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

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.]

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.

The fiscal policy of Warren Harding

Warren Harding succeeded Wilson in 1921 as the American economy fell into a post-World War I inflationary recession. Although almost never mentioned, he turned an incipient Great Depression into the Roaring Twenties. I use this story in class as the last example of a classical economic policy ever put into play. Here is how his approach is described:

Harding’s pledge to restore America to a condition of “normalcy” led to his landslide victory in November 1920. In office, he cut government spending to the bone and reduced federal income tax rates across the board. As he said to Congress, the government acted during the war as if “it counted the Treasury inexhaustible”; if that pattern continued, it would result in “inevitable disaster.” To get government spending under control, Harding established the nation’s first Budget Bureau (the forerunner of today’s Office of Management and Budget) in the Treasury Department. As a result, federal spending dropped from $6.3 billion in 1920 to $5 billion in 1921 and then $3.3 billion in 1922. He supported the Revenue Act of 1921, which eliminated the wartime excess-profits tax, lowered the top marginal income tax rate from 73 to 58 percent, decreased surtaxes on incomes above $5,000, and increased exemptions for families. . . .

Many people, he noted, benefited from the gains made “as a result of the economic measures he implemented.” Unemployment fell from 15.6 percent to 9 percent. The industrial side of the economy revived at a rapid pace. A boom took place in construction, clothing, food, and automobile sectors. From 1921 to 1923, the volume of manufacturing climbed 54 percent.

Cut public spending, cut taxes and balance the budget. A radical idea even then and today beyond the pale.

Keynes and the coming Chinese recession

I realise I haven’t been haranguing you about the menace of Keynesian economics for a while so thought I’d remind you of its enduring horrors as there is unanimous agreement that Australia has to get its fiscal house in order. The origins of that disorder are, of course, in the Keynesian policies put in place during the GFC. Just hearing about Kevin Rudd’s 48-hour decision process for the pink batt adventure is a reminder of just how useless, in terms of productivity and real growth, almost all government spending is. A perfect paradigm example. Past the first ten percent, government spending is unproductive whatever other benefits there may or may not be.

As for a recantation from the economics community, not so much as a word. You do have to wonder if they are ever going to get it right. And if they don’t get it right, how policy is ever going to get it right. The latest episode of wrongheaded analysis shows up on the ABC with this story not about Australia but about China. Apparently the problem with the Chinese economy is debt:

In recent times, the boom has been sustained by an explosion in lending by banks and so-called “shadow banks”. If the current scale of lending proves to be unsustainable, could that end the boom and result in China becoming the next country to succumb to the impact of unproductive debt? [my bolding]

Ah, “unproductive debt”! What, pray tell, is that? It is, in fact, exactly what every pre-Keynesian classical economist warned against. It’s spending on non-value-adding forms of production, the usual object of government spending in virtually every one of its forms. There it is, the problem right before their eyes but invisible all the same. Whether one thinks of it in money terms, so that debt is taken on for forms of production which ultimately do not earn sufficient revenue to repay what is owed, or it is thought of it as using up productive resources in ways which do not replace the capital that has gone into that particular form of production, one way or the other the economy is going backwards and not ahead. Keynesian economics is poison but who’s to know? This is what the Chinese did:

The program clearly lays out how the Chinese leadership responded to the prospect of a global financial crisis and possibility of a world-wide depression. The response focused on a spending and investment program carried out on a scale never seen before in human history. Over the past five years, a new skyscraper has been built every five days in China – along with 30 new airports and 26,000 miles of motorways.

Well there was certainly an enormous quantum of resources used up which, incidentally, also happens in highly productive investments. In this case, however, there are the office building, there are the roads, there are the airports, but none of them will generate the revenue to repay their costs. A Keynesian program to the back teeth with predictable results, or at least predictable if you start with Say’s Law. Starting from Keynes it is all a mystery with no explanation. And where do they think it will end up:

Interviewing key players including former American Treasury Secretary Henry Paulson, former Chairman of the Financial Services Authority Lord Adair Turner and Charlene Chu, a leading Chinese banking analyst, reporter Robert Peston reveals how China’s extraordinary spending has left the country with levels of debt that many believe can only result in an economic crash with untold consequences for the world – particularly resource-driven economies like Australia.

If you thought the last five years were bad, apparently the next five will be even worse. Meantime, ending the reign of Keynes and return to classical economic theory would be a start in even understanding what’s going on never mind actually getting our economies untracked.

If it’s not in itself value adding don’t do it

I share Judy’s exasperation at the push for more infrastructure spending which is a code word for more government waste. If it is government spending, it will never repay its costs. Occasionally a government will grab hold of some natural monopoly – Telecom in the old days – from which even with all of the usual incompetence they were able to take in more money than they paid out. But past those few and far between projects, I cannot think of a single instance where governments take on projects which leave us economically better off. So this from The Australian this morning fills me with tremendous foreboding:

Joe Hockey says state treasurers will find it “very hard to resist” a federal proposal to recycle government-owned assets and boost spending on infrastructure.

State treasurers are in Canberra this morning to discuss spending on infrastructure and the carve-up of the good and services tax.

The federal Treasurer expressed optimism about the discussions ahead of today’s meeting.

The Abbott government is pushing for a deal that will unlock billions of dollars from the privatisation of state government assets to be reinvested in significant new infrastructure projects.

It’s understood proposals put to state treasurers will include new incentive payments from the commonwealth which will be linked to qualification deadlines.

“I have no doubt that the states will find it very hard to resist what the commonwealth is prepared to offer them,” Mr Hockey said.

Mr Hockey said the proposal would be “for the recycling of state government assets and investment in new productive infrastructure that is going to create jobs and improve the capacity of the economy”.

Governments do not create jobs. If you believe that government spending leads to an outcome where there are more jobs in an economy than there would have been had the government not indulged in this kind of spending, or that the economy will end up stronger and more productive, you will never understand a thing about how an economy works. And as an added extra, with increased government spending there will be lower real earnings as well. So let me repeat what Judy said below:

The bigger issue is with all this talk of INFRASTRUCTURE, what we are about to witness is just a monumental waste of taxpayer money on politically popular and excessively expensive projects for which there have been inadequate assessments. Just a continuation of Albo, really, who ramped up infrastructure spending from 1 to 2 per cent of GDP.

The disaster that overcame the Victorian economy in the dismal Cain-Kirner years were built on just those same “hollow logs” they thought they could tap into. If it’s not value adding – that is, if it does not pay for itself after every cost is taken into account – it makes us worse off, not better. Call it charity or welfare or whatever else signifies that it draws down on our productivity if you must do it. But for heaven’s sake, don’t pretend it is a contribution to economic growth.

UPDATE: Here is the Treasurer’s press release, Treasurers agree to boost infrastructure.

The Commonwealth’s incentive will be 15 per cent of the assessed value of the proposed asset being sold for capital recycling. If proceeds are used by the States and Territories for the retirement of debt or other purposes, rather than for agreed, new productive infrastructure, they will not be eligible to receive payments under the initiative.

This is an important initiative to remove debilitating infrastructure bottlenecks, stimulate construction and drive real activity in the economy when it is most needed, as investment in the resources sector declines.

Infrastructure Australia estimates that at least $100 billion in commercial infrastructure assets are currently tied up on government balance sheets and could be sold.

The partnerships could overcome the fiscal constraints Governments face to increase the pipeline of projects and improve Australians’ quality of life, tackle congestion, reduce business costs and help firms better link with their employees and customers.

Those who think this will be of the roads-rail-and-sewers variety of expenditure will just have to wait to see what gets floated instead. At least on the up-side, the States will have to sell up various capital assets to private owners to secure the funds so it’s not all bad.

Just don’t do it

Two articles at opposite ends of today’s AFR both discuss public spending on infrastructure but with a different message from each. There is firstly on the front page, Project spree risks AAA rating ,which begins:

The government’s AAA credit rating may be at risk if it embarks on major infrastructure initiatives before sweeping changes to how projects are funding are made, according to the ­Productivity Commission.

The rest is behind the paywall but the article discusses the views of Peter Harris, the Chairman of the Productivity Commission, who is trying to get the government to think long and hard before it spends our money. Infrastructure is seldom the best use of our resources and before we commit to such spending there needs to be a very thorough cost-benefit analysis undertaken with a real intent to ensure we are getting value for money.

Pet projects have been an ongoing disaster. There is only one reason for a government to enter into such expenditure and that is because there is a net dividend to the economy. If you think, for example, that Building the Education Revolution contributed anything at all to the Australian economy, you should not be making infrastructure judgments. Only if you are able to articulate why the BER was an almost total waste of money and resources could you be trusted to assess our future infrastructure needs.

Then at the back of the paper we have Peter Sheehan with an opinion piece, The new Keynesians: accident or design?. And his point: however it may have come about the Abbott government is about to launch into a Keynesian stimulus which he thinks is a great idea. As he writes:

Strong underlying growth cannot be assumed. The Keynesian response is clear: there needs to be a major program of infrastructure investment. This should be large-scale additional spending of 1.5 per cent to 2 per cent of GDP a year for five years.

If the government listens to this kind of thing they will end up as bad as Labor. They should dwell instead on this before they start spending money as if we are in some deep depression, also from today’s AFR:

Employment jumped in February by the most in almost two years, led by an oversized 80,500 surge in full-time work, Australian Bureau of Statistics data shows.

Some small part of government spending is productive, some is necessary because it provides assistance to those who are in need, but for the most part government spending is a drag on the economy not a stimulus. Cut the deficit. Get unions out of the road. Reduce unnecessary regulation. And leave recovery to the private sector which is already starting the process we need to continue along.

Macro follies continue

It’s been five years of this Keynesian mess with the notion that economies are driven from the demand side. At the start it was direct government spending. As an approach to recovery it has comprehensively failed as no one now denies. So we have now gone to the monetary policy approach with Quantitative Easing, pour money out into the economy and low interest rates will finally lift things up. Also not working but no one knows why. So here’s why, and odd that you have to come to this website to get the only sound economic advice available anywhere. But here is why. Economies are driven forward by increases in value adding supply and by absolutely nothing else. Others can tax, steal or otherwise appropriate the productivity of others and squander what they get. But this will NEVER lead to a recovery, not ever. So we have kept rates low and watched as nothing has happened. Unexpected to others but not to anyone who understands the classical theory of the cycle and Say’s Law.

Anyway, it’s that time of year again. Macro follies continue and no one seems to have learned a thing. And it’s not just consumer spending but all unproductive spending that is a draw down on productivity. Consumer demand is, of course, the reason for bothering with any production at all. But if we are thinking about growth and employment, consumer and government demand has nothing to contribute, nothing whatsoever. Nor does mis-directed investment spending. If you don’t understand why, ask someone to give you a copy of Free Market Economics: an Introduction for the General Reader for Christmas. It’s what I gave everybody last year so why shouldn’t you have a copy yourself?