Reflections of a Neo-Liberal

Reprinted from Quadrant – April 2009. The story is basically that you can count on socialists to revert to type on the very first occasion they find. More famously stated as “never let a crisis go to waste,” which means, never miss an opportunity to socialise the economy a bit more whenever the opportunity arises. This is about Kevin Rudd’s self-revelation following the GFC after being elected as a fiscal conservative. What follows below is a full reprint from the magazine.


It is quite astonishing to come across the economic and political philosophy of a prime minister and find that a self-described economic conservative turns out to be anything but. After years of seeing the phenomenal success of market-based economies in comparison with all other varieties of economic organisation, and having watched the fall of the Berlin Wall not all that long ago, there is a frightening recognition that amongst some people, nothing much at all has been learned. The same ideas that have populated and driven the Left for the past two hundred years just seem to come out of the woodwork at the first sign of an economy in trouble.

Let this be understood about free market economies, and every other kind of economy for that matter in the modern world. All are subject to the business cycle. Economies have periods in which everything goes well and there are periods when they seem to fall apart. The business cycle was the name once used by economists for what is now called macroeconomics. But that earlier term had the added benefit of actually stating out front what can and must be expected in any and every market-based economy. Economic activity is cyclical. There will be periods of recession when economic growth slows and may even become negative, and during such periods unemployment will rise.

It is another one of the many problems brought into the world by Keynesian economics that a proper understanding of the nature of the business cycle has almost disappeared. According to Keynes and those who have followed along since, because we had supposedly finally learned the secrets of aggregate demand, the business cycle, in particular its recessionary phase, had become a thing of the past. We could now control the level of activity by maintaining the level of aggregate demand through raising public spending when recessions threatened. As a result, even amongst economists there is no longer the degree of recognition there had once been that recessions are an inevitable feature of economic life.

There is, moreover, only a single known way to avoid recessions. One can run an economy with little growth and next to no change, an economy in which everything stays pretty well as it always was. It is possible that North Korea and Burma have economies that are recession-proof, but they are hardly a role model for us or anyone. If we are going to have the tremendous benefits that come from constant change, innovation and invention, we are simply going to have to accept that every once in a while the economy will turn down, just as it did in 1975, 1982 and 1992, merely to pick dates more or less within the thirty years the Prime Minister has cited as the horror years of neo-liberal capitalism. And what is notable about those dates is that one has to be one of those rare students of the business cycle even to remember those years as having been especially bad.

For most people, those particular downturns have for all practical purposes disappeared from conscious memory, although I expect the current downturn will be of a different historical character. But what the present recession will share with all of its predecessors is that one day, and not all that long from now unless we really do mismanage the downturn, even this current recession will also be a creature of the past while everyone busily gets on with rebuilding their wealth.

But in every such downturn we find ourselves confronted with visions of salvation that have a common character and which seem to reappear almost the moment an economy finds itself on rocky ground. And with a certain kind of inevitability, these visions are based on the belief that it is the government that can save us from such periods of instability by spending our money for us before we can spend it ourselves, by running through our national savings and putting us into collective debt, by taking on a greater role in the allocation of finance through greater control of the banking and financial system, and by regulating the private sector so that there is almost nothing of any significance a firm can do without some government bureaucrat having the right to second-guess its every decision.

These beliefs appear to be shared by the American President as well, which makes it seem that there is something in the air that has affected the times we live in. It is one thing for such beliefs to be held by small groups disgruntled with life, but it is quite another when these same beliefs are held by those at the pinnacle of our political structures.

Since there is always a suspicion amongst some proportion of the population that running a business is in some vague sense disreputable, that business profits always come at the expense of the poor and the disadvantaged, and that there are so many external forms of harm caused even by the normal operation of commercial activities, there is always a constituency of varying size for such beliefs.

Yet these are beliefs that will themselves cause great harm the more they become entrenched as the basis for political action. The discovery of the market and its power to provide for our material wellbeing is really only some 250 years old. It is, as these things go, a new idea, similar in its age to democracy itself, the political counterpart to the market economy. And given the transformation that capitalism has brought to our material wellbeing, it is plainly astonishing that there are still large numbers who want to overhaul and dismantle what has clearly worked so sensationally well, and put in its place some form of centrally directed economic system in which those who hold political power hold immense amounts of economic power as well.

“The Global Financial Crisis”

The Prime Minister has written a tract on political and economic philosophy with the title, “The Global Financial Crisis” (Monthly, February). The first paragraph gives some sense of what’s in store:

From time to time in human history there occur events of a truly seismic significance, events that mark a turning point between one epoch and the next, when one orthodoxy is overthrown and another takes its place. The significance of these events is rarely apparent as they unfold: it becomes clear only in retrospect, when observed from the commanding heights of history. By such time it is often too late to act to shape the course of such events and their effects on the day-to-day working lives of men and women and the families they support.

Kevin Rudd has obviously gone into the future to look back at today from these historical commanding heights so that he can already foretell how years from now we will retrospectively be interpreting our current economic events. History has changed and we can confidently look forward to the days when we will be able to look back and finally recognise the new world that was being created while we ate, slept and went about our business.

The election of Kevin Rudd was, however, not some world historical event. On the other hand, the election of Barack Obama may have been just that. We may well have entered a different stage of history with a different ruling orthodoxy of which Obama’s elevation to the presidency is the consequence, and in the fullness of time he may yet become the active agent of change. Whether this is a good thing, I have very serious doubts. Not all change is for the better, and some changes make things decidedly worse.

The question of the moment is whether Obama’s presidency, like Jimmy Carter’s, will end up reminding the American electorate why it is that their prosperity is bundled up in the existence of free markets, or whether instead, some other less market-oriented form of economic arrangements will take the place of our present structures as the preferred means of managing our economic affairs.[1]

Market-based economies are, after all, the only economic system that not only can provide us with the extraordinarily high standard of living we enjoy but is also the only economic system consistent with personal freedom. It is true that many people do get tired of having to look after themselves all the time. It is a great burden. But if they believe anyone else can and will look after them, they are in for a great and dismal surprise.

Political Economy

The economic world we inhabit in the West developed out of the political changes that took place during the seventeenth and eighteenth centuries, although the roots are much older and should be traced back through ancient Greece. But it was not until perhaps three to four hundred years ago that personal freedom and individual liberty became important values within certain populations mostly found amongst nations bordering on the North Atlantic. The essence of these revolutionary ideas was that all of us individually should be recognised as having rights to pursue our own chosen course in life. These were radical ideas in places where the standard political philosophy was based on the divine right of kings. They are still radical ideas in a very large part of the world even now.

Closely related to these political developments was the emergence of the concept of economic freedom. The market economy was itself something of a newly emerging phenomenon. Almost all production was local and related to the agriculturally-based economies of the time. The genius of the early Physiocrats and then of Adam Smith was to recognise the emergence of markets as the means through which output would and should develop and the recognition that this held immense advantages in making economies productive and protean in the face of changing demands. The passage which has remained justifiably famous is the one in which Adam Smith explains in the plainest English how a market can be expected to work:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.

Is this cynicism or plain good sense? Should economies be forms of charity,[2] or should they be self-sustaining organic structures in which all persons provide for themselves by producing what others want, then exchanging what one has produced for money, and then using the money received to buy the goods and services others have put up for sale?[3]

Nothing said by Smith nor by any other economist would even remotely suggest that such an economic system, a system dependent on free individuals and personal responsibility, should be an unregulated lawless jungle. But what he and others did say was that making individuals responsible for their own economic rewards would set in motion an economic process that would cause the momentum of economic growth to accelerate and the average level of prosperity to rise.

Has any other social philosopher ever said anything more accurate or important than this? Has there been any other single instance in the whole of the social sciences in which a proposal has been shown to have been as true as this one?

Leaving things to the market means leaving things in the hands of civil society. It means leaving decisions on what to produce and how to produce and where to produce and when to produce and who to hire and who to fire and how much to pay and all of the rest of it—it means leaving such decisions to any and all individuals who decide to try their hand at production for others.

Anyone who produces must, of course, do so within the laws of the land, and not just within the letter of the law but also within its spirit. But what is important is that no one in government chooses who will run our businesses, nor do they decide which businesses will receive finance and which ones will not. All of this takes place within the community itself. In healthy economic environments, such decisions remain almost entirely out of the reach of government influence.

This is partly economic, but is also partly political. On the economic side, in a productive economic environment, no one needs to get anyone’s official permission to start a business. There may be paperwork to be dealt with, and on other occasions the processes may be more difficult. But the terms of compliance are found in legislation. In properly managed market economies, fulfilling whichever are the legislative conditions takes hardly any time and is all that needs to be done.

In this way, Bill Gates started Microsoft, an enterprise that was, not all that long ago, a very small microbusiness. This was not the “People’s Computer Company”. In starting the business, no one had to be related to anyone with political connections. No bribes were paid. It was just a matter of filling in some paperwork and the show was on the road. How many other firms just like Microsoft were started at the same time that have now disappeared? How many have been started since? The point is that all such firms were nothing other than the result of a private decision by private individuals to start a business to see where it might go.

This is how, in part, innovation and technological change take place. It happens because we live in a society that encourages individuals to try their hand at business and to take on the risks and responsibilities of running their own firms. It is a society that teems with commercialised ideas. We are all the beneficiaries of such activities.

But as important as are the economic benefits, the political benefits are perhaps even more important. In a community of free individuals who produce and trade amongst themselves, the government cannot threaten anyone with economic deprivation if they do not toe the government’s line. The freedom of individuals is in large part dependent on their freedom to earn a living and go about their lives without having to worry whether they have offended the government of the day.

We no longer worry as much as we should about concentrations of political power. And with each passing year we seem to worry less and less about putting ever greater economic power into the hands of governments. A diffusion of political power was once understood as an essential if personal liberties were to be preserved. The nature of the problem does not seem as well understood as it once was and therefore the need for such diffusion is not understood as well as it once was.

The Prime Ministerial View of the Current Crisis

So to the Prime Minister’s article. Here we find a polemic on the evils of the capitalist system as it exists today. It is an imaginary system, bearing little reality to the world in which we actually live.

The article is 7700 words long. No précis can give any more than a taste of how extreme the language is and how misconceived the thoughts. He has invented a villain, the neo-liberal, whose demise is now the mission the Prime Minister intends to hasten. The Prime Minister apparently believes that those on the other side of the political fence, the neo-liberals of his imagination, “fundamentally despise” the state and its role. He apparently believes that in the view of such neo-liberals, “government activity should be … ultimately replaced, by market forces”. He takes it as read that these neo-liberals have “sought, wherever possible, to dismantle all aspects of the social-democratic state”.

To capture as least some of the rhetorical overdrive, I reproduce the two insert quotes displayed in large print across the page. The first:

The great neo-liberal experiment of the past 30 years has failed … the emperor has no clothes. Neo-liberalism, and the free-market fundamentalism it has produced, has been revealed as little more than personal greed dressed up as an economic philosophy.[ellipses in the original]

And then there’s this:

The stakes are high: there are the social costs of long-term unemployment; poverty once again expanding its grim reach across the developing world; and the impact on long-term power structures within the existing international political and strategic order. Success is not optional. Too much now rides on our ability to prevail.

We are here not discussing whether some policy or another might make the economic system work more effectively. This is not about whether there ought to be a stimulus package and if so, how it ought to be structured. This is beyond the technical side of economics and into the realm of good and evil. It is a psycho-drama in which Frodo and his mates take on Gollum in a bid to save the world.

Bits of Analysis

Not that there aren’t a few actual discussions of some of the causes of our present problems. The most lengthy deals with the Glass-Steagall Act passed into law by the American Congress in 1933 at the lowest point of the Great Depression but repealed in 1999 at the pinnacle of the dotcom boom. Its objective was to keep the banking function of financial institutions separate from their investment function. If you are a bank, you should not be investing in sharemarket equities. If you are an investment house, you should not be taking bank deposits.

There is now a strong case for putting those prohibitions back, but there are arguments to be made on both sides. But to mention the problems of the banking system without also discussing the most egregious of the banking problems to have beset the American economy leaves out the single most important part of the story. The major distortions in the American financial system, and the single most significant distortion in bank regulation in causing the boom to finally descend into bust, were the directions given by Congress to the American finance industry, and particularly to its federally legislated arms, Fannie Mae and Freddie Mac, to provide housing loans to those who would not normally qualify.

This is government failure of the highest order. A banking institution needs to be prudent in its lending practices. For a government to insist that banks and other lenders ignore what their balance sheets tell them is to create the conditions for just the kind of downturn we find ourselves in the midst of. A bubble is in essence activity financed by rising asset prices. The moment prices of such assets stop rising, an actual collapse in prices looms into view. The more that prices have been bid up by considerations of speculative future gains, the greater the subsequent fall. It was the flooding of money into the housing industry under government directive that caused this problem and has directly led to the painful readjustments which must now take place.

The Prime Minister also points to what he sees as the inadequate institutional structures designed to assess risk. The Basel II Guidelines, he wrote, “have now been demonstrated to be inadequate because they left the determination of risk to flawed credit-ratings processes and the banks’ own ‘self-regulated’ internal assessment models”. What point is being made? Is it not perfectly clear that all credit-rating processes are flawed? No one can design a perfect credit-rating system, proof against all forms of market instability, since no one can ever know everything that needs to be known. By all means, come up with a better design if you can. But to believe that governments can guarantee the safety of an investor’s money, and in the place of such necessarily imperfect market-based institutional structures introduce some government scheme that will prevent mistaken decisions from being made, never mind put an end to out-and-out criminal activity and fraud, is, to put it mildly, an impossibility.

Lessons from the Downturn

We can argue the toss over the forms of bank regulation, the role of sub-prime mortgages, the inadequacies of risk-assessment institutions and any of the other issues raised by the Prime Minister.[4] They will undoubtedly be debated for decades to come. The lessons to be learned from the present downturn are only at the start of an extended series of analyses that will stretch well into the next upturn and beyond. But there are two issues that need serious consideration, with more urgency given the policy options that have been chosen to deal with the present downturn.

The first is the American budget deficits which have been in place since the start of the decade. There has been no end of concern by “neo-liberal” economists at the loose spending and flood of liquidity that has occurred in the United States which began as an economic counterweight to the ending of the dotcom boom and then accelerated as a means to maintain economic momentum after 9/11. However well meant those expenditure policies were, they were mistaken.

But what allowed those deficits to occur without major dislocations in the United States was the economic role played by China. The American deficits were in large part used to finance Chinese imports. Under any normal scenario, the yuan would have rapidly risen relative to the US dollar and the imbalances would have been at least partially righted. Instead, the dollars that flowed into China were invested in American securities with the exchange rate largely unaffected. The Chinese had their own economic motives, which possibly included a wish to protect themselves against some future downturn just like the one we are presently in. But what can be said about the United States? If ever there was a bubble set to burst with devastating consequences, that was the one.

The real lesson not apparently learned are the dangers of the budget deficit. The US dollar, being the world’s most important reserve currency, has an acceptance available to no other nation’s money. Whether with the present size of the projected deficit the US dollar will any longer be the currency of choice remains to be seen. But in the meantime, the deficits initiated a problem that we are going to try to solve by making the problem of the deficit infinitely worse than it already is.

The Keynesian stimulus packages we see everywhere are an invitation to an even more unstable economic future. There is very little in what we see that ought to make anyone believe that the answer to past government failures is to increase the range and depth of such potential government failures in the future.


But the second issue is by far the more important. That is the problem of complacency. The world’s economy has had it so good for so long that the kinds of internal mechanisms that normally pervade all economic and financial dealings seem to have weakened and in many important instances to have all but disappeared. Beyond that, many of the forms of retribution that the market is supposed to mete out for failure have been muted and on some occasions entirely suppressed.

The most important deficiency that has slipped into the financial system over recent times has occurred because of its phenomenal success. That success has beguiled far too many into the belief that even without doing their homework everything will work out and where it does not, the government will put things right. This is a fatal mistake. And the more it is believed the more frequent will be the kinds of downturn we are now in. The government has a crucially important legislative and regulatory role to play, but the bottom line is this. The only form of regulation that works, and has ever worked, has been dependent on the self-interested controls imposed by people who are acutely aware that their own personal wealth is perpetually at risk.

Much of what a government can be expected to do occurs after the fact, when regulators look at what has already happened and at breaches in the law that have already taken place. Laws make certain practices illegal, they do not put an end to illegal practices. The legal system must take the side of our financial institutions in ensuring that the rules of the market system are strictly enforced. In doing so, the legal system must be explicitly on the side of a smoothly functioning market capitalist system and there should be no bones about it. Allowing markets to work should be the cornerstone of the government’s role in creating prosperity.

The evolution of the capitalist system has occurred side by side with the evolution of legal and institutional structures. The role of commercial law is to give all members of the community the opportunity to produce goods and services for each other without fear of plunder either by brigands or by the state. For the capitalist system to work, protections are needed from both.

Government Failure

From the Prime Minister’s perspective, it seems the most important figure in the organisation of production ought to be the central planner. Based in some remote location, Canberra let us say, it is such planners who should be asked to direct our economic traffic in ways that best suit the whole community, which in reality can only ever mean directing traffic in ways that suit themselves. For us descendants of Adam Smith, however, the single most important character in the drama of prosperity and economic growth is the entrepreneur. It is entrepreneurs, taken collectively but acting individually, who do all of the work such planners would do in assessing community needs, securing finance, locating the business, putting capital in place, hiring labour, buying inputs and paying the bills. And not only do they rid us of the need for central planners, they do so with infinitely greater effect than could ever be achieved by some government employee, which is all that such planners can ever actually be.

The Prime Minister tells us that he is going to remake our economic system. He writes with the kind of certainty no one can actually have:

The magnitude of the crisis and its impact across the world means that minor tweakings of long-established orthodoxies will not do. Two unassailable truths have already been established: that financial markets are not always self-correcting or self-regulating, and that government (nationally and internationally) can never abdicate responsibility for maintaining economic stability. These two truths in themselves destroy new-liberalism’s claims to any continuing ideological legitimacy, because they remove the foundations on which the entire neo-liberal system is constructed.

Both of these “truths”, to the extent they actually say something that has not been known for at least two hundred years, imply that we will see the introduction of a regulatory environment much different and more intrusive than the one that has existed in the past.

The Prime Minister is going to fix our economic and financial problems with more regulators and new regulations. He will put in place an entire new phalanx of public sector busybodies who will mess with our lives and undermine our productive capabilities. He is under the impression that it has been the unconstrained activities of profit-making enterprises that have been responsible for our troubles. Well, that is one view. Here is another, and it’s from John Taylor, the author of the Taylor Rule used by central banks across the world to guide their interest rate adjustments, writing in the Wall Street Journal:

Many are calling for a 9/11-type commission to investigate the financial crisis. Any such investigation should not rule out government itself as a major culprit. My research shows that government actions and interventions —not any inherent failure or instability of the private economy—caused, prolonged and dramatically worsened the crisis. (Wall Street Journal, 9/2/09)

Well then, how about something closer to home. A year before the economy went into its downward turn, we had the Reserve Bank along with the Prime Minister and Treasurer going on and on about how the inflation genie had been let out of the bottle and how it was an unfortunate necessity to be raising rates to cool the economy down. Yet even then—and we are talking about a policy that continued from November 2007 through to the middle of 2008—it was becoming very clear that the economy was slowing, not overheating. How much more mistaken in hindsight could this policy have been, to try to slow an economy that was about to plunge into recession?

Are these the people we want to be adding to their portfolio of tasks? Do we really want to increase the government’s role in micromanaging our economy when it can so badly misread every international warning light that was then flashing in neon red? Who is the Prime Minister to tell us we need even more of his handling of the economy with all of its intricacies when he cannot even work out whether the economy is heading up or heading down, the most basic of all questions anyone with a mandate to keep an eye on economic conditions needs to get right?

The Stimulus Package

Now we are into a new and different panic mode, this time to provide a “Keynesian” stimulus to minister to our suddenly worsening economic prospects, a downturn having in large part been brought on by the monetary policies of the year before. And with this $42 billion package we are heading deep into deficit. We are racking up massive levels of debt in a previously debt-free economy. And for what? To insulate our houses and build new libraries for our schools.

The stunning lack of imagination is possibly the most astonishing part about the stimulus. Even if I thought it would do some overall economic good, which I don’t, are these really the priority issues for the country? Is there really nothing better we can throw $42 billion at? For all the Prime Minister’s criticisms of neo-liberal economists, is this really the best we can do?

The idea that building better schools will add to Australian productivity in anything other than the longest of runs is one of those nonsensical ideas that have been bequeathed to us by Keynesian economics. According to Keynesian theory, it is the spending itself that supposedly causes growth, not the value created by the outputs of the economic activity. We will chew up many billions of dollars of existing value to improve our schools, but when will we get the payoff? Even if we ultimately make every one of our sixteen-year-olds 20 per cent more productive because of all this expenditure, when is the soonest we can get the productive dividend? In twenty years, perhaps, but no sooner than ten.

In the meantime it is money spent that adds nothing to our productive capacity while adding huge amounts to our national level of debt. Not till those sixteen-year-olds are out there in the workforce and pulling their economic weight will we have the additional wherewithal to pay off the debts we are accumulating now. Until then, we pay the billions of dollars of interest. And that, of course, assumes we actually do end up making our workforce more productive because of these outlays today.

It is pointless to go on. If you are of the opinion that we can make ourselves richer by having each of us write ourselves a cheque, then there is nothing more to be said. Perhaps we have become so wealthy that we can take a huge proportion of our annual output and sink it into the sea without serious misadventure. But however you look at it, that is what is happening. We are taking our productive capabilities and directing them into dead ends and dark corners. It is a terrible waste. If you really were worried about the poor and the disadvantaged, the low-paid and the unemployed, this is not how you should go about giving them jobs, adding to their wealth and improving their lives.

Governments tend to like Keynesian economics because it gives them the answers they want to hear. So until that eventual day of reckoning, and that day of reckoning will eventually come, it is unfortunately the only kind of advice to which governments are likely to listen.

Dr Steven Kates teaches economics at the RMIT University in Melbourne. He will be completing his term as a Commissioner on the Productivity Commission this month. He is currently writing a book, Defending the History of Economic Thought, which will be published in 2010.


[1] Obama’s stimulus package is breathtaking in its potential to cause damage. We will know soon enough whether massive deficits and immense levels of government waste are the answer to an economy in recession.

[2] Smith’s very next line reads, “nobody but a beggar chuses [sic] to depend chiefly upon the benevolence of his fellow-citizens”. In the welfare state there are many who now do precisely that, depend for their livelihoods on the benevolence of their fellow-citizens.

[3] Just for completeness I note that it is possible to buy before producing and earning an income. That is what credit markets allow people to do. But it will only happen if those who offer credit have a realistic belief that the goods and services that will be bought when the loans are repaid with interest will actually be produced in time to meet the new expenditure. Basically, however, goods buy goods through the intermediation of money.

[4] I should add one more, which is somewhat esoteric but is now an area of quite some debate. These are the “weak and defective” mark-to-market accounting rules that have been imposed on business by government decision (p 24). There are some who believe the deflation in the American economy will continue well into the future unless these rules are reversed which only the government can do.

The wages of economic sin

The disconnect between the stimulus and our subsequent problems seems ever-present. You spend money on waste – school halls, pink batts, NBN, green technologies – and the result is a draining of productivity into the swamp. Real wages cannot rise if you do not increase our ability to produce the goods and services those wages are intended to buy. Here’s the latest news:

The growth in wages in the private sector is at a record low and is forcing workers to lower their expectations.

The 2.2 per cent increase over the past year recorded by the Australian Bureau of Statistics will not surprise those workers experiencing real wage cuts because employers have imposed temporary pay freezes or granted below-inflation salary rises.

The funny bit about wages is that no one has to do anything in a market economy to raise real earnings when the economy is going well. The competition for good employees does all the work for them. Unions can raise wages in some areas by killing off parts of an expanding industry, but overall wage rates remain almost entirely untouched. It is national productivity that matters, and we haven’t seen it grow in a while.

It may make everyone warm and fuzzy to pretend to be doing something about unemployment by some kind of Keynesian stimulus or helping the environment by promoting green (ie very expensive) energy. But reality is all too real. We have squandered billions and now cannot afford the incomes we once did.

Policy in the pub

krugman and me july 2015

I will be debating the Chief Economist of the National Bank on Stimulus versus Austerity on August 19 at the Imperial Hotel in Melbourne on the corner of Spring and Bourke @ 5:30. These are the notes I am putting together, which will be added to as I go along. The picture is, of course, myself with Paul Krugman on 12 July at Freedomfest in Las Vegas. We were obviously separated at birth.

Using the term “Austerity” as the noun meaning sound finance and fiscal prudence already tips the debate, both here and internationally, in a negative direction

Back in the 1990s, before their ill-fated stimulus, I sat next to the Japanese Finance Minister at a lunch where I told him not to do it. His reply – “Don’t you care about the unemployed?”

I teach non-Keynesian economics and those who have never done economics before get it and those who have studied Keynes already find it difficult

Keynesian economics is a cult – believed in spite of the fact that it makes no economic sense and has never actually worked in practice

What’s the matter with you people?

The GFC was not, obviously, caused by a failure of demand. It was not caused by too much saving. In America, it was the product of a crash in the housing industry that fed into its financial system. In the rest of the world, the problem was entirely financial, with credit frozen across the globe.

The answer was the TARP which unfroze credit. The subsequent stimulus was not only unnecessary, but positively harmful.

See my Quadrant article from February 2009: The Dangerous Return to Keynesian Economics.

I also wrote my Free Market Economics, now in its second edition, to explain why the hysteria surrounding the GFC was misplaced and the stimulus would be a disaster

The notion of a “stimulus” is, of course, Keynesian. Economic theory always accepted a role for public spending as a palliative. No one thought of spending as a cure.

The idea of a stimulus is based on the belief that economies enter recession because there is too much saving. The government must therefore enter the picture and put those savings to use if the economy is not to enter a long drawn out recession and unemployment is to come down in a reasonable period of time.

The belief is that government must put those savings to work asap, even if the form in which the spending takes place is not in itself value adding. Even if the initial spending is not value adding, the multiplier will do the work of ensuring that the rest of the expenditure is properly based on profit-making activities.

The basis: Y=C+I+G. If C and I fall, G is raised to replace the missing expenditure.

C, I and G are final demand. The rest of the economy, the hinterland behind final demand, is ignored. It will simply structure itself to conform to whatever is being bought at the end of the production trail. Eventually everyone will be employed if there is enough spending on final goods and services.

Let’s take Bronwyn Bishop’s helicopter ride. It would be ludicrous to defend it as a way to stimulate demand. She could not claim that with a multiplier of three, let us say, she has added around $15,000 to GDP.

No one would think it would make sense if the Government said that every ministerial journey between 50 and 200 kms had to be by helicopter as a means to create jobs. We can all see straightaway how government waste of this kind has no positive economic effects.

Suppose we heard that entrepreneurially-driven construction activity with no government subsidy was to double over the next ten years, would we not all agree that the economy would be bigger and stronger at the end of that time, more jobs would be created and real incomes would rise.

But suppose, instead, we heard that over the next ten years there would be twice as many meetings of the Economic Society and the number of journal articles would double. What then would be the effect on output and employment, do you think?

Record 93,770,000 Americans Not in Labor Force…
Participation Rate 38-Year Low…
Record 56,209,000 Women Not Working…

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.

Paul Krugman has no idea what Say’s Law means

In the same week that the 2nd edition of my Free Market Economics has been published, which I began specifically in response to the stimulus that followed the GFC and the certainty that it would fail because of the principles that underlie Say’s Law, I have received copy of a review of a book titled, Seven Bad Ideas. The book is by Jeff Madrick while the review is by none other than Paul Krugman. And here once again we find Say’s Law, as the second worst idea in economics, just after the number one bad idea, “the invisible hand”. If you think the invisible hand is the worst idea economists have ever come up with, you are near enough not an economist, more a charlatan but then he has the Nobel Prize so who’s to argue. This is what Krugman thinks the invisible hand means amongst economists:

Today the phrase is almost always used to mean the proposition that market economies can be trusted to get everything, or almost everything, right without more than marginal government intervention.

What “everything, or almost everything” might consist of is a quite bizarre notion. The reality is that no one thinks an economy will run without institutional intervention at almost every facet of an economy’s operation. Every economist is perfectly aware of the absolute necessity of an institutional structure, much of it at the hands of government, and much of it based on legislation and regulation. There are debates about the sorts of regulation needed and the kinds of legislative penumbra that has to surround an economy. But the notion an economy requires only “marginal” intervention is nonsensical and straightforwardly untrue.

But so what if there are economists who think this. The absolute reality is that every economy has regulation up to its eyeballs. If some of us think less regulation would be better is hardly evidence that the economy is doing poorly because of its absence. You would have to be utterly out to lunch to think the regulation of any economy in the world could be described as light-handed. There must be quite a few gullible types out there if the kind of statement that Krugman makes can carry any weight at all.

But it is the second supposedly bad idea that is an old story. It is what is known as Say’s Law which in its micro form states that demand is created by value adding supply and in its macro form states that no economy ever goes into recession because of a lack of demand and that an economy in recession cannot be resurrected by a stimulus made up of non-value adding forms of expenditure. The macro version condemns just the kinds of expenditure every single stimulus has consisted of. The issue isn’t crowding out. The issue is that public spending uses up more value than it creates. If you waste your resources, your economy will shrink. That is what has happened universally since the “stimulus” and Krugman has not a clue in the world what has gone wrong. Here is what he wrote:

No. 2 on Madrick’s bad idea list is Say’s Law, which states that savings are automatically invested, so that there cannot be an overall shortfall in demand. A further implication of Say’s Law is that government stimulus can never do any good, because deficit spending by the public sector will always crowd out an equal amount of private spending.

But is this “mainstream economics”? Madrick cites two University of Chicago professors, Casey Mulligan and John Cochrane, who did indeed echo Say’s Law when arguing against the Obama stimulus. But these economists were outliers within the profession. Chicago’s own business school regularly polls a representative sample of influential economists for their views on policy issues; when it asked whether the Obama stimulus had reduced the unemployment rate, 92 percent of the respondents said that it had. Madrick is able to claim that Say’s Law is pervasive in mainstream economics only by lumping it together with a number of other concepts that, correct or not, are actually quite different.

Economists can say all they like that the stimulus lowered the unemployment rate but the fact of the matter is there cannot be any actual evidence one way or the other. That the models used by economists almost universally say that a stimulus will reduce unemployment is of itself the only “proof” that it has. The logic goes:

Major premise: a public sector stimulus will reduce unemployment below the level it would otherwise have reached

Minor premise: most economies introduced a public sector stimulus

Conclusion: the stimulus reduced unemployment below the level if would otherwise have reached.

That is, A causes B. There was A so therefore B. There is no evidence since there are no controlled experiments. All this is by assumption only. Well two can play at that game.

Major premise: a public sector stimulus consisting of non-value adding forms of expenditure will keep unemployment higher than it would otherwise have been

Minor premise: most economies introduced a public sector stimulus consisting of non-value-adding forms of expenditure

Conclusion: the stimulus has kept unemployment higher than it otherwise would have been.

And the fact of the matter is that the American labour market has not returned to the level it was at in 2008. Unemployment is a disaster without the slightest evidence that matters are on the mend.

Paul Krugman has not a clue. He is stuck in that Keynesian bunkum from which no actual evidence from the real world will ever dislodge him. The American economy continues to sink because of the straight out ignorance of basic economics of pretty well the entire economics profession (approximately 92 percent). Nothing can be done about it in the short term, but the smug smarmy superiority in the face of the immense harm that he and his likeminded colleagues have caused makes me very angry indeed.

Krugman is obviously a hopeless case. But I will simply state that economic theory will never provide useful guidance during recessions until Say’s Law is once again seen as the fundamental principle it is. And if you are interested in what it means and why it matters, the 2nd edition of my Free Market Economics is the place to start finding out.

Where are the critics of Keynes?

I put the following post up at the History of Economics list the other day because it exactly reflects a problem I am having.

I am doing some work on Keynesian economics in the period following the Global Financial Crisis. It just may be that I do not know where to look but I am having trouble finding articles of any kind criticising Keynesian models and the theory behind public sector spending and the stimulus. Can anyone help?

And as an additional query, although Mises, Hayek and Friedman are seen as “anti-Keynesian” whatever that may mean, again there seems to be a dearth of articles by them critical of Keynesian theory as it relates to public sector spending and the stimulus. So again, can anyone help?

Responses both online and offline would be greatly appreciated.

There are other economic traditions, from Austrian to Marxist, but each keeps to itself without bothering to actually criticise explicitly what they think is wrong with Keynesian analysis. And for many of the traditions, public spending in recessions is the least of their aims in changing the nature of policy based on the theories proposed. And while there have been a number of useful suggestions that have been sent to me offline as well as discussed online, there is no great cache of anti-Keynesian material anywhere that anyone has been able to unearth.

It would be one thing if the stimulus had been a no-questions-asked success, or even a mid-level so-so success, but instead it has been the most abject failure with every economy struggling to untrack from the debt and deficits the stimulus has caused. So where are the critics?

The economics equivalent of Godwin’s Law

This is a correspondence that began on the Societies for the History of Economics (SHOE) website that originally dealt with wages and productivity. But as the thread developed, the issues drifted over towards Keynesian economics, and not I emphasise because of anything I had contributed. So on November 15, there was the following contribution which began with a quote from something that had been written by James Ahiakpor:

It was with much amusement that I read Michael Ambrosi’s comments. Amusement because I remain puzzled as to why some historians of economic thought can’t seem to shed their Keynesian beliefs in the face of analysis clearly contradicting them … I’m getting to the point of accepting that some people just can’t be helped with arguments or clarifications. It’s just a waste of time. Would that I did not encounter them in the academic refereeing process …

Following which the following question was asked:

There are ex-Marxists and ex-Keynesians: where are the ex-Austrians?

So on the very same day, I wrote the following response:

Rob asks an interesting question which I think is worth a thread of its own:

‘There are ex-Marxists and ex-Keynesians: where are the ex-Austrians?’

Austrian economics was one strand of pre-Keynesian classical economic theory but an important strand today since it is the only strand that survived the Keynesian Revolution. I don’t classify myself as an Austrian but as a classical economist which gives me an overlap of around 75% with the Austrian School and about 10% with modern neoclassical macro. And there is almost nothing in Mises and Hayek I ever find myself in serious disagreement with.

There are, no doubt, ex-Austrians but I suspect none of them end up in any of the modern strands of economic theory. I often mention Mill but a more modern and accessible version of the classical school can be found in almost any text pre-1930. My favourite for a variety of reasons is Henry Clay’s 1916 Economics: an Introduction for the General Reader but there are many to choose from. Haberler’s Prosperity and Depression published in 1937 moves you closer to the depth and breadth of the classical theory of the cycle.

I have for many years found Keynesian demand side analysis utterly wrong but where was the evidence? Now we have had a radical experiment in economic policy across the world and if it is not obvious beyond argument that a Keynesian stimulus will not work then I don’t know what conceivable evidence there could ever be that would convince anyone just how poorly structured the underlying Keynesian theory is. Y=C+I+G in my view and the view of many others provides no insights into either the causes of recession nor what to do when they happen.

There are therefore no ‘ex-Austrians’ in the same sense as ex-Marxists or ex-Keynesians because the world continues to behave more or less as we classical/Austrian economists expect it to. Classical theory does explain and it does provide policy answers which we are seeing put in place under the name of austerity as an attempt to restore balance after the Keynesian excesses of the past five and more years. Those who are taking this road are guided by intuition without textbook answers but are doing pretty well what a classical economist would have recommended. That is, they are doing exactly what the UK, Australia and others did to take our economies out of the Great Depression.

A series of responses followed this, some reply to Rob and others to me. But the largest complaint about what I had written was not about Keynesian theory but whether I had gone to far in stating that the failures of the Keynesian stimulus had been “obvious”. That the stimulus has made things worse in every economy it has been tried seems so self evident that I still don’t know how the obviousness of the mess the stimulus has caused can be question. Nevertheless, this is what I wrote in reply on 16 November:

I should not have said ‘if it is not obvious beyond argument that a Keynesian stimulus will not work etc etc’ since it is not obvious. But even here in Australia, where for a variety of reasons we probably experienced the least damaging downturn following the GFC, the general assessment is that the stimulus has left us with massive problems that will require a repair job going over many years. No one goes around talking about how well the stimulus turned out and even as unemployment has now returned to its post-GFC high and still heading north, our new government is attempting to cut spending and bring the budget into balance just as the previous government attempted to do. And on this we are not alone.

So it is not obvious what went wrong, merely a conundrum: this is what it says in the textbooks and this is what we feel we need to do. Why are they different?

Every economist seems to be in some ways eclectic. They put their own worldviews together built around one of the existing frameworks that for individual reasons appeal to themselves. And over time they shift and change as they learn more and observe. But with macro just about everyone starts from AS-AD which has now become a major dividing line. Keynesians versus Austrians is the way it is often portrayed but this is a short form which leaves out much of what is relevant.

But however you would like to describe the nature of this divide, we as economists should in my view be having some kind of in-house review on the relevance of AS-AD to the formation of policy. It’s true that AS-AD is a very seductive concept, not obviously wrong. But still, starting from casual empiricism and then working through the econometric work of Alesina, say, but also others, and with theoretical considerations also then brought into this discussion, alternatives to AS-AD might eventually emerge in our textbooks. In the meantime, ever fewer policy makers are willing go near AS-AD to work out what ought to be done in the real world. That much anyway is obvious. Given that our economic texts ought to be a guide to economic policy, all this should be seen as something of concern to the profession.

The only reply since then has been to say this:

If I may offer just one more quote from some people who care about the evidence. Jordà, Òscar and Alan M. Taylor, 2013:

The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy

[W]e have a measure of the multiplier that explicitly accounts for failures of identification due to observable controls. Our estimates … suggest even larger impacts than the IMF study when the state of the economy worsens. … It appears that Keynes was right after all.

As Steve now allows, it is *not* obvious that the fiscal responses to the Great Recession invalidate Keynesian claims about the role of aggregate demand. Not in the least.

To prove using a Keynesian model that Keynesian theory delivers the goods in the face of the massive disasters that ought to be the unarguable evidence that the US economy is sinking, only proves there are some people who cannot see because they will not see.

There really needs to be an equivalent to Godwin’s Law in economic discussion. Whoever is the first to bring empirical results into an argument about economic theory automatically loses.