Tag Archives: keynesian economics

Keynes and Keynesian Economics in Light of the Financial Crisis

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The economic societies of the United States meet over the first few days of the year, with the meeting this year in Boston. This is the full conference program which is gigantic. My interest is what is being said about the sad state of economic theory and its inability to provide guidance on how to find our way out of the present low state of our economies. This was the part of the conference I was most interested in myself:

Keynes and Keynesian Economics in Light of the Financial Crisis

So in its own way, you might say that these issues were on the agenda. However, not only was this the sole manifestation across the hundreds of papers given during the conference, but this was also not in any way part of the mainstream program, only tucked away as part of the program devoted to the history of economic thought. Clearly, none of this is of any genuine interest to virtually the entire profession. Nevertheless, all credit to Robert Dimand for putting the session together, and for treating this as the serious contemporary issue it is. These were the papers found in this session.

Keynes and Financial Crises
ROBERT DIMAND (Brock University)

The global economic and financial crisis that began in 2007 has renewed interest in Keynes’s analysis of whether the economic system is self-adjusting and of his proposals for ending depression. This analysis is complemented by Keynes’s more specific accounts of financial crisis, notably in his incisive “The Consequences to the Banks of the Collapse in Money Values” (in his Essays in Persuasion, 1931) and his Harris Foundation Lectures, a body of work that is much less well-known.

Keynes, Wages and Employment in Light of the Great Depression
HARALD HAGEMANN (Universität Hohenheim)

The wage-employment relationship is one of the central and most controversial issues in the General Theory. . . . and etc for another 200 or so words.

James Meade and Keynesian Economics
SUE HOWSON (University of Toronto)

James Meade (1907-1995), although Oxford-educated, was one of the very first Keynesians, a member of the Cambridge “circus” which met to analyze and criticize Keynes’s just published Treatise on Money in the early months of 1931. Not only did he use Keynesian ideas in his writings throughout his long career; he was a major player in the implementation of Keynesian policies in Britain during and immediately after World War II. My paper will discuss his encounters with Keynes and his use and development of Keynesian economics in his own academic and policy work.

Not that you should think that Keynesian economics was mentioned nowhere else. It showed up one more time, under “Heterodox Macroeconomics”, a session put on by the Union for Radical Political Economics. But I do love his first line, which is something the rest of the profession would prefer to forget. I’ve put it in bold just because, and left the rest in just to see how tedious this stuff can be.

Keynes is Dead — Long Live Marx
ISMAEL HOSSEIN-ZADEH

Many liberal/progressive economists envisioned a new dawn of Keynesianism in the 2008 financial meltdown. More than five years later, it is clear that the much-hoped-for Keynesian prescriptions are completely ignored. Why? Keynesian economists’ answer: “neoliberal ideology,” which they trace back to President Reagan. Using a Marxian method of inquiry, this study argues, by contrast, that the rise/dominance of neoliberalism has much deeper roots than pure ideology, that the transition from Keynesian to neoliberal economics started long before Reagan was elected President and that the Keynesian reliance on the ability of the government to re-regulate and revive the economy through policies of demand management rests on an optimistic perception that the state can control capitalism. Contrary to such hopeful perceptions, public policies are more than simply administrative or technical matters of choice. More importantly, they are class policies—hence, continuation/escalation of neoliberal policies under the Obama administration, and frustration of Keynesian/liberal economists. The study further argues that the Marxian theory of unemployment, based on his theory of the reserve army of labor, provides a much robust explanation of the protracted high levels of unemployment than the Keynesian view, which attributes the plague of unemployment to the “misguided policies of neoliberalism.” Likewise, the Marxian theory of subsistence or near-poverty wages provides a more cogent account of how or why such poverty levels of wages, as well as a generalized predominance of misery, can go hand-in-hand with high levels of profits and concentrated wealth than the Keynesian perceptions, which view high levels of employment and wages as necessary conditions for an expansionary economic cycle.

The largest single problem with economic theory today is that economists do not even know they have a problem. But the second most important problem is that what ought to have been the most important part of the entire program was relegated to students of the history of economic thought, which is the one area of economic theory economists are trying to rid themselves of. It’s as if these are issues so completely settled that no one any longer has to waste their time thinking about any of it at all.

AND LET ME JUST ADD THIS: From the Wall Street Journal, The Depression That Was Fixed by Doing Nothing. Before Keynes, there was no such thing as a Keynesian stimulus, but recessions got fixed anyway:

Beginning in January 1920, something much worse than a recession blighted the world. The U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression), as well as a 31.6% drop in industrial production and a 46.6% fall in the Dow Jones Industrial Average. Unemployment spiked, and corporate profits plunged.

What to do? “Nothing” was the substantive response of the successive administrations of Woodrow Wilson and Warren G. Harding. Well, not quite nothing. Rather, they did what few 21st-century policy makers would have dared: They balanced the federal budget and—via the still wet-behind-the-ears Federal Reserve—raised interest rates rather than lowering them. Curiously, the depression ran its course. Eighteen months elapsed from business-cycle peak to business-cycle trough—following which the 1920s roared.

That was what they did, but with the low state of economic knowledge today, there is little likelihood anyone will understand why it worked.

Excessive savings[!] and Keynesian economics

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There was a comment on my previous post, Krugman’s Keynesian cluelessness reaches new heights, that got me to thinking. Here is the comment, for which I am very grateful:

I was looking up the “broken window fallacy” in comments at the link that Steve Kates provided about Skousen’s Gross Output… the words that were a howler to me was the concept of “excessive savings.”

Excessive savings!

Insane, right? Who could believe such idiocy that our central economic problem is too much saving? Completely ridiculous and beyond bizarre. Utter nonsense! How stupid would you have to be to believe such stuff!

And yet, I’m afraid, that this is indeed the very central point of Keynesian economics. There is demand deficiency because there is too much saving. There is no one who has studied economic theory that has not heard this, and absorbed it from their first days of study. You may think this is an obvious blunder, but it is a blunder shared by 95% of the economists in the world. Don’t believe it? Let me take you back to the General Theory itself, from whence it all began. In the following passage I have substituted the words “return on investment”, in place of Keynes’s own terminology, “marginal efficiency of capital”, since Keynesian terminology is part of the problem that people have in seeing through what a threadbare patchwork of stupidity the General Theory actually is.

I do hate to be technical. But with Rich raising the point, I can do no other than try to show that what he finds absurd beyond reason is in fact the single most central idea of Keynesian theory and policy, taught in every text to every student of economics. The following is from page 217-19. Keynes is pointing out that the central problem for economies is that there can be too much capital relative to its willingness to spend. If there is too much capital, an economy will produce more than it is willing to buy. If interest rates cannot be brought low enough, there won’t be enough investment to soak up all of these excess savings. Capital has to be kept scarce; it is not naturally so since the problem he is discussing is an excess of saving. So Keynes writes:

We have seen that capital has to be kept scarce enough in the long-period to have a return on investment which is at least equal to the rate of interest for a period equal to the life of the capital.

What then happens, if the community nevertheless keeps producing more capital, is that it will eventually find that spending is insufficient to absorb all of the savings. A poor community can maintain growth and full employment longer than a rich community, but eventually, as Keynes writes, the propensity to save will overwhelm the propensity to spend, and even the richest of communities will fall into recessions that have been caused by too much saving.

It follows that of two equal communities, having the same technique but different stocks of capital, the community with the smaller stocks of capital may be able for the time being to enjoy a higher standard of life than the community with the larger stock; though when the poorer community has caught up the rich ⎯ as, presumably, it eventually will ⎯ then both alike will suffer the fate of Midas. [GT: 219]

“The fate of Midas”: the more productive your economy becomes, the more it will be driven into recession and high unemployment. And if you should think that this is some far off prospect, given that we are dealing with the 1930s, that is not the case at all. Here is Keynes again, in the passage that actually precedes the passage above, saying that the high unemployment of the Great Depression has been literally because there has been such a large prior increase in capital accumulation, that the two richest economies in the world have fallen into depression.

The post-war experiences of Great Britain and the United States are, indeed, actual examples of how an accumulation of wealth . . . can interfere, in conditions mainly of laissez-faire, with a reasonable level of employment and with the standard of life which the technical conditions of production are capable of furnishing. [GT: 219 – my bolding]

Keynesian economics is stupid. Its assumptions have never been validated by any actual experience of the world, but its logic is even worse. It is the dumbest economic theory every peddled to the world. But as noted in the comment that began this post, you put excessive saving in the company of ‘the list of weasel words, including: “inequality”, “fairness” and “social justice” to justify wealth redistribution and big government taking a cut’ and you can see its allure to governments and public servants, who in spite of having no idea how to get a positive return on the money spent, nevertheless get to spend more money than the largest corporations in the land.

Cochrane may think he’s anti-Keynes but he doesn’t go far enough

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I am happy to find that others see me in the way I see myself, as a centre for anti-Keynesian thought. The article by John H. Cochrane in the Wall Street Journal with the title, An Autopsy for the Keynesians, made its way to me from a number of directions. I am, of course, content to see Keynesian economics being hammered. But the fact remains that so far as I am concerned, Cochrane makes only an averagey sort of anti-Keynesian. I shouldn’t quibble since slagging Keynes is all to the good, but he needs to go farther.

The essence of classical economics, and the core point made by Say’s Law, was that the economy NEVER receives momentum from the demand side. You cannot make an economy grow by buying more, only by producing more. And even that’s not enough. The “more” that is produced will make an economy grow if, and only if, the value of what is produced is greater than the value of what had been used up during production. Demand is created by value-adding supply. Here is the excerpt from Cochrane’s article that leaves me unsatisfied; I don’t think he quite understands it himself.

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

It never happened. Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Keynesian policy has now mutated into a policy of low interest rates, again with the intent of trying to make the economy grow from the demand side. You need to go to the final two chapters of the second edition of my Free Market Economics, where the problems of low interest rates are discussed, to understand the problem. As he says at the end of the article:

Yes, there is plenty wrong and plenty to worry about. Growth is too slow, and not enough people are working.

He doesn’t see that low interest rates are the very essence of the problem, even after all the spending has slowed down. I will think he has finally got it when he starts worrying about quantitative easing, and recognises that rising interest rates are what is needed if recovery is every to take hold.

At least one of us has no idea how an economy works, and I don’t think it’s me

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I don’t normally do this, but I was asked about this article at The Conversation, Why the federal budget is not like a household budget, and out of pure exasperation I sent off this reply. My title is, “An Endless Supply of Keynesian Nonsense” of which there is no shortage. I shouldn’t write things at two in the morning since the exasperation does seem to overwhelm me, but here it is for what it’s worth.

The state of economic theory today truly is a scandal. The effect of Keynesian theory on the way economists think is so disturbing that the reality is there is no likelihood anytime soon that things will begin to come good. Let me take a case in point, which comes from the article by Warwick Smith which came with the title, “Why the federal budget is not like a household budget”, which I suppose is true, but it all depends on what conclusion you therefore draw.

He also says that, “the whole deficit/surplus thing has been greatly exaggerated”, which again I am willing to accept, depending on how he follows up from this. He goes on to add that “the focus on deficits and surpluses distracts us from what’s really important in the macro economy.” OK. So just what is it that is the really important thing? And this is his great insight:

“Inflation is the limiting factor for government expenditure, not taxes or borrowing”.

That is, governments can keep spending right up until we reach the point where prices begin to rise too much. There is therefore plenty of room for government stimulus that is not limited to the amount of spending that is covered by one’s revenues. Here are his words:

“A government that can create money doesn’t need your money from taxation or from borrowing in order to spend. There is no limit to how much money a sovereign government can spend, but if government spending plus private spending exceeds the productive capacity of the economy then you get inflation.”

Until the government reaches the point where the economy is at its capacity level, it can, it seems, keep spending without taxing or borrowing, and it is all to the good. The economy will keep growing and inflation will remain under control. Here is his conclusion, in his own words so you can see for yourself I am not making it up:

“Times like these represent opportunities for the government to finance productivity improving infrastructure and provide much needed services for nothing. I know it sounds too good to be true but this is the reality of a fiscally sovereign government.” (My bolding)

How is it possible to believe anything like this and call yourself an economist?

So here is the answer to why this is nonsense, which I hope will also help you understand why the American economy is falling to bits, and if we are not very very careful, ours will do exactly the same.

An economy only grows by producing goods and services whose value is greater than the value of the inputs plus labour-time used up during production. There was a time every economist understood this. If you have some timber, a hammer, a few nails and some time, you can do many things with them, but only some of the things you might do will end up with the value of what was produced greater than the value of the timber, nails and time used up.

The belief that a government has any idea where value adding activities can be found is one of the dopeyist ideas ever concocted. Governments can certainly spend the money they create, and some of what they do is value adding, but hardly everything. To believe that what governments produce automatically has greater value than the resources they use up is so nonsensical it is hard to believe any economist would ever peddle such a notion.

Take our own stimulus. The two major projects were pink batts and school halls. If you ask me if we are better off with a larger number of insulated houses and a better school infrastucture, I am happy to say that, all things being equal, we are. But if you ask me whether we have had a return of more than $43 billion on our outlay – the approximate price tag of this spending – then the answer is that we have not had anything like that amount of benefit.

You may delude yourself from now till the end of time that these benefits were provided “for nothing”, but have you not seen our own reality. The dollar is falling, our standard of living is being dragged down and unemployment is on the rise.

Ah, but where is that inflation? For most, real incomes are not rising, so however small the official inflation rate may be, it is plenty high enough to erode our ability to demand. Have you tried to buy a house lately to take one example?

But the real damage comes through the other mechanism in which inflation affects an economy, which is the deterioration in our capital stock. Our economy is just not being maintained, never mind allowed to grow, because the government is diverting our resources into its own projects, instead of allowing businesses to replace their capital as it erodes during production. The real side of the economy is slowly but ever so surely falling to bits.

If you don’t understand it, well you are in good company since people with economics degrees apparently don’t seem to understand it either. But even if you don’t understand the process, you can certainly feel the effects.

On the first Keynesian texts but when will there be the last?

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In the discussion thread on introductory texts on economics from the 1890s to the 1950s, in which I discussed Clay’s Economics, the issue has swung round to what is a story frequently told on the left, how political pressure from the right killed off the supposedly great first Keynesian text, Loris Tarshis’s The Elements of Economics. To which I contributed the following:

This note is in regard to Lorie Tarshis’s first “Keynesian” text in the US, his Elements of Economics, which supposedly was killed off by an attack from William F. Buckley, thereby clearing the way for Samuelson to take the field with his own more cautiously written Keynesian tract. This story about Buckley and Tashis is an old established myth. In fact, Buckley went after Samuelson just as much as Tarshis. This is the start of Buckley’s assessment, which in some eyes might even look quite prescient:

“Marx himself, in the course of his lifetime, envisaged two broad lines of action that could be adopted to destroy the bourgeoisie: one was violent revolution; the other, a slow increase of state power, through extended social services, taxation, and regulation, to a point where a smooth transition could be effected from an individualist to a collectivist society. The Communists have come to scorn the latter method, but it is nevertheless evident that the prescience of their most systematic and inspiring philosopher has not been thereby vitiated.

“It is a revolution of the second type, one that advocates a slow but relentless transfer of power from the individual to the state, that has roots in the Department of Economics at Yale, and unquestionably in similar departments in many colleges throughout the country. The documentation that follows should paint a vivid picture.” — William F. Buckley, Jr. God and Man at Yale: The Superstitions of Academic Freedom, Henry Regery, 1951, p. 46-47.

And I might also mention Buckley’s attitude to Keynes, also from the same source, which would have applied to Samuelson quite as much as Tarshis:

“The individualist insists that drastic depressions are the result of credit inflation; (not excessive savings, as the Keynesians would have it) which at all times in history has been caused by direct government action or by government influence. As for aggravated unemployment, the individualist insists that it is exclusively the result of government intervention through inflation, wage rigidities, burdensome taxes, and restrictions on trade and production such as price controls and tariffs. The inflation that comes inevitably with government pump-priming soon catches up with the laborer, wipes away any real increase in his wages, discourages private investment, and sets off a new deflationary spiral which can in turn only be counteracted by more coercive and paternalistic government policies. And so it is that the “long run” is very soon a-coming, and the harmful effects of government intervention are far more durable than those that are sustained by encouraging the unhampered free market to work out its own destiny.”

The true reason, in my view, that Samuelson’s text won out over Tarshis’s is because it is a far better book, much much more accessible. The macroeconomic side, with its C+I+G diagrams and others of a similar kind, is a fantastic improvement in the underlying power of explanation. I have first editions of both Samuelson and Tarshis, and there is no comparison. Even Samuelson’s 1948 version is an order of magnitude better, both to teach and to learn from. There are virtually no diagrams in the macro half of Tarshis’s text (and the diagrams in the micro half are often bizarrely complex), while Samuelson has a number of diagrams (a small number, especially in comparison the text we are now all familiar with), which bring out the underlying message in a way that the hundreds of pages of diagramless text in Tarshis does not.

I might add, but only just for fun, that in my Defending the History of Economic Thought, I discuss the ways in which diagrams have dumbed down economic thought, so that we now move lines in a two-dimensional space, instead of trying to think through the actual economic adjustments that are supposedly going on. But that is just by the way.

And if you have reached this far, Nato asked a very interesting question, for which I am grateful, and for which there is a very interesting answer. The question: “Talking about your contributions, Say’s law and the classics, is the Elgar debate with Rochon still running?”

The answer: We had agree to a third letter each and when I sent off my third letter off, I suggested that perhaps we could even go for a fourth. The reply that came back was that Rochon had decided that he no longer even wished to do the third, so we would stop there without publishing this third letter.

It is clear that he is no longer game to go on, but that was, in my view, all the more reason to hold him to what he had agreed. Keynesian economics is the absolute standard in macroeconomics at the moment. If anyone should have been overwhelmed in this debate – going only by the numbers – it should have been me. My third letter was a clarification of some of the issues already raised, I replied to what had been written previously, as well as going on with a further discussion of the problems with Keynesian theory. That is just what such a debate should be. Each of us gets to respond to the issues the other has raised. By probing for the weak points in each other’s arguments, we bring the various tensions on our own positions to light and, hopefully, learn something at the same time.

I can only say that if Keynesian theory is as indefensible as it appears from the the first two letters defending Keynes, and which I think my third letter would have helped to emphasise to others, then I think there is some kind of moral duty to publish my third letter. This is not some small matter, but involves the entire theoretical and strategic approach to managing our economies. If the Keynesian defence is as feeble as it has been shown it to be – and I would hardly deny that there may be others who could do a better job – then I think my third letter should enter into the public debate, and if there are others who think they can do better, they can come forward to try to explain the Keynesian position more clearly. But to me this is a debate that we need to have.

I will only add at this point that the matter is not yet closed.

Debating Keynesian theory – the story so far

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I am in the midst of a debate on the Elgar blogsite with the editor of the Review of Keynesian Economics over the question: How to Promote a Global Economic Recovery. The issue is the validity of Keynesian theory and policy. Such debates are strangely rare, and what is more astonishing is that there really is very little of it at the present time, even with our economies having been subjected to a Keynesian stimulus with no apparent positive results. Even Paul Krugman has insisted that the stimulus has been disastrous, but in his view because there was too little and not too much.

I, of course, represent the anti-Keynesian side of the story which, as surprising as this may seem, is not all that common. There are some who are non-Keynesian, but who do not make much if any effort to draw distinctions between their own theoretical arguments and the arguments of modern Keynesians. Whatever it is they might believe, they do not spell out chapter and verse what they believe is wrong with Keynesian theory. They argue on behalf of their own views and leave it at that. They therefore provide little assistance in policy debates to those who are trying to explain what is wrong with the single most common treatment found in macroeconomics texts across the world, and in particular, what is wrong with public spending as a means to bring recessions to an end.

There are also some who rest whatever disagreements they have with Keynes on the results of empirical investigations. They also do not specify any particular disagreement with Keynes but rely on the specifications of their own empirical results to show that the results of Keynesian policies do not lead to the outcomes that were expected. The theoretical side is either played down or ignored altogether.

Thus far there have been four posts, two from each of us.

Here are the four in order of publication.

First I weighed in on The Free Market approach which is as much a critique of Keynesian theory as can be fitted into 1700 words.

Louis-Philippe Rochon replied with “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets”.

To this, I replied with “Markets… have been the single most liberating institution in possibly the entire history of the human race” which, in spite of its title, is almost entirely devoted to criticising Keynesian theory.

LPR then replied with this: “It is pure fantasy to believe that anything but demand is the driving force of economic activity” which puts the issue squarely before us. This is his opening para:

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

Although Keynesian theory comes in many different disguises – there is a different Keynes for every Keynesian – this is pretty close to the real thing. Any thoughts would be welcome.

What is the defence against Keynesian theory

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You may think I go on a bit about this Keynesian economics but it is the source of every government’s warrant to spend like there’s no tomorrow. So long as the universal view is that economies are driven by demand, there is no effective answer to decisions to spend. Since according to Keynesian theory, the spending ends up in jobs, and the multiplier effects ensure that, no matter what the original spending is on, it will lead to higher growth, even if the first round of such expenditure is a total waste, it all contributes one way or another to our prosperity. Once you have tossed Say’s Law aside – which specified that demand could only come from the supply of products whose revenues covered their production costs – there is no intellectual defence against public spending. Don’t you care about the unemployed? Are you not interested in economic growth? Then surely governments must spend to put people into jobs and raise our living standards.

No economist today has a ready answer to this that builds out of the economics we teach. Accept as valid that Y=C+I+G+(X-M) and you seem to me to be defenceless against public spending as a certain social good.

We worry about public sector waste, misdirected production, a tonne of money lost on useless green programs, a proliferation of public servants whose main role in life is to prevent other people from producing. We are apparently content to see government hand tax money over to businesses to complete projects that will never repay their costs. We do this because, at the back of everyone’s minds, there is the belief that it will all be to the good, as it stimulates growth and puts people into jobs.

Honestly, what is the reason not to do any and all of it if the Keynesians are right? Why not spend the money if it will create jobs that would otherwise not be there and stimulate faster growth that would otherwise have not occurred? It amazes me that whether this is actually true is never the issue. We discuss deficits and debt but the underlying premise, that public spending is good for growth, is never challenged. We build schools, hospitals, infrastructure and every dollar spent is seen as a net positive. But unless you understand in your very bones in what circumstances this is untrue, you will never rise up and bring this madness down. We are bankrupting our societies and slowly grinding our capital into the ground, but so long as we have Keynes to tell us it is all to the good, it will go on forever, until the collapse. And if Japan is anything to go by, it will continue even after that. If no one understands why it should be stopped, it won’t be.

Shifting in a Keynesian direction

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First there were two articles, one by Paul Krugman with the title, Keynes is slowly winning and the other by Tyler Cowen in reply to Krugman titled, Keynes is slowing losing (winning?). There is now a third, Krugman’s reply to Cowen, In Front Of Your Macroeconomic Nose, in which he says what I believe myself:

Cowen seems to have missed my point; I wasn’t talking about the merits of the Keynesian case, which I believe have always been overwhelming, but about the way macroeconomics is discussed in the media and among VSPs in general. My sense is that this is shifting in a Keynesian direction.

There is no other theory known to anyone other than Keynesian. You can talk about debt and deficits until the end of time, but unless you can relate it to a theoretical understanding of what needs to be done and more importantly why, there is nothing to grab onto when trying to craft policy. Keynesian economics may be ruinous, but you can find it in a million texts and it has been taught for three generations, coming up to four. Even Cowen in his pussycat weak attack on Keynes can do no better than this at the end:

It would be wrong to conclude that Keynes was anything other than a great, brilliant economist. Rather these citations, plus many of Krugman’s points, give you some beginnings for this issue. It’s not nearly “Keynes’s time” as much as many people are telling us, after all his biggest book is from 1936 and that is a long time ago. Keynes is both winning and losing at the same time, like many other people too, fancy that.

Economies are not driven from the demand side. But other than myself and a handful of others, you will find hardly anyone else to say it across the wide expanse of economics. So on we go, tilting back to public spending while real incomes descend and our economies weaken with not a clue why that might be. So at least there is Johnny Cochrane writing this in a discussion of the articles by Cowen and Krugman:

I posted this last week, but I was unaware at the time of the Paul Krugman’s “Keynes is slowly winning” post; Tyler Cowen’s 15-point response, documenting not only Keynesian failures but more importantly how the policy world is in fact moving decidedly away from Keynesian ideas, right or wrong (that was Krugman’s point); and Krugman’s retort, predictably snarky and disconnected from anything Cowen said, changing the subject from Keynesian ideas are winning to the standard what a bunch of morons they’re not Keynesians though I keep telling them to be. . . .

In that context, I added two “Facts in front of our noses.” Keynesians, and Krugman especially, said the sequester would cause a new recession and even air traffic control snafus. Instead, the sequester, though sharply reducing government spending, along with the end of 99 week unemployment insurance, coincided with increased growth and a big surprise decline in unemployment. And ATC is no more or less chaotic than ever. Keynesians, and Krugman especially, kept warning of a “deflation vortex.” We and Europe still don’t have any deflation, and even Japan never had a “vortex.” These are not personal prognostications, but widely shared and robust predictions of a Keynesian worldview. Two strikes. Batter up.

But still no theory to explain why cuts to public spending will raise economic growth while increased public spending will slowly but surely reduce our standard of living. If, however, you are interested in understanding why, there is always the second edition of my Free Market Economics.

UPDATE: One of the great anti-Keynesians has written an article for this month’s Standpoint in the UK, Don’t let the Keynesians Wreck the Recovery. He discusses the famous letter signed by 364 economists across Britain warning of the consequences of Thatcherism, that is, the consequences of fiscal discipline:

Famously or notoriously, depending on one’s viewpoint, the 364 were wrong. To quote Nigel Lawson, who would become Chancellor of the Exchequer in 1983, the timing of the recovery was “exquisite” in refuting the 364’s prognoses. Demand and output started to move upwards in the second quarter of 1981, just as the debate about the Times letter was at its most intense. Although unemployment remained high for some years, the economy gathered pace and in the late 1980s entered another boom. If this was a laboratory experiment for Keynesian economics, its results suggested that the textbook formulas were flawed. Old-fashioned principles of sound finance returned to favour in the UK, while the ratio of public debt to gross domestic product fell to manageable levels. For more than 25 years Keynesian fiscal activism was ignored or even forgotten.

But the events of the 1980s have been ignored, particularly by writers of textbooks. As Tim notes:

But university economists continued to teach Keynesian macroeconomic as if nothing had happened. Sure enough, in Britain many academics realised from the sequel to the 1981 Budget that something was wrong with Keynesianism or, at any rate, with the naive versions of Keynesianism which emphasised the blessings of fiscal fine-tuning. But in the American East Coast universities — notably the Ivy League establishments — the UK’s 1981 Budget was too parochial an event to justify rewriting textbooks and lecture notes. Such influential figures as George Akerlof and Robert Shiller of Yale, Paul Krugman of Princeton and Joseph Stiglitz of Columbia, all now Nobel prize laureates, continued to teach that an increase in the budget deficit adds to aggregate demand and a decrease deducts from it.

And so here we are, dragging our economies down by pretending we are doing them good.

Debating Keynes – part 2

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The one thing about our economies everyone can agree on is that they are in a mess. The question then is, what’s the reason for the mess they are in and what should be done to fix things up? The potential for the present dismal state of affairs to drag on for another decade or more is a genuine possibility, just it has done in Japan since it tried its own stimulus in the 1990s. Such an outcome is all the more likely given the continuous belief, fostered by standard textbook macroeconomics, that a government stimulus is essential if a recovery is to occur. It is this belief that will keep our economies in permanent disarray. There is therefore no economic issue of more importance at the present time than whether such Keynesian policies should be continued.

I am in the midst of an “exchange of letters” on Keynesian economics with Louis-Philippe Rochon, the editor of the Journal of Keynesian Economics. We had each written one letter – (my first is discussed here) – and now I have written my second, which may be found at this link under the title: “How to Promote a Global Economic Recovery? ‘Markets… have been the single most liberating institution in possibly the entire history of the human race’.” You can find all three of our letters, my two and Louis-Philippe’s reply to the first, at the link.

The letter that has just been published was, in fact, the second I had written in response to his. What follows below is the first version I wrote in reply, which is still trying to get at the same ideas but in a different way.

Dear Louis-Philippe

Thank you for your reply which I must confess was not really a reply to the issues I raised. I wrote to explain why a stimulus could not possibly have worked, emphasising the theory. Your reply has merely stated that we have not really had a stimulus since it was prematurely brought to an end and that in your view, it is the absence of a stimulus that is causing our economies to fall into deeper recession. You then go on to provide your own Keynesian program with nothing to support it other than your own set of preferences for public spending.

But if we are to examine the record, let me remind you that there has never been a single example of a Keynesian stimulus that has ever succeeded in returning an economy to full employment and strong rates of growth. Not a single one, not one, not ever.

The one example that gets trotted out from time to time was the outcome of the Kennedy tax cuts of 1962. But tax cuts are not increases in public spending, and are in perfect keeping with pre-Keynesian policy. It was the same approach that Ronald Reagan took in the 1980s and with equal success.

Increases in public spending have never succeeded in bringing an economy out of recession. The United States notoriously, in spite of the spending and deficits of the Roosevelt administration, never returned the American economy to full employment. It was only the coming of the war in 1941 that brought the Great Depression in the US to an end.

By then, the rest of the world had left the Depression behind long before. Even by the time The General Theory was published in 1936, the Great Depression had long disappeared in the UK. Unemployment was still high but the worst was well and truly over. By 1937 Keynes was worrying about inflation, not unemployment.

Moreover, the policy approach in the UK had been entirely classical. The British Chancellor of the Exchequer (ie the Secretary of the Treasury) in his 1933 budget speech specifically noted that the budget had finally been balanced, and correctly forecast that recovery would therefore soon be under way.

Where are the success stories to go with the obvious failures that were found pretty well everywhere in the 1970s and 80s, in Japan in the 1990s, or the experience of every economy that had tried a stimulus after the Global Financial Crisis in 2009. There is not a single example of a successful stimulus you can point to.

Let me also remind you of the greatest disproof of Keynesian economic policy in history. Everyone always points out that one Keynesian data point which is the so-called boom that came at the start of World War II. Not a boom at all since what most people remember about the home front was rationing and controls of every kind. And if you are thinking about the labour shortages, merely recall that around half the male workforce under thirty was drafted into the armed forces. But that’s not that point either, although it should put quite a dent into such Keynesian thought.

It is the coming of peace in 1945 that is the grand refutation of Keynesian economics. At the end of the war, in the space of a year millions who had been overseas fighting, or had been part of the war effort at home, were suddenly in the labour market looking for work. Think of these as millions of people who had suddenly lost their jobs all at once. Many women who had taken jobs while the men were overseas also remained in the workforce. The Keynesians were continually badgering Truman to maintain war-time deficits since, they said, if he did not the US would go straight back into the depression which in the United States had ended only four years before.

Truman, however, having had a business background, was adamantly opposed to deficits and as a result the US virtually balanced its budget in a single year. No deficits, no stimulus, no nothing. The US slashed its expenditures, balanced its budget and in so doing set off the greatest economic boom in world history, a boom that lasted straight through until ground into the dust by the war on poverty, and dare I say it, the unfunded, deficit-financed war in Vietnam.

Thinking about macroeconomic issues from the demand side is amongst the biggest mistakes anyone in economics can make.

Given its perfect record of failure, why does Keynesian macro persist? Why is it still taught in our textbooks? Aside from being very simple to understand, it remains in place because, disastrous though the policies Keynesian theory promotes may be, it is loved by governments, the bureaucracy and that brand of entrepreneurial activity that today goes under the name of “crony capitalism”. Keynesian policies may not do much for the poor and unemployed but it brings amazing dividends to our economic and political elites.

Before Keynes, governments knew their limits. There was no pretence that beyond a narrow range of activities, there was little a government could do that would be value adding. It was universally appreciated that during recessions governments could take various steps to reduce unemployment and that there was a limited role for governments to have projects available that could soak up some of those who lost their jobs. Nothing new in that.

Today, with macro so drenched in Keynesian conceptions, government spending of all kinds on just about anything, is seen as wealth creating. Politicians, who know nothing about running a business, nevertheless believe themselves capable of making billion dollar decisions because they believe that whatever they spend on will, of necessity, raise the level of economic growth and add to communal prosperity.

The confidence with which governments devised expenditure programs following the GFC in the apparent belief that recovery would follow soon after was incredible to those few of us who understood that it is impossible to increase growth by increasing public waste of resources.

In his introduction to The General Theory, Paul Krugman summed up Keynes’s message in four points, which are almost identical to my own description of Keynesian economics:

“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.”

This is the theory that is drummed into every introductory student in economics and which maintains its grip unless specifically taught that these four propositions are fundamentally wrong.

And within the worldwide community of economists, no more than around two in a hundred are ever taught to reject such beliefs, and even with this two percent only a small proportion ever come to understand what is actually wrong with the macro they have been taught. The rest more or less accept the theory as it comes, which is why when the Global Financial Crisis struck, there was virtually no opposition to the stimulus from within the economics community.

Even now, as governments struggle to deal with the debt and deficits they have created in their various expenditure programs – almost none of which will ever have a positive return – there is still no general understanding of what went wrong or how to fix what is clearly broken.

The four fundamental principles of Keynesian economics are so ingrained that most economists are not even aware that before Keynes, such beliefs were recognised as utterly fallacious and the mark of an economic illiterate.

Again, I can do no more than remind you of the second edition of my Free Market Economics which discusses both the Keynesian and the classical theories of the cycle. Here I can do not much more than raise your interest in these wrongly discarded theories of the cycle. If you would like to know more about what they said, and why modern macro is so deeply flawed, it is to my text you must go.

The endless supply of Keynesian nonsense

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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.