anticipating much improvement on things when I come to write the ten-year review in 2019.

Again, I thank you for your query and I hope these articles will provide you with the insight into the material you are being taught. And, let me remind you, there is also the course text which covers these same issues in greater theoretical depth.

With kind regards.

The consequences of a Keynesian stimulus

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These are really 15 consequences of using a Keynesian stimulus to turn your economy around. Wasteful spending blows your productivity on useless junk while passing purchasing power over to the people on the receiving end of government payments who almost never create value with the funds they receive. The genius is that while our political elites help out their friends, they can pretend they are doing it all to help the people who they harm the most. This is a depressing list, which the linked article goes into with some depth.

1: Wage Stagnation.

2: Most people still haven’t recouped what they lost in the crash: Typical Household Wealth Has Plunged 36% Since 2003.

3: Most working people are still living hand-to-mouth.

4: Millennials are Drowning in Red Ink.

5: Downward mobility is the new reality.

6: People are more vulnerable than ever.

7: Working people are getting poorer: The Typical Household, Now Worth a Third.

8: Most people can’t even afford to get their teeth fixed.

9: The good, high-paying jobs have vanished.

10: More workers are throwing in the towel: Labor Participation Rate Drops To 36 Year Low.

11: Nearly twice as many people still rely on Food Stamps than before the recession.

12: The ocean of red ink continues to grow.

13: No Recovery for working people.

14: Most people will work until they die.

15: Americans are more pessimistic about the future.

It is astonishing to see how rapidly the deterioration has overtaken even so strong an economy as the United States. But at the centre of this disaster is the Keynesian theory that has allowed it to happen with virtually no one any longer able to understand the nature of the problem.

Ha-Joon Chang – please copy

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Ha-Joon Chang seems to be the economist of the moment, with yet another book published by Penguin, Economics: The User’s Guide. But what is notable for me is that he has obviously, but only obviously to me, looked either at what I have written about Say’s Law or looked at someone else who has picked up on what I have written on Say’s Law. He does the usual ritual on “supply creates its own demand” but then adds:

“There can be no such thing as a recession due to a shortfall in demand.” [p 116]

You who have heard me harangue on this for many a moon may think nothing of this, but this is precisely the definition I use myself. It is apparently and pleasingly getting out and about. Because once the focus is in the right place and on the right thing, then we can have a genuine debate. Are recessions caused by a shortfall in demand? Because you would have to be demented to believe that the Global Financial Crisis was in any way caused by a fall off in demand. Same for every other recession in history up until now. But if one merely looks at the GFC, a fall in demand because of decisions to save has to be the least plausible of all possible explanations. In fact, Chang, and I think following my lead, goes on to describe the kinds of things that those classical economists used to look at for explanations, which again you would have to be demented not automatically to look at yourself. He writes:

Any recession had to be due to exogenous factors, such as a war or the failure of a major bank.

He thinks bank failures are exogenous [ie external to the operation of the economy, like being hit by a meteorite, say]! A bank failure is precisely what might be thought of as both endogenous and not in any way a Keynesian explanation, which is based around demand failure due to too much saving, not some kind of crisis on the production side. And you would like then to know what caused the bank to fail, and whether the problem was more widespread than a single bank, since during a financial crisis there is never only one bank going to the wall.

But then he goes on to add the usual Keynesian idiocies since economists just do not seem to be able to help themselves:

Since the economy was incapable of naturally generating a recession, any government attempt to counter it, say, through deliberate deficit spending, was condemned as disturbing the natural order. This meant that recessions that could have been cut short or made milder became prolonged in the days of Classical economics.

You really do have to wonder about these blockheads! We are the midst of what may already be the most prolonged of all recessions in history, and it is by no means over yet, and he complains about classical economists’ reluctance of try to fix things by public spending. Let me once more quote from my Quadrant piece from February 2009 which was titled, The Dangerous Return to Keynesian Economics:

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.

That is classical economics forecasting almost six years ago the prolonged recession every economy in the world is in the midst of and cannot shake off. If you would like to understand more fully what classical economists actually believed, you cannot do better than this.

Government must get out of the way

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Keynesian economic theory has turned out to be a device for the rich to rob the poor, for the unproductive to raid the incomes of those who work. We are supposedly all to be made better off through massive diversion of the wealth of our nations into the pockets of the crony capitalist friends of our ruling elites and union leaders who fleece their members in the name of protecting them from the employers who gave them their jobs.

Rupert Murdoch has spoken on this to the G20, the first person not from a government to be allowed to make such a presentation. Paul Kelly discusses Murdoch’s speech under the heading, Equality at risk in the West, says Rupert Murdoch. It’s a damned sight more than just equality that is at risk, but our very prosperity. We are being made poor across the broad expanse of our communities because governments are now the chief agents for dispensing purchasing power. Obama was right: you didn’t earn it. The government earned it, and you will only be allowed to keep what it decides you should keep. This is part of what Murdoch said:

“In America, the most highly paid 1 per cent now pay 46 per cent of all income tax.” . . . “In Britain, the top 1 per cent pay 28 per cent of all income tax. That is a massive shift from what our society looked like 30 years ago. We should all be concerned about this polarisation which was never the intent of policy but is certainty a consequence.

“Quantitative easing has increased the price of assets, such as stocks and real estate, and that has helped first and foremost those who already have assets. Meanwhile, the lack of any real wage increase for middle-income workers means growing societal divisions and resentment.”

Quantitative easing is a disaster but you will not find out why by reading any economics book that I know of, other than mine. The last two chapters deal with what had once been stock standard economics before the General Theory. Even Keynes dealt with the money rate of interest (the price of credit) and the natural rate of interest (the price of actual resources, such as bricks and mortar), but that was in his 1930 Treatise on Money, which he wrote before he was sidetracked by Say’s Law. We are ruining our economies in the belief that we are actually doing them good by higher levels of public spending and lower interest rates to encourage investment. But we are ruining them, which is a fact that is obvious to everyone. The only thing invisible is why. But what Murdoch proposed is absolutely right:

The significance of his nine-page speech is his argument about the limits to both monetary and fiscal policy and the imperative for a new approach based upon the need “for government to get out of the way”. Mr Murdoch called for: labour market reform; lower and more competitive corporate taxes; a crackdown on multinationals — naming Google — for not paying taxes where they make their profits; a rethink on excessive bank regulation, warning “you would have to be mad to join the board of a bank these days”; and recognition that high taxes and over-regulation were damaging economic growth and the public interest.

But if you start from Y=C+I+G you cannot make any sense of what he suggests. Read Chapters 16 and 17 of my Free Market Economics second edition if you would like to understand the classical explanation for what is happening right before your eyes and why these kinds of reforms are needed. I do find it odd that this is the only book I know of, at least one that has been written since the 1930s, that can explain what was once obvious to every economist in the world. But odd or not, that is how it seems to be.