Tag Archives: classical theory

“In case you are not familiar with Kates . . .”

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The video is Economics for Independent Thinkers which discusses the way economics is discussed outside the mainstream. There are many many reason for watching the above video from end to end, but this especially works for me, starting at the 14:30 mark.

“The lesser known terms are mostly thanks to the Australian economist Steven Kates. In case you are not familiar with Kates, Kates wrote possibly the most thoroughly researched of the studies showing that there was a fairly strong consensus before the Keynesian Revolution about how the business cycle worked.”

And not only that, I explain in modern terms what that theory was. And as strange as you may find this, there is no other modern source where you can find classical theory explained.

The presentation was to The Heritage Foundation in Washington. This is the synopsis and I could not agree more with what he says:

Too many mainstream economists view the world as a collection of equilibrium models, without concern for when these models fail to explain real-world risks. In Economics for Independent Thinkers, author Daniel Nevins scours under appreciated corners of the economics and investment worlds for more realistic thinking. What results is a no-nonsense approach to economics that appreciates the importance of credit and banks in business cycles, and provides a different perspective on Keynesian stimulus and the consequences of government debt accumulation.

The speaker is Daniel Nevins.

Daniel Nevins, CFA, has invested professionally for thirty years, including more than a decade at both J.P. Morgan and SEI Investments. He is perhaps best known for his behavioral economics research, which was included in the curriculum for the Chartered Financial Analyst® program and earned him recognition as one of the founders of “goals-based investing.” He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania’s engineering school.

And you know what? Till now I did not think it was possible but you never know the way things are going. We may yet rid ourselves of this Keynesian economic mess, but to do that we will need to understand economic theory before Keynes. Speaking of which, have I mentioned my introductory text before: Free Market Economics, now in its third edition?

The classical theory of the cycle rediscovered once again

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Maximillian Walsh has just re-discovered the classical theory of the cycle. This is from today’s AFR: The crises are different, but the cause is the same. Here is the sub-head:

In a global era, the next crisis is always just around the corner. The continuous expansion of debt is the cause at the bottom of all of them.

I suspect that we have been living in a “global era” for the last 250 years at least so technically I suppose he’s right, but I think he is trying to say there is something new in the world. He could, if he cared to look, find the same kinds of instability across the whole of the nineteenth century. If he would like to go back farther, I could send him to The Wealth of Nations, or he could investigate the Mississippi or South Sea bubbles, both eighteenth century.

The point, of course, is that with the advent of Keynesian economics, the classical theory of the cycle has disappeared and to my knowledge a full discussion is available from only a single source at the present time, although the Austrians are pretty close.

So yes, there is always another crisis around the corner, all the more so since those who manage our economies are the single most certain cause of it. The real question, then Max is this: what should we do, right now, to prevent this crisis from coming full term, or at least what can we do to make it less of a problem? For this, too, you need to go back to the classical theory of the cycle. They had no guaranteed answers either, but at least they knew what you should not do. And if you would like to see the kinds of things they would not have done in action, check out the Federal Reserve in the US, along with most of the other central banks now in charge, and see what they are doing right now.

Classical economics rediscovered

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I have come across a summary of David Simpson’s The Rediscovery of Classical Economics written by David Simpson himself and published by the Royal Economic Society. Before I quote more extensively, I will note where he wrote:

I refer to an intellectual tradition that began with Adam Smith, was continued by Marx, Menger and Marshall, Schumpeter and Hayek and in the present day is represented by theorists of complexity.

It never surprises me to see the name of John Stuart Mill missing from such lists since Mill is the most difficult of all of the classical economists to access for any one schooled in modern theory. Yet it was Mill who set the standard for the second half of the nineteenth century and was explicitly followed by Marshall and even Hayek even as they turned economics into the more familiar form we find today. I might also mention that what makes Marx interesting even now is found in Mill only with much more common sense as well as a far deeper economic understanding. Mill is the high point of classical thought, and in many ways the high point of economic thought. But who amongst any of you would be able to contradict me, you followers of Keynes and marginal analysis, who barely know Mill’s name never mind have any idea of what he wrote? This is Simpson’s description of the economics that has all but disappeared.

The hallmarks of this classical tradition are principally three. The first is the belief that the growth of the economy, rather than relative prices, should be the principal object of analysis. Coupled with that belief is an understanding of the market economy as a collection of processes of continuing change
rather than as a structure, and that the nature of this change is self-organising and evolutionary. Finally there is a conviction that economic activity is rooted in human nature and the interaction of individual human beings.

The differences between classical theory and equilibrium theory can be summarised in the following terms. Classical theory focuses on change and growth within open, dynamic nonlinear systems that are normally far from equilibrium. Equilibrium theory, on the other hand, analyses the theory of value within closed, static linear systems that are always in equilibrium. As to the essential nature of economic activity, classical economics makes no distinction between micro- and macroeconomics. Patterns of activity at the macro level emerge from interactions at the micro level. Evolutionary processes provide the economy with novelty, and are responsible for its growth in complexity. In equilibrium theory micro-and macroeconomics remain separate disciplines, and there is no endogenous mechanism for the creation of novelty or growth.

The behaviour of human beings in classical theory is analysed individually. People typically have incomplete information that is subject to errors and biases, and they use inductive rules of thumb to make decisions and to adapt over time. Their interactions also change over time as they learn from experience. In equilibrium theory, individual behaviour is assumed to be homogeneous and can be modelled collectively. It is assumed that humans are able to make decisions using difficult deductive calculations, that they have complete information about the present and the future, that they make no mistakes and have no biases, and therefore have no need for adaptation or learning.

Simpson finishes by discussing where economics now needs to go under the heading, “The Implications for Economic Theory”. I think this is both very limited in what is sought but also almost impossible to imagine being taken up within the profession. I’m not so sure about the need for non-linear algebra, but at least with this we have the commencement of a program for change:

First of all, courses in economic history and in the history of economic thought should be a required part of the curriculum for every student of economics. The study of economic history, like the study of complex systems, reveals the importance of context in understanding economic behaviour. The study of the development of economic thought helps us to appreciate the weaknesses as well as the strengths of a theory. Macroeconomics should be downgraded, and give way to the study of business cycles.

Secondly, more space should be found for the analysis of dynamic processes at the expense of static theory. The study of the processes of economic growth should be restored to centre stage. This probably means a greater emphasis on nonlinear algebra.

At the same time, the limitations inherent in applying mathematics to economics need to be acknowledged. The importance of the human factor and of human institutions in economic activity means that more attention needs to be given to non-quantitative methods of analysis.

With the scale of disaster that has befallen us since the GFC, there is something radical that needs to be done. And if you are interested in seeing a twenty-first century update on Mill and classical theory, you can always try this.

Classical economic theory and the modern world

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A post in two sections.

Section I

The March issue of Quadrant has an article of mine which has just been put up online. In the magazine itself the title is, The Dangerous Return of Keynesian Economics – Five Years On. What it is five years on from is an article of mine that found its way into the March 2009 issue which dealt with that very dangerous return of Keynesian economics in the form of the worldwide stimulus that economies across the world were beginning to apply. The original title was The Dangerous Return to Keynesian Economics for which this was the single most important passage:

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 this outcome was absolutely assured in my own mind is, of course, not the same as it being absolute assured in reality. And indeed, it is not too much to say that 99% of the economic opinion of the world went quite the other way. The best example of this attitude may be seen in this comment made to me by Senator Doug Cameron during my appearance before the Senate Economic References Committee in September 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?

This is, of course, a question I ask myself but also one for which I have an answer. The odd part is that no one else asks this question although it is the question that ought to go to the heart of the matter. Which takes me to the second part of this post.

Section II

The economics I use I did not invent but am near enough unique in applying it to economic questions in the modern world. This is the economic theories of the cycle as developed by classical economists which was the theory accepted universally across the profession prior to the coming of the Keynesian Revolution in 1936. So to see things as I see things about the nature of this theory, let me take you to the opening part of a form I have just sent to my publisher on how to advertise the second edition of my Free Market Economics. It was a book whose first edition I wrote at white heat over the twelve weeks of the first semester in 2009, from March to May, to explain in more detail why the stimulus would with certainty fail, as fail it did.

1. Please describe the book in non-technical layman’s terms (in no more than 150 words). Include brief details of the book’s main objectives and conclusions.

Have you ever wondered why no public sector stimulus has ever worked? You are holding in your hands a book that is unique in our times. It is a text on economic principles based on the economics before Keynesian theory became dominant in macroeconomics and equilibrium analysis became standard in micro. It looks at economics from the perspective of an entrepreneur making decisions in a world where the future is unknown, innovation occurs at virtually every moment, and the future is being created before it can be understood.

Of particular significance, this book assumes Keynesian theory is flawed and policies built around attempting to increase aggregate demand by increasing non-value-adding public spending can never succeed but will only make conditions worse. The theories discussed are the theories that dominated economic discourse prior to the Keynesian Revolution and are thus grounded in the economics of some of the greatest economists who have ever lived.

It is, of course, possible that I might have been right for the wrong reasons, but it might also be the case that I was right for the right reasons. I go on about Say’s Law, John Stuart Mill and classical theory, but you know, when have they ever let me down? The world, so far as the evidence shows, works exactly like their theory says it does. And it’s not even that I picked this downturn as a one-off instance, but I also picked the upturn that followed the massive cuts to public spending after the Costello budget in 1996. Who else did that then? What theory is there other than the classical theory of the cycle that could even explain it let alone predict it? And there is no other text anywhere in the world written more recently than the 1920s that can tell you what that theory is other than mine.

You could, of course, buy the first edition right now or you can wait until the much improved second edition is published in July or August.

Say’s Law and the business cycle at SHOE

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My likely final posting on this fascinating thread that began with my bring up Francois Hollande’s pointed comment on Say’s Law. The interesting thing for me to have seen in this instance is that others study the business cycle and find Say’s Law invisible. I began from examining Say’s Law and found its concepts an intrinsic part of the theory of the cycle.

Between Daniele Besomi and Barkley Rosser, I am beginning to get some idea why it is so hard for me to get my papers published.

But they are not the only ones who have published books on the classical theory of the cycle. I have my own as well, Free Market Economics: an Introduction for the General Reader (Elgar 2011). It’s an unusual title, perhaps, but I adopted it from Henry Clay’s Economics: an Introduction for the General Reader published in 1916, and after many reprints, with a second edition in 1942. My book is a cross between Clay, John Stuart Mill and a number of more modern features economic theory has picked up over the past century or so. I also teach Keynes, but those sections come with a skull and cross bones just so my students are warned about the dangers this kind of stuff can cause.

In this book I have a chapter on the classical theory of the cycle which is largely adopted from Haberler (1937) and then three more chapters explaining in more detail the nature of economic management using classical theory. But because I think of Say’s Law as the very core in understanding the cycle, what you see is the result of an enormous amount of additional reading on everything I could get my hands on about the pre-Keynesian theory of the cycle. In the days when I was starting my work on Say’s Law, I would tell people that I was working on classical business cycle theory because, as you know and can see from this thread, putting in a good word for Say’s Law is not apt to get you published or promoted. But I can do no other.

So let us suppose you were interested in the classical theory of the cycle, who do you think would get you closer? Someone who accepts Say’s Law, agrees with Mill on his fourth proposition on capital, thinks Keynes was right when he stated that he had introduced aggregate demand into mainstream economics where it had never been before, and uses classical reasoning to argue, at the very moment the stimulus packages were introduced, that they would lead to exactly the kind of economic stagnation we find today.

Would you trust that person, or would you trust someone who thinks you can boil most of what the classical economists had said down to deficient aggregate demand, even when Ricardo has explicitly stated that demand deficiency is not a valid explanation for recession, while Keynes had argued that what he was doing was overturning Ricardian economics and bringing demand deficiency into economic theory.

You can disagree with the classical theory of the cycle and why not, millions already do even though they have no idea what it is. But to argue that you have understood classical theory when you don’t agree with a word of it makes me have to ask why you are so sure you have it right? Some of the smartest people who ever lived were classical economists. Are you really going to set John Stuart Mill straight, or W.S. Jevons, or David Ricardo or Alfred Marshall? What will you add to their sum total of insight? That following a downturn business people become more tentative and hang onto their funds for a longer time before committing them to some project? That demand deficiency actually does cause recession? That wasteful public spending will increase employment and generate faster growth?

Does it really make any sense to believe that the Global Financial Crisis was caused by an almost overnight decision of people around the world to stop spending and start saving. What possible insight do you get by saying there was a shift to the left of an aggregate demand curve? Or that what we must now do is shift the AD curve to the right?

The GFC was a classical recession which is described almost down to its last gory details by Walter Bagehot in Lombard Street who had seen many just like it. Money and resources had been poured into the housing construction industry in the US and houses bought by people who could not make their payments. Events flowed on from there, including a financial crisis. Since demand is constituted by value adding supply, the fact that people could not afford what had been supplied, meant that resources had been misdirected. The recession was just a necessary correction with the prior lending practices the eventual disaster in waiting.

I will merely state that if you cannot incorporate the classical understanding of Say’s Law into what you write, you will have a problem understanding how classical economists analysed recessions. If you are going to reproduce the classical theory of recession, then you must begin with these words: “Recessions are, of course, never ever caused by too little demand and excessive levels of saving, but in spite of that recessions are a frequent occurrence because . . . .”

Let’s go to the policy level as well. Your explanation of recession must also help you to complete a sentence that begins with these words: “Even though the most evident signs of recession are warehouses filled with unsold goods and extremely high levels of unemployment, we cannot get out of recession by increasing public spending because . . . .”

Although we are mostly academics on this thread, this is not some academic exercise. There is an awful lot riding on this. The Japanese had their lost decade (times two) following their stimulus in the early 1990s. We are ourselves already half way into our own lost decade and there is nothing to suggest it might not go another half decade, or even stop then.

If you want to understand how I think about recessions and what needs to be done, you can read my text, or you can read Henry Clay. The one advantage you get from reading mine is that I have actually experienced Keynesian economic theory and have been taught this classical fallacy as the best economic theory we have today. I have seen the enemy, and it is us.

Say’s Law makes it to the AFR

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afr - steve kates on says law

says law and the keynesian revolution

Is it possible that economic theory has regressed over the past hundred years. Well if you ask me, it’s a certainty. (For further confirmation, see Alan’s post on Larry Summers below.) An economist in 1914 knew more about how an economy worked than an economist in 2014. Less detail, fewer stats but a greater grasp of how it all fit together. How odd is that!

What’s the difference. Economics is now infused, both in it theory and in its practitioners, with socialists who simply refuse to believe that markets left to themselves will generally speaking produce the optimal economic outcome. The idea is now so outré that economics texts – aside from one or two that I am aware of – are no longer designed to explain how the market works. They instead start from the premise that markets will go wrong and that governments must take action at every turn to set things right.

Anyway, I have an article in the Financial Review today which is titled, “What Say’s Law has to say about the financial crisis” which really is, what pre-Keynesian classical theory has to say about the crisis.

There you have the core of the classical theory of the cycle which may be broken down into the following components.

• Misconceived production decisions are what starts the rot.

• These misconceived decisions lead to a greater output of particular goods and services than there is a market for them at prices that will repay all of the previous costs of production.

• The economy must therefore backtrack to remove those parts of economic activity in which production is greater than demand.

• And thus we have recessions.

Recessions are thus structural. Instead our textbooks teach Y=C+I+G and explain recessions as a result of too much saving and too little demand, the fallacious notions that Say’s Law was specifically designed to expose.

Macroeconomic theory is not just nonsense but dangerous nonsense. Using it to manage an economy will leave wreckage in its wake as it has consistently done everywhere and every time it has been used to solve some economic problem.

Economies are built up by genuinely value adding activities which most government forms of spending most definitely are not. That doesn’t say governments shouldn’t do them. It merely says they should not deceive themselves into believing that public spending is the road to rapid rates of non-inflationary growth. Public spending draws down on our productivity rather than building it up. If the last five years have taught us anything, hopefully at least it has taught us that.