A rare debate on Keynesian economics

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

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

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

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

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

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

The vast majority of economists are Keynesian

I will preface this with my own invention, the National Accounting Stimulus Trap, which is built around Y=C+I+G. An increase in public spending will, inevitably, show up as an increase in Y because that is how the accounts are designed. A fall in public spending will inevitably show up as a fall in Y, for exactly the same reason. If you think that the real effects of a change in policy can ever be detected in less than a year, you have to be blind to the basics.

Which brings me to a blog post by Simon Wren-Lewis, University of Oxford, with the title, The academic consensus on the impact of austerity. The consensus is negative; most economists are either Old or New Keynesians:

Unfortunately we do not have a great deal of information on what academic economists as a whole think about austerity, but we do have two important survey results which are pretty conclusive. In the US, there is the IFM Forum, which regularly asks a group of distinguished economists – including many macroeconomists – their views on key policy issues. The last poll I have seen suggests that 82% of that panel thought the 2009 Obama stimulus had reduced unemployment, while only 2% disagreed. In the UK, the CFM survey asked a similar question to a smaller group of academic economists, most of whom are macroeconomists. Only 15% agreed that the austerity policies of the coalition government have had a positive effect on aggregate economic activity, while 66% disagreed. That consensus is not universal – it would not apply in Germany for example – but I doubt if anyone would disagree when I say that US economists call the shots as far as academic macroeconomics is concerned.

This is why economists the world over continue to teach Keynesian macro to undergraduates, and normally not as one ‘school of thought’ but rather as an initial approximation of how the economy actually works. As Amartya Sen so forcefully reminds us, the experience of the last hundred years has earned Keynesian theory this central role.

There’s more of the same:

We have another, more indirect, source of evidence. If you asked whether there was a standard model for analysing the business cycle among economists in academia and in policy making institutions, the answer would have to be the New Keynesian model. I want to include economists in central banks in particular because they have to put theories of the business cycle into practice on a regular basis. The key macromodels that central banks use to forecast and to analyse policy are Keynesian, and many are New Keynesian. [his italics]

And I have to give you this, which is a jargon-filled sentence of such raw stupidity that it amazes me that anyone can write such a nauseating sentence with such smug certitude given how anaemic the American “recovery” has been:

This is why, among economists with expertise, there is a clear majority view that fiscal austerity is significantly contractionary in a liquidity trap.

No economy that has had a stimulus applied has recovered in any interesting sense. The business cycle is cyclical. Every downturn turns up. Nothing falls forever. But if you are going to call the present pathetic example of a recovery a serious upturn, I will merely point out that you have not got a clue.

For more of the same, go here.

Criticising Keynes – four years later nothing has changed

The following are four notes I wrote to the Societies for the History of Economics website back in November 2011. Brad Bateman and Roger Backhouse had written a book on Keynes and Keynesian economics – Capitalist Revolutionary-John Maynard Keynes – and had put up a note to let others know. I had also written a book just then, so thought I would mention it since there are alternative ways of looking at things. As it happens, even four years later, six years following the dead hand of the stimulus was first applied – no one else has written a book explaining what is wrong with Keynesian economics and laying out the alternative. These four posts could have been written yesterday, given how economic theory has dug in and refuses even to so much as notice how useless its advice has been. In reading these, please note that others had written comments as as well, only some of which I mention.

Professors Backhouse and Bateman invite us to indulge in a visionary perspective in dealing with the Global Financial Crisis and the subsequent recession that will not go away. They wish us to look at alternative ways of thinking about the economy and how it works.

As it happens, I have done just that. In August this year, Edward Elgar published my Free Market Economics: an Introduction for the General Reader which outlines the mechanics of an entrepreneurially-driven market economy embedded within a political structure where the rules and regulations that businesses work within are determined by others. And what is particularly notable about the book is that while it explains Keynesian economics as accurately as any other introductory text on the market, it is also at the same time the most relentlessly anti-Keynesian book written in the past forty years. Moreover, if you would like to have an economics text that explains the classical theory of the cycle – the best alternative I know to Keynesian theory – my book does that as well, and I think in this regard, it may be the first book to do so in over three-quarters of a century. To my knowledge, there is no other book like it, although I truly do wish the market was flooded by hundreds of alternative titles along the same lines.

Let me therefore highlight one of the sentences in the Backhouse-Bateman article:

“Even Keynes himself was driven by a powerful vision of capitalism. He believed it was the only system that could create prosperity, but it was also inherently unstable and so in need of constant reform.”

Well I can agree with half of this but the other half is plain wrong. Capitalism is without question the only system that can create prosperity. But as the existence in 1936 of the by then hundred year old classical theory of the cycle should tell you, there has never been much doubt that capitalist systems are subject to instability. Nor was Keynes intention to explain to his fellow economists that our economies were in need of constant reform, whatever that might mean. The point of The General Theory was to introduce into mainstream economic theory the notion of aggregate demand. (Read page 32 of the GT on Malthus and Ricardo if you are in any doubt). There is nothing else in the book that is novel or that has spread like a weed throughout the discipline the way this concept has. And its adoption has been the single most disastrous mistake economic theory has ever made. Because economists now think in terms of aggregate demand we are no longer capable of explaining even the basics of the cycle and cannot provide sound advice to governments when economies fall into recessions as they inevitably will.

Let me finally say that I endorse everything written by James Ahiakpor in his earlier post. But let me also add that while the tremendously faulty structure of the bailouts can only be explained by the need to do something straightaway, that there was a need for government action could have been found by reading Bagehot’s Lombard Street which was published in 1873. It was the stimulus that came after, pure Keynes in both structure and intent, that is the core problem we are dealing with right now. The stimulus packages themselves are the most important cause of the prolonged recession most economies are facing today. It is the problems of debt and deficit that are the major problems we must find answers to, not a failing financial system which was the problem in 2009. So where Backhouse and Bateman ask:

“How do we deal with the local costs of global downturns? … If economists want to help create a better world, they first have to ask, and try to answer, the hard questions that can shape a new vision of capitalism’s potential.”

OK, I’m in. Let’s find a solution to all of this and more. But if you think Keynesian theory is any part of the answer, then my friends, you are in my view part of the problem and in no way part of the solution.

Second tranche.

I appreciate Mason Gaffney’s query about the nature of my book. And if I could, I will reply using the text of a note I sent to Roger Sandilands after reading his brilliant compilation of some of the more difficult-to-find works of Allyn Young. Two of the longer parts within Roger’s compilation were Kaldor’s notes of Young’s LSE lectures which were delivered in 1927-29, and the various entries Young wrote in the 1920s for the Encyclopaedia Britannica. If you would like to see how economists thought about economic issues prior to the publication of The General Theory, this is the place to go. Hopefully, Roger will be able to let us know how to obtain copies of his compilation of Young’s work. But to explain what my book is about, I hope this note I wrote to Roger will explain how I think of this book myself:

“I have been meaning to write to you for some time. I took Allyn Young’s LSE lectures and Britannica entries with me as my morning train reading for many many mornings in a row and it was fantastic. The first thing that it confirmed for me was that the book I have written on Free Market Economics is actually what I wanted it to be. It is the book that an economist schooled in the classical tradition would have written in the absence of the arrival of the General Theory. I learned an immense amount from Young but all of it merely deepening my own understanding of things that I had absorbed from the classical literature generally. I attach the flyer for the book which you should ask your library to buy anyway, but if you look at it, you will see that it is classical theory right down to its downward sloping supply curves and its discussion of the theory of the cycle in an almost identical way to Young’s.

“The theory of the cycle as Young portrays it (discussed pp 76-84) is not just the classical stuff in general, but is explicitly soaked through with Say’s Law. He notes that J.-B. Say “pointed out” that “what is commonly called overproduction is merely ill-balance production” (p 77). And then on the next page, “people do not over-save, they miscalculate” (p 78). Where can you find that written in a textbook any more, other than in mine, of course.

“And if you look at my book, you will even find the history of economics discussed more or less in the same place, just half way past the middle (pp 85-88). He not only feels the need to say these things, but the logic of when to put the history into the text occurs to him in just the same way and at just the same point as it occurred to me.

“But it is not merely coincidence that our work is so in parallel, but it is that he and I both think about things in the same sort of way. I have the advantage of actually having seen Keynesian economics in action whereas one can only conjecture just how savage Young would have been about the GT had he seen it for himself. Given what he has written here, there is little doubt he would have found the GT nonsense from end to end. And now, today, instead of discussing Mises and Hayek alone, we would be also discussing Young.”

That is where my letter to Roger ends. But to supplement your reading of Young, for an explanation of the nature of the business cycle as understood by classical economists, the first edition of Haberler’s Prosperity and Depression is hard to beat. That is what I built my own chapters on. But if you go to Young, who unfortunately died at 53 in 1929, you will see these same theories described in more or less exactly the same way by someone writing before there was even a hint of the Great Depression to come.

Third tranche.

It is interesting to see just how relentlessly Roger Backhouse and Brad Bateman choose to ignore what I wrote. That was the reason I thought I would bring Allyn Young into the conversation since I understand perfectly well that some faraway economist living in the antipodes would have no standing in such discussions but I thought Allyn might. Nevertheless, I do wish to impress upon them once again that what I am writing about is a direct response to the issues raised. And since the only compass in which these issues can be properly discussed is the evolution of economic theory over the past hundred years, in every way this is a subject matter for this site.

Going back to the original NYT article, let me take the final sentence as the core point Backhouse and Bateman wished to make. What they wrote was: “If economists want to help create a better world, they first have to ask, and try to answer, the hard questions that can shape a new vision of capitalism’s potential.” To do this, they argued, economic theory should include a major recognition of government and its role. To emphasise how important this point is, they criticised Hayek and Friedman for ignoring the important contributions of government, writing:

“In the 20th century, the main challenge to Keynes’s vision came from economists like Friedrich Hayek and Milton Friedman, who envisioned an ideal economy involving isolated individuals bargaining with one another in free markets. Government, they contended, usually messes things up. Overtaking a Keynesianism that many found inadequate to the task of tackling the stagflation of the 1970s, this vision fueled neoliberal and free-market conservative agendas of governments around the world. That vision has in turn been undermined by the current crisis.”

Well, what I am trying to tell them is that I have attempted to do in my book on “Free Market Economics” exactly what they have argued needs to be done. It is not perfect but what is? And because of its hostility to Keynes and what he stands for, I fear that if they read it they would unlikely find much in it that would give them pleasure. But (a) it is obviously about capitalism (although the word does not appear anywhere in the book) and (b) it provides a vision of the world in which economic actions are of necessity buried inside a political structure. Don’t believe it? Here are the opening three paragraphs of the book:

“This is a book about the market economy.

“A market economy is one in which overwhelmingly the largest part of economic activity is organised by private individuals, entrepreneurs, for personal profit. Such entrepreneurs are private citizens not government employees. They make decisions for themselves on what to produce, who to hire, what inputs to buy, which machinery to install and what prices to charge.

“There are, of course, in every nation state legislative barriers put in place by governments which limit every one of these decisions. No market is or ever has been even remotely laissez-faire. Entrepreneurial decisions are circumscribed by the laws, rules and regulations that surround each and every such decision.”

My aim in writing the book was to explain to governments, and to their citizens, how an economy can be run so that prosperity for the largest number is the result. This is not a book about how governments should be kept away from economic interactions, a completely weird and self-defeating idea. This is a book that embeds within the text the very necessity for governments to intervene to make free markets work. The point that I try to make is that since governments not only are going to intervene but must, they should do so in a way that actually does some good.

But Backhouse and Bateman do not just say we need a new vision and leave it at that. In their article and subsequent post, they are promoting a book with the title, “Capitalist Revolutionary: John Maynard Keynes”. In their view, it is in Keynes that we are to find that vision. Well the point I wish to make is that it is precisely in Keynes that we will not find that vision, and that if we economists had any sense we would abandon Keynesian theory and policy root and branch. To draw some inference from Keynes that capitalism is in constant need of reform is about as vacuous a statement as I can imagine. The need for institutional adjustment to the changing nature of the world is hardly some great insight.

Fourth tranche.

Roger Backhouse and Brad Bateman have done us all an immense favour by opening up an issue that really ought to be at the top of the economics agenda today, and that is, given what we have discovered in the past two years, whether the Keynesian policy vision still makes much sense. They think it does, which is why they wrote their book, wrote their article for the NYT, and finally initiated this thread to alert the rest of us to what they have done.

Unless they were of the opinion that no one disagrees with them about Keynes and his vision, they must take it as a rightful expectation that there are some who are of a different persuasion and that they will actually say so in reply. And what seems to trouble some is this comment of mine and particularly the word “rancid”:

“The Keynesian policy vision has created a global nightmare both politically and economically, a nightmare whose end is nowhere in sight. There may be an old guard that wishes to cling to such rancid and outdated ideas but by now it ought to be obvious beyond argument that Keynesian policies do not work. There is not a single economy in the entire world that is safe from the ravages that the stimulus has caused.

“By all means, let us find a new vision, but for heaven sake, the last place we should be looking for that vision is in the works of John Maynard Keynes.”

There is nothing ad hom in this. It is, as Brad Bateman has himself noted, the ideas which I describe as rancid. It may not be a typical word used by economists but it gets my point across. Keynesian economic theory, assuming it was ever valid which I do not, should be seen by now as well past its use-by date and recognised as having become stale and moldy over the past three-quarters of a century. But in the use of this word, it is quite clear that it is the sin and not the sinner being attacked.

Thomas Humphrey has entered into this discussion thread in exactly the right way. A great scholar and one whose writings I admire, he has posted to say that the way Keynesian economic theory has developed since the 1930s has created a macroeconomic theory of immense power and penetration and that my approach would throw baby out with bathwater. And with this, the issues thatI think are important are engaged. And unless there were anything further for me to say on the issue of Keynesian theory and vision, I would have feel there is nothing else to add. I have said my piece. Keynes, yes or no. We report; you decide.

Rob Leeson has now, however, suggested that the moderator not only determine whether something ought to be published depending on its relevance, but also dependant on the choice of words used, on the number of words used and on some determination of the degree of ad hominem involved. I take it that Rob would not therefore have published my posts had he been the moderator which makes me grateful that he is not and Humberto is.

Of course we are all bad judges in our own case but I don’t think any of my posts, nor any of the others on this thread, have been too long. I have read each one through with great interest. And if they are too long, it is only the writer who loses out since eventually others stop reading what they have to say.

Excessive savings[!] and Keynesian economics

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.

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

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

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.

Debating Keynesian economics – the posts in order of publication

debate format jean-leon-gerome-a-collaboration-corneille-and-moliere

I began with this in the form of a letter to Louis-Philippe Rochon, the editor of The Review of Keynesian Economics amongst other accomplishments.

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.

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. (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader</em>. There is literally nothing else like it anywhere.

Best wishes,

Steve

This was the reply:

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. 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. 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. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! 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. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. 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. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

This then was my reply:

Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

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!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

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.

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, 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. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you 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.

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least 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 worse. You describe what I see, but I expected things to end like this from the start.

You only began 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 continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, 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.

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, 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 production. You must do more than build brick walls, you must build where what is built actually contributes to 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 if we were looking to make matters worse, it’s hard to go past items 1-3 of 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.

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 deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear 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 sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the 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 appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. 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.

Kind regards

Steve Kates

And now Louis-Philippe’s reply to my second letter.

My dear Steven,

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.

You seem to view markets as “the single most liberating institution in possibly the entire history of the human race.” Well, I can see where we disagree indeed. Markets are where goods are produced and sold, where incomes are determined. But they are not efficient, in the way that they do not always produce an optimum result; that is why we need some regulator and some other institution to intervene when markets fail. I would go further, I would argue that markets never allocate efficiently, and never perform optimally, so that there is a permanent and on-going need for the State to precisely regulate the cycles and minimize the pains that recessions and crises can inflict upon us, and to reduce the injustice of inequality. You say this is socialising our economies. I assume you say this in a derogatory way. I am by no means a socialist; like Keynes, I want to save capitalism from itself. But I will wear that label proudly if you meant it as somehow to denigrate. Rather, I see it as the only way of making capitalism work for mankind. In that sense, I stand proudly on the shoulders of Keynes and others who have defended that very notion. I will proudly stand and argue, supported by a vast literature of empirical research that the State is in a unique position, given its power to spend, to create wealth and prosperity for all.

You then suggest that my claim that economies grow from demand, both in the short and long term, is a mere statement devoid of a theory. Of course, you will pardon me if I did not, in less than 1,500 words, write a complete theoretical treatise on the economics of aggregate demand. But there is a vast literature on this topic, with which you are familiar I am sure, and well-developed theories, with considerable empirical support to buttress the argument.

But why are you so dismissive of Keynesian policies? The problem here, I believe, is your interpretation of what consists of Keynesian aggregate demand policies. Twice now you mention Keynes’s assertion that we should bury bottles full of banknotes as representative of Keynesian policy. My dear Steven, Keynesian economics is much more than that, and to isolate that sentence as representative of Keynes is both misleading and, well, dishonest. Keynes of course said much, much more, and Keynes was being more sarcastic than anything.

In fact, Keynes was clear, a bit later in the same often-quoted passage, that “It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing” (GT, p. 129). Did you not read that part of the General Theory?

Keynes’s message was that ideally, it would be better to build houses, or roads and bridges than to do nothing, the latter condemning us to misery and, yes, the tyranny of the markets. Keynes’s point about the bottles is that even something as silly as that would be better than doing nothing.

I suspect your insistence of that quote as an example of Keynesian economics is perhaps more sinister, knowing full well of course that the population would instantly be opposed to the silliness of that policy. So you must admit, there is some treachery afoot in your argument. If we are to have a dialogue, you cannot reduce the Keynesian edifice to ‘wasteful projects’. I know that you know that Keynesian economics is more than digging holes: there are large infrastructure projects and public investment. I suspect if we explained to the masses that Keynesian policy is about infrastructure, investing in the future, social justice and building civilizations, then I am convinced that they would see the wisdom residing within it.

Now regarding that ‘piece of arithmetic’, which you call the Y = C + I + G + (X – M), I am afraid that is simple national accounting, no more no less. But more than that, for me it is a point of pure logic: when consumers, private firms or governments spend, that increases the demand for goods, which firms must produce. Please, tell me where the flaw in that logic is? And when the private sector is incapable or unwilling to spend, governments must above all step in to sustain that level of demand, which will be hopefully met by the private sector producing.

I was struck at how different we interpret history, and recent history at that. I must admit I am at a loss for words. Keynes once famously said, “When the facts change, I change my mind. What do you do, sir?”, but I fear that no matter what I say, or in fact anything you read anywhere by anyone won’t change your mind. I think perhaps if you got away from digging holes as representative Keynesian policies would be a good start.

In closing, let me address what I consider the biggest lie in economics at the moment: the idea that reductions in government spending will lead to higher economics growth. This is pure theoretical poppycock. For instance, in Europe, it has proven to be disastrous. Austerity never works. After a few years of austerity, Europe is no closer to sustained economic growth as before. For instance, in France, after imposing several fiscal cutbacks, the government expected deficits of 2.2%. Austerity now translated into deficits running at double that, at 4.4%. This is because of that piece of arithmetic: austerity leads to depressed demand and economic activity that then deflates the entire system, more proof that demand is what matters. Policies based on supply do not work, never work, and never shall work. It is pure fantasy to believe that anything but demand is the driving force of economic activity. So we may not all be Keynesians now, but the real world is, and it operates along lines described by Keynes and Keynesians. And the General Theory, while written over 75 years ago, like you point out, remains to this day the best guide to successful macroeconomic policy we have. Granted, it needs updating, but the basic logic of the book is as relevant and as important today as it was back when it was published.

You say that what we need is value-adding production, and not just building brick walls as you put it. I completely agree. But, my dear Steven, that is what Keynesian spending does: by contributing to infrastructure building, by contributing to crowding-in, it value-adds to society.

In conclusion, the empirical evidence is squarely on the side of Keynesian economics and the importance and vital role of aggregate demand and the State. To advocate for free markets under the illusion of the efficiency dogma is pure nonsense and self-delusional. As Keynes said, that would be disastrous if we tried to apply it to the facts of experience. The real world is government by Keynesian laws, and any attempt to deny and interfere with those laws can only result in more hardship.

Finally, let me leave you with this wonderful quote by Keynes: “the man who regards all this [public expenditures] as a senseless extravagance which will impoverish the nation, as compared with doing nothing and leaving millions unemployed, should be recognized for a lunatic.” (Collected Writing, Volume XXI, p. 338).

Best wishes,

Louis-Philippe

——

What is the defence against Keynesian theory

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.

Debating Keynes – part 2

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.

Debating Keynes

The single most timely piece of economic writing I ever managed to put together was for Quadrant which was published online in February 2009 just as the various stimulus packages were being rolled out across the world. The title it was given, much more aggressive than I might have chosen myself, was The Dangerous Return to Keynesian Economics. And while the whole thing could have been written today without the need for a single change to bring it up to date, the passage I have quoted time and again is this:

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.

Keynesian economics is, was and always will be a disaster wherever it is applied. That virtually no one understands why that is after three generations of economists have gone through their economics education with standard Keynesian macro at its core is to be expected. What is far less expected is that there has been no serious effort to examine more closely what went wrong after the failures of the stimulus.

As it happens I am at the start of an online debate with Louis-Philippe Rochon, Associate Professor of economics at Laurentian University, the founding co-editor of Review of Keynesian Economics and co-editor of New Directions in Post-Keynesian Economics which is an Edward Elgar book series. One presumes that if anyone can defend Keynesian economics he is the one to do it.

I, however, have been the one to open the batting. Keynesian economics has so many different disguises that unless I could narrow the lines of the debate to within some kind of practical dimensions there would have been no hope of limiting the range of where such a conversation might end up. Elgar has now published the first of these exchanges, How to Promote a Global Economic Recovery? The Keynesian vs. Free Market Approach. Crucially, the delimiting of the debate was the first essential. I therefore began with this:

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

What I can tell you from personal experience is that the notion of aggregate demand as a driver of economic activity is now so universally believed that it is nearly impossible to get anyone even to see that it might possibly be wrong, that there is another way of thinking about things. But before Keynes came on the scene, no economist, other than a handful of cranks, ever thought that economies were driven from the demand side. What they believed instead was this:

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

This is the classical pre-Keynesian view of how an economy works and why a stimulus never will. That the classical theory so perfectly captures the economics world we see around us should at least make someone stop and think about the macroeconomics we teach. There should therefore have been at least some consideration that giving politicians and public servants the power to direct such large proportions of our economic resources could not possibly have improved economic outcomes but would only make conditions worse. These are people who, except in the rarest of circumstances, have absolutely no ability to direct a productive enterprise in a value adding way, as they have shown at every turn. It has therefore been astonishing to see that thus far there has been virtually no re-consideration of Keynesian theory and the policies it underwrites, given the evident failures of the stimulus everywhere it has been introduced.

In a week’s time, Louis-Philippe will provide his reply to what I have written. I will naturally post what he writes since I am extremely curious to find out whether there is something I have missed, some bone-crunching reply to the issues I have raised. Although I have looked everywhere for some such reply, thus far I have found nothing, but we shall see.

Obviously, my arguments cannot be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader. There is literally nothing else like it anywhere, which is itself a large part of the problem we have.