What’s Wrong with Keynesian Economic Theory? 1785363735, 9781785363733

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What’s Wrong with Keynesian Economic Theory? Edited by

Steven Kates Associate Professor of Economics, School of Economics, Finance and Marketing, RMIT University, Melbourne, Australia

Cheltenham, UK • Northampton, MA, USA

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© Steven Kates 2016 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2016935802 This book is available electronically in the Economics subject collection DOI 10.4337/9781785363740

ISBN 978 1 78536 373 3 (cased) ISBN 978 1 78536 375 7 (paperback) ISBN 978 1 78536 374 0 (eBook)

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Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents List of figures and tablesvii List of contributorsix Introduction: what’s wrong with Keynesian economic theory? Steven Kates   1 The Keynesian liquidity trap: an Austrian critique Peter Boettke and Patrick Newman

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  2 What the entrepreneurial problem reveals about Keynesian macroeconomics26 Per L. Bylund   3 A critique of two key concepts in Keynesian textbooks Tim Congdon   4 The misdirection of Keynesian aggregates for understanding monetary and cyclical processes Richard M. Ebeling

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  5 Cycles and slumps in an overly aggregated theoretical framework92 Roger W. Garrison   6 The problems with Keynesianism: a view from Austrian capital theory106 Steven Horwitz   7 The dangers of Keynesian economics Steven Kates

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  8 The problem of Keynesian aggregation Arnold Kling

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  9 What’s wrong with Keynesian economists? Arthur B. Laffer

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10 Capital, saving and employment George Reisman

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What’s wrong with Keynesian economic theory?

11 What’s wrong with Keynesian economics? David Simpson

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12 Move over Keynes: replacing Keynesianism with a better model218 Mark Skousen 13 The conclusive fault line in Keynesian economics Peter Smith

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Selected bibliography251 Index259

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Figures and tables FIGURES   3.1 Growth rate of nominal broad money in the UK, 1964–2015 55   3.2 Growth rate of real broad money in the UK, 1964–2015 56   3.3 The savings ratio in the UK 64   3.4 Net worth changes compared with fiscal policy in the USA, 1998–201366   3.5 Net worth changes compared with fiscal policy in the UK, 1998–201366   9.1 Real GDP: recoveries indexed to NBER cycle peak = 100 166   9.2 Real GDP: Roaring Twenties versus Great Depression 167   9.3 Short-­term interest rates 168   9.4 Supply and demand: price below equilibrium 169   9.5 Supply and demand: price above equilibrium 171   9.6 Tariffs and duties collected as a percentage of all imports versus total trade (imports + exports) as a percentage of GDP174   9.7 Government spending as a percentage of GDP 175   9.8 Total government spending as a percentage of GDP 180 12.1 AS–AD curves showing equilibrium unemployment (Yu) and full employment (Yf)220 12.2 Increased government spending causes aggregate demand (AD) to increase to AD’ and move toward full employment (real GDP) 222 12.3 GDP and the four-­stage general model of the economy 226 12.4 US business spending and consumer spending, 2007–15 229 12.5 Percentage changes in business spending and consumer spending, 2007–15 230

TABLES   3.1 The National Institute’s forecast of UK output growth in early 1973, compared with the outturn

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  3.2 Changes in view (on six quarters to mid-­1974) from February 1973 to February 1975 issues of National Institute Review 59   3.3 The National Institute’s forecasting record in the Lawson boom61 3A.1 Changes in net worth, compared with fiscal policy, in the USA, 1998–2014 74 3A.2 Changes in net worth, compared with fiscal policy, in the UK, 1998–2014 75   7.1 Unemployment rates, 1929–38 128   8.1 The effect of government purchases on GDP 160   9.1 Top statutory tax rates: Great Depression versus Great Recession172   9.2 Top statutory tax rates: Roaring Twenties and Reagan Eighties173

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Contributors Peter Boettke is the Vice President and Director of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center as well as the BB&T Professor for the Study of Capitalism and a University Professor of Economics and Philosophy at George Mason University, USA. He specializes in Austrian economics, economic history, institutional analysis, public choice and social change. He has authored and co-­authored 11 books, his most recent being Living Economics (2012). He is also editor of the Review of Austrian Economics, series editor of the New Thinking in Political Economy book series, and co-­editor of the Cambridge Studies in Economics, Cognition and Society series. Per L. Bylund, PhD, is Assistant Professor in the School of Entrepreneurship at Oklahoma State University, USA, where he holds the Records-­Johnston Professorship of Free Enterprise. His research and teaching interests lie at the intersection of economics, strategic management and ­entrepreneurship, especially focusing on the organizational and institutional problem of ­production. His research aims to insert and embed entrepreneurship within the constant flux of the market process, primarily by using the open-­ended and uncertain production of value as framework and lens. Production thus lies at the core of his research, as it does in the real economy. Tim Congdon is an economist and businessman. He is often regarded as the UK’s leading “monetarist” economist, and was one of the foremost advocates of so-­called “Thatcherite monetarism” in the late 1970s and early 1980s. Although most of his career was spent as an economist in the City of London, he has been a visiting professor at the Cardiff Business School and the City University Business School (now the Cass Business School). He is currently a Professor of Economics at the University of Buckingham, where he has established a new research institute, the Institute of International Monetary Research (www.mv-­pt.org). His books include Keynes, the Keynesians and Monetarism (Edward Elgar, 2007) and Money in a Free Society (Encounter Books, 2011). Richard M. Ebeling is the BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel, in Charleston, South Carolina, USA. He is the author of Monetary Central Planning and the State ix

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(Future of Freedom Foundation, 2015), Political Economy, Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition (Routledge, 2010) and Austrian Economics and the Political Economy of Freedom (Edward Elgar, 2003), as well as the editor of the Selected Writings of Ludwig von Mises (3 vols, Liberty Fund, 2000–2002). He was previously Professor of Economics at Northwood University (2009–14), President of the Foundation for Economic Education (2003–08) and Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003). He received his PhD in economics from Middlesex University, UK and his master’s degree in economics from Rutgers University in New Jersey. Roger W. Garrison received his doctorate from the University of Virginia in 1981 and is now Emeritus Professor of Economics at Auburn University, Alabama, USA, where he taught from 1978 to 2012. He was a Postdoctoral Fellow at New York University in 1981. He was winner of the Smith Prize in Austrian Economics in 2001 for his book Time and Money: The Macroeconomics of Capital Structure. In 2003 he was named First Hayek Visiting Scholar at the London School of Economics (LSE), where he delivered its First Memorial Hayek Lecture. He served as President of the Society for the Development of Austrian Economics in 2004. His Austrian-­ oriented writings appear in Economic Inquiry, Journal of Macroeconomics, History of Political Economy, and Journal of Economic Education as well as in a number of conference volumes and reference volumes. Steven Horwitz is Charles A. Dana Professor of Economics at St. Lawrence University in Canton, New York, an Affiliated Senior Scholar at the Mercatus Center in Arlington, Virginia, USA and a Senior Fellow at the Fraser Institute of Canada. He is the author of three books, including most recently Hayek’s Modern Family: Classical Liberalism and the Evolution of Social Institutions (2015). He has written extensively on Hayek and Austrian economics, monetary theory and history, and American economic history. His earlier book Microfoundations and Macroeconomics: An Austrian Perspective (2000) explored what Austrian School macroeconomics looks like and how it differs fundamentally from the broadly Keynesian paradigm that has dominated economics since World War II. Steven Kates spent most of his career as the Chief Economist for Australia’s national employer association, the Australian Chamber of Commerce and Industry, and is now Associate Professor of Economics at RMIT University in Melbourne, Australia. His academic work since his discovery of Say’s Law in the 1980s has focused on classical economics, the pre-­Keynesian theory of the cycle, and the deep-­set flaws in modern macroeconomic theory and policy. He has written his own economics text, Free

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Contributors ­xi

Market Economics: An Introduction for the General Reader (Edward Elgar, 2nd edn, 2014), which recasts classical economic theory for the twenty-­first century. His doctoral thesis was published in 1998 as Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way, and in 2013 he published Defending the History of Economic Thought to highlight the necessity of an historical approach to the study of economics if economists are to understand properly the theories they seek to apply. Arnold Kling earned his PhD in economics from MIT in 1980. His published work on macroeconomics includes “Macroeconometrics: the science of hubris” (Critical Review, 2011), “PSST: patterns of sustainable specialization and trade” (Capitalism and Society, 2011), and “The 1970s: the decade the Phillips Curve died” (Routledge Handbook of Major Events in Economic History, 2013). Other publications include Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008 (Mercatus Center, 2009) and From Poverty to Prosperity: Intangible Assets, Hidden Liabilities, and the Lasting Triumph over Scarcity (co-­authored with Nick Schulz, Encounter Books, 2009). Arthur B. Laffer is founder and chairman of Laffer Associates and was a member of President Reagan’s Economic Policy Advisory Board for both of the latter’s terms in office. Dr Laffer also advised Prime Minister Margaret Thatcher on fiscal policy in the UK during the 1980s. He has been a faculty member at the University of Chicago, the University of Southern California and Pepperdine University, USA. Dr Laffer received a BA in economics from Yale University in 1963 and an MBA and PhD in economics from Stanford University in 1965 and 1972, respectively. Patrick Newman is a graduate student in the Department of Economics at George Mason University, USA, working towards his doctorate. His research interests include late nineteenth-­and early twentieth-­ century United States economic history and Austrian economics. George Reisman, PhD, is Pepperdine University Professor Emeritus of Economics and the author of the 1096-­page Capitalism: A Treatise on Economics (Jameson Books, 1996; Kindle edition, 2012). Along with his book, more than a dozen of his numerous articles and essays regularly appear among the 100 bestsellers in Amazon.com’s Kindle-­book category “Free Enterprise”. Dr Reisman was a student of Ludwig von Mises, whose New York University seminar he attended for eight years and under whom he obtained his doctorate in economics in 1963. He is the translator of Mises’s Epistemological Problems of Economics (D. Van Nostrand, 1960). From 1957 until her death in 1982, he was an associate of the Russian-­born US author and philosopher Ayn Rand.

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David Simpson received his PhD in economics from Harvard University, USA, where he was research assistant to Wassily Leontief. He was Professor of Economics at the University of Strathclyde, UK from 1975 to 1988, and from then until 2001 he was economic adviser to Standard Life. He is the author of several books, including The End of Macroeconomics (1994) and The Rediscovery of Classical Economics (2013). He has also written numerous articles that have appeared in periodicals ranging from Econometrica and Scientific American to The Financial Times and The Spectator. Mark Skousen (PhD, economics, George Washington University) is a Presidential Fellow at Chapman University in California, USA. He has taught economics, finance and business at Columbia Business School, Barnard, Mercy, and Rollins colleges, and at Chapman University. Since 1980, Skousen has been editor-­ in-­ chief of Forecasts & Strategies, a popular award-­winning investment newsletter published on his website (www.markskousen.com). He was an analyst for the CIA, a columnist on Forbes magazine, chairman of Investment U, and past president of the Foundation for Economic Education (FEE) in New York. He is also the producer of FreedomFest, “the world’s largest gathering of free minds”, which meets every July in Las Vegas (www.freedomfest.com). His ­economics works include The Structure of Production (NYU Press), The Big Three in Economics (M.E. Sharpe) and Economic Logic (Capital Press). His investment books include Investing in One Lesson (Regnery Publishing) and The Maxims of Wall Street (Eagle Publishing). In honour of his work in economics, finance and management Grantham University in Kansas, USA renamed its business school “The Mark Skousen School of Business”. Based on his work The Structure of Production, the US federal government now publishes Gross Output (GO) every quarter along with GDP. Peter Smith was CEO of Australia’s payments clearing company for 14 years up until the end of 2005; thereafter he consulted on payments matters. Before that he was chief economist at a major Australian bank, economic adviser to the bankers’ association, headed the department responsible for monetary policy in the public service of Papua New Guinea, and tutored at the Universities of Western Australia and Adelaide, where he also completed a PhD in the area of Keynesian monetary theory. His wide-­ranging publications include a number of articles on Keynesian economics. He has spoken at a large number of economics and payments conferences and seminars. Now retired, he writes and blogs regularly for the leading Australian political and literary magazine Quadrant and has authored the book Bad Economics (Connor Court, 2012).

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Introduction: what’s wrong with Keynesian economic theory? Steven Kates INTRODUCTION I was in the process of writing an introduction to a book which I like to call my Anti-­Keynesian Reader, but whose official title is Keynesian Economic Theory and its Critics. It is a compendium of all of the major critics of Keynesian economics written since the publication of The General Theory in 1936. In writing the introduction to this other volume, it became obvious that no one had ever written an all-­encompassing critique of Keynesian economic theory from a classical pre-­Keynesian perspective. This was because when the General Theory was published, although there were many classical economists, no one at the time truly understood what the General Theory was about. Now that we do understand what the General Theory is about, there are no classical economists left to explain from a pre-­Keynesian perspective what is wrong with Keynesian macro. What else I learned was how few economists there are today who are actively anti-­Keynesian. The entire literature since 1936 devoted to explaining what is wrong with Keynesian theory would hardly cover a single library shelf, and this would include both books and articles. Those of us writing critiques of Keynesian economics today are part of a very small cohort of economists. And while I have my own form of understanding of why Keynesian economic theory is fallacious, I well understand that others also recognize the damage Keynesian policies cause, but base their criticisms on different kinds of reasoning. Yet, in spite of these differences, all of the contributors to this volume agree that Keynesian economic theory is fallacious to its very roots and cannot be used as a sound basis for public policy. Each of us has our own particular reason for our beliefs. And, in saying this, Keynesian economic theory, for the purposes of this collection, is defined as the mainstream macroeconomics that forms the core of virtually every introductory economics text and which had been the basis for the stimulus that followed the Global Financial Crisis (GFC) in 2008–09. 1

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What’s wrong with Keynesian economic theory?

The essential element of Keynesian theory is recognizable by its signature equation: Y = C + I + G + NX. The equation states that aggregate output is the sum of the various components of aggregate demand: consumption, investment, government spending and net exports. It is then assumed that output can be increased through an increase in aggregate demand that occurs through an increase in any of the components, with the particular emphasis on the level of government spending. The further assumption is that the higher the level of aggregate demand, the higher the level of employment. This has been the basis for economic policy since the 1940s. And while there has never been a policy success that has followed the introduction of a Keynesian stimulus, the undeniable fact is that Keynesian theory has remained embedded in our texts, impervious to all of its failures. The aim of this book is to assist others in understanding the flaws in Keynesian ­economics and the urgent need for alternative approaches to policy. In putting this collection together I approached only those who had previously written critically on Keynesian economics. What follows is a composite of all of the various letters sent out, which were each tailored to the specific person I was writing to. Edward Elgar has agreed to publish a collection of articles on what is wrong with Keynesian economics. I am therefore writing to ask you to contribute to this collection. In preparing for my own role in this, I went back and re-­read Henry Hazlitt’s incomparable The Failure of the New Economics, which has not aged a day since it was published in 1959. What is also true is that hardly any economist today could understand what he was getting at, since economic theory no longer even teaches what needs to be understood to make sense of what any economist would have found second nature in 1935. But at the end, on page 437, there was this, which is even more true now than it was then. There must be hundreds of economic books that may be variously described as Keynesian, pro-­Keynesian, semi-­Keynesian, or “post-­Keynesian,” and there must be thousands of such pamphlets and articles; but there is a great dearth when we come to any literature since 1936 that may be described as definitely anti-­Keynesian – in the sense that it is explicitly and consistently critical of the major Keynesian doctrines. In the works of such writers as Ludwig von Mises, F.A. Hayek, Wilhelm Röpke, Frank H. Knight, Jacques  Rueff, and others, we do indeed have an impressive non-­Keynesian literature, based on “neo-­ classical” premises, with occasional explicit criticism of Keynesian tenets. But full-­length books exclusively devoted to a critical analysis of Keynesianism may be counted on the fingers of one hand. (Hazlitt 1959: 437) There is then an equally startling passage from William Hutt’s Keynesianism – Retrospect and Prospect, which is a quite sobering statement given the state of theory today. This was published in 1963: The Keynesian fallacies remain deeply rooted, and the lag is likely to be long before they are eradicated. In spite of the retreat, there have so far

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Introduction ­3 been practically no changes in the textbooks or in undergraduate teaching. Students of this generation are still, on the whole, being trained in defective methods. A minority of them manage ultimately to think their way through. The majority are unable to. The confused thinking on which Keynes’s case was framed remains the conventional foundation of the modern teaching of economics. (Hutt 1963: 431) I have just finished for Elgar an 1800-­page two-­volume set on the critics of Keynesian economics which covers just about everything written since 1936 that is critical of Keynesian theory. The book would have been published sooner but was delayed because I was certain, given the comprehensive failures of the stimulus after the Global Financial Crisis, that there had to be a large cache of articles that for some reason I had not yet stumbled upon. My conclusion now is that there are no such articles anywhere. I am not even sure there are a hundred economists in the world who would explicitly describe themselves as “anti-­Keynesian” in any kind of active sense. Here is the thing: there are, for all practical purposes, no anti-­Keynesians left. We are trying to hold the fort for a better time. But if after all of the problems and the non-­recovery in the US there are not now legions of economists who are seeking answers to what went wrong, I don’t know what can be done to change economic opinion over the immediate future. What I am aiming to do is to set down a battle standard so that others will at least know that there are serious economists who completely disagree with Keynesian macro and that there are other ways of understanding how an economy works. What I am saying is that I need you to contribute to this book because it requires people of your standing to ensure that it will get read. Nor has the catastrophe that has followed the introduction of the stimulus been unforeseeable by those who understand matters differently from those who follow the modern Keynesian consensus. At the very start of the stimulus at the end of 2008 I wrote an article published the following March, titled “The Dangerous Return to Keynesian Economics”. My five-­years-­ later follow-­up, which basically noted that everything I had said then had come to pass, had the title: “Keynesian Economics’ Dangerous Return – Five Years On”. [The two articles are brought together as my own contribution to this volume.] I moreover wrote what may be the only actively anti-­Keynesian introductory text, Free Market Economics: An Introduction for the General Reader, as the class text for my course, which I wrote over a twelve week period at the start of 2009 to explain in more detail what I was trying to say. The second edition published in 2014 is better (and co-­published by the IEA in London) but conveys the same message. An article by you would make a major difference to the willingness of others to take the problem with Keynesian economics seriously. The rest of this note is a template letter I have sent out to those who have already agreed to contribute.

THE TEMPLATE LETTER The following is the template letter that was sent out to each of the ­contributors to this volume.

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What’s wrong with Keynesian economic theory? The working title is: What’s Wrong with Keynesian Economics? As I do not wish to pre-­empt any approach that you might take, I will merely make a few observations and lay out a set of general guidelines that seem to me essential. There are also “further notes” that more or less repeat what is said in this letter but add further detail. First, this is a book about economic theory. There is no need to demonstrate that the stimulus did not work. That is the premise and is beyond dispute. What is needed is an explanation of why it did not work. What is wrong with the Keynesian macroeconomics that was the basis for this undoubted policy failure? That is the central question I am asking you to answer. Moreover, I don’t think there is a great deal of value in going back to the General Theory to determine what “Keynesian” refers to. There is the “Keynesian economics” of 1936 and then there is the “Keynesian economics” of today. They are related but not the same. It is today’s version we need to be responding to. Speaking for myself, the essence of “Keynesian” is the belief you can make an economy grow from the demand side, but I am very open to other ways of looking at even this threshold question. Some indication of what you believe makes a Keynesian model “Keynesian” might be useful, but again, let me emphasize, I am not intending to be prescriptive in any way. Second, I will publish what you send. I will read through what I receive but only to ensure that the article has had at least a second set of eyes cast over it before publication. I will ask for clarification if I think it necessary but at no stage will I argue the economics with you although I can’t promise I won’t ask you to expand on some area. This is a forum for you to put your views across in a place that will be read. By being in the company of others who also think Keynesian economics is deeply flawed, your own contribution will be amplified by the company it keeps. Third, the fundamental purpose of the book is to alert others that there are economists of standing who believe economic policy has been based on a false premise. Although we should attempt to have Keynesian economists re-­think their allegiance to standard macro, they are not the intended core readership for this book. The aim is to encourage economists who are not committed to standard macro to recognize that there are other ways of looking at these issues, as well as to have policy makers and the public begin to question the standard Keynesian assumptions that have allowed the stimulus to occur without much appreciation of the risks that were being run. Four, I would like each chapter to contain a bibliography of articles and books you believe are helpful in understanding what is wrong with Keynesian macro. These do not have to be cited in your article. The aim is to enable readers to deepen their own knowledge by being able to go to additional material that supports your perspective. Five, the length of the article should be around 6000 words +/− 2000. By all means longer if you think the extra length is required. The essence, however, is that the article be accessible but please say everything you believe needs to be said, remembering that these are only articles and not a book-­length discussion. Lastly, if there is anyone you think ought to be invited to participate, please let me know. There seem to be only a very small number of economists that I can think of who have had a public position opposed to Keynesian economic theory and policy. There must be more. I just don’t know who they are. Any suggestions would be greatly appreciated.

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Introduction ­5

ADDITIONAL CONSIDERATIONS Below are the “additional considerations” that were sent out to each of the authors which emphasized the points made above. In the correspondence I have had in putting this book together I have had some extremely valuable feedback which has helped me refine what I am seeking to do and how to explain my intentions to others. These are further considerations about the article I am seeking. There is a logical order to these but there is also some repetition. I provide this only as an additional means to clarify the aim of the book and to assist you in framing your own article.

 This is to be a collection of newly written chapters on what is wrong with

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Keynesian economics.

 The emphasis is on what is wrong with Keynesian theory as a means to

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explain why Keynesian policies do not work.

 It is to be directed at an audience that will have previously studied eco-

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nomic theory, but will also partly be made up of an interested lay audience with no formal study in economic theory. ●  The book is not, however, aimed at convincing committed Keynesians. It would, of course, be desirable if this could be done but that is very far from the primary focus. ●  It is, instead, aimed at those who remain open to alternative views about the theoretical understanding that is required so that policies can be properly framed to restore more rapid growth and higher levels of employment. ●  The book is premised on a recognition that the stimulus has been a failure. Increased public spending did not lead to recovery. ●  The arguments ought to be the kind that would be read by a politician who is wondering why the stimulus has turned out to be such a failure or could be put before a first year economics class. ●  You should feel free to use any argument you believe might be persuasive but my hope is that you will concentrate on the theoretical issues. ●  Any statistics or maths used will need to have a great deal of explanatory power and ought to look as if they will be relevant a decade or more from now. But the decision is entirely yours. ●  As to what constitutes a Keynesian approach, for the purposes of this volume it is the belief that following an increase in something called the level of aggregate demand, there will be an increase in economic activity, and as a result of the induced increase in economic activity, employment will rise along with living standards. ●  Many who have been observing economic events must now be wondering why that has not happened. How would you explain to them: (1) what they have misunderstood and (2) how they should think about these issues instead? ●  We each do part (2) whenever we explain to others why we prefer something else, and usually only in a piecemeal fashion. There seems to be little diagnosis about part (1), about where Keynesians go wrong. ●  Here are some questions that come to mind in thinking about these issues but feel free to ignore these if they do not suit the direction you wish to travel:

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What’s wrong with Keynesian economic theory?

 What does it mean to be a Keynesian today, especially if you see it dif-

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ferently from being a framework based on raising aggregate demand? What do Keynesians believe is true that is not true? ● What are the flaws in their arguments? ●  In looking at the world, what should they notice that would help them see why they have been misreading the way an economy works? ●  How could they verify that there is a hole in their arguments? ●  What could you point to that would help them see what is wrong with Keynesian theory. ●  It need hardly be mentioned that this needs to be a polite discourse, however much exasperation we may feel. ●  Nothing as direct and comprehensive has been done since Henry Hazlitt in 1959. Others who have attempted to do the same were Arthur Marget (2  volumes, 1938 and 1942), William Hutt (1963) and Mark Skousen (1992). But given the enormous extent of the Keynesian literature, this is a drop in the ocean. ●  If you can think of anyone else who this request might go to, please also let me know. I cannot believe how few people there are who such a request might even go to. ●  What I am seeking to do is to appeal to those who are not yet committed, and to those in policy-­making roles to ensure that they understand that there is another point of view. ●  Few will change their mind based on the work we have done specifically on Keynes. But our own previous work has brought us to the point where we can now write a simplified but compelling version of our beliefs in a way that will gain attention. ●  We would be deceiving ourselves to believe that writing some book on ­economic theory dealing with Keynes’s own writings and aimed at other economists would suffice as a means to change either modern theory or policy. ●  If we are going to have an impact, we must assume that something called “Keynesian” economic theory is the intellectual support mechanism for “Keynesian” policy and that the events since 2009 have at least to some extent discredited that theory. ●  We must explain that whatever it is about modern Keynesian macro that supports a stimulus is flawed. To go back to the General Theory and refute what Keynes wrote in 1936 is, in my view, futile. ●  To attack the modern policy-­focused version will at least give us an opportunity to shape our arguments in a way that others can learn from as to why the stimulus has been a failure. ●  That is where we begin: everyone knows the stimulus has not worked. Everyone equally knows that macroeconomic theory says it should have worked. What, then, is wrong with the theory that has led to this disastrous policy outcome? That is the chapter I am looking for you to write. ●  We are not arguing with Keynesians; we are arguing about why the policies did not work and the contribution that modern Keynesian macro has made to that failure. That is what I wish us to explain.

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Introduction ­7

OUR PRESENT CIRCUMSTANCES Little has changed since the time of Hazlitt and Hutt. There are many economists, almost certainly the majority, who believe the stimulus following the GFC had a positive effect on economic activity and employment. Yet employment growth has been dismal, with even the minimal recoveries in activity so far experienced occurring only after the growth in public spending had been contained and in some cases even reversed. The problems of deficits and debt are everywhere to be seen. A return to rapid rates of output and employment growth remains distant and uncertain. Our economies are being ruined by Keynesian macroeconomics. The ­chapters in this volume are designed to help you understand why that is. It is a scandal how little reflection and analysis there has been across the ­profession in the wake of the disastrous outcomes that have followed the stimulus. This volume is our attempt to redress at least some part of this grotesque imbalance. While some kind of summary of the chapters might have been d ­ esirable, each is so unique that there really is no common theme other than an agreement that Keynesian economic theory needs to be replaced. While there are overlapping arguments between contributions, it would be the profoundest error even to attempt a summary of any of them. These are chapters which should be read on their own and in full. To provide a summary would be worse than futile; it would be certain to mislead you about the authors’ intentions since they would have to be placed in a framework of my own. Each chapter is self-­contained. No summary of mine could do them justice. Each is argued from the premises each of the authors makes for themselves which can only be understood by reading the article in full. Not  only do I feel myself incapable of summarizing what each author has said, it would also be a mistake even to try. If you have reached  this  far,  you have shown at least that much interest in these issues. Reading the chapters for yourself is the only advice I can now give.

A SUMMARY OF KEYNESIAN THEORY’S HISTORIC FAILURES What can be said is that the one thing all the authors do have in common is recognition that the application of Keynesian policies in a real-­world environment does not provide answers to our economic problems. It is the very

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durability of Keynesian theory within modern macroeconomics that is perhaps its most remarkable achievement. The aim of each of the authors is to bring the demise of Keynesian economic theory that much closer. The theory of aggregate demand entered our textbooks in the 1940s, where it has remained ever since. The occasions when one might have thought that Keynes had finally been discredited include all of the following, which is a summary of each of the major instances in which Keynesian economic policies had been applied and in which Keynesian theory had therefore failed. ●●

●●

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There is, first, the prolonged duration of the Great Depression in the United States following the introduction of high levels of public spending under the New Deal. Although much of it occurred before The General Theory was published, Roosevelt’s increased levels of spending and deficit finance have often been highlighted as the prototype Keynesian policy. The failure of the New Deal, especially when contrasted with the almost instantaneous success of the diametrically opposite policies pursued by Harding at the commencement of an inflationary recession in the early 1920s, should have provided a warning to others. It did not. The post-­war recovery after 1945, arguably the most robust and sustained period of economic growth in history, followed the immense cuts to public spending and the balancing of the budget in the United States which occurred from the moment the war had ended. Millions of soldiers were returning from overseas and needed to find peacetime jobs. Wartime industries were closing down. Public spending fell like a rock. Yet, in spite of the downturn in wartime industries, the huge increases in the number of persons looking for jobs and the massive cuts to public spending, the American economy boomed. There were, as one might have expected, many warnings by Keynesians that the American economy would immediately return to recessionary conditions if some kind of deficit-­financed stimulus were not introduced. Again the failure to predict ought to have been a warning, but again it was not. The Great Inflation of the 1970s and 1980s was brought on by immense increases in deficit spending starting from the end of the 1960s which remained until the 1990s. The combination of recession and inflation was itself said to contradict Keynesian theory. But while the theory was shown to provide no guidance to policy, aggregate demand remained embedded within textbook theory, although now supplemented by aggregate supply. Whatever lessons might have been learned were ignored.

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The Japanese economic stimulus of the 1990s ought itself be a reminder of the potential for harm that Keynesian policies bring. In many ways, the Japanese economy had been the single greatest post-­war success story. By the late 1980s, Japan’s was the most robust economy in the world. The downturn experienced by the Japanese at the end of the decade was experienced across the globe. What was different was the deficit-­financed public spending stimulus that was introduced during the early 1990s to generate recovery. And while there are many different explanations that have been offered over the years for the subsequent failure of the Japanese economy to return to full employment and robust rates of growth, the absence of a post-­mortem in which the stimulus was closely investigated indicates the extent to which the application of Keynesian theory has moved to become a position of unquestionable authority. Even where Keynesian policy could be seen not to have succeeded, other explanations for that failure were central to every such analysis, not the expenditure policy itself. The confidence with which stimulus packages were applied across the world over the period 2009–11 to reverse the effects of the Global Financial Crisis indicates that whatever past failures may have been associated with Keynesian policies, these associations were extremely weak in the minds of those who set out to restore growth and full employment by deficit-­financed increases in public spending. The lack of recriminations and the policy soul-­searching – though no recovery has occurred and, indeed, even though economic problems have deepened – indicates the extent to which Keynesian macro remains more entrenched than ever. An abject failure though the policy has been, to the extent that recovery remains the actual measure of success, the absence of any public recognition among mainstream economists that standard macroeconomic theory has shown itself to be a disastrous guide to policy may be the most astonishing aspect of the entire sequence of economic events since the start of the GFC.

What unifies the writers in this collection is their recognition that Keynesian economic theory provides no useful guidance in dealing with our economic problems. The book brings together the views of economists from a number of different schools of thought. Their aim is to have you share their understanding of what is wrong with Keynesian economic theory and the policies this theory promotes.

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REFERENCES Hazlitt, Henry (1959), The Failure of the “New Economics”: An Analysis of the Keynesian Fallacies, New Rochelle, NY: Arlington House. Hutt, W.H. (1963), Keynesianism – Retrospect and Prospect: A Critical Restatement of Basic Economic Principles, Chicago: Henry Regnery Company. Kates, Steven (2009), “The dangerous return of Keynesian economics”, Quadrant, LIII (3), March. Kates, Steven (2014a), Free Market Economics: An Introduction for the General Reader, 2nd edn, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Kates, Steven (2014b), “Keynesian economics’ dangerous return – five years on”, Quadrant, LVIII, March. Marget, Arthur W. ([1938] 1966a), The Theory of Prices: A Re-­Examination of the Central Problems of Monetary Theory, Vol. I, New York: Augustus M. Kelley. Marget, Arthur W. ([1942] 1966b), The Theory of Prices: A Re-­Examination of the Central Problems of Monetary Theory, Vol. II, New York: Augustus M. Kelley. Skousen, Mark (ed.) (1992), Dissent on Keynes: A Critical Appraisal of Keynesian Economics, New York: Praeger.

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1. The Keynesian liquidity trap: an Austrian critique1 Peter Boettke and Patrick Newman 1 INTRODUCTION Few economists can deny the influence of John Maynard Keynes and his The General Theory of Employment, Interest, and Money (1936). As Mark Blaug put it: “The Keynesian Revolution is one of the most remarkable episodes in the entire history of economic thought; never before had the economics profession been won over so rapidly and so massively to a new economic theory, and nor has it since.” “Within the space of about a decade, 1936–1946,” he continues, “the vast majority of economists throughout the Western world were converted to the Keynesian way of thinking” (Blaug 2010 [1997], 642). In short, Keynes forever changed the course of economic thinking and policy. To some, particularly the younger economists, The General Theory was a blessing. Paul Samuelson described the sensation of both being an economist when The General Theory came out and also to be younger than 35 as “Bliss it was in that dawn to be alive, but to be young was very heaven.” Samuelson considered the book, although poorly written and confusing, to be the “work of a genius” (Samuelson 1947, 145–9). However, some of the older economists over 50, as Samuelson noted, were not so easily swayed. Frank Knight had argued in his review of The General Theory that “Mr. Keynes’s own doctrines are, as he would proudly admit, among the notorious fallacies to combat which has been considered a main function of the teaching of economics” (Knight 2009 [1937], 69). And in his Presidential Address to the American Economic Association (AEA) in 1951, Knight criticized the Keynesian Revolution for dragging economic thought “well back into the dark age” (Knight 1951, 2). In an early review of the book Henry Simons claimed that “Mr. Keynes ­proceeds to espouse the cause of an army of cranks and heretics simply on the grounds that their schemes or ideas would incidentally have involved or suggested mitigation of the deflationary tendencies in the economy.” And he warned that Keynes and The General Theory might very well 11

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become “the academic idol of our worst cranks and charlatans” (Simons 1936, 1017).2 To Knight, Simons, and other critics they saw The General Theory as overturning the basic tenets of economic theorizing and, most ­importantly, the self-­correcting power of markets.3 However, the critics did not succeed in forestalling the Keynesian Revolution as Keynesian ideas came to dominate the economics profession from the late 1930s to the late 1970s, when the New Classical Macroeconomics represented a challenge to the hegemonic paradigm of Keynesianism. There are two important qualifiers to this familiar narrative. First, while New Classical Macroeconomics offered a theoretical challenge and raised policy doubts about the effectiveness of traditional Keynesian demand management policies, its influence was always restricted to pure academic research and not to the practical policy world. In the practical policy world, the basic Keynesian policy tools were employed, and what oscillated was either a “conservative” Keynesianism or a “liberal” Keynesianism; but macroeconomic demand management and fine-­tuning policies never disappeared in western democracies. And, second, even given the impact of New Classical Macroeconomics among elite researchers in academic economics, there was still a very strong contingency of elite economists who maintained the core Keynesian intellectual agenda. As James Tobin announced in a wonderful essay – “How dead is Keynes?”, published right in the middle of the so-­called New Classical Revolution (1977) – Keynes was far from dead and was in fact very much alive and kicking. A close look at modern economics will reveal that Keynesianism never left center stage in economic thought and certainly never in policy circles, as not just older economists, such as Tobin, but members of the generation after him, such as Stanley Fisher, continued to have an o ­ versized influence and one that impacted the leading economic thinkers and economic policy makers, such as Joseph Stiglitz and Lawrence Summers – both of whom have cycled in and out of Ivy League academic posts and high-­level economic policy positions since the 1970s. In a profound sense, the Keynesian Revolution never ended. What exactly were the main tenets of the Keynesian Revolution? Aside from the theory of underemployment equilibrium, in which Keynes argued that there could be a static state with involuntary unemployment even with flexible prices (that is, that wage cuts would not reduce ­unemployment), most notably there is his theory of liquidity preference and the related idea of a “liquidity trap.”4 Seeking to reject the classical theory, Keynes explained the rate of interest as being determined by the supply of money and individuals’ demand for money, also known as their liquidity ­preference. Individuals’ speculative demand for money was a decreasing function of the interest rate. Keynes argued that in some scenarios, most

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notably in depressions, at a certain rate of interest the demand to hold money would be infinitely elastic and market forces could not be relied upon to lower interest rates and stimulate investment to get the economy out of the depression. This is because individuals will just hoard their money and not spend it on bonds because they believe their price will fall in the future (that is, that interest rates will rise). In this situation monetary policy would be ineffective at combating depressions because it could not lower interest rates to boost investment spending, and expansionary fiscal policy would be the only remedy. Monetary policy would be like “pushing on a string” but aggressive fiscal policy could stimulate aggregate demand. This situation is known as a liquidity trap, and it constitutes one of the fundamental distinctive features of Keynesianism in contrast to Monetarism, which champions expansionary monetary policy during a depression.5 While previously considered a remote possibility extremely unlikely to occur, with the 1990s Japanese slump and the 2008 financial crisis, economists have argued that the liquidity trap theory is empirically relevant now (Krugman 2009 [1999]). The liquidity trap is a powerful ­argument not only against the idea that monetary policy is effective, but also that market forces unaided by government can work during a depression. How effective can the market be at reallocating resources and promoting a recovery if investors just hoard their money and do not spend it? At an analytical level, it is our contention that the real opponents of Keynes are the Austrians, who belong to the school of thought that best champions the theory of a self-­correcting market economy. As a result, the Austrian economists offer the starkest differences from Keynesians. Austrians were some of the first and most prominent to criticize Keynes and his economics, as started with Hayek (2008 [1931, 1932]) and through the Keynes–Hayek debates. To Hayek, Mises and Rothbard, the countercyclical policies embraced by Keynesians, as well as the Chicago School Monetarists, in order to combat downturns are generally seen as counterproductive because they stifle the reallocation process of resources that were poorly invested during the previous boom.6 However, does this argument apply in such scenarios where a liquidity trap exists? Can the market unaided by government involvement actually be expected to work in such a situation? The present chapter argues that in such a scenario the market can be expected to work provided that it is allowed to work. This chapter provides critiques of the liquidity trap theory from an Austrian perspective. In doing so it will rely primarily on older Austrian writers, as the new Austrian macroeconomists such as Garrison (2006 [2001]) do not discuss the concept of the liquidity trap in their analyses. This is mainly due to the fact that most economists thought that the empirical possibility of a

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liquidity trap was very slim until recently. In addition, we also use older writers to show that these Austrian criticisms are not new and novel modern-­day arguments against the Keynesian system, but rather old and fundamental critiques that were made back in the heyday of Keynesianism that went unnoticed. And the criticisms that were raised are as relevant as ever since the Keynesian liquidity trap has regained popularity in the Global Financial Crisis as an explanatory tool and guide for public policy. The main problem these authors note is that the Keynesian theory concentrates on the loan rate of interest, which is only subsidiary to the natural interest rate expressed in the price spread in the structure of production that is determined by time preferences and not liquidity preferences. Since the loan rate is a reflection of the natural rate, an expected rising loan rate means that the price spread in the economy is expected to rise (that is, factor prices will fall relative to the prices of the outputs they produce), which is a requisite for a market-­based recovery. Provided that prices are allowed to fall freely and are not propped up by government intervention the liquidity trap roadblock poses no genuine threat for the free market economy. Only when prices are rigid and government intervention is pervasive does the phenomenon of a liquidity trap and hoarding money result in a stagnant economy. This chapter is structured as follows. Section 2 presents a brief analysis of the Austrian theory of interest and shows both how it is determined by time preference and its coordinative role for entrepreneurial calculations. Section 3 describes the liquidity trap and critiques it with the ­aforementioned Austrian theory of interest, and section 4 concludes.

2  AUSTRIAN INTEREST RATE THEORY Keynes famously argued that the interest rate is determined by liquidity preference, or the demand for money. Interest, according to Keynes, is the “reward for parting with liquidity” (Keynes 1964 [1936], 167). After deciding how much out of income to consume and not consume, which is determined by his propensity to consume, an individual then decides how much of his leftover funds he will invest in securities or keep in his cash balance, the latter of which is determined by his liquidity preference. Keynes splits liquidity preference and the demand for money into transactions demand, precautionary demand, and speculative demand. The first two are related to spending and are a function of real income. On the other hand, the speculative demand is a function of the interest rate, which represents the opportunity cost of holding money. At a higher interest rate there is a greater opportunity cost of holding money relative to investment, and

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correspondingly there will be a smaller quantity of money demanded since individuals will instead decide to buy securities with their funds. Therefore the speculative demand for money is a decreasing function of the interest rate and the demand curve slopes downwards. The interest rate equilibrates the supply and demand for money and the equilibrium rate is determined by their intersection (Keynes 1936, 166–74, 194–204; Modigliani 2009 [1944], 136–43).7 If the interest rate is above equilibrium, then there is an excess supply of money and individuals will buy bonds in order to reduce their cash balances. This pushes up the price of bonds, which decreases their yield (that is, the interest rate), which increases the quantity of money demanded until equilibrium is restored. The reverse occurs for an interest rate below equilibrium. Thus, increases and decreases in the money supply lead to excess supplies or demands for money, and correspondingly change the interest rate through buying and selling securities. To the Austrians, this entire analysis of the interest rate is completely misplaced. In the first place, the demand for money is unrelated to the interest rate as the interest rate is not determined by liquidity preference but instead by time preference. Time preference is the premium on present consumption over future consumption, and is more generally described as the premium on present goods over future goods. The interest rate is the societal rate of time preference, or the specific premium on present goods over future goods. It is the premium on present money (money that can be spent on consumer goods for present consumption) over future money (money that is earned from investments for future consumption). In order to earn monetary interest an individual must supply present money for future money. The interest rate bears a strict relationship with the proportion of total money spent on consumption to total money spent on investment during a given period, as both are two sides of the same coin and are determined by time preferences. The proportion represents the degree of present consumption versus future consumption, whereas the interest rate represents the particular premium on present consumption over future consumption. A fall in time preferences is embodied in a fall in the consumption-­investment proportion and a decline in the interest rate, and vice versa (Mises 2008 [1949], 529–30; Rothbard 2009 [1962], 400–404, 549, 860). The unimportance of the demand for money to the interest rate can be seen in the above analysis. The reservation demand for money determines how much money an individual does not spend on either consumption or investment and instead keeps in his cash balance. On the other hand, time preferences determine the interest rate and the relative proportion between consumption and investment. An increase in the demand for money does not affect the interest rate if it does not change the

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relative consumption-­investment proportion. An increase in the demand for money could also either increase or decrease the interest rate if the relative proportion is raised or lowered as well (Rothbard 1962, 773–6, 788–9; Rothbard 2008 [1963], 37–40). In the second place, the interest rate is not simply the loan rate that is determined in either the money market (the supply and demand for money) or the loanable funds market (the supply and demand for loanable funds). Instead, the interest rate is the price spread between stages of production, and is sometimes described as the relative difference between the cumulative prices of consumer goods and the prices of producer goods that make them (Mises 1949, 521; Rothbard 1962, 371). It can be termed the natural rate because it is the interest that comes “naturally” by investing in production processes, as opposed to the loan, or contractual rate of interest that is fixed in the contract (Rothbard 1962, 441). The natural rate is a monetary rate of interest and not the rate of interest that would exist under barter conditions. There is not a separate natural rate of interest for each “real” good that cannot be equilibrated. Instead, in the monetary economy, all present and future goods on the time market refer to present and future money, and so the rates of return are in terms of the same good (money) and can be equilibrated (Rothbard 1962, 375). Money is its own good and is not simply a “veil” that is added onto a barter economy (Mises 1949, 203, 414–15; Rothbard 1962, 235, 269–70). A unitary rate of interest that can be isolated could not exist in a barter economy (Mises 1990 [1932], 65). This point bears emphasizing because the natural rate of interest concept has been criticized on these grounds, particularly by Sraffa in the Sraffa–Hayek debate in the early 1930s (Skousen 2007 [1990], 49–51). While earlier Austrian expositions could be criticized using the faulty barter natural interest rate framework (for example, Mises 2006 [1928], 107–8), the modern Austrian monetary and interest theory is immune to this criticism. At each stage of production businesses, or, more strictly, the capitalist-­ entrepreneurs, either purchase or rent capital goods and land as well as hire labor. They then use these factors in a production process to produce goods that will be sold in the future. In long-­run equilibrium the rate of return earned, or the price spread between the cumulative prices of factors of production and the products they produce, is the natural rate of interest. In such a static world the natural rate is equal to the pure, or originary, rate of interest which is determined in the general time market, that is, by the supply of present money (the money entrepreneurs spend in production processes) and the demand for present money – the money land and labor demand in production and the money businesses demand when they sell their products (Rothbard 1962, 375–89; 417–19).8 In the dynamic real

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world, of course, the natural rate of interest earned in a line of production is not equal to the pure rate as it also includes a specific entrepreneurial “risk” component and a general purchasing power component, both of which would be eliminated in the long run (Rothbard 1962, 550–52, 792–8). Moreover, capitalist-­entrepreneurs’ returns or price spreads are often greater than or less than the underlying natural rate as they earn profits and losses due to the general uncertainty of the marketplace. Capitalist-­entrepreneurs earn profits when their rate of return is greater than the underlying natural interest rate, and earn losses when the opposite occurs (Mises 1949, 291; Rothbard 1962, 510–13). However capitalist-­ entrepreneur arbitrage, which is shifting factors of production from lower return processes to higher return processes in order to earn profits, instills a tendency towards the wiping out of profits and losses that equalize the rates of return or price spreads so only the natural rate is earned, a tendency that is never reached because the data are always changing (Mises 1949, 293, 531, 533; Rothbard 1962, 371–2, 409–10, 511–12, 625–6). The coordinating role of profits and losses cannot be overemphasized. The lodestar in allocating scarce means among competing ends in a modern economy is economic calculation. Economic calculation is monetary calculation, or estimating the value of resources according to the monetary returns they can earn in various production processes. In the market economy qualitative consumer values are imputed into quantitative prices. Through their various purchases consumers send signals to producers about what they value highly and consequently what should and should not be produced.9 When resources are shifted from a less profitable venture to a more remunerative one, they are shifted from producing goods that consumers value less highly to producing goods that consumers value more highly. The opposite occurs for losses. A profit return is not just a return greater than costs, but also a return greater than the underlying natural interest rate, since this return represents the average rate the businesses could have earned by investing their money in another line of production, which is the opportunity cost. The loan rate is simply a reflection of this more general and fundamental natural interest rate (Mises 1949, 524; Rothbard 1962, 379). In fact, the irrelevance of the loan market in determining the rate of interest can be seen by acknowledging that an economy without a loan market would still have interest expressed through the price spreads (Rothbard 1962, 425–6). The pure rate found in loan interest is not only mixed in with entrepreneurial risk and purchasing power components, but also potentially profit since this return is fixed at the time of the contract (Mises 1949, 455–6, 533, 536–42). As with the price spreads there prevails a tendency for the equalization of loan rates due to profit-­seeking entrepreneurs. Individuals

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on the loanable funds market borrow and lend based on the estimated rates of return in the production structure. Borrowers will only borrow at an interest rate greater than or equal to the rate of return they plan on earning. Similarly, lenders will only lend at an interest rate greater than or equal to the rate of return they could earn by directly investing in a production process. When the natural rate rises, the loan rate rises; when the natural rate falls, the loan rate falls (Rothbard 1962, 420–41).10 Clearly, the loan rate aids in determining the feasibility of various lines of production as they will be deemed profitable or unprofitable depending on whether or not their estimated return is greater than or less than the rate of interest, and businesses who need to borrow to embark upon the projects will only do so if the return is greater. Moreover, in contrast to the Keynesians, the interest rate plays a coordinating role in the intertemporal allocation of resources according to consumer preferences due to its relationship with time preferences. Businesses are able to gauge the profitability of investments through present value discounting using the interest rate. When the factors of production are cumulatively priced less than the present value of a project, it is profitable to engage in; when they are priced more, it is not. The interest rate acts as a brake on the length of production processes, since the present value of long-­term projects are affected more than short-­term projects by changes in the interest rate (Mises 1949, 524, 529, 544; Rothbard 1962, 539, 996). A lower interest rate is a reflection of lower time preferences and signifies that consumers are more willing to spend money on consumption in the future. As a result, long-­term production processes are now more profitable to embark upon then before, which is reflected in the fact that present value discounting with the new rate of interest shows an increased profitability of long-­term investments relative to short-­term investments. Consequently, higher interest rates result in the adoption of more ­short-­term processes. These strictures bear emphasizing because the interest rate is often seen in the Keynesian framework as a parameter that the monetary authorities can costlessly change without any real effects on the capital structure of an economy. Moreover, not only is the coordinating role of interest rates neglected in Keynes’s analysis but, more fundamentally, there is no reference to the natural rate of interest in the production structure as the true interest rate. Instead, the natural rate is referred to as the marginal efficiency of capital and the entire emphasis is on the loan rate of interest.11 Keynes in fact goes so far as to explicitly criticize Mises, as well as Hayek and Robbins, with confusing the two (Keynes 1936, 192–3). But Rothbard points out that the marginal efficiency of capital is actually the rate of interest, and that the loan rate only mirrors it (Rothbard 1962, 371–2).12

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This Austrian point, which was continually emphasized by Rothbard in his various discussions of the Keynesian system (1962, 1963, 1992), constitutes an important Austrian critique. In fact, it will be shown that the reason for the liquidity trap is due to an expected rise not only in the loan rate but also in the natural rate, which is a necessary correction in order for the economy to get out of a depression. Rothbard spoke wisely when he said that “it is precisely this preoccupation with the relatively unimportant problems of the loan market that constitutes one of the greatest defects of the Keynesian theory of interest” (Rothbard 1962, 372).

3 THE LIQUIDITY TRAP AND THE NEED TO LET MARKET FORCES WORK As discussed above, the speculative demand for money is a decreasing function of the rate of interest (the demand curve slopes downwards). Traditionally, an increase in the supply of money causes an excess supply of money which incentivizes individuals to buy bonds, which in turn pushes up their prices and lowers the interest rate, thereby increasing the quantity of money demanded. However, when the speculative demand for money is infinitely elastic (the demand curve is horizontal) at a given rate of interest, the economy is instead said to be in a liquidity trap. In this case, with the increased supply of money individuals will not spend it on bonds and will instead hoard the money. Individuals are said to not buy bonds because they are anticipating a fall in bond prices (a rise in the rate of interest), and are correspondingly holding back purchases. The increased supply of money does nothing, and interest rates do not fall to stimulate investment (Snowden and Vane 2005, 104–8, 118). The problem with this theory is that it considers the loan rate of interest to be the rate of interest, when in reality the loan rate of interest is based on the natural rate of interest. The loan rate only increases if the natural rate also increases. The loan rate would not rise if the natural rate is expected to remain the same because it would not pay to borrow funds. Therefore, if individuals do not buy bonds because they are expecting bond prices to fall in the future (that is, they are expecting the loan interest rate to rise), then this is because individuals are expecting the natural rate to rise. Austrians seek to explain depressions in price theoretic terms. Austrian Business Cycle Theory (ABCT) is neither a theory that is founded on non-­ economic assumptions about the volatility of human psychology and confidence nor a theory focusing on the movement of aggregate variables unconnected to human decision making. ABCT is instead a theory grounded in a microeconomic analysis of the consequences of

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the distortion of a functioning price system through the manipulation of money and credit. This theory holds that when a central bank expands the money supply to increase loans to businesses, it artificially lowers interest rates and sets in motion an unsustainable boom as the interest rates and the production structure are no longer based on time preferences. This includes not only the loan interest rate but also the natural rate. Under normal conditions, when time preferences fall there is a decrease in the consumption-­investment proportion. The decreased consumption spending lowers the prices of factors in the stages closest to consumption, while the additional investment spending pushes up the prices of factors in the stages farthest from consumption (that is, long-­term production processes). There is decreased profitability in the stages closest to consumption and increased profitability in those which are farthest away. As stated earlier, the loan interest rate often guides this process by increasing the profitability of more long-­term projects through present value ­discounting.13 The result of this is, as a reflection of lower time preferences, to lower the natural rate of interest and consequently the loan rate of interest. The same phenomenon with the natural rate occurs initially when increased bank credit substitutes for lower time preferences and pushes down the loan rate. Except for the important exception when consumption does not fall, increased investment pushes up the prices of capital goods and lowers the natural rate of interest. However, interest rates are artificially below what is supportable by time preferences. As time goes on and the public attempts to reassert its consumption–investment spending proportions, the natural rate rises as the price spreads increase from the increased consumption and decreased investment spending (Mises 2009 [1953], 362–3). The loan rate correspondingly rises as well. The crisis sets in as many of the recent additions to the capital stock are revealed to be not as profitable as businesses thought they would be, leading to a large burst of unemployed labor and capital goods in the overextended industries. In order for recovery to occur and resources be put back to work, the price of consumption goods relative to the price of capital goods must rise. This requires reductions in the prices of factors of production, particularly in the level of wages paid.14 In a depression, more than ever are profit and loss and adjustment in interest rates needed to guide entrepreneurial decisions to adjust prices and wages to the configuration of scarce societal resources required according to the new (and correct) consumer preferences. It was this mechanism that had been disrupted with the government-­induced credit expansion. Neither expansionary fiscal nor monetary policy should be used, as expansionary fiscal policy in the form of deficit spending diverts savings and resources away from the productive sector, while expansionary monetary

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policy props up bad investments and may lead to another business cycle (Mises 1949, 792–4, 576–8; Rothbard 1962, 19–23). In a depression the expected rise in the loan rate is a normal feature as it is based on the fact that the price spread between present and future goods will rise, which is an essential requisite for a market-­based recovery. Thus, if businesses judge that their rates of return will rise in the future, barring an increase in spending this means that they expect prices of factors of production in the unprofitable industries to fall. When individuals expect that the price of a good will be lower in the future they withhold purchases and hoard money, decreasing their demand for those goods, which instills a lowering of prices in the present (Mises 1949, 566). The situation is no different for factors of production (Hutt 1954, 395). On the free market, prices, including wages, are relatively flexible downwards.15, 16 Therefore, when individuals hoard money, a fall in the necessary prices will soon follow. This will incentivize entrepreneurs to disgorge their cash balances and start investing again. Thus, the phenomenon of i­ndividuals not investing and instead building up their cash balances requires no “labyrinthine explanation” of a liquidity trap, as Rothbard describes it, but instead is just speculation that factor prices will fall, and actually helps speed up rather than inhibits the recovery process (Rothbard 1963, 40–41). Why then do economies suffering under a liquidity trap not get out of it? This is because the loan rate does not rise since the natural rate does not rise because factor prices, particularly wages, do not fall. Interest rates also do not rise to the extent that governments conduct expansionary monetary policy to lower loan rates and pump money into the economy. Wages are rigid and not relatively flexible due to interventions such as government-­ supported unions, unemployment benefits, and mandated price ceilings (that is, the minimum wage). In addition, wages can also be rigid downwards to the extent that laborers are resistant because they expect that prices will rise in the future – that is, they have inflationary expectations. In addition, businessmen may be hesitant to invest in general because of “regime uncertainty,” which is policy uncertainty about future government interventions that affect investors’ private property (Higgs 1997; 2010). This greatly reduces the demand for factors and exacerbates the required fall in prices. Under such situations, wages do not fall enough and unemployment continues to persist. The price spread, moreover, does not rise and so the necessary corrections in the economy do not occur (Mises 1949, 566–7; Rothbard 1962, 790; 1963, 47–50). Thus, the longstanding phenomenon that results in a stalled recovery described by a liquidity trap is not due to the demand for money being horizontal at a given interest rate, but instead is fundamentally due to rigidity of prices from government intervention that prevents necessary

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relative price adjustments to increase the price spread. The solution is not to engage in expansionary fiscal policy, which would serve to further misallocate resources, but instead to remove government-­induced price rigidities and let the market adjust.

4 CONCLUSION The liquidity preference theory of interest and the liquidity trap are critical concepts in understanding the Keynesian way of thinking about macroeconomic theory and policy. In a liquidity trap, the demand for money is infinitely elastic and interest rates do not fall because individuals speculate that they will rise in the future. Any explanation of the Keynesian Revolution would be incomplete without highlighting the role that ­liquidity traps play in the canonical model, and how that model was built to show that the market economy could not work on its own or even that monetary policy could not get economies out of depression. Instead, fiscal policy would be the only availability. This chapter has argued the theory is wrong because it inappropriately suggests that the interest rate is determined by liquidity preference instead of time preference, and that it concentrates on the loan rate of interest instead of the natural rate of interest. The loan rate is only a reflection of the natural rate, which is found in the average rate of return or price spread in the economy. When individuals withhold purchases of securities because they expect the loan interest rate to rise in the near future, this means that the natural rate is expected to rise in the future. Investors’ withholding of purchases of factors due to their anticipated fall sets processes in motion that lower their price in the present, which adjusts the price spread and allows for a market recovery to occur. The phenomenon of a liquidity trap only continues to persist and become a problem when prices, particularly wages, are propped up through government intervention.

NOTES   1. It should be noted that many of the technical terms and concepts in the Austrian theories discussed in this chapter are simplified for ease of readers’ understanding without loss of the underlying arguments.   2. For a brief summary of other critical reviews of Keynes – such as from Pigou, Knight, Schumpeter, and Viner – see Harris (1947, 29–35).   3. To be fair, this is not saying that all earlier economists, or even the above writers, were purely laissez-­faire theorists who argued that complete government nonintervention was the appropriate response to take in a depression (Blaug 1997, 644; Friedman 1969 [1967], 86–9). But it cannot be denied that the profession in general thought that

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  4.

  5.

  6.

  7.

  8.   9.

10. 11. 12.

13.

14. 15.

16.

The Keynesian liquidity trap ­23 Keynes’s biggest influence was his attack on the self-­correcting powers of the market, which he attributed to the older group of economists he called the “Classicals.” Friedman and Schwartz include the underemployment equilibrium and the liquidity trap as two of Keynes’s unique and important challenges to orthodoxy (Friedman and Schwartz 1982, 41–2). Friedman notes that while Keynes’s theory of interest and its relationship to the demand and supply of money was important, earlier quantity theorists had recognized the relationship between interest rates and the demand for money. Friedman considered Keynes’s liquidity trap to be the distinctive difference between the two groups (Friedman 1969 [1966], 152). However, the earlier quantity theorists had never systematically integrated the relationship in their analysis (Blaug 1997, 618). Related to the liquidity trap is the idea of the investment trap, in which investment spending is a decreasing function of the interest rate and is extremely inelastic, so even if interest rates could be lowered investment spending would not increase very much at all. Krugman (1999, 20–21) considers the idea that depressions are the inevitable consequences of previous manipulations of money and credit that result in misallocations of resources as “fatalism.” This is completely incorrect because the position is not one of pessimistic rigid determinism but instead one that emphasizes the amazing capacity of a free market economy to recalculate the use of scarce resources and reshuffle investment plans according to the changing constellation of consumer preferences. Strictly speaking, the interest rate here is nominal, as it is the nominal interest rate that is the opportunity cost of holding money. However, for the purposes here it makes no difference to describe it as the interest rate, since in the Keynesian framework prices are sticky. For a more in-­depth analysis of the demand for present goods, see Newman (2014a). The usefulness of profits and loss are especially important during a depression when various lines of production have been shown to be unprofitable and consequently there is a need to readjust the structure of production to consumer preferences. For more, see section 3. Contrary to Wicksell, when prices are stable this does not necessarily mean that the natural rate of interest is equal to the loan rate of interest (Hayek [2008] 1931, 213–21). Strictly, the marginal efficiency of capital is the rate of discount that equalizes the sum of future earnings with the present price of an asset. In a different context Rothbard (1963, 37) approvingly cited Hayek’s review of Keynes’s earlier work and emphasized that Hayek made this point to Keynes, that is, that the difference in the relative prices of capital goods in the stages of production represents the interest rate (1931, 434). Often (but not always), the increased investment funds are first lent on the producer’s loan market, and so the loan rate falls before the natural rate. But the increased funds are only absorbed by borrowers at a lower rate because they can now borrow more to invest in projects that were previously not profitable (since their rate of return was too low relative to the loan rate). The borrowers’ investing of the funds sets in motion the process that lowers the natural rate. Therefore, the loan rate only falls in the present due to a fall in the natural rate in the future. The loan rate is still determined by the natural rate. For a more in-­depth analysis of ABCT as well as sources, see Newman (2014b, 476–9). Of course, this is not to say that prices automatically and instantaneously adjust and all exchanges take place at equilibrium prices, but only that there is a tendency for prices to adjust based on the underlying supply and demand conditions. Moreover, often when prices are adjusting the underlying supply and demand conditions change, which sets in motion new equilibrium prices that markets tend towards. The assertion that wages on the free market are flexible downward requires some backing up. This is not to deny that nominal wage rigidity appears to be a fundamental feature of modern market economies. However, the present authors argue that this rigidity is due fundamentally to government intervention in the economy (see below).

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Earlier, when governments intervened less, wages were not as rigid. In the United States from 1841 to 1891, back when there was less government involvement and falling prices were the norm, wages were more flexible and did not show signs of downward rigidity (Hanes and James 2003, 1423; Hanes 2013, 123).   There have been papers that argue that nominal wage rigidity became a pervasive feature in the US economy starting in the 1890s (for example, Hanes 1993). These results are based on surveys collected by state governments during this time that appear to show that most businesses did not report wage cuts during the downturns in these years. However, the accuracy of the surveys can be questioned, and as a result they appear to overstate wage rigidity (O’Brien 2000). More research on the late nineteenth and early twentieth centuries should be conducted. For examples of wage flexibility during the 1870s and 1920–21 depressions, see Newman (2014b, 494–5; forthcoming, 30–33).

REFERENCES Blaug, M. (2010 [1997]), Economic Theory in Retrospect, 5th edn, Cambridge: Cambridge University Press. Friedman, M. (1969 [1966]), “Interest rates and the demand for money”, in M. Friedman, The Optimum Quantity of Money and Other Essays, London: Macmillan. Friedman, M. (1969 [1967]), “The monetary theory and policy of Henry Simons”, in M. Friedman, The Optimum Quantity of Money and Other Essays, London: Macmillan. Friedman, M. and Schwartz, A.J. (1982), Monetary Trends in the United States and the United Kingdom, Chicago: University of Chicago Press. Garrison, R. (2006 [2001]), Time and Money: The Macroeconomics of the Capital Structure, New York: Routledge. Hanes, C. (1993), “The development of nominal wage rigidity in the late 19th century”, American Economic Review, 83 (4), 732–56. Hanes, C. (2013), “Business cycles”, in R. Parker (ed.), Routledge Handbook of Modern Economic History, New York: Routledge. Hanes, C. and James, J.A. (2003), “Wage adjustment under low inflation: evidence from U.S. history”, American Economic Review, 93 (4), 1414–24. Harris, S. (1947), “Introduction: the issues”, in S. Harris (ed.), The New Economics, London: Dennis Dobson Ltd. Hayek, F. (2008 [1931]), “Prices and production”, in F. Hayek and J. Salerno (eds), Prices and Production and Other Works, Auburn, AL: Ludwig von Mises Institute. Hayek, F. (2008 [1931, 1932]), “Reflections on the pure theory of money of Mr. J.M. Keynes”, in F. Hayek and J. Salerno (eds), Prices and Production and Other Works, Auburn, AL: Ludwig von Mises Institute. Higgs, R. (1997), “Regime uncertainty – why the Great Depression lasted so long and why prosperity resumed after the war”, The Independent Review, 1 (4), 561–90. Higgs, R. (2010), “Recession and recovery – six fundamental errors of the current orthodoxy”, The Independent Review, 14 (3), 465–72. Hutt, W.H. (2009 [1954]), “The significance of price flexibility”, in H. Hazlitt (ed.), The Critics of Keynesian Economics, Auburn, AL: Ludwig von Mises Institute.

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Keynes, J.M. (1964 [1936]), The General Theory of Employment, Interest, and Money, London: Macmillan. Knight, F. (1951), “The role of principles in economics and politics”, American Economic Review, 41 (1), 1–29. Knight, F. (2009 [1937]), “Unemployment: and Mr. Keynes’s revolution in economic theory”, in H. Hazlitt (ed.), The Critics of Keynesian Economics, Auburn, AL: Ludwig von Mises Institute. Krugman, P. (2009 [1999]), The Return of Depression Economics and the Crisis of 2008, New York: Norton. Mises, L. von (1990 [1932]), “The position of money among economic goods”, in L. von Mises, Money, Method, and the Market Process, Norwell, MA: Kluwer Academic Publishers. Mises, L. von (2006 [1928]), “Monetary stabilization and cyclical policy”, in L. von Mises and P. Greaves (eds), The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Auburn, AL: Ludwig von Mises Institute. Mises, L. von (2008 [1949]), Human Action, Auburn, AL: Ludwig von Mises Institute. Mises, L. von (2009 [1953]), The Theory of Money and Credit, Auburn, AL: Ludwig von Mises Institute. Modigliani, F. (2009 [1944]), “Liquidity preference and the theory of interest and money”, in H. Hazlitt (ed.), The Critics of Keynesian Economics, Auburn, AL: Ludwig von Mises Institute. Newman, P. (2014a), “Rothbard’s time market and the demand for present goods”, Quarterly Journal of Austrian Economics, 17 (1), 46–66. Newman, P. (2014b), “The depression of 1873–1879: an Austrian perspective”, Quarterly Journal of Austrian Economics, 17 (4), 474–509. Newman, P. (forthcoming), “The depression of 1920–1921: a credit induced boom and a market based recovery?”, Review of Austrian Economics. O’Brien, A. (2000), “Were money wages always rigid? A look at the reliability of survey evidence on changes in wage rates”, Industrial Relations: A Journal of Economy and Society, 39 (1), 48–61. Rothbard, M. (1992), “Keynes, the man”, in M. Skousen (ed.), Dissent on Keynes: A Critical Appraisal of Keynesian Economics, New York: Praeger. Rothbard, M. (2008 [1963]), America’s Great Depression, Auburn, AL: Ludwig von Mises Institute. Rothbard, M. (2009 [1962]), Man, Economy, and State with Power and Market, Auburn, AL: Ludwig von Mises Institute. Samuelson, P. (1947), “The general theory (3)”, in S. Harris (ed.), The New Economics, London: Dennis Dobson. Simons, H. (1936), “Keynes comments on money”, The Christian Century, July, 1017. Skousen, M. (2007 [1990]), The Structure of Production, New York: New York University Press. Snowdon, B. and Vane, H. (2005), Modern Macroeconomics: Its Origins, Development and Current State, Cheltenham, UK and Northhampton, MA, USA: Edward Elgar Publishing. Tobin, J. (1977), “How dead is Keynes?”, Economic Inquiry, 15 (4), 459–68.

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2. What the entrepreneurial problem reveals about Keynesian macroeconomics Per L. Bylund At any point in time, if we assume and hold constant the market data that exist at that very moment, there is a perceivable state in which the economy maximizes utilization of productive resources. At every real point in time, however, the economy is sure to be in a state that is different from this theoretical ideal. The efficient state remains unachieved and the economy is therefore necessarily suboptimal – it is, in economic terms, inefficient, as contemporary economic models correctly show. Whereas this type of static equilibrium analysis provides insight into the present state of an economic system, it reveals little about how it changes over time or its direction as things play out, for it is a fact that the market and its production apparatus change, that the market is in constant flux and must be to remain relevant. Part of the reason is that consumer preferences change, fads come and go, and the production apparatus of the market must respond to these changes. But it is also the case that knowledge and production capabilities change: new resources, production methods, and products are innovated and discovered with the passing of time. This makes the static or snapshot analysis fundamentally inapplicable to the real economy, since the latter is more of a process than it is a state. Indeed, a better understanding of how the market works acknowledges that the many uses of productive resources in the present are specifically for the purpose of attaining some anticipated end at some point in time in the near or distant future. Already finished goods may be consumed immediately, and can therefore satisfy wants already in the present; but goods in process – goods that are being produced but not yet finished and ready for consumption – will not and cannot be available until some future time. This future time is yet to exist and therefore cannot yet be fully known. Production in the present is therefore always intended to satisfy wants that are unsatisfied in the present yet are expected to remain, or that do not exist but are anticipated to arise in the future. 26

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It follows that what can be observed in the snapshot view of the economy, and the efficient equilibrium state that can be theoretically derived (and is potentially perceivable) from existing market data, is a mix of that which applies to the present and present adaptations to anticipated and imagined future states. What is evident in the snapshot view, whether or not we are able to identify the details thereof, comprises bits and pieces of production plans that have been brought to their fruition and are revealed as either successes or failures; production plans that are underway but yet to be concluded and were set in motion at earlier points in time; and plans made or preliminary actions taken to establish production processes aimed at exploiting anticipated opportunities for future sales. It is in this dynamic market situation that we find the entrepreneur, whose role it is to gather, combine, and configure resources available in the present, and produce capital resources deemed necessary in future production, suited to produce goods and services to meet demand in the future. It should therefore be no surprise that contemporary economic models, and their focus on static efficiency and equilibrium, disregard or even disallow the entrepreneurial function. Economic action for the attainment of some end at a later time, which therefore faces the inherent uncertainty of the unknown future, has no place in static modeling. It is argued in this chapter that the innovative entrepreneur is indeed necessary to understand the market economy, and especially the entrepreneurial problem of employing scarce productive resources in production processes in the present to satisfy future demand. The entrepreneurial problem, I argue, is not only largely missing from John Maynard Keynes’s General Theory but also suggests fundamental shortcomings in the theory itself.

THE ENTREPRENEURIAL PROBLEM Entrepreneurship is sometimes conceptualized as simple arbitrage in response to exogenous change (Kirzner, 1973). But even in this limited-­ scope definition of entrepreneurship it is obvious that it is tightly linked with, if not fully composed of, production of economic value. Whether in the passive sense of an agency responsive to exogenous change or the active sense of meeting or creating a future market state, production amounts to the process of using and combining scarce resources in order to attain a certain valuable end. That this process is time-­consuming, in the sense that some time must elapse from the inception to conclusion of a productive effort, is obvious. One cannot acquire, (re)arrange, and make use of productive resources in order to, as an intended effect of such

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effort, achieve some specific outcome without the passing of time. Action always takes place in and over the course of the passing of real time. Consequently, the entrepreneur must always bear some degree of uncertainty, as economic scholars since at least the early eighteenth century have concluded (see, for example, Cantillon, 1755). In this chapter, we follow this tradition in recognizing the entrepreneurial function as one constituting uncertainty-­bearing. The entrepreneurial problem, therefore, is how to properly respond to and anticipate future market states so that production can be properly aligned through actions taken in the present to generate sufficient profits in the future. To be clear, the entrepreneur must acquire or otherwise gain control of necessary resources in the present to be used in production for the future. To further elaborate on the nature of the entrepreneurial problem, let us consider three cases of increasing complexity (and also of increasing realism and therefore relevance). In the first case, the entrepreneur is the sole producer in a market setting where consumer preferences are not expected to change. Whereas this market is conducive to exogenous change beyond the scope of consumption and use, such as disruptive forces of nature, the present structure of consumer wants will remain unchanged in the future. The opportunity for future profit is therefore known to the entrepreneur to the degree that present preferences are known or can be accurately estimated. Therefore, the entrepreneur can expect his or her produced good or service to be demanded by consumers in the future to the same extent as demand in the present. But to earn a profit from this endeavor, the entrepreneur must also successfully establish a production process that makes use of available productive resources in the present to produce the good or service at a cost that is lower than the price consumers will be willing and able to pay. Production, in other words, responds to and is intended to satisfy the anticipated (in this example, mostly known) demand. Even though demand is for all practical purposes constant, the entrepreneur still bears uncertainty in this production process. The ­ ­entrepreneur’s uncertainty-­bearing is, however, limited to technological errors or miscalculations – problems of engineering the production process properly – and the effects on production (and possibly on consumer demand) of exogenous shocks such as earthquakes or tsunamis. Note that both of these categories of potential problems have an economic aspect as well: even if a production process is technologically feasible, and perhaps efficient from an engineering point of view, it is only economically feasible to the extent that the cost is lower than consumer valuation of the outcome. The outcome of the entrepreneurial endeavor is consequently uncertain for both technological and economic reasons, even though

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there is known future consumer demand. The entrepreneurial problem is limited to finding the proper response to satisfy future demand, which amounts to choosing and establishing a type of production process that is ­technologically sound and where the cost of production is lower than the value consumers place in the good produced. Let us now consider another case. We here add the possibility of changing consumer demand with the passing of time. Consumers’ valuation of the entrepreneur’s imagined good or service per se is now uncertain and unpredictable, which affects the entrepreneur’s ability to accurately calculate the profitability of a specific production process. A production process that would have earned a profit in the previous case may no longer do so because consumer preferences are no longer expected to be constant. In other words, the entrepreneur must now bear the uncertainty of the production process (as in the previous case) as well as the uncertainty of consumers’ future valuation of the good or service to be produced (changing preferences). To be successful, the entrepreneur must accurately predict future demand, which may or may not be a function of the demand structure at present, and choose a product or service and production process that produces at a cost sufficiently lower than the expected price consumers will be willing and able to pay. The proper entrepreneurial course of action now depends on two levels of unknowns to generate a profit, where the unknown structure of future consumer demand will determine the price that must cover the unknown costs of the chosen production process. Needless to say, this greatly complicates the entrepreneurial problem.  The entrepreneur faces uncertainty in the production process, including the  cost of production, as well as the valuation and therefore ­salability of the good or service. Until this point, we have assumed that there is only one producing entrepreneur in the market. While there are numerous consumers with different and, in the more complex second case, changing preferences, the fact that there is only one producer is an unrealistic simplification of the real market. As there are no alternative goods or services produced, the profit function remains essentially the same in both of the first cases: profits will be earned where the price consumers are willing and able to pay exceeds the cost of producing the good or service sold. But this changes when we now, in our third case, introduce several producers and several goods and services. With more than one entrepreneur, even if all producers were to produce and sell the same good or service, any single entrepreneur’s profit opportunity could be completely undermined by another entrepreneur offering the good or service at a lower price or at an earlier time. Consequently, even if the entrepreneur accurately anticipates the structure of future market demand and the cost structure of the preferred production process,

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demand may be fully satisfied and satiated by another entrepreneur who is able to produce at slightly lower cost and thus offer a substitute at a lower price. So here the entrepreneur must anticipate not only the structure of future demand and the willingness and ability of consumers to pay for the good, but also to what extent he or she will be able to meet it in the face of competition from other entrepreneurs. Add to this picture the complexity of a modern market with a myriad different products and services offered. Whereas any entrepreneur’s future product offering can be undercut by competing entrepreneurs offering substitutes at lower prices, the entrepreneur must also compete with other goods and services offered in the market. The real demand for his or her product is the demand that remains after consumers consider the full extent of their opportunity costs: effective demand for this product will exist only where the consumers’ expected value of the offered good or service, after taking into account the cost of procurement, exceeds the net value expected from other products offered in the market. The entrepreneurial problem amounts to producing a good or service that provides consumers with sufficient value, in the eyes of those very consumers, to exceed all other offerings of value to those consumers – and to do so at a cost that is lower than the final selling price.

PRODUCTION VERSUS CONSUMPTION AND THEIR TIMING As was shown in the previous section, the uncertainty borne by the entrepreneur in production is far from trivial. It should therefore not be surprising that many entrepreneurs fail in their undertakings and that they sometimes suffer devastating losses. This, indeed, is the nature of the game; most entrepreneurs fail most of the time. Entrepreneurial failure, and therefore the suffering of losses, always follows from errors in solving the entrepreneurial problem, that is, failure to accurately anticipate the real value offered to consumers. This may be due to one or a combination of the sources for miscalculation discussed above: the costs of production may turn out to be too high and therefore require a selling price that consumers are unwilling or unable to pay; the product may not be considered as valuable by consumers as the entrepreneur had anticipated; and the entrepreneur may underestimate the ability of competing entrepreneurs to provide value to consumers beyond what he himself can offer them. The other side of the entrepreneurial-­problem coin is that ­entrepreneurial failure, which suggests there is insufficient demand for an entrepreneur’s offered product at a price that covers production costs, is due to offering

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insufficient value to consumers. Entrepreneurial failure is a result of the value offered being lower than the cost, that the net value does not sufficiently satisfy consumer wants, or that consumers can find greater value elsewhere (either from goods and services offered by other entrepreneurs or from postponing consumption altogether). The lack of demand for this good, in other words, is fundamentally the entrepreneur’s failure to produce, from the point of view of consumers’ real demand, the right type of good in the right way (that is, using the best resource combinations and production methods) and in the right quantity: the net value offered to consumers is too low relative to their other valuable opportunities. From the point of view of consumers, the entrepreneur’s undertaking is then, relatively speaking, too costly. Their opportunity costs will direct their purchasing activities elsewhere, where they can get comparatively more value for their money. But there is a social aspect to production as well. Entrepreneurial failure means not only that the entrepreneur suffers a loss of invested capital, but is also an indication that society as a whole has suffered a loss compared to what could otherwise have been. It is true that the entrepreneur made an error in and of itself, but it is equally true that the resources allocated to the failed production process could have found more valuable uses elsewhere. The suffered loss indicates that the entrepreneur has erred, but ultimately serves the purpose of making the entrepreneur release the resources from their relatively inefficient uses and thus make them available for other types of productive efforts. This societal or macro perspective on the result of productive investment is indicative of the purpose of production: the use of scarce resources to satisfy more or greater consumer wants overall, whatever they may be. This is an important point, for with scarce productive resources it is essential that all resources are used in the best way possible so that they can satisfy as many and as urgent wants as possible. But as future demand is unknown when a production process commences, it cannot be the driver of production. Rather, production is an entrepreneurial endeavor under market uncertainty that attempts to anticipate future states of the market; it is the lure of profit from accurately anticipating and meeting consumers’ future wants and needs, which may indeed be very different from their present ones, that (re)directs an economy’s whole production apparatus. In this sense, entrepreneurship is the true “driving force” of the market process (Mises, 1949) and the engine of improvements in production that facilitate consumption. It is a fact that entrepreneurship engages in production of goods and services that are anticipated to serve some end of, and therefore be of value to, consumers. The entrepreneur must consequently bear the uncertainty of producing, and therefore suffer losses

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from erring and earn profits from accurately anticipating and successfully meeting future consumer demands. The role of the consumer is limited to being the judge of the entrepreneur’s productive efforts and to, where found sufficiently valuable, consume what has been produced. The consumer is in this latter sense the beneficiary of all economic action, and his consumption is the ultimate purpose of productive efforts, but does not actively take part in the process until production is completed and the goods and services are offered for sale. Value is the satisfying of wants, which is only possible where production meets real wants to consume. Consumption, and therefore the realization of entrepreneurial profits, happens on the consumer’s terms. Indeed, production is intended to and steered toward satisfying real wants, whatever they may turn out to be, while economizing on resources. It is a time-­consuming and costly process during which preferences, wants, and needs may change. Suppose consumption leads to production, that is, the very opposite of what we have here shown to be the case. As there is nothing to consume in advance of concluded production, the demands will remain unsatisfied until the corresponding production process has been established and the process brought about the good or service to satisfy the want. In order to truly consume, production must still take place first: it is impossible to consume what has not yet been produced. And as this is the case, this leads us back to anticipative entrepreneurship. Even if consumer preferences are truly known in advance and are not expected to change, entrepreneurs must anticipate the market situation in which they will be able to provide a good or service to satisfy the wants (case one above). With more than one potential entrepreneur, as in case three above, the market situation is highly uncertain – even if preferences are fully known. No entrepreneur can know the actions of all other entrepreneurs, and must therefore anticipate which demands will remain unmet as the planned production process is finalized and products sold. The market situation as production is completed is unknown – even if demand is constant and unchanging. Considering how consumer preferences change over time rather than are constant, it becomes clear that the entrepreneur is required to attempt to anticipate future market conditions – both supply and demand – rather than rely on present market data. It makes little sense to work toward how things are when it is fully possible that what will be when one is ready to meet the market is very different; and under such circumstances it makes much more sense for entrepreneurs to attempt to anticipate what preferences consumers will hold at the time when production is expected to be completed. It is, of course, not possible to attempt to satisfy wants in the present using means available only in the future; and as the future market

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situation is uncertain even with constant preferences the chance for success should be greater if production is aligned with a best guess of what the future will hold. There is a further complication that we should consider. Imagine a situation in which willing entrepreneurs study a market situation that has no existing production. Needless to say, in this market all consumer wants necessarily remain unsatisfied – all entrepreneurial opportunities are ready to be exploited. Let us assume that these wants (­opportunities) are clearly communicated and not expected to change. With scarce resources available for production, we prefer greater wants satisfaction to less of it. Consequently, the objective of willing entrepreneurs is to identify the greatest opportunity for profit, which would be aligned with satisfying the most urgently felt needs among consumers, and use resources in an economizing manner. But as there is no production and therefore no products to choose from, there are no trade-­offs made and therefore no indication of opportunity costs. In other words, how can entrepreneurs figure out which needs are most urgently held? Those most urgently held would be the ones that can be satisfied at the highest prices, and therefore the highest profits; but as prices are themselves expressions of relative urgencies of consumer wants, there is no means to properly economize on resources. So how can productive efforts be directed toward more efficient resource use? The only way of doing this is by producing in a market; but markets consist of the very production to satisfy wants – that is, the entrepreneurial bidding for productive resources and the choices made by consumers – that we assumed have not yet emerged. If there is a market, as we saw above, there is also production that satisfies consumer wants, which creates uncertainty about which wants are still be to satisfied. This, again, leads us to the only possible solution: production based on anticipated market demand, and therefore that production precedes (and therefore also shapes) consumption. Production thus shapes the structure of and may even “create” demand by figuring out how to satisfy wants. This is the task of the entrepreneur.

VALUE AND PRODUCTION GLUT The previous section noted in very brief terms, almost in passing, that value is the satisfaction of real wants, and that this is what happens only where completed goods – the result of a resource-­ using (costly) and time-­consuming (temporal) production process – coincide with consumer wants. Value takes the form of real want satisfaction, or the relief of a felt uneasiness, through consumption of a good. It follows that successful

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entrepreneurship is production that accurately anticipates consumer demand and manages to offer proper means to meet demand and therefore satisfy consumers’ real wants. This is possible only if the good is offered at the right time, in the right place, and at a proper price. The only price that can lead to an exchange, and thereby the satisfaction of a want, is a price at which the consumer expects to gain greater value (satisfaction) than is given up (price). Any loss is therefore solely the entrepreneur’s. Indeed, if the good is produced at a cost that is higher than the price consumers are willing and able to pay, the entrepreneur must choose between selling at a loss and, as an alternative, keeping the product for own consumption or future sale and therefore forego money income in the present. As the good does not warrant a price that exceeds cost, the cost of the entrepreneurial failure is borne by the entrepreneur. We therefore find that the only possible outcomes of an entrepreneurial endeavor are value creation (sale of the produced good at a profit) or value destruction (sale at a loss or non-­sale). The former benefits the consumer, the entrepreneur, and society as a whole because more wants are satisfied as a result of using resources in more efficient ways. In the alternative case, benefits will only accrue to the consumer of the product, who buys at the market price. Since the market price is below cost, any such purchase will necessarily be at the entrepreneur’s expense. As is evident from the inability to charge a price exceeding cost, the entrepreneur’s investment in production fails to generate sufficient value and society as a whole consequently suffers a loss. The entrepreneur may conclude that the failure to sell at a cost-­covering price is simply a problem of timing – of offering the goods too soon, before they are sufficiently desired by a large enough number of consumers – and therefore choose to keep the goods for the purpose of selling at a later time, when higher market prices may be expected. Such postponement of finalizing production through sale does not affect the analysis, however, since storage in anticipation of sale is necessary to differing degrees in all production. Storage, transportation, packaging, and so forth are normally part of that period of provision during which the entrepreneur bears the uncertainty of the endeavor. The revision of a plan for production and sale of a good is a normal part of entrepreneurship. The cost of entrepreneurial failure, as we have seen, is inescapable. It must be borne by the entrepreneur personally – through loss of capital and therefore reduced ability to invest in and coordinate future p ­ roduction – and by society as a whole, through the loss of productive resources available in production. Specific consumers may benefit in the short run if the entrepreneur decides to sell the produced goods at prices that do not cover production costs. These consumers, however, would benefit all the same from this purchase had the goods been produced at a profit and

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therefore utilized productive resources more efficiently – they will not pay higher prices because the entrepreneur produced at too high a cost. The cost of production does not determine price – price is always limited by what the market will bear, that is, by consumers’ willingness and ability to pay. Ultimately, consumers overall are worse off because the entrepreneur’s inefficient production effectively consumes too much productive capital and for this reason leaves less for other, potentially better, entrepreneurs to use in production of other goods. The economy’s ability to produce in order to satisfy future wants is therefore adversely affected by the entrepreneur’s failure to anticipate and produce for real demand. An entrepreneur’s failure in the present therefore has repercussions both in the present, for those directly affected by production, and in the future, through forcing the combined production apparatus onto a less efficient production path. The latter social cost restricts the growth of prosperity while it at the same time threatens to offset the appeal of future entrepreneurship. It may therefore be tempting to try to alleviate the burden of entrepreneurial failure on the entrepreneur and society. The only way of doing this, using economic means, is for a third party to intervene with the express purpose of “increasing demand” for this entrepreneur’s products. This ­intervening third party can do one of two things: increase demand by purchasing goods from the entrepreneur at a cost-­covering price or act to increase other consumers’ willingness to pay a cost-­covering price. Buying the entrepreneur’s goods at the higher price will lessen the ­entrepreneur’s burden of the loss. It can also provide the full benefit to ­ consumers if the good is resold to them at their preferred price, thereby leaving the third party to cover the difference. As an alternative, ­consumers’ willingness (and, to the degree they lack it, their ability) to pay a higher price for this (and other) good(s) can be raised by using means to boost their purchasing power.1 As purchasing power can be used in many ways and is subject to consumers’ specific preferences though also diminishing marginal utilities, to get the intended effect their purchasing power must be boosted sufficiently for them to consider buying this specific ­entrepreneur’s products at the price required to cover the entrepreneur’s real costs. This may require substantial investment by the third party, since consumers may prefer purchasing greater quantities of other goods before buying this entrepreneur’s goods at that price. This type of stimulation of demand, either by outright buying of the ­otherwise unsalable goods (which really amounts to stimulating production) or by providing consumers with enough means to make a sufficiently large subset of them willing and able to pay the cost-­covering price for this good, redirects resources from other parts of the economy. Any well-­ functioning market allocates all available resources of value in production

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toward their preferred productive uses, so redirecting them toward lessening the burden of this one entrepreneur’s failure means the economy will suffer losses of productive effort (that is, value-­creation) elsewhere. Resources must themselves be produced to be usable (in the simplest form, they are extracted from nature) and become valuable as they are used. They cannot be created out of thin air, so they must be taken from somewhere  – from their current use – in order to be used for another purpose. This redirection from one use to another has negative consequences in those sectors of the economy that the resources are taken from. Will it be worth it? The answer to this question depends on the value scales of the intervening party, who must foot the final bill for this intervention. Considering the size of investment necessary for this type of action, it seems likely the costs would tend to exceed any benefits that can be derived from saving this single entrepreneur in most or all cases. As there is also a cost of redirecting resources from their current productive to new and relatively unproductive uses, this type of interference would amount to little more than a special favor to the individual failed entrepreneur. But is this true if we instead consider the effects of this type of action in the aggregate, for a subset of or all entrepreneurs in the market?

AGGREGATE ENTREPRENEURIAL PROBLEM Whereas saving one entrepreneur from the burden of failure, and thereby eliminating his or her cost of failing to properly solve the entrepreneurial problem, is clearly akin to doing the entrepreneur a special favor; there may be strategic reasons for governments or societies to do the same thing for subsets of entrepreneurs. For instance, a government can choose to subsidize a specific sector of the economy that is deemed of great national importance because it strengthens the country’s prestige, defense, or ability to be self-­sustaining in case of war. Alternatively, a sector can be identified by non-­economic actors (that is, by parties other than entrepreneurs and their financiers) as necessary for future success or to strengthen an economy’s relative competitiveness in the longer term. This type of reasoning commonly relies on the ­assumption that certain innovations or even types of production – whole sectors of the economy – are impossible to bring about through market means, which therefore necessitates public investments. Such sectors would commonly include education (increasing the productivity of the national labor force by subsidizing getting an education or degree); infrastructure (targeted investments to improve or expand on existing infrastructure to facilitate transportation of goods and services and thereby strengthen the

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economy’s vitality); high-­tech (investments in computers and particular technologies that are considered to be “the future”), and so on. There is reason to be highly skeptical of the argument that private actors cannot do what public ones can, especially when referring to entrepreneurship, which is our main concern here. Whether or not a sector “needs” to be established by government (an argument we will not discuss further here) or is only subsidized by it in order to survive, such action necessarily involves – as in the case of a single entrepreneur above – redirection of productive resources: that is, the redirection of resources from sectors that have already put them in value-­ creating uses, based on entrepreneurial anticipation of future demand, to sectors where entrepreneurs have not done so. This suggests that ­entrepreneurs have not deemed the latter to be of sufficient interest from a business perspective to make the necessary investments. In other words, entrepreneurs have chosen not to enter these sectors but to instead invest in other sectors. To undo this necessarily comes at a cost. Our interest here, however, is primarily the case where there is ­entrepreneurial failure post entry, not the case where whole sectors of the economy are shunned by entrepreneurs but preferred by governments. There are, after all, many possible kinds of production, types of goods, and potential sectors of any economy that are never realized.2 Those are not what we here refer to as the entrepreneurial problem, which specifically relates to investments made in the present for completion at a future time subject to the anticipated structure of consumer demand for final sale. Consider an existing sector of the economy in which all or most entrepreneurs at some point fail to accurately meet demand and the ­ ­entrepreneurial problem therefore remains unsolved. We have not assumed that all sectors of the economy see extensive entrepreneurial failure, so it is not a problem of entrepreneurship per se. There must consequently be something about this sector in particular that has made entrepreneurs unable to accurately anticipate real demand. In other words, we should be able to find the cause (or at least an explanation) of such widespread entrepreneurial error in what differentiates this specific sector or the ­entrepreneurs who have entered it. What we have here is a sector of the economy that experiences a glut or over-­ production as entrepreneurs in this sector specifically fail to accurately anticipate consumer demand. The failure does not consist of producing too little, which only increases the selling price and attracts further investment, but too much: they overestimate demand. The effect of this failure in the aggregate is falling prices with respect to all other goods and services, because there is insufficient demand to purchase the stock of goods produced. Over-­production is here excess production relative to real

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consumer demand for this type of good (or types of goods), which is an expression of consumer valuation of this sector’s goods relative to other goods available (offered by entrepreneurs in other sectors) as well as their expectations of their purchasing power in the near future. In other words, entrepreneurs in this sector cannot sell their goods as they had anticipated because consumers prefer goods produced and offered in other sectors. The issue is not failure on the part of an entrepreneur to anticipate demand for his or her specific goods, but the failure of entrepreneurs throughout this specific sector to foresee accurately what quantity of goods can be sold at cost-­covering prices. An implication of over-­ production in this sector, which should be obvious in retrospect when produced goods remain unsold, is that the productive resources available for production were inefficiently allocated. Why? Because entrepreneurs in this sector bid and paid higher prices for them than they should have. This means these productive resources that should have been used elsewhere, had the economy been properly ­positioned to satisfy consumer wants, were instead used in this sector. The result is two-­fold: too little production in sectors where there is sufficient, and now unsatisfied, consumer demand, and too much production in our focal sector. This over-­production resulted in losses for entrepreneurs in this sector, who over-­invested in production capacity and used this ­capacity to produce in excess of real consumer demand. Of course, this story is not in principle different from our discussion above about the errors of the single entrepreneur. What has changed is that we are here discussing the relation between production in different sectors in the economy – and therefore entrepreneurs’ aggregate behavior in those sectors. An error in a sector should therefore have greater consequences than an error by a single entrepreneur, and the effect of over-­production of a whole sector would be of comparatively greater magnitude. The main difference, however, is what caused the rate of entrepreneurial error in this sector to become so much greater than in other sectors. Or, to put it in ­different terms, what caused entrepreneurs in this sector to invest in error to a much greater extent than entrepreneurs in other sectors. To explain this type of “clustering” of errors in a specific sector, we must ask what caused the entrepreneurs specifically in this sector, but not in other sectors, to invest incorrectly (specifically, to over-­invest). They were so willing to over-­invest, in fact, that they bid up the purchasing prices for the productive resources necessary above and beyond what entrepreneurs in other sectors were willing and able to invest. It should be obvious that the entrepreneurs must have responded to the wrong or faulty signals, something that persuaded them that this particular sector would see much greater demand – and also profitability – than it actually did.

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Such errors could conceivably happen in response to a hype or ­ rummed-­up fad thought to be of much greater substance than is the d case, or that is believed to have significant impact on future production or consumer behavior. This, in turn, may be a consequence of, for example, the development or discovery of revolutionary technology that offers great promise but is too slow (or ultimately fails) to deliver. In the case of revolutionary technology, the promise may indeed be exaggerated but the technology should rarely be without use. The problem regards expectations of the degree to which this technology will meet expectations. Investment in response to the hype should therefore at best cause temporary malinvestments due to errors in scale of production, which would quickly be adjusted as the consequences of those errors are revealed. Prudent entrepreneurs would invest in flexible production structures that allow for downscaling should anticipated demand not be realized. A problem of similar implications, but with much more far-­reaching consequences, would emerge in response to faulty rather than exaggerated market signals; examples of this include policy-­based credit expansion (as is analyzed in the Austrian theory of the business cycle).

ENTREPRENEURSHIP AND A GENERAL GLUT So far we have considered issues resulting from entrepreneurs’ failure to accurately anticipate demand and therefore the misalignment of ­production with respect to consumer demand. We found that entrepreneurs can and do fail in their undertakings, and that this causes losses due to inefficiencies: productive resources are used in the wrong production processes, with the result being over-­production of some goods relative to other goods that are more highly demanded but insufficiently supplied. Two cases were considered: the errors of a single entrepreneur and the implications thereof on market production; and the possibility of a cluster of errors in a specific sector of the economy. Both are examples of partial gluts, or over-­production, in the economy due to entrepreneurial failure. Both cause misalignment to the overall production structure of the market, which causes a costly readjustment process in which entrepreneurs as a group, through individual investment decisions, reallocate resources. What remains to consider is the possibility for a general glut, which is the assumption behind Keynesian macroeconomic analysis. Rather than failure of a single entrepreneur or even a clustering of entrepreneurial failure within a single or several specific sectors of the economy, a general glut means there is universal over-­production: too many goods are produced and there is therefore a general lack of demand, which causes losses

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and cutbacks for entrepreneurs throughout the economy. From the point of view of the entrepreneurial problem, this means all or at least a large majority of entrepreneurs have failed to accurately anticipate consumer demand: they all produce too much. The logic in the discussions above therefore no longer applies because resources are no longer misallocated toward suboptimal uses. Au contraire, the problem with a general glut is of a different kind altogether: productive resources in the economy are overall used too much. A general glut means that there is too much productive power in use in the market. Consequently, goods are produced beyond what is demanded. The implication is that entrepreneurs fail because they produce, not because they invest in the wrong lines of production. Or, to simplify, consumers are not willing or able to purchase sufficient quantities of the goods produced at prices that cover entrepreneurs’ costs. There ­consequently is no entrepreneurial problem of the type discussed above because production itself, not specific types of production, is without value. The proper course of action for entrepreneurs is not to choose what and when to produce, but whether to produce at all. As consumers do not demand any goods to the degree they are p ­ roduced and all entrepreneurs therefore face losses, production does not contribute value. This has absurd implications because it suggests that p ­ roductive resources are no longer scarce, but exist in abundance relative to consumer demand. Indeed, the general glut arises because resources that should not have been used to produce have nevertheless been ­committed to ­production processes aimed toward satisfying demands. There is no economic problem because there are more means than there are ends that can be achieved, so there are no trade-­offs to be made: over-­production of one good does not mean resources could have been used more productively in production of other goods. This also means that there is no proper entrepreneurship in this economy, since there is no entrepreneurial problem: resources cannot be efficiently allocated in production for the simple reason that they are better not used at all. Or, to put it another way, the resources are without value because they cannot be used to produce valuable goods to be consumed – consumers consequently cannot be made better off. This is not to say that consumers are content with the present ­situation, only that their demands are fulfilled to the extent of their willingness or ability to buy the goods offered in the market. In other words, they ­consider themselves better off and therefore satisfy greater wants by not consuming. Keynes argues that this situation emerges because consumers lack the willingness to demand: deficient demand arises because c­ onsumers lack the will, but not the ability, to buy. Their preference is to save rather

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than to spend. This conclusion, however, contradicts core aspects of the ­entrepreneurial problem. First, we found above that production takes time and that the ­entrepreneur bears the uncertainty of the production undertaking. This means the entrepreneur suffers the losses should he or she inaccurately anticipate demand. But this can only be the case if resource owners who are not entrepreneurs are paid their expected worth during the period of production – that is, that wages are paid prior to the result of the production process regardless of whether it is found successful. In other words, even failed entrepreneurship results in workers earning wages. Failed entrepreneurship, therefore, does not entail the non-­payment of workers and consequently does not to the same (and certainly not larger) extent impose a limitation on effective demand. Furthermore, the entrepreneurial problem is to satisfy future demand by coordinating production in the present directed toward generating goods of anticipated value to consumers. The success of the entrepreneur hinges on his or her ability to produce and deliver value to consumers that exceeds the price they pay, which in turn covers the entrepreneur’s costs. This value-­ creation process ultimately depends on whether real value is offered to consumers on their terms. Consumers’ unwillingness to pay the requested price is primarily an entrepreneurial failure, not a failure by consumers to pay more than they value the goods produced. What is more, should entrepreneurs as a group fail to satisfy demand by providing too much of all produced goods, the failure is first and ­foremost at the expense of the entrepreneurs. The immediate result of such large-­scale failure is rapidly falling resource prices as entrepreneurs sell off their loss-­generating productive assets and, eventually, go out of business. However, this makes productive resources available, and at lower cost, for other entrepreneurs, who may be more successful in anticipating future demand.

CONCLUSION The Keynesian theory begins with an assumed general deficiency of demand, that is, a general glut, because consumers are unwilling to ­effectively demand that which has been produced and is offered in the market. Another way of putting this is to say that entrepreneurs have failed en masse in their undertakings, and that production consequently has failed to produce value because consumers don’t find it sufficiently valuable to pay the entrepreneur’s selling price. But this effectively puts the cart before the horse because it assumes that consumers – primarily workers

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rather than entrepreneurs and capitalists – lack the wish to demand the products completed and that entrepreneurs will even give up trying to find goods and services to try to sell. In contrast, and more properly, ­entrepreneurs are in the business of producing to meet consumer demand; their failure to do so is a failure of production, not a failure of consumers to demand, and thus requires correction. Indeed, our discussion above shows that when the entrepreneur fails to properly address the entrepreneurial problem, he or she loses the capital invested in the production process. This does not undo payments to resource owners, but releases productive capital bound in this production process. Entrepreneurial failure thus makes the productive resources used available to other entrepreneurs, who may be better equipped to deal with the entrepreneurial problem. Failure is not an irrevocable error as much as it is a means toward improving the market’s overall productive apparatus. The conclusion is that the Keynesian story has no room for the ­entrepreneurial problem of value creation through production, and we have seen that adding it makes it rather obvious that the Keynesian reasoning is backwards. The problem that is the starting point for the Keynesian theory simply cannot arise in a real market, but this fact is not obvious because entrepreneurship is not to be found anywhere in the theory.

NOTES 1. As the purpose of overcoming the burden of failed entrepreneurship is its otherwise negative effect on general prosperity, we cannot consider the option of forcing consumers to purchase the entrepreneur’s goods at prices they are not willing to pay. The only option is to increase their willingness and ability so that they prefer to make the purchase because they expect to benefit from it. 2. This is analyzed at length in Bylund (2016b).

REFERENCES AND FURTHER READING Bylund, P.L. (2016a), The Problem of Production: A New Theory of the Firm, Abingdon: Routledge. Bylund, P.L. (2016b), The Seen, the Unseen, and the Unrealized: How Regulations Affect Our Everyday Lives, Lanham, MD: Lexington Books. Cantillon, R. ([1755] 1931), Essai sur la nature du commerce en général (C.B. Henry Higgs, trans.), London: Macmillan. Hayek, F.A. von (1948), “The meaning of competition”, in Hayek, F.A. von  (ed.), Individualism and Economic Order, Chicago: University of Chicago Press. Hayek, F.A. von (1978), “Competition as a discovery process”, in Hayek, F.A. von,

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New Studies in Philosophy, Politics, Economics, and the History of Ideas, Chicago: University of Chicago Press, pp. 179–90. Kirzner, I.M. (1973), Competition and Entrepreneurship, Chicago: University of Chicago Press. Lewis, H. (2009), Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts, Mount Jackson, VA: Axios Press. Mises, L. von ([1949] 2008), Human Action, Auburn, AL: Ludwig von Mises Institute.

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3. A critique of two key concepts in Keynesian textbooks Tim Congdon The purpose of this chapter is to discredit Keynesian income-­expenditure analysis and the concept of the multiplier embedded within it. These two  key concepts of the Keynesian textbook mainstream omit variables critical to the determination of macroeconomic outcomes. The omissions are so serious that the income-­ expenditure circular flow is incomplete and misleading if it pretends to constitute a policy-­making framework. Critically, when organized in its familiar textbook form, income-­expenditure analysis has no room for either the banking system or the quantity of money. But changes in the quantity of money have major impacts on asset portfolios and expenditure decisions. These changes must be integrated in all discussions of the macroeconomic conjuncture if such discussions are to make any claim to real-­world plausibility. Income-­expenditure analysis is a close associate of the proposition in The General Theory that, with the marginal propensity to consume fixed, national income can be viewed as a multiple of autonomous ­expenditure. As autonomous expenditure includes the government’s outlays, the ­multiplier proposition is commonly regarded as endorsing a widening of the budget deficit as an appropriate counter to a serious downturn in aggregate demand.1 Led by Samuelson’s influential and much re-­edited 1948 contribution, the idea was promoted by Keynesian textbook writers in the 1950s and 1960s.2 It has remained a staple item in university tuition ever since.3 Given this background, it is perhaps not surprising that the slide into the Great Recession in late 2008 provoked top policy-­makers at the G20 Washington summit to seek fiscal stimulus orchestrated across the world’s largest economies. Fiscal stimulus meant increases in public expenditure and the budget deficit, as if the Keynesian textbooks still had the answer. Indeed, the Great Recession spurred the publication of several books asserting the renewed relevance of the Keynesian framework.4 However, within a few months European governments rethought their position. In particular, the Eurozone authorities urged the need for fiscal restraint over the medium term, to comply with the requirements for 44

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strong public finances contained in the 1998 Stability and Growth Pact. Sceptics about fiscal expansionism included Alberto Alesina, the most prominent member of the so-­called “Bocconi boys”. Alesina has been credited with persuading Eurozone governments to return in 2010 to fiscal consolidation.5 Since then an active and unresolved debate on fiscal ­austerity has developed between rival schools of economists. It has been pointed out that in the 25 years to 2008 medium-­term reductions in the structural budget deficit (as defined by the International Monetary Fund) were consistent in both the USA and the UK with above-­trend growth in demand.6 “Expansionary fiscal contraction” was the norm in these two countries over a long period, even though American Keynesians – such as Larry Summers – have described that notion as “oxymoronic” or worse. Clearly, a big debate is under way not only between academic ­economists but also between the policy-­making establishments in leading nations. Further, in that debate the conceptual legitimacy of Keynesian income-­ expenditure analysis is fundamental. The first part of the chapter reviews statements that define income-­expenditure analysis in order to pin down the subject more precisely. The next four sections show that Keynes’s own work suggested a more holistic and compelling approach to ­macroeconomic thinking, with attention paid to the value of transactions as well as national income and expenditure.7 The chapter then considers the risk of forecasting errors due to the weaknesses in income-­expenditure modelling, with illustrations from the forecasting record of the UK’s National Institute of Economic and Social Research (NIESR). The following sections present numerical information on the stability (or rather the instability) of the savings ratio and on the comparative size of changes in household net worth and fiscal policy. It turns out that changes in net worth are typically many times larger than “fiscal policy”, as that notion is commonly understood. On this basis such changes could well be more important to the macroeconomic outlook than purportedly contra-­cyclical adjustments to government spending and taxation. In conclusion, ­macroeconomics textbooks still in thrall to the Keynesian paradigm – which in practice means the overwhelming majority of the textbooks recommended to students – need to be rewritten.

THE INCOME-­EXPENDITURE MODEL: SOME FAMILIAR ACCOUNTS The core of the income-­expenditure model is well known. National income is set equal to national expenditure; national expenditure is seen as a multiple of autonomous expenditure; and the value of the multiplier is the

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inverse of the marginal propensity to save, which is one minus the m ­ arginal propensity to consume. In most statements output is said to depend on expenditure, so the equivalence of national income and expenditure is expanded into the notion of “the circular flow”. In the circular flow national expenditure is made possible by the spending of national income, which arises from the production of national output, which responds to national expenditure, which is made possible by the spending of national income and so on. Much university teaching of macroeconomics begins with the circular flow. According to Mankiw in the eighth edition of his widely used Macroeconomics, it is “a good place to start” as it “shows the linkages among the economic actors”.8 When fleshed out, statements of the income-­expenditure model can become appreciably more complex than the skeleton presented in the last paragraph. In the extreme, large econometric models with hundreds of identities and equations can be elaborated, and yet they still depend on the circular flow for their underlying conceptual integrity. In the UK one such model has been employed by the National Institute of Economic and Social Research for over 50 years. Christopher Dow, who moved from the Treasury to the National Institute in 1954 in order to develop the model, and later became chief economist at the Bank of England, was among its champions. In his words: Interpretation of events cannot depend on unstructured observation, but has to be based on assumptions . . . about the causal structure of the economy . . . Total demand is defined in terms of real final expenditure; its level (in the absence of shocks) is determined by previous income; its result is output, in the course of producing which income is generated; income in turn goes to ­determine demand in the subsequent period.9

Alternatively put, once it has been established at equilibrium values, the circular flow of income, expenditure and output can carry on indefinitely from one period to the next unless it is upset by “shocks”. What determines the equilibrium values? Here the multiplier and Keynes’s treatment of national expenditure come into play. In the most basic versions expenditure consists of just two components, consumption and investment. Consumption depends on income, with agents having average and marginal propensities to consume from income.10 Investment does not depend on income and in that sense is “autonomous”. The m ­ ultiplier concept can be expounded in two ways. It can be presented in static terms, when national income comes out of the analytical process just once and then stays the same, period after period, as the circular flow keeps the variables repeating themselves. It is equal to consumption (C or c.Y, where c is the marginal propensity to consume and Y is income) plus investment (I), which logically

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must be (1 − c).Y. Rearrangement gives Y = (1/[1 − c]).I, where 1/(1 − c) is the multiplier. The static presentation implies an obvious comparative static result. When investment increases from I1 to I2 equilibrium national income rises from (1/[1 − c]).I1 to (1/[1 − c]).I2. The other approach is to envisage a multiplier “process” dynamically. The exposition starts from national income, Y, equal to national ­expenditure, E, and in equilibrium at (1/[1 − c]).I1, and posits an increase in investment to I2. This increase in investment continues in all future periods. In the first period immediately affected by the “shock”, expenditure rises to (1/[1 − c]).I1 + (I2 − I1). This is clearly not (1/[1 − c]).I2. However, in a well-­known textbook discussion, the first shock to expenditure gradually becomes larger over successive periods and a sequence of shocks amounts to a geometric series that sums to (1/[1 − c]).I2.11 Over time a new equilibrium is reached, with consumption rising to a new and higher level, when national income and expenditure are both (1/[1− c]).I2. Reassuringly, in equilibrium the static and dynamic multipliers reach the same conclusion. Both static and dynamic accounts of the multiplier go back to the 1930s, when many of Keynes’s critics objected that the static version was “mechanical” and little more than “a tautology, devoid of any behavioural significance whatsoever”.12 The critics were generally more sympathetic to the dynamic interpretation. Indeed, Robertson had written an Economica article in 1933 in which he used period analysis to illustrate the response of consumption to investment on the way to the new equilibrium. Hawtrey pointed out that “the adjustment of income to which saving and active investment are made equal takes time”.13 Although the introduction of a time dimension was an analytical advance, it also created a potentially serious new problem. What would remain of the multiplier story if the value of the propensity to consume (that is, the ‘c’ that was being compounded in the geometric series) changed radically from one period to the next, before the new equilibrium values of Y and E were reached? For the multiplier theory to retain credibility in real-­world policy-­making, it was essential both to understand the determinants of the propensity to consume and to be confident of their stability.

THE SIGNIFICANCE OF THE VALUE OF TRANSACTIONS Nowadays university economics teaching pays little or no attention to the value of transactions. The tacit assumption is that the income– expenditure–  output circular flow is sufficiently comprehensive as a description of “how real economies function”, to quote again from the

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Mankiw textbook.14 In fact, in all real-­world economies the value of transactions is many times higher than any of income, expenditure and output, and the circular flow is incomplete as a characterization of the economy’s payments flows. The discussion here focuses on UK data, but the same point applies in all economies. At one time bank cheque clearing represented well over 95 per cent of the total value of transactions in the UK, but technological change has resulted in much settlement now being done electronically. UK Payments Administration Ltd is a service company for a range of quite diverse organizations specializing in payments settlement, including (for example) credit card and fraud prevention companies. According to its website, “The brands we support manage the systems behind UK payments, and every year these systems process payments nearly four times the value of the world economy.”15 According to the World Bank, the value of world output in 2013 was $75.6 trillion (that is, $75.6 thousand billion) in nominal terms. So in the recent past the UK’s payments organizations have been overseeing transactions worth roughly $300,000b or (at an exchange rate of $1.6 to the £) almost £190,000b, a fair proportion related to international transactions, with some transactions – notably inter-­bank foreign exchange settlement – clearly not relevant to the matters under consideration in this chapter. According to the Annual Summary of Payments Statistics 2014 published on the website of Faster Payments Scheme Limited (a member of UK Payments Administration Ltd), the total value of payments in the UK in 2014 was £73,804b. The latest national accounts estimates (at August 2015) give gross domestic product at market prices in 2014 as £1,791b.16 So the value of transactions was over 40 times the value of GDP. In comparing with the circular flow, allowance needs to be made for income, expenditure and output, which together are of course three times GDP. Nevertheless, the value of all transactions in the UK in 2014 was roughly 13 times the value of transactions in the circular flow.17 For many economists, nothing of any significance has been suggested in the last paragraph. It is well known that the value of transactions is exaggerated, relative to the three categories in the circular flow, by intermediate transactions and transfer payments. Intermediate transactions arise from companies’ buying and selling of inputs, which have the effect of causing transactions to be a multiple of value added. But so what? The purchases and sales of inputs cancel out, so that nothing fundamental follows for the determination of value added, and hence of national output or income. Similarly, transfer payments move the location of purchasing power from one agent to another, and perhaps from that agent to yet another, but do not represent the exercise of purchasing power in the sense that matters to the circular flow. They do not constitute the “effective demand” that

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motivates output and employment, and which Keynes emphasized as the concept at work in the analytical schema of The General Theory.18 However, two further types of transaction are overlooked entirely by the circular flow. It will now be argued that their non-­appearance undermines both the realism and the analytical coherence of the circular flow notion. Perhaps paradoxically in view of the later development of thought, Keynes’s own work contained one of the best presentations of the first of these transaction types. The two volumes of his 1930 Treatise on Money devoted many pages to the discussion of different classes of transaction, and the relationship between the functions of different money balances and the classes of transaction. The discussion began in Chapter 3 of the first volume, The Pure Theory of Money, where – despite the title – the main observations were empirical and quantitative. Keynes noted that two kinds of circulation could be distinguished, “the industrial circulation” and “the financial circulation”. He also referred to the total cheque transactions in 1927 in Great Britain of £64,000m, “to which must be added the transactions for which notes are used, making a total of more than sixteen times national income”.19 These remarks were the prelude to a much more detailed account of the two “circulations” in Chapter 15. By “industry” Keynes meant “the business of maintaining the normal process of current output, distribution and exchange and paying the factors of production”, whereas “finance” was to be understood as “the business of holding and exchanging existing titles to wealth, ­including stock exchange and money market transactions, speculation and the process of conveying current savings and profits into the hands of entrepreneurs”.20 Is it too much of a leap to suggest that Keynes’s “industrial circulation” in the Treatise is equivalent to the circular flow of income, expenditure and output, as presented in modern textbooks? After all, he did say that it corresponded to the “normal process” of spending income on output. Moreover, he added a page later that the money balances involved – which he termed “income deposits”, mostly held by individuals – “are constantly flowing into the business deposits [that is, the money in company hands] through the purchases of goods and out again through payment of wages”.21 This does sound like a flow of payments that is repeated period after period. An unfortunate consequence of circular flow thinking is to believe that expenditure is constrained by income, unless agents take on debt. Given the ubiquitous holding of money by virtually all agents in contemporary economies, and given also the obtrusive fact that people own assets that can be sold and consumed, this might seem strange. At any rate one result – endorsed in a much-­anthologized 1944 Modigliani paper – is the

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notion that consumption depends on income plus an allowance of some kind for consumer borrowing, hire purchase or whatever.22 As will emerge later, consumers’ supposed dependence on borrowing to pay for above-­ income expenditure has had an influence on forecasting from the NIESR.

THE FINANCIAL CIRCULATION AND ITS LEAKAGES What then is to be made of the “financial circulation”? Keynes undoubtedly thought that this circulation mattered to the economy’s behaviour. Chapter 15 of the first volume of the Treatise had four pages of comments on the industrial circulation, but nine on the financial circulation. The determinants of the financial circulation were “quite different” from those of the industrial. The money balances required “to look after ­financial business” depended, apart from changes in velocity, on “the volume of trading [multiplied by] the average value of the instruments traded”. Indeed, new investment in capital equipment and structures was, according to Keynes, “quite a small proportion of the total turnover of securities”.23 Additions to the nation’s capital stock in any one period were only a fraction of that capital stock, which had been accumulated over many past periods. In short, transactions in Keynes’s financial circulation are to be viewed as purchases and sales of claims on existing wealth. Such claims include, for example, title deeds to buildings and land, and unquoted corporate equity as well as quoted securities.24 The transactions in the financial circulation are distinct from the transactions in Keynes’s industrial circulation or the textbook income–expenditure–output circular flow, while the industrial circulation and the circular flow might be seen as the same thing. So here is an important category of transaction that is outside the circular flow and overlooked in the vast majority of macroeconomics textbooks. Indeed, the available information suggests that in the UK it is these ­transactions that account for the greater part of the gap between the total value of transactions and the sum of national income, expenditure and output. In 2014 the value of “wholesale financial” transactions through the UK’s Clearing House Automated Payment System (CHAPS) was £53,073b, whereas “retail and commercial” transactions came to £14,887b. In principle, the buying and selling of existing assets could be sustained indefinitely, and yet have no contact with the transactions in the circular flow. But another type of transaction has now to be identified. It is this type of transaction – or, better perhaps, this sequence of transactions – that upsets the credibility and usefulness of the circular flow, and is pivotal

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to the argument of the chapter. The crux is that agents sometimes sell assets in order to create or add to money balances, which are then used in the circular flow. For the most part, when people sell shares they intend to buy other shares, or at least another financial asset. But sometimes they sell shares to buy cars or holidays. Alternatively, they can draw on their equity in the housing stock. They do not use all the proceeds of a home sale to invest in the equity of another home, but again buy cars or holidays.25 Of course, the transactions can be in the reverse direction, with reductions in consumption in order to rebuild financial assets or housing equity. More generally, Keynes’s financial and industrial circulations are not in separate, watertight compartments with no leakages between them. Instead agents – particularly individuals and households – have constantly to assess, over a life cycle of earning and spending, whether they wish to accelerate and increase consumption (relative to the previous period) or to postpone and decrease it. Payments can be made that link transactions in existing assets with the circular flow. The statistics show that the financial circulation is a multiple of any of income, expenditure or output. The possibility of large leakages to and from the financial circulation must be recognized. The disparity in size between the financial circulation and the circular flow implies that any diversion from the financial circulation is equal to a higher percentage of the circular flow. Suppose that the total value of transactions is constant. If, say, 2 per cent of the financial circulation leaks into the circular flow, the value of income, expenditure and output rises by, say, 4 per cent. In an economy with a trend growth of 2 per cent a year in real terms, a swing of this kind is the difference between a cyclical upturn and downturn. Larger leakages – involving a modest share of the financial circulation (perhaps 5 per cent of it) – would result in booms and busts.

THE TRICK OF THE SAVINGS-­INVESTMENT IDENTITY The Keynesian textbooks tend to view “savings” as income minus  ­consumption, and to emphasize its ex post identity of savings with ­“investment”. The investment-­savings identity in this sense is the trick that makes the multiplier hang together conceptually. But the word ­“investment” is being used in a special way, as a component of effective demand and an item in national income accounting. In effect, the definition has been rigged so that investment cannot be anything other than equal to savings. As Humpty Dumpty would have warned Alice, the word has been defined to mean just what the Keynesians wanted it to mean.

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In everyday life “investment” tends to be seen as the commitment of funds to a financial asset, with the purchase of unit trust units, life ­insurance policies or whatever. The commitment of funds for these purposes is part of “household savings”, as such savings are understood in, for example, the UK’s official sources-­and-­uses-­of-­funds data. The national accounts statements behind these data show the extraordinary c­ omplexity of “savings” and “investment” in the topsy-­ turvy real world. Indeed, the latest international conventions have made the notions of “net” and “gross” alarmingly flexible, with meanings jumping around according to the context.26 In the UK’s annual Blue Book, with its supposedly definitive presentation of the national accounts, households’ gross saving (which is the denominator in “the savings ratio”) is the sum of their gross fixed capital formation and their net lending or borrowing of financial assets. Gross fixed capital formation is “gross” in that it includes depreciation, which here is predominantly depreciation of the housing stock. But the concept of depreciation is not applicable to financial assets. So the “net” in the phrase “net acquisition of financial assets” means the acquisition of money, bonds, equities and other financial instruments minus disposals of the same assets, while the “net” in “net lending” is that net acquisition figure minus the net incurrence of financial liabilities (that is, of debt). Needless to say, with all the complexity official statisticians have difficulty reconciling the numbers actually at hand with the numbers that ought to come out conceptually. In the 2011, 2012 and 2013 calendar years, the statistical discrepancies between UK households’ financial and non-­financial accounts were £13.0b, £12.5b and £11.7b respectively. These figures were more than 10 per cent of estimated “gross saving” in all three years.27 The disingenuous investment-­ savings identity of the Keynesian ­textbooks draws a veil over both these troublesome real-­world statistical issues and an immense amount of financial market activity. If households’ net acquisition of financial assets is positive, that reflects purchases of financial assets by households from other sectors of the economy (the financial and corporate sectors, mostly) above sales of financial assets to those sectors. Asset transactions between sectors can be a multiple of “net  acquisition” by one sector. Further, and perhaps more fundamentally, a massive volume of asset transactions takes place within each sector. Changes in leakages between the financial circulation and the income–expenditure circular flow are usually trivial in size relative to the volume of asset transactions. One symptom of such changes is likely to be fluctuations in the savings ratio. As noted earlier, if the savings ratio is volatile while the dynamic multiplier process is unfolding, that process loses its analytical neatness and clarity.28 The later section on the savings ratio

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shows that, in the UK at least, its ups and downs within cycles are large enough to cast doubt on the meaningfulness of the dynamic m ­ ultiplier as anything more than a classroom exercise.

LEAKAGES FROM THE FINANCIAL CIRCULATION AND ASSET PRICES In the Treatise Keynes was well aware that he was treading on p ­ roblematic conceptual ground. He was unsure about how best to classify and designate the phenomena in which he was interested. In a footnote to Chapter 3 he mentioned “the non-­ income transactions of private individuals, arising out of (e.g.) loans for building or other purposes or changes of investments”, and wanted such transactions to be seen as “business ­transactions”.29 In Chapter 15 agents were interpreted as seeking to balance “the quantity of money available for the industrial circulation” against the money balances at work in the financial circulation. Keynes noted that, with the prices of securities vulnerable to erratic mood swings, the central bank might have difficulty in managing the quantity of money to preserve equilibrium. In a big equity bull market (such as that in the United States of America in 1928 and early 1929, when Keynes would have been writing), the central bank might be tempted to boost the quantity of money in order to prevent a fall in share prices. But, in Keynes’s words, “If the [central] bank increases the volume of bank money so as to avoid any risk of the financial circulation stealing resources from the industrial circulation, it will encourage the ‘bull’ market to continue”.30 In Chapters 16 to 19 the potential tension between the two circulations was one theme in the playing out of what Keynes termed “the credit cycle”. Keynes has been invoked in these pages partly for polemical reasons, since his writings are often seen as the source of income–expenditure analysis. The last few paragraphs have demonstrated that his work also provides the basis for a fundamental critique of such analysis. Is it mischievous to suggest that the “Keynes” of the Treatise is different from the “Keynes” of The General Theory, and the “Keynes” of The General Theory is different from the “Keynes” of the 1948 Samuelson textbook? Appeals are constantly made to a canonical Keynes, but fashions in the notion of “Keynes” come and go. Whether Keynes is taken as an authority for the present argument or not, one question is evidently crucial. What determines the sign and size of the leakages between the two circulations which, undoubtedly, he did ­ distinguish? Alternatively, when is the income–expenditure–output

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circular flow most likely to be subjected to big shocks in the form of leakages to and from the financial circulation? The conjectures in the Treatise point towards the answers. When asset prices in general are high (relative to the long-­run norms expected over a lifetime), people may be keen to sell assets in order to boost consumption. Similarly, when the prices of financial securities are strong (again relative to long-­run norms), they are more prepared than usual to sell those securities, and to convert the proceeds into either consumption or tangible investments such as houses and other structures. (Conversely, when asset prices are low, people may be reluctant to sell assets and instead defer consumption to rebuild wealth.) Major interactions are to be expected between the level of asset prices and the size of leakages from the financial transactions, and between fluctuations in such leakages and the savings ratio. That raises a further issue: what is the key driver of the overall level of asset prices? This is a large topic and space constraints prevent detailed discussion. But an argument can be made that cyclical movements in asset prices – that is, of equities and real estate especially (although bonds need also to be incorporated in the analysis) – are heavily influenced by roughly contemporaneous fluctuations in the quantity of money created by the banking system.31 On this basis, the key defect of the income– expenditure flow as an analytical device is that it has no room for the banking system to determine the quantity of money, for the quantity of money to motivate asset prices, and for large swings in asset prices to cause big leakages to and from the financial circulation. (The quantity of money relevant to these statements is always one that is broadly defined to include balances that have little connection with retail expenditure, but are critical to the portfolio decisions of large corporate and institutional investors.) Unhappily, the standard textbook presentation of the circular flow says nothing whatever about banks, money and asset prices. Let it be acknowledged that more advanced statements are sometimes much better. For example, the entry on income–expenditure analysis in the first edition New Palgrave said that most textbooks oversimplified, with “the stock of productive capital, wealth and the ‘state of expectations’” as “given” and expenditures as “cash-­ constrained”.32 These radical concessions might appear to anticipate the dissection of the circular flow in the current chapter. Perhaps so, but many of the exponents of income–expenditure analysis in real-­world forecasting do not seem to appreciate the force of the critique that is being levelled against it. The next section reviews the pitfalls of real-­world forecasting when leakages from the financial circulation are largely overlooked.

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LEAKAGES FROM THE FINANCIAL CIRCULATION: THEIR SIGNIFICANCE FOR FORECASTING The discussion so far implies that forecasts based on income–expenditure models are most likely to go wrong when asset prices are volatile, since it is asset price volatility that is seen here as a key influence on leakages between the financial circulation and the income–expenditure circular flow. Further, large fluctuations in asset prices are attributed to roughly contemporaneous fluctuations in the rate of growth of the quantity of money, broadly defined. These remarks suggest that macroeconomic forecasts based on the income–expenditure model ought to fail most seriously when the economy is subjected to instability in the rate of money growth. What have been the most well-­defined periods of unstable money growth in the UK in recent decades? Figures 3.1 and 3.2 show the annual rates of growth of broad money, both nominal and real, in the five decades since 1964.33 In general, accelerations in money growth are gentler than d ­ ecelerations, suggesting that the decelerations ought to have been more troublesome in their macroeconomic impact. Figure 3.1 reveals three ­significant decelerations in the growth of nominal broad money: 25

Actual data, quarterly Average, 1964–2015

20

15

10

5

14 20

09 20

04 20

99 19

94 19

89 19

84 19

79 19

74 19

69 19

19

64

0

Figure 3.1  Growth rate of nominal broad money in the UK, 1964–2015 (annual percentage growth rate of M4 until Q4 1998 and M4x from Q4 1998, quarterly)

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18 13 8

14 20

09 20

04 20

99 19

94 19

89 19

84 19

79 19

74 19

69 19

19

–2

64

3

–7 Actual data, quarterly

–12

Average, 1964–2015 –17

Figure 3.2  Growth rate of real broad money in the UK, 1964–2015 (annual percentage growth rate of nominal M4/M4x adjusted for change in GDP deflator) ●● ●● ●●

from 22.3 per cent in the fourth quarter (Q4) 1973 to 10.9 per cent in Q4 1974; from 17.0 per cent in Q2 1990 to 3.5 per cent in Q4 1992; and from 10.7 per cent in Q4 2007 to 3.7 per cent in Q4 2008 (and to 0.9 per cent in Q1 2010).

In Figure 3.2 the same three decelerations remain salient, although two others – at the end of the 1960s and the start of the 1980s – deserve notice. (The change in real broad money dropped from plus 10.4 per cent in Q4 1967 to minus 2.5 per cent in Q1 1970, and from plus 5.2 per cent in Q2 1978 to minus 6.3 per cent in Q2 1980.) All five of the identified phases of monetary contraction were accompanied by marked weakness in aggregate domestic demand, with at least one quarter of falling output. How good were the UK’s so-­called “leading ­forecasting groups” in alerting policy-­makers to these disturbances? Unhappily, they made large errors ahead of and during the cyclical upheavals in which monetary contraction occurred. They either misjudged the scale and timing of the recessions or were slow to see the strength of the above-­trend growth ahead of the recessions. In short, they failed to warn about “boom and bust”. As noted above, the forecasting model at the NIESR was built in the mould of Keynesian income–expenditure

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theorizing, and its quarterly Review exemplified the approach. However, the impression should not be given that the National Institute was unique in its understanding, or misunderstanding, of “how the economy worked”. Other forecasters, with similar models, were also wrong or very wrong. The UK economy enjoyed reasonable macroeconomic stability in the first 25 years after the Second World War, an era sometimes known as “the Age of Keynes”.34 But economic growth was slow compared with that recorded in other advanced economies, notably those in the UK’s European neighbours. The Conservative government under Edward Heath attempted, from late 1971, to secure faster output growth by deliberate demand stimulus, with a widening of the budget deficit associated with reductions in interest rates, financial liberalization and extremely fast growth of the quantity of money. Inflation was to be held in check by direct statutory control of prices and wages, in a “Counter-­inflation Programme” spelled out in a January 1973 Act of Parliament. In its February 1973 Review the National Institute said nothing whatever about the growth of the money supply. But it approved of the main elements in government policy, ­especially fiscal expansionism and statutory wage restraint. The Review provided an annual forecast out to 1976. Real GDP growth in 1972 was estimated to have been 2¼ per cent, and it was forecast to be an extremely fast 6¼ per cent in 1973. High but less extreme numbers of 5¼ per cent, 5 per cent and 3¼ per cent were to follow in 1974, 1975 and 1976 respectively.35 Detailed quarterly projections in line with this medium-­term view were set out only for 18 months (or six quarters) ahead, with Q2 1974 being the last one for which precise forecast values were given. Total final expenditure, excluding stocks, was envisaged as being 5.9 per cent higher in Q2 1974 than in Q1 1973, which was put at £12,491m “in 1963 prices”. The Counter-­inflation Programme was assumed to be “rigidly adhered to” and in that sense to work, with the consumer price index in Q2 1974 coming out 6.1 per cent higher than in Q1 1973.36 Consumers’ expenditure (in real terms) in Q2 1974 was forecast to be 5.1 per cent above its level in Q1 1973, with the savings ratio falling from 9.6 per cent at the start of the 18-­month period to 8.6 per cent at its end.37 The detailed forecast of consumption mentioned a “credit effect” as among the factors relevant to the outcome. The thinking behind this credit effect may have been that expenditure is constrained by income, unless the personal sector borrows by means of hire purchase or consumer credit facilities. If so, the possibility that agents could spend above income by running down money balances or by selling assets seems to have been overlooked.38 The credit effect amounted to 1 per cent or more of consumption, and was evidently viewed as important to the change in consumption between years. (As noted above, an effect of this kind seems to have been proposed

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in a celebrated 1944 Modigliani paper. It must be noticed that, both then and now, personal sector assets are a multiple of consumer credit, and changes in the value of assets are usually many times larger than changes in consumer borrowing. But in 1973 the National Institute’s economists neglected the point altogether. See Appendix 3A.1 for further discussion of the size of changes in household net worth relative to changes in one financial flow, the budget balance.) The National Institute continued to advocate fiscal reflation and wage restraint during 1973, but demand proved to be more buoyant than forecast and inflation much worse. Six months later, in its August 1973 issue, the increase in consumer prices in the 18-­month period to Q2 1974 was seen as likely to be 11.8 per cent. (Might a viable argument be that the surge in money was at least partly responsible, with M4 up by 22.9 per cent in the year to Q3 1973? But the National Institute’s Review contained no references to the money aggregates.) In the August issue total final expenditure, excluding stocks, was taken from official information as being £12,799m in Q1 1973, again in 1963 prices. This was 2.5 per cent more than believed when the January 1973 Review was published, a difference equivalent to one year’s normal output growth. All the same, the forecast growth rate of aggregate demand from Q1 1973 to Q2 1974 was kept at a very high 5.9 per cent. Relative to the original starting point understood in the February 1973 Review, real demand growth over the six-­quarter period was to be a massive 8.5 per cent. By the time the February 1974 issue of the National Institute’s Review was published, the UK’s economic prospects had darkened dramatically. Inflation was running way ahead of the levels envisaged in legislation just a year earlier. Moreover, the government was embroiled in a bitter dispute with the coalminers’ union, which wanted a much larger pay rise than allowed by the Counter-­inflation Programme. With the dispute interrupting coal supplies, industry was unable to maintain continuous production and was put on a so-­called “three-­day week”. Not only did the loss of output render implausible the National Institute’s growth enthusiasm of February 1973, it also created so much uncertainty that the February 1974 issue of its Review gave alternative “optimistic” and “pessimistic” forecasts. The average of the two forecasts can presumably be seen as “the house view”. On the key variable, the growth of aggregate demand, a vast reappraisal was made. The average of the two February 1974 forecasts was that total final expenditure would be lower, by 2.7 per cent, in Q2 1974 than in Q1 1973.39 The difference (in the assessment of real demand growth in an 1­ 8-­month period) between the August 1973 and February 1974 issues of the National Institute Economic Review was therefore not far from 9 per cent of aggregate demand. For such a short period, this is the largest change in forecasting

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Table 3.1  The National Institute’s forecast of UK output growth in early 1973, compared with the outturn Forecast in February 1973 Review 1972 1973 1974 1975 1976

Outturn, according to latest data in 2015

2¼ 6¼ 5¼ 5 3¼

3.9 8.0 −0.9 −0.2 2.1

Note:  Mnemonic CDID – referring to gross value added in 2010 constant prices – in September 2015 database. Note that the outturn is on a 2010 price basis, whereas the 1973 forecast was on a 1963 price basis, and this may affect the comparison. Source:  National Institute Review for February 1973 and Office for National Statistics for outturn.

Table 3.2  Changes in view (on six quarters to mid-­1974) from February 1973 to February 1975 issues of National Institute Review

Level of national output in Q2   1974 compared with Q1 1973 Rise in consumer prices  (consumer exp. deflator), Q1 1973 to Q2 1974 Change in savings ratio from   Q1 1973 to Q2 1974

Feb-­73

Feb-­75

Difference

+5.4%

−0.1%

5.5%

6.1%

16.3%

10.0%

Fall of 1.0% of PDI

Rise of 3.6% of PDI

4.6% of PDI

Note:  PDI is an abbreviation for “personal disposable income”.

view by a reputable body known to the author.40 In the event 1974 suffered the worst slide in demand and output until then in the post-­1945 period, an outcome that had become clear by early 1975. Table 3.1 compares the Institute’s February 1973 annual growth forecast for the 1972–76 period with the outturn, as the official data now judge the matter. Table 3.2 summarizes the major differences between the February 1973 and February 1975 issues of the Review in the numbers for the six-­quarter period to Q2 1974.41 Note that, instead of falling from Q1 1973 to Q2 1974, the latest official data show that the savings ratio increased from 6.8 per cent to 7.9 per cent, and was to move up to 11.9 per cent in Q1 1975. (Note also that

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the increase in the savings ratio in the six quarters to Q2 1974, as shown in the latest national accounts data, is much less than that given in the February 1975 Review. The claim that the propensities to consume and save from income are stable lies at the heart of Keynesian macroeconomics. It is untrue as a matter of fact, but would in any event be difficult to establish in the real world because of serious measurement problems. The savings ratio is volatile, while the data series for it in the national accounts is subject to large and frequent revisions. See Figure 3.3 below and the discussion above on the trick of the savings-­investment identity.) The next big downturn in the economy after 1974 came in 1980 and 1981, but forecasters were fairly successful in flagging it up before it occurred. The above discussion of monetary trends showed that a major drop in broad money growth occurred in 1990 and 1991. It too was associated with a recession, although acknowledgement must again be made that forecasters did generally anticipate – six months to a year ahead of the event – that the economy would enter an awkward patch. (Business had to cope with the high interest rates and overvalued exchange rate due to the UK’s membership of the European Exchange Rate Mechanism.) The serious misjudgements by leading forecasters in the boom–bust cycle of 1986–92 came early in its course, not at the end. In particular, virtually without exception, they were too late in spotting that the boom of 1986–89 was under way and too hasty during the boom in saying that it would soon halt without any significant change in government policy. From 1987 the tendency to make premature predictions of a slowdown was so widespread and recurrent that it even acquired its own label, “forecasters’ droop”.42 Broad money growth started to turn upwards in late 1985, after the “overfunding” of the budget deficit was stopped and the growth of banks’ deposit liabilities increasingly approximated to the growth of their loans to the private sector. (At this period banks’ claims on the private sector were typically rising at percentage annual rates well into double digits.) The stock market advanced strongly in 1986 and early 1987, and the prices of houses and commercial real estate also increased sharply. But none of this was of any interest to the National Institute. In its February 1987 Review it instead noted that the “monetarist” policy framework in the early years of the Thatcher government had been “almost entirely abandoned”, so that the exchange rate had resumed its traditional role in UK policy-­making of being “the main indicator of monetary stringency”.43 The quarterly forecast ran out to two years rather than the 18 months which had been the practice in the early 1970s. The Review predicted that GDP would rise by 1.5 per cent between Q1 1987 and Q4 1987, and by 2.5 per cent between Q1 1987 and Q4 1988. Despite the marked asset price gains that had occurred in the preceding year and were still being recorded, the National Institute did not envisage

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Table 3.3  The National Institute’s forecasting record in the Lawson boom Forecast growth of GDP from Q1 1987: Date of Review Feb-­87 Aug-­87 Nov-­87 Feb-­88 Aug-­88 Outturn

To Q4 1987

To Q4 1988

1.5 1.7 2.6 3.9 4.5 4.9

2.5 3.8 4.1 5.8 7.3 9.8

Source:  National Institute Reviews for the dates in question and Office for National Statistics for outturn. (Mnemonic CDID in September 2015 database.)

an upturn in domestic demand growth, let alone a boom. Indeed, since real GDP had risen by 5.4 per cent in the year to Q4 1986, its February 1987 assessment was for a pronounced growth slowdown over the next two years.44 Table 3.3 shows the evolution, in more or less successive issues of the National Institute Review, of numbers on the change in GDP from Q1 1987 over the next three quarters (that is, to the end of 1987) and over the next seven quarters (to the end of 1988) and compares them with the eventual outturn.45 By August 1988 the phrase “the Lawson boom” had wide currency, as the economy’s indisputable cyclical buoyancy was attributed to the policy decisions of Nigel Lawson, the Chancellor of the Exchequer. But it is clear from the table that the National Institute was repeatedly behind events. In February 1988 it realized that it had been wrong about 1987, but it opined, “We expect the boom to be followed by a period of relatively slow growth.”46 Its forecast was for growth in 1988 to run at about half that in 1987. Even in August 1988, with only four months of the year left, it significantly underestimated the outturn. In practice, growth in demand was higher in 1988 than in 1987. (The growth in output was much the same in the two years, because a high proportion of 1988’s demand surge could not be met by UK producers and resulted in a widening balance-­of-­payments deficit.) To summarize, actual growth to end-­1987 was three times that forecast by the National Institute in its first 1987 assessment, while growth in the seven quarters to end-­1988 was four times higher. Again, it must be emphasized that the National Institute’s forecast was not an outlier. The Treasury’s forecast in March 1988 was somewhat more positive about the outlook for demand and output than the National Institute in its Review a month earlier, but not markedly so.

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Most independent private sector forecasts in early 1988 were similar to those from the National Institute and the Treasury. According to Christopher Smallwood, then the economics editor of The Sunday Times, “For  ­economic forecasters 1988 will go down as the annus horrendous. It was the year they all got it wrong. And not just a little bit wrong, but ­spectacularly wrong.”47 By the start of the twenty-­first century the importance of economic forecasting in the National Institute had been downgraded. Its forte had traditionally been an assessment of the budgetary stance (that is, of fiscal policy) and analysis of this stance in macroeconomic strategy. But the 1997 decision to give the Bank of England independence in the setting of interest rates altered the relative significance of monetary and fiscal policy, and the National Institute chose not to second-­guess the bank’s Monetary Policy Committee. Its Review gave more space to research papers on topical themes and less to detailed macroeconomic forecasting. But the forecasting continued, and had many of the same biases and emphases as before.48 After a period of reasonable macroeconomic stability in the years of the Great Moderation (that is, the 15 or so years from end-­1992), broad money growth accelerated in 2006 and 2007 to annual percentage rates in the double digits. Faster money growth had preceded earlier periods of cyclical turbulence and served as a warning signal of future inflation trouble. Disquiet was expressed by a handful of commentators, some with known “monetarist” leanings.49 But in the run-­up to the Great Recession, as in the prelude to both the Heath and Lawson booms, the main text of the National Institute’s Review did not mention the behaviour of monetary aggregates at all. The July 2008 issue contained an 18-­page analysis of “Prospects for the UK economy”, with quarterly changes in output projected out to the end of 2010.50 Not one quarter of falling output was foreseen. The judgement was made that inflation would peak at 4.3 per cent in Q3 2008, “before gradually returning to [the 2 per cent] target over the next few years”. Interest rates were expected to remain at much the same level as then prevailing, with clearing bank base rate at 6 per cent. A fair verdict is that the risk of the Great Recession, or even the possibility of major macroeconomic instability, was overlooked almost entirely. (In practice, output fell over 5 per cent from Q2 2008 to Q3 2009, while the annual rate of consumer inflation was more than 1 per cent above the 2 per cent target continuously from January 2010 to April 2012, and for a few months in late 2011 was above 5 per cent.) As with earlier examples of major analytical lapses from the ­macroeconometric forecasting fraternity, the National Institute was far from alone. The Great Recession of late 2008 and early 2009 was global in impact, with the UK economy buffeted around by forces over

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which London-­based policy-­makers had little direct influence. None of the supranational authorities with forecasting capability – such as the International Monetary Fund, the Bank for International Settlements and the Organisation for Economic Co-­operation and Development – ­anticipated in mid-­2008 that 2009 would see the worst demand downturn in the developed countries since the 1930s.

CYCLICAL INSTABILITY IN THE SAVINGS RATIO When presented with evidence that their forecasts had been badly awry in periods of asset price turmoil, a common ploy of the UK’s Keynesian macroeconomists was to point out that the savings ratio had fluctuated sharply. Given the textbook claim that consumption tends to be stable relative to income, and given the further premise that the multiplier ought therefore to be a robust and worthwhile conceptual category, the fluctuations in the savings ratio came as a surprise to them. The fluctuations could then be indicted as “unprecedented” aberrations that were difficult or impossible to predict.51 According to this kind of Keynesian, the blame for the forecasting errors could be placed on structural shifts in behaviour rather than on the exclusion of money and banking from income–expenditure modelling. It was noted earlier that stability of the savings ratio was indeed a central assumption of the Keynesian textbook approach to macroeconomics, but that large changes in the savings ratio might be due to asset price swings and hence to money growth variability. If money growth variability did indeed have this power, the Keynesians’ attempt to attribute their forecasting ­mistakes to structural behaviour shifts was at best misleading. Figure 3.3 shows the UK savings ratio from 1963 to 2015. One message comes out immediately, that the savings ratio was not stable in any absolute sense. It was certainly not stable enough for the multiplier to be assumed constant from one cycle to the next, or even within cycles. Admittedly, this does not demonstrate that large changes in the savings ratio were due to variability in money growth. However, the author has been able to find two periods when big changes in money growth were accompanied by a drastic shift in the savings ratio. Money growth decelerated abruptly in late 1990 and during 1991, in association with severe asset price declines. (This was the first occasion since the 1930s when UK house prices fell in nominal terms.) It also fell sharply over the year from mid-­2008 as the main official response to banks’ funding problems, namely a tightening of regulation, caused them to restrict balance sheet expansion. On both occasions the savings ratio increased substantially. From Q3 1990 to Q1 1992 the increase was from 12.2 per cent to 16.6 per cent, and from Q1 2008 to Q3 2009 it

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18 16 14 12 10 8 6 4 2

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Figure 3.3  The savings ratio in the UK (savings as a percentage of personal disposable income) was from 4.8 per cent to 10.1 per cent. While further research is needed, these experiences suggest a possible link between money growth and asset prices, and then from asset price movements to savings behaviour. If a link of this sort does obtain in reality, mechanical application of the ­multiplier concept in cyclical analysis is artificial and improper. Hawtrey and Robertson were right to be concerned in the 1930s about the length of the period, in terms of calendar time, that was needed for the Keynesians’ dynamic multiplier to make sense.

CHANGES IN NET WORTH, COMPARED WITH FISCAL POLICY Recall Dow’s jibe about the need to avoid “unstructured observation”. According to the earlier quotation from his book Major Recessions, income–expenditure analysis is built around a circuit of payments which is never-­ending unless “shocked” in some way, unless – in other words – an

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injection or leakage of demand comes “from outside”. With the financial circulation forgotten, and the banking system, the quantity of money and asset prices all neglected (or even ignored), the structure of income– expenditure analysis biases policy-­makers towards fiscal actions as the necessary and benign deus ex machina. As was discussed at the start, the renewed interest in Keynes at the start of the Great Recession was accompanied by an attempt at large-­scale fiscal stimulus concerted across the economically largest nations. The argument here has been that changes in net worth can motivate ­volatile leakages between the financial circulation and the income–­ expenditure circular flow. It follows that the relative size of fiscal policy and changes in household net worth is an important empirical issue. If the reader accepts that a surge in home prices and the stock market (that is, an increase in household net worth) can affect people’s asset re-­dispositions and consumption, the scale of changes in household net worth needs to be remembered in appraisals of the macroeconomic conjuncture. In general, national statistical agencies commit more resources to estimating the components of national income, expenditure and output than they do to preparing data on the national balance sheet. However, the USA has consistent official data on the household sector balance sheet back to 1945, and most other countries have some data on the subject, even if it is not consecutive over such a long period. In recent years the International Monetary Fund has provided figures on “fiscal policy” for many c­ ountries, with the concept at work being the change in the general government “structural” (that is, cyclically adjusted) fiscal balance as a percentage of GDP. The tables in Appendix 3A.1 compare changes in household net worth with the IMF fiscal policy numbers for the USA and the UK since 1997. Figures 3.4 and 3.5 are based on those tables. No doubt these figures invite and permit many interpretations. However, two comments seem justified. First, changes in net worth are much larger, relative to national income and output, than fiscal policy. On average over the 1998–2013 period annual changes in net worth were 21 per cent of GDP in the USA and just under 12 per cent of GDP in the UK, if the sign is ignored. In both countries the annual change in the budget balance implied by “fiscal policy” was on average 1.2 per cent of GDP. Of course, agents do not try to run down assets by the full extent of recent capital gains, and they do not compensate for capital losses by reductions in consumption that are exactly the same size.52 But, if their adjustments of current plans to recent balance sheet changes amount to only a sixth or a quarter of such changes, it is clear that these adjustments are usually more powerful influences on aggregate demand than fiscal policy. Secondly, the two tables add insights on apparent puzzles about the

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% 60

Change in household net worth as % of actual GDP Change in government balance as % of potential GDP (sign reversed)

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Figure 3.4  Net worth changes compared with fiscal policy in the USA, 1998–2013 (see Appendix 3A.1 for details)

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Figure 3.5  Net worth changes compared with fiscal policy in the UK, 1998–2013 (see Appendix 3A.1 for details)

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ineffectiveness of fiscal policy in the 1998–2013 period. The “fiscal cliff ” episode is an example. As is well known, numerous American economists of Keynesian leanings had expected in late 2012 that the looming drop in the US budget deficit would cause a plunge in aggregate demand. Most of the prospective tightening of fiscal policy did occur, but aggregate demand grew faster in the four quarters to end-­2013 than in the previous four quarters.53 The seeming anomaly becomes readily explicable by the surge in household net worth, which amounted to about half of GDP in the year. The persistence of the US recovery in 2013 might have led the American   Keynesians to re-­examine their models and to rethink their ideas. But that has not been the sequel. In 2015 Paul Krugman, a Nobel laureate and influential Keynesian columnist on The New York Times, switched his attention to the UK. In his view Britain was “a snookered isle” which suffered from a “terrible, no-­good economic discourse” indifferent to Keynesian ­precepts. He expressed dismay about the tightening of UK fiscal policy by the Conservative government since 2010.54 However, significant apparent fiscal “austerity” had not prevented a recovery. Altogether over the four years to 2012 households net worth rose by 60 per cent of GDP, implying significant positive “wealth effects”. Along with other demand drivers, these effects seem in practice to have outweighed the “deflation” that was widely expected to stem from the government’s drive to lower the budget deficit. (Remember that the UK’s Keynesians – notably the 364 signatories of a letter to The Times – had forecast a deepening of the then recession in the British economy, to follow the Budget statement of 10 March 1981. The consensus view today is that the 364 were wrong, as the six years from mid-­1981 saw trend or above-­trend growth in the British economy, and a big rise in employment. Alternative claims are sometimes made.55 The debate on UK fiscal policy since 2010 has run on parallel lines to that after the 1981 Budget.)

CONCLUSION Is the income–expenditure circular flow a “good place to start” in ­macroeconomics? And is the multiplier a valid and serviceable concept when confronted by the real-­ world challenges of data collection and appraisal, and then of policy-­making? The income–expenditure circular flow pretends to be an all-­embracing representation of the economy’s payments patterns. It is no such thing. In the UK the sum of income, expenditure and output is less than 10 per cent of the value of all transactions passing through the banking system. Some economists may dismiss this concern, by asserting that the

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remaining 90  per cent or more of transactions are derivative from the circular flow. But that is just not true. The standard textbook account of the c­ ircular flow is misleading on two counts. First, it fails to notice that transactions in existing assets – dubbed “the financial circulation” by Keynes over 80 years ago – are a high multiple of any of national income, expenditure or output. Secondly, and yet more fundamentally, it is blind to the obvious ­possibility that agents’ net sales of assets allow them to spend above income, while net asset purchases require them to run expenditure beneath income. At an even more banal level, agents can purchase goods and services by running down their money balances. They do not in fact pay for goods and services with an amorphous blob of “income”. Most suppliers and retailers do not extend credit, and do not even know their c­ ustomers’ income levels. Sometimes people can be net purchasers of assets, but also match income and expenditure, in which case they must logically be ­reducing their money holdings. Statements about their equilibrium conditions, and indeed about such conditions for the economy as a whole, must therefore refer to money and wealth. A well-­established proposition in macroeconomics is that agents’ money holdings, as well as their non-­ money asset portfolios as a whole, must be at desired levels if national income is to be at equilibrium.56 But textbook statements of the circular flow typically do not mention as essential requirements of macroeconomic equilibrium that the demand to hold money be equal to the quantity of money actually created by the banking system, or that the market value of the capital stock be equal to its replacement cost. To reiterate, big shocks can be delivered to the circular flow by l­eakages to and from the financial circulation, with these leakages in turn the result of swings in asset prices that may have been motivated by oscillations in the rate of growth of the quantity of money. This chapter has not ­presented detailed econometric work, but it has offered evidence that the savings ratio can be volatile even in the course of a single business cycle. It is plausible that this volatility is attributable to large changes in h ­ ousehold net worth. The multiplier argument is central to the Keynesian view of national income determination and to the defence of fiscal reflation as a response to aggregate demand weakness. But the static version of this argument is merely a tautology, while the dynamic presentation depends on the stability of the savings ratio during the sequence of periods in which a demand injection is having its effects. As far as the UK is concerned, the facts are plain. In periods of asset price turbulence and monetary ­disequilibrium the savings ratio does not have the stability needed for the multiplier to be a useful or valid way of thinking about reality. For good or ill, the circular flow is entrenched in practical

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­ acroeconomics. It has been part of the apparatus of the Keynesian mind m since the 1940s and will not be soon dislodged. Robert Neild, one of the two Cambridge economists who organized the letter from the 364 in 1981, remarked correctly in a 2012 note to the Royal Economic Society that Keynes proposed the income–expenditure approach in his 1940 articles in The Times on ‘How to pay for the war’. In that sense the circular flow was part of Keynesianism, as he and many others conceived it. Neild was also right to say that Keynes’s thinking transformed UK policy, because he “pioneered the use of national income accounts in ­macroeconomic management”.57 Indeed, it has become unimaginable nowadays to attempt a course in macroeconomics that does not appeal to both the “effective demand” notion advanced by Keynes in The General Theory and the national accounting concepts being developed, more or less simultaneously, by Colin Clark, Richard Stone and James Meade. But students need to be told, at the earliest opportunity, that the equilibrium levels of national income and national wealth are interrelated, and that movements in the quantity of money are fundamental to the determination of both national income and wealth. They should also be alerted to two key features of modern economies, that the value of transactions in existing assets is a multiple of transactions in the circular flow, and that agents can pay for goods and services by running down money balances or by tapping into their wealth. Expenditure does not depend solely on income. The circular flow and the financial circulation are not separate, but interconnected, and leakages between them are likely to be substantial in periods of financial instability. The circular flow is a Keynesian construct, but the financial circulation was also one of Keynes’s most striking and useful innovations. The two ideas should be taught together in u ­ niversity macroeconomics courses. Is the circular flow “a good place to start”, as Mankiw has claimed? This chapter has argued that it is incomplete and unsatisfactory, and that the Mankiw textbook is wrong to imply that the circular flow embraces all “the linkages among the economic actors”. In the second half of the twentieth century too many economists became addicted to the concepts in the Samuelson 1948 textbook and its epigones. The textbooks have remained much the same even into the early twenty-­first century, and hydraulic Keynesianism is now a bad and widely ingrained habit. The income–expenditure circular flow and the multiplier may give a kick to short-­term macro-­forecasters, but they have become dangerous intellectual narcotics. Like tobacco, they have done much long-­term harm and should be marketed only with health warnings. A new generation of textbooks is needed. Less prominence should be given to the circular flow and the multiplier, and more attention should be paid to transactions in assets, the quantity of money and the banking system.

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NOTES   1. “On average, the short-­run multiplier for the US economy is around 1.5. If the government spends about a billion dollars now, GDP this year will go up by $1.5 billion.” Joseph Stiglitz, Freefall: America, Free Markets, and the Sinking of the Global Economy (London: Allen Lane, 2010), p. 60.   2. Paul Samuelson, Economics (York, PA: McGraw-­Hill, 1948).  3. See the Introduction, especially pp. xxv–xxx, in O.F. Hamouda and B.B. Price (eds), Keynesianism and the Keynesian Revolution in America (Cheltenham, UK and Lyme, NH, USA: Edward Elgar Publishing, 1998) for a discussion of the textbook revolution.  4. Bradley Bateman, Toshiaki Hirai and Maria Cristina Marcuzzo (eds), The Return to Keynes (Cambridge, MA: Belknap Press of Harvard University Press, 2010), John Eatwell and Murray Milgate, The Fall and Rise of Keynesian Economics (Oxford: Oxford University Press, 2011) and Robert Skidelsky, Keynes: The Return of the Master (London: Allen Lane, 2009) are examples.   5. “This is Alesina’s hour. In April in Madrid, he told the European Union’s economic and finance ministers that ‘large, credible, and decisive’ spending cuts to reduce budget deficits have frequently been followed by economic growth. He backed his proposal with historical research on rich countries’ experiences since 1980.” “Keynes vs. Alesina. Alesina, who?”, by Peter Coy, 29 June 2010 issue of Bloomberg Businessweek magazine.  6. Tim Congdon, “In praise of expansionary fiscal contraction”, pp. 21–34, Economic Affairs, February 2015, vol. 35, no. 1.   7. The concept of a “transaction” is more awkward than it seems. The procedure here is to regard the value of the transactions in a nation as roughly equal to bank settlement business plus transactions in cash, to the extent that cash transactions can be monitored. This follows Irving Fisher in his 1911 Purchasing Power of Money and, as acknowledged in the text, Keynes in the 1930 Treatise on Money. Note that this excludes, for example, most transactions in specialized exchanges (such as commodity, securities and currency exchanges) and the transactions that are recorded in trade credit.   8. N. Gregory Mankiw, Macroeconomics (International Version, 8th edition) (Basingstoke: Palgrave Macmillan, 2013), p. 45.   9. J.C.R. (Christopher) Dow, Major Recessions: Britain and the World, 1920–95 (Oxford: Oxford University Press, 1998), p. 38. 10. In this chapter the consumption function is assumed to be linear, in line with most textbook treatments, so that the average and marginal propensities to consumer are the same. 11. To elaborate, extra incomes have been received in this first period and a proportion of them, c.(I2 – I1), is spent in the second period, so that expenditure in the second period rises to (1/[1 – c]).I1 + (I2 – I1) + c.(I2 – I1). This means that yet another boost to incomes occurs in the second period, and again a proportion of that boost c.(c.[I2 – I1]), or c2(I2 – I1) is spent in the third period, so that expenditure in the third period rises to (1/ [1 – c]).I1 + (I2 – I1) + c.(I2 – I1) + c2(I2 – I1), and so on. Clearly, the successive additions to expenditure – due to the original shock to investment – constitute a geometric series: c.(I2 – I1), c2(I2 – I1), c3(I2 – I1) . . . The sum of the series is (1/[1 – c]).(I2 – I1), or the multiplier times the increase in investment. 12. David Laidler, Fabricating the Keynesian Revolution (Cambridge: Cambridge University Press, 1999), p. 289. Robertson’s contribution was a response to Richard Kahn’s seminal 1931 article in The Economic Journal (R.F. Kahn “The relation of home investment to unemployment”, The Economic Journal, vol. 41, no. 162, pp. 173–98). 13. The discussion draws on Laidler’s discussion on pp. 290–91 of Fabricating the Keynesian Revolution, which in turn draws on Ralph Hawtrey’s 1937 Capital and Employment and Dennis Robertson’s 1936 writings on The General Theory. 14. Mankiw, Macroeconomics, p. 45. 15. See the home page of www.ukpayments.org.uk, as at the time of writing (August 2015).

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16. Office for National Statistics press release, 28 May 2015, Second Estimate of GDP, Quarter 1 2015, Table A.2. 17. The value of non-­cash payments in the USA in 2006 is estimated to have been $75,800b, compared with nominal GDP in the same year of $13,856b. See Geoffrey R. Gerdes, “Recent payment trends in the United States”, pp. A75–A106, Federal Reserve Bulletin (Washington, DC: Federal Reserve), October 2008 issue. The circular flow appears to be larger relative to total transactions in the USA than in the UK. 18. Patinkin believed that the notion of “effective demand” was “the major innovation” of The General Theory. See p. 155 of Don Patinkin, “A study of Keynes’ ‘theory of effective demand’”, pp. 155–76, Economic Enquiry (April 1979), vol. 17, no. 2. 19. Donald Moggridge and Elizabeth Johnson (eds), The Collected Writings of John  Maynard Keynes, vol. V, A Treatise on Money: 1. The Pure Theory of Money (London: Macmillan, 1971, originally published in 1930), p. 42. 20. Keynes, Treatise on Money: 1. Pure Theory, p. 217. 21. Keynes, Treatise on Money: 1. Pure Theory, p. 218. 22. See footnote 6 to Franco Modigliani, “Liquidity preference, and the theory of money and interest”, Econometrica, January 1944, vol. 12, pp. 45–88. 23. Keynes, Treatise on Money: 1. Pure Theory, p. 222. 24. For current purposes the phrase “financial circulation” might be better replaced by “asset circulation”. Transactions in existing assets include, for example, transactions in second-­hand cars and other long-­lived consumer durables, antiques and works of art, jewellery, collectibles, vintage wine and indeed chattels of all sorts. It hardly makes sense to view these as transactions in financial assets. 25. The author proposed the concept of “mortgage equity withdrawal” in a joint paper with Paul Turnbull. (See “Introducing the concept of ‘equity withdrawal’”, pp. 274–87, in Tim Congdon, Reflections on Monetarism [Aldershot, UK and Brookfield, VT: Edward Elgar Publishing, 1992], based on a paper of 4 June 1982 for the stockbroking firm of L. Messel & Co., “The coming boom in housing credit”.) Dozens of articles have subsequently been written about “mortgage equity withdrawal” and its influence on personal expenditure, and the Bank of England regularly prepares estimates of its size. See also, for example, for the USA, Stiglitz, Freefall, p. 2, for an estimate of “mortgage equity withdrawals” in the USA of $975b in 2007, the year just before the Great Recession. 26. Dudley Jackson, The New National Accounts (Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 2000), pp. 366–8. 27. UK 2014 Blue Book (London: Office for National Statistics, 2014), Table 6.1.7. 28. Because the propensity to consume is forever changing, the process cannot be thought of the summation of a geometric series. 29. Keynes, Treatise on Money: 1. Pure Theory, p. 38. 30. Keynes, Treatise on Money: 1. Pure Theory, p. 227. 31. The author gave an argument on these lines in Money and Asset Prices in Boom and Bust (London: Institute of Economic Affairs, 2005) and in the final part, part V on “How does the economy work?”, of his Money in a Free Society (New York: Encounter Books, 2011). The argument is related to Keynes’s extensive observations in the Treatise, as quoted in the current chapter. 32. Michael Artis, “Income-­expenditure analysis”, in Peter Newman, Murray Milgate and John Eatwell (eds), New Palgrave Dictionary of Money & Finance (London: Macmillan, 1992), p. 341. The entry originally appeared in the 1987 edition of The New Palgrave Dictionary of Economics. 33. Modern UK monetary data started in 1963, following a recommendation in the 1959 Radcliffe Report. 34. Robert Lekachman’s The Age of Keynes (New York: Random House, 1966) is an example of this sort of thing. 35. National Institute Economic Review (London: National Institute of Economic and Social Research), February 1973 issue, Table 9, p. 46.

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36. National Institute Economic Review, February 1973, p. 36. 37. National Institute Economic Review, February 1973, p. 43. 38. Franco Modigliani – in his classic 1944 paper with much discussion of portfolio balance between money and bonds – thought that new personal borrowing was a key influence on consumption. Belief in the macroeconomic importance of new credit creation by itself persists, even though in all economies the value of transactions is a multiple – usually a several hundred-­fold multiple – of new consumer credit or bank lending to the private sector. For an example of emphasis on credit, see the note by Richard Werner on “Quantitative easing and the quantity theory of credit”, Royal Economic Society’s Newsletter Online, July 2013. 39. The forecast (in Table 1 of the February 1974 issue of the National Institute Economic Review) was given in 1970 prices, reflecting the official shift from national accounting in 1963 prices. In 1970 prices total final demand in Q1 1973 was £17,353m. The optimistic forecast was that total final demand in Q2 1974 would be £17,167m, down by 1.1 per cent from Q1 1973; the pessimistic was that it would be £16,630m, down by 4.2 per cent on the same basis. 40. The May 1974 issue of the National Institute Economic Review conducted a ­post-­mortem (pp. 14–17) on the forecasting fiasco and concluded that it had not been much more wrong than the Treasury or the London Business School. Apart from the National Institute (which was in any case close to the Treasury both intellectually and in terms of its physical location), the London Business School was at the time the main alternative source of macroeconomic forecasts outside the government machine. 41. In qualification, the price basis of the UK’s national income accounts changed in 1974, from a 1963 basis to a 1970 basis, and this would have had an effect on the growth rates of national income and the demand categories. 42. Tim Congdon, Keynes, the Keynesians and Monetarism (Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, 2007), p. 73. 43. National Institute Economic Review, February 1987, p. 4. 44. National Institute Economic Review, February 1987, p. 7. 45. The numbers in the May 1987 and May 1988 Reviews are not included, as they were close to those in the preceding February issues. The outturn is from GDP data series “in 2010 prices”, with a different weighting of various GDP components from that applicable to contemporary analyses in the late 1980s, but the point is technical. 46. National Institute Economic Review, February 1988, p. 3. 47. Smallwood overlooked that the author produced a February 1988 forecast (with his team at the stockbrokers L. Messel & Co.) that was right in essentials and even quite a lot of detail, envisaging continued high growth, rising inflation and a large payments deficit. Unlike the mainstream forecasts with their income-­expenditure model, the author’s approach assessed the credit counterparts to money growth; arrived at a forecast for the growth of the money stock; considered how different sectors of the economy would hold the extra money balances; and then drew conclusions for asset prices, demand and output, and for the direction of monetary policy. A brief account is given in Tim Congdon, “The importance of money in macroeconomic ­forecasting – part 2”, pp. 191–4, based on an article in The Spectator of 11 March 1989, in Congdon, Reflections on Monetarism. The success of the author’s approach was noted in three chapters (pp. 50–154) of Gordon Pepper, Inside Thatcher’s Monetarist Revolution (Basingstoke: Macmillan, 1989). UK Treasury officials rejected the suggestion that, in the Lawson boom, the relative accuracy of the money-­based forecasts was due to the use of a different and possibly superior method. In response to a question at the House of Commons Treasury Committee in October 1991, Colin Mowl, head of the Treasury’s economic analysis and forecasting group at the time, said: “Certain monetarists’ forecasts in the later 1980s were more accurate than a number of other forecasts, but if you have 20, 30, 40 forecasts being published, there will always be a handful more accurate than the majority.” (Martin Summers, “Free the Liverpool Six!”, pp. 30–33, Economic Affairs, June 1992 issue. The Mowl quotation is given on p. 32.)

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48. In fairness it should be pointed out that the Institute increasingly incorporated changes in house prices, and even in equity prices, in its forecasting exercises. The July 2008 issue (p. 58) of its Review contained a ready-­reckoner of the effect of a 10 per cent fall in house prices on consumption over the subsequent two quarters for six countries, including the UK. The possible relationship between movements in broadly defined money and the general level of asset prices was not discussed. See also note 52. 49. “Higher rates may be needed to contain inflation”, letter in the Financial Times, signed by Tim Congdon and others, 27 September 2006, included the remark, “. . . rapid growth of money will lead to higher inflation”. 50. Simon Kerby, “Prospects for the UK economy”, pp. 39–56, in National Institute Economic Review, July 2008 issue. 51. See, for example, the remarks from Jim Hibberd, a Treasury economist, in the summer 1990 issue of the Treasury Bulletin. In his words, the failure to recognize the buoyancy of demand in the late 1980s was due to “structural changes (primarily the deregulation of the financial sector) which led to unprecedented and unpredictable shifts in personal and company sector behaviour”. Hibberd’s remarks were quoted on p. 33 of Martin  Summers “Free the Liverpool Six!”. 52. The literature is enormous. See for a nice summary of the link between housing wealth and consumption in the USA, Congressional Budget Office Housing Wealth and Consumer Spending (Washington, DC: Congress of the United States, January 2007). Its concluding paragraph, which must have been written more than a year before the start of the Great Recession, ran: “If homeowners currently expected home prices to rise by 10 percent during 2007 but they instead fell by 10 per cent, housing wealth would end 2007 more than $4 trillion lower than expected. That would raise the saving rate by between 1.0 and 3.1 percentage points . . . After adding in a moderate estimate for the impact of [mortgage equity withdrawal], the total impact on consumer spending would be . . . between 0.7 percent and 2.2 percent of GDP. The upper end of that range . . . would most likely be enough to tip the economy into recession.” 53. According to the latest US national accounts data (August 2015) from the Bureau of Economic Affairs, gross domestic purchases in real terms rose by 2.1 per cent in the year to the fourth quarter of 2013, compared with 1.0 per cent and 1.7 per cent in the years to the fourth quarters of 2011 and 2012 respectively. (In terms of domestic final sales, the three years were similar, with increases of about 1.5 per cent.) 54. Paul Krugman, 23 March 2015 column in The New York Times, “This snookered isle”. 55. Stephen Nickell, “The Budget of 1981 was over the top”, pp. 54–61, in Philip Booth (ed.), Were 364 Economists All Wrong? (London: Institute of Economic Affairs, 2006). The author responded to Nickell’s contribution in the December 2006 issue of Economic Affairs. The subsequent exchange appears in “An exchange 25 years later between Professor Stephen Nickell and Tim Congdon”, pp. 206–29, in Congdon, Keynes, the Keynesians and Monetarism. 56. John Maynard Keynes, The General Theory of Employment, Interest and Money, vol. VII, in Donald Moggridge and Elizabeth Johnson (eds), Collected Writings of John Maynard Keynes (London: Macmillan, 1973 [originally published 1936]), pp. 84–5. 57. Robert Neild, “The ‘1981 statement by 364 economists’ revisited”, Royal Economic Society’s Newsletter Online, October 2012.

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APPENDIX 3A.1 DATA ON HOUSEHOLD NET WORTH IN THE USA AND THE UK One of the main arguments in this chapter is that changes in household net worth, because of asset price movements, are large relative to incomes, both within and between cycles. Leakages from the “financial circulation” (that is, the payments circuits in which settlement is made for asset transactions) can disturb the income–expenditure circular flow and cause expenditure to differ markedly from income. In most nations official statistical agencies do not generally give much prominence to estimates of household net worth, preferring to concentrate their resources on estimates of national income and expenditure. However, in the USA quarterly estimates of household net worth have been prepared by the Federal Reserve on an annual basis from 1945 and on a quarterly basis from Q1 1952. In the UK, where quarterly national accounts began in 1955, no official estimates of household net worth are available before 1997 and these are only end-­year. Table 3A.1 Changes in net worth, compared with fiscal policy, in the USA, 1998– 2014 Net worth & GDP data

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Calculation of “net worth” effect

Fiscal policy

$b. Net worth

GDP

Net worth as % of actual GDP

Change in net worth as % of actual GDP

Change in government balance as % of potential GDP, with sign reversed

34,486 38,343 43,232 43,951 44,403 44,074 49,481 56,581 62,604 67,392 67,832 57,198 58,981 63,364 64,692 70,815 80,274

8,788 9,326 9,926 10,472 10,701 11,104 11,817 12,562 13,382 14,066 14,685 14,550 14,567 15,230 15,785 16,297 16,958

392.4 411.2 435.5 419.7 414.9 396.9 418.7 450.4 467.8 479.1 461.9 393.1 404.9 416.0 409.8 434.5 473.4

18.7 24.4 −15.9 −4.8 −18.0 21.8 31.7 17.4 11.3 −17.2 −68.8 11.8 11.1 −6.2 24.7 38.9

−1.1 −0.9 −1.3 −0.7 1.1 2.2 1.1 0.0 −0.8 −0.7 0.8 1.9 1.7 1.8 −1.4 −1.6 −1.5

Sources:  Federal Reserve for household net worth, Bureau of Economic Analysis for GDP at market prices and International Monetary Fund for fiscal policy.

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Table 3A.2 Changes in net worth, compared with fiscal policy, in the UK, 1998–2014 Net worth & GDP data

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Calculation of “net worth” effect

Fiscal policy

£b. Net worth

GDP

Net worth as % of actual GDP

Change in net worth as % of actual GDP

Change in government balance as % of potential GDP, with sign reversed

3,199.0 3,322.4 3,630.9 4,065.2 4,245.5 4,798.7 5,242.3 5,658.2 5,932.2 6,374.4 6,864.1 6,722.1 6,478.8 7,144.5 7,306.6 7,320.6 7,644.5

894.7 941.6 982.1 1,031.7 1,074.8 1,143.2 1,199.8 1,273.3 1,358.3 1,429.8 1,508.1 1,489.0 1,505.9 1,571.8 1,630.5 1,665.4 1,740.6

357.6 352.8 369.7 394.0 395.0 419.8 436.9 444.4 436.7 445.8 455.2 451.4 430.2 454.5 448.1 439.6 439.2

−4.7 16.9 24.3 1.0 24.8 17.2 7.4 −7.6 9.1 9.3 −3.7 −21.2 24.3 −6.4 −8.5 −0.4

−1.4 −0.6 0.1 1.1 2.5 1.7 0.5 −0.1 −0.6 0.7 1.3 3.1 −1.7 −2.3 −0.3 −1.9

Sources:  Office for National Statistics for household net worth and GDP at market prices and IMF for fiscal policy.

The numbers for household net worth in Tables 3A.1 and 3A.2 are for the fourth quarter in the USA and the end-­year in the UK, and in both cases the net worth to income ratio is the net worth figure divided by Q4 seasonally adjusted GDP at market prices multiplied by four. Changes in the net worth to income ratio are therefore for net worth relative to actual income, where GDP at market prices is taken to be ­“household income” conceived in the large, in that ultimately all income and output belongs to people and only to people. For some years the International Monetary Fund has published data on the “structural” (that is, cyclically adjusted) budget balance for most of its member states, where the budget balance is expressed as a percentage of potential output (that is, output when the “output gap” is zero). The change in the structural balance provides a measure of fiscal policy, although it should be noted that it is relative to potential, not actual, output. (The differences are likely to be small.) In comparing with changes

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in net worth, the numbers derived from the IMF database have been given with the sign reversed. An increase in net worth should encourage more expenditure, as should an increase in the budget deficit (that is, the inverse of the budget balance), according to the textbooks.

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4. The misdirection of Keynesian aggregates for understanding monetary and cyclical processes Richard M. Ebeling SHUNTING ECONOMICS OFF ON THE WRONG TRACK Near the beginning of the marginalist revolution in economic theory in the 1870s, William Stanley Jevons stated that in his view, “David Ricardo shunted the car of Economic science on to the wrong track” (Jevons, 1879, p. li). The classical labor theory of value had misdirected economic thinking concerning the basis upon which the relative values of goods exchanged one for the other. Ricardo and those who were influenced by him had looked for some objective and measurable quantity that could be used for explaining the long-­run structure of relative prices and costs. It was to serve as the Archimedean point around and towards which the everyday, short-­run fluctuations of prices and costs gravitated. The subjectivist foundation of the marginalist revolution had demonstrated that value of goods originated in the evaluating judgments of a choosing and deciding human mind. The value of a unit of a good was based on its estimated importance or significance for an assignable particular and discrete purpose in mind. And the estimation of additional units of this good diminished in significance as further units were applied to its other purposes or uses in descending order of importance to the chooser. Costs were not objective or measurable quantities of labor devoted to the production or manufacture of particular goods. Costs were the personal or subjective estimations by that evaluating mind concerning the significance or importance of a next best alternative forgone, due to the use of limited means being applied for a purpose considered more important than the one given up in the mental act of exchanging possible courses of action that might be undertaken. 77

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Economic theory and its applications were restructured in the decades following the formulation of this subjectivist and marginalist approach by Jevons, Carl Menger and Léon Walras, each in his own way. (For a comparison of the “Austrian” subjectivist development of the marginalist conception of price formation in the market with that of Walras and Pareto, see Ebeling, 2010b.)

MICRO-­FOUNDATION MONETARY THEORY AND THE KEYNESIAN AVALANCHE It is true that successful attempts to consistently and logically apply this marginalist approach to the demand for money and the determination of money’s value or purchasing power only happened in the early decades of the twentieth century, especially in the writings of economists such as Ludwig von Mises, Arthur C. Pigou, Alfred Marshall, and Edwin Cannan (Ebeling, 1992). And certainly by the late 1920s and early 1930s there were a variety of attempts to develop “micro-­foundational” theories of economic fluctuations of output, employment, and the general price level. In Great Britain this was certainly the case with Dennis Robertson, for example. On the European continent the Swedish and Austrian Schools had been influenced by the turn-­of-­the-­century writings of Knut Wicksell, as especially taken up in the writings of Erik Lindahl and Gunnar Myrdal, and Ludwig von Mises and Friedrich A. Hayek, respectively (Ebeling, 2010a, pp. 302–31) The Great Depression of the early and mid-­1930s clouded the clarity and persuasiveness of these expositions due to the magnitudes of the economy-­ wide phenomena of the downturn – double-­digit rates of ­unemployment, falling production, and declining price levels – that seemed to swamp any focus on and tracing out of the microeconomic lines of causation bringing about this collapse in many of the major economies of the industrialized West (Ebeling, 2015). John Maynard Keynes’s General Theory of Employment, Interest, and Money (Keynes, 1936) offered a theory of economy-­wide fluctuations in terms of a handful of “aggregate” magnitudes that seemed to have conceptual moorings and interrelationships separate and independent from the theoretical logic of the determination of relative prices and wages, and the demands and supplies for particular goods and services. Alvin Hansen, who in the post-­World War II era became one of the leading proponents and proselytizers for Keynesian economics in the United States, may have said in his early review of The General Theory a

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few months after it was published that, “The book under review is not a landmark in the sense that it lays a foundation for a ‘new economics’ . . . [It] is more a symptom of economic trends than a foundation stone upon which a science can be built” (Hansen, 1936, p. 686); but the theory propounded by Keynes soon became nonetheless, to use Paul Samuelson’s phrase, “the Gospel” of just such a “new economics” (Samuelson, 1946, pp. 146–7). The Keynesian avalanche soon swept away virtually all the competing approaches, ideas, or theories with which to explain the business cycle. Indeed, there was hardly a voice in the mainstream of the economics profession that was willing or able to directly question or challenge the near Keynesian monopolization of economic thinking on problems of economy-­wide fluctuations in employment, output, and prices. When Frank H. Knight declared in his 1951 presidential address before the American Economic Association that in his view “The latest ‘new economics’ and in my opinion rather the worst, for fallacious doctrine and pernicious consequences, is that launched by the late John Maynard (Lord) Keynes, who for a decade succeeded in carrying economic thinking well back to the dark age” (Knight, 1951, p. 2) it must have created shock and disbelief among many who heard these words spoken. Few besides Frank Knight could have been so blunt without permanently risking their reputation and standing in the economics profession of that time.

THE NEW “DARK AGE” OF MACRO-­ANALYSIS What was this “dark age” back to which Keynes took economic thinking? At its core, I would suggest, was its focus on macroeconomic aggregate building blocks: Aggregate Demand, Aggregate Supply, Total Output and Employment, and the average Price Level and Wage Level. This new world of Keynesian or macroeconomics turned its back on the contributions of nearly a century and a half before the appearance of The General Theory. Practitioners of Keynes’s macroeconomic framework threw to the wind the alternative theories developed for understanding many of the subtleties of the intricate and interdependent relationships of a market system, including monetary and cyclical processes. Of course some had been willing to challenge this core conception of Keynes’s approach from the start. Thus in his review of The General Theory shortly after it appeared Joseph Schumpeter said: “Mr. Keynes speaks of Aggregate Demand in the one case and Aggregate Supply in the other and makes them yield a unique ‘point of intersection’ ” but

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there was “little justification for this extension of the ‘Marshallian cross’” to an analytical dimension to which it did not apply (Schumpeter, 1936, p. 162). And Raymond Saulnier, in his detailed critical analysis of Keynes’s approach, along with those of Dennis Robertson and F.A. Hayek, questioned the efficacy of Keynes’s entire aggregate method of economic analysis: The market conditions relevant to the distribution of particular goods are so different, the technical conditions of production vary so greatly as between special goods, and changes in conditions of demand affect various goods so differently that propositions expressed in terms of total demand, total output, general technical conditions, etc., while they may attain a certain internal consistency, are no more than the very first steps in a theory of prices. The traditional methods of value analysis, which place emphasis on the demand and cost conditions of particular goods, seem to be lost sight of in this general interest in the “whole” . . . (Saulnier, 1938, p. 357)

By shifting focus away from the structure of relative demands and supplies, and the relationships between the prices, costs, and profitability between various goods, Keynes, in addition, broke economic analysis away from its logical moorings in the choices and actions of the individual ­decision-­making units of an economy – individuals as consumers and business units – that are the logical and causal basis for all that happens in the market arena. This was especially emphasized by that master of all things concerning monetary and related theory in the middle decades of the twentieth century, Arthur W. Marget (1942): It is a fundamental methodological proposition of “modern” versions of the “general” Theory of Value that all categories with respect to “supply” and “demand” must be unequivocally related to categories which present themselves to the minds of those “economizing” individuals (or individual business firms) whose calculations make the “supplies” and “demands” realized in the market what they are . . . The type of problem raised by the necessity for establishing a relation between these “microeconomic” decisions and these “macroeconomic” processes is not solved by the arbitrary introduction of an “aggregate supply function” and an “aggregate demand function” for industry as a whole, in defiance of the fact that neither of these “functions” deals with elements which enter directly into the calculations of the individual entrepreneurs whose “microeconomic” decisions and actions make “macroeconomic” processes what they are. On the contrary, it must be said, of such an attempt at “solution,” that it misconceives entirely the true nature of the relation between microeconomic analysis and macroeconomic analysis. (Marget, 1942, pp. 541, 544)

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THE MISPLACED CONSTRUCTION OF AGGREGATE DEMAND AND SUPPLY Indeed, it can be argued that the very notion of an “aggregate demand” or an “aggregate supply” is inconsistent with the very definitions of the meaning of supply of or demand for a good. “Supply” is usually understood to mean units of a good that are viewed as perfectly interchangeable for desired purposes by a decision-­maker and choice-­maker (Rothbard, 1962, p. 19). It is this perfect interchangeability from the market actor’s point of view that distinguishes one good from another, and on the basis of which the economic analyst then distinguishes between and elaborates on the relationships connecting complement and substitute goods, through which the various direct and indirect ramifications of changes in market conditions may be theoretically analyzed and understood. Now for analytical purposes, of course, it seems equally relevant and conceptually legitimate to distinguish between categories of goods between which market actors may and must choose due to the inescapable scarcity of these goods or the factors of production out of which these competing goods may be produced at the (marginal) cost of forgoing some quantity or use of the other. Thus it seems reasonable for various theoretical purposes to refer to the relative demands and supplies of “consumer goods” versus “producer goods” (capital), or between the competing uses, applications, and trade-­ offs in production between “capital” and “labor.” But it is also the case that there are many instances where even these wider categories of goods are too aggregated, such as when it becomes useful or essential to distinguish between “skilled” or “unskilled” labor, or various different types of skilled labor, which market participants in their choices and decisions classify and act towards in terms of distinctions they make between them. The same applies to between different types, qualities, or uses for “land” or different types and uses for more narrowly defined forms of “capital,” since in all these instances there may exist choice-­relevant relationships of complementarity and substitutability between the uses of various capital goods that the analysis should incorporate for greater logical and factual completeness (Lachmann, 1947, pp. 197–213). But when the level of aggregation is taken to the summing of the ­“aggregate demand” all goods “as a whole” in relation to the summing of the “aggregate supply” of all goods “as a whole,” one has aggregated away most if not virtually all of the choice-­theoretic relationships in the context of which real decisions and actions are made in the market.

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At the “microeconomic” level it is possible to separate and distinguish between the demands and supplies of, say, hats from shoes, horses from cows, bottling machines from cookie-­making equipment. These demands appear and for choice purposes are “independent” of each other precisely because the chooser considers them different from each other for a­ lternative goals or ends in mind; and the supplies appear and for choice purposes are ­“independent” of each other since they compete for some of the same scarce means through which one supply is increased or decreased relative to another.

THE INTERCONNECTEDNESS OF “AGGREGATE” DEMAND AND SUPPLY But as John E. Cairnes, one of the last of the great “classical economists,” argued a long time ago: The fundamental truth to be seized in connection with Supply and Demand . . . is that, conceived as aggregates, as each comprising all the facts of that kind occurring in a given community, Supply and Demand are not independent phenomena, of which either may indefinitely increase or decrease irrespective of the other, but phenomena strictly connected and mutually dependent; so strictly connected and interdependent that (excluding temporary effects and contemplating them as permanent and normal facts) neither can increase nor decrease without necessitating and implying a corresponding increase or diminution of the other. Aggregate demand can not increase or diminish without entailing a corresponding increase or diminution of aggregate supply; nor can aggregate supply undergo a change without involving a corresponding change in aggregate demand. (Cairnes, 1874, p. 23)

The introduction of money as the intermediary that turns the single transaction of barter exchange into two transactions – a good for money and then money for a good – may make the two “aggregate” sides of the market appear to be independent of each other. But once we have summed up “total demand” relative to “total supply” it should be fairly clear that one side could not increase (or decrease) without the equivalent on the other side. Or, as Cairnes also explained: It is true, where we have a medium of exchange, we can form the conception of general Demand as distinct from general Supply . . . But in point of truth and fact the two things are not separable. Purchasing power, in the last resort, owes its existence to the production of a commodity, and, the conditions of industry being given, can only be increased by increasing the quantity of commodities offered for sale; that is to say, [aggregate] Demand can only be increased by increasing [aggregate] Supply . . . This, I repeat, is fundamental in the theory of exchange; and all assumptions to the contrary must be regarded as baseless and absurd. (p. 31)

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And, likewise, if there is a decrease in the offering of goods or services in exchange for units of money (“general purchasing power”), this ­reciprocally decreases demand in the economy. “If a given group of laborers and capitalists produce less . . . they have, as an aggregate, less to offer for sale,” Cairnes reasoned, “and the diminution of general Supply would be exactly balanced by a corresponding diminution of general Demand” (p. 33). However, what can happen, and in a world of constant change will happen, is supply and demand for particular commodities being out of balance at the specific price at which the good may be bought and sold at a moment of time. The “normal” process in such situations, Cairnes argued, was for any respective excess demand or excess supply in a particular market to bring about a change in that good’s price in the required direction to, over time, bring that market back into balance. If there were to be a series of “excess supplies” for particular commodities at the given market prices, there could appear to be an excess of “aggregate supply” over “aggregate demand.” But this would be only the case in that the prices of those goods in excess supply had not, yet, been lowered sufficiently to earn the “general purchasing power” (money income) that would enable the suppliers of goods in excess amount to demand more of the goods they desire on the “aggregate demand” side of the market (Cairnes, 1874, pp. 38–41). And, finally, a long-­run increase in “aggregate demand” can only come from a long-­run growth in aggregate supply, which, in turn, can only result from the necessary accumulation of capital through savings and investment to expand production, increase the productivity of labor, and bring about a rise in the wages of labor (pp. 194–200). Of course, this is simply a way of explaining the fundamental logic of Jean-­Baptiste Say’s “Law of Markets” (Kates, 1998; Ebeling, 2015, pp. 68–70). All of these relative price relationships are lost from view, understanding, and insight once the conceptual focus is shifted to the Keynesian aggregate level. Then it may easily seem that the only reason that ­“aggregate supply” is below “potential” or “full employment” is a deficiency in the level of “aggregate demand.” In fact, however, the reason there may be an overall “imbalance” in the economy as a whole is due to a delay or a failure in bringing about needed adjustments in relative prices, wages, and production on the “supply side” to reflect the actual and underlying structure of relative demands, which are themselves submerged from easier view due to that focus on “aggregate demand” in general.

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THE STATISTICAL ILLUSION OF AN OBJECTIVE “PRICE LEVEL” The same applies to the undue attention in the aggregate approach to the general “price level.” Here, too, there is a conceptual misdirection, an instance of what is sometimes called the “fallacy of misplaced c­ oncreteness.” That is, to view and treat a concept as if it represented sometime “real” or “objective” in the social or economic world. The price level is merely a statistical creation resulting from a selection, summing, and averaging of series of actual prices for specific goods in particular markets at a moment in time. The price level does not really exist; the structure of relative prices that has emerged and been formed out of the interactions of individual demanders and suppliers for specific goods bought and sold do exist. They are the basis upon and the context in which individuals in the marketplace make their consumption and production decisions.1 As Benjamin Anderson argued: The general price level is, after all, merely a statistician’s tool of thought. Businessmen and bankers often look at indexes as indicating price trends, but no businessman makes use of index numbers in his bookkeeping. His bookkeeping runs in terms of the particular prices and cost that his business is concerned with . . . Satisfactory business conditions are dependent upon proper relations among groups of prices, not upon an average of prices. (Anderson, 1929, p. 23)

It should be fairly clear that all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macroeconomic aggregates and totals.

BALANCED MARKETS ASSURE FULL EMPLOYMENT Balanced production and sustainable employment in the economy, as a whole, requires coordination and balance between the demands and supplies of all the particular goods and services in each of the specific markets on which they are bought and sold. And parallel to this there must be comparable coordination and balance between the business demands for resources, capital equipment, and different types of labor in each production sector of the market and those supplying them. Such coordination, balance, and sustainable employment requires adaptation to the ever-­ changing circumstances of market conditions

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through adjustment of prices and wages, and to shifts in supplies and  demands in and between the various parts and sectors of the economy. In other words, it is these rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that assure “full employment” and efficient and effective use of available resources and capital, so entrepreneurs and businessmen are constantly and continuously tending to produce the goods we, the consumers, want and desire, and at prices that are covering competitive costs of production. All this is lost from view when reduced to that handful of macro-­ aggregates of “total demand” and “total supply” and a statistical average price level for all goods relative to a statistical average wage level for all workers in the economy.

THE KEYNESIAN “AGGREGATE” BIG SPENDER In this simplified and, indeed, simplistic Keynesian-­type view of things all that needs to be done from the government’s policy perspective is to run budget deficits or create money through the banking system to push up “aggregate demand” to assure a targeted rise in the general price level so profit-­margins “in general” are widened relative to the general wage level so employment “in general” will be expanded. We can think of a Keynesian-­inspired government as a “big spender” who comes into a town and proceeds to increase “aggregate demand” in this community by buying goods. Prices for final output rise; profit margins are widened relative to the general wage level and other general cost prices. Private businesses, in general, employ more workers, purchase or hire other inputs, and “aggregate supply” expands to a point of desired “full employment.” The presumption on the part of many central bankers, nowadays, in targeting a rate of an average annual price inflation of, say, 2 percent is that while selling prices are to be pushed up at this average annual rate through monetary expansion, the average level of cost prices (including money wages in general) will not rise – or not by the same percentage increase as the average increase in the “price level.” If cost prices in general (including money wages) were to rise at the same rate as the price level, there would be no margin of additional profits to stimulate greater aggregate output and employment.

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MARKET ANTICIPATIONS UNDERMINE KEYNESIAN ASSUMPTIONS The fallacy in thinking that cost prices in general will permanently lag behind the rate of increase in the price level of final goods and services was pointed out long ago, in 1898, by the famous Swedish economist Knut Wicksell: If a gradual rise in prices, in accordance with an approximately known ­schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum. Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be more certain of catching their train. But to achieve their purpose they must not be conscious or remain conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account, and so after all, in spite of their artfulness, arrive too late . . . (Wicksell, 1898, pp. 3–4).

THE KEYNESIAN BIG SPENDER UNBALANCES MARKETS But the more fundamental error and misconception in the macro-­aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary “stimulus” was meant to cure. Let us revert to our example of the “big spender” who comes into a town. The townspeople discover that our big spender introduces a greater demand into the community, but not for “goods in general.” Instead, he announces his intention of building a new factory on the outskirts of the town. He leases a particular piece of land and pays for the first few months’ rent. He hires a particular construction company to build the factory. The construction company in turn increases its demand not only for workers to do the work but also orders new equipment that, in turn, results in the equipment manufacturers adding to their workforce to fulfill the new demand for construction machinery. Our big spender, trumpeting the wonders for the community from his new spending, starts hiring clerical staff and sales personnel in anticipation of fulfilling orders once the factory is completed and producing its new output.

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The new and higher incomes earned by the construction and machinery workers as well as the newly employed clerical and sales workers raise the demand for various and specific consumer and other goods on which these people want to spend their new and increased wages. The businesses in the town catering to these particular increased consumer demands now attempt to expand their supplies and, perhaps, hire more retail store employees. Over time the prices of all of these goods and services will start to rise, but not at the same time or to the same degree. They will go up in a temporal sequence that more or less tends to match the pattern and sequence of the changed demands for those goods and services resulting from the new money injected by the big spender into this community.

“AGGREGATE” SPENDING NEEDS TO CONTINUE AND INCREASE Now, whether some of the individual workers drawn into this specific pattern of new employment were previously unemployed or whether they had to be attracted away from existing jobs they already held in other parts of the market, the fact remains that their continued employment in these particular jobs is dependent on the big spender continuing to inject and spend his new money, period after period of time, in the same way and in sufficient amounts of dollar spending to assure that the workers he has drawn into his factory project are not attracted to other employment due to the rise in all of these alternative or other demands as well. If the interdependent patterns of demands and supplies, and the structure of interconnected relative prices and wages generated by the big spender’s spending are to be maintained, his injection of new money into the community must continue, and at an increasing rate of spending if they are not to fall apart. An alternative image might be the dropping of a pebble or stone into a pond. From the epicenter where the stone has hit the surface of the water a sequence of ripples will be sent out which will be reversed when the ripples finally hit the surrounding shore, and will then finally come to rest when there is no longer any new disturbances affecting the surface of the pond. But if the pattern of ripples created is to be sustained, new pebbles or stones must be continuously dropped into the pond, and with increasing force if the resulting counter-­waves coming back from the shore are not to disrupt and overwhelm the ripple pattern moving out from the original epicenter.

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THE “AUSTRIAN” ANALYSIS OF INFLATIONARY PROCESSES There is no doubt that this way of analyzing and understanding the dynamics of how monetary expansion affects market activities is more complex than the simplistic Keynesian-­style of macro-­aggregate analysis. But, as Joseph A. Schumpeter highlighted: The Austrian way of emphasizing the behavior or decisions of individuals and of defining the exchange value of money with respect to individual commodities rather than with respect to a price level of one kind or another has its merits, particularly in the analysis of an inflationary process; it tends to replace a simple but inadequate picture by one which is less clear-­cut but more realistic and richer in results. (Schumpeter, 1954, 1090)

And, indeed, it is this “Austrian” analysis of monetary expansion with its resulting impact on prices, employment and, production – especially as developed in the twentieth century by Mises and Hayek – that explains why the Keynesian-­originated macro-­aggregate approach is fundamentally flawed. As Hayek once explained the logic of the monetary inflationary process: The influx of the additional money into the [economic] system always takes place at some particular points. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about . . . It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances for borrowing for that purpose; it may be spent in the first instance on securities, or investment goods, on wages or on consumers’ goods . . . The process will take very different forms according to the initial source or sources of the additional money stream . . . But one thing all these different forms of the process will have in common: that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of others and the whole structure of relative prices therefore will be very different from what the pure theorist describes as an equilibrium position. (Hayek, 1979, p. 142)

An inflationary process, in other words, brings about distortions, ­mismatches, and imbalanced relationships between different supplies and demands; and these relationships between the structure of relative prices and wages only last for as long as the inflationary process continues, and often only at an accelerating rate. Or, as Hayek expressed it:

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The misdirection of Keynesian aggregates ­89 Any attempt to create full employment by drawing labor into occupations where they will remain employed only so long as the [monetary and] credit expansion continues creates the dilemma that either credit expansion must continue indefinitely (which means inflation), or that, when it stops unemployment will be greater than it would be if the temporary increase in employment had never taken place. (Ibid.)

THE INFLATIONARY “CURE” CREATES MORE MARKET PROBLEMS Once the inflationary monetary expansion ends or is slowed down, it is discovered that the artificially created supply and demand patterns and relative price and wage structure are inconsistent with non-­inflationary market conditions. In our example of the “big spender,” one day the townsfolk discover that he is really a con artist who had only phony counterfeit money to spend, and whose deceptive promises and temporary spending drew them into all of those specific and particular activities and employments. They now find out that the construction projects begun cannot be completed; the employment created cannot be maintained; and the investments started in response to the phony money the big spender injected into this community cannot be completed or continued. Many of the townspeople now have to stop what they have been doing and try to discover other demanders, other employers, and other possible investment opportunities in the face of the truth of the big spender’s false incentives to do things they should not have been doing from the start. The unemployment and underutilization of resources that “activist” monetary policy by governments are supposed to reduce, in fact, set the stage for an inescapable readjustment period of more unemployment and temporary idle resources, when many of the affected supplies and demands have to be rebalanced at newly established market-­based prices if employment and production are to be sustainable and consistent with actual consumer demands and the availability of scarce resources in the post-­inflationary environment. Thus, recessions are the inevitable result of prior and unsustainable inflationary booms. And even the claimed “modest” and “controlled” rate of 2 percent annual price inflation that has become the new panacea for economic stability and growth in the minds of central bankers can bring in its wake a “wrong twist” to many of the microeconomic supply and demand and price–wage relationships that are the substance of the real economy beneath the superficial macro-­aggregates.

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But as long as the Keynesian way of thinking about and looking at the market in terms of economy-­wide aggregates continues to prevail it will be difficult to once more put monetary and cyclical analysis back on the right track.

NOTE 1. These objections to a statistically constructed “price level” should not be taken to mean a denial or ignoring that there is a general purchasing power, or value, of the monetary unit. The array or network, or structure, of relative prices between each individual good traded on the market in exchange for the monetary unit reflects at any moment in time the greater or lesser purchasing power possessed by the monetary unit over goods. And if market participants have expectations that the general purchasing power of the monetary unit will rise or fall, even though not all prices will be increasing or decreasing at the same time or to the same degree, such expectations may, of course, influence their decisions concerning their demands for various goods relative to their demand for holding cash balances.

REFERENCES Anderson, Benjamin M. (1929), “Commodity Price Stabilization a False Goal of Central Banking Policy,” Chase Economic Bulletin (May). Cairnes, John E. ([1874] 1967), Some Leading Principles of Political Economy, New Expounded, New York: Augustus M. Kelley. Ebeling, Richard M. (1992), “Variations on the Demand for Money Theme: Ludwig von Mises and Some Twentieth Century Views,” in John W. Robbins and Mark Spangler (eds), A Man of Principle: Essays in Honor of Hans F. Sennholz, Grove City, PA: Grove City College Press, pp. 127–38. Ebeling, Richard M. (2010a), Political Economy, Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition, London and New York: Routledge. Ebeling, Richard M. (2010b), “An ‘Austrian’ Interpretation of the Meaning of Austrian Economics: History, Methodology, and Theory,” Advances in Austrian Economics, 14, 43–68. Ebeling, Richard M. (2015), Monetary Central Planning and the State, Fairfax, VA: Future of Freedom Foundation. Hansen, Alvin H. (1936), “Mr. Keynes and Unemployment Equilibrium,” Journal of Political Economy, 44 (5) (October), 667–86. Hayek, Friedrich A. (1979), A Tiger by the Tail: The Keynesian Legacy of Inflation, ed. Sudha R. Shenoy, Washington, DC: Cato Institute. Jevons, William S. ([1879] 1965), Theory of Political Economy, New York: Augustus M. Kelley. Kates, Steven (1998), Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost Its Way, Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Keynes, John Maynard ([1936] 1973), The General Theory of Employment, Interest and Money, London: Macmillan.

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Knight, Frank H. (1951), “The Role of Principles in Economics and Politics,” American Economic Review, 41 (1) (March), 1–29. Lachmann, Ludwig M. ([1947] 1977), “Complementarity and Substitution in the Theory of Capital,” in Walter E. Grinder (ed.), Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, Kansas City: Sheed, Andrews & McMeel. Marget, Arthur W. ([1942] 1966), The Theory of Prices: A Re-­Examination of the Central Problems of Monetary Theory, vol. 2, New York: Augustus M. Kelley. Rothbard, Murray N. (1962), Man, Economy, and State: A Treatise on Economic Principles, Princeton, NJ: D. Van Nostrand. Samuelson, Paul A. (1948), “The General Theory,” in Seymour E. Harris (ed.), The New Economics: Keynes’ Influence on Theory and Public Policy, New York: Knopf. Saulnier, Raymond J. (1938), Contemporary Monetary Theory: Studies of Some Recent Theories of Money, Prices, and Production, New York: Columbia University Press. Schumpeter, Joseph A. ([1936] 1989), “Review of Keynes’ General Theory,” in Richard V. Clemence (ed.), Essays on Entrepreneurs, Innovation, Business Cycles, and the Evolution of Capitalism, New Brunswick, NJ: Transaction Books, pp. 160–64. Schumpeter, Joseph A. (1954), History of Economic Analysis, New York: Oxford University Press. Wicksell, Knut ([1898] 1965), Interest and Prices: A Study of the Causes Regulating the Value of Money, New York: Augustus M. Kelley.

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5. Cycles and slumps in an overly aggregated theoretical framework1 Roger W. Garrison INTRODUCTION John Maynard Keynes’s two most notable books, A Treatise on Money (1930) and The General Theory of Employment, Interest, and Money (1936), were separated in time by an economy gone wrong. Though just six years apart, these two perspectives on the macroeconomy can hardly be described as companion volumes. Rather, they stand in stark contrast to one another and reflect a sea change in Keynes’s thinking about macroeconomic relationships. In the earlier book, Keynes’s theoretical framework assumes continual full employment of labor and other resources and tracks macroeconomic adjustments in terms of relative prices, making do, though, with just two price levels. Keynes let “P be the price-­level of liquid Consumption-­goods,” . . . and “Pʹ be the price-­level of new ­investment-­goods” (Keynes 1930: 135 and 137). In the later book, Keynes focuses on economy-­wide unemployment and idle resources. He assumes sticky-­ downward wage rates ‒ sometimes relaxing that assumption but, for the most part, in ways that fail to ease the problem of unemployment. In his Chapter 19, “Changes in ­Money-­Wages,” he even suggests that in “the contemporary world it is more expedient to aim at a rigid money-­wage policy than a flexible policy responding by easy stages to changes in the amount of unemployment” (Keynes 1936: 266), though he immediately back-­pedals on actually having such a policy, owing to qualms about its possible effects on other variables. We recognize that in the preface to The General Theory Keynes portrays the two books as exhibiting “a natural evolution in a line of thought which I have been pursuing for several years” (ibid.: vi). But, for his readers, his embellishing on that claim creates doubt about its veracity. The leap from theorizing “on the assumption of a given output” to portraying “the scale of output and employment as a whole” as the macroeconomy’s key endogenous variable (p. vii) can hardly be seen as a natural evolution. Given the wholesale neglect of unemployed resources in his earlier book, 92

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the sea change in Keynes’s thinking was undoubtedly provoked – virtually mandated – by the economic downturns in the western countries and the enduring depressions that followed. Joan Robinson puts the “natural ­evolution” into perspective: Keynes started life as a monetary economist. When he was working on his Treatise on Money, he had thought that he had to be concerned strictly with the general price level. He rejected the suggestion that his subject was connected with the problem of unemployment. But in 1929 he had descended from this high theoretical plane to practical policy . . . (Robinson 1975: 124)

SETTING THE STAGE FOR A CRITIQUE OF KEYNES’S APPROACH TO PRACTICAL POLICY While a visiting scholar at New York University in 1923–24, Friedrich  A.  Hayek focused his attention on the ten-­year-­old American central bank. He watched the early phases of the 1920s’ boom and saw a connection between Federal Reserve policy and the ramped-­up economic activities (Hayek [1925] 1984). The early dynamics of that decade mirrored the dynamics of an unsustainable boom as set out briefly by Ludwig von Mises in his Theory of Money and Credit ([1912] 1953: 357– 66). According to Hayek, the seeds of the downturn were sown in the US in the form of easy money maintained by the Federal Reserve during the 1920s, the most salient consequence of which was the accelerating – and increasingly ­unrealistic – stock prices. The most insidious consequences, however, stemmed from the policy-­tainted loan-­market signals that created conflicts within the economy’s capital structure. Falsified loan-­ market signals can throw early-­stage production processes out of line with the temporal pattern of consumer demand. This is the essential causal element in the Austrian school’s theory of business cycles. Policy-­tainted interest rates give rise to internally conflicted production activities.2 Artificially low interest rates stimulate early-­stage – or, more broadly, interest-­ rate sensitive – production processes, creating employment ­opportunities in those areas and hence raising incomes earned in those early-­stage undertakings. Had the low interest rates been the consequence of increased saving rather than of policy actions by the Federal Reserve, the increase in early-­stage capital formation would have been accompanied by a contemporaneous reduction of consumption – and hence a reduction in late-­stage inputs and outputs. Accordingly, consumable output would have been shifted to the more distant future. This is the temporal pattern that characterizes sustainable, market-­directed, economic growth. By contrast, a policy-­induced boom as occurred in the 1920s and especially as it intensified

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near the end of that decade saw an increase in both early-­stage production and contemporaneous consumer demand, creating a virtual tug-­of-­war centered on resources usable in both early-­stage and late-­stage markets – and with rising prices of those resources dimming profit prospects. These are the kinds of internal dynamics within the economy’s investment sector that lead to a crisis and warrant the charge that Keynesian theory is based on an overly aggregated macroeconomic framework. Even in reviewing Keynes’s earlier book, Hayek (1931: 277) clearly saw that “Mr Keynes’s aggregates conceal the most fundamental mechanisms of change.” Keynes’s 1930 “theorizing in terms given output” raised no issues about the temporal profile of that output or about the capital structure that gives rise to that temporal pattern; it simply limited the applicability of his theory to a fully employed economy, whatever the mix of capital goods. His 1936 theorizing, which allowed for a dramatic idling of resource, should have been of a quite different character. A malfunctioning of the economy in which changes in the level of output have a first-­order claim on our attention is all but certain (by virtue of varying price, income, and interest-­rate elasticities among different goods and services) to involve also a malfunctioning in the relative allocations within both capital and labor markets. Similarly, interest-­rate policies aimed at changing the level of output will inevitably affect relative allocations as well. Keynes, however, in his final chapter – “Concluding Notes . . . ” – downplays the connection between volume (level of output) and direction (relative allocations): “It is in determining the volume, not the direction, of actual employment that the existing system has broken down” (1936: 379). Clearly, Keynes was comfortable in focusing on “volume” while ignoring “direction.” Axel Leijonhufvud explains: Keynes regards the substitution effects of interest rate changes as “open to a good deal of doubt,” as “secondary and relatively unimportant,” – a phrase which in his works means, in effect, that the relationship is ruled out of ­consideration . . . [For Keynes, then] preference functions defined for alternative time paths of consumption are assumed to exhibit a considerable degree of intertemporal complementarity. (Leijonhufvud 1968: 196)

But, according to the Austrian theory, both volume and direction are affected during a cyclical episode. More pointedly, we can say that the boom–bust sequence consists of (1) the misdirection of resources brought about by policy-­infected interest rates, which (2) entails an initial rise in volume with (3) the cumulative effect of the misdirection eventually provoking a fall in volume – (4), the extent of the fall being compounded by ill-­conceived fiscal, monetary, and regulatory policies. The 1920s’ policy-­ driven economic boom in the US was inherently

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unsustainable, and the eventual crash and onset of depression was soon felt by Great Britain and much of the rest of the western world. Unlike the US, though, Great Britain experienced no boom during the 1920s, and the relatively minor British counterpart to America’s Great Depression was dubbed a “slump” – a word that, along with “slumps,” appears 26 times in The General Theory (Glahe 1991: 231).3 Dominating that decade in Great Britain was the slow recovery from the devastation of World War I. And greatly retarding the recovery was the inept decision, made by Churchill in 1925, to put the country back on the gold standard at pre-­war parity – a decision that was supported by Montagu Norman, Governor of the Bank of England, and Benjamin Strong, Governor of the Federal Reserve Bank of New York. Prices in 1925 were substantially higher than pre-­war prices, the pre-­war exchange rate of $4.87 to the pound being about 10 percent higher than what would be the market rate in 1925. Failing to adjust the exchange rate meant that Great Britain would be accepting 10 percent less revenue for exports, which would result in decreased wage rates or increased unemployment (or some of both). Also, to defend the higher exchange rate, the Bank of England kept interest rates high, which discouraged ­production projects and hence further limited employment opportunities. From Keynes’s window on the world, then, the worsening of his country’s economic conditions at the end of the 1920s did not appear as the second phase of a boom–bust sequence. It appeared only as a worsening of an already slack economy. Keynes was certainly aware that the Americans’ postwar experience was different, but he was inclined to attribute that difference not to a policy-­induced unsustainable boom but to the American psyche. According to Keynes, “Americans are apt [in financial matters and even other matters] to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market” (Keynes 1936: 159, emphasis added). In a related pronouncement by Keynes, this time focused on people’s demand for liquidity, he sees the American psyche at issue and not the discoordinating effects of policy and their attendant uncertainties: “in the United States . . . everyone tends to hold the same opinion at the same time, [while] in England differences in opinion are more usual” (ibid.: 172).

POLICY-­INDUCED BOOM–BUST EPISODES VERSUS ONGOING VACILLATIONS IN AN INHERENTLY SLACK ECONOMY Hayek, following Mises, pointed to the systemic credit market distortions that trigger a protracted but ultimately unsustainable boom. The contrast

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between the Austrians’ theory and Keynes’s could not have been sharper. The Austrians focused on what they considered to be the key causal element that predetermined the eventual cyclical downturn, while Keynes’s focus was on the downturn’s most salient features and on prospects for extra-­market remediation. Those most salient features, of course, were widespread downward co-­movements of investment, employment, and consumption. Business cycles occurring in the inter-­war period and certainly the ones occurring in more recent years in the US – in the forms of the dot-­com bubble that peaked in 2000 and the housing bubble that peaked in 2005 – were clear instances of boom and bust. The characteristic policy-­induced boom, the endogenous upper turning point, and, after a downward spiral, the eventual recovery are what give these episodes their cyclical quality. We should note that Keynes relegated to his Chapter 22 the discussion of cycles of this genre (calling them “trade cycles” – the term used also by Hayek). This chapter is the first of three in Book V, which is the final “book” in The General Theory. All three of the Book V chapters are ­identified as “Notes,” suggesting that the material is fragmented and not well integrated with the chapters in Books I through IV. It is worth reporting that the word “cycle” (together with the words “cycles” and “cyclical”) appears 27 times in Chapter 22 but only 11 times elsewhere – and with those instances scattered in eight of the rest of The General Theory’s other 23 chapters (Glahe 1991: 58). Keynes’s characterization of the Chapter 22-­style “trade cycle” clearly entails a boom phase that eventually has the economy pressing up against its limits, but even here Keynes sees human psychology rather than ­monetary policy as driving the boom: It is of the nature of organized investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital assets, that, when disillusion falls upon an over-­optimistic and over-­bought market, it should fall with sudden and even catastrophic force. (Keynes 1936: 315–16)

It is at the end of this particular section of Chapter 22 that Keynes, citing psychological issues once again, writes, “I conclude that ordering the current volume of investment cannot be safely left in private hands” (ibid.: 320). So, if it is only Chapter 22 that is actually about boom and bust (though with human failings rather than policy actions being the key driver), what is the rest of The General Theory about? The answer is: it is about chronic secular stagnation and Keynes’s recommended policy tools for

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propping up what he saw as an inherently dysfunctional market system. In his Chapter 15, titled “The Psychological and Business Incentives to Liquidity,” Keynes writes: [The rate of interest] may fluctuate for decades about a level which is chronically too high for full employment; – particularly if it is the prevailing opinion that the rate of interest is self-­adjusting, so that the level established by convention [that is, not by the borrowing and lending in loanable-­funds markets – rwg] is thought to be rooted in objective grounds much stronger than convention, the failure of employment to obtain an optimal level being in no way associated, in the minds either of the public or of authority, with the prevalence of an ­inappropriate range of rates of interest. (Keynes 1936: 204, emphases mine)

Here, Keynes is not at all dealing with the phases of a boom–bust cycle; he is simply claiming that widespread, chronic under-­performance is inherent in market economies. More specifically, he is indicating that consumption spending and investment spending vacillate, moving up and down together, though at rates that differ (as indicated by the Keynesian multipliers), and that even the highest levels of consumption and investment may not be sufficient to fully employ the labor force – hence the need for ongoing extra-­ market forces to achieve and maintain a fully employed economy. These extra-­market forces (government spending and money creation) are not seen as countering unruly market forces but rather as filling a void that is inherent in the mechanisms of a market economy. The void, though  – or rather the perception of it – is more logically attributable, as the Austrian theorizing reveals, to Keynes’s overly aggregated m ­ acroeconomic framework.

HOW KEYNES’S METHODS CONSTRAINED HIS THEORIZING It is widely recognized that neither correlations nor co-­movements imply causation. Correlations characterizing movements in X, Y, and Z do not imply that there are direct causal relationships among these magnitudes. It is much less widely recognized, however, that even a small change in some other magnitude can play a key causal role in the subsequent movements of X, Y, and Z. The Austrians provide a case in point when they focus on policy-­determined interest rates held persistently below what would have been market rates (or simply kept from rising when market forces are pushing in that direction). Keynes turned a blind eye to this small-­ cause-­ cum-­large-­effect ­possibility – partly, no doubt, because he rejected the notion that market

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interest rates are governed by supply and demand conditions in a broadly ­conceived loanable-­funds market (Keynes 1936: 180) but also because he was ­assuming, if only implicitly, that large effects must have large causes. Allan Meltzer notes that: Keynes was the type of theorist who developed his theory after he had developed a sense of relative magnitudes and of the size and frequency of changes in these magnitudes. He concentrated on those magnitudes that changed most, often assuming that others remained fixed [or were otherwise out of play – rwg] for the relevant period. (Meltzer 1988: 18)

And he took the “relevant period” to begin just before the fall in the magnitudes of income, consumption, and investment. Any interest-­rate movements before that period – that is, during the start and development of the boom – were too small to require his attention and, at any rate, were simply outside his field of vision. Even in his chapter on the “trade cycle,” in which both boom and bust should have been fully in play, Keynes prefaced his remarks by saying “I can best introduce what I have to say by beginning with the later stages of the boom and the onset of the “crisis” (Keynes 1936: 315, emphasis mine). Here, apart from ­psychological factors, the early and middle stages of the boom had no claim on his attention. Keynes based his theorizing on the relative movements in the highly aggregated macroeconomic magnitudes and on the extent and frequency of changes in these magnitudes. The Austrians’ theorizing provides quite a contrast. Taking his cue from Mises and earlier Austrians, Hayek argued that the role of the economist is to look behind the dramatic co-­ movements of the magnitudes emphasized by Keynes and identify the root cause of the boom–bust episode – a cause which is “apt to be hidden from the untrained eye” (Hayek 1941: 409). As earlier implied, even a seemingly modest difference between interest rates that are biased d ­ ownward by the actions of the central bank and the market rates of interest that would have prevailed in the absence of extra-­market controls can in time threaten the stability of the economy. Eye-­catching effects need not be linked to eye-­catching causes. Seemingly small but persistent causes may be in play. Policy-­infected interest rates may have a cumulative effect, giving rise to systemic disequilibria that eventually necessitate economy-­ wide reallocations of capital and labor. And, of course, in actual episodes this disrupting eventuality is likely to be exacerbated by ill-­conceived and counterproductive stabilization policies that trigger dramatic movements in those macroeconomic magnitudes monitored by Keynes. It is largely the underlying methodological precepts that determine what kind of theory emerges from the economist’s thinking. If it is

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acknowledged that an inconspicuous cause can, in time, have a dramatic effect, then adopting the Keynesian approach to macroeconomics may well preclude identifying the root cause of a macroeconomic problem. The actual cause may be ruled out precisely because of its contemporaneous inconspicuousness. However, it seems to be inconceivable, in the judgment of those who have followed Keynes – that is, adopting his method of ruling in or ruling out potential causes – that rates of interest being held below their true market levels can cause an economy to experience a boom and then eventually, and inevitably, a bust. We should recognize that even Milton Friedman and Anna J. Schwartz, in their Monetary History of the United States, 1867–1960, side with Keynes on this particular methodological point. In dealing with the Great Depression, they write, “It is a sound general principle that great events have great origins” (1963: 419). Then, as if whistling in the dark, they write in the very next paragraph (but without elaboration or application): “Yet it is also true that small events at times have large consequences, that there are such things as chain reactions and cumulative forces.” Robert  Lucas (1981: 237), whose new classicism is a dynamic general-­equilibrium version of Friedman’s monetarism, shares the Friedman and Schwartz view – but without any whistling. The magnitude of the cause alleged by the Austrians (a policy-­induced decrease in interest rates) is so small compared to the magnitude of the alleged effect (a dramatic economy-­wide downturn) that the Austrian theory of boom and bust cannot be entertained. In his own words, “Given the cyclical amplitude of interest rates, the investment-­ interest elasticity needed to account for the observed amplitude in investment is much too high to be consistent with other evidence” (Lucas 1981: 237, emphasis in original). Note here that Lucas misunderstands the Austrian theory on three counts. He does not recognize that small causes can have large effects; he thinks in terms of interest elasticity of investment-­as-­a-­whole rather than the divergent interest-­rate elasticities of early-­stage and late-­stage investment goods; and he takes “the effect” to be the entire, peak-­to-­trough movement in the investment magnitude, a movement that invariably entails complicating factors, including ill-­ conceived policies aimed at rekindling the boom. Friedman, too, has a similar misunderstanding of the Austrians, as evidenced by his reaction to an Austrian-­oriented 2003 paper by Barry Eichengreen and Kris Mitchener: [The] issue is whether the depth and seriousness of the [Great Depression] is attributable to what took place during the twenties or what took place during the thirties. The only item that has any bearing on that is the correlation of the measures of the credit boom with the depth of the subsequent recession . . . The bulk of the evidence is that what happened in the thirties explains the

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thirties, not what happened in the twenties. (Skousen 2005: 181, fn. 1, emphasis mine)4

The Austrians would argue that even if the monetary authority simply kept interest rates from rising in the face of upward pressures deriving from technological innovations or, more generally, from increases in productivity, the economy would be set off on an unsustainable growth path that would eventually result in a downturn. Undoubtedly, this circumstance was characteristic of the interest-­rate movements during the 1920s in the US. That is, the unwillingness of the central bank to allow market interest rates to rise in the face of new technological ­possibilities and hence in greater demands for credit for turning those possibilities into realities was as important, if not more so, than any actual reductions in interest rates. However, the order of the day at the Federal Reserve was to “accommodate the needs of trade.” Hayek ([1933] 1975: 179) succinctly summarizes the importance of central-­bank “braking” rather than central-­bank “accommodating” in the context of a boom–bust episode: The immediate consequence of an adjustment of the volume of money to the “requirements” of industry is the failure of the “interest brake” to operate as promptly as it would in an economy without credit. This means . . . that new adjustments are undertaken on a larger scale than can be completed; a boom in thus made possible, with the inevitably recurring “crisis.”

It is revealing to note that Keynesian-­oriented central-­bank ­policymakers use the brake metaphor too, but at a different point in the course of a business cycle. An Austrian’s advice to a central banker on the occasion of technological advances would be to let the braking action of rising rates of interest temper the increased demands for credit so as to avoid an unsustainable boom. The Keynesian policymakers “accommodate” the unsustainable boom by making credit, now in greater demand, no more expensive than it was before the enhanced investment opportunities. They begin to think about tapping on the monetary brake only when the boom threatens to careen out of control. However, the incentives ­actually to tap on the brake are weak. Agnosticism, real or feigned, weighs against braking on the grounds that you don’t really know that the boom is unsustainable until you witness the bust. And, in any case, (1) if the central bank actually raised interest rates, it would, for sure, get the blame for causing the bust; and (2) if the boom actually is unsustainable, it will go bust on its own and the central bank’s blameworthiness would not so easily be seen.

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SO, HOW WAS IT THAT KEYNESIANISM PREVAILED OVER AUSTRIANISM? Let us start with the preface to The General Theory and the worst-­kept secret about that book. Keynes announced in his preface that “this book is chiefly addressed to my fellow economists” (Keynes 1936: v) and indicated that “the general public, though welcome at the debate, are only ­eavesdroppers” (ibid.: vi). It is doubtful, though, that there have been many, if any, fellow economists – or modern economists – who have understood Keynes’s book on the first reading. And the “eavesdroppers,” if any, would soon realize that Keynes’s welcoming them was essentially a matter of courtesy. While Keynes is generally known to be a good writer, this most influential book was very badly written. Paul Samuelson, who soon enough climbed aboard the Keynesian bandwagon, recognized the book’s many literary shortcomings but ultimately praised it: Herein lies the secret of the General Theory. It is a badly written book, poorly organized; any layman who, beguiled by the author’s previous reputation, bought the book was cheated of his five shillings. It is not well suited for classroom use. It is arrogant, bad-­tempered, polemical, and not overly generous in its acknowledgments. It abounds in mares’ nests or confusions . . . In it the Keynesian system stands out indistinctly, as if the author were hardly aware of its existence or cognizant of its properties; and certainly he is at his worst when expounding its relations to its predecessors. Flashes of insight and intuition intersperse tedious algebra. An awkward definition suddenly gives way to an unforgettable cadenza. When finally mastered [after how many readings? – rwg], its analysis is found to be obvious and at the same time new. In short, it is a work of genius. (Samuelson 1946: 178)

Yet, despite the considerable headwind that even the economists would have to face in deciphering The General Theory’s message, Keynes predicted, in a 1935 letter to George Bernard Shaw, that there would be a timely embracing of the book’s message: I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years –the way the world thinks about economic problems . . . I don’t merely hope what I say; in my own mind I’m quite sure.

In retrospect it appears that the opaqueness of Keynes’s writing may well have aided in the early triumph of Keynesian policymaking, but without his actual message being understood. Debate about just what his message is continues even now – after 80 years. Anatol Murad’s 1962 book is

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immodestly titled What Keynes Means. Other interpreters dwell on what Keynes must have had at the back of his mind or hint about how he would have changed his mind had he only lived a few more years. Modern recastings of The General Theory, such as the so-­called New Keynesianism, take the form of a conjectured vision of the macroeconomy, largely if not wholly of the recaster’s own making, followed by a search through Keynes’s book for passages that provide at least some evidence of such a vision. Though there has been no strong convergence among academic economists about just what, exactly, is in The General Theory, there has been a convergence among policymakers. While possibly eavesdropping on academic discussions based on some notion of the Keynesian vision, they fully embraced the idea – many already having stumbled onto it – that printing money and spending money, as well as cutting taxes and running deficits, has positive effects, even if only in the short run, and that, mercifully (for the policymakers), any subsequent long-­run effects, most of which are negative, are not likely to be laid at the feet of those ­policymakers. To the contrary, the policymakers are more likely to be encouraged to double-­ down and recreate those positive effects. Despite the long and continuing puzzles among academics about what Keynes meant, Keynes’s prediction in his letter to George Bernard Shaw was pretty much on the mark. Eleven years after the publication of his book, the US Congress passed the Employment Act of 1946. And though that piece of legislation was a watered down version of the defeated Full Employment Act of 1945, the 1946 version still had a strong Keynesian flavor. Its main purpose was to put the responsibility of economic stability, that is, of controlling inflation and unemployment, squarely on the federal government – which, of course, meant on the policymakers. Some time ago I used the decidedly ugly term “Keynesianized” to characterize the US economy – and undoubtedly other economies (Garrison 1993). Shortly thereafter several fellow critics of Keynes alerted me to the fact that this ugly term was already in use, but with a very different meaning from what I had given it. “To Keynesianize” had been used to mean, in effect, outfitting the government’s policymaking bodies with the requisite Keynesian policy tools for stabilizing what was seen as an ­otherwise self-­destabilizing market economy. The meaning I attached to the term was virtually the opposite: Keynesian policy is a set of self-­justifying policy prescriptions. For instance, if the policymakers are convinced that, in face of a decrease in the demand for labor, wage rates will not fall or will fall too slowly, they stand ready to employ the idled workers in make-­work projects or provide generous unemployment compensation. In these circumstances, unemployed

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workers would understandably be less willing to accept job offers that are inferior to their earlier wage rate, ensuring that wage rates, in fact, will be sticky downwards. Thus, while the purported intention of Keynesian policy is to stabilize the economy, its actual effect is to “Keynesianize” the economy: it causes the economy to behave in precisely the same perverse manner as that implied by the Keynesian vision. Yet this perverse outcome is likely to worsen with still further doses of Keynesian policies. This convoluted interrelationship between theory and policy has long obscured the flaws in the theory itself.

CONCLUDING REMARKS In the final analysis, Keynesian theory is a set of mutually reinforcing but jointly questionable propositions purporting to show how, in a market economy, a few excessively broad macroeconomic aggregates play off against one another. The writing style of The General Theory, coupled with its poor organization and seeming conflict with Keynes’s earlier writings, has subjected academic economists to years of conflicting interpretations of Keynes’s message. Meanwhile policymakers, seeing the short-­run advantage to fiscal and monetary stimulation, have been quick to adopt Keynesian thinking. And finally, the less than satisfactory performance of the so-­called mixed economies has allowed for differing opinions among the electorate about whether the Keynesianized (both meanings) economy’s lackluster performance has been bolstered or hampered by Keynesian policies.

NOTES 1. While participating in a 1986 Liberty Fund Conference in San Francisco, I heard Allan  Meltzer remark, in an almost forlorn tone, that “Once you start writing about Keynes, you can never stop.” While the present chapter was drafted anew, the reader will recognize a family resemblance to Garrison (1985, 1989, 1992, 1993, 1994, 1995, 2001 [Chs. 7–9], 2006, and 2009). 2. Hayek developed Mises’ theory in his Prices and Production (1931 and 1935) by introducing the Hayekian triangle, a pedagogical device for illustrating the temporal profile of the economy’s structure of production. With one leg representing production time and the other representing final output, Hayek showed how a policy-­distorted rate of interest distorts the temporal profile of the economy’s multistage production processes, eventually provoking an economic crisis. 3. However, Keynes used “slump” in referring to the US experience too – even using the phrase “Boom and Slump” in this regard. See Keynes 1936: 144. 4. See also Friedman (1993) and Garrison (1996) for the significance of Friedman’s “Plucking Model” in the context of the debate between Friedman and the Austrians.

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REFERENCES Eichengreen, Barry and Kris Mitchener (2003), “The Great Depression as a Credit Boom Gone Wrong,” BIS Working Paper No. 137: Bank for International Settlements. Friedman, Milton (1993), “The ‘Plucking Model’ of Business Fluctuations Revisited,” Economic Inquiry, 31 (2), 171–7. Friedman, Milton and Anna J. Schwartz (1963), A Monetary History of the United States, 1867–1960, Princeton, NJ: Princeton University Press. Garrison, Roger W. (1985), “Intertemporal Coordination and the Invisible Hand: An Austrian Perspective on the Keynesian Vision,” History of Political Economy, 17 (2), 309–21. Garrison, Roger W. (1989), “The Austrian Theory of the Business Cycle in the Light of Modern Economics,” Review of Austrian Economics, 3, 3–29. Garrison, Roger W. (1992), “Keynesian Splenetics: From Social Philosophy to Macroeconomics,” Critical Review, 6 (4), 471–92. Garrison, Roger W. (1993), “The Trouble with Keynes,” The Freeman, 43 (10), 386–89. Garrison, Roger W. (1994), “The Persistence of Keynesian Myths,” in Richard M. Ebeling (ed.), Economic Education: What Should We Learn About the Free Market, Hillsdale, MI: Hillsdale College Press. Garrison, Roger W. (1995), “Keynes was a Keynesian,” Review of Austrian Economics, 9 (2), 165–71. Garrison, Roger W. (1996), “Friedman’s ‘Plucking Model’: Comment,” Economic Inquiry, 34 (4), 799–802. Garrison, Roger W. (2001), Time and Money: The Macroeconomics of Capital Structure, London and New York: Routledge. Garrison, Roger W. (2006), “From Keynes to Hayek: The Marvel of Thriving Economies,” Review of Austrian Economics, 19 (1), 3–15. Garrison, Roger W. (2009), “Mainstream Macro in an Austrian Nutshell,” The Freeman, 59 (4), 10–17. Glahe, Fred R. (ed). (1991), Keynes’s The General Theory of Employment, Interest, and Money: A Concordance, Savage, MD: Rowman & Littlefield. Hayek, Friedrich A. (1925), Die Wahrungspolitik der Vereinigten Staaten seit der Uberwendung der Krise von 1920, in Zeitschrift fur Volkswirtschaft und Sozialpolitik, two parts: vols 1–3, pp. 35–63 and vols 4–6, pp. 254–317. Hayek, Friedrich A. ([1925] 1984), “The Monetary Policy of the United States after the Recovery from the 1920 Crisis,” in Roy McCloughry (ed.), Money, Capital, and Fluctuations: Early Essays, Clifton, NJ: August M. Kelley, pp. 5–32. (This article, rendered in English, is an extract from Hayek (1925), vols 4–6, pp. 255–82.) Hayek, Friedrich A. (1931), “Reflections on the Pure Theory of Money of Mr J.M. Keynes,” Economica, 11 (31), 270–95. Hayek, Friedrich A. ([1933] 1975), Monetary Theory and the Trade Cycle, New York: Augustus M. Kelley. Hayek, Friedrich A. ([1935] 1967), Prices and Production, 2nd edn, New York: Augustus M. Kelley. Hayek, Friedrich A. (1941), The Pure Theory of Capital, Chicago: University of Chicago Press. Keynes, John Maynard (1930), A Treatise on Money (2 vols), New York: Harcourt, Brace and Company.

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Keynes, John Maynard (1936), The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace and Company. Keynes, John Maynard (1973), The Collected Writings of J.M. Keynes, vol. xiv, Donald Moggridge (ed.), London: Macmillan. Leijonhufvud, Axel (1968), On Keynesian Economics and the Economics of Keynes, New York: Oxford University Press. Lucas, Robert E. Jr (1981), Studies in Business Cycle Theory, Cambridge, MA: MIT Press. Meltzer, Allan H. (1988), Keynes’s Monetary Theory: A Different Interpretation, Cambridge: Cambridge University Press. Mises, Ludwig von ([1912] 1953), The Theory of Money and Credit, New Haven, CT: Yale University Press. Murad, Anatol (1962), What Keynes Means: A Critical Clarification of the Economic Theories of John Maynard Keynes, New York: Bookman Associates. Robinson, Joan (1975), “What Has Become of the Keynesian Revolution,” in Milo Keynes (ed.), Essays on John Maynard Keynes, Cambridge: Cambridge University Press, pp. 123–31. Samuelson, Paul A. (1946), “Lord Keynes and the General Theory,” Econometrica, 14 (3), 187–200. Skousen, Mark (2005), Vienna & Chicago: Friends or Foes?, Washington, DC: Regnery.

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6. The problems with Keynesianism: a view from Austrian capital theory Steven Horwitz Pinpointing the reasons for the failure of stimulus programs across the globe requires identifying the theoretical framework that justified such programs and the flaw in the framework that explains their failure. The justificatory theoretical framework for stimulus spending during the Great Recession was Keynesianism writ large. I use the term “Keynesianism” intentionally to distinguish the larger body of ideas that has come to be associated with Keynes from Keynes’s own views. However, in the argument to follow, I will make use of both the larger Keynesian paradigm and Keynes’s own words in showing the flaws in that framework. Even where Keynesianism moved beyond Keynes, it often did so by implicitly incorporating assumptions from Keynes himself, including ones about which he was far more explicit. It has been said that in foxholes there are no atheists. Similarly, after the last decade, it would appear that in a financial crisis there are almost no non-­Keynesians. Despite the numerous advances in macroeconomic theory over the course of the last several decades, including many criticisms of the simple Keynesian model, what seemed to drive both economists and politicians in the winter of 2008–09 was a firm belief that more government spending would make up for the collapse of investment spending and pull total income back to somewhere closer to its full employment level. This was the simple logic of the Keynesian cross, long thought to be found only in the early sections of macroeconomics textbooks. Although the politicians were clearly playing bootleggers to the economists’ Baptists, it was still surprising how quickly so many economists argued for the most simplistic of models of counter-­cyclical policy.1 As it turns out, the very simplicity of that model provides the most ­powerful explanation of its failure. Specifically, both Keynes himself and the Keynesians do not have a theory of capital that enables them to comprehend the processes of intertemporal coordination and complexities of capital usage that are central to the market economy. When the Keynesian approach is looked at through 106

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the eyes of the Austrian school’s contrary perspective, and its theory of capital in particular, these flaws become more obvious and their relevance to policy concerns becomes clear. In short, the logic of offsetting a fall in investment spending with an increase in net spending by government is made at a level of aggregation that never considers the microeconomic questions at stake. From an Austrian perspective, capital is always embodied in specific goods that have multiple possible uses. For any spending to create sustainable growth, there must be the right kinds of capital goods to produce the outputs that receive the flow of new spending. It matters where the spending goes because capital goods, including human capital, are not sufficiently homogeneous to be applied with equal productivity to every type of spending. Keynesian models implicitly treat capital as being more or less perfectly homogeneous, thereby ignoring the questions of capital coordination that are at the heart of the Austrian approach. In what follows, I explore the role, or lack thereof, of capital and intertemporal coordination in The General Theory and in the IS–LM model through a comparison with the capital theory of the Austrian school. I then examine the ways these two conceptions of capital generate two distinct visions of intertemporal coordination. In a final section, I use these differences to examine the stimulus spending that characterizes the counter-­cyclical policy of the Great Recession. I do so through the metaphor of seeing capital-­using economies as akin to jigsaw puzzles, which lays bare the shortcomings of Keynesian theory and policy recommendations.

KEYNES AND THE AUSTRIANS ON CAPITAL Although discussions of capital are not absent from both A Treatise on Money (1930) and The General Theory of Employment, Interest, and Money (1936), the conception of capital that Keynes deploys in each book sees capital as either an undifferentiated aggregate in its role as one of the factors of production or as an asset for investment in the model of The General Theory. Neither of these views of capital is a theory of capital goods and their role in the specific production plans of entrepreneurs. The level of aggregation in both conceptions of capital precludes an understanding of how specific capital goods are valued and allocated in the production process. Speaking of “capital” in the aggregate obscures important microeconomic coordination processes through which allocative decisions are made. In particular, the level of aggregation in Keynes renders invisible the role of prices in guiding entrepreneurial decision making about what to produce and how to produce it. Keynes of the Treatise was working out of a Wicksellian tradition that

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focused on the relationship between investment and savings and its effects on the price level. In his original work on those issues, Wicksell (1965 [1898]) drew upon the theory of capital associated with Böhm-­Bawerk and the Austrians to look at the way in which investment and savings were or were not coordinated through the market. That theory envisioned production as taking place in stages, starting from the raw materials and working its way through to the finished product. A stages of production approach recognizes the role of time in production and sees the interest rate emerging from the price differentials between goods at different points in time. Capital, for the Austrians, refers to the specific goods in process that entrepreneurs make use of to execute their particular production plans. Kirzner (1966) calls capital goods the “unfinished plans” of entrepreneurs. The flour, yeast, water, and salt that are part of the plan for making bread are all capital goods, or “unfinished bread.” What is also important about the Austrian conception of capital is that specific capital goods are heterogeneous in use. That is, capital goods have a limited number of uses to which they can be put. They are neither completely homogeneous and able to be used to produce any output, nor are they useful for producing one output only. The challenge is in determining which of the multiple, but not infinite, uses of a capital good delivers the most value. At the same time, any given output can be produced with a variety of combinations of inputs. The challenge of production in a market economy is figuring out not just which goods people wish to consume, but which combinations of inputs to use to produce them, taking into consideration that any given capital good has multiple rival uses that must be accounted for. The other assumption underlying this vision of production is the scarcity of those capital goods. Production decisions always have opportunity costs, and producing any given output not only means not producing other outputs, it also means that capital goods must be bid away from their alternative uses. The price system sits at the center of the production process as entrepreneurs need to engage in monetary calculation to formulate budgets and determine profits and losses. For the Austrians, aggregative conceptions of capital misapprehend the central challenge of production in a market economy. Such a mistaken conception of capital is at the center of Keynesian economics.2 Keynes and Keynesian models suggest that changes in the volume of investment lead to changes in the volume of output and employment because of their effects on the aggregate capital of the community. The focus on aggregates prevents Keynes and Keynesian models from seeing the microeconomic adjustment processes that matter within the total volume of production, or the aggregate capital of the community, as market processes unfold. In particular, it prevents Keynesians from

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seeing production as a series of stages through time. For the Austrians, the changes in the price differential between goods of different stages of production determine the flow of resources in the production process. Hayek argues that Keynes’s “neglect” of the “possibility of fluctuation between these stages” leads to the errors of the Treatise precisely because Keynes is attempting to extend the Wicksellian model without the microeconomic foundations provided by the capital theory that Wicksell was using. It is this disagreement over the nature of capital that provides the context for Hayek’s (1995 [1931]: 128) famous observation in his review of the Treatise that, “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.” Large-­scale economy-­wide change can only be understood, Hayek is arguing, as the emergent outcome of the microeconomic process of capital usage through the stages of production. Further textual evidence for the aggregative view of capital found in Keynes comes from the brief discussions of capital in The General Theory. One place is a footnote that discusses Frank Knight’s view of capital, which was the subject of repeated criticisms by Hayek and other Austrians. Knight’s capital theory was a perfect example of treating capital as a homogeneous aggregate from which specific quantities could be applied to various production processes. In other words, it was the opposite of the Austrian view. The footnote in question is in Keynes’s (1936: 176) chapter on “The Classical Theory of Interest.” There Keynes cites an article of Knight’s from 1932 which Keynes argues shows the superiority of Knight’s conception of capital to that of Böhm-­Bawerk and the Austrians. In that chapter’s appendix, Keynes has an explicit discussion dismissing the Austrian theory of interest and its relationship to the intertemporal price structure. In his attempt to reconstruct the Austrian argument, Keynes suggests that Mises is “confusing the marginal efficiency of capital with the rate of interest” (1936: 193). As should be clear from the prior discussion, the idea that capital as a whole can be spoken of in terms of its marginal efficiency is a concept that itself runs against the Austrian theory. Capital is always about specific goods and the value they have in particular places in the production process. We can only speak of the productivity or value of specific capital goods, not capital as a whole.3 In another passage in The General Theory, Keynes has difficulty seeing the difference between a change in the value of capital and the destruction of physical capital goods. This passage is the only real discussion of the Austrian view of capital in the book. Keynes (1936: 76) says: It seems probable that capital formation and capital consumption, as used by the Austrian school of economists, are not identical either with investment and disinvestment as defined above or with net investment and disinvestment. In

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particular, capital consumption is said to occur in circumstances where there is quite clearly no net decrease in capital equipment as defined above. I have, however, been unable to discover a reference to any passage where the meaning of these terms is clearly explained. The statement, for example, that capital formation occurs when there is a lengthening of the period of production does not much advance matters.

Keynes does not understand how capital can be “consumed” without the destruction of physical capital. What he misses is that the Austrian conception of capital is focused on the value of specific goods rather than the physical manifestations of the goods themselves. For example, if an entrepreneur makes use of a specific input based on the expectation that the output it helps to make will have a particular value, he or she is also attributing a value to that input by being willing to pay a particular price for it. Should the output not be as valuable as expected, or should its value drop over time, the value of that input will fall as well, even though there might be little to no change in the physical properties of that input. A machine that produces an output that drops in value, and whose next best use is producing another output of similarly low value, will see its own value drop (and this is capital consumption) – even though the machine might be no less physically productive than it was when its value was higher. It is the value productivity not the physical productivity that matters for capital consumption. The “Concluding Notes” chapter of The General Theory encapsulates Keynes’s view of capital and its differences with the Austrians quite clearly, especially in the context of his call for more social control over the level of investment and the interest rate. There he argues for the use of monetary policy and state management to ensure “the growth of capital up to the point where it ceases to be scarce” (1936: 376). He supports that policy by arguing that there are no intrinsic reasons why capital has to be scarce and that, at least at the time he was writing, interest involved “no genuine ­sacrifice.” His argument for the socialization of investment was premised on the need for the state to determine what proportion of resources should be used to enhance capital and determine the rewards to the owners of those capital resources. This passage is particularly important for why this abstract discussion of capital matters for understanding the failure of Keynesian stimulus policies. Modern Keynesian models continue to keep the basic assumption of The General Theory that capital is best understood as an undifferentiated aggregate, particularly in simple multiplier models where an increase in net government spending will translate into a large change in total income or output. From an Austrian perspective, the problem in Keynes’s discussion is that he has no understanding of how the relative

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price mechanism, as it operates across the prices of goods in different stages in the process of production, and the corresponding profit and loss signals it generates might matter for the efficient allocation of capital. For Keynes, the problems of capital and investment are problems of the volume of each, not what happens to the specific capital goods or where the particular acts of investment are taking place. For the Austrians, the problem of capital usage and the appropriateness of investment is all about the process of monetary calculation outlined earlier. Real money prices are needed to determine which capital goods should be used to produce which outputs. As Mises (1920) argued in his original article on economic calculation under socialism, the only way to allocate resources rationally is through market prices, and having market prices requires real markets – and those require the exchange of privately owned property. Policymakers and planners who wish to allocate capital by fiat from the top down are inevitably going to fail because they do not recognize that “allocating capital” involves not just determining the overall volume of capital and investment, but also figuring out which specific goods the public wants and what specific capital goods are required to make them most efficiently. The latter task is the one to which Keynes and Keynesian models have not paid nearly enough attention. In his discussion of The General Theory in his 1941 book The Pure Theory of Capital, Hayek claimed that Keynes was effectively assuming the abundance of capital goods by ignoring the relative price mechanism and focusing on the aggregate level of capital and its relationship to a monetarily determined rate of interest. Expansionary monetary policy could drive the money rate of interest so low as to make capital appear abundant, but Hayek argued: It is clear that if we want to understand at all the mechanism which determines the relation between costs and prices, and therefore the rate of profit, it is to the relative scarcity of the various types of capital goods and of the other factors of production that we must direct our attention, for it is this scarcity which determines their prices. (2007 [1941]: 343)

In an equally important follow-­ up, Hayek also pointed out that the assumption of idle resources does not change the basic argument. If capital is heterogeneous in the way that the Austrians understand it, then it is clear that not every idle resource is a perfect substitute for another, which makes it impossible to assume away the scarcity of capital even where resources are idled. Hayek’s clear implication is that Keynes was seriously mistaken about the nature of capital and its importance in generating ­economic coordination.

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INTERTEMPORAL COORDINATION AND THE STRUCTURE OF PRODUCTION Another fundamental problem with the vision underlying most Keynesian models is that they misunderstand the nature of intertemporal coordination in the market, even at the aggregative level that such models operate. In more extreme versions, especially the argument in The General Theory itself, Keynesian models deny that markets can, in fact, produce this sort of intertemporal coordination. These theoretical issues also help us to understand one of the flaws behind the policy prescription that increased spending on consumer goods, either by consumers themselves or by government, can stimulate investment and recovery. The theoretical debate here is over the role of the interest rate and the relationship between consumption and investment. The Austrians use a classical loanable funds theory of the interest rate to understand intertemporal coordination. The interest rate is the price of time, emerging from the interaction of the supply of loanable funds from savers and the demand for loanable funds by investors. So, for example, if the public wishes to increase its savings (lower its rate of time preference), this would increase the supply of loanable funds and reduce the interest rate, which would increase the quantity of loanable funds demanded by borrowers and investors. The loanable funds market would react like any other market by restoring market clearing after a shift in supply or demand. That market process also showed that any reduction in consumption expenditures coming from households increasing their savings would be counteracted by the new investment spending that the savings made possible. In terms of Keynesian models, the Austrian view can be understood as arguing that the consumption and investment terms in total income are not additive but trade off against each other. The relevance is that a change in one, such as a drop in consumption when households save more, will be offset by a change in the other in the opposite direction (the increase in the quantity of investment coming from the lower interest rate) so as to maintain the total level of expenditures. Changes in time preference cannot lead, at least in the short run, to changes in total income. This process of intertemporal coordination can also be expressed in terms of the Austrian theory of capital. What lower time preferences and increased saving means is that households are more willing to wait for outputs to consume. The resulting lower interest rate makes it more profitable to invest in longer-­term processes of production that have more stages. Households signal their willingness to wait by saving more, which lowers the interest rate and leads entrepreneurs to lengthen their production processes in coordination with that heightened desire to wait. In the short

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run this prevents total income from falling due to the implied reduction in consumption; and over time it increases total income through the greater productivity of production processes with more stages. Keynes, in contrast, denied that there was such a nexus that coordinated savings and investment. In The General Theory (1936: 21), he wrote: Those who think [that an act of individual saving inevitably leads to a parallel act of investment] are deceived . . . They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for consumption; whereas the motives which determine the latter are not linked in any simple way with the motives that determine the former.

Later in the book he identifies these motives and explains why they are not linked. The simple Keynesian income–expenditure model today still views saving as a function of income via the marginal propensities to consume and save, while investment is driven by entrepreneurial expectations, or what Keynes called the “animal spirits.” The factors affecting saving and investment are completely distinct, in contrast to the Austrian loanable funds theory where the interest rate serves as the nexus that brings investment and saving together. Having broken the link between saving and investment, Keynes then constructs the basic income–expenditure model in which consumption and investment move in the same direction, preventing the loanable funds market from being the way in which total income (and the volume of employment) is maintained when households change their desire to save or firms change their willingness to invest. Keynes’s understanding of the relationship, or lack thereof, between consumption and investment helps us to understand a criticism raised by Hayek that has relevance for turning Keynesian theory into policy. Hayek argued that Keynes did not understand correctly the relationship between the demand for consumption goods and the demand for inputs.4 We know from microeconomics that if the demand for a specific consumption good increases, the demand for the specific capital goods needed to produce the consumption good will also increase. However, arguing that an aggregate increase in the demand for consumption goods can cause an aggregate increase in the demand for investment goods is to fall for the fallacy of composition. If households, for example, decide to save less and consume more, this will not, Hayek argued following Mill, increase the demand for all investment goods. From an Austrian perspective, the reduction in savings will actually decrease the demand for some capital goods, namely those associated with the earlier stages of production that will disappear as entrepreneurs shorten their production processes with reduction in saving and higher interest rate. The new configuration of savings and

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consumption requires that entrepreneurs reshuffle their production processes and patterns of capital goods use, and goods used in the early stages (and the labor complementary to them) will see their demand as well as their value fall. Hayek’s Austrian conception of capital as being embodied in specific goods with a limited number of alternative uses enables him to see why an increase in the demand for consumption goods as a whole does not necessarily imply an increase in the demand for investment goods as a whole. Keynes’s failure to understand this idea, along with the general level of aggregation of Keynesian models, leads to the typical Keynesian result that savings will lead to a reduction in employment and total income. As Keynes (1936: 210) also argues: “Since the expectation of consumption is the only raison d’être of employment, there should be nothing paradoxical in the conclusion that a diminished propensity to consume has, cet. par. a depressing effect on employment.” He might be correct about what happens in the consumer goods industries, but Keynes’s denial of the link between savings and investment prevents him from understanding how the reduction in consumption will increase investment and thereby lengthen the structure of production. With reduced consumption implying more saving, and therefore more capital devoted to the earlier stages of production, the demand for complementary labor there will increase, offsetting the “depressing effect” on employment in the stages of production closest to consumption. For example, a reduction in the propensity to consume might reduce the employment of retail clerks or restaurant workers, but create new demands for scientists, technicians, and office workers in laboratories and research institutions. The Austrian conception of capital seen as a staged structure of production allows us to disaggregate the “I” of investment into its component parts and see the adjustments within that aggregate that are facilitated by the changing interest rate. In the Keynesian vision, the market’s ability to achieve intertemporal coordination would be a matter of sheer luck in which savings and investment just happen to be equal at the level of full employment. In the absence of such luck, the basic Keynesian model relies on adjustments in income, and therefore employment, to ensure equilibrium between savings and investment. There is no counterpart in Keynesian models to the interest rate’s role in ensuring market-­driven intertemporal coordination as understood by the classicals and the Austrians. Without that interest rate mechanism, simple Keynesian models must rely on changes in income (and thus employment) to adjust savings to the exogenously determined quantity of investment. Where the classical and Austrian economists saw the interest rate as ensuring that ex ante savings and investment would be coordinated,

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Keynes requires changes in income and employment to turn a pervasive ex ante inequality of savings and investment into an ex post equality. It is not a stretch to see how this whole discussion might matter for policy. I will have more to say in the next section, but the problem is that the logic of the simple income–expenditure model is still implicit in so many Keynesian-­style policy recommendations for stimulus spending. One need only consider the argument that by increasing government spending to offset declines in consumption or investment, we will somehow get the multiplier effect through an increased demand for capital and labor needed to make the goods that governments will be buying, or providing the funds for households to buy. Once one understands the Austrian conception of capital, the simple income–expenditure model story becomes problematic. The IS–LM model suffers from similar underlying assumptions about the nature of capital, interest, and intertemporal coordination, particularly the IS curve. As it is presented in the standard textbook model, the IS curve shows combinations of levels of income and interest rates at which the goods market (investment and savings) are in equilibrium. The basis for constructing the curve is the equilibrium assumption that investment is equal to savings. If savings is a function of income (Y) and investment depends to some extent on the interest rate (r), a slight break from strict Keynesian animal spirits assumption of the more simple income–­ expenditure model, then the assumed equilibrium between investment and savings allows for the model’s relationship between Y and r. If the interest rate rises, investment will fall; and, given the assumption that I = S, savings must also fall. The lower level of savings is functionally related to a lower level of income, thus along the IS curve higher rates of interest are associated with lower levels of income and we get the downward sloping IS curve in the r, Y space of the IS–LM model. Movements along the IS curve are conditioned by the I = S equilibrium, as are movements in the whole curve. Suppose expectations improve, leading to an autonomous increase in investment. This will cause income to rise, via the multiplier process. The increase in income must generate precisely enough savings to finance the original increase in investment in order to maintain the assumed I = S equilibrium at the new higher level of income. Once again, the assumption of an investment–savings equilibrium drives the whole story. The assumption of an investment–savings equilibrium obscures the sort of microeconomic adjustments processes that we saw in the earlier discussion of Austrian capital theory. The key to the problem is the failure of Keynesian models to distinguish ex ante and ex post equilibria. It is definitionally true after the fact that whatever was invested must have been saved, just as it is definitionally true after an exchange that what was bought (“demanded”) was also sold (“supplied”). But economics is, or at least

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should be, about the plans of human actors, and should therefore focus on the ex ante question of whether the plans of investors and savers are coordinated at the current interest rate. By subtly transforming the truth of the ex post equilibrium of investment and savings into an assumption of ex ante equilibrium in the goods market equilibrium as a condition of the analysis, the IS curve does not allow for the possibility of discoordination, either at a point in time or intertemporally. As Gunnar Myrdal’s (1965 [1939]: 46) work established, the key issue from a market process perspective is: “How does [an ex ante] tendency to disparity in the saving-­ investment equation develop into an ex post balance?” The assumption of equilibrium obscures the market process by which 1) ex ante expectations might be coordinated or 2) ex ante expectations that are discoordinated play themselves out to an ex post equilibrium. The extra savings or investment needed to turn ex ante inequalities into ex post equalities must come from somewhere, and that process presumably has important macroeconomic consequences; yet there is nothing in the IS curve construction that permits examination of those questions. Monetary theories of the interest rate, found in both traditional Keynesian models and the neoclassical synthesis, invite a level of aggregation that obscures other fundamental market processes related to capital and investment. The problems with aggregating additions to the capital structure under the term “investment” noted earlier are compounded with a monetary theory of the interest rate. In both traditional Keynesian and IS–LM models, treating the interest rate as a (nearly) pure monetary phenomenon eliminates its role in coordinating the various stages of production. Although the ruling rate of interest plays a central role in the total volume of investment taking place, its more important role, as noted by the Austrians, is to ensure consistency among the various goods at the various stages in the production process. The uncertainty of the future, so eloquently emphasized by Keynes, requires some process by which producers can form expectations of consumer wants and the prospective value of their intermediate goods. In the Austrian approach, the microeconomics of the interest rate and capital structure, as driven by monetary calculation based on market prices, are that process. However, because Keynesian models separate the interest rate from both the aggregate supply and demand for capital and the structural composition of that capital, they have no mechanism for examining those coordinative processes and the ways in which mistaken monetary or fiscal policy might undermine them. In the various versions of the Keynesian model, the lack of attention paid to the microeconomic role of the interest rate causes a blind spot in the theory about how markets might ever ensure intertemporal coordination. That theoretical blind spot then leads to the inability to see how activist fiscal

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and monetary policy might either disrupt such coordination processes or prevent such processes from restoring order in a recovery from a recession.

JIGSAW PUZZLES AND STIMULUS SPENDING One way to capture the ways in which these theoretical differences matter for policy, and stimulus spending in particular, is through a metaphor.5 In the Austrian vision, the economy is something like a large jigsaw puzzle, with capital goods serving as the individual puzzle pieces and with no final picture to guide the various independent efforts to create a meaningful image. Without a final picture to guide people, they will need some way of knowing that they have fit the pieces together correctly. Like capital goods for the Austrians, the puzzle pieces come in a large variety of shapes, and each of those shapes is able to interlock with some finite number of other pieces to form a potentially meaningful pattern when joined in the right ways. If we further imagine that the jigsaw puzzle signals to us that we have joined pieces together correctly, by emitting a pleasurable beep when we do so and a very unpleasant one when we do not, we have a fairly good analogy to the Austrian conception of the market. Those beeps serve as the analog to profits and losses and help producers, each working their own area, to construct this puzzle without a picture to guide them. From this perspective, the capital structure and the process of monetary calculation that drives it comprise the fundamental coordinating processes of the market economy. Fitting those pieces together as correctly as possible in response to the knowledge and incentives produced by the pleasurable and unpleasurable beeps of profit and loss is what ensures ongoing economic coordination and growth. Imagine that we start constructing this jigsaw puzzle; but, rather than the beeps reflecting combinations that create meaningful patterns, suppose the beep mechanism is suffering from a computer virus that leads it to commit both Type I and Type II errors. We will end up with pieces that sort of interlock but produce no intelligible or meaningful image. Suppose further that we eventually use up all of the pieces and discover we have wasted our time because no meaningful picture has emerged. Faced with this outcome, what would people have to do to fix it? For one thing, they would have to spend some time pulling the puzzle apart, as what they have created produced no meaningful picture. Next they might want to fix the bug in the beeping mechanism. Once fixed, they would want to get back to the task of building a puzzle that did create a meaningful pattern. This extended metaphor serves as a proxy for the way in which the Austrians understand intertemporal discoordination and the business

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cycle. The distortions of the interest rate and other prices that arise from expansionary monetary policy are the equivalent of the computer virus, and the lack of a meaningful emergent pattern represents the way in which those price distortions lead to an unsustainable boom. Once people realize that no meaningful pattern is emerging, they will start to pull the pieces apart, which is the turning point from boom to bust. The ongoing process of pulling the pieces apart is the recession, or bust, while the attempts to put them back together in a meaningful way, ideally abetted by the virus having been eliminated, represent the recovery process. Now suppose they are in the process of dismantling the old puzzle. Suppose further that as they pull pieces apart, they have to wait for a beep to inform them that doing so was a good “pulling apart” decision. Once they know they have correctly dismantled it, they can try to “refit” those pieces into the puzzle. As they engage in this process, there will be a bunch of pieces that are sitting around waiting to be refit into the puzzle, ideally generating a true beep and helping create a meaningful picture when refit correctly. Of course if they have really fixed the beep mechanism, there will be an increasing number of these pieces “in waiting” in the short run as they do more dismantling than reconstructing. That number will eventually reverse as refitting outnumbers dismantling. So while the Austrian economists observing this process nod approvingly as the dismantling and reconstruction continues slowly but effectively onward as puzzle makers learn from the beeps, along comes their friend the Keynesian. The Keynesian bemoans the fact that there are so many puzzle pieces sitting “in waiting.” He says: Wouldn’t things be better if we just starting putting those pieces into the puzzle in any old way? Even if we don’t get a meaningful pattern, at least we would use up all the pieces. After all, isn’t using up all the pieces the way you know you have reached the goal of a finished puzzle?

The Austrians might respond by saying: No, the point isn’t to just use all the pieces. That is easy to do, but it is not the point of this kind of jigsaw puzzle. The challenge here is to produce a meaningful pattern without having a picture on the box, and which might not even require that all of the pieces be used, because the meaningfulness of that pattern derives from the way in which the organization of the pieces matches what puzzle demanders want in a picture even though they cannot articulate it ahead of time.

Granting the limits of metaphors, the underlying contrast of visions here seems to capture the essence of the debate over stimulus spending and why

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it consistently fails. The argument for stimulus spending by Keynesians amounts to saying we need to activate idle resources, especially labor, without worrying about whether the puzzle pieces actually fit together the right way to produce a meaningful pattern. The point is just to make sure they are being used and no longer remain idle. The quest for full employment, without asking whether what people are fully employed at doing, is a good example of this mentality. Not caring about whether the puzzle pieces fit reflects the debate over capital, with the lack of concern about fit implicitly seeing capital as a homogeneous substance that can be applied wherever needed, as is often assumed by Keynesian models. Whether the pieces fit matters if one ­understands capital the way the Austrians do as embodied in specific heterogeneous goods that have multiple but not infinite uses. The Austrians’ emphasis on the meaningfulness of the pattern is a reflection of their insistence that economic growth is ultimately about microeconomic coordination and whether the structure of production correctly aligns with household time preferences and whether the goods produced match consumer preferences. That perspective on economic growth suggests, echoing Hayek’s criticism of Keynes, that aggregates such as GDP or even unemployment are not the best way to measure economic progress. By recognizing that sustainable growth only comes when the puzzle pieces actually fit together and make a meaningful pattern, Austrians have a way to criticize the Keynesian insistence on the need for stimulus spending in order to make use of idle resources. The point of an economy is not to have every person and machine working, but to deliver what consumers want – that is, to make a meaningful pattern, or what Hayek termed “coordination.” Trying to jam all the pieces together, regardless of whether or not they truly fit, will not create sustainable growth because it does not create a meaningful pattern. Just using the pieces in any old way will necessitate another round of pulling apart and refitting later. You do not solve a jigsaw puzzle just by using the pieces any which way at all; you solve it by using the pieces in the right way to generate a meaningful pattern and picture.6 Getting such a pattern to emerge requires the decentralized coordination generated by the microeconomic discovery process, and that process is obscured when our focus is only on aggregates and getting resources into use regardless of the purpose to which they are put. Keynesian advocates of stimulus spending seem to treat the jigsaw puzzle of the economy as if the goal is to use as many pieces as possible, without much concern about whether they fit together properly or if the combinations make a meaningful pattern. For Austrian critics, the fit of the pieces and the pattern they create are what ultimately matter. From this Austrian perspective, much of the Keynesian analysis starts

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in the middle of the story, where the resources are already idled and thus appear to be “abundant.” If one does not have a good explanation for why resources are idled, one will be likely to make errors in how to correct those mistakes. In the Austrian theory, the artificially low interest rate has misdirected resources into the early stages of production (that is, malinvestment), creating specific capital goods and building specific human capital geared toward the particular outputs that those production processes generate. When these resources become idled, it is not that we just have homogeneous “stuff ” sitting around that can be activated into whatever use we wish. Instead, these capital resources (including human capital) have the characteristics of multiple specificity that is at the core of Austrian capital theory. They cannot be used to make just anything, and even the limited number of alternative uses they might have will likely involve some cost of refitting. Bringing idle resources into productivity, even during the depths of the bust, is not costless. When one understands the multiple specificity of capital goods, it would be only the most unusual of capital goods that could be called into activity without some increased cost to the owner, either in the form of a higher price or some investment in refitting. Once we are out of the world of apparent abundance, getting out of the bust is not as easy as Keynesian models make it seem by just spending more and bringing the idled factors of production costlessly into the process. The assumption in most stimulus spending arguments is that there are projects just waiting to be pursued if only we would spend the money.7 What is overlooked is whether the capital and labor that are idle are the resources best suited to those projects, not to mention whether consumers and citizens even want those outputs, especially given their true production costs. Just buying, hiring, and producing for the sake of “doing something” will create a structure of production that is quickly found to be unsustainable. A few projects may be “shovel ready,” but most will also require engineers and others to do the planning. If the unemployed are mostly construction workers and financial managers, these projects will not be able to find the engineers they need at wages they can afford, and unemployment will not be reduced. Politicians and bureaucrats lack the knowledge to know which pieces fit with which pieces as they cannot know the nature of the idled resources and what consumers want. They are unable to know what is needed to create a sustainable recovery. Politicians who are driven by short-­term political considerations, and are in any case unable to know how best to allocate stimulus resources, will inevitably distribute them to those persons and groups who will give them the most electoral support. The limits of politicians’ knowledge suggests that, no matter what is drawn on the

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blackboard, the inevitable politicization of stimulus spending is not an accident and cannot be avoided. Stimulus spending going to groups that provide the most votes – along with the inevitable ignorance of politicians, policymakers, and economists with respect to how best to allocate resources – will ensure that the right combinations of capital and labor will not be formed. This is precisely what we have seen in the way that stimulus spending has played out in the US and in Europe. Is there an alternative to the failed Keynesian stimulus model? The answer lies in the criticism: free up competition, prices, profits, and losses so that entrepreneurs and others can finish the process of tearing down the mistakes of the boom and figure out how to reallocate those resources to their new best uses. Let people break up the puzzle with no meaningful picture and follow the signals of the marketplace to find better uses for those pieces. That process takes time; but if politicians cease meddling in it and start allowing market processes to do their job, particularly by allowing failed firms to go bankrupt and sell off their assets for more valuable uses, recovery will take place more quickly. Keynesians might be concerned with just how much time this process will take. Markets have shown themselves, for example after the end of World War II, to be very capable of quickly absorbing labor when free to do so. Before the advent of Keynesianism, most recessions were short-­lived as producers were left free to shuffle the jigsaw pieces into better combinations. It is the very lack of trust in markets, and the misguided trust in the political process, that Keynesianism produced as a result of its theoretical errors with respect to capital that now leads us to think stimulus spending is necessary and effective. The approach of Hayek and the Austrians gives us good reasons to think otherwise. The evidence would seem to be in their favor.

NOTES 1. See Yandle (1983) on the bootleggers and Baptists phenomenon. 2. The discussion to follow draws heavily on Horwitz (2011). 3. The only exception to this is in equilibrium. If we know that all capital goods are being used in their highest valued uses, we can add up their current prices to determine the unambiguous value of the capital stock as a whole. 4. Hayek (2007 [1941]) discusses this in the context of what he calls “Mill’s Fourth Fundamental Proposition.” See also Kates (2015). 5. I owe the jigsaw puzzle metaphor to Don Boudreaux. I have extended his use of it here in ways he did not. 6. One of the limits of the jigsaw puzzle metaphor is that actual jigsaw puzzles do use up all of the pieces, but just in the right way. Economies, by contrast, will find it efficient to have some resources idled at any given time. See Hutt (1977 [1939]). 7. The remainder of this section draws heavily on Horwitz (2012).

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REFERENCES Hayek, F.A. 1995 [1931]. “Reflections on the Pure Theory of Money of Mr. J.M. Keynes,” in Bruce Caldwell (ed.), The Collected Works of F.A. Hayek, Vol. 9: Contra Keynes and Cambridge – Essays, Correspondence, Chicago: University of Chicago Press. Hayek, F.A. 2007 [1941]. The Pure Theory of Capital, Chicago: University of Chicago Press. Horwitz, Steven. 2011. “Contrasting Concepts of Capital: Yet Another Look at the Hayek–Keynes Debate,” Journal of Private Enterprise, 27: 9–27. Horwitz, Steven. 2012. “The Work of Friedrich Hayek Shows Why EU Governments Cannot Spend Their Way Out of the Eurozone Crisis,” European Politics and Policy blog, London School of Economics, available at: http://blogs. lse.ac.uk/europpblog/2012/08/21/hayek-­eurozone-­crisis/. Hutt, William H. 1977 [1939]. The Theory of Idle Resources, Indianapolis, IN: Liberty Press. Kates, Steven. 2015. “Mill’s Fourth Fundamental Proposition on Capital: A Paradox Explained,” Journal of the History of Economic Thought, 37: 39–56. Keynes, J.M. 1930. A Treatise on Money, Volumes 1 and 2, London: Macmillan and Company. Keynes, J.M. 1936. The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace and Company. Kirzner, Israel M. 1966. An Essay on Capital, New York: Augustus M. Kelley. Mises, Ludwig von. 1920. “Economic Calculation in the Socialist Commonwealth,” in F.A. Hayek (ed.), Collectivist Economic Planning, Clifton, NJ: Augustus M. Kelley, 1935. Myrdal, Gunnar. 1965 [1939]. Monetary Equilibrium, New York: Augustus M. Kelley. Wicksell, Knut. 1965 [1898]. Interest and Prices, New York: Augustus M. Kelley. Yandle, Bruce. 1983. “Bootleggers and Baptists: The Education of a Regulatory Economist,” Regulation, 7 (3): 12.

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7. The dangers of Keynesian economics Steven Kates My own contribution to this collection is to reprint the articles that I published to warn on the dangers of a return to a Keynesian stimulus. The first was published in March 2009 in the Australian magazine Quadrant just as those first stimulus packages after the Global Financial Crisis were being introduced. The second was published five years later, again in Quadrant, to demonstrate how accurate the first article had been.1 The following is the point that I had been trying to make, which is taken from that first article: Just as the causes of this downturn cannot be charted through a Keynesian demand deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist. What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.

Following publication of the first of these articles, I was asked to provide testimony to the Australian Senate Economics References Committee. The following exchange of views was reported in the Sydney Morning Herald following my Senate appearance. Labor senator Doug Cameron said Prof Kates’s comments had certainly embedded in his mind that you should never let an “academic economist run the economy”. “Why have the IMF, the OECD, the ILO, the treasuries of every advanced economy, the Treasury in Australia, the business economists around the world, why have they got it so wrong and yet you in your ivory tower at RMIT have got it so right?”

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to recovery and a return to full employment. My answer to Senator Cameron was that the stimulus would not succeed being as it was based on Keynesian theory. The fallacies of modern macroeconomics are discussed in both of the articles reprinted below.

THE DANGEROUS RETURN TO KEYNESIAN ECONOMICS, QUADRANT, MARCH 2009 The Great Depression, in most places, began with the share market crash in 1929 and by the end of 1933 was already receding into history. In 1936, well after the Great Depression had reached its lowest point and recovery had begun, a book was published that remains to this day the most influential economics treatise written during the whole of the twentieth century. The book was The General Theory of Employment, Interest and Money. The author was John Maynard Keynes. And his book overturned a tradition in economic thought that had already by then stretched back for more than a hundred years. The importance of these dates is important. The economics which Keynes’s writings had overturned is today called “classical theory”,2 yet it was the application of this self-­same classical theory that had brought the Great Depression to its end everywhere but in the United States, where something else was tried instead. And at the centre of classical thought was a proposition that Keynes made it his ambition to see disappear absolutely from economics. It was an ambition in which he was wildly successful. Following a lead set by Keynes, this proposition is now almost invariably referred to as Say’s Law.3 It is a proposition that since 1936 every economist has been explicitly taught to reject as the most certain obstacle to clear thinking and sound policy. Economists have thus been taught to ignore the one principle most necessary for understanding the causes of recessions and their cures. Worse still, they have been taught to apply the very measures to remedy downturns that are most likely, from the classical perspective, to push them into an even steeper downward spiral.4 Keynes wrote, and economists have since then almost universally accepted, that Say’s Law meant full employment was guaranteed by the operation of the market. To accept this principle therefore meant that the models then used by economists could not be used to analyse recessions and unemployment because within these models was buried the tacit assumption of full employment. After 150 years of capitalist development, with the business cycle having

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been the most unmistakably visible aspect of the operation of economies everywhere, Keynes in 1936 could still write that economists in accepting Say’s Law had accepted “the proposition that there was no obstacle to full employment” (Keynes 1936: 26). Keynes wrote that Say’s Law meant that “supply creates its own demand”.5 In his interpretation of this supposedly classical proposition, everything produced would automatically find a buyer. Aggregate demand would always equal aggregate supply. Recessions would therefore never occur and full employment was always a certainty. That economists have accepted as fact the proposition that the entire mainstream of the profession prior to 1936 had believed recessions could never occur when in fact they regularly did shows the power of authority in allowing people to believe three impossible things before breakfast. But what was important were the policy implications of Keynes’s message. These may be reduced to two. First, the problem of recessions is due to a deficiency of aggregate demand. The symptoms of recession were its actual cause. And then, second, an economy in recession cannot be expected to recover on its own, and certainly not within a reasonable time, without the assistance of high levels of public spending and the liberal use of deficit finance. The missing ingredient in classical economic theory, Keynes wrote, had been the absence of any discussion of aggregate demand. It was this missing ingredient that Keynes made it his mission to put in place. Aggregate Demand And how successful he was. Aggregate demand has since 1936 played the central role in the theory of recession. Recessions are attributed to an absence of demand, and even where they are not, overcoming recessions is seen as dependent on the restoration of demand which is the active responsibility of governments. Until 1936, no mainstream theory of recession had so much as glanced at the notion of demand deficiency as a cause of recession. It was specifically to deny the relevance of demand deficiency as a cause of recession that Say’s Law had been formulated in the first place. Accepting the possibility of demand deficiency as a cause of recession was then seen as the realm of cranks. How the world does change. This, it cannot be emphasized enough, did not mean that the possibility of recessions was denied. There were, and are, no end of potential causes of recession that have nothing to do with demand failure. Indeed, no one explains the present economic downturn, the global meltdown we are in the midst of, in terms of deficient aggregate demand.

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It would be an absurdity to suggest the problems now being experienced have been caused by consumers no longer wishing to buy more than they have or savings going to waste because investors have run out of new forms of capital into which to invest their funds. The Classical Theory of Recession Classical theory had taught that whatever might cause a recession to occur, it would never be a deficiency of aggregate demand. Production could never exceed the willingness to buy, and therefore treating the symptoms of a recession by trying to raise demand through increased public spending was in policy terms utterly mistaken. Governments could create value but their income was derived from taxation. Taking money from those who were productively employed and directing production towards a government’s own purposes remained acceptable so long as the level of such spending was limited and, most importantly, the government’s budget remained in surplus. These were the self-­ imposed restraints that Keynesian theory overturned. Public spending in combination with budget deficits, he argued, would propel an economy out of recession. It is this belief that is now accepted by a very large proportion of the economics community. Yet for all that, no recession has been brought to an end through increased levels of public spending, but many recessions have been ended by a return to sound finance and fiscal discipline. The Great Depression The history of public policy during recessionary periods has a number of lessons to teach, assuming we are capable of learning from them. In Britain, economic policy during the Great Depression saw the application of a full-­scale classical approach. A policy of balancing the budget and the containment of expenditure was adopted. By 1933, the budget had been balanced and it was from 1933 onwards that Britain emerged from the downturn of the previous four years. It is worth noting that it was balancing the budget that was seen to have made the all-­important difference. In rejecting deficit financing during his budget speech of 1933, the British Chancellor of the Exchequer, Neville Chamberlain, made this explicit statement: At any rate we are free from that fear which besets so many less fortunately placed, the fear that things are going to get worse. We owe our freedom from that fear largely to the fact that we have balanced our budget.

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The same story could be told about Australia, where the Scullin Labor government made the decision in adopting the “Premiers’ Plan” which sought a cut in public spending, a return to budget surplus and cuts to wages. In the light of later Keynesian theory, nothing would have been seen as less likely to have achieved a return to prosperity, but a return to prosperity was most assuredly the result. All this is perfectly captured by Edna Carew (The Language of Money, 1996): A strategy was adopted in June 1931 by Australia’s Scullin government to reduce interest rates and cut expenditure by 20 per cent, partly through slashing public-­sector wages. The objective was to reduce Australia’s huge budget deficit problems. Australia had to get its books in order if the country was to continue to get overseas finance. Devaluation had already been forced and increased tariffs tried. The rationale behind the Premiers’ Plan was to revive business confidence. The plan was welcomed as an example of creative economic planning; Douglas Copland claimed it was “a judicious mixture of inflation and ­deflation”. Later it was criticised as overly deflationary.

Certainly it was “later” criticized as overly deflationary after the depression had passed and Keynesian economics had become the vogue, but at the time, while the Great Depression was an actual fact of life, rather than it having been criticized, this was the consensus view of the economics profession of Australia. And it worked. Australia was amongst the first countries to recover from the Great Depression. The trough was reached in 1932 and from then on there was continuous improvement year by year. Contrast the English and Australian experience with the United States. Roosevelt’s New Deal applied a “Keynesian” prescription before Keynes had so much as published a word. From 1933 onwards, public works, increased public spending and deficit financing were the essence of economic policy. And with what results? The data in the table below show the unemployment rates in the United States, the UK and Australia between 1929, the last pre-­depression year, through to 1938, the last year before England and Australia went into the war. None of these figures should be taken as anything more than indicative since there were no official unemployment statistics at the time. All are reconstructions based on incomplete data. But what these figures do provide is an accurate reflection of the reality experienced on the ground at the time. Although major pockets of unemployment remained, Australia and England had by the mid-­1930s left the depression behind while the United States did not do so until the war finally brought recessionary ­conditions to an end.

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Table 7.1  Unemployment rates, 1929–38 Year

US (%)

UK (%)

Australia (%)

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938

3.2 8.7 15.9 23.6 24.9 21.7 20.1 16.9 14.3 19.0

10.4 16.1 21.3 22.1 19.9 16.7 15.5 13.1 10.8 12.9

8.0 12.7 20.1 23.0 21.0 17.9 15.5 12.6 10.9 8.9

Sources:  Australian data: Pope and Withers (1993); United States data: US Bureau of Labor Statistics; UK data: Garside (1990).

The Postwar Recovery By the time the war came to an end, much of the economics profession had been converted to Keynesian theory. Although there was no evidence that the theory would actually work in a peacetime economy,6 a high proportion of economists advocated a continuation of the deficits and high levels of public spending that had prevailed during the war. The major debate took place in the United States. Only four years before, it was pointed out, the American economy had been in deep recession. Millions of its men and women, who had served overseas or in war-­related industries, were returning to the civilian economy in which the resumption of recession seemed a genuine possibility. Yet Harry S. Truman resisted the pressure to provide a fiscal stimulus to the American economy. In his State of the Union address in January 1946, the American President made his policy direction clear: It is good to move toward a balanced budget and a start on the retirement of the debt at a time when demand for goods is strong and the business outlook is good. These conditions prevail today.

Truman, in refusing to apply a Keynesian stimulus, touched off the most  sustained period of economic growth in American and world history.

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Stagflation It has been argued that the slow development of the welfare state in the postwar period was the actual meaning of Keynesian policy. The “fine tuning” of the economy, as it was called, had in the eyes of some demonstrated the value of Keynesian policies. Whatever such fine tuning did or did not involve, at no stage in the twenty-­five years after the war did Keynesian theory actually have to confront an economy in deep recession. The first serious attempt to use Keynesian theory to deal with a major downturn did not occur until the late 1960s and early 1970s. Some have argued that President Kennedy had applied a Keynesian approach to end the mild recession of the early 1960s, but he had used tax cuts to stimulate growth. As with the Reagan tax cuts two decades later, this too was not a Keynesian approach. Keynesian economics is about increased levels of public spending. Tax cuts are entirely classical in nature. They leave funds in the hands of those who have earned the income in the first place. Public spending diverts expenditure into directions of the government’s own choosing. The first is market oriented, the second is not. The first would be expected to succeed under classical principles, the second would not. The 1970s are in many ways a special case. It was a period which combined rapid growth in wages with huge increases in the cost of oil. But it also included an attempt to manufacture growth through a deficit-­financed stimulus package on top of the expenditure related to the Vietnam War. The result was what has gone down in history as the “stagflation” of the 1970s. It was a period that pulled economies into a downward spiral, combining high inflation with low growth, the very outcome any classical economist would have foretold. It took well over a decade to return the world’s economies to high and sustained rates of non-­inflationary growth. The Japanese Recovery Program The most recent large-­scale example of an attempt to use a Keynesian deficit-­ financed spending program to restore growth to a depressed economy occurred in Japan during the 1990s. The end of the 1980s had seen brief recessions across the world from which most economies rapidly recovered. Only Japan attempted to hasten recovery with a series of very large spending packages. Far from achieving recovery, this expenditure drove the Japanese economy into such deep recession that even today its economy, at one time the envy of the world, remains subdued. Yet, oddly, because economic theory continues to insist that the spending could only have been

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a positive, the example of the Japanese disaster is a lesson no one has been prepared to absorb. Listen, however, to the following advice offered to the Japanese during the 1990s. It is the same advice offered to governments today, with the difference being that we at least now know the outcome in Japan. Stanley Fischer, who in 1998 was the First Deputy Managing Director of the IMF, was very clear on the need for the massive increases in spending. Addressing a symposium in Tokyo in April that year, he said: Japan’s economic performance is of course a matter of grave domestic concern. But given the prominent role of Japan in the world economy, and especially in Asia, it is also a legitimate matter for concern by Japan’s neighbors and by the international community. There is little disagreement about what needs to be done. There is an immediate need for a substantial fiscal expansion . . . On fiscal policy, the recent suggestion of a package of 16 trillion yen, about 3  per cent of GDP, would be a good starting point. But, unlike on previous occasions, the program that is implemented should be close to the starting point. The well-­known reservations about increases in wasteful public spending are correct: that is why much of the package, at least half, should take the form of tax cuts. Anyone who doubts the effectiveness of tax measures need only consider the effectiveness of last year’s tax increases in curbing demand. The IMF is not famous for supporting fiscal expansions. And it is true that Japan faces a long-­term demographic problem that has major fiscal implications. But after so many years of near-­stagnation, fiscal policy must help get the economy moving again. There will be time to deal with the longer-­term fiscal problem later.

Another example of the same kind of advice is found in a February 28, 1998 editorial in the Economist under the heading, “Japan’s feeble economy needs a boost”: The [Japanese] government says it cannot afford a big stimulus because its finances are perilous. It is true that Japan’s gross public debt has risen to 87% of GDP, but net debt amounts to only 18% of GDP, the smallest among the G7 economies. The general-­government budget deficit, 2½% of GDP, is smaller than its European counterparts. Rightly, the Japanese are worried about the future pension liabilities implied by their rapidly ageing population. But now is not the time to sort the problem out. Far better to cut the budget later, when the economy has recovered its strength.

Both took the view that Japan should immediately increase its spending and only afterwards clean up whatever problems were created. In Fischer’s view, “there will be time to deal with the longer-­term fiscal problem later”. The Economist wrote that “now is not the time to sort the problem out. Far better to cut the budget later, when the economy has recovered its

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strength.” These are conclusions that come directly from a Keynesian model that concerns itself with deficient demand as the cause of recession and looks to increased spending as its cure. The Economist even added that “just now, in fact, Japan is a textbook case of a country in need of fiscal stimulus”. Whatever may have been the case then, it ought to be the textbook case now for why all such forms of economic stimulus should be avoided at all costs. Because, say what you will about the causes of the Japanese downturn and the failure to recover, all major economies experienced the same deep recession at the start of the 1990s, but only the Japanese economy has never fully recovered its previous strength. The Level of Demand versus the Structure of Demand Recessions occur because goods and services are produced that cannot be sold for prices that cover their costs. There are reams of possible reasons why and how such mistaken production decisions occur. But when all is said and done, the causes of recession are structural. They are the consequence of structural imbalances that result from errors in production decisions, not the fall in output and demand that necessarily follows. This cannot be emphasized enough. Modern macroeconomics is built around the notion of the level of demand, while prior to Keynes recessions were understood in terms of the structure of demand. The difference could not be more profound. To policy-­makers today, the basic issue in ­analysing recessions is whether there is enough demand in total. To economists prior to Keynes, the central issue was to explain why markets had become unbalanced. In modern economic theory, rising and falling levels of spending are for all practical purposes what matters. That is why increasing public spending and adding to deficits are seen as an intrinsic part of the solution, not as the additional problem that such spending actually is. Missing in modern economic debates is an understanding of the importance of structure, that the parts of the economy must fit together. What’s missing is an understanding that if the entire economic apparatus goes out of alignment, recession is the result and recession will persist until all of the parts once again begin to mesh. Think of what has caused this downturn in the first place. None of it is related to demand having suddenly evaporated for no good reason. All of the most visible causes can be brought back to distortions in decision making that led to the production of goods and services whose full costs of production cannot now be met. Look at the list: ●●

the meltdown in the housing sector in the United States after financial institutions were encouraged to lend to borrowers who would

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not in normal circumstances even remotely be considered financially sound the bundling of mortgages into financial derivatives whose value crashed with the crash in the value of housing and which has left the banking industry in a shambles the massive American budget deficits that were allowed to continue for years on end largely because the Chinese chose to recycle the dollars received in the American money market without either allowing the value of the yuan to rise, as it most assuredly ought to have done, or using the funds received to purchase American goods and services the phenomenal rise and subsequent fall in the price of oil which radically changed production costs in one industry after another the instability still being created across the world’s economies over the actions that might or might not be taken to limit carbon emissions and reduce the level of greenhouse gases the arbitrary and erratic use of monetary policy to target inflation, the results of which have been to raise interest rate settings at one moment and lower them at another depending on assessments made by central banks the plunge in share market prices across the world, with savage effects on the value of personal savings.

There have been few periods in which so many forms of financial and economic uncertainty would have confronted the average business at one and the same moment. That business confidence has evaporated and an economic downturn has gained momentum is a matter of no surprise to anyone. The fact of recession is a certainty; only the depth to which it will descend remains in question. But just as the causes of this downturn cannot be charted through a Keynesian demand-­deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand, and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist. What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. Keynes’s Final Thoughts In an article (“The Balance of Payments of the United States”) published posthumously in the Economic Journal in 1946, Keynes wrote on one last

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occasion about the classical economics he had done so much to undermine. The Keynesian revolution had ripped through the economics world and had by then displaced almost all previous thought on the nature and origins of the business cycle. In looking out on the monster he had created, Keynes wrote in some dismay about the importance and value of classical economics and its modes of thought. The specific issue he was addressing was international trade. The actual underlying issue was the need for free markets and decentralized decision making. Here is what Keynes wrote: I find myself moved, not for the first time, to remind contemporary economists that the classical teaching embodied some permanent truths of great significance, which we are liable to-­day to overlook because we associate them with other doctrines which we cannot now accept without much qualification. There are in these matters deep undercurrents at work, natural forces, one can call them, or even the invisible hand, which are operating towards equilibrium. If it were not so, we could not have got on even so well as we have for many decades past.

In looking at the anti-­market policies then finding their way into public discussion, he noted just how damaging they would be in practice. He had been advocating free market solutions, the “classical medicine” of his description, but which others were reluctant to apply. Keynes wrote: We have here sincere and thoroughgoing proposals, advanced on behalf of the United States, expressly directed towards creating a system which allows the classical medicine to do its work. It shows how much modernist stuff, gone wrong and turned sour and silly, is circulating in our system, also incongruously mixed, it seems, with age-­old poisons . . . I must not be misunderstood. I do not suppose that the classical medicine will work by itself or that we can depend on it. We need quicker and less painful aids . . . But in the long run these expedients will work better and we shall need them less, if the classical medicine is also at work. And if we reject the medicine from our systems altogether, we may just drift on from expedient to expedient and never get really fit again.

It is this “modernist stuff, gone wrong and turned sour and silly”, these “age-­old poisons” that are the economics of the present day. We are on the precipice of adopting economic policies that will drag us into a deep and ongoing recession and which will diminish our economic prospects possibly for years to come. We may, just as Keynes said, drift on from expedient to expedient and never get really fit again. These are issues of immense importance. To get them wrong may well leave our market economies in the wilderness for a generation. The question before us really is whether markets should be allowed to find their way

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with only minimal government direction, or whether the economic system should be directed from above by elected governments and the public service. This is not a mere matter of regulation but of actual direction and expenditure. No one disputes the importance of regulating the operation of markets. There is also a minor role that increased public sector spending might play in allowing some additional infrastructure projects to go forward while economic conditions are slack. But to believe it is possible for governments to spend our way to prosperity would be a major error in policy. There is no previous occasion in which such spending has been shown to work, while there are plenty of instances in which it has not. On every occasion that such spending has been used, the result has been a worsening of economic conditions, not an improvement. The only lasting solution also consistent with restoring prosperity, growth and full employment is to rely on markets. The repeated attack on the market economy, and the role of the private sector, is a mindset begging for trouble. Certainly there are actions that governments can take to relieve some of the problems of recession, but they are limited. Sure, this is a better time than most to build infrastructure. Absolutely, there need to be measures taken to assist the unemployed. Yes, the central bank should be lowering interest rates and ensuring the viability of the banking sector. All such steps are mandatory and largely non-­controversial. But what must be explicitly understood is that recovery means recovery of the private sector. It is business and business investment that must once again take up the load of moving our economy forward. It is the banking system that must be allowed to allocate funds. To expect and depend on anything else will take this economy down deflationary pathways that will require years to reverse. The Keynesian model makes the engine of growth appear to be expenditure, irrespective of what that spending is on. And the most important element in the recovery process, according to these same models, is an increase in the government’s own level of expenditure, and again it appears to matter not much at all on what that money is actually spent. Here is a passage from page 129 of the General Theory that will give you some idea of what’s in store. If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-­tried principles of laissez-­ faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-­bearing territory), there need be no more

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The dangers of Keynesian economics ­135 unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. 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.

This is the earlier Keynes, the Keynes of the General Theory, the one who created and established the mindset in which policy is now devised. Productive government spending is rare and difficult to achieve. Wasteful profligate spending is easy and common as clay. There are now no end of projects coming forward, with hardly a one having been tested with any kind of rigour to ensure funds are not being drained away into unproductive fiscal swamps. The standard macroeconomic model, the model that the proposed fiscal expansion will be based upon, is a model that will endanger our future economic prospects for years on end. If the Argentine economy is your idea of utopia, this is the way to bring it about faster and with more certainty than anything else that might conceivably be tried.

KEYNESIAN ECONOMICS’ DANGEROUS RETURN – FIVE YEARS ON, QUADRANT, MARCH 2014 The Global Financial Crisis enveloped the world’s economies at the end of 2008 and the start of 2009 but is now long gone. There is no financial crisis anywhere, although you would not be game to say that another might not be far ahead. But the GFC itself did not last half a year. It left in its wake a subdued world economy and higher unemployment, but the financial crisis was over. The efforts made by central banks to stabilize the financial system had done their job, and while not everything they did might have been done had they had a second chance, these kinds of unique economic events happen at great speed and policy mistakes are inevitable. And then, from the start of 2009, stimulus packages were introduced one by one almost everywhere. The textbook approach to dealing with a deeply subdued economy is for governments to spend money, lots of money, as quickly as possible. According to the theory, economies are pulled along by demand. Since what was clearly missing, according to economists and policy-­makers who had been brought up on this theory, was a sufficiently high level of demand, large increases in public spending were seen as the only answer that would get us out of recession and into recovery more rapidly than any other possible approach. In the United States, the stimulus package was measured at around

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$787 billion but in actuality went much higher. In Australia the figure as a percentage of GDP was similar, and in dollar terms came in at around $43 billion. With only a handful of exceptions, a spending binge was put in place in every country of significance. And while even now, though there is talk of “austerity” – as in, “We are cutting spending” – so far the only thing that has been cut is the upwards trend in the rate of growth of expenditure. Public spending is higher by entire percentage points of GDP than it was when the GFC began. Yet far from the world’s economies having returned to reasonable rates of growth, conditions have remained in the doldrums without much sign of an upwards momentum. Nowhere has there been a return to low rates of unemployment or, more to the point, to faster rates of employment growth. Real incomes are falling and confidence in the future is low and continuing to ebb. No one would say that our economic problems are over. The future looks more uncertain than ever. While the upheavals of the GFC are behind us, there is little confidence that better times are before us. Keynesian Economics The problem is Keynesian economics, the bedrock element of modern macroeconomic theory. Hardly anyone else sees this as the problem, which from my perspective is of itself a large part of the problem. It is called “Keynesian” because our modern approach to macroeconomic analysis was introduced by the English economist John Maynard Keynes. During the GFC and the early days of the stimulus, it was Keynes: Return of the Master (an actual book title) and other comments of a similar kind one would hear all too often. Such talk has now disappeared and with good reason. Keynesian economics is built on the notion that what causes economies to grow and businesses to employ are increases in aggregate demand. The more demand there is in total, the faster an economy will grow, and therefore the more people will be employed. Keynes’s theories were an outcrop of the Great Depression, whose dates are traditionally given as 1929 to 1933. Keynes’s response, his General Theory of Employment, Interest and Money, the centrepiece of macroeconomic theory ever since, was published in 1936. Whatever did or didn’t bring the Great Depression to an end, it was not the economics of Keynes. The one and only place where you could say a “Keynesian” response was applied was in the United States under Roosevelt. There the depression did not end until the USA entered the war in 1941. So far as understanding the theory goes, it takes about five minutes to turn anyone into a Keynesian. Keynesian economics is extremely easy to

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follow, combining a superficial understanding of how economies work with a truism that has been made to act as a theory. It is so simple and so beguiling that almost no one in politics can resist it and before they know it they find themselves in the quicksands of a sinking economy that will not behave in the way the theory says it should. Here, then, is the base Keynesian formula, leaving out international trade, which matters not at all in understanding the point: Total output is the sum of everything spent by consumers on consumption goods, plus everything spent by businesses when investing in capital goods, plus everything spent by governments in buying whatever it is that governments buy.

The standard formula, using “Y” to represent total output, or GDP if you like, is this, taught to economists worldwide with virtually no exception:

Y=C+I+G

“C” represents spending on consumer goods, “I” represents spending on capital investment, and “G” represents government spending on goods and services. Add them up and, and since everything bought must have been produced, total spending must be equal to total output. If you accept this truism as economics, the policy response to recession is immediately obvious. With the coming of recession, there is a fall in consumption spending and a much larger percentage fall in investment. Therefore, as a matter of arithmetic, the level of output must also fall. Therefore, again as a matter of arithmetic, the answer to the fall in demand is an increase in demand, which in this case comes as a massive government stimulus. The fall in C and I is replaced with a compensating increase in G. Output is then restored, employment is maintained and the economy returns to the robust level of activity that had existed before the recession had set in. With that theory in hand, you too could be Prime Minister or Secretary of the Treasury. While there are more sophisticated and complex ways of explaining Keynesian economic theory, for all practical purposes that is all you need to understand about what has driven our economies into the ground. The Role of Government But if you are to understand the criticisms that follow in the rest of this article, it is also important to understand that none of it is based on a view that governments should do nothing when economies enter difficult times.

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During the GFC, I strongly supported the actions of central banks to stabilize, as best they could, the troubled economies they were managing. I also think these same central banks had brought on many of the problems we were facing. But when the world’s credit system collapsed as it did at the end of 2008, there was, to my mind, little else that governments and their central banks could do but take deliberate action to restore stability. I have, over the years since the GFC, pondered my judgment and still continue to believe that the actions by central banks in the USA, Europe, the UK and elsewhere were necessary and beneficial. This is still an open question, but after five years looking at the alternatives, I can only think things would have been much worse had central banks not intervened. So in arguing, as I do here, against the stimulus, I am not arguing against the principle of government action to deal with economic problems. There is no principle I can think of that would lead one to the conclusion that economies are best left alone by governments to run themselves. What matters for me is whether some policy will actually provide a net benefit when all things, both short-­term and long-­term, are taken into account. The actions by central banks to stabilize a financial crisis were appropriate. The subsequent actions to stimulate our economies after the crisis was past were a mistake we will be paying for over many years to come. Two Expectations From the start of the stimulus I had two expectations. One has been more than confirmed over the past five years; the other has not. The one that has been confirmed was that the economic consequences of the stimulus would be dismal. There was something very specific about my own criticisms, which you will find hardly anywhere else. The criticisms were not based on some blanket principle that governments should not intervene in economic affairs. They were not based on the fact that these expenditures would lead to an increase in the deficit and the level of debt. My criticisms were based on the argument that such public spending could not possibly work to bring a recovery about, and that, in fact, they would only cause economic conditions to deteriorate. Here is an extract from a report in the Sydney Morning Herald following my testimony to the Senate Economic References Committee on September 21, 2009: The Senate is hearing from a number of academics . . . to examine the impact of the government’s series of stimulus measures since October 2008 and whether economic circumstances warrant changes to the initiatives.

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The dangers of Keynesian economics ­139 Professor Steven Kates from the Royal Melbourne Institute of Technology (RMIT) backed the government’s measures to support the banking system, but said interest rates should have been lowered further and taxation lowered. “But one thing you shouldn’t do, you should not have this blanket expenditure as a stimulus – four per cent of GDP (gross domestic product) is an unbelievable amount of money,” Prof. Kates told the Senate Economics References Committee. “That will not create growth and, in fact, wastes resources so comprehensively. They are destroying our savings, they are going to push up interest rates, they are going to push taxation in the future, and may push up our inflation rate.” He calculated that unemployment would have been 6.1 per cent now rather than 5.8 per cent, calculating that the government has spent $1.5 million saving each job.

There it is, on the record. I had “backed the government’s measures to support the banking system” but did not support the stimulus. As I noted then, and will return to momentarily, the stimulus had destroyed our savings and, even in doing so, would not create growth and jobs. But it was the response of Senator Cameron, also published by the SMH, which I will also come back to, since this gets to the very core of the questions at hand: Labor senator Doug Cameron said Prof Kates’ comments had certainly embedded in his mind that you should never let an “academic economist run the economy”. “Why have the IMF, the OECD, the ILO, the treasuries of every advanced economy, the Treasury in Australia, the business economists around the world, why have they got it so wrong and yet you in your ivory tower at RMIT have got it so right?”

The very question I ask myself. The Expectation Not Fulfilled My second expectation, the one that has not been fulfilled, was that with the certain failure of Keynesian economics there would be a major reassessment across the profession over the theoretical accuracy of the macroeconomics that has been dominant since the 1930s. It is one thing to have a hypothesis that is never tested against reality. It is quite another to find when you use a theory and, based on that theory, forecast an outcome that does not occur, that you just get on with things and not have an in-­depth review to see where, perhaps, that theory might have gone wrong. No one can at this stage argue that the stimulus was a success. The increases in public expenditure have not brought recovery. Every economy

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in which the stimulus was applied with any kind of force is now in the midst of having to deal with subdued economic conditions that show no sign of ending. Economic growth has not returned to levels found before the GFC. There is not an economy anywhere whose long-­term prospects can be said to have been improved as a result of the Keynesian policies that were applied. What I had therefore expected was a reaction of some kind amongst the economics community. It had seemed obvious that economists would ask themselves what had gone wrong and why the policies that had been built on their theories didn’t work out. Because whether or not economists have such thoughts, there is no doubt policy-­makers do. From Greece on up, governments of countries mired in their post-­GFC torpor have abandoned any thought of stimulus and, in spite of high unemployment and low rates of growth, have embarked in a new direction, which Keynesians have named “austerity” – austerity, as in wartime, where the resources of the nation are diverted away from domestic consumption goods. That’s the name given by Keynesians to policies designed to save their economies from the obvious dangers of deficits and the rising levels of debt. Cutting spending levels and the deficit are the policies of choice today. Where, however, are the economic theories that explain, not just why these policies are sensible, but why they are even appearing to work? It’s a slow process to be sure, but governments are getting on top of their debts and are trying to pull down their deficits. And while you would hardly call such policies “popular”, there is general if sullen recognition of the grim necessity that these policies represent. It’s always fun to spend like drunken sailors. It’s not fun having to introduce cuts across a wide swathe of government outlays that have been put in place for some purpose, but there does seem to be at least some appreciation that all of this needs to be done. The group which has said the least in support of this pulling back of public spending are economists. And the appalling fact is that they just don’t know any better. They have been taught Y = C + I + G with their mother’s milk and they are extremely reluctant to go back on the only macroeconomic organizing principle they know. Take away aggregate demand and they are completely lost. Say’s Law It was not always thus. Economists and economic theory once knew perfectly well that aggregate demand was of no relevance in understanding the operation of an economy. Certainly for individual products there was supply and demand, but for the economy as a whole there was only supply.

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If the economy produced what people wished to buy, there was no difficulty in ensuring there would be sufficient demand. This principle had no name amongst economists until the 1920s. Even then the name given to this principle became known to every economist only when it was included in Keynes’s General Theory as the designated villain within pre-­Keynesian economics, which Keynes called “classical economics”, another Keynesian innovation that has stuck. The principle, at least in the garbled version used by Keynes, is referred to as “Say’s Law” and its meaning, also from Keynes, is that “supply creates its own demand”. So first let me tell you what Say’s Law does not mean and then after that what it does mean. What Say’s Law does not mean is what Keynes said it meant. It does not mean that everything produced is guaranteed to be bought and therefore recessions are impossible. In the minds of most economists, a return to Say’s Law would be similar to biologists deciding that, come to think of it, evolution by natural selection doesn’t really happen, or for physicists to say that perhaps, after all, e does not equal mc2. Denying the validity of Say’s Law is as fundamental as you can get. If economists came to the conclusion that this proposition, in spite of generations of vilification, is actually a valid statement of how economies work, just about every macroeconomics textbook in the world would be worthless, since what they have been teaching is not just nonsense but dangerous nonsense. To come back one last time to that article in the Sydney Morning Herald: Prof Kates said the response to the crisis had been based on Keynesian economics that backs government intervention to stabilise growth during a downturn in a business cycle. “The use of Keynesian economics has been one of the great catastrophes for economic theory in the west.”

And a catastrophe not just for economic theory, but for every one of those governments which have followed Keynesian prescriptions to bring their economies out of recession, not to mention those populations who have had to endure the results. Keynesian policies have never worked, not in a single instance. Nevertheless, the theory has remained the guide to policy since it was first introduced. While there was some weakening in acceptance during the great inflation of the 1970s and 1980s, Keynesian macroeconomics remains as entrenched within economic theory as supply and demand.

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Say’s Law Correctly Understood But here I am made to confront that old economics joke about why there can never be a twenty-­dollar bill on the floor, because if there were, someone would already have picked it up. Because the extraordinary part has been – and you can only imagine how extraordinary I find this – that there has been hardly another economist on the planet who thinks Say’s Law is true. There are probably no more than a handful, and I near enough know every one of them. If there are others, I have never come across anything they have written. This proposition, which seems simplicity itself, accepted by every economist for more than a hundred years up until 1936, is apparently an impassable obstacle in the modern world. Nor is it as if I and these few others haven’t tried to make the profession see the point. For my own part, I have written books and papers, monographs and articles, but I don’t think I have personally convinced more than a few. So whatever gifts it may take to make this concept understood, I may just not have what’s required. Bear with me anyway, and we will see how we go. Some History The issue rose out of a controversy that emerged in England in the midst of the Napoleonic Wars. In 1807, an economist by name of William Spence wrote a book to argue that England, which had been shut out of trade with the continent, had nothing to worry about since to maintain employment, they just had to encourage landowners to stop saving and start spending. Their additional demand would drive the economy along and jobs would be preserved. The following year, the economist James Mill took it upon himself to respond to Spence and in his reply gave the first unambiguous statement of Say’s Law: No proposition however in political economy seems to be more certain than this which I am going to announce, how paradoxical soever it may at first sight appear; and if it be true, none undoubtedly can be deemed of more importance. The production of commodities creates, and is the one and universal cause which creates a market for the commodities produced.

The last sentence is strikingly similar to Keynes’s “supply creates its own demand”. But what Mill was arguing was that if there is to be demand at the aggregate level, what must come first is supply. It is production of goods and services, and production alone, which will create a market for other goods and services.

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That’s where demand comes from. It comes from supplying what other people want to buy. And if sellers do not supply what others want to buy, that is, if what they produce is not bought, the result is recession. This too is from James Mill in what is more or less a throwaway line since in this discussion the causes of recession were not the issue: “All that here can ever be requisite is that the goods should be adapted to one another.” Mill is making the point that if purchase and sale are going to increase, each person’s production must be adapted to the wishes of others. It is producing what others want that creates demand. But it was not for another decade before the causes of recession became the central issue. The General Glut Debate The next staging post in understanding the actual meaning of Say’s Law takes you to what is known in economics as the “General Glut” debate. A glut is excess supply, too much production relative to demand. No one doubts you can have a glut of an individual good or service, too much milk or wheat perhaps, relative to the willingness of buyers to buy everything that had been produced. That is referred to as a “particular” glut, a glut of a particular commodity. But could you have a “general” glut, that is, too much of everything relative to the willingness of the community to buy the lot at prices that covered their cost of production? A general glut represents demand deficiency across the economy, not enough aggregate demand, as it is described today. The possibility of a general glut was the issue of issues amongst economists for almost thirty years, commencing with the publication of T.R. Malthus’s Principles of Political Economy in 1820. Malthus had argued that the recessions which followed the end of the Napoleonic Wars had been caused by an absence of demand for output. People had chosen to save rather than spend and, like Spence, he recommended having the landed aristocracy lead the way by supplying the missing demand needed to employ the entire working population. The General Glut debate continued for almost thirty years, at the end of which the entire mainstream of the economics community came to the universal conclusion that demand deficiency was never a valid explanation for recession. The single most striking and informative statement during the whole of this debate was made by David Ricardo, the greatest economist of his day. In a private letter to Malthus, Ricardo wrote: “Men err in their productions, there is no deficiency of demand.” This is the full, comprehensive and to me anyway, irrefutable evidence that Keynes completely misunderstood what Say’s Law meant. Keynes may have been right about the

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economics – although by now that’s a very shaky claim – but that he was wrong on what classical economists had believed is undeniable based on what Ricardo wrote as far back as 1820. What was Ricardo arguing? First, that of course you can have recessions. Second, that the cause of such recessions was errors made by those in business who had been wrong in their decisions on what to produce. Third, whatever else might have caused these recessions, it was not a deficiency of demand. These are the constituent elements of Say’s Law from a theoretical perspective. It is a refutation of everything found in a modern macro text. For the reasoning you could do worse than to go to James Mill, but the language is more than 200 years old and no longer accessible to an economist today. But if you would like seriously inaccessible, I now turn to John Stuart Mill. Mill’s Fourth Proposition on Capital The General Glut debate came to an end with J.S. Mill’s Principles published in 1848. He was writing at the tail end of the debate, so no one at the time was in any doubt about what he was talking about. Right at the beginning of the book, he has what he calls his four “Fundamental Propositions Respecting Capital”, of which the fourth has possibly been the single most difficult statement made in the whole history of economic theory. At least it’s been difficult since the time of Mill. But what has kept this proposition an evergreen conundrum is a statement made in 1876 by Leslie Stephen. In a two-­volume discussion of eighteenth-­century thought, out of nowhere Stephen wrote of Mill’s fourth proposition that it is a “doctrine so rarely understood, that its complete apprehension is, perhaps, the best test of a sound economist”. And what was this doctrine? It comes in eight words, although backed by pages of text in Mill: “Demand for commodities is not demand for labour.” Some of the greatest minds economics has ever produced have had a crack at it but cannot solve what Mill meant. Yet in Mill’s own lifetime there was not a single dissenting voice. Since then, there has been almost total incomprehension. We are talking about discussions that include Alfred Marshall, A.C. Pigou, Friedrich Hayek, Sam Hollander and others including J.M Keynes in two separate footnotes in The General Theory (1936: 359, 364). Not one could work out what Mill had meant in a way that didn’t make it seem that he had been prey to some obvious error. Surely, they said, buying shoes creates a demand for shoemakers. But Mill was not discussing an individual market and derived demand. He was ­discussing the entire economy looked at as a whole.

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To others, it seemed Mill had expressed himself badly. Substitute explanations were suggested. You will have to go elsewhere to find Mill’s reasoning. Here we dwell only on his conclusion: the demand for labour cannot be increased by increasing the demand for goods and services. Why Mill thought so has remained a mystery since the 1870s. But what is not a mystery is that however you might argue the toss, the reality of the world we live in conforms to Mill’s views and not Keynes’s. There have been massive increases in the aggregate demand for commodities that have not translated into an increase in the demand for labour. Classical economics to a Keynesian has become like another old economics joke: “That’s all right in practice, but will it work in theory?” Well, whatever you want to say, classical theory works in practice, and if you understood the theory, it would work just as well. Economic Theory in Practice There was a time when it looked as if Keynesian economics was finally on its way out. During the 1970s, following the great inflation which ought to have exposed as pure nonsense the idea that spending of itself is good either for employment or economic growth, there was a small-­scale retreat from Keynesian economics as a guide to policy. The most famous recantation was provided by Britain’s former Labour Prime Minister, James Callaghan, when he spoke to the Labour Party Conference in 1976: We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.

This was wisdom hard won but eventually lost. The textbooks remained as they were, still teaching Y = C + I + G. In spite of the massive failures of demand to lift the level of production and employment in the 1970s and 1980s (and in Japan in the 1990s), there it lay in every text, waiting for the next recession when it would be called upon again. And so an entire generation went by between the 1970s and the coming of recession in 2009. Thirty years later there was almost no memory of anyone in decision-­making roles who had seen the problems created by the expenditure of that earlier time. So when the moment came, so too did the decisions, across almost the whole expanse of the world’s economies, to apply a stimulus to short-­circuit recession. Almost any economy could be chosen to hold up as an example of the failure of policy, but the moribund American economy had the

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best-­known stimulus, which has been followed by its worst recovery since the Great Depression. Rather than the American economy having returned to any kind of robust condition, it has continued to sink. The recession may have officially ended in June 2009, but there has been no improvement in the labour market, while economic activity continues to stagnate. Evidence is hardly needed, since no one pretends that the US economy has turned the corner. And even with the pumping of money into the economy hand over fist (a disastrous idea that will come back to haunt the American economy, as well as the rest of us, for years to come), the American economy continues to flounder. Which economy today is not in a similar boat? No economy anywhere can be said to be performing at full throttle. Keynesian economic theory is therefore quietly being set aside. L’offre crée même la demande What ought to be, but won’t be the final epitaph for Keynesian economics has been spoken by the French President, François Hollande, in January this year. I will provide the words first in French, because they need to be seen to be believed, and then in translation: Le temps est venu de régler le principal problème de la France: sa production. Oui, je dis bien sa production. Il nous faut produire plus, il nous faut produire mieux. C’est donc sur l’offre qu’il faut agir. Sur l’offre! Ce n’est pas contradictoire avec la demande. L’offre crée même la demande.

This is the socialist President of France quoting Say’s Law with approval. The words in italics are Hollande’s version of Keynes’s version of Say’s Law. This is the passage in my free translation: The time has come to work through the number one problem in France: which is production. Yes, that’s what I said, production. We must produce more, we must produce better. Hence, it is upon supply that we must concentrate. On supply! This is not in opposition to demand. Supply really does create demand.

Perhaps it is easier for a President of France to speak well of Say’s Law, since Jean-­Baptiste Say was the greatest French economist of the early nineteenth century, a contemporary of James Mill and Ricardo, who had opposed Malthus, possibly more strongly than any other economist of his time. Will Hollande’s declaration, in company with the incredible failures of the stimulus, finally do the trick? I am no longer as optimistic as I once was, although you would think that the failures of the Keynesian stimulus are becoming too obvious to ignore.

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Yet the attacks by the mainstream on Hollande for his entirely sensible statement have been astonishing. How it is possible not to understand that demand is created by supply is beyond me. But then I have been saying the same for years, even while this commonsense and logical proposition has been, with some honourable exceptions, denied across the board. Say’s Law and Policy How, then, is policy different if Say’s Law is true? It starts from recognition that not only is it production alone that creates demand, but that this production must be value-­adding. A Keynesian policy starts from the belief that it literally does not matter what the spending is on. Just spend and things will take care of themselves. Since the problem of under-­ employment and slow growth to a Keynesian is too much saving, the most urgent need, especially during recessions, is to put those savings to use. So if you look at the various stimulus programs found everywhere, you could hardly pretend they were a careful use of money. Money was spent with wild abandon. The core understanding that comes with Say’s Law is that supply has to be value-­adding if it is to create jobs and strong growth. Every dollar of spending draws down on existing resources. Even producing paperclips uses up resources. Paperclip production may create value, but the resources that were used up also had value. The labour, capital and whatever else required was used in this way and not some other way. Only if the value of what was produced was greater than the value of the resources used up could it be said production had been value-­adding. In sharp contrast to the private sector, where firms will go out of business if revenues do not cover costs, government spending is almost never value-­adding – perhaps the most productive 10 to 15 per cent, but not the rest. That is not of itself an argument against public spending, but it is an argument against thinking that when governments spend they are necessarily helping the economy grow. They almost never are. The belief that public spending is good for growth is the largest fallacy associated with modern macroeconomic theory. Being unable to tell the difference between welfare and wealth creation is possibly Keynes’s most lasting legacy, a legacy which has been poisoning public policy since the 1930s.

NOTES 1. And let me express my deep appreciation to Quadrant and its editor, Keith Windschuttle, for having allowed me to put these views into print in such a timely way.

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2. “Classical” was the name given to the economics of his predecessors by Keynes himself. The origins of the term as applied to economics and economists dates back to Karl Marx who used it as a brush with which to tar his predecessors. Keynes, a polemicist of some genius himself, took up the term for exactly the same purpose, but extended its range to include his own contemporaries as well. 3. The term “Say’s Law” was not, it should be noted, an invention of Keynes’s nor was it classical in origin but had been introduced into economics at the start of the ­twentieth century by the American economist, Fred Manville Taylor. However, once the words appeared in the General Theory, they immediately entered the lexicon of the entire economics profession where they have remained embedded ever since. 4. It might be hard for non-­economists to appreciate just how deeply felt the rejection of Say’s Law is. Such attitudes are, however, not universal. Schumpeter, in full knowledge of what Keynes had written, was himself still able to write “Say’s Law is obviously true . . . It is neither trivial nor unimportant” ([1954] 1986: 617). 5. This phrase is practically the only statement from the whole of the economics literature that an economist is uniquely bound to know even if very few ever understand what it actually means or have the slightest clue as to its original source. The only other sets of words known to all economists are “the invisible hand” of Adam Smith and, again from Keynes, “in the long run we are all dead”, both of which are also well known amongst non-­economists. 6. Some point to the economic conditions during the war as evidence that Keynesian policy actually works. But the war did no more than demonstrate that unemployment can be made to disappear if a large proportion of the workforce is removed from the workplace and a government-­directed war economy is introduced. But the actual performance of the economy – as in the existence of an institutional apparatus that will deliver goods and services to the community at reasonable prices – was dismal. Rationing and shortages of consumer goods existed throughout the war as one would expect.

REFERENCES Carew, Edna. 1996. The Language of Money. St. Leonards, NSW: Allen & Unwin. Garside, W.R. 1990. British Unemployment 1919–1939: A Study in Public Policy. Cambridge: Cambridge University Press. Kates, Steven. 1998. Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost Its Way. Cheltenham, UK and Lyme, NH, USA: Edward Elgar Publishing. Kates, Steven. 2009. “The Dangers of Keynesian Economics”, Quadrant, LIII (3), March. Kates, Steven. 2010a. “The Crisis in Economic Theory: The Dead End of Keynesian Economics.” In Steven Kates (ed.), Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 112–26. Kates, Steven. 2010b. “Influencing Keynes: The Intellectual Origins of the General Theory”, History of Economic Ideas, XVIII (3), 33–64. Kates, Steven. 2014a. “Keynesian Economics’ Dangerous Return”, Quadrant, LVIII (3), March. Kates, Steven. 2014b. “Why Keynesian Concepts Cannot Be Used to Explain Pre-­Keynesian Economic Thought: A Reader’s Guide to Classical Economic Theory”, Quarterly Journal of Austrian Economics, 17 (3), 313–26. Kates, Steven. 2014c. Free Market Economics: An Introduction for the General

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Reader. 2nd edn. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Kates, Steven. 2015. “Mill’s Fourth Fundamental Proposition on Capital: A Paradox Explained”, Journal of the History of Economic Thought, 37 (1), 39–56. Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. Vol. VII of The Collected Writings of John Maynard Keynes. Edited by Donald Moggridge. London: Macmillan. Mill, John Stuart. [1871] 1921. Principles of Political Economy with Some of Their Applications to Social Philosophy. 7th edn. Edited by Sir W.J. Ashley. London: Longmans, Green and Co. Mill, John Stuart. [1874] 1974. Essays on Some Unsettled Questions in Economics. 2nd edn. Clifton, NJ: Augustus M. Kelley. Pope, David and Glenn Withers. 1993. “Do Migrants Rob Jobs? Lessons of Australian History, 1861–1991”, Journal of Economic History, 53 (4), 719–42. Schumpeter, Joseph A. [1954] 1986. History of Economic Analysis. London: Allen & Unwin.

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8. The problem of Keynesian aggregation Arnold Kling INTRODUCTION Where does Keynesian economics go wrong? In this chapter, I suggest that Keynesian economists go off track by treating the economy as if it were one gigantic business producing a single output called GDP using a known technology. This leads Keynesians to propose misguided theories of ­unemployment while ruling out by assumption the main likely source of unemployment. In a complex economy, unemployment is likely due to the time and cost that it takes for entrepreneurs to discover new products, processes, and trading patterns when existing patterns become unprofitable. In the following sections of this chapter, I pose and answer four questions about Keynesian economics: 1. 2. 3. 4.

What is Keynesian economics? What is the alternative? Can we use macroeconomic data to confirm or reject Keynesianism? Where does Keynesian economics go wrong?

In answering the first question, I will suggest that there are two main strands of Keynesian economics that differ from one another yet are used in complementary ways. One strand, which I term popular Keynesianism, is used to communicate with policy makers and with the public. The other strand, which I term rigor-­seeking Keynesianism, is used to address issues raised by trained economists. In answering the second question, an alternative explanation for unemployment suggested by conventional economics is one in which some existing patterns of specialization and trade become unprofitable. At that point, entrepreneurs face the challenge of discovering, through trial and error, new sustainable patterns of specialization and trade. This alternative explanation for unemployment is at a disadvantage in competing with Keynesianism, because the latter offers a relatively simple purported 150

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cure for unemployment. In contrast, the alternative explanation suggests that public policy faces the same challenge as that faced by entrepreneurs. How do we find new patterns of specialization and trade that productively employ workers whose previous tasks are no longer needed? Unfortunately, Keynesianism can neither be decisively confirmed nor decisively refuted by macroeconomic data. The challenges of using the data start with the fact that macroeconomic phenomena are observational, not experimental. This problem is compounded by the fact that, over any given period of macroeconomic history, there are many influential factors relative to the number of independent observations. This makes the range of possible empirical specifications wide and the selection from among those specifications arbitrary. Thus, even though the data are collected and presented in the form of Keynesian aggregates, the Keynesian framework cannot be decisively confirmed or falsified using data. However, there are many anomalies in the historical record that justify considerable skepticism about the Keynesian framework. Finally, one can answer the question about where Keynesian economics got off track. I believe that the fundamental flaw in Keynesian economics is that it relies on aggregation and thereby ignores the need for discovery and adjustment. Treating the economy as if it were a single GDP factory is a defect in both popular Keynesianism and rigor-­seeking Keynesianism.

WHAT IS KEYNESIAN ECONOMICS? Keynesian economics has always eluded a precise definition. The controversy over “what Keynes really meant” that began as soon as The General Theory was published remains active and unsettled. This poses a problem for those of us who would attack Keynesian economics. There is usually a rebuttal available that says “You are criticizing a straw man. What Keynesians really believe is . . . ” I think that this ambiguity, which one might expect to be an intellectual disadvantage, actually serves the Keynesian cause. In particular, Keynesians seem to me to fight with two fists. One fist is what I call popular Keynesianism, which arrives at appealing narratives and powerful policy conclusions while creating or glossing over some important theoretical difficulties. The other fist is what I call rigor-­seeking Keynesianism, which attempts to grapple with the theoretical problems but connects only loosely with the narratives and policy prescriptions of popular Keynesianism. What I call popular Keynesianism can be reduced to a bumper sticker: Spending creates jobs, and jobs create spending. Popular Keynesianism holds strong appeal to the intuition of non-­economists and to policy

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makers seeking a prescription for the problem of unemployment (and an excuse for tax cuts or increased spending). However, as an economic framework, popular Keynesianism does away with price adjustment, and thus it suffers from a nagging inconsistency with standard training in economics. What I call rigor-­seeking Keynesianism is the Keynesianism that one finds in academic journals. Rigor-­seeking Keynesians have sought to allow for the price mechanism to operate (albeit imperfectly) while justifying policies that resemble Keynesian prescriptions. Popular Keynesianism permeates economic journalism. In the everyday narrative of the economy, when the economy is “strong,” that is because consumers and businesses are spending freely. When it is “weak,” that is because consumers and businesses are reluctant to spend. Lack of spending causes businesses to cut back on employment, which in turn causes households to be reluctant to spend. Popular Keynesianism also is embedded in first-­year economics textbooks. Students are shown the “circular flow” of spending: households obtain goods and services from businesses, and businesses obtain labor and capital from households. In the opposite direction are money flows: businesses pay households for labor and capital, and households pay businesses for goods and services. The circular flow presents an economy with no price mechanism. Completely divorced from the standard economics of supply and demand, the circular flow makes it appear that quantities depend only on other quantities. Examining the circular flow, the student sees that the money that households have to spend comes from payments by businesses, and those payments in turn come from household spending on goods and services. It is easy to imagine a recession as something that interrupts or slows down this circular flow. Factors that increase or decrease the circular flow can be termed injections and leakages. An increase in business investment provides an injection into the circular flow. Household saving provides a leakage out of the circular flow (even though it is by saving that households supply capital to businesses). When we add government to this framework, government purchases become injections and taxes become leakages. Thus, an increase in spending or a cut in taxes will increase the circular flow, leading to more output and employment. The central bank also plays a role in popular Keynesianism. In textbooks, when the monetary authority reduces interest rates, this leads households and businesses to inject more spending into the circular flow. Economic journalists will even describe the central bank as giving households more money to spend, confusing monetary policy with tax cuts.

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Popular Keynesianism offers the non-­economist an appealing narrative to explain economic fluctuations. Every household understands that if the demand for its labor were to increase then it would have more money to spend. Every businessman understands that if the demand for the firm’s output were to increase then it would have more reason to hire additional workers. If an economy is in a recession, it then seems quite natural to think of it as a business suffering from insufficient demand and as a household suffering from underemployment. However, to someone well trained in conventional economics, popular Keynesianism is not intuitive at all. In fact, it violates a number of standard microeconomic precepts. 1. In conventional economics, we teach that the fundamental economic problem is scarcity. People have unlimited wants and limited resources. In popular Keynesianism, the notion of deficient aggregate demand describes an economy in which some resources are superfluous because wants are limited. 2. In conventional economics, saving promotes capital formation. Businesses deploy savings to acquire capital goods. The interest rate balances the rate of intertemporal substitution in production (how much businesses can increase output tomorrow by undertaking investment today) with the rate of intertemporal substitution in consumption (the consumer’s preference to satisfy wants now rather than later). In popular Keynesianism, rather than financing investment, saving takes spending out of the circular flow and leads to unemployment. The interest rate does not play a balancing role. 3. In conventional economics, price adjustment serves to eliminate surpluses and shortages. In popular Keynesianism, a surplus of goods exists without any mitigating downward adjustment of prices. The shortfall in aggregate demand leads to a surplus of labor, without any mitigating downward adjustment of wages. In Keynes’s General Theory, as in popular Keynesianism, the interest rate does not balance saving and investment. Instead, saving and investment depend importantly on psychological factors. Consumers habitually save a proportion of their income. Business managers base their investment decisions on unreliable expectations about the future, and ultimately on “animal spirits,” which I take to mean a desire to create a legacy. For Keynes, saving represents an irrational urge to hoard. Such hoarding behavior is particularly harmful when households maintain their hoards in the form of money. When households are hoarding, they are not sending signals to businesses to invest.

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In a well-­known paper, John Hicks (1937) began the search for what I call rigor-­seeking Keynesianism by reintroducing the interest rate as a determinant of investment. In what is known as the IS–LM model, a balance between saving and investment can be achieved at various combinations of income and interest rates. Other things equal, as income is higher (leading to more saving), interest rates must be lower (to induce enough investment to achieve balance). Also, there are combinations of interest rates and income that stabilize the demand for money (the supply of money is taken as fixed). As income rises, people want to hold more money to keep pace with transactions. To offset this, higher interest rates are needed to induce an increase in the velocity of money. Combining these two sets of balancing considerations yields a single equilibrium level of income and the interest rate. One problem with IS–LM that would trouble future rigor-­seeking economists is that there is some fudging going on in speaking of “the” interest rate. In fact, the interest rate that seems most appropriate for achieving balance in money demand is a short-­term nominal interest rate. On the other hand, the interest rate that seems most appropriate for balancing investment and saving is a long-­term real interest rate. The difficulty with this becomes apparent when inflation is introduced as a consideration. The next development in rigor-­seeking Keynesianism was the introduction of the concept of aggregate supply. This took place for two reasons. First, there arose an interpretation of the inverse relationship between inflation and unemployment, known as the Phillips Curve. This interpretation, promoted in an address by Milton Friedman (1967) and in a conference volume edited by Edmund Phelps (1970), was that changes in the inflation rate produce distortions in the real wage rate. Unexpectedly low inflation causes real wages to rise, reducing the demand for labor and raising unemployment. Conversely, unexpectedly high inflation causes a reduction in real wages, raising the demand for labor and lowering unemployment. This gives rise to an aggregate supply relationship in which higher inflation leads to higher output. The next reason for a focus on aggregate supply was the empirical phenomenon of the “oil shock” of 1973–74. As the price of oil rose, the effect on the US economy was exactly what conventional economics would predict would happen to a single business using oil as an input: the price of output rose, and the quantity sold declined. An increase in the price of oil acted like an upward shift in the supply curve for the entire economy. With the concept of aggregate supply, economists could depict the economy as a whole using the same sort of diagram that one might use to depict the market in a single industry. However, the concepts of aggregate demand and aggregate supply are awkward in several respects.

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First, there is an ambiguity in the effect of higher prices on aggregate demand. Other things equal, a higher price level reduces aggregate demand, because it increases the demand for money and raises the short-­ term nominal interest rate. However, other things equal, a higher rate of increase in the price level (in other words, a higher rate of inflation) increases aggregate demand, because it reduces the long-­term real interest rate. Second, there arose a need to break inflation into two components – expected inflation and unexpected inflation – with different effects on employment and output. The component of inflation that is expected should be approximately neutral with respect to employment. When expectations of inflation are built into wage negotiations, the real wage should not be affected by inflation. Only inflation that is surprisingly high (low) should cause a fall (rise) in the real wage and a consequent increase (decrease) in labor demand. This in turn leads to a focus on how expectations of inflation are formed. One approach was to presume that expectations adapt slowly to past behavior. This leads to a characterization of aggregate supply that in the short run behaves like an economy with inflexible prices (or perhaps only inflexible wages) and in the long run behaves like an economy with fully flexible prices and wages, operating at the “natural” rate of unemployment, or at the “non-­accelerating inflation rate of unemployment” (NAIRU). The next development was to suggest that this model of (backward-­ looking) adaptive expectations be replaced by an assumption of (forward-­ looking) rational expectations. As Robert Lucas (1972) pointed out, if expansionary demand policy works by fooling workers into accepting lower real wages, then workers may thwart the policy by looking ahead and trying to avoid being fooled. What eventually emerged has been described by Olivier Blanchard in a paper that reported on the then-­current consensus of leading macroeconomists. Blanchard wrote that what I am calling rigor-­seeking Keynesianism presumes that although expectations are forward looking, there are important nominal rigidities, meaning that firms are inhibited in the short run from adjusting wages and prices. Taking such rigidities as given, the consensus has three central elements: An aggregate demand relation, in which output is determined by demand, and demand depends in turn on anticipations of both future output and future real interest rates. A Phillips-­curve like relation, in which inflation depends on both output and anticipations of future inflation. And a monetary policy relation, which embodies the proposition that monetary policy can be used to affect the current real interest rate (a proposition that would not hold absent nominal rigidities). (Blanchard, 2009, 213–14)

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Blanchard then elaborates. The aggregate demand equation is derived from the first-­order conditions of consumers, which give consumption as a function of the real interest rate and future expected consumption. As there is no other source of demand in the basic model, consumption demand is the same as aggregate demand. (Ibid.)

This is a far cry from the Keynesian consumption function. The representative consumer, instead of being governed by habit, now solves a mathematically challenging problem of dynamic optimization under uncertainty. Blanchard notes that “The aggregate demand equation ignores the ­existence of investment, and relies on an intertemporal substitution effect in response to the interest rate, which is hard to detect in the data on consumers.” On the translation of fluctuations in output to fluctuations in employment, Blanchard cites: A parallel effort, developed over the past twenty years by, in particular, Peter Diamond, Chris Pissarides, and Dale Mortensen . . . In this approach, unemployment arises from the fact that the labor market is a decentralized market, where, at any time, some workers are looking for jobs, while some jobs are looking for workers. (Ibid., 214)1

Remarking that the disagreements that erupted in the 1970s seemed to have narrowed, Blanchard wrote that “the state of macro is good.” However, the paper was completed just as the financial crisis of 2008 was challenging the contentment regarding that consensus. As of 2015, rigor-­seeking Keynesians do not seem to have coalesced around a single explanation for the deep recession that coincided with the financial crisis or the sluggishness of the recovery that followed. In short, a precise definition of Keynesianism is elusive. Popular Keynesianism discards the price mechanism in favor of an intuition that spending creates jobs and jobs create spending. Rigor-­seeking Keynesianism attempts to identify economy-­wide obstacles to the ability of movements in wages, prices, and interest rates to achieve market clearing and full employment. However, rigor-­seeking Keynesians generally use an aggregate production function, which treats the economy as if it were a single business.

WHAT IS THE ALTERNATIVE TO KEYNESIANISM? An alternative explanation for unemployment is to point to the time and cost involved in creating patterns of specialization that are sufficiently

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profitable to be sustained. This alternative approach does not suffer from inconsistency with standard economic thinking. However, it does not yield the sort of appealing popular narrative or policy solutions that make Keynesianism so attractive. Economists, beginning with Adam Smith, have pointed out that a modern economy is characterized by a high degree of specialization. Typically, we consume nothing of what we produce, and we could produce nothing that we consume. The knowledge and skills needed to provide the goods and services of today’s economy are widely dispersed. Every day, someone living in an advanced economy consumes goods and services that require millions of tasks to produce. Simply eating a piece of toast in the morning involves putting into a toaster a slice of bread baked by specialists, in ovens produced by other specialists, using ingredients produced by yet other specialists who used materials gathered by yet other specialists. The toaster that we use is assembled out of many metals and plastics refined by specialists in different parts of the world. It runs on electricity that is delivered by processes that require yet other specialists. Operating the supply chain for the stores who sold us the bread and the toaster required many specialists in transportation, logistics, wholesale and retail trade, finance, marketing, and more. In contrast to the millions of tasks that go into producing the goods and services we consume in a day, our jobs involve only a few tasks. Those tasks pertain to particular stages of production, many of which, such as accounting or benefits administration or computer network management, are quite remote from final output. The set of tasks that make up a job must add sufficient value to cover the cost of undertaking those tasks. The value added of a set of tasks is highly dependent on context. In 1900, the economy had a big need for horseshoe makers but not for software developers. Since then, innovations have caused that to reverse. Today, the opposite would be true. Thus, we arrive at the following definition of a job: A job is a context for performing a particular small set of tasks that can be exchanged for the means to obtain goods and services produced by a far larger set of tasks.

A modern economy consists of many jobs, which reflect highly developed forms of specialization and trade. The patterns of specialization and trade are very complex, and yet no single person is in charge of creating them. The patterns are created by entrepreneurs acting in a decentralized fashion, coordinated by the price system and by the profit incentive. For a pattern of specialization and trade to be sustainable, businesses must make profits.

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Unprofitable patterns will disappear, and eventually new patterns will take their place. In this alternative framework, which I call patterns of sustainable ­specialization and trade (PSST), unemployment increases when patterns of trade become unsustainable faster than entrepreneurs can create new, sustainable patterns. This is what happens during what we call a recession. For example, when there is overbuilding of houses in a region, some construction jobs become unsustainable. Moreover, businesses that provide goods and services to workers and firms in the construction sector in that region will find that some of their specialized jobs are no longer sustainable. Another example was suggested by Joseph Schumpeter as a phase in the process of creative destruction. Prior to a recession, upstart businesses might be experimenting with new concepts, such as websites that deliver news, at the same time that incumbent businesses, such as traditional ­newspapers and magazines, are still operating. However, at some point one or both groups of businesses will experience disappointing sales and operating losses, leading to closures and loss of jobs. The popular Keynesian story for job creation makes it seem as if the job structure in the economy is given. All that is needed is the pump-­priming of more aggregate demand. People who lose jobs when demand falls will return to similar jobs once demand recovers. In the PSST alternative, job creation requires entrepreneurs to experiment with new patterns of specialization. Will an Italian restaurant work in this neighborhood? Will the providers of a new service for social media marketing be able to convince businesses to use this service? The problem of unemployment cannot be solved simply by adjusting wages and prices, or even by connecting the skills of workers with job openings. Entrepreneurs must discover, through trial and error, profitable enterprises for which they can use the skills of the unemployed. For a worker, losing a job means that the particular set of tasks that one has been used to performing no longer adds sufficient value in its context. The options available to this worker include: 1. taking a different job at much lower wages; 2. waiting for another job to be created that requires similar tasks and pays similar wages; 3. obtaining training in a different set of skills, hoping that this will increase the likelihood of finding a new job. In labor force statistics, only workers who choose to take a lower-­wage job will be counted as employed. Workers who prefer to wait will be counted

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as unemployed. Workers who choose to obtain training will show up as out of the labor force. Keynesianism treats all workers and all jobs as identical. Keynesian theory implies that an increase in government spending raises demand, leading to increases in jobs. In the PSST alternative, the effect of government spending on employment will depend on how well the spending is targeted. Even in a recession, 90 percent of the labor force is employed. If government spending adds to sales of businesses where jobs currently exist, nearly all of the demand may be satisfied by this already employed work force, with very little additional job creation. Meaningful job creation comes from entrepreneurs creating a context in which workers who are currently unemployed can have sustainable jobs. It would seem that government spending must be wisely targeted in order to have an impact on this process. Government must spend on the products and services that are embedded in new patterns of specialization and trade that will be profitable going forward. In order to accomplish this, the government would have to be as insightful as a successful entrepreneur in identifying opportunities to utilize the skills of the unemployed. The PSST alternative raises a number of questions. For example, in the United States, the Job Openings and Labor Turnover Survey statistics (JOLTS) show that millions of jobs are created and destroyed each month, even though on net it is typical to see net monthly gains or losses in employment of less than 300,000. Is a recession the result of jobs being destroyed at an unusually fast pace or jobs being created at an unusually slow pace? Another question concerns the role of key sectors. Work by Acemoglu et al. (2015) using input-­output analysis suggests that weakness in an industry does indeed spill over into related industries, with spillovers taking place in the expected direction (supply problems having an impact on later stages of production and demand problems having an impact on earlier stages of production). It seems plausible that when patterns of trade become unprofitable in an industry that is tightly connected to other large industries that this would have a large overall effect. In the wake of the financial crisis, it is reasonable to ask whether the financial industry or credit conditions are particularly central to sustaining patterns of specialization and trade. It is plausible that patterns of trade are maintained more easily in a financial environment that is forgiving than in an environment in which entrepreneurs are required to quickly demonstrate the profitability of their experiments.

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Table 8.1  The effect of government purchases on GDP Year

Total GDP

Federal Government Purchases

GDP Excluding Federal Government Purchases

2007 2008 2009 2010 2011

14477.6 14718.6 14418.7 14964.4 15517.9

1049.8 1155.6 1217.7 1303.9 1303.5

13427.8 13563 13201 13660.5 14214.4

CAN WE USE MACROECONOMIC DATA TO CONFIRM OR REJECT KEYNESIANISM? It would be helpful to have an empirical basis for choosing between Keynesianism and the PSST alternative. Unfortunately, neither Keynesianism nor the PSST alternative is falsifiable using macroeconomic data. Macroeconomic events take place within an unfolding historical process. Determining the cause of a major macroeconomic event, such as a steep recession, is as fraught as trying to determine the reason that some countries industrialized earlier than others or why the First World War broke out when it did. Consider Table 8.1 showing total GDP, the US federal government purchases component of GDP, and the sum of the remaining components of GDP in the years 2007 through 2011, in billions of current dollars. From 2007 to 2009, federal purchases climbed by just over $168 billion, or more than 15 percent. However, the remaining components of GDP fell even more, by almost $227 billion, so that overall current-­dollar GDP was slightly lower in 2009 than in 2007. Conversely, from 2010 to 2011, federal government purchases edged down, while the remaining components of GDP increased by almost $554 billion, so that total GDP increased by close to 4 percent. These observations appear to show that the “multiplier” for government purchases is negative. Does this constitute proof that Keynesian policies do not work? Unfortunately, one cannot make such a definitive statement. In fact, in a poll of leading economists, most agreed with the statement that “Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.”2 The problem is that macroeconomic data result from many different factors. The macroeconomists who believe that the fiscal multiplier was positive rather than negative would argue that other factors, such as credit

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conditions and household balance sheets, affected the GDP data in the relevant years. The challenge of empirical macroeconomics is to try to account for all of the possible causal factors. In the 1960s, American economists made extensive use of multi-­equation multiple regression techniques to estimate statistically the properties of the US economy. These large-­scale ­econometric models soon fell into disrepute. Their out-­of-­sample forecasting results were poor, and they ran into strong theoretical headwinds. Starting in the mid-­1970s, economists became particularly concerned about what became known as the Lucas Critique. Robert Lucas (1976) pointed out that if households and businesses are forward-­looking but the econometrician treats them as backward-­looking, then the structural parameters of a macroeconometric model will be unstable. With forward-­ looking rational expectations theories becoming overwhelmingly popular among macroeconomists, the older econometric models fell out of favor. A different critique, and one that I think is ultimately more important, was made by Edward Leamer (1978). Leamer observed a deeply troubling discrepancy between statistical theory and econometric practice. Much of the data that economists use, in both macroeconomic and microeconomic studies, do not come from controlled experiments. Instead, we make use of what are known as observational studies, in which data are generated by processes that are not under the control of the investigator. We use multiple regression techniques to attempt to control for the factors that one would like to hold constant if one were running an experiment. What Leamer pointed out is that while in theory the specification of control factors should be done once, prior to examining data, in practice an econometrician engages in an iterative process of re-­using the data, searching for a specification that leads to results that please the investigator. Microeconomists have responded to Leamer’s critique by relying much less on multiple regression and instead looking for “natural experiments” in which the observational data happen to be generated in a way that provides the sort of controls that an experimenter might have designed (see Angrist and Pischke, 2010). However, such “natural experiments” are generally not available to macroeconometricians. Each country has exactly one historical record of macroeconomic events, and there is no opportunity to observe what would have happened under different circumstances. This problem is made much worse by the fact that there are many plausible causal factors at work in determining macroeconomic outcomes. Some of these factors primarily affect the economy at short time scales, such as month-­to-­month or quarter-­to-­quarter. Other factors primarily affect the economy at long time scales, meaning five years or more. At short time scales, macroeconomic data are dominated by noise due

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to imprecise measurement and by idiosyncratic events, such as unusual weather or labor strikes, or transitory policy changes, such as a tax rebate or a government hiring freeze. Statistically, when observed at short time scales, many macroeconomic time series appear to follow a random walk. Each macroeconomic aggregate appears to follow its own idiosyncratic path, rather than bearing a reliable relationship with other aggregates as assumed by Keynesian theory. At long time scales, of five years or more, data appear to be better behaved. However, at long time scales, one must pay attention to additional factors, such as changes in the composition of the labor force. There are so many variables that obey long-­term trends that at long time scales one can readily find correlations without being able to determine the magnitude of any causal relationship, or even to verify that a causal relationship truly exists. The net result is that economists with very different macroeconomic theories have all been able to fit or calibrate the historical record to support their divergent points of view. It seems as though just about any interpretation of the record is possible, and no interpretation can be ruled out. The inadequacy of macroeconomic data means that unlike physicists, whose theories can be tested rigorously, economists must work with interpretive frameworks that cannot be definitively falsified or confirmed. We will never be able to prove that a Keynesian interpretive framework is right or wrong. However, we can say that a framework is weak if it suffers from many anomalies, meaning observations that are difficult to explain within the framework. The Keynesian framework has suffered from a number of such anomalies, such as the “negative multiplier” in recent US data. Another anomaly is that the large, rapid fiscal contraction that took place in the United States after the Second World War did not result in the long, deep recession that Keynesian theory would have predicted. The “stagflation” that took place in the United States in the 1970s was an anomaly relative to the Phillips-­curve theory that previously had prevailed, and recent behavior of inflation also appears to confound the Phillips-­curve story. As noted earlier, the JOLTS data show that millions of jobs are created and destroyed each month. The Keynesian framework does not predict this phenomenon, and indeed its discovery appeared to take many macroeconomists by surprise.

WHERE DOES KEYNESIANISM GO WRONG? Keynesianism treats the economy as a single business producing one output, called GDP. This modeling strategy focuses all attention on the

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problem of choosing how much to produce. It assumes away the problem of choosing among outputs or the problem of choosing from among many possible production methods or supply-­chain configurations. This single output, GDP, is produced by a single technique, called the aggregate production function. Thus, the Keynesian modeling strategy ignores the existence of multiple alternative patterns of specialization. Keynesians act as if there were exactly one pattern of specialization in the economy. There is no need to choose among alternative patterns, to discard outmoded patterns, or to discover new patterns. In the Keynesian framework, jobs are only lost when there is a drop in demand. In the PSST framework, and in the real world, jobs are constantly being destroyed, for a variety of reasons. Economic progress consists of rearranging production of output to be more efficient. It is an always-­ongoing process that necessarily destroys jobs. A new consumer product makes other products obsolete, or at least less desirable. A new invention or managerial innovation makes it possible to produce the same output with fewer workers. A new configuration of trade uses labor more efficiently. Consider the simple two-­by-­two model of comparative advantage, such as the Ricardian story of England and Portugal and wine and cloth. Prior to trade, both countries “waste” workers in industries that are not to their comparative advantage. Once trade is opened up, firms can shed excess workers in these industries. In the real world, there is no guarantee that when an opportunity for trade arises the industries that enjoy comparative advantage will want to employ all of the workers made redundant in other industries. Perhaps the unemployed workers will need to be retrained; or perhaps they will need to discover work elsewhere, in entirely new industries made possible by the efficiency that comes from new trading opportunities but which are not immediately apparent at the time that the efficiency is created. In the Keynesian story, all unemployment looks like the temporary layoffs that used to occur in automobiles and steel when firms accumulated excess inventories. Once inventory balance was restored, workers were recalled to the same jobs. In the PSST story, all unemployment looks like structural unemployment. That is, workers who lose jobs will not find that those jobs return in several months, or ever. Instead, displaced workers will have to be employed by different firms, often in different industries. In the Keynesian story, the process of economic adjustment to a shock consists of arriving at the correct relationships between the money supply and the aggregate price level, and between the price level and the aggregate wage. In the PSST story, the process of economic adjustment to a shock requires entrepreneurs to discover new arrangements of tasks that add

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sufficient value to generate sustainable profits. As with all entrepreneurial effort, this is a trial-­and-­error process. Some new businesses will fail, generating no sustainable employment. Only a few will be so successful that they create large numbers of new jobs. Sorting out this process will take time. From the perspective of someone who finds that the PSST story fits well with economic thinking, the Keynesian modeling strategy seems contrived and misguided. By aggregating the economy into a single business, Keynesianism necessarily shoves the phenomenon of structural adjustment and the ferment of entrepreneurial trial and error into the background. Keynesians regard this as a useful simplification. Instead, Keynesianism is more like Hamlet without the Prince.

NOTES 1. A year after Blanchard’s paper was published, Diamond, Pissarides, and Mortensen were awarded the Nobel Prize in economics. 2. See Institute for Global Management Forum (2014).

REFERENCES Acemoglu, Daron, Ufuk Akcigit and William Kerr. 2015. “Networks and the Macroeconomy: An Empirical Exploration,” National Bureau of Economics Research Conference Paper. http://economics.mit.edu/files/10611. Angrist, Joshua D. and Jörn-­Steffen Pischke. 2010. “The Credibility Revolution in Empirical Economics: How Better Research Design is Taking the Con Out of Econometrics,” Journal of Economic Perspectives, 24(2): 3–30. Blanchard, O.J. 2009. “The state of macro,” Annual Review of Economics, 1: 1–20. Friedman, Milton. 1967. “The Role of Monetary Policy,” Presidential address to the American Economic Association, American Economic Review, 58(1) (March 1968): 1–17. Hicks, J.R. 1937. “Mr. Keynes and the ‘Classics’: A Suggested Interpretation,” Econometrica, 5(2): 147–59. Institute for Global Management Forum. 2014. http://www.igmchicago.org/ igm-­economic-­experts-­panel/poll-­results?SurveyID=SV_5bfARfqluG9VYrP. Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan. Leamer, Edward. 1978. Specification Searches: Ad Hoc Inference with Non-­ experimental Data. New York: Wiley. Lucas, Robert E., Jr. 1972. “Expectations and the Neutrality of Money,” Journal of Economic Theory 4(2): 103–24. Lucas, Robert E., Jr. 1976. “Econometric Policy Evaluation: A Critique,” Carnegie-­ Rochester Conference Series on Public Policy, 1(1): 19–46. Phelps, Edmund S., ed. 1970. Microeconomic Foundations of Employment and Inflation Theory. New York: Norton.

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9. What’s wrong with Keynesian economists? Arthur B. Laffer The point that baffles me even more than the failures of Keynesian economic policies is the even greater failure of Keynesian economists’ common sense.1 Just how can highly reputed economists with their long pedigrees get everything so wrong? I mean seriously, who would actually believe that: 1. 2. 3. 4.

an economy can be taxed into prosperity; a poor man can spend his way into wealth; low interest rates increase the supply of mortgages; redistribution from rich to poor increases the number of rich and reduces the number of poor; and 5. taxing work and paying for non-­work increases the amount of work? But I digress. Let’s look at a handful of the most important and widely used policies in the Keynesian toolkit and examine how they’ve fared in the historical narrative of the US economy. On February 20, 2015, The New York Times wrote: “Keynesians . . . have gotten most things right even as the supply-­siders were getting e­ verything wrong.”2 Not only is The New York Times wrong on this account, but the truth is the opposite. When economics mattered most – as in the Great Depression, the Great Recession, the “Roaring Twenties” and the Reagan Eighties – supply-­side economics was correct, and Keynesian economics was incorrect. The Keynesians, whether Republican or Democrat, have had a lock on public policy during two long periods in US history – the period leading up to and including the Great Depression and the period called the Great Recession including the last two years of the Bush presidency and the entire tenure of President Obama. In both the Great Depression and the Great Recession, the Keynesians pushed hard for quantitative easing, tax rate increases on the rich, ­protectionist legislation, and lots of government spending.3 165

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In modern times, the antithesis of the period of the Great Recession was the period beginning in the early 1980s running through calendar year 1988, a period which I will call the Reagan supply-­side years. During these supply-­side years, tax rates – especially on high-­income earners – were cut, sound monetary policy was implemented, the dollar appreciated, and ­government spending was kept under control.4 Given that we are all pretty much up to speed on the events and ­policies that preceded and were coincident with the Great Recession and the Reagan miracle, just look at the facts (Figure 9.1). In spite of the deep dive of the Great Recession itself, the aftermath was the single worst recovery since World War II. Preceded by an equally severe deep dive, the Reagan recovery was the best recovery since World War II. These two recoveries differed by so much because of the administration of Keynesian remedies during the Great Recession and supply-­side policies during the Reagan recovery. There you have it. And if the Reagan/Obama comparison isn’t enough to sway your 135

135 Reagan Recovery 130

130

Obama Recovery

125 NBER Cycle Peak

125 120 115 110

120 115 110

4Q-14 / 3Q-88

4Q-13 / 3Q-87

4Q-12 / 3Q-86

4Q-11 / 3Q-85

95 4Q-10 / 3Q-84

95 4Q-09 / 3Q-83

100

4Q-08 / 3Q-82

100

4Q-07 / 3Q-81

105

4Q-06 / 3Q-80

105

Source:  US Bureau of Economic Analysis, National Bureau of Economic Research (NBER).

Figure 9.1  Real GDP: recoveries indexed to NBER cycle peak = 100 (quarterly, NBER cycle peaks are 4Q-­2007 and 3Q-­1981)

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150 145

145

Roaring Twenties

140

140

Great Depression

135

135

130

130

125

125

120

120

115

115

1929 / 1938

1928 / 1937

75 1927 / 1936

80

75 1926 / 1935

85

80 1925 / 1934

90

85

1924 / 1933

95

90

1923 / 1932

100

95

1922 / 1931

105

100

1921 / 1930

110

1920 / 1929

110 105

Source:  Historical Statistics of the United States, US Bureau of Economic Analysis.

Figure 9.2  Real GDP: Roaring Twenties versus Great Depression (annual, indexed to 1921 and 1930 = 100) opinion, then we can also focus our attention on another pair of equally contrasting periods: the Roaring Twenties and the Great Depression. In the 1920s tax rates were cut, government spending was restrained, sound money prevailed, and regulations were reasonable. In the 1930s tax rates on trade and the rich rose by enormous amounts, spending was out of sight, the dollar was devalued, and government interfered in virtually every aspect of economic life. Now look at these results (Figure 9.2). As was the case in the comparison between the Bush/Obama Great Recession period and the Reagan supply-­side years, the supply-­side era of the Roaring Twenties vastly outperformed the Keynesian era of the Great Depression. In all honesty, there wasn’t even a contest. Keynesians lose again. In the Keynesian toolkit, policy prescriptions start with quantitative easing including the printing of money, a weak dollar, and, most of all, low interest rates. Quantitative easing is intended to stimulate investment, including home purchases, which, in conjunction with the Keynesian

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% 6.5

% 6.5

6.0

6.0

Great Recession

5.5

5.5

Great Depression

1Q-42

1Q-41

1Q-40

1Q-39

1Q-38

0.0 1Q-15 / 1Q-37

0.5

0.0 1Q-14 / 1Q-36

1.0

0.5 1Q-13 / 1Q-35

1.5

1.0

1Q-12 / 1Q-34

2.0

1.5

1Q-11 / 1Q-33

2.5

2.0

1Q-10 / 1Q-32

3.0

2.5

1Q-09 / 1Q-31

3.5

3.0

1Q-08 / 1Q-30

4.0

3.5

1Q-07 / 1Q-29

4.5

4.0

1Q-06 / 1Q-28

5.0

4.5

1Q-05 / 1Q-27

5.0

Source:  Federal Reserve Board of Governors.

Figure 9.3  Short-­term interest rates5 (quarterly, Great Depression 1Q-­ 1927 to 4Q-­1941; Great Recession 1Q-­2005 to 2Q-­2015) concept of the multiplier, would lead to further increases in overall output, employment and income. In Figure 9.3 I have plotted the key indicator of monetary ease, short-­ term interest rates, for the years immediately preceding and including both the Great Depression and the Great Recession. Pretty amazing! Remembering that the Federal Reserve System was created in 1913, interest rates fell from some 6 percent in 1929 to less than 1 percent during the next decade. In 1933, the dollar was devalued by almost 60 percent in terms of gold and foreign currencies. In the last decade from 2005 through 2015, short-­term interest rates fell from about 5 percent in 2007 to near zero from 2009 on. The monetary base rose as never before, and for the beginning years the US dollar was weak. The housing market – the sine qua non of the US economy – is the primary area of the economy that the Fed wants to stimulate through low interest rates, as homebuilding and homeownership are integral to so many facets of the total economy. The bond market has traditionally been a relatively free market where individual market participants could express

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their expectations for future events and interest rates by buying and selling bonds. Thus, the ten-­year bond yield would reflect the market’s average expected annualized nominal return over the full ten-­year period of that bond’s duration (risk-­adjusted, of course). Anyone who believed yields should be higher could always sell bonds, thus putting downward pressure on bond prices and raising yields. On the other hand, anyone who believed yields should be lower could buy bonds, thereby pushing bond prices higher and yields lower. When buyers balance out sellers, the bond market should reflect the risk-­adjusted balance, and yields of any maturity should reflect the market’s collective expected nominal return over the period of maturity of that bond. Once the Federal Reserve started quantitative easing in September of 2008, however, the bond market began to reflect less and less of market participants’ expectations of the future and more and more the interest rate manipulations of the Federal Reserve. In my opinion, the Federal Reserve’s actions post-­September 2008 have not helped the economy to recover. In addition, the Federal Reserve’s actions have also resulted in a Fed balance sheet at considerable risk of insolvency and unable to contain inflation if inflation ever were to rear its ugly head again.6 To see just how the Fed’s actions have hurt the economy, imagine a simple demand curve and a simple supply curve plotted against price (the vertical axis) and quantity (the horizontal axis) (Figure 9.4). The demand curve D goes from upper left to lower right, and the supply curve S goes from lower left to upper right. The two curves intersect at a price P* and at a quantity Q*. At (P*,Q*) demand and supply are in equilibrium. Neither

Price (Interest Rate)

S

P* PL

point 1

point 2

D QL

Q*

Quantity

Figure 9.4  Supply and demand: price below equilibrium

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demand nor supply by itself can determine either price or quantity, but together determine both price and quantity. This is the point where free markets lead us. In the words of Professor Alfred Marshall, comparing demand and supply intersections to a pair of scissors: We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility [the demand curve] or cost of production [the supply curve]. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.7

But now let’s imagine that the Fed does what it did starting in September 2008. Quite simply, it started to manipulate prices (interest rates) by intervening in the bond markets through three successive rounds of quantitative easing and one round of Operation Twist. These price manipulations weren’t minor either – they were huge. The Fed literally forced interest rates to be way below where they would have been in a free market. Their rationale was to keep interest rates low to stimulate housing. Going back to Figure 9.4, you can quickly see what happens if prices are pushed below the equilibrium price of P*. By pushing prices down to PL, demand would be a lot higher at PL (point 2) and supply would be greatly reduced (point 1). With supply and demand no longer in equilibrium, you need a theory of the allocation of frustrations in order to determine whether the new price and quantity will lie on the supply curve (point 1) or on the demand curve (point 2). As linear programmers know, the adjustment stops at the first constraint. To see what I mean, let’s imagine that a king in the Middle Ages has decided to execute his court jester and is considering the execution options at his disposal. Wanting to be perfectly certain that his order of execution goes off without a hitch, the king chooses to have his witch poison the jester with a concoction known to lead to death in precisely 24 hours. The jester is then hanged at the gallows immediately after the witch administers the poison. If the rope at the gallows is strong, the hanging represents the operational constraint because it will be the immediate cause of death of the jester. If, instead, the jester is saved and escapes to the forest, the poison will soon become the operational constraint. In the case of mortgages, the first constraint is the supply curve, which places us at point 1.8 That is to say output, instead of increasing to where it would be were the demand curve operational, will decline to the supply curve at QL. In other words, pushing interest rates down below equilibrium

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Price (Interest Rate)

S PH

point 1

point 2

P*

D QL

Q*

Quantity

Figure 9.5  Supply and demand: price above equilibrium reduces the quantity of private bonds (mortgages) supplied to the market. And even though demanders want to borrow more, suppliers are unwilling to supply as much. Said differently, who in their right mind would want to write a 30-­year fixed-­rate mortgage loan at today’s rates? No one! Quantity falls below the equilibrium quantity to QL. So much for low interest rates stimulating housing production. A similar story unfolds when prices are pushed above their equilibrium level. At higher prices, suppliers are going to supply more, but demanders withdraw. Therefore, above equilibrium prices the demand curve dominates and below equilibrium prices the supply curve dominates. If you force a price above equilibrium (Figure 9.5), you won’t be constrained by the supply curve any longer; you will be constrained by the demand curve (point 1 in Figure 9.5). In this case you will still get less output (QL), but this time at a higher price (PH). Therefore, whenever a government agency enters a market and pushes the price away from the equilibrium price – either up or down – the quantities of the good fall. The Fed, by pushing interest rates down, actually curtailed the housing market. Tax rate increases on the rich don’t actually fit into the Keynesian economic model per se, but are always adopted by Keynesians to foment class warfare. This “soak the rich,” they’ll agree, is not good economics; but it’s damn good politics which keeps Keynesians in power. To rationalize their position, Keynesians like to argue that “Tax rate increases on the rich don’t

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Table 9.1 Top statutory tax rates: Great Depression versus Great Recession Year

Personal Income

Capital Gains

Corporate Income

Year

Personal Income*

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

24% 25% 25% 63% 63% 63% 63% 79% 79% 79% 79%

12.5% 12.5% 12.5% 12.5% 12.5% 18.9% 18.9% 23.7% 23.7% 15% 15%

11% 12% 12% 13.75% 13.75% 13.75% 13.75% 15% 15% 19% 19%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

36.45% 36.45% 36.45% 36.45% 36.45% 36.45% 36.45% 41.05% 41.05% 41.95% 41.95%

Capital Corporate Gains Income 15% 15% 15% 15% 15% 15% 15% 15% 15% 23.8% 23.8%

35% 35% 35% 35% 35% 35% 35% 35% 35% 35% 35%

Note:  * Personal income tax rates include the employee-­paid portion of the Medicare payroll tax which is not capped at certain income levels. For 2013 and 2014, this rate includes the 0.9 percent “Additional Medicare Tax” which was part of the Affordable Care Act legislation.

really affect the earning or spending behavior of the rich all that much, but they do raise tax revenues and higher tax rates on the rich, which we all agree, are fair.” When push comes to shove, Keynesians also will argue that there is a second-­order effect on aggregate spending. The poor, they say, spend more of each additional dollar of income than do the rich. Therefore, when income is redistributed from rich to poor, total aggregate demand increases by the difference in spending proclivities. Table 9.1 compares the highest (on the rich) statutory tax rates for personal income, capital gains, and corporate income for the Great Depression and Great Recession years of 1929–39 and 2004–14, respectively. Just look at what happened. In 1930, Hoover signed into law the largest tax increase on traded products in US history. On January 1, 1932, the highest marginal personal income tax rate rose from 25 percent to 63 percent. The highest personal income tax rate was then raised again on 1 January 1936 to 79 percent. All kinds of other taxes were also raised at both the federal and state levels. The differences in tax policies between the Keynesian periods of 1929–39 and 2004–14 and supply-­side periods of 1921–29 and 1981–89 couldn’t be greater. Supply-­side economics is predicated on incentivizing work, output and employment by improving the marginal rate of substitution between those activities and leisure, idle capacity and unemployment through marginal tax rate reductions. Table 9.2 lists the individual highest

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Table 9.2  Top statutory tax rates: Roaring Twenties and Reagan Eighties Year

Personal Income

Capital Gains

Corporate Income

Year

Personal Income

Capital Gains

Corporate Income

1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929

77% 73% 73% 73% 56% 56% 46% 25% 25% 25% 25% 24%

77% 73% 73% 73% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5%

12% 10% 10% 10% 12.5% 12.5% 12.5% 13% 13.5% 13.5% 12% 11%

1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

70% 70% 70% 70% 70% 50% 50% 50% 50% 50% 38.5% 28%

39.875% 39.875% 28% 28% 20% 20% 20% 20% 20% 20% 28% 28%

48% 48% 46% 46% 46% 46% 46% 46% 46% 46% 40% 34%

marginal tax rates on personal income, capital gains and corporate income by year for each year of the two supply-­side eras. Just look at what happened. If it’s tax cuts you wanted then during these two periods it’s tax cuts you got. In the Reagan era – from, say, 1977 through 1988 – the highest personal income tax rate went from 70 percent to 28 percent, and brackets were indexed for inflation. The highest capital gains tax rate went from near 40 percent to 20 percent and then back up to 28 percent while the corporate tax rate fell from 48 percent to 34 percent. Not to be outdone, the Roaring Twenties ushered in massive cuts in tax rates as well. The highest personal income tax rate, for example, which had peaked in 1918 at 77 percent, fell all the way down to 24 percent in 1929. That’s amazing. Tariffs and quotas also often accompany Keynesian prescriptions for prosperity. Higher tariffs, like devaluations, they argue, incentivize Americans to buy less from abroad and buy more at home, thereby stimulating demand for domestic products at the expense of demand for foreign products. This “improvement” in the trade balance also gets magnified according to the Keynesian mantra by their omnipresent multiplier. In Figure 9.6 I have plotted the US effective tariff rate pre and post the Smoot–Hawley Tariff legislation and total US trade, exports plus imports, as a share of US GDP. As you can see from Figure 9.6, the huge increase in tariffs brought on by the Smoot–Hawley Tariff is precisely coincident with a more than halving of total US trade. And trade, by the way, is part of the returns to income from working and investing. People work and invest to buy foreign

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% 22

% 22

20

20

18

18

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14

14

12

12

10

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6

4 2

2

1939

1938

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1931

1930

1929

1928

1927

Total Trade (Imports+ Exports) as a % of GDP 1926

1925

0

4

Tariffs and Duties Collected as a % of All Imports

0

Source:  US International Trade Commission, UN.

Figure 9.6  Tariffs and duties collected as a percentage of all imports versus total trade (imports + exports) as a percentage of GDP (annual, tariffs 1925 to 1939; total trade 1925 to 1938) products, and, as such, a tax on trade is precisely equivalent to taxes on income. The Smoot–Hawley Tariff was the precipitous event leading up to the Great Depression.9 And last, if not least, government spending as a share of GDP rose like mad during both the Great Depression and the Great Recession. Keynesians advocate increased government spending – the more the better. Again, their logic is to stimulate aggregate demand which, to them, is the

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What’s wrong with Keynesian economists? ­175 % 40 Great Depression

19

39

Great Recession

18

38

30

9

29 1940 / 2014

10 1939 / 2013

31

1938 / 2012

11

1937 / 2011

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1936 / 2010

12

1935 / 2009

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1934 / 2008

34

13

1933 / 2007

14

1932 / 2006

35

1931 / 2005

15

1930 / 2004

36

1929 / 2003

16

2002

37

2001

17

Great Recession Gov't Spending as a % of GDP

% 20

2000

Great Depression Gov't Spending as a % of GDP



Source:  US Bureau of Economic Analysis.

Figure 9.7 Government spending as a percentage of GDP (annual, includes federal, state, and local spending; NIPA-­Basis, Great Depression 1929 to 1940, Great Recession 2000 to 2014) increase in government spending times the multiplier. By putting more spending power in people’s hands, especially lower-­income people’s hands, aggregate demand will increase, as will the economy, output and employment. Voila. There you have it – their recipe for economic prosperity. In Figure 9.7 I have plotted total government spending as a share of GDP for the periods encompassing both the Great Depression and the Great Recession. Government stimulus spending is the single most important policy instrument in the Keynesian arsenal. Without further ado, Keynesians believe that in times of underachievement, an additional dollar of government spending will have a magnified impact on output and employment. As a result, as seen in Figure 9.7, from 1929 through 1939 government spending grew from 9.8 percent of GDP to 19.5 percent, and from 2000 through 2009 grew from 30.0 percent of GDP to 38.6 percent. And what were the consequences of these policies? It’s fair to write that the Great Depression was the single worst period in the American economy’s long historical record, followed by the second worst period – called the Great

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Recession. In 1939, President Roosevelt’s Secretary of the Treasury, Henry Morgenthau Jr, had this to say about Keynesian economics: Now, gentlemen, we have tried spending money. We are spending more than we have ever spent before and it does not work . . . I say after eight years of this Administration we have just as much unemployment as when we started . . . And an enormous debt to boot!10

To supply-­ siders, the old adage often repeated by Professor Milton Friedman, “Government spending is taxation,” is their guiding light. Whenever government spends, it takes resources from some and gives those resources to others. For supply-­side economics, cutting government spending is an economic stimulant, while for Keynesians, cutting government spending is a depressant. To illustrate the conceptual error embedded in the idea of government spending as a stimulant – often bundled and labeled as a “stimulus package” – I’m going to use the example that was put forth by Larry Summers when he was lobbying for the stimulus package that was passed by Congress in early 2008. Summers’s package called for a $600 per capita stimulus check to be given to every individual who filed a tax return or, for couples filing jointly, $1,200.11 The total cost of the stimulus package was $170 billion. Let’s focus for a moment on the eligibility requirements. In order to receive a stimulus check, a person doesn’t have to do anything – the recipient gets the transfer payment check just for being there. A stimulus check is technically a payment to people based upon something other than work effort. According to the logic espoused by Larry Summers, the person who receives the transfer payment check of $600 will spend more than they would have spent had they not received that transfer payment check. The next step in the logic is that the additional spending by the people who receive the transfer payment checks will create jobs for people who supply the additional goods that otherwise would not have been purchased. The people who supply the additional goods and services will have higher incomes and thus they, too, will spend more. And there will be a chain, a cascading effect if you will, of demand trickling down, which creates a multiplied stimulus of aggregate demand in the overall economy from the initial stimulus check. The Summers logic is simply an example of the Keynesian concept of a multiplier, where the numerical value of the multiplier in Keynesian terminology is one divided by one minus the marginal propensity to consume [1 ÷ (1 – MPC)]. Real GDP, therefore, is equal to total autonomous

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expenditures times the multiplier. The additional output created by the stimulus is the value of the stimulus times the multiplier.12 What Larry Summers said about the stimulus package is true as far as it goes. If the federal government gives a person $600 and doesn’t require that person to do anything for the money, such as work, that person will spend more than he or she would otherwise have spent. That additional spending, in turn, will create jobs, output, and employment for people who otherwise would not have been employed. That is all true. And there also will be a trickle-­down effect of spending throughout the economy. But this chapter of the story, while true, isn’t the whole truth. In fact, there are two missing chapters to the story. Whenever resources are transferred to people based upon some characteristic other than work effort, those resources have to come from transfer payers. Resources don’t miraculously materialize out of thin air. You can’t have a transfer recipient without having someone who is a transfer payer. What one person receives without working for, another person must work for without receiving. For example, if society produces 100 apples and 10 of those apples are given to people, gratis, then someone has to lose those 10 apples. As economists, we say that the income effects in an economy always sum to zero. Literally, they always sum to zero. The government cannot give anybody anything that the government does not first take from somebody else. While transfer recipients will spend more, transfer payers will spend less. Those people from whom the resources are taken will be poorer and, as a result, will reduce their purchases of goods and services. The reduced spending from the transfer payers, in turn, will disemploy people who had heretofore been supplying those people with goods and services that now are not being purchased. The disemployed suppliers will have lower incomes; and they, in turn, will spend less, leading to a cascading effect of reduced demand in the whole economy. The positive income effects of the transfer recipients, which will boost the economy, will be exactly offset by the negative income effects of the transfer payers. The two income effects will offset each other, dollar for dollar. When it comes to government deficit spending, there is no stimulus in the stimulus package. Ultimately, it is people who are responsible for funding the transfer payment, not the government. Now, the specific concept of offsetting income effects from a transfer payment (or tax rate change, for that matter) is not new – it was brought into macroeconomics long ago by the French economist Léon Walras.13 My favorite example of Walras’s point is that if the price of apples rises, apple growers will be wealthier, they will have higher incomes, and they will spend more on goods and services. But if the price of apples rises, apple

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consumers will be poorer, their incomes will be lower, and they will spend less. The income effects for apple growers and apple consumers literally offset each other to the 5,676th decimal place, by the hour, by the day, by the week, by the month, and by the year. It’s basic math and accounting. There are no lag effects where one group happens to respond faster than another. It just doesn’t happen that way. While the income effects in an economy always sum to zero, the substitution effects do not.14 All substitution effects resulting from a stimulus are in the same direction for every participant, and therefore accumulate. In the example I used to illustrate Léon Walras’s principle, if the price of apples rises, the higher apple prices will incentivize growers to produce more apples and apple consumers to consume fewer apples. Both groups are incentivized to bring apple prices back to where they had been. It is substitution effects that assure us that the stimulus plan à la President Obama actually hurts the economy. Substitution effects in the case of the stimulus plan really are as simple as the following: if you pay people not to work and tax people who do work, don’t be surprised if lots of people aren’t working. If a government stimulus program gives people money only if their income is below a certain threshold, those people are incentivized to stop supplying work effort as they approach the income limit. At the same time, those people who are supplying the goods and services in order for the government to provide the stimulus now find that their work effort is worth less because there are fewer goods and services available to them at any given income. The higher-­income earners are thus also incentivized to substitute away from supplying work effort. Because the substitution effects for those receiving the stimulus and those supplying it move in the same direction, they accumulate, ensuring that the stimulus program actually hurts the economy. In the case where the government taxes the producers to transfer the goods and services to non-­producers, the disincentive for both groups is obvious. But even when the government transfer of goods and services to non-­producers is financed by government debt, the effect is the same on producers, only spread over a longer time period. I had a very hard time explaining the concept of substitution effects back in the early 1970s when I was testifying before Congress on President Gerald Ford’s tax-­rebate plan. While the conceptual error underlying President Ford’s tax-­rebate plan was the same conceptual error as that underlying both President George W. Bush’s and President Barack Obama’s stimulus packages, it was proportionally a whole lot smaller than either President Bush’s or President Obama’s plan. Struggling to explain the substitution effects of government transfer

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payments in plain English, I finally said that if my esteemed colleagues on the stand with me who thought the tax rebate would stimulate the economy were correct, then what is wrong with Congress for proposing only a $600 per-­capita tax rebate? Why just try to boost the economy a little bit? Let’s go for the gold! Let’s create an economic boom. Why not make the tax rebate $1,000 per person? $6,000? $60,000? $1 million? In fact, why don’t we transfer 100 percent of GDP? “Senator,” I asked, “can you imagine what would happen to GDP, if all those people who didn’t work and didn’t produce received everything, and all those people who did work and did produce received nothing? Obviously, GDP for the economy would fall to zero.” Unfortunately, the illustration I used back in the early 1970s is perilously close to what is actually happening today. Again, if an economy produces 100 apples and 10 of those apples are given to people based on some characteristic other than work effort, then the producers of those 100 apples will now receive 10 fewer apples for producing 100 apples. Their incentives for producing 100 apples will be reduced and they will produce fewer apples. How someone can theorize that more apples will be produced is beyond me. To reiterate, the three chapters that Larry Summers should have covered: ●●

●●

●●

Chapter 1, which he did cover, the transfer of resources and spending power to the transfer recipients will stimulate their demand for goods and services. Transfer recipients will spend more. Chapter 2, the transfer payers will reduce their demand for goods and services. The increase in the demand for goods and services of the transfer recipients will be exactly offset by the reduction in the demand for goods and services by the transfer payers. There will be no net stimulus to the economy from a transfer payment. Chapter 3, the substitution effects will reduce the incentives for people to work and produce, and output will fall. C’est ca!

Using our comparison between Keynesian and supply-­ side eras, this point becomes even more clear. As demonstrated, the two eras in which Keynesian policies prevailed – the years surrounding the Great Depression and the Great Recession – were two of the worst eras the US economy has endured. Alternatively, in Figure 9.8 I have plotted government spending as a share of GDP for the Reagan Eighties. During the Roaring Twenties we know government spending did not rise appreciably, but the comparable data for the chart simply don’t exist. Both the Reagan Eighties and the Roaring Twenties were periods of spending restraint, diametrically opposed to the spending patterns of the

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% 40

% 40

39

39

Same scale range as prior spending chart

33

33

32

32

31

31

30

30

29

29 1Q-89

34

1Q-88

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35

1Q-86

35

1Q-85

36

1Q-84

36

1Q-83

37

1Q-82

37

1Q-81

38

1Q-80

38

Source:  US Bureau of Economic Analysis.

Figure 9.8 Total government spending as a percentage of GDP (quarterly, includes federal, state, and local spending; NIPA-­Basis, 1Q-1980 to 4Q-­1988) Great Depression and the Great Recession. And, of course, the Roaring Twenties and the Reagan Eighties were two of the best periods in US history and represent supply-­side economic policies. The evidence for Keynesian economic prescriptions in times of crisis harkens back to another old adage: “Whenever people make decisions when they are either panicked or drunk, the consequences are rarely ­attractive.” If you are as convinced as I am of the healing powers of free markets, or vis medicatrix naturae, then the ideal public policies should be: a) a low rate broad-­based flat tax; b) spending restraint; c) sound money; d) free trade; and e) minimal regulations. And at no time are these healing powers of free markets more important than during periods of crisis. In times of crisis the motto should be “Don’t just stand there, undo something!” History and free markets have our back.

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What’s wrong with Keynesian economists? ­181

NOTES   1. I am not sure that Lord Keynes himself believed the model now bearing his name. As recounted in Bruce Caldwell’s (1998) article “Why didn’t Hayek review Keynes’s General Theory?”, History of Political Economy, 30 (4) (available at: http://public.econ.duke. edu/~bjc18/docs/Why%20Didn’t%20Hayek%20Review%20General%20Theory.pdf), which draws from Hayek’s own writings on Keynes:

In 1952 Hayek recalled [the last conversation he had with Keynes], in which he asked Keynes “whether he was not concerned about what some of his disciples were making of his theories. After a not very complimentary remark about the persons concerned, he proceeded to reassure me by explaining that those ideas had been badly needed at the time he had launched them. He continued by indicating that I need not be alarmed; if they should ever become dangerous I could rely on him again quickly to swing around public opinion – and he indicated by a quick movement of his hand how rapidly that would be done. But three months later he was dead.”

  2. Paul Krugman, “Cranking Up for 2016,” New York Times, 20 February 2015, http:// www.nytimes.com/2015/02/20/opinion/paul-­krugman-­cranking-­up-­for-­2016.html.   3. To quote Robert Frank and Ben Bernanke’s popular intro macroeconomics textbook, “The idea that a change in spending may lead to a significantly larger change in short-­ run equilibrium output is a key feature of the basic Keynesian model.” Robert H. Frank and Ben S. Bernanke, Principles of Macroeconomics, 2nd edn, Boston, MA: McGraw-­ Hill, 2004, p. 346.   4. I often refer to the Reagan/Clinton supply-­side years as one era, as Bill Clinton continued many of Reagan’s supply-­side policies and implemented many of his own – such as pushing the North American Free Trade Agreement (NAFTA) through Congress, eliminating the retirement test on Social Security, and cutting government spending as a share of GDP by more than any other US president in modern times. The supply-­side policies of the Reagan/Clinton era resulted in one of the longest and most impressive economic expansions in history, lasting from the early 1980s through the early 2000s.  5. Great Recession data series is 90-­ Day AA Nonfinancial Commercial Paper rates. Source: Federal Reserve Board of Governors, http://research.stlouisfed.org/fred2/series/ RIFSPPNAAD90NB. Great Depression data series is the rate on four–six-­month prime commercial paper. Source: “Table #120 – Short-­Term Open-­Market Rates in New York City, Monthly 1890–1941,” Banking and Monetary Statistics, 1914–1941, Part I, p. 448.   6. For more on the Fed’s quandary, see Arthur B. Laffer and Ford M. Scudder, “Interest Rate Risk in the U.S. Financial System,” Laffer Associates, March 14, 2013; Arthur B. Laffer and Kenneth B. Petersen, “Huge Fed Balance Sheet Floating Into Uncharted Territory,” Laffer Associates, April 9, 2013; or Arthur B. Laffer and Ford M. Scudder, “The Reserve Risk to Banks,” Laffer Associates, October 17, 2013.  7. Alfred Marshall, Principles of Economics, Book 5, Chapter 3, London: Macmillan, 1890.   8. To find the constraint, start on the vertical axis at the government-­enforced price level and move to the right toward higher and higher quantities. The first curve you hit is the operational constraint.   9. For more discussion on the Smoot–Hawley Tariff’s role in causing the Great Depression, see Jude Wanniski, The Way the World Works, Washington, DC: Regnery, 1978. 10. “May 9, 1930,” Henry Morgenthau Diary, Microfilm Roll #50, Franklin D. Roosevelt Library, Hyde Park, New York, 1939, http://www.burtfolsom.com/wp-­ content/ uploads/2011/Morgenthau.pdf. 11. Now that’s not quite true, according to the initial legislation, as those who made more than a certain amount were ineligible to receive such checks – that is, the stimulus check was “means tested.” 12. Frank and Bernanke, Principles of Macroeconomics, pp. 345–6; N. Gregory Mankiw,

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Principles of Macroeconomics, 4th edn, Mason, OH: Thomson, 2007, pp. 483–6; Roger A. Arnold, Economics, St. Paul, MN: West, 1989, pp. 229–31; Bradley R. Schiller, The Economy Today, 10th edn, Boston, MA: McGraw-­ Hill, 2006, pp. 212–14; William Boyes and Michael Melvin, Economics, 6th edn, Boston, MA: Houghton Mifflin, 2005, pp. 255–63. 13. Léon Walras, Éléments d’économie politique pure, 1874, trans. William Jaffé, Elements of Pure Economics, London: George Allen & Unwin, 1874. 14. Here again the Slutsky equations of microeconomics are instructive. When aggregated over all people, the substitution effects all move in the same direction. They don’t cancel each other out like the income effects; they accumulate.

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10.  Capital, saving and employment George Reisman* There are two fundamental views of economic life. One dominated the economic philosophy of the nineteenth century, under the influence of the British Classical Economists such as Adam Smith and David Ricardo. The other dominated the economic philosophy of the seventeenth century, under the influence of Mercantilism, and has returned to dominate the economic philosophy of the twentieth century, largely under the influence of Lord Keynes. What distinguishes these two views is this: in the nineteenth century, economists identified the fundamental problem of economic life as how to expand production. Implicitly or explicitly, they perceived the base both of economic activity and economic theory in the fact that man’s life and well-­being depend on the production of wealth. Man’s nature makes him need wealth; his most elementary judgments make him desire it. The problem, they held, is to produce it. Economic theory, therefore, could take for granted the desire to consume, and focus on the ways and means by which production might be increased. In the twentieth century, economists returned to the directly opposite view. Instead of the problem being understood as how continuously to expand production in the face of a limitless desire for wealth resulting from the limitless possibilities of improvement in the satisfaction of man’s needs, the problem was erroneously believed to be how to expand the desire to consume so that consumption may be adequate to production. Economic theory in the twentieth century took production for granted and focused on the ways and means by which consumption may be increased. It proceeded as though the problem of economic life were not the production of wealth, but the production of consumption. These two diametrically opposed and mutually exclusive basic premises concerning the fundamental problem of economic life play the same role in economic theory as do conflicting metaphysics in philosophy. Point for point, they result either in opposite conclusions or in the advancement of opposite reasons for the same conclusion. So thoroughly and fundamentally do they determine economic theory that they give rise to two completely different systems of economic thought. 183

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TWO VIEWS OF EMPLOYMENT If one is on the nineteenth-­century, productionist premise, one realizes first of all that there is no such thing as a problem of “creating jobs.” There is a problem of creating remunerative jobs, but not jobs. At all times, the productionist holds, there is as much work to be done – as many potential jobs to be filled – as there are unsatisfied human desires which could be satisfied with a greater production of wealth; and as these desires are limitless, the amount of work to be done – the number of potential jobs to be filled – is also limitless. The employment of more and better machinery, therefore, argues the productionist, does not cause unemployment. It merely allows men, to the extent that they do not prefer leisure, to produce more and thus to provide for their needs more fully and in a better way. Nor does the working of longer hours or the employment of women, children, foreigners, or people of minority races or religions deprive anyone of employment. It simply makes possible an expansion of production. If one is on the twentieth-­century, consumptionist premise, one takes another view of machinery and the employment of more people. One regards every expansion of production as a threat to some portion of what is already being produced. One imagines that production is limited by the desire to consume. One fears that this desire may be deficient and, therefore, that an expansion of production in any one segment must force a contraction of production in some other segment. Hence, one fears that the work performed by machines leaves less work to be performed by people; that the work performed by women leaves less work to be performed by men; that the work performed by children leaves less to be performed by adults; that the work performed by Jews leaves less to be performed by Christians; that the work performed by black people leaves less to be performed by white people; and that the extra work of some means a deficiency of work available for others. Neither the productionist nor the consumptionist desires long hours or child labor. Here, to this extent, both reach the same conclusion. But their reasons are completely different. The consumptionist does not desire them because he thinks there is a problem of what to do with the resulting products, unless other products are to cease being produced and other workers are to become unemployed. The productionist does not desire long hours or child labor because he attaches no value to fatigue or premature exertion. The problem, in the eyes of the productionist, is not what to do with the additional products produced by longer hours or by child labor – only the intense need for the additional products calls forth this additional labor – but how to raise the productivity of labor to a level at which people

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can afford to have time for leisure and to dispense with the labor of their children.

WEALTH THROUGH SCARCITY? Because he imagines production to be limited by the desire to consume (rather than consumption being limited by the ability to produce), the consumptionist values not wealth but the absence of wealth. For example, after World War II, he imagined that the relative absence of houses, automobiles, television sets, and refrigerators in Europe was an asset of the European economy because it represented a large supply of unused consumer desire, thereby supposedly ensuring a strong consumer demand. By the same token, he imagined that the relative abundance of these goods in the United States was a liability of the American economy because it represented a depleted supply of consumer desire, thereby supposedly ensuring only a weak consumer demand. Prosperity depends on the absence of wealth, and poverty follows from its abundance, the consumptionist concludes, because that priceless commodity, consumer desire, more limited in supply than diamonds, is produced by the absence and consumed by the presence of wealth. It is on this principle that the consumptionist relishes war and destruction as sources of prosperity and attributes the poverty of depressions to “overproduction.” The consumptionist does not believe that the destruction of wealth is the only means of achieving prosperity. Though he believes it difficult of accomplishment, he has hopes that the supply of his commodity, consumer desire, may nevertheless be increased by positive measures. One such measure is a high birth rate. By bringing more people into the world, one brings more consumer desire into the world. The existence of a larger number of people, the consumptionist tells businessmen, will make it possible for business to find someone upon whom to unload its otherwise superfluous goods. Business will prosper because its supply of goods will find a counterpart in an adequate supply of desire for goods. In the absence of a high birth rate, or along with a high birth rate, the consumptionist believes advertising may suggest to the otherwise fully sated consumers some new desire. And, on a somewhat different plane, technological progress, the consumptionist argues, may provide new uses for an expanding supply of capital goods which otherwise would find no “investment outlets.” Or, if all else fails, the government may be counted upon to supply an unlimited ­consumption – even in the absence of desire. Or perhaps, the ­consumptionist hopes, a country may be fortunate enough to be in danger

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of attack by foreign enemies and therefore stand under the necessity of maintaining a large defense establishment. In either case, the consumptionist imagines that the government will be able to promote prosperity by exchanging its consumption for the people’s products.

PRODUCTION LIMITS CONSUMPTION The productionist, of course, takes a different view of matters. He argues that the birth and upbringing of children always constitutes an expense to the parents. In raising children, the parents must spend money on them which they otherwise would have spent on themselves. Of course, the parents may, and hopefully will, consider the money better and more enjoyably spent on their children; but still, it is an expense. And if they have a large enough number of children they will be reduced to poverty. This is a fact, the productionist argues, that anyone may observe in any large family which does not possess a correspondingly large income. The presence of children does not make the parents spend more than they otherwise would have, but only spend differently than they otherwise would have. They buy baby food, toys, and bicycles instead of more restaurant meals, a better car, or costlier vacations. There is no stimulus given to production. Production is merely differently directed, to the different distribution of demand. The only increase in production that could take place, the productionist maintains, would be as a result of the parents having to take an extra job or work longer hours to support their children and still be able to maintain their own previous standard of living. And when the children grow up, the additional market which they are supposed to constitute for houses and automobiles and the like will only materialize to the extent that they themselves are able to produce the equivalent of these things and thereby earn the money with which to purchase them. It will only be by virtue of their production, and not by virtue of their desire to consume, that they will be able to constitute an additional market.

ADVERTISING AND THE CONSUMER Advertising, the productionist holds, does not create consumer desire where no desire for additional goods would otherwise have existed. It is not the case that, in the absence of advertising, people would be at a loss as to how to spend their money. Advertising is not required, and would not be sufficient, to rouse vegetables into men. What advertising does is to lead people to consume differently and in a better way than they otherwise

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would have. Advertising is a tool of competition, and, as such, for every competing product whose sale is increased by it, there is another competing product whose sale is decreased by it. The consumptionist’s attitude toward advertising brings into clear relief some further corollaries and implications of his basic premise. His estimate of advertising, like that of war and destruction, is ambivalent – and necessarily so. On the one hand, he approves of it, on the grounds that by creating consumer desires it creates the work required to satisfy those desires. However, this very belief – that advertising creates desires where absolutely no desires would otherwise exist – also makes him condemn advertising, for if it were true that, in the absence of advertising, men would be perfectly content with very little, the desires created by advertising must appear to be only superficial and basically unnecessary and unnatural. And this is precisely how the consumptionist regards such desires. In his eyes, all desires men have for goods, beyond what is necessary to make possible bare physical survival and a vegetative existence, represent an unnatural taste for “luxuries.” These desires the consumptionist considers to be inherently unimportant. Their only justification is the creation of work. The consumptionist’s conception of the greater part of economic activity, therefore, is that it represents senseless motion, with deceit and deception required to make people desire goods for which they have no need, in order to enable them to pass their lives in the production of those very same goods. Paradoxical as it may first appear, it is the productionist who attaches importance to consumer desires. In his view, the desire for “luxuries” is important; it is necessary and natural, for it is nothing but the desire to satisfy one’s inherent needs (including the need for aesthetic satisfaction) in an ever more improved way. It is from the importance which attaches to the satisfaction of the desire for “luxuries,” the productionist maintains, that the importance of the work required to produce them is derived, and not vice versa.

TECHNOLOGY AND CAPITAL GOODS The value of technological progress, the productionist holds, does not lie in the creation of “investment outlets” or “investment opportunities” for an expanding supply of capital goods. If the concept of capital goods is properly understood, as denoting all goods which the buyer employs for the purpose of producing goods which are to be sold, then, the productionist maintains, there is no such thing as a lack of “investment opportunity” for capital goods. So long as more or improved consumers’ goods are desired, there is need of a larger supply of capital goods.

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For example, 10 million automobiles of a given quality require the employment of twice the quantity of capital goods – twice the quantity of steel, glass, tires, paint, engines, and machinery – in their production as do 5 million automobiles. If the quality of the automobiles is to be improved, then a larger quantity of capital goods is required for the production of the same number of automobiles. For example, a given number of cars of Chevrolet quality require a larger quantity of capital goods in their production than the same number of cars of Volkswagen quality; the same number of cars of Cadillac quality require still a larger supply of capital goods; and the same number of cars of Rolls-­Royce quality require yet an even more enlarged supply. The identical principle applies to houses of different size and quality. A given quantity of eight-­room houses of a given quality requires the employment of a larger supply of capital goods than the same number of seven-­ room houses of the same quality. A given number of brick houses requires a larger supply of capital goods than the same number of wooden houses of the same size; the bricks or any more expensive material constitute a larger supply of capital goods because a larger quantity of labor is required to produce it. The principle applies to food and clothing, to furniture and appliances, to every good. So long as more of any consumer’s good is desired, so long as not every consumer’s good that is produced is of the very best known quality, there is a need for a larger supply of capital goods.

AS TECHNOLOGY ADVANCES It is not the case that in the absence of technological progress the supply of capital goods would continue to expand, but find no “investment outlet.” It is not the case that what we have to fear from a lack of technological progress is a flood of goods in which every car produced will be the equivalent of the finest known model Rolls-­Royce; in which every house that is built will be a palatial mansion; in which every suit of clothes produced will be fit for the Duke of Windsor; and in which every morsel of food will be a rare delicacy, and that then we shall be at a loss as to how to employ our expanding supply of capital goods. On the contrary, what we have to fear from a lack of technological progress, the productionist argues, is that we shall not have an increase in the supply of capital goods, that we shall not be able to exploit any considerable portion of the virtually limitless “investment outlets” which already exist within the framework of known technology. The value of technological progress, the productionist maintains, consists in the fact that it enables us to obtain a larger supply of capital goods,

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and not that it solves the problem of what to do with a larger supply. The technological advances which made possible the canal building and railroad building of the nineteenth century and the development of the steel industry were valuable not because they absorbed capital goods, as the consumptionist maintains, but because they made possible the accumulation of capital goods. The consumptionist does not realize that capital goods can only be expanded in supply by means of an expansion in their production, and that precisely this is what technological progress makes possible. For capital accumulation to continue for any period of time, technological progress is indispensable. Only it can make possible continued increases in production, and only continued increases in production can make possible continued capital accumulation. The consumptionist is not aware that the very thing which he considers to be the solution to his imagined problem is the source of what he imagines to be the problem. Nor is he aware that when he advances technological progress as the solution to the problem of what to do with more capital goods he is presenting himself with the problem of what to do with the larger supply of consumer goods, which even he admits results from technological progress. The consumptionist is faced, in addition to other quandaries, with the dilemma of explaining how it is that technological progress may raise the rate of profit by, as he puts it, “increasing the demand for capital” while at the same time, as he admits, it increases the production of consumer goods, which, he maintains, lowers the rate of profit through “overproduction.”

CONSUMPTIONISM AND PARASITISM The idea that by consuming his product one benefits the producer by giving him the work to do of making possible one’s consumption is absurd, the productionist holds. Only the use of money lends it the least semblance of plausibility. If it were true, then every slave who ever lived should have cherished his master’s every whim, the satisfaction of which required of him more work. A slave should have been grateful if his master desired a larger house, an improved road, more food, more parties, and so on, for the provision of the means of satisfying these desires would have given him correspondingly more work to do. The belief that the consumption of the government benefits and helps to support the economic system is on precisely the same footing, the productionist argues, as the belief that the consumption of the master benefits and supports the slave. It is a belief the absurdity of which is matched only by the injustice it makes possible. It is the means by which parasitical

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pressure groups, employing the government as an agent of plunder, seek to delude their victims into imagining that they are benefitted and supported by those who take their products and give them nothing in return. The only economic benefit which one can give a producer, argues the productionist, consists in the exchange of one’s own products or services for his products or services. It is by means of what one produces and offers in exchange that one benefits producers, not by means of what one consumes. To the extent that one consumes the products or services of others without offering products or services in exchange, one consumes at their expense. The use of money makes this point somewhat less obvious but no less true. Where money is employed, producers do not exchange goods and services directly, but indirectly. The buyer exchanges money for the goods of a seller. The seller then exchanges the money for the goods of other sellers, and so on. But every buyer in the series must either himself have offered goods and services for sale equivalent to those he purchases or have obtained his funds from someone else who has done so. The fact that in a monetary economy everyone measures his benefit by the amount of money he obtains in exchange for his goods or services is interpreted by the consumptionist to imply that the mere spending of money is a virtue and that economic prosperity is to be found through the creation and spending of new and additional money – that is, by a policy of inflation. In rebuttal, the productionist argues that for everyone who spends newly created money and thereby obtains goods and services without having produced equivalent goods and services, there must be others who suffer a corresponding loss. Their loss, says the productionist, takes the form either of a depletion of their capital, a diminution of their consumption, or a lack of reward for the added labor they perform – a loss precisely corresponding to the goods and services obtained by the buyers who do not produce. The consumptionist’s advocacy of consumption by those who do not produce, to ensure the prosperity of those who do, is, the productionist argues, a pathological response to an economic world which the consumptionist imagines to be ruled by pathology. The consumptionist has always before him the pathology of the miser. His reasoning is dominated by the thought of cash hoarding. He believes that one part of mankind is driven by a purposeless passion for work without reward, which requires for its fulfillment the existence of another part of mankind eager to accept reward without work. This is the meaning of the belief that one set of men desire only to produce and sell, but not to buy and consume, and the inference that what is required is another set of men who will buy and consume, but who will not produce and sell. In the consumptionist’s world, the producers

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are imagined to produce merely for the sake of obtaining money. The consumptionist stands ready to supply them with money in exchange for their goods  – he proposes either to take from them the money he believes they would not spend, and then have someone else spend it, or to print more money and allow them to accumulate paper as others acquire their goods. Hoarding is not the only phenomenon upon which the consumptionist seizes. Where nothing in reality will serve, the consumptionist is highly adept at bringing forth totally imaginary causes of economic catastrophe. Invariably, the solution advanced is consumption by those who have not produced, for the sake of those who have. Always, the goal is to demonstrate the necessity and beneficial effect of parasitism – to present ­parasitism as a source of general prosperity.

THE RATIONALITY OF ECONOMIC LIFE In view of the overwhelming absurdities and contradictions of consumptionism and the gross perversion of values which it engenders, one may only conclude that its support is founded on the interest which it obviously serves: parasitism. This, of course, does not relieve the economist of the duty of identifying the particular errors of every consumptionist argument. It does, however, disqualify every consumptionist as an economist. No scientist, in any field, can accept the view that reality is irrational or that irrational action is required to deal with it. Those economists of the present day who openly and defiantly proclaim that the economic world is “non-­Euclidean” do so happily. That is the way they would like the economic world to be. If they merely believed that economic life appeared to be irrational, and did not at the same time desire it to be irrational, they would never proclaim it to be so in fact. Instead of leaping to the support of consumptionism after only the most casual examination of their subject, they would not rest until they had identified the errors which could make them believe that economic life possessed the appearance of irrationality; and the greater such an appearance might be, the greater would they realize their own ignorance to be, and the harder would they work to overcome it and expose the errors. It is this which ­distinguishes an economist from a Lord Keynes.

CAPITAL AND RECESSION Let us get to the heart of what happens during recession. The economic system is not functioning properly because it has lost capital. Capital is

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the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest. Capital embraces all the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-­manufactures, and finished goods that are owned by business firms. Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumer goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings. The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumer goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.

SAVING AND HOARDING Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services. Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumer goods, or to lend funds to others who will use them for any of these purposes. To the extent that “hoarding” or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets. Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but also occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of

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numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions. All of this represents a reduction in asset values, that is, in the value of accumulated savings. In an economic downturn, people turn to cash in order to avoid further losses of their accumulated savings. Of course, widespread attempts to convert assets other than cash into cash entail further declines in the value of accumulated savings, since the unloading of those assets reduces their value. During the General Financial Contraction, accumulated savings in the economic system fell by several trillion dollars; and nothing could be more incredible than that, in the midst of this, many people – including the great majority of professional economists – were fearful that saving was rising and thought it necessary to stimulate consumption at the expense of saving. Such is the complete and utter lack of economic understanding that prevails. One might expect that a group of people such as most of today’s economists, who pride themselves on their empiricism, would once in a while look at the actual facts of the world in which they live, and, in the midst of the loss of trillions of dollars of accumulated savings, begin to suspect that there might actually be a need to replace savings that have been lost rather than do everything possible to prevent their replacement.

DEPRESSIONS AND CREDIT EXPANSION The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions, and the losses that accompany them, are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not. The fact of its appearing to be new and additional capital creates an exaggerated, false understanding of the amount of capital that is available to support economic activity. Like individuals who believe they have grown rich in the course of a financial bubble, and who are led to adopt a level of living that is beyond their actual means, business firms are led to undertake ventures that are beyond their actual means. For individual consumers, the purchase of an expensive home or automobile in the delusion that they are rich later on turns out to be a major loss in the light of the fact that they cannot actually afford these things and

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would have been better off had they not bought them. In the same way, business construction projects, stepped-­up store openings, acquisitions of other firms, and the like carried out in the delusion of a sudden abundance of available capital turn out to be sources of major losses when the delusion of additional capital evaporates. Credit expansion also fosters an artificial reduction in the demand for money for cash holding, which sets the stage for a later rise in the demand for money for cash holding, such as was described a few paragraphs ago. The reduction in the demand for money for cash holding occurs because, so long as credit expansion continues, it is possible for business firms to borrow easily and profitably and thus to come to believe that they can substitute their ability to borrow for the holding of actual cash. The rising sales revenues created by the expenditure of the new and additional money that is lent out also encourages the holding of additional inventories as a substitute for the holding of cash, in the conviction that the inventories can be liquidated easily and profitably. Recessions and depressions are the result of the loss of capital in the ­malinvestments and overconsumption that credit expansion causes. The losses are then compounded by the rise in the demand for money for cash holding that subsequently follows. They can be further compounded by reductions in the quantity of money as well, such as would occur if the losses suffered by banks resulted in losses to the banks’ checking depositors. The vast majority of people – including, of course, most professional economists – are ignorant of the actual nature and cause of the financial crisis. This is because they are ignorant of the role of capital in the ­economic system. They are all Keynesians. The crisis did not originate in any sudden refusal of consumers to consume, or in any surge in unemployment. To the extent that ­unemployment is growing and consumption is declining, they are both the consequence of the economy’s loss of capital. The loss of capital is what precipitated a reduction in the availability of credit and a widening wave of bankruptcies, which in turn has resulted in growing unemployment and a decline in the ability and willingness of people to consume.

WHAT ECONOMIC RECOVERY REQUIRES What all of the preceding discussion implies is that economic recovery requires that the economic system rebuild its stock of capital and that, to be able to do so, it needs to engage in greater saving relative to consumption. This is what will help restore the supply of credit and thus help put an end to financial failures based on a lack of credit.

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Recovery also requires the freedom of wage rates and prices to fall, so that the presently reduced supply of capital and credit becomes capable of supporting a larger volume of employment and production. Recovery will be achieved by the combination of more saving, capital, and credit along with lower wage rates, costs, and prices. In addition, recovery requires the rapid liquidation of unsound investments. If borrowers are unable to meet their contractual obligation to pay principal and interest, the assets involved need to be sold off and the proceeds turned over to the lenders as quickly as possible, in order to put an end to further losses and thus salvage as much capital from the debacle as possible. Economic recovery requires greater saving and the accumulation of fresh capital, to make up for the losses caused by credit expansion and the malinvestment and overconsumption that follow from it. Yet the imposition of “stimulus packages” results in the further loss of capital. The Keynesians not only do not know this, but also would not care even if they did know it. Because of their ignorance of the role of capital in the economic system and resulting inability to see even the clearest evidence that suggests it, the Keynesians can conceive of no cause of a recession or depression but an insufficiency of consumption, and no remedy but an increase in consumption. This is the basis of their calls for “stimulus packages” of one kind or another. They assume that the economic system always has enough capital – indeed, that it is in danger of having too much capital – and that the problem is simply to get it to use the capital that it has. The way that this is done, they believe, is to get people to consume. Additional consumption will be the “stimulus” to new and additional production. When people consume, the products of past production are taken off the shelves and disappear from the stores. These products, the Keynesians believe, now require replacement. Hence, the shops will order replacement supplies and the manufacturers will turn to producing them, and thus the economic system will be operating again and recovery will be achieved, provided the “stimulus” is large enough. The essential meaning of a “stimulus package” is the government’s financing of consumption – indeed, practically any consumption, by anyone, for almost any purpose – in the conviction that this will cause an increase in employment and production as the means of replacing what is consumed. Despite talk of avoiding wasteful spending and being “careful with the taxpayers’ money,” the truth is that, from the point of view of the advocates of economic stimulus, the bigger and more wasteful the project, the better.

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Indeed, no one could be more clear or explicit concerning the nature of government “fiscal policy” and its “stimuli” than Keynes himself, who declared (1936: 129) that: “Pyramid building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.” Acts of sheer destruction, such as wars and natural disasters, appear as beneficial to Keynes and his followers for the same reason the “stimulus” of government-­financed consumption appears beneficial. This is because they too create a need for replacement, and thus allegedly result in an increase in employment and production. So widespread is this view that one can very often hear people openly express favorable opinions about the alleged economic benefits of such things as earthquakes, hurricanes, and even wars.

STIMULUS PACKAGES MEAN MORE LOSS OF CAPITAL Despite the fact that what the economic system needs for recovery is saving and the accumulation of new capital, to replace as far as possible the capital that has been lost, the effect of stimulus packages is further to reduce the supply of capital, and thus to worsen the recession or depression. The reason that stimulus packages cause a further loss of capital is that their starting point is the consumption of previously produced wealth. That wealth is part of the capital of the business firms that own it. The stimulus programs offer money in exchange for this wealth and capital. But the money they offer does not come from the production of any comparable wealth by the government or those to whom it gives money – wealth which has had to be produced and sold and thus put into the economic system prior to the withdrawal that now takes place. The starting point for the government and its dependants is an act of consumption, which means a using up, a loss of previously existing wealth in the form of capital. The supporters of stimulus packages look to the fresh production that is required to replace the wealth that has been consumed. It will require the performance of additional labor. They are delighted to the extent that this fresh production and additional employment materialize. They believe that at that point their mission has been accomplished. They have succeeded in generating new and additional economic activity, new and additional employment. The only shortcoming of such a policy, they believe, is that it may not be applied on a sufficiently large scale. Unfortunately, there is something they have overlooked. And that is the fact that any fresh production and employment that results is

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incapable by itself of replacing the capital that was consumed in starting the process. The reason for this is that all production, including any new and additional production called into being by stimulus packages, itself entails consumption. And this consumption tends at the very least to approximate the fresh production and, indeed, is capable of equaling or even exceeding it. The effect of capital decumulation, whether caused by stimulus ­packages or anything else, is a reduction in the ability of the economic system to produce, to employ labor, and to provide credit, for each of these things depends on capital. The reduced ability to produce and employ labor may not be apparent in the midst of mass unemployment, but it will become apparent if and when economic recovery begins. At that point, the economic system will be less capable than it otherwise would have been, because of the reduction in its supply of capital. Real wages and the general standard of living will be lower than they otherwise would have been. And, all along, the ability to grant credit will be less than it otherwise would have been.

STIMULUS PACKAGES ARE A DRAIN ON THE REST OF THE ECONOMIC SYSTEM Even though stimulus packages may be able to generate additional ­economic activity, they cannot achieve any kind of meaningful economic recovery. Their actual effect is the creation of a system of public welfare in the guise of work. That is in the nature of employing people not for the sake of the products they produce but having them produce products for the sake of being able to employ them. But stimulus packages are much more costly than simple welfare. On top of the welfare dole that allows unemployed workers to live, stimulus ­packages add the cost of the materials and equipment that the workers use in producing their pretended products. The work created by stimulus packages is a make-­believe work that is carried on at the expense of the rest of the economic system. It draws ­products and services produced in the rest of the economic system and returns to the rest of the economic system little or nothing in the way of goods or services that would constitute value for value or payment of any kind. In other words, stimulus packages and the needless work they create cause the great majority of other people to be poorer. I have already shown how they cause them to have less capital. Shortly, I will show how they also cause them to consume less.

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RISING PRICES IN THE MIDST OF MASS UNEMPLOYMENT If economic recovery is to be achieved, the first thing that must be done is to stop stimulus packages and undo as far as possible any that are already in progress. This is because their effect is to worsen the problem of loss of capital that is the underlying cause of the economic crisis in the first place. Unfortunately, they are not likely to be stopped. If they are i­ mplemented, especially on the scale already approved by Congress, the effect will be a decumulation of capital up to the point where scarcities of capital goods, including inventories of consumer goods in the possession of business firms, start to drive up prices. Higher prices of consumer goods will result not only from scarcities of those goods (which, of course, are capital goods so long as they are in the hands of business firms) but also from scarcities of capital goods further back in the process of production. Thus a scarcity of steel sheet will not only raise the price of steel sheet but will also carry forward to the price of automobiles via the higher cost of producing automobiles that results from a rise in the price of steel sheet. Likewise, a scarcity of iron ore will carry forward to the price of steel sheet, which, again, will carry forward to the price of automobiles. And, of course, the pattern will be the same throughout the economic system, in such further cases as oil and oil products, cotton and cotton products, wheat and wheat products, and so on. A rise in the prices of consumer goods is capable of stopping further capital decumulation stemming from the stimulus packages. When the point is reached that additional funds spent on consumer goods serve merely to raise their prices, then no additional quantities of them are sold. The same quantities are sold at higher prices. This ends the decumulation of inventories. From this point on, the buyers who obtain their funds from the government consume at the expense of people who have earned their incomes but now get less for them. Once inventories become scarce in relation to the spending for goods, all the funds that the government has been pouring into the economic system become capable of launching a major increase in prices. This rise in prices can take place even in the midst of mass unemployment. This is because the abundance of unemployed workers does nothing to mitigate the scarcity of capital goods that has occurred as the result of the attempts to stimulate employment. Even though rising prices can deprive stimulus packages of the ability to cause further capital decumulation, the inflation of the money supply by the government results in continuing capital decumulation. In large part, this occurs as the result of the fact that the additional spending resulting

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from a larger money supply raises business sales revenues immediately while it raises business costs only with a time lag. So long as this goes on, profits are artificially increased. Despite the fact that most or all of the additional profits may be required simply in order to replace assets at higher prices, the additional profits are taxed as though they were genuine gains. This impairs the ability of firms to replace their assets. The destructive consequences of this phenomenon can be seen in the transformation of what was once America’s industrial heartland into the “rustbelt.” At the same time, throughout the economic system – starting long before today’s stimulus packages and continuing on alongside them – regular, almost year-­ in, year-­ out government budget deficits do their work of destruction. They cause a continuing diversion into consumption not only of a considerable part of whatever savings might be made out of income but also of the replacement allowances for the using up of plant and equipment and all other fixed assets. Generations of government budget deficits have sucked up trillions of dollars of what would have been capital funds and have gone a long way toward turning America into an industrial wasteland. The blind rush into massive “stimulus packages” is the culmination of generations of economic ignorance transmitted from professor to student in the guise of advanced, revolutionary thinking – the “Keynesian revolution.” The accelerating destruction of our economic system that we are now experiencing is the product of a prior destruction of economic thought. Our entire intellectual establishment has been the victim – the willing victim – of a massive intellectual con job that goes by the name “Keynesianism.” And we are now paying the price.

NOTE * This chapter has been adapted from two previous articles by Dr Reisman: “Production versus consumption” (2006) and “Economic recovery requires capital accumulation, not government ‘stimulus packages’” (2009a).

FURTHER READING Keynes, John Maynard (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Reisman, George (1998), Capitalism: A Treatise on Economics, Ottawa, IL: Jameson Books. Reisman, George (2006), “Production versus consumption,” Mises Daily website, 17 March, https://mises.org/library/production-­versus-­consumption.

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Reisman, George (2008), “Standing Keynesian GDP on its head: saving not consumption as the main source of spending,” Mises Daily website, 13  February, https://mises.org/library/standing-­keynesian-­gdp-­its-­head-­saving-­not-­consumpt ion-­main-­source-­spending#4. Reisman, George (2009a), “Economic recovery requires capital accumulation, not government ‘stimulus packages’,” Mises Daily website, 25 February, https:// mises.org/library/economic-­recovery-­requires-­capital-­accumulation-­not-­govern ment-­stimulus-­packages. Reisman, George (2009b), “Standing Keynesianism on its head: as employment increases in response to a fall in wage rates, the rate of profit rises, not falls,” Mises Daily website, 15 April, https://mises.org/library/standing-­keynesianism-­its-­head. Reisman, George (2009c), “The fundamental obstacles to economic recovery: Marxism and Keynesianism,” Mises Daily website, 30 March, https://mises.org/ library/fundamental-­obstacles-­economic-­recovery-­marxism-­and-­keynesianism.

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11. What’s wrong with Keynesian economics? David Simpson 1 INTRODUCTION At the time of writing in September 2015 it looks as if the Western world may be nearing the end of a period lasting several decades in which the principal object of economic policymaking has been the attempted manipulation of aggregate demand to achieve growth and stability. While other areas of policymaking, such as the extension and regulation of international trade, can claim some successes, fiscal and monetary policymaking have lost almost all credibility. Following the financial crisis of 2007–08 and the subsequent recession, the already tenuous links between monetary theory and monetary policy have finally been broken. Central bankers are just making it up as they go along. Likewise, the expectations inspired by the ‘Keynesian revolution’ that the budgets of national governments could be used by wise civil servants and prudent politicians to ‘steer’ their respective economies along paths of stable non-­inflationary growth have proved equally illusory. The results of these experiments in monetary and fiscal mismanagement have led us to our present situation of stagnation of output and investment together with widespread government, corporate and personal indebtedness. Such debts are likely to be liquidated only by a further, perhaps even larger, recession. What happens after that? We can expect a return to some form of anchor for our money supply – maybe a commodity reserve system, or perhaps competing currencies. On the fiscal side, balanced budgets will once again become the norm, although in a political democracy that principle will always be under threat from the willingness of politicians to buy votes. As Lord Salisbury observed, democracy is like putting the cat in charge of the cream jug. Does this mean that we should give up the idea going back almost a century that political management of the money supply and of government budgets is to be preferred to adherence to a set of abstract rules? Perhaps not quite yet; but experience suggests that we lack the knowledge to make a success of it. 201

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For the purposes of this chapter, ‘Keynesian economics’ will mean the type of analysis that is to be found in textbooks under that heading. Specifically, it is the proposition that a fiscal or monetary stimulus to aggregate demand induced by a government will result in a predictable and quantifiable increment in real output and employment in the long run. In other words, Keynesian economics is the belief that you can make an economy grow from the demand side alone. Few people would doubt that, in certain circumstances, a temporary increase in output can be brought about by an exogenous increment in spending. The question at issue is whether a sustained growth of output can be achieved thereby.1 The order of topics addressed in this chapter will be as follows. The next section will sketch out the theoretical background, while the third  section will cover macroeconomic policy. Section 4 will explore in more detail a number of the things that are wrong with Keynesian ­economics as we have defined it. We shall then put forward an alternative to the Keynesian perspective, namely recognition that a market economy is a self-­organizing system. This has implications for economic policy. The chapter concludes with an indication of the kind of policy principles that might contribute to an improvement in an economy’s rate of growth and development.

2  THE THEORETICAL BACKGROUND One of the novel features of The General Theory was its formulation of relationships between aggregate economic variables. These supposed aggregate relationships were subsequently located by Hicks and others within a static equilibrium model. Whatever was lost in this way was thought to be outweighed by gains in allegorical simplicity and analytical rigour.2 Unfortunately the use of equilibrium analysis left the central Keynesian proposition, namely that only a government-­induced stimulus to aggregate demand could restore full employment in a market economy, vulnerable to theoretical refutation. The existence of the ‘real balance’ effect could be used to demonstrate that cutting money wages would restore full employment. Those who wish to deny the efficacy of wage cutting as a remedy for recession have therefore been obliged to abandon the static equilibrium model and rely instead on the dynamic effects of falling wages and prices on expectations, or else resort to ad hoc-­kery. So long as it continues to be framed in terms of equilibrium theory, the Keynesian Revolution appears to have achieved nothing. The macroeconomic framework that it had initiated has been colonized by

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neoclassical economists. By introducing further restrictive assumptions (a single representative agent and so-­called ‘rational’ expectations), the neoclassicals have been able to show, at least to their own satisfaction, that any policies of stimulating aggregate demand by whatever means would be ineffective. Since the mid-­1950s, macroeconomic theorizing evolved from what has been aptly called ‘hydraulic Keynesianism’ into dynamic stochastic general equilibrium (DSGE) models of the economy. In the process, this type of theorizing has come to dominate mainstream economics, absorbing both Keynesians and neoclassicals within the same methodological paradigm. Neoclassicals insist that changes in monetary conditions can have no effect on real outcomes, whereas Keynesians invoke ‘price stickiness’ and other rigidities to come to different conclusions. Despite longstanding and convincing objections to the DSGE model,3 on the eve of the financial crisis of 2007–08 it commanded almost universal support within the mainstream of the economics profession. The unquestioning nature of this support has been compared by Roger Koppl to John Stuart Mill’s endorsement of the cost-­of-­production theory of value shortly before its overturning by the marginalist revolution in the last quarter of the nineteenth century.4 The credibility of mainstream macroeconomic thinking has been fatally undermined, not yet by an alternative theory but by its inability to explain either the proximate or the underlying causes of the crisis of 2007–08. Nor has it been able to offer any explanation for the unexpected duration of the subsequent recession. It is widely acknowledged that the proximate cause of the financial crisis was a loss of confidence on the part of some major financial intermediaries in the ability of counterparties to meet their obligations. Hence the ‘credit crunch’ by which this loss of confidence was transmitted to the real economy. The more fundamental origins of the crisis are to be found in the loose credit and regulatory policies that were pursued in earlier years, permitting an unsustainable boom in house and other asset prices. Neither of these factors appears among the list of variables specified in most DSGE models, so it is not surprising that few academics or policymakers ‘saw the crisis coming’.

3  MACROECONOMIC POLICIES The prolonged recession which followed the financial crisis of 2007–08 has reopened the policy debate. For some time prior to the crisis interest rates, not fiscal policy, had been used to try to manage aggregate demand; but

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after the crash interest rates fell close to zero, where they have remained without producing any discernible response in terms of investment or output. As a result of the recession most Western governments suffered significant budget deficits. They were faced with an urgent policy choice between fiscal contraction – that is raising tax revenues and/or cutting expenditures – and the Keynesian remedy of fiscal expansion. Keynesians argued that the stimulus to aggregate demand provided by continuing to run budgets deficits would restore economic growth, thereby generating higher government tax revenues and lower social security expenditures. This was of course the same choice as had faced policymakers in the slump that followed the financial crisis of 1929. Essentially the same battle lines were drawn again. It is the very issue that Keynesian economics was supposed to have laid to rest. It is as if The General Theory had never been written. In the US a fiscal stimulus amounting to some 4 per cent of GDP was provided in the closing months of the Bush Presidency and the early months of Barack Obama’s first term. In the UK the Labour Government’s budget of November 2008 provided a fiscal stimulus of only about 1 per cent of GDP. In neither country was there more than a sluggish response in GDP. In June 2010 the newly elected Coalition Government in the UK announced its intention to eliminate the current budget deficit within five years by raising taxes and cutting spending. This proposal to embark on a period of sustained fiscal contraction in the midst of a deep recession flew directly in the face of Keynesian orthodoxy. It provoked an immediate backlash from many academic ­ economists. However it received some intellectual support from the results of recent research. Cross-­country statistical comparisons using data from 1980 onwards carried out by Alesina and Ardagna (2009) and by Congdon (2015b) appeared to suggest that, in most of the countries and time periods ­surveyed, episodes of fiscal contraction proved to be expansionary rather than contractionary in terms of output. In other words, when governments embarked on episodes of reducing their budget deficits this was associated with a subsequent growth in GDP – exactly the opposite of what Keynesian theory would have predicted. Keynesian economists were quick to respond. Criticizing these studies, Krugman wrote: Most historical episodes of austerity took place under conditions very different from those confronting Western economies in 2010. For example when Canada began a major fiscal retrenchment in the mid-­1990s interest rates were high. So the Bank of Canada could offset fiscal austerity with sharp rate cuts – not a useful model of the likely result of austerity in economies where interest rates were very low.

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What’s wrong with Keynesian economics? ­205 [I]n 2000 Finland’s budget deficit dropped sharply thanks to a stock market boom which caused a surge in government revenue – but Alesina mistakenly identified this as a major austerity programme.5

But in the same article Krugman presents a chart of his own that is open to similar objections. He plots a measure of austerity (the annual average change in the cyclically adjusted primary surplus) for the period 2009–13 against a measure of economic growth (average annual rate of growth) for several Organisation for Economic Co-­operation and Development (OECD) countries. A negative correlation among the points plotted on the graph is clearly visible. One of these points appears to represent Ireland. When the experience of Ireland in the period concerned is examined more closely it points to a different conclusion from that which Krugman wishes his readers to draw. Following the collapse of its banks in 2008, and the Government’s unwise decision to guarantee all their debts, Ireland underwent a period of draconian fiscal tightening, from which it emerged in 2013. In 2014 it recorded the fastest rate of economic growth of any country in Europe, an achievement that was repeated in 2015. Ireland is surely the ‘poster boy’ for ‘expansionary fiscal contraction’. Krugman’s implicit suggestion that Ireland in 2009, burdened as it was with a huge budget deficit, should have embarked on a programme of further fiscal expansion if it had had its own currency is simply not credible. Debates need to be settled by appeals to the evidence; but evidence from cross-­country econometric comparisons can be misleading unless they are accompanied by a narrative of each episode that includes details of the country’s circumstances together with a chronology of events. In fact, most econometric studies can be dispensed with altogether, because they exclude factors that may be decisive but which are peculiar to each context. Such studies literally subtract from rather than add to our knowledge of the events concerned. And, of course, statistical parameters for counterfactual narratives cannot be estimated. When qualitative as well as quantitative factors are taken into account, and the chronological sequence of events is dispassionately analysed, a particular episode can sometimes be shown, to the satisfaction of all but the most partisan of observers, to support one side of the debate or the other. Thus in March 1981, when 364 academic economists signed a public statement claiming that the UK Government’s sharply contractionary budget of that month would ‘deepen the depression’, events proved them unambiguously wrong. Subsequently published data showed that the UK economy began to grow again at about the same time that the statement was signed.

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On the other hand, the narrative explaining the behaviour of the UK economy in the period 2010–14 put forward by Krugman and Wren-­Lewis (2015) does appear to fit the known facts better than the official alternative. This Keynesian narrative says that the contractionary Budget of July 2010, which set out a five-­year plan for severe deficit reduction, led to the stagnation of output that lasted for the next three years. Once the pace of fiscal contraction slackened in 2012 (contrary to Chancellor of the Exchequer George Osborne’s original plan), growth resumed in 2013, albeit rather weakly.6

4 WHAT’S WRONG WITH KEYNESIAN ECONOMICS 4.1  The Fundamental Flaws in Macroeconomic Analysis Keynesian economics, in the sense in which that term is used throughout this book, is inseparable from macroeconomics, the method of analysis to which it gave birth and in which it has since been embedded. Keynesian economics is therefore inescapably subject to all the difficulties that are associated with that method. The characteristic feature of macroeconomics is that it is fundamentally ad hoc. It might fairly be described as ‘back-­of-­an-­envelope’ economics. Microeconomic concepts are unjustifiably transposed into a macroeconomic context. Unwarranted assertions are made about the stability of empirical relationships between aggregates, and their unchanging composition is assumed. Macroeconomics places an exclusive reliance on such aggregates as well as on averages. Unfortunately, looking at economic activity exclusively in terms of aggregates and averages obscures rather than assists an understanding of activity in a market economy. The principal defects of the macroeconomic method are three: an inappropriate formalism; the level of abstraction; and the assumption of the unchanging composition of aggregates. Inappropriate formalism can occur when a concept devised for one context is later used in another. So the concept of equilibrium, originally devised for a microeconomic context, is out of place when applied to the economy as a whole. While it may be reasonable to speak of the equilibrium of a household or a firm, or even of an individual market, it is surely too much to expect equilibrium in a whole economy. Where durable and specific capital goods play a significant part, as they do in all advanced economies, the attainment of anything that could plausibly be described as ‘equilibrium’, even momentarily, becomes very unlikely.

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The second major problem of macroeconomic analysis consists in its level of abstraction. While, in general, the acceptable level of abstraction in an analysis depends on the nature of the problem being investigated, one should never abstract from essentials. The baby must not be thrown out with the bathwater. The essential features of a developed market economy include such things as institutions, entrepreneurship, diverse expectations, and the incessant introduction of new goods and services and new processes of production and distribution. All of these elements are normally excluded from macroeconomic analyses: the baby is thrown out while the bathwater remains. The third big difficulty with macroeconomics is the implicit assumption that the aggregates which form the variables of the analysis are of unchanging composition – or, to be more exact, that any variation in their composition will have no effect on outcomes. But the aggregates that are the constituent elements of macroeconomic analysis are themselves the cumulative outcomes of millions of individual interactions. Since these microeconomic interactions seldom repeat themselves on a daily or a monthly basis, let alone annually, there is no reason to believe in their aggregate stability over time. In fact, it seems likely that the changing composition of macroeconomic variables affects the values of other macro variables as much as, or even more than, changes in the values of the aggregates themselves. Suppose, for example, that aggregate investment had an arithmetic value of zero. The effects on the rest of the economy, including other macro variables, would be very different if this measure were the result of all firms investing a zero amount, or if some firms were investing positively while others disinvested. The effects would be different again to the extent that positive investments were complementary to, or competing with, existing capacity.7 The assumption of a constant composition of macroeconomic variables is particularly misleading in the case of two important variables, the state of expectations and profits. The daily fluctuation of prices in financial markets reflects the changing balance of expectations held by individual traders, some of whom are ‘bullish’ while others are ‘bearish’. Contrary to the assumptions of such artifices as the ‘aggregate production function’, there is no such thing as the rate of profit, but only a range of rates of profit that differ widely from one another because of the ever-­changing patterns of price-­cost difference in thousands of different markets, reflecting in part the heterogeneity of the capital stock. A macroeconomic theory of profit therefore makes little sense, while an ‘equilibrium’ rate of profit is an oxymoron – if not an outright contradiction in terms.

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4.2 Context In Chapter 10 of The General Theory, where he discusses the multiplier, Keynes sets out some of the conditions limiting its operation. The most important of these is context. In his words: ‘But clearly it is not possible to carry any generalisation very far.’8 In other words, as we saw in section 3 above, circumstances differ from one time period and one country to another. As the contemporary Keynesian commentator Martin Wolf puts it: ‘Whether or not fiscal expansion is expansionary depends on circumstances.’9 The proposition of course has wider applications. For example, Gottfried Haberler argued that the Austrian theory of the business cycle was not applicable to all recessions: Hayek’s business cycle theory is an impressive structure. It presents an ideal type but it should not be routinely applied to every cycle . . . each cycle is, after all, embedded in its historical environment and is thus influenced by all sorts of forces both random and systematic.10

Haberler believed that the price distortions and malinvestment which Austrian theory emphasizes played only a minor part in causing the Great Depression of 1929–33. These effects were ‘completely swamped’ by the deflationary effects of the collapse of the US banking system as described by the monetarists.11 And Congdon reminds us that ‘in real world conditions in recent ­experience, changes in the quantity of money have smothered changes in the budget deficit as an influence on aggregate demand’.12 On the other hand, Miller suggests that the characteristic Austrian distortions of the production structure played a much larger part in the current crisis than it did in the 1930s. He dismisses the monetarist assumption that the credit expansion of the decade before 2007–08 did not ­seriously distort the real economy as being ‘simply incredible’. For him, as for all Austrians, ‘stability in macroeconomic aggregates can mask price disco-­ordination that can have severe consequences for the economy.’13 What exactly are these distortions? The bank rate in the UK has been held at 0.5 per cent since March 2009. House prices are high, and the number of houses for sale is at a record low. Equity prices seem to be higher than future earnings might justify. On the US stock market the biggest buyers have been companies buying back their own shares with cheap borrowed debt. And in the UK low interest rates have forced companies with defined benefit pension schemes to put cash into their pension funds to keep them technically solvent, money that might

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otherwise have gone into productive investment. Such distortions have been slowly accruing for over six years. It is hard to believe that when interest rates return to more normal levels the consequences of their unwinding will be painless. 4.3 Confidence Just because the state of confidence is intangible and difficult to measure does not mean that it is unimportant, as Krugman has claimed. Keynes himself emphasized the importance of confidence as a factor determining the level of business activity in a market economy. As he wrote in his discussion of the multiplier: ‘with the confused psychology that often prevails, the Government programme [of fiscal expansion] may, through its effect on “confidence” . . . retard other investment unless measures are taken to offset it’.14 It is the confidence factor that may account for the curious fact that the UK Chancellor George Osborne has twice in five years announced a more severe rate of fiscal tightening than he delivered. By the end of the Parliamentary term in 2015 he had failed to eliminate the Government’s budget deficit as he had promised in May 2010 to do. Then in the campaign leading up to the General Election of May 2015 he promised a further round of ‘austerity’. Having won the election, his subsequent budget suggested a slower rate of fiscal contraction than had been promised in the campaign. A possible explanation for this behaviour is that he sought the political credit from promising fiscal prudence, thus building public confidence while in practice avoiding the deflationary risks of too severe a fiscal contraction. His Keynesian critics have attributed the apparent political popularity of fiscal contraction to public ignorance abetted by a dishonest media. They argue that a country that can create its own currency has nothing to fear from running an increased government deficit during a recession, especially when interest rates are low. Those critics should ask themselves why the Labour Government budgets of 2008 and 2009 provided such a miserly fiscal stimulus. The answer can only be that the Government was afraid of provoking a run on sterling. Why should that matter, Keynesians will say, if the selling of sterling can be absorbed by a falling exchange rate? The answer is that once markets lose confidence in a currency it becomes very hard to recover. And a falling exchange rate has adverse consequences in terms of inflation and the costs of borrowing. Even Krugman agrees that a country cannot sustain a large budget deficit indefinitely. Apart from any other considerations, interest payments would eventually swallow up too large a proportion

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of government spending. Countries like Italy that joined the euro did so in large part because they wanted to escape the consequences of falling exchange rates. The early practitioners of macroeconomics, including neoclassical economists like Friedman, took it for granted that government intervention in the market process by means of fiscal or monetary policies could strengthen business confidence. The predictability of government policies, it was thought, could reduce the uncertainty and instability inherent in a system of multiple interdependent markets. What those early macroeconomists did not appear to anticipate was that changes in policy on the part of governments, regulators and central banks would themselves increase uncertainty and thus diminish confidence, resulting in what has come to be known as ‘policy uncertainty’. Since the financial crisis of 2007–08, many of the new policies proposed by governments represent further steps in the direction of direct intervention in markets by monetary authorities, treasuries and regulators. The nature of these interventions is increasingly discretionary rather than rule-­based. Discretionary regulation means that the applicability of a particular rule or regulation may vary from one firm to another in ways that individual firms may be unable to anticipate. From the point of view of the individual business, policy has become more arbitrary. This must surely heighten uncertainty and diminish business confidence. One example of discretionary financial regulation is the 2010 Dodd– Frank Act introduced in response to the financial crisis in the United States. In the UK, a recent government policy change to abolish the Climate Change Levy has led to some well-­publicized losses for investors, and thus has undermined the confidence of potential investors in future government-­supported projects. In both the US and the UK, rates of economic growth have been unusually low since the financial crisis, and in the UK the level of private business investment has been exceptionally low. At the same time, levels of policy uncertainty in those countries have been quite high. It is not unreasonable to suppose that the two factors may be related.

5 THE ECONOMY AS A SELF-­ORGANIZING SYSTEM The chief characteristic of a market economy is that it is a process in historical time characterized by incessant and irreversible change. New goods and services are continuously being introduced, while old ones disappear. New technologies for production and new methods of distribution displace

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old ones. New sources of raw materials are discovered and exploited, and new tastes are acquired or created. Equilibrium models, in contrast, treat the market economy as a structure not a process; they exclude novelty and endogenous change. It therefore seems rather inappropriate to use a static equilibrium model, a class into which most macroeconomic models fall, to try to analyse the workings of a market economy.15 As Marx, Marshall, Mises, Schumpeter and other classical economists have attested, it is this characteristic of continuously changing from within that distinguishes the market economy from all other systems of economic organization.16 In every market economy, up to many millions of people and hundreds of thousands of companies are continuously interacting with each other by buying and selling goods and services, including their personal labour services. Individuals are generally trying to improve their own standard of living. To do that, they may be looking for better-­paying jobs, or even setting up their own businesses. Companies meanwhile are trying to survive, to make profits and, if possible, to increase them. To do this they need to discover what new products consumers will buy, what new processes of production or distribution might be profitable, and what steps they might take to fend off actual or potential threats from their competitors. All market economy participants are therefore obliged to adjust continuously to the changing environment in which they operate, the most important part of that environment being the actions of other businesses and other people. These adjustments are mutual and voluntary; there is no control exercised from the top down. Nevertheless the adjustments themselves are frequently likely to be disruptive to the individuals and businesses concerned. But however destructive change may be to the individual household or business at the bottom of the market economy, what emerges at the top is not chaos or anarchy but what seem like relatively stable and orderly patterns in the movements of the aggregates of output, employment and prices. Despite the fact that in any given year the output of some industries may be rising rapidly whereas in others it is falling, in most advanced economies the levels of aggregate output, employment and output per head grow more or less steadily over long time periods. The annual rate of growth of output per head in Western countries has averaged between 2 and 3 per cent over the past half-­century. Likewise patterns of relative prices and wages change quite slowly at the aggregate level over time. These relatively stable patterns observed on the surface of market economies do not represent exact regularities but rather recurring and persistent patterns of behaviour.

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This is a description of a self-­ organizing system. A self-­ organizing system is one whose elements organize themselves through mutual adaptation of their behaviour at the individual level so that the system as a whole exhibits relatively stable and persistent patterns of behaviour at the aggregate level. A self-­organizing system is really a network of self-­organizing processes, and self-­ organizing processes are pervasive throughout the social and natural worlds. In human societies, self-­organizing processes are to be found in the development of common law, in language, in scientific procedure and in politics as well as in economics. Adam Smith and his eighteenth-­century contemporaries David Hume and Adam Ferguson were among the earliest philosophers to recognize the significance of self-­organizing processes in human societies. But they and their nineteenth-­century successors lacked the analytical apparatus to be able to explain clearly how such processes worked. The development of appropriate methods for analysing such phenomena had to await the work of natural scientists in the 1970s.17 The modern theory of self-­organizing systems, more commonly known as complex systems, is concerned with dynamic nonlinear systems having very many interdependent variables. Because of their nonlinearity the properties of such systems are difficult to investigate without the help of computers. Recent multidisciplinary investigations have advanced our knowledge of the properties of complex systems, and in doing so have shed light on how market economies work.18

6  IMPLICATIONS OF SELF-­ORGANIZATION If we look at the economy as a complex system, this has a number of implications for economic analysis and policy. First of all, in contrast to the determinacy to which equilibrium theory aspires, point predictions can in general be shown not to be possible. In other words, in a market economy we cannot say with confidence what the rate of interest is likely to be in 12 months’ time, or what the level of a stock market index will be. In this respect, the outcomes of complexity theorizing are consistent with what experience has long taught us to expect. On the other hand, some pattern predictions may be possible. For example, we can normally predict with confidence that a sustained rise in the price of a commodity will, in most circumstances, result in a decline in the quantity of that commodity demanded. But even pattern predictions are not always possible. Economists who believe in the efficacy of a fiscal stimulus might take the view that, although the effect of the stimulus cannot be exactly quantified, the direction of change will always be positive. But this cannot be safely assumed.

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As we have seen, there is much empirical evidence in favour of ‘expansionary fiscal contraction’. A finance minister might announce his intention to plan for a budget surplus in the coming year. A decline in real output predicted by the Keynesian multiplier might follow. But, in other circumstances, the minister’s actions might engender a rise in confidence among business investors that could lead to an offsetting increase in output. This illustrates a second characteristic of complex systems, namely that outcomes are heavily context specific. To translate this into principles of policymaking means that general prescriptive rules are unlikely to be helpful. Economic policies need to be tailored to the relevant ­circumstances of a particular region, sector and time period. A third implication of treating an economy as if it were a complex system rather than a machine is an awareness of the possible importance of quite small differences in leads and lags in determining outcomes. Since leads and lags are themselves context specific, and therefore unlikely to be knowable in advance, this helps to explain why prediction in economics, and in human affairs generally, is so difficult. Bringing the foregoing considerations together, the general conclusion must be that economists should be very conscious of the practical limitations of our knowledge. Whatever we may believe, we cannot afford to be dogmatic about it. Does this mean that economists can have nothing to say about economic policy? Not at all. It just means that our recommendations may be more safely embodied in general principles rather than in precise rules.

7  PRINCIPLES OF ECONOMIC POLICY The classical economists of the past were careful to formulate their ideas in the form of broad principles that required interpretation in particular contexts. Even Marshall and Keynes, who were both proficient in mathematics, avoided the temptation to express their ideas with the exactness which that medium requires. Indeed, Marshall went out of his way to spell out the dangers of using mathematics in economic theorizing, a piece of advice resolutely ignored by the neoclassical economists who claim to be his followers. Adam Smith’s first principles for promoting economic growth could hardly have been more stark: Little else is required to carry a state to the highest degree of opulence from the lowest barbarism but Peace, Easy Taxes and a Tolerable Administration of Justice; all the rest being brought about by the natural course of things.19

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As the market and other social institutions have evolved over the succeeding two and a half centuries, things have got a bit more complicated. But in 1989 John Williamson was able to encapsulate his policy advice on how Latin American countries might improve their rates of economic growth in ten principles that he called the Washington Consensus (a name he later came to regret). These principles essentially incorporated what OECD countries had for a number of years considered to be good policy practice.20 Williamson’s principles include both macro-­and microeconomic policies. Following the crash and the recession Koppl (2014) has proposed three very general principles for macroeconomic policy: ●● ●● ●●

long-­term fiscal discipline – no large or prolonged budget deficits, and no bail-­outs; monetary competition; a limited role for government and regulators.

So far as microeconomic policy is concerned, an example of good principles are those set out in the report of the 2002 Hartz Commission established to propose reforms to the German labour market. Implementation of these reforms is generally credited with the subsequent improved performance of the German economy, and they have been widely imitated throughout Europe. The proposition that economic theories and policies might be better formulated as principles rather than as rules is supported by the experience of government regulation of business. If the desire for predictability in government policies is to be reconciled with the need for flexibility of regulation in the face of changing circumstances, then the formulation of principles rather than rules may be the answer.

8 CONCLUSIONS The essential message of Keynes’s General Theory was that, left to itself, a market economy would settle down for prolonged periods at an aggregate equilibrium which fell short of full employment. It was therefore the function of government, by appropriately stimulating aggregate demand, to restore aggregate output to a full employment level. In this way, wrote Hayek later, Keynes and his disciples lent scientific authority to the ‘age-­ old superstition that by increasing the aggregate of money expenditure we can lastingly ensure prosperity and full employment’.21 The failure of Keynesian economics is part of a broader picture of the

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failure of fiscal and monetary policymaking as a whole, of the failure of macroeconomics as whole. Despite their best efforts since the 1930s, central banks and treasuries throughout the world have been unable to deliver that improvement in the stability of output and price levels that had been hoped for. This has not been because of the intellectual weaknesses of the individuals concerned. On the contrary, these organizations have frequently attracted the services of some of the best brains available. It is simply a problem of the distribution of knowledge. Just as central planning failed because it could not adequately replicate the ability of markets to discover, process and distribute new information, so the centralized fiscal and monetary organs of government lack the information required to manipulate successfully aggregate demand in a market economy. Accordingly, we shall have to look again at arrangements that are consistent with the dispersed nature of economic information. For money, this suggests a consideration of commodity reserve systems, or perhaps competing currencies. For fiscal policies, it indicates a return to the principle of balanced budgets.

NOTES   1. A classic example of the transient nature of a fiscal stimulus was the 1936 US Veterans’ bonus payout, amounting to some $300 billion in today’s dollars. It produced a temporary rise in GDP, followed by a return to stagnation in 1937 when the payments dried up. See Stockman (2013), pp. 163–4.   2. Blaug (1997), p. 647.   3. See, for example, Kirman (1992).   4. ‘Happily there is nothing in the laws of value which remains for the present or any future writer to clear up; the theory of the subject is complete’ (Mill, 1848, III, I, ii).   5. Krugman (2015), p. 33.   6. While a Keynesian narrative is more plausible as an economic analysis of the period 2010–14, the government decisively won the political argument thanks to the dialectical ineptitude of the official Opposition.   7. Schumpeter (1954), p. 279.   8. Keynes (1936), p. 121.   9. Wolf (2015), p. 34. 10. Haberler (1986), pp. 421–35. 11. Ibid., p. 427. This monetarist explanation of the causes of the Great Depression is vigorously rejected by Stockman (2013), who argues that it was brought about by the liquidation of debt built up in 1929 and earlier. 12. Congdon (2015a), p. 35. 13. Miller (2009), p. 33. 14. Keynes (1936), p. 120. 15. Many macroeconomic models claim to be ‘dynamic’, but Kohn (2004) has shown ­convincingly that they are not truly dynamic at all. 16. Marx and Engels ([1848] 1955), p. 37; Marshall ([1920] 1962), p. xiii; Mises ([1949] 1963), p. 34; Schumpeter (1942), p. 82. 17. Nicolis and Prigogine (1977).

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18. Anderson et al. (1988); Arthur et al. (1997). 19. Smith (1980), p. 322. 20. Fifteen years later Williamson augmented and updated his principles, by which time they had attracted some abuse from those who disliked their title. Williamson himself agreed they should have been labelled the Universal Convergence rather than the Washington Consensus. See Williamson (2004). 21. Hayek (1978), p. 218.

REFERENCES Alesina, F.A. and S. Ardagna (2009), ‘Large changes in fiscal policy: taxes versus spending’, NBER Working Paper No. 15438, Cambridge MA: National Bureau of Economic Research. Anderson, P.W., K.J. Arrow and D. Pines (1988), The Economy as an Evolving Complex System, Reading, MA: Addison-­Wesley. Arthur, W.B., S.N. Durlauf and D.A. Lane (1997), The Economy as an Evolving Complex System II, Reading, MA: Perseus Books. Blaug, M. (1997), Economic Theory in Retrospect, Cambridge: Cambridge University Press. Congdon, T. (2015a), ‘The Keynesian versus the Monetarist: time to re-­ read Keynes’, Standpoint, March. Congdon, T. (2015b), ‘In praise of expansionary fiscal contraction’, Economic Affairs, 35 (1), 21–34. Haberler, G. (1986), ‘Reflections on Hayek’s business cycle theory’, Cato Journal, 6 (2), 421–35. Hayek, F.A. (1978), New Studies in Philosophy, Politics, Economics and the History of Ideas, London: Routledge and Kegan Paul. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Kirman, A. (1992), ‘What does the representative individual represent?’, Journal of Economic Perspectives, 6 (2), 117–36. Kohn, Meir G. (2004), ‘Value and exchange’, Cato Journal, 24 (3), 303–35. Koppl, Roger (2014), From Crisis to Confidence: Macroeconomics After the Crash, London: Institute of Economic Affairs. Krugman, P. (2015), ‘The austerity delusion’, The Guardian, 29 April. Marshall, A. ([1920] 1962), Principles of Economics, 8th edn, London: Macmillan. Marx, K. and F. Engels ([1848] 1955), The Communist Manifesto, New York: Appleton-­Century-­Crofts. Mises, L. von ([1949] 1963), Human Action, Chicago: Contemporary Books. Mill, J.S. (1848), Principles of Political Economy, London: Longman’s, Green and Co. Miller, R.C.B. (2009), ‘The Austrians and the crisis’, Economic Affairs, 29 (3), 27–34. Nicolis, G. and I. Prigogine (1977), Self-­Organisation in Non-­Equilibrium Systems, New York: Wiley. Schumpeter, J.A. (1942), Capitalism, Socialism and Democracy, London: Allen and Unwin. Schumpeter, J.A. (1954), History of Economic Analysis, New York: Oxford University Press.

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Smith, A. (1980), Essays on Philosophical Subjects, edited by W. Wightman, J. Bryce and I. Ross, Oxford: Clarendon. Stockman, David A. (2013), The Great Deformation, New York: Public Affairs Press. Williamson, John (2004), ‘A short history of the Washington Consensus’, available at http://www.iie.com/publications/papers/williamson0904-­2.pdf. Wolf, M. (2015), ‘The Keynesian versus the Monetarist: an exchange’, Standpoint, March. Wren-­Lewis, Simon (2015), ‘The austerity con’, London Review of Books, 37 (4), 19 February.

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12. Move over Keynes: replacing Keynesianism with a better model Mark Skousen It is now widely agreed that the Keynesian proposition is erroneous of the level of pure theory . . . There always exists in principle a position of full employment equilibrium in a free market economy. (Friedman and Meiselman 1963, p. 167) Keynes is in large measure responsible for the extreme short-­term focus of modern politics, of modern economics, and of modern business . . . Short-­ run, clever, brilliant economics – and short-­run, clever, brilliant politics – have become bankrupt. (Drucker 1986, p. 104) Even though the always clever Keynes temporarily buried J.-­B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away. And, yes, the alleged importance of fiscal policy withers away, too. Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures. (Hanke 2014)

Keynes and Keynesian economists have created and perpetuated a series of myths and misunderstandings that have done more harm than good to countries that adopt them. Underlining their theories are several anti-­ capitalist themes: that a market economy is inherently unstable; that saving is frequently bad; and that consumer spending drives the economy. Policy prescriptions include chronic debt financing, easy money, and progressive taxation. Their model justifies currency depreciation, the consumer society, short-­termism, big government, and the welfare state. For decades, members of the media and the financial community have fallen under the Keynesian spell, emphasizing the importance of demand over supply, of deficits over surpluses, of debt over equity, and of consumption over saving. Nations pay a price for adopting the Keynesian worldview; they tend to grow slower than freer economies. It’s high time we replaced Keynesian macroeconomics with a new model. But what? In this chapter, I discuss the principal defects of Keynes and his theories, and suggest a viable alternative. 218

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Keynes is the most influential and revolutionary economist of the twentieth century, because he succeeded in turning classical economics on its head. Prior to Keynes, the classical model was the “general” theory of the economy as developed over the years by Adam Smith, Jean-­Baptiste Say, David Ricardo, John Stuart Mill, Carl Menger, Alfred Marshall, and other classical economists. It stood for the virtues of thrift, balanced budgets, free trade, low taxes, the gold standard, and Say’s law (capital formation, productivity, entrepreneurship, and the supply-­side are more important than consumer spending, government stimulus and the demand-­side). But then Keynes came along in the 1930s and relegated the classical model of Adam Smith to a “special case,” applicable only in times of full employment. He made his own model of “aggregate effective demand” the “general” theory that would apply whenever labor and resources were underemployed – which, under Keynesianism, could exist frequently and indefinitely. The Keynesian model promoted spending over saving; debt over equity; deficit spending and active fiscal stimulus (public works projects and transfer payments) over balanced budgets; big government over laissez-­faire, including protectionism; and easy money over the inflexible gold standard. I have published several books and papers criticizing Keynesian economics and its influence in the profession (for example, Skousen 1991, 1992). In this chapter, I focus on three wrong-­headed claims by Keynes and the Keynesians: 1. The free-­market economy is inherently unstable. 2. To fight recessions, the federal government should run massive deficits and keep interest rates permanently low. 3. Consumer spending drives the economy (anti-­saving mentality). Let us discuss each one. After this discussion, I will offer a more powerful alternative to the house that Keynes built.

IS THE MARKET ECONOMY INHERENTLY UNSTABLE? First, the idea that the inner workings of a free-­market economy contains the seeds of its own destruction (the contradictions of capitalism) has had many adherents, including Karl Marx, Joseph Schumpeter, and Hyman P. Minsky. During the prolonged Great Depression of the 1930s, Keynes contended that capitalism can be stuck indefinitely at varying degrees of “unemployed

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equilibrium,” depending on the level of uncertainty and “animal spirits” in a fragile financial system. In The General Theory, he claimed that the economy can remain “in a chronic condition of sub-­normal activity for a considerable period without any marked tendency either toward recovery or toward complete collapse” (1936, pp. 249–30). As David Colander and Harry Landreth commented, “The ­depression .  .  . was endemic to the system: the economy was not self-­regulating and needed to be controlled” (1996, p. 16). In the late 1970s, Keynesians developed the Aggregate Supply (AS) and Aggregate Demand (AD) schedules to demonstrate Keynes’s argument. In Figure 12.1, national output – gross domestic product (GDP) – is stuck indefinitely at less than full employment. In reality, the idea of a general equilibrium with unemployed resources makes no sense. Clearly the labor market is not in equilibrium. Something has to give. Subsequent to the Great Depression, when Keynes wrote his magnum opus, economists have shown that the government engaged in many policies that kept business from hiring and discouraged workers from going back to work. See especially Higgs’s seminal article from 1997, “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War” (in Higgs 2009, pp. 3–29). In “The Great Contraction,” the central chapter of their monumental work A Monetary History of the United States, Milton Friedman and Anna Schwartz demonstrated that the fault of the Great Depression lay at

Price Level

AS

AD

Real National Income

Yu Yf

Figure 12.1  AS–AD curves showing equilibrium unemployment (Yu) and full employment (Yf)

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the feet of government, not the animal spirits of market players (Friedman and Schwartz 1963). By ineptly failing to be a lender of last resort, the government-­controlled Federal Reserve allowed the banking system to collapse – and the economy with it. As he summarized in Capitalism and Freedom: “The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy” (Friedman 1962, p. 28). Furthermore, he wrote that: “Far from the depression being a failure of the free-­enterprise system, it was a tragic failure of government” (Friedman and Friedman 1998, p. 233). Had the government provided a stable monetary system and sound banking model, there would have been no Great Depression and no serious business cycle of boom and bust; no cluster of business errors; no liquidity trap; no separation of AS and AD; and no development of the “new economics” of Keynes.

SHOULD THE GOVERNMENT RUN DELIBERATE DEFICITS? But we did suffer a Great Depression, and Keynes came up with a clever, ingenious, and revolutionary model of aggregate demand management in the mid-­1930s that has bedeviled us ever since. In his General Theory, Keynes offered a simple way out of the Depression without resorting to totalitarian measures or destroying individual liberty. Since the cause of the economic contraction was a “lack of effective aggregate demand,” the government had the independent means of restoring aggregate demand through deficit financing and easy money that would encourage consumers to spend money and businesses to hire workers – and thus get the economy going again. Figure 12.2 demonstrates the power of Keynes’s message. By increasing public works, transfer payments and government spending, the AD curve could shift upwards toward full employment. As John Kenneth Galbraith, a Harvard economist and early supporter, wrote: “Here was a remedy for the despair . . . It did not overthrow the system [like Marxist Communism] but saved it” (Galbraith 1965, p. 136). Even Milton Friedman was attracted to Keynes’s message when it first came out. By contrast with the dismal picture [the Austrian laissez-­faire prescription of “doing nothing”], the news seeping out of Cambridge (England) about Keynes’s interpretation of the depression and of the right policy to cure it must have come like a flash of light on a dark night. It offered a far less hopeless

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SRAS

GDP Price Deflator

LRAS

AD

AD’

Real GDP

Figure 12.2  Increased government spending causes aggregate demand (AD) to increase to AD’ and move toward full employment (real GDP) diagnosis of the disease. More importantly, it offered a more immediate, less painful, and more effective cure in the form of budget deficits. It is easy to see how a young, vigorous and generous mind would have been attracted to it. (Friedman 1974, p. 163)

But has the Keynesian solution of deliberately running red ink and building up massive federal debts proven to be a good idea to fight recessions? At first, the evidence was overwhelming positive. Didn’t World War  II vindicate the benefits of massive deficit spending and get us out of the Depression? It certainly convinced the economics profession, which adopted Paul Samuelson’s Keynesian textbook almost universally for the next 30 years.1 Since then, economic historians and economists have revised their ­pro-­Keynesian view of World War II. It turns out that it was not an ideal experiment confirming the benefits of an activist fiscal policy. Was it deficit spending that cured the Depression, or was it an easy-­money policy (the Fed kept interest rates deliberately low and increased the money supply at a 20 percent clip)? During the post-­World War II era, studies by Harvard professor Robert Barro and others have questioned the strength of the fiscal “spending” multiplier. Due to crowding out of private investment, Barro has shown that the US Department of Defense spending

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multiplier is less than one, and may be zero, even during World War II and other post-­war eras (Barro 2009). Keynes was also mistaken in disparaging the power and importance of monetary policy, the Fed’s ability to influence interest rates and the money supply. Keynes was convinced that, during a depressed economy, pumping money into the banking system would increase excess reserves but would not necessarily increase business activity. For the Keynesians “money doesn’t matter.” It would be like “pushing on a string.” But Friedman proved otherwise. “The Great Contraction,” as Friedman and Schwartz called it, “is in fact a tragic testimony to the importance of monetary forces” (1963, p. 300). Their nearly 100-­year study demonstrated time and time again that “money matters.” Even Paul Krugman, today’s strongest advocate of Keynesianism, has admitted that every post-­war business cycle was precipitated by a changing monetary policy by the Federal Reserve. Ultimately, Friedman came to the opposite conclusion to Keynes. According to Friedman’s empirical work, fiscal policy – deficit spending and taxes – did have an impact on the long-­term economic growth rates, but had little impact on the ups and downs of the business cycle. Furthermore, monetary policies – money supply and interest rates – have the greatest impact on the business cycle. Although he died in 2006 and did not live to witness the 2008 financial crisis, undoubtedly he would have opposed the Troubled Asset Relief Program (TARP) and other fiscal stimuli during the Great Recession, while supporting “quantitative easing” and other measures by the Fed to keep the monetary system afloat. Friedman saw little need for an activist fiscal policy when monetary policy could do all the heavy lifting to get us out of a downturn.

THE UNINTENDED CONSEQUENCES OF KEYNES’S PRO-­CONSUMER, ANTI-­SAVING MENTALITY The final unfortunate consequence of Keynesian economics is its anti-­ saving mentality. Under a Keynesian mindset, America has wonderful shopping malls, but poor roads and infrastructure to get to the malls. Roads, bridges, and other infrastructure are in excellent condition in most of Europe because it has emphasized saving and good capital investment. Yet, according to the Robert Poole Jr, Reason Foundation’s expert on roads and infrastructure, half the roads in the United States are substandard. American airports, from Los Angeles to New York, are antiquated and cannot compare to advanced structures built in China, South Korea, and other parts of Asia.

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Another example of Keynesian thinking: we have generous pension programs for the current retired government employees, but children and grandchildren face the heavy burden of financing billions if not trillions of dollars in unfunded liabilities. Former Social Security/Medicare trustee Tom Saving (economist at Texas A&M University) and his colleague Andy Rettenmaier have analyzed the most recent trustees report. Looking indefinitely into the future, the unfunded liability in both programs is $72 trillion. And that assumes the Medicare cuts legislated by ObamaCare hold fast. If they don’t, the unfunded debt will exceed $100 trillion, about six times the size of the entire US economy. Larry Kotlikoff has calculated that expected social security benefits for a 62-­year-­old couple with average income are worth $1.2 million today. And that’s with early retirement. If the couple delays claiming benefits until age 70, their social security wealth is worth $1.7 million; add in Medicare and the total is well above $2 million. Most retirees are entitlement millionaires, even if they don’t have a penny in the bank. Management guru Peter Drucker blames this short-­termism in government and business on Keynesian economics. He writes: “Keynes is in large measure responsible for the extreme short-­term focus of modern politics, of modern economics, and of modern business . . . Short-­run, clever, brilliant economics – and short-­run, clever, brilliant politics – have become bankrupt” (Drucker 1986, p. 104). It’s true that Keynes himself recognized in The General Theory that business investment was the key to economic growth and the business cycle. From Simon Kuznets to Paul Krugman, Keynesians are alert to the fact that the “I” (gross private investment) is the most volatile of part of GDP. Consumer spending (C) and government (G) are relatively stable and rising. Thus business investment is the key to the ups and downs of the business cycle.

WHY GDP IS MISLEADING Unfortunately, the Keynesian data gatherers, starting with Simon Kuznets in the 1930s and 1940s, failed to measure the full level of business spending in the economy. Following Keynes’s lead, they decided to measure “final effective aggregate demand” only, which means calculating the sales of finished goods and services, and not the entire economic activity. GDP is officially defined as “the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports” (emphasis added).

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Using GDP as “the” measure of the economy, the media and economic analysts often misconceive how the economy works. According to the latest data, consumption expenditures represent around 70 percent of GDP in the United States. Government purchases are second at around 18 percent; and private business investment, which includes residential housing, comes in third at 15 percent. By making the standard assumption that GDP measures total economic activity, the unsophisticated j­ournalist has concluded that consumer and government spending are by far the most important sectors of the economy, while business investment rates a poor third. That is why the press constantly declares that “consumer spending drives the economy.” For them, the key to prosperity is found in encouraging a high level of consumption, even if it means going deeply into debt. If consumers cut back spending, and start saving, the economy will sputter. The establishment press is so enamored with consumption that it highlights monthly changes in retail sales, consumer debt, consumer prices, and surveys of consumer confidence, looking for any encouraging signs. After all, doesn’t consumer spending represent two-­thirds of total economic activity? Keynesian economist Hyman Minsky correctly identified consumer spending as the source of Keynesian prosperity: “The policy emphasis should shift from the encouragement of growth through investment to the achievement of full employment through consumption production” (Minsky 1982, p. 113). Much mischief in government policy has arisen in consequence of this misinterpretation of national income statistics. Many lawmakers have passed legislation encouraging consumption at the expense of investment. At the same time, they see no reason to cut capital gains taxes or corporate income taxes, since the business investment sector appears to be relatively small and unimportant.

THE SOURCE OF THE FALLACY What’s gone awry? The source of the error is that GDP is not a measure of total economic activity. As anyone who has taken Econ 101 knows, GDP measures the purchase of final goods and services only. GDP deliberately leaves out spending by business in all the intermediate stages of production before the retail market. It does not include spending – what business calls business-­to-­business (B2B) spending – by natural resource companies, manufacturers, and wholesalers. What’s missing from GDP? It deliberately excludes trillions of dollars in

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#1 Resources #2 Production #3 Distribution #4 Final output (GDP) Money ($)

Source:  Skousen (2014b).

Figure 12.3  GDP and the four-­stage general model of the economy B2B spending in the supply chain. It ignores all the intermediate stages of production that produces the final product.

MOVE OVER, KEYNES: INTRODUCING A BETTER MACRO MODEL The simplified four-­stage model of the economy in Figure 12.3 shows how GDP fits into the whole production process. This four-­stage model, first developed in my work The Structure of Production (1990), serves as the basis of an alternative macro model to Keynes’s. How do you get rid of a bad model? Replace it with a new model. Keynesian macroeconomics will never be rejected until a new model takes its place. I believe my four-­stage model of the economy is a better theory to explain how the economy works, and can easily be integrated in the standard textbooks, as I seek to demonstrate in my own textbook, Economic Logic (2014b).

GROSS OUTPUT: A MORE ACCURATE MEASURE OF THE ECONOMY To determine total economic activity we need to measure spending at all stages of production, not just the final stage. In The Structure of Production, I called this measure Gross Output (GO). It is a way of measuring Hayek’s triangles, named after the Austrian economist Friedrich Hayek (Hayek 1935). Good news! On April 25, 2014, the US Bureau of Economic Analysis followed my lead and began releasing gross output on a quarterly basis

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(BEA 2014). It is the first quarterly macroeconomic statistic to be produced since GDP was developed in the 1940s. I consider it the most significant triumph in supply-­side “Austrian” economics since Hayek won the Nobel Prize in 1974. GO quarterly data can be found under “GDP by Industry” at www.bea. gov. It is officially defined as “a measure of an industry’s sales or receipts, which includes sales to final users in the economy (GDP) and sales to other industries (intermediate inputs).” GO is a measure of the “make” economy, while GDP represents the “use” economy. Both are essential to understanding how the economy works. As Dale Jorgenson, Bill Nordhaus, and Steven Landefeld (former director of the BEA responsible for the development of new quarterly gross output data) conclude: “Gross output [GO] is the natural measure of the production sector, while net output [GDP] is appropriate as a measure of welfare. Both are required in a complete system of accounts” (Jorgenson et al. 2006, p. 5). GO evolved from the input–output tables developed by Wassily Leontief (1966). However, his focus was the inner relationship between industries rather than the aggregate figure itself. The BEA began publishing GO on a yearly basis in the 1990s, but it was largely ignored by economists and the media because it was always three or four years out of date. In my works The Structure of Production (1990) and Economics on Trial (1991), I made the case that GO should be an essential macroeconomic tool that should be published on a quarterly basis along with GDP to give us a more complete picture of the economy. Now a quarterly GO has become a reality. Since the BEA began publishing it, most textbook writers are planning to add GO to their next editions. Other G20 countries are considering producing their own GO measurement. The UK has recently begun releasing an annual figure called Total Output. Economists who have written favorably on the new quarterly statistic include Steve Hanke, economics professor at Johns Hopkins University (2014), and David Colander, who writes: “For forecasting, the new measure [Gross Output] may be more helpful than the GDP measure, because it provides information of goods in process” (Colander 2014, p. 451). See also my rejoinder (Skousen 2015c). In the US, gross output reached over $31 trillion in 2015, almost twice the size of GDP ($17 trillion). However, the official GO does not include all sales and B2B spending in the economy. When sales at all stages of production are included (amounting to $40 trillion in 2015), I estimate that consumption expenditures actually represent only about 33 percent, or one-­third, of economic activity in the United States, not two-­thirds as is commonly reported. Moreover, gross business spending (B2B) represents

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the majority (54 percent) of total spending in the economy if you add together gross intermediate expenditures, business fixed investment, and residential housing. Government purchases represent the remainder, or 13 percent. As you can see from Figure 12.4, business spending (B2B) is almost double the size of consumer spending. Moreover, business spending is far more volatile than consumer spending (Figure 12.5). During the financial crisis of 2008–09, B2B spending fell more sharply than consumer spending. After the crisis, B2B rose faster than consumer spending. GO provides a more complete indicator of total economic activity. As such, it suggests a far different interpretation of how the world works. In fact, we come to the opposite conclusion: business spending and investment are far bigger and therefore more important than consumption. The US economy, like all economies, is investment-­driven, not consumption-­ driven. Consumption is ultimately the effect, not the cause, of a nation’s prosperity, confirming Say’s Law. As Steve Hanke states: Even though the always clever Keynes temporarily buried J.-­B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away. And, yes, the alleged importance of fiscal policy withers away, too. Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures. (Hanke 2014)

An individual becomes wealthy by producing and investing first, then increasing consumption – not the other way around. To go on a spending spree using credit cards or other forms of debt may initially give the impression of a higher standard of living, but eventually the individual and business must pay the piper or face bankruptcy. The same principle applies to a nation as a whole. But, retort the big spenders, if consumers stop buying, business will eventually stop producing. Granted, the whole purpose of production is eventual consumption. Per capita consumption is usually a reasonable measure of national wellbeing, and business must be responsive to consumer needs. But the real question is, how do we improve our standard of living? In responding to this issue, it is vital to remember that business investment and decision-­making depends on two factors: (1) current consumer demand, and (2) future consumer demand. Too often the media focuses solely on the first and ignores the second. A fall in current consumer demand can and often is offset by business spending in anticipation of higher consumer demand in the future.

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Consumer spending = Gross private consumption expenditures

Business spending = B to B transactions plus gross private investment (excel, residential real estate & intellectual property)

Credit Ned Piplovic

Figure 12.4  US business spending and consumer spending, 2007–15

Source:  Ned Piplovic.

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Figure 12.5 Percentage changes in business spending and consumer spending, 2007–15

Source:  Ned Piplovic.

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CONSUMER SPENDING NOT A LEADING INDICATOR If the US economy is consumption-­driven, why aren’t retail sales a leading indicator of economic activity? Of the ten components in the Conference Board’s Index of Leading Indicators, only one, the Consumer Expectations Index, is directly linked to future retail sales – and even the index has now changed to indicate “average consumer expectations for business conditions.” The other leading indicators are almost entirely related to capital investment and earlier stages of production, such as manufacturers’ new orders, building permits, the interest rate spread, and stock prices (Conference Board 2015). Retail sales are in reality an unreliable indicator of where the economy and the stock market are headed. Industrial output is a much better forecaster. And, contrary to what the national media often reports, retail sales are relatively stable compared to industrial production, just as consumer prices are nowhere near as volatile as commodity prices. Financial analysts seeking to pinpoint changes in the direction of the economy and the stock market will be disappointed if they rely entirely on retail sales as a guide.

THE CRISIS IN PRODUCTIVITY AND INVESTMENT Stimulating consumer spending in the short run will undoubtedly encourage some lines of investment. If people go on a buying spree at a local grocery store or shopping mall, merchants and their suppliers will see their profits go up. But the consumer spending binge will do little or nothing to upgrade tools and computers, construct a bridge, build a hospital, pay for a research program, or provide funds for a new invention or a new production process. Only a higher level of saving will do that. Thus, in nations following Keynesian pro-­consumption policies, it is not surprising to see luxurious retail stores and malls alongside dilapidated roads and infrastructure. Their consumption/investment ratio is systematically out of balance. Peter Drucker chastises the United States and other Keynesian industrial nations for a “crisis in productivity and capital formation” and “underinvesting on a massive scale” (Drucker 1981, p. 8). Saving, investing, and capital formation are the principal ingredients of economic growth. Countries with the highest growth rates (most recently in Southeast Asia and Latin America) are those that encourage saving and investing – that is, investing in new production processes, education, technology, and labor-­saving devices. Such investing in turn results in better consumer

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products at lower prices. They do not seek to artificially promote consumption at the expense of saving. Stimulating the economy through  excessive consumption or wasteful government programs may provide artificial recovery in the short run, but cannot lead to genuine prosperity in the long run. Steve Forbes has argued that “as time passes, [GO] will have a profound and manifestly positive impact on economic policy and politics” (Forbes 2014). Indeed, using the new statistic, GO, we now see that cutting taxes on corporate business and investments (interest, dividends, and capital gains) will have a dramatically favorable effect, far more than previously thought. When business investment represents 54 percent of the economy, not 15 percent, reducing investment taxes can have a multiplying impact on the nation’s economy. In sum, it is capital investment, not consumer spending, that ultimately drives the economy. As economist Ludwig von Mises declared many years ago, “Progressive capital accumulation results in perpetual economic betterment” (Mises 1980, p. 197). An emphasis on supply-­side “Austrian” economics will do a better job than Keynesianism to encourage sound capital investment and higher living standards. Economist Larry Kudlow set the record straight when he wrote: Though not one in a thousand recognizes it, it is business, not consumers, that is the heart of the economy. When businesses produce profitably, they create income-­paying jobs and then consumers spend. Profitable firms also purchase new equipment because they need to modernize and update all their tools, ­structures and software. (Kudlow 2006)

NOTE 1. The details of the Keynesian Revolution and the monetary counter-­revolution can be found in my history, The Making of Modern Economics (2001, 2007, 2015).

REFERENCES Barro, Robert. 2009. “Government Spending is No Free Lunch.” Wall Street Journal (January 22). Bureau of Economic Analysis (BEA). 2014. “New Quarterly Statistics Detail Industries’ Economic Performance” (April 25). http://www.bea.gov/newsreleases/industry/gdpindustry/2014/gdpind413.htm. Colander, David. 2014. “Gross Output.” Eastern Economic Journal, 40, 451–5. Colander, David C. and Harry Landreth, eds. 1996. The Coming of Keynesianism to America. Cheltenham, UK and Brookfield, VT, USA: Edward Elgar Publishing.

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Conference Board. 2015. “The Conference Board Leading Economic Index.” https://www.conference-­board.org/data/bcicountry.cfm?cid=1. Drucker, Peter F. 1981. Toward the Next Economics and Other Essays. New York: Harper & Row. Drucker, Peter F. 1986. The Frontiers of Management. New York: Harper & Row. Forbes, Steve. 2014. “New, Revolutionary Way to Measure the Economy is Coming: Believe Me, This is A Big Deal.” Forbes Magazine (April 14). Friedman, Milton. 1962. Capitalism and Freedom. Chicago: University of Chicago Press. Friedman, Milton. 1974. “Comment on the Critics.” In Robert J. Gordon (ed.), Milton Friedman’s Monetary Framework. Chicago: University of Chicago Press, pp. 132–7. Friedman, Milton and Rose Friedman. 1998. Two Lucky People: A Memoir. Chicago: University of Chicago Press. Friedman, Milton and David Meiselman. 1963. “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897–1958.” In Stabilization Policies. Englewood Cliffs, NJ: Prentice-­Hall, pp. 165–268. Friedman, Milton and Anna J. Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press. Galbraith, John Kenneth. 1965. “How Keynes Came to America.” In Milo Keynes (ed.), Essays on John Maynard Keynes. Cambridge: Cambridge University Press, pp. 132–41. Hanke, Steve. 2014. “GO: J.M. Keynes vs J.-­B. Say.” Globe Asia (July). Hayek, Friedrich A. 1935. Prices and Production. 2nd edn. London: Routledge. Higgs, Robert. 2009. Depression, War, and the Cold War. San Francisco: Independent Institute. Jorgenson, Dale W., J. Steven Landefeld and William D. Nordhaus. 2006. A New Architecture for the US National Accounts. Chicago: University of Chicago Press. Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan. Kudlow, Larry. 2006. “On Jobs, Tax Cuts, and the Democrats.” National Review Online (September 5). Leontief, Wassily. 1966. Input–Output Economics. New York: Oxford University Press. Minsky, Hyman. 1982. Can “It” Happen Again? Essays on Instability and Finance. Armonk, NY: M.E. Sharpe. Mises, Ludwig von. 1980. “Capital Supply and American Prosperity.” In Planning for Freedom, 4th edn. South Holland, IL: Libertarian Press. Skousen, Mark. 1991. Economics on Trial: Lies, Myths and Realities. Homewood, IL: Irwin. Skousen, Mark, ed. 1992. Dissent on Keynes: A Critical Appraisal of Keynesian Economics. New York: Praeger. Skousen, Mark. 2013. “Beyond GDP: Get Ready for a New Way to Measure the Economy.” Forbes Magazine (December 16). Skousen, Mark. 2014a. “At Last, a Better Economic Measure.” Wall Street Journal (April 23). Skousen, Mark. 2014b. Economic Logic. Washington, DC: Capital Press. Skousen, Mark. 2015a (1990). The Structure of Production. New York: New York University Press.

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Skousen, Mark. 2015b (2001, 2007). The Making of Modern Economics. 3rd edn. New York: Routledge. Skousen, Mark. 2015c. “On the GO: De-­ Mystifying Gross Output.” Eastern Economic Journal, 41, pp. 284–8.

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13. The conclusive fault line in Keynesian economics Peter Smith INTRODUCTION It is polarizing. For example, read Krugman (2008) and Woods (2009). They are close in time, commenting on the same events, yet they have diametrically opposing views. My own view shifted sharply in the past. I bought the whole Keynesian story during my undergraduate years; I subsequently disavowed the whole story. Now, numbers of decades later, having grappled anew with Keynesian economics, my view remains s­ ubstantively unchanged, though it is more nuanced. As it is generally understood and practised, Keynesian economics is without merit. However, it cannot be summarily dismissed on a theoretical level when viewed, as it is by a fringe group of academic economists, through an informed Post-­Keynesian prism. On these terms, it is internally consistent. That said, whatever its theoretical guise, it becomes empty and counterproductive when applied by governments to cure recessions. And, tellingly, it has a conclusive fault line that comes to the fore and is fatal at a policy level. Recessions are visible as broad aggregates of falling production and spending and rising unemployment. But the real action is on the ground among many individual businesses. Against this landscape, Keynesian policy is a blunt instrument which, by muddying and distorting market signals, hinders and protracts the process of economic recovery. It is best to focus on that, I posit, to win the argument. As I will explain, other criticisms of Keynesian policy, which largely fall under the heading of “crowding out”, have practical force but are not as conclusive or as watertight. At one level, macroeconomics is the subject matter in textbooks; usually encapsulated in Hicks–Hansen IS–LM analysis. It is neater than the complex world it purports to describe. Economic policy must deal with disordered markets; with different responses of households and businesses to changed economic circumstances; and with untoward price signals. I 235

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explore this complexity – and where Keynesian economics fits – under the three headings of “disequilibrium”, “aggregation” and “prices”. Finally, under the heading of “policy prescriptions”, I specifically consider the policy face of Keynesian economics. As my opening, I start with what Keynes (1936, p. 25) called “the substance of the General Theory of Employment”. This is the concept of “effective demand”. Effective demand has often been misconstrued. Yet it is the key to understanding the macroeconomic worldview that Keynes held and that his Post-­Keynesian followers still hold; that is until theory morphs into policy.

EFFECTIVE DEMAND [T]he theory of effective demand consists of both supply and demand arguments, in that it is based on the cost structure of firms as well as expected sales. (Jespersen, 2009, p. xv)

I was inexpertly taught that effective demand was simply the quantity of demand backed by money – by purchasing power. There was notional demand: wishful demand for a Lamborghini, if you like. Then there was effective demand, expressed as the purchase of its affordable utilitarian counterpart. I thought about it. Millions of Lamborghinis were not produced, because the demand for them was not effective. On the other hand, millions of modest family sedans were. Why? The answer seemed obvious: because the demand for them was ­effective – that is, backed by money. Accordingly, it seemed clear that production and income were generated by demand. Y = C + I + G followed as night does day, with the direction of causation running from the right-­hand side to the left. No one actually read The General Theory. My faulty leap of logic was pervasive, universal even. Armies of Keynesian economists, in and out of public service, believed and still believe that demand independently controls the economic fate of nations. Effective demand is misleading as a term. It does not resonate with onomatopoeia. In fact, effective demand is essentially, at its core, more of a supply-­side concept than it is demand-­sided. As defined by Keynes, it is the quantum of investment determined by the interplay between the sales proceeds which entrepreneurs believe (expect with limited and uncertain information) they will get from adding employees and the proceeds that will cease making it worthwhile to go on adding employees. Keynes mistakenly charged the classical economists with assuming that

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entrepreneurial expectations of sales proceeds would always adjust to ensure full ­employment: “supply creating its own demand”, as it were. But that battle is, by the way, for my purposes. It must be understood that consumption expenditure initially comes into play in effective demand as an expectation in minds of entrepreneurs that not all wage income will be spent. It follows, unless investment expenditure is expected to fill the whole breach, that entrepreneurs will cut employment. That’s the story anyway. And its postscript is what should be done in such circumstances. Increase G, Keynesians say; or do they? Well, not all of them apparently do, all of the time. Leading Keynesian economist Lance Taylor says this: Increase G, or if in doubt boost government spending, is the simplistic version of Keynes’s fiscal message. In fact he never said that. The idea was an invention of his mainstream followers . . . (Taylor, 2010, p. 170)

Yet we have this from the same author on the immediately preceding page: Even in a crisis the basic income = output accounting framework applies. That is the reason why the Obama stimulus package of 2009 had traction. By generating public demand for output by tax cuts and government spending at a time when private investment and consumption were contracting, it gave enough support to income to rule out a very deep recession (or even depression).

Confused? It appears, after all, that Taylor supports the “simplistic” version of Keynesian economic policy. Let me explain. Keynesian economists can be grouped collectively into two. In one group, constituting the vast majority, are those who know nothing at all about effective demand and follow the simplistic version of Keynesian economics across theory and policy. In the other are (mostly academic) Post Keynesians, who embrace effective demand as a theoretical construct but give it no evident policy role. Effective demand is universally missing in action on the policy front. That is a pity because it may have led to a more enlightened approach to economic policy than the one we are stuck with and have been since the immediate aftermath of The General Theory. As it is, increasing G is the sine qua non of Keynesian policy. I won’t intrude further into the epistemology of what Keynes said and the ways it has been understood (and misunderstood) by his followers. But, for the moment, effective demand can’t be left aside. Though it has no policy face, it places theoretical Keynesian economics into the maelstrom of disequilibrium – where real economic life happens.

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DISEQUILIBRIUM The Keynesian revolution is . . . the essential background without which the emergence of disequilibrium macroeconomics cannot be understood. (Backhouse and Boianovsky 2013, p. 32)

Macroeconomics is at its simplest when it is assumed that market economies “quickly” track back towards a market-­clearing “Walrasian equilibrium” after a disturbance. In practice, economic forces are not so homeostatic. Market economies behave capriciously at times. No, that’s not quite right. They behave at times as it might be thought they would behave if, in fact, they behaved capriciously. In any event, no one can get a clinical handle on it. Macroeconomic modelling bears this out. Substantive turnarounds in national economic fortune confound modellers (see, for example, Boland, 2014, pp. 103–4). An economy moving away from equilibrium at pace because of an untoward shock is pretty well impossible for mortals, even extremely clever ones, to model a priori. Equally, the sheer complexity of economic life makes it difficult to evaluate, after the event, which policies have worked and which haven’t. What we do know is that recessions end, whatever governments do or do not do. Reinhart and Rogoff (2009) provide evidence for that over a long period of history. At the same time, some recessions are steeper or longer lasting than others. The question is whether market economies can be stuck for periods in disequilibrium, with no effective market forces operating to restore equilibrium. “New Keynesian” macroeconomics answers this question by bringing into play price and wage rigidities to explain why the economy might get stuck in disequilibrium. In this version of Keynesian macroeconomics, as Roger Backhouse and Mauro Boianovsky (2013, p. 6) put it: “Disequilibrium is presented as the economics of price rigidity.” Essentially, this is a Walrasian equilibrium world undone by artificial constraints. This is not the Post-­Keynesian world, which takes its lead directly from Keynes. Effective demand is the key: “With his [Keynes’s] principle of effective demand operating there is no tendency for the economy to arrive at full employment” (Taylor, 2010, p. 167). According to Taylor, this does not depend at all on the existence of artificial constraints – even though, of course, it is true that they always exist to one extent or another. Robert Clower’s “dual income hypothesis” provides an instructive insight into this worldview. The unemployed cannot effectively express their desire for consumption goods; perforce, there is no evident excess demand to pique the interest of entrepreneurs.

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Within its terms of reference, the concept of effective demand does explain why market economies could get stuck in disequilibrium. However, it is a quite separate question as to whether this is a common phenomenon, or even a realistic one. It is a stretch, and self-­evidently contradictory, to assume an economy could get stuck in a “specific” state of disequilibrium. At the same time, it is beyond dispute that market economies are always in a state of disequilibrium to one extent or another. In itself this is not ­contentious. Contention is wrapped around the direction and speed of adjustment of market economies after they have fallen into serious ­disarray – and what if anything should be done about it. I will come back to this when discussing economic policy. By definition, in a state of disequilibrium not everyone is happy to be where they are. But that is not to say that similarly positioned participants will necessarily respond in the same way. There is, therefore, a potential aggregation problem in going from individual behaviour (of consumers and firms) to the behaviour of economies as a whole. Building macroeconomic theories and models on appropriate microfoundations is a subset of the problem.

AGGREGATION The justification for thinking about collective actors is that the socioeconomic circumstances in which groups of people operate – be they sweepers in Mumbai or traders on Wall Street – impel them towards shared economic attitudes and patterns of behaviour. (Taylor, 2010, p. 167)

A first thing to say is that macroeconomics is not alone in having an aggregation problem. In microeconomics individual behaviours of ­consumers and firms are melded to form a whole. At the same time, it seems reasonable to conclude that whatever the difficulties of aggregating at a microeconomic level, they become magnified at a macroeconomic level. Macroeconomic model builders impose conditions on their models to mitigate the aggregation problem. These might include the assumption of rational expectations; of Walrasian equilibrium; or of the concept of a representative agent standing for all agents (akin to Taylor’s justification above). Boland (2014) provides a comprehensive account of all this and its shortcomings. The shortcomings, it should be said, have not deterred the work. Franklin Fisher (1987, p. 55) maintains that “the analytical use of such aggregates as “capital”, “output”, “labour” or “investment” as though the production side of the economy could be treated as a single

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firm is without foundation.” But this, he says, “has not discouraged macroeconomists from continuing to work in such terms.” “Macroeconomics” as an overarching term has had a relatively short life. It was apparently first used by Norwegian economist Ragnar Frisch in 1933. However, it didn’t come to prominence until the late 1940s. While Keynes did not use the term in The General Theory, undoubtedly he is the inspiration behind the field of inquiry it represents. His was not an academic endeavour. He wanted to make a difference by convincing governments and policymakers that there was an endemic problem of unemployment which needed to be fixed. At question therefore is whether the economy as a whole is susceptible to manipulation by policymakers. And, critically, have they any idea where it is likely to go when they pull a policy lever, given that individual economic agents may react differently? This question, in a sense, presumes the absence of rational expectations. As Holt and Pressman (2001, p. 2) explain, under the influence of rational expectations, “many economists now hold that economic policies have little or no affect on real output . . . ”. Macroeconomic policy is powerless if, in fact, economic agents always understand that increased government expenditure will eventually lead to corresponding increases in taxation and that open market operations will be undone by price movements. However elegant the theory, I think this fails the common-­sense test as a guide to economic policy. The world is not full of fully informed agents. Moreover, to step briefly into the world of “Nash-­equilibrium” and game theory, individual agents simply don’t know how other agents will react before deciding on their own “optimum” reactions. Rosser (2001, p. 58) notes that some Post Keynesians “see uncertainty about others’ expectations as the fundamental source of general uncertainly.” You don’t have to go that far to understand that if the government were to devise one of those hare-­brained schemes to stimulate a particular industry (for example, the car industry) companies would need to second-­guess how their competitors would respond in developing their own responses. There is also an implied assumption of full employment in believing that economic agents will act to fully offset policy changes. So the game is over before it begins. But plainly unemployment does exist, which is why ­policymakers see the need to act in the first place. Of course, it is quite a separate matter as to whether that action is likely to be helpful if it is inspired by Keynesian economics; and, more generally, whether macroeconomic policy without microfoundations, however styled, can ­ have predictable results. Paul Krugman, among others, believes that it can. [O]f course we want to understand things as well as we can, but is it unreasonable to assume that lower interest rates mean higher demand under pretty much

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The conclusive fault line in Keynesian economics ­241 any detailed story. A foolish insistence on microfoundations at all times and no matter the issue is the hobgoblin of little minds. (Krugman, 2015)

Jespersen (2009, p. 55) goes further by questioning the worth at all of trying to build macroeconomic policy on microfoundations; to wit: ­“methodological individualism is rejected as the starting point for macroeconomics.” The fallacy of composition is often invoked, as Jespersen does, to question the reliability of building a whole from a sum of parts – particularly in disequilibrium situations. The views of Krugman and Jespersen have some force in some circumstances. However, distancing wholes from their constituent parts carries risk. It can lead to a loss of insight into the direction of causality. The favoured Keynesian example of the fallacy of composition – the paradox of thrift – is a case in point. So goes the story: individual saving decisions are self-­defeating by bringing down consumer demand and, correspondingly with it, income and the collective capacity to save. The problem with this story is that it simply slots into a worldview that income is the handmaiden of demand. This is Keynesian economics at its most simplistic; and it owes a lot to Keynes’s own flights of fancy that superabundance was in sight – expressed both in The General Theory and in his 1930s essay “Economic Possibilities for our Grandchildren”. Production underpins demand not the other way. In the normal course, the economic problem is one of production failing short of unmet demands. It defies experience to think otherwise. There is no evidence that we are remotely in striking distance of sating demand. This is not to say, of course, that production and demand are always in proximate sync. John Stuart Mill had that well covered way back in the nineteenth century. As he described in Principles of Political Economy, production, at times, might be “ill-­sorted” and out of kilter with demand. Severe problems can arise, at times producing “an excess of all commodities above the money demand [and a] temporary derangement of markets,” for which “restoration of confidence” is the remedy (Mill 2006, pp. 573–4). Mill brings complex market forces into play (“microeconomic forces” if you like) to explain economic downturns. Keynesian economics has nothing to say about market forces. It explains downturns as the product of overall demand deficiency. The problem for Keynesian policymakers is that complex market forces exist whether they are acknowledged or not. Such forces make it extremely difficult to predict the ultimate effects of intervention. True, in the first round lowering interest rates will tend to boost investment. Income tax cuts will tend to increase consumer spending. Government spending on

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construction projects will tend to increase employment. Those conclusions are unexceptional, but they are also superficial. At question is what happens in the second and subsequent rounds. That question leads to the disaggregated world of market prices and their role in the scheme of things, a role not brought into calculation at all by the aggregative m ­ ethodology of Keynesian economics; and therein sits its fatal flaw, though not in plain sight.

PRICES Prices . . . transmit information, they provide an incentive to users of resources to be guided by this information, and they provide an incentive to owners of resources to follow this information. (Friedman, 1976, p. 10)

Imagine a “happy” state of Walrasian general equilibrium. All products are being profitably produced and exactly matched at prevailing prices by the demand for them. To complete this picture assume that the labour market is also in full-­employment equilibrium. How could this happen? Well, of course, it couldn’t. Technological progress and innovation, changing tastes, incomplete knowledge and mistaken judgements all disrupt progress towards equilibrium. Market economies still produce unparalleled progress and prosperity. One reason for this that price signals, however haltingly at times, eventually tend to push markets and whole economies broadly in the direction of equilibrium. Prices perform their “magic” by rationing demand and by guiding the allocation of resources. Price adjustments take place interactively among literally thousands upon thousands of products. An important take for macroeconomic policy out of this is that there is a great deal of complexity in economic life. For practical purposes, this must be put aside to a large extent when it comes to macroeconomic theorizing and model building. It can’t be put aside when it comes to policymaking. The way in which supply, demand and price come together was enriched by the “marginal revolution”. In a rational and informed world, businesses will keep on supplying a product until the incremental contribution it makes to revenue meets its incremental cost. Equivalently, users of the product will keep on buying it until its incremental value or utility meets its price. A unique stable market clearing price will emerge provided some heroic assumptions are made about the homogeneity of producers and the relative shapes of the demand and supply curves. It is all hocus-­pocus in a sense. Such fine calculations cannot be made. Theory and practice diverge.

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Nonetheless, the theory provides an insight into the way prices guide the pattern of supply and demand, and provides a benchmark against which experience can be compared. Experience at times sees the prices of particular long-­life assets driven to unstably high levels as expectations of continuing price increases feed demand. There are stable market clearing prices in there somewhere but they’re buried by “irrational exuberance”. Mob psychology inveigles its way into demand functions. Inevitably, at some point, irrational exuberance gives way to reality. As Mill (2006, p. 574) describes it, there is “sudden recoil from prices extravagantly high”. Unfortunately, prices might not simply fall to stable levels. Sudden price falls of particular assets can prompt expectations of still further falls, which spread contagiously to related businesses and, ultimately, to unrelated business as unemployment rises and disposable income falls. A recession or “commercial crisis”, as Mill called it, ensues: “Almost everybody is a seller and there are scarcely any buyers”. Marginal theory still applies and will eventually have its say. But, for a time at least, expectations might be pushing demand and prices away from the direction of general equilibrium. Businesses become hesitant to invest. Unemployment rises. There is marked disequilibrium. Two things should be borne in mind. First, a recession is not a stable state in a free market economy. Corrective forces come into play. New businesses start up; others change course. Employees change their occupations. Consumers alter their patterns of expenditure. The fact that not everything goes smoothly or to plan is by the way. Price and wage rigidities are a fact of life and hinder the adjustment process. Nonetheless, history tells us that in varying amounts of time market economies eventually right themselves – under the guidance of informed relative price adjustments – unless they are overwhelmingly dead-­weighted by regulations, restrictions and/or corruption. Second, no one doubts the periodic experiences of rising unemployment in market economies and the deprivations they bring. Recessions produce distressing consequences, and Keynesian economics is right to ask whether something can and should be done. But good intentions are not the same as effective policies. At question is whether p ­ olicymakers have at their disposal a prescription to foreshorten recessions and mitigate their severity; and, in particular, whether government stimulus ­expenditure fits the bill.

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POLICY PRESCRIPTIONS At the policy level, instead of trying to “stimulate” the economy through spending, government responsibility should be confined, ideally, to attempts at improving the working of the pricing system. (Hutt, 1979, p. 13)

Unemployment is raging. What to do? If you are an economist advising government you do not take your lead primarily from Keynes himself, having never read his work at university, and certainly not from Mill. As a textbook trained Keynesian macroeconomist, what you do is to advise the government of the day to borrow and spend or to “print money” and spend, or both. You may additionally advocate reduced taxation, but this is unlikely to be given the same priority or emphasis. You will no doubt advise that an orchestrated fall in market interest rates would be helpful, but this theoretical policy to counter unemployment well predates Keynesian economics. R.G. Hawtrey (1925, pp. 43–4) made an instructive comment on bank credit and public works in the light of the topic at hand: If the new works are financed by the creation of bank credits, they will give additional employment . . . But then the same reasoning shows that the creation of credit unaccompanied by any expenditure on public works could be equally effective in giving employment. The public works are merely a piece of ritual, convenient to people who want to be able to say that they are doing something, but otherwise irrelevant.

Hawtrey’s comment is also a reminder that the advocacy of public works expenditure as a means of creating employment also well predated Keynesian economics. P. Bridel (1987, p. 1072) called it “an idea as old as the pyramids”. However, that said, the theoretical imprimatur for public works expenditure is distinctly Keynesian. Keynesian economics has a breadth of theoretical content but, perforce, it becomes narrowly focused when it comes to economic policy. Once insufficiency of demand is accorded the principal role in causing unemployment, one remedy follows reflexively, and that is to boost demand by applying government stimulus expenditure to fill the gap. It is essential to understand that Keynesian economics is relevant only in situations of unemployment. Keynes called his theory a general one because it encompassed dynamic behaviour influenced by changing expectations about the future. He included classical theory as a special case (1936, p. vii). But this special case (to him) was one of full employment. “All economists agreed that Say’s Law would apply in wartime [when there is full employment],” says Taylor (2010, p 164) in commenting on Keynes’s

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1940 pamphlet How to Pay for the War. Ergo, Keynes’s non-­special case is one of unemployment. Unemployment (the more the better) is the theatre of action for Keynesian economics. It doesn’t play well to a full house. But then again flops come around regularly enough, and its supposed resuscitating powers are lauded by its academic and practitioner devotees. Books poured out amid and immediately following the 2007–09 economic crisis. As prominent examples: The Return of Depression Economics and the Crisis of 2008 by Paul Krugman; Keynes: The Return of the Master by Robert Skidelsky; The Keynes Solution by Paul Davidson; and Maynard’s Revenge by Lance Taylor. In obeisance to Keynesian economics, economic advisers to Western governments were mostly at one in recommending stimulus spending to mitigate the recession and growing unemployment. I have little doubt that the same script will continue to play out whenever recessions occur, unless constrained by the sheer weight of prevailing government indebtedness. It is clear that neither monetarism nor new classical economics, heavily armed as the latter is with rational expectations, have managed to do more than put the occasional dent in the edifice of Keynesian economics. It has Nobel Prize winning adherents. Come the witching hour, it is the only game in town. If it were badly wrong, would it have survived for so long? Unfortunately, the answer is yes. It has had three props: it has become a “conventional wisdom”; it has political friends; and it has been subjected to theoretical attacks which fall short of being conclusive. As J.K. Galbraith pointed out in The Affluent Society, vested interest tenaciously protects any conventional wisdom. Keynesian economics is certainly a conventional wisdom. It has been around for a long time now. If it topples, academic reputations will come down with it. Trillions of dollars of stimulus expenditure down the years will be shown to have been futile and wasteful. Perish the thought! Politics is also part of the equation. Keynesian economics isn’t now just an economic theory. It’s become as much a political theory as an economic one. As a political theory it explains why capitalism is inadequate in maintaining full employment and must be augmented by government. It has been adopted by the left of the political spectrum and will not be let go easily. Keynesian economics will be hard to topple under any circumstances. It would be delusional to think otherwise. Criticism which is short of being conclusive makes it harder. And that is the case when it takes the typical form of turning on the crowding-­out effects of stimulus spending. To understand this it is necessary to step inside the Keynesian worldview.

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In this worldview investment drives saving, not the other way around. Baldly stated, this makes no sense. In a monetary economy, financial capital fuels investment and financial capital is the counterpart and product of past saving. In a fully employed economy, net new investment cannot occur without commensurate savings. However, Keynesian economics occupies the terrain of substantial unemployment. In this terrain, central bank credit (and, in some cases, commercial bank credit and overseas borrowings) obtained by government can potentially stand in lieu of savings in supplying the financial capital to fuel net new investment and employ the unemployed. This provides Keynesian economics with a narrative to withstand the criticism that stimulus spending must necessarily be at the expense of (more productive) private investment. The Keynesian story is simple enough. That is its strength. In a situation where resources are unemployed they can be deployed on government-­ financed projects and add to production and income generation; and, resultantly, lift business confidence more generally. This story has flaws. Unemployed resources are not neatly walled off from the rest of the economy; therefore, practically speaking, stimulus expenditure is likely to crowd out some private investment expenditure no matter how substantial unemployment may be. Moreover, private investment, driven by market forces and subject to market discipline, generally adds more economic value than stimulus expenditure, which is often driven in haste by guesswork and political expediency. Experience shows that stimulus expenditure is usually misdirected and wasteful, and simply leaves government debt and/or inflation in its wake. Finally, as to business confidence, the production of goods of considerably less value than their cost of production – burying and digging up bottles filled with banknotes (Keynes, 1936, p. 129), for example – seems unlikely to engender much confidence. The above flaws are compelling. But, still, they are not quite telling enough; they are not conclusive. The higher unemployment is and the more value that the unemployed can potentially produce, the more Keynesian economics has an avenue to defend its position and bolster its credibility. There is a better argument against Keynesian economics. True, it is not as overtly intelligible; nonetheless, it is powerful. It goes to the centrepiece of economics, to the role of market prices in steering economic affairs. Price adjustments figure prominently at times of widespread economic distress, but aggregation serves to relegate prices to a footnote. Aggregation, dealing with the economy as though it were a homogeneous whole, simply doesn’t work well when an economy is in disequilibrium and suffering unemployment and untoward price movements – the very situation in which Keynesian economics is supposed to have answers. The conclusive fault line in Keynesian economics is rooted in its own

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aggregated view of the economy, which serves to bypass price signals. Aggregation does little disservice to generalizations of the kind that says that lower interest rates promote more investment. In that case, however, the market is deciding the allocation of investment. It is a totally different matter when government fiat is determining how much is being spent and on what, without reference to the market. Sure, it is still possible to say that government-­financed bridge building, for example, will create some employment. But what of the flow-­on effects on price signals? These are simply not considered. In bypassing price theory, Keynesian economics fails to account for the deleterious effect of stimulus expenditure on the role prices have in restoring equilibrium. Ludwig von Mises nailed it: to give an artificial stimulus to economic life by public works schemes . . . has had the consequence of eliminating those forces which in previous times of depression have eventually [my italics] effected the adjustment of prices and wages to the existing circumstances and so paved the way for recovery. (Mises, 1953, p. xx)

The inclusion by Mises of the word “eventually” is an important qualification. As I noted above, price movements in the initial stages of a recession might well overshoot their equilibrium level as sellers chase prices down. But this ends. It always has. Eventually, the price mechanism sets to work to restore employment. Prices of those resources made unemployment begin to fall, perhaps absolutely, certainly relative to those resources in demand. These price signals guide entrepreneurs and businesses in determining their future activities. Put government-­financed projects into the mix. It makes no difference whether they use idle resources or how much value they add or how little they crowd out private sector activity. They distort price signals. “Anything that prevents prices from expressing freely the conditions of demand or supply interferes with the transmission of accurate information” (Friedman and Friedman, 1980, pp. 16–17). Government stimulus expenditure adds discordant and confusing noise to the price adjustment process. It does this whatever phase the price adjustment process is in. Even if prices are behaving in an untoward manner, there is absolutely no reason to believe that adding more noise in the form of doses of stimulus expenditure will help rather than hinder. Informed price adjustments are essential if the economy is to head in the direction of a new general equilibrium. It would be extremely surprising if this pathway were characterized by increased production of whatever the government decides to spend money on. It is important to appreciate that those who buy things can only do

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so because things are produced. The wherewithal to spend turns on ­production and what influences it to go up or go down or to turn this way or that. We can’t say a priori which products and in what quantities will generate a proximate match between the legion of individual supplies and demands. That can only be decided by free-­market price movements, nothing else. The more government intervenes, the more likely it will be that an otherwise speedy recovery will become hesitant and half-­baked. A prime example is America’s halting and prolonged recovery in the 1930s under the onerous burden of President Roosevelt’s New Deal. Then, the distorting effects of public expenditure were compounded by government price fixing, a heady brew which inevitably subverted economic adjustment. Keynesian economics has been responsible for giving demand primacy in economic affairs. As Post Keynesians, Holt and Pressman (2001, p. 1) attest: “For Keynes, as well as Post Keynesians, it is demand that drives the overall economy.” It bears repeating that in this context “effective demand” – as defined by Keynes and, selectively, adopted by Post Keynesians – is not in the frame. Demand here is the aggregate of consumer, investment and government expenditure. Moreover, these components of demand are conflated as though they are comparable. No particular distinction is made between consumption and investment. This is anomalous on its face and revealing of the deep-­seated fault of putting demand in the driving seat. Consumption and investment both use up economic value. However, if well made, investment subsequently generates more value than it uses. Consumption and investment are not remotely comparable. But the distinction is lost among policymakers, who have been taught to see economic growth through the prism of demand, where one demand is like another. That is why they see increasing G as the answer when production and income dip, because they don’t focus on the left-­hand side of the income– expenditure equation. They focus on the right-­hand side, where they see that C or I or both have fallen. Increasing G becomes reflexive to make up the shortfall. If policymakers were to focus on the left-­hand side of the equation – on production or income – their attention would be drawn to the impediments to income generation and, inexorably, to the role of prices in guiding economic adjustment and recovery. Keynesian economics occupies disequilibrium terrain in which, it is claimed, unemployment can become intractable. At its theoretical best it is hinged on the concept of “effective demand”, but this (supply-­leaning) concept has no policy face. Keynesian policy is wholly demand-­sided. Its application has led to deficits, debt and insipid recoveries. Nonetheless, it has been able to withstand the most common charges made against it. That is because those charges, in essence, fall under the heading of

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“crowding  out”. As compelling as they are, they simply do not fly conclusively enough at times of high unemployment. The key to undoing Keynesian economics is via the price system. Aggregation leads Keynesian economics down the flawed path of giving primacy to demand instead of to production. In turn, this shifts its focus away from the role of prices in determining the makeup of production and in guiding the economy out of trouble. The damage stimulus expenditure – the epitome of Keynesian policy – inevitably and conclusively does in retarding recovery, by interfering with price signals, is thus buried out of sight.

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Selected bibliography ­257

Simpson, D. 2013. The Rediscovery of Classical Economics: Adaptation, Complexity and Growth, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Skousen, Mark. 1991a. Economics on Trial: Lies, Myths and Realities, Homewood, IL: Irwin. Skousen, Mark (ed.). 1991b. Dissent on Keynes: A Critical Appraisal of Keynesian Economics, New York: Praeger. Skousen, Mark. 2015. The Making of Modern Economics, 3rd edn, New York: Routledge. Smith, Adam. 1776 [1976]. An Inquiry into the Nature and Causes of the Wealth of Nations, edited by Edwin Cannan, Chicago: University of Chicago Press. Sowell, Thomas. 1974 [1994]. Classical Economics Reconsidered, Princeton, NJ: Princeton University Press. Stockman, David A. 2013, The Great Deformation, New York: Public Affairs Press. Taylor, Lance. 2010. Maynard’s Revenge: The Collapse of Free Market Macroeconomics, Cambridge, MA: Harvard University Press. Viner, Jacob. 1936. “Mr Keynes on the causes of unemployment,” Quarterly Journal of Economics, 51 (1), 147–67. Wanniski, Jude. 1978. The Way the World Works: How Economies Fail – and Succeed, New York: Basic Books. Wicksell, Knut, 1898 [1965]. Interest and Prices: A Study of the Causes Regulating the Value of Money, New York: Augustus M. Kelley. Wolf, Martin. 2015. “The Keynesian versus the monetarist: a lost decade,” Standpoint, March. Woods, Thomas E. Jr. Meltdown: A Free-­Market Look at Why the Stock Market Collapsed, the Economy Tanked, and the Government Bailout Will Make Things Worse, Washington, DC: Regnery.

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Index abstraction level of macroeconomic analysis 207 advertising and the consumer 186–7 tool of competition 187 advice to Japanese 1998 from the Economist 130–31 “age-old poisons” 133 Aggregate Demand (AD) 79, 83, 136, 140, 220 awkwardness 154–5 central role in theory of recession 125–6 consumption, investment, government spending, net exports 2 “aggregate” demand and supply big spender, Keynesian 85 interconnectedness 82 misplaced construction 81–2 aggregate demand equation 156 aggregate demand plunge 67 aggregate demand relation 155 aggregate demand restoration deficit financing 221 aggregate demand stimulation for restoration of aggregate output to full employment level 214 aggregate economic variables relationships 202 aggregate entrepreneurial problem 36–9 aggregate investment supposed arithmetic value of zero 207 “aggregate” spending, need to increase 87 Aggregate Supply (AS) 79, 125, 154–5, 220 aggregate supply concept 154 aggregates, focus on 108

aggregates of GDP 119 aggregation 151, 239–42 aggregation problem 246 macroeconomics 239 microeconomics 239 allocation of capital 111 alternative to Keynesianism 156–60 American budget deficits 132 American Economic Association (AEA), 1951 11 American economy sinking economic activity 146 American heartland into “rustbelt” 199 American psyche in financial matters 95 annus horrendous 1988 62 Annual Summary of Payments Statistics 2014 48 anti-capitalist themes 218 anticipated market demand 33 anti-Keynesian Free Market Economics: An Introduction for the General Reader 2 anti-market policies damaging in practice 133 Argentine economy, 135 asset portfolios 44 asset price declines, severe, 1990 63 asset price movements 74 asset prices, high 54 asset prices, leakages 53–5 asset price turbulence 68 asset price volatility 55 asset replacement 199 asset transactions between sectors 52 assets, buying and selling 50–51 assumption of unchanging composition of aggregates 206 259

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260

What’s wrong with Keynesian economic theory?

“austerity” 140 austerity episodes 204 “austerity” promise from George Osborne 209 Australia cut in public spending, wage cuts 127 “Premiers’ Plan” 127 “Austrian” analysis of inflationary processes 88–9 Austrian Business Cycle Theory (ABCT) 19, 208 Austrian capital theory 115, 120 Austrian conception of capital 108 value of specific goods 110 Austrian conception of the market 117 Austrian distortions of production structure 208 Austrian economists 13 Austrian interest rate theory 14–19 Austrian laissez-faire prescription 221 Austrian macroeconomists, new 13–14 Austrian perspective capital in specific goods with multiple uses 107 Austrian theory of boom and bust 99 Austrian theory of capital 112 Austrian view of capital, by Keynes 109–10 automobile production 198 qualities and quantities 188 autonomous expenditure 44 Average Price Level 79 balanced budgets “general” theory of economy 219 balanced markets assuring full employment 84–5 bank credits 244 Bank for International Settlements 63 Bank of England independence, 1997 62 bank rate in UK, house prices high 208 bankruptcies 194 barter economy 16 big government justification 218 big government over laissez faire Keynesian model 219

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Blue Book, UK presentation of national accounts 52 bond market 168–9 bond markets Operation Twist 170 bond prices 15, 19 books on Keynes after 2007–09 economic crisis 245 “boom and bust” warning 56 boom–bust episode 100 root cause identification 98 boom–bust sequence misdirection of resources 94 British Classical Economists Adam Smith, David Ricardo 183 broad money growth, 1985 60 broad money growth drop 1990 and 1991 60 budget balancing policy 126 budgets deficits 204 building permits 231 business and business investment 134 business as heart of the economy 232 business confidence 246 business cycles dot.com bubble, 2000 96 housing bubble, 2005 96 business firms 192 business investment dependence on current and future consumer demand 228 business reluctance to spend 152 business spending 228 business-to-business (B2B) spending 225–6 “business transactions” 53 buyers and sellers 190 C + I + G 2, 137, 140, 145, 236 Cairnes, John E., “classical economist” 1874 on Supply and Demand and aggregate demand 82–3 Callaghan, James, 1976 on spending way out of recession 145 capital, accumulated wealth, earning profit or interest 192 capital accumulation 189

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capital, aggregative view in Keynes 109 capital and investment problems volumes of each 111 capital and labor, idle 120 capital and recession 191–2 capital, Austrian view 119 capital creation on credit expansion 193 capital decumulation 197 capital-entrepreneur arbitrage 17 capital goods 107, 188 investment 231 driving the economy 232 loss 194, 196 of economic system 195 productivity or value 109 relative scarcity 111 resources 120 scarcity 198 stock 50 use 114 capitalism, contradictions of 219 capitalist development, 150 years 124–5 capitalist-entrepreneurs 16–17 capital, saving and employment 183 capital, views of 107 Carew, Edna The Language of Money (1996) 127 cash balance 15 cash hoarding 190 cash holdings 192, 194 catastrophe for economic theory 141 central bank “braking” rather than “accommodating” 100 central bank role in popular Keynesianism 152 Chamberlain, Neville, British Chancellor of the Exchequer, 1933 on balancing the budget 126 changes in level of output 94 changes in net worth 1998–2013, 12 percent of GDP in UK 65 1998–2013, 21 per cent of GDP in USA 65 larger than fiscal policy 65 Chicago School Monetarists 13

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Index ­261 childbirth expense to parents 186 child labor 184 Chinese recycling dollars in American money market 132 chronic debt financing policy prescriptions 218 chronic secular stagnation 96 Churchill, Winston decision, country back on gold standard 95 circular flow 46 circular flow notion 49, 54, 68, 69 “circular flow” of spending 152 classical economics Keynesian undermining 133 classical economic theory 125 classical economists broad principles 213 “classical medicine” 133 “classical theory” 124 classical theory of recession 126 Climate Change Levy losses for investors 210 Coalition Government in UK, June 2010 tax raising and cutting spending 204 coalminers’ union dispute for pay rise 58 commodity reserve systems 215 co-movements 97 competing currencies 215 competition with other goods or services 30 components of expenditure consumption and investment 46 conceptual legitimacy of Keynesian income-expenditure analysis 45 confidence importance of consumer desires 209–10 consumable output 93 consumer borrowing 50 consumer demand inaccurate anticipation 37 consumer demand change with passage of time 29 consumer desire consumed by presence of wealth 185 production by absence of wealth 185

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262

What’s wrong with Keynesian economic theory?

consumer desire unused strong consumer demand 185 Consumer Expectations Index link to future retail sales 231 “consumer goods” versus “producer goods” (capital) 81 consumer goods and producer goods 16 consumer goods, higher prices 198 consumer goods industries 114 consumer inflation 1 per cent over 2 per cent target 62 consumer preferences 20, 28 consumer role 32 consumers’ expenditure (in real terms) forecast, 1974 57 consumer society justification 218 consumer spending 228 not driving the economy 232 not leading indicator 231 consumer spending drives the economy (anti-saving mentality) 219 Keynesian myth 218 consumer spending stimulation in some lines of investment 231 consumer wants 33 consumption 46–7 effect of nation’s prosperity 228 entrepreneurial profits 32 leading to production 32 uses up economic value 248 consumption and investment 15–16 relationship between 113 consumption expansion twentieth century 183–4 consumption expenditures in United States 225 consumption, financing of 195 consumption, high level key to prosperity in US 225 consumption–investment proportion decrease 20 consumption of the government support for economic system 189–90 consumption over saving Keynesian economics 218 consumptionism 189 perversion of values 191 consumptionist and advertising 187

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consumptionist belief, 191 people eager to accept reward without work 190 purposeless passion for work without reward 190 consumptionist’s values absence of wealth 185 consumptionists and productionists 189 context specific outcomes 213 contra-cyclical adjustments to government spending 45 control factors, specification of 161 conventional economics fundamental economic problem, scarcity 153 price adjustment eliminates surpluses and shortages 153 savings promotes capital formation 153 “conventional wisdom” Keynesian economics 245 “coordination” (Friedrich Hayek) 119 coordination and balance 84 corporate equity 50 correlations 97 cost-covering prices, sale at 34 cost-of-production theory of value 203 costs 77 “Counter-Inflation Programme” (1973 Act of Parliament) 57 country with own currency 209 credit and regulatory policies, loose boom in house and other asset prices 203 credit card 48 credit creation 244 “credit crunch” loss of confidence 203 “credit cycle” 53 credit effect 57 credit expansion, 39 loss of capital 194 currency depreciation justification 218 cycles and slumps in an overly aggregated theoretical framework 92 cyclical instability in the savings ratio 63–4

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Index ­263

cyclical movements in asset prices equities and real estate 54 daily fluctuation of prices in financial markets 207 damage of stimulus expenditure 249 dangers of Keynesianism economics 123 “dark age” of macro-analysis 79–80 data on household net worth in the USA and UK 74–6 debt over equity Keynesian economics 218–19 debts, rising levels 140 decline in real output 213 declining price levels 78 defects of macroeconomic method 206 deficit financing Keynes’s way out of Depression 221 deficit spending, fiscal stimulus over balanced budgets Keynesian model 219 deficits, dangers of 140 deficits over surpluses Keynesian economics 218 definition of a job 156 demand and supply intersections comparison with pair of scissors 170 demand comes from supply 142–3 demand curve 170 demand deficiency as cause of recession 125 “Demand for commodities is not demand for labour” (Mill) 144 demand insufficiency 38 demand, level versus structure 131–2 demand over supply, importance of Keynesian economics 218 demand overestimation 37 demand rationing 242 demand stimulation 35 demographic problem of Japan major fiscal implications 130 dependence on income plus allowance 50 depreciation of housing stock 52 depressions 20 rise in loan rate 21 depressions and credit expansion 193–4

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desire, only to buy and consume, not produce and sell 190 to produce and sell, not buy and consume 190 desires, as creation of work 187 devastation of World War I 95 development of common law self-organizing process 212 discretionary financial regulation 2010 Dodd–Frank Act 210 discretionary regulation 210 disequilibrium 238–9 distortions, Austrian 208 domestic products, demand stimulation for 173 Dow, Christopher chief economist at Bank of England 46 “dual income hypothesis” 238 dynamic stochastic general equilibrium (DSGE) 203 early-stage capital formation 93 easy money 221 policy prescriptions 218 easy money over inflexible gold standard Keynesian model 219 easy-money policy 222 econometric models 46 economic activity increase 5 economic benefit for a producer 190 economic consequences, dismal 138 economic coordination and growth 117 economic depressions 193 economic downturns 193, 241 economic forecasting in National Institute downgrading 62 economic growth from micro-economic coordination 119 economic growth in US and UK unusually low since financial crisis 210 economic journalism 152 economic life, rationality 191

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264

What’s wrong with Keynesian economic theory?

economic policy during Great Depression full-scale classical approach 126 economic policy, false premise 4 economic policy, principles of 213–14 economic prosperity a policy of inflation 190 economic recovery, requirements 194–5 greater saving, fresh capital 195 more saving, capital and credit 195 economic theory 4, 78, 183 economic theory in practice 145–6 economics, Keynesian ambiguity of 151–6 economic world “non-Euclidean” 191 Economica article, 1933, period analysis 47 Economist, The on Japan in need of fiscal stimulus 131 economy as a self-organizing system 210–12 economy, deeply subdued 135 economy downturn after 1974, 1980 60 economy malfunctioning 94 economy, taxed into prosperity 165 economy-wide aggregates 90 economy-wide unemployment 92 education, infrastructure 36–7 effective demand 239, 248 backed by money 236–7 consumption expenditure 237 Keynes’s definition 236 supply-side concept 236 theoretical construct, no evident policy role 237 “effective demand” notion, 30, 41 The General Theory 69 eligibility requirements 176 empirical macroeconomics, challenge 161 employment 2 Employment Act of 1946 US Congress 102 employment restoration 247 employment, views of 184 endemic problem of unemployment 240

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entrepreneur as sole producer in market setting 28 entrepreneur in production, uncertainty 30 entrepreneurial failure 30–31, 34, 42 entrepreneurial function 27 entrepreneurial problem 26–30 entrepreneurship and a general glut 39–41 exogenous change 27–8 failed 42 true “driving force” of market process 31–2 equilibrium analysis 202 equilibrium levels national income and national wealth 69 equilibrium models 211 equilibrium prices 170 demand and supply curves 171 equilibrium theory Keynesian Revolution, main tenets 202–3 equilibrium values 46 equity bull market US 1928 and 1929 53 equity prices high 208 European Exchange Rate Mechanism 60 Eurozone authorities 44–5 ex ante and ex post equilibria 115–16 excess demand 83 excess of “aggregate supply” over “aggregate demand” 83 excess supply 83 exchange rate 95 exchange rates, falling Italy joining euro 210 exogenous change 28 exogenous shocks earthquakes, tsunamis 28 “expansionary fiscal contraction” 45 expansionary fiscal policy 20–21 expansionary monetary policy 20–21 expenditure containment 126 expenditure cutting slashing public sector wages, 1931 127 expenditure decisions 44 expenditure on public works 244

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Index ­265

extra-market forces government spending and money creation 97 Failure of the New Economics, The (1959) 2 failure of stimulus programs 106, 110 fall in demand answer, increase in demand 137 falling production rates, double-digit 78 faster output growth by deliberate demand stimulus 57 federal purchases, 2007 to 2009 160 Federal Reserve 221 Federal Reserve policy 93 Federal Reserve System 168, 169 Ferguson, Adam, eighteenth-century philosopher 212 “final effective aggregate demand” 224 “finance” 49 financial circulation 49–51, 65, 69 and circular flow 51 financial circulation prices leakages 53–5 financial crisis 159 cause 203 no non-Keynesians 106 United States 2010 Dodd–Frank Act 210 financial crisis of 2007–2008 101, 156 direct intervention in markets by monetary authorities, treasuries, regulators 210 prolonged recession 203 financial securities, strong 54 fiscal and monetary policymaking loss of credibility 201 fiscal austerity 45 fiscal contraction in deep recession 204 expansionary not contractionary 204 raising tax revenues, cutting expenditures 204 rapid in US after Second World War 162 fiscal expansion 204 arguments for substantial need in Japan 130

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fiscal expansionism Alberto Alesina, “Bocconi boys” 45 fiscal expansions International Money Fund, no support 130 fiscal policy deficit spending and taxes 223 “fiscal policy” of government 196 fiscal policy tightening 67 fiscal reflation 68 fiscal “spending” multiplier strength questioned 222 fiscal stimulus 44 Bush Presidency 204 flat tax, low rate, broad-based 180 fluctuations in employment 156 fluctuations in output 156 forecast growth rate of aggregate demand very high 58 forecasting model of NIESR 56 four-stage model of economy macroeconomics 226 fraud prevention companies 48 free-market economy inherently unstable 219 free market solutions Keynes, advocating 133 free markets, power of 180 free trade 180 “general” theory of economy 219 freedom of wage rates 195 Friedman, Milton misunderstanding of the Austrians 99–100 Monetary History of the United States, 1867–1960 (1963) 99 “The Great Contraction” 220, 223 Frisch, Ragnar, Norwegian economist “macroeconomics” term (1933) 240 “full employment” 85, 119, 125, 156 full employment, implied assumption 240 fundamental flaws in macroeconomic analysis 206–7 future demand 29

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266

What’s wrong with Keynesian economic theory?

future market conditions anticipation, supply and demand 32–3 future money 15 G20 Washington summit 44 Galbraith, John Kenneth, Harvard economist 221 GDP (gross domestic product) 139, 160–61 growth in 1972 57 misleading 224–5 a measure of the economy 225 not a measure of total economic activity 225 single output aggregate production function 163 the “use” economy 227 General Financial Contraction fall of accumulated savings 193 general glut 40, 41 General Glut debate 143–4 “general” theory of economy 219 General Theory of Employment, Interest and Money, The (1936) 11, 49, 78–9, 92, 96–7, 107, 110, 124, 134–5, 202 Preface 101–3 see also Keynes, John Maynard German labour market 214 Global Financial Crisis (GFC) 1–3, 7, 9, 14, 135, 140 glut, excess supply 143 gold standard “general” theory of economy 219 goods production millions of tasks 156 government budget deficits destructive 199 government deficit spending 177 government expenditure, increased 240 government-financed consumption beneficial appearance 196 government income taxation 126 government indebtedness 245 government-induced credit expansion 20 government level of expenditure increase in 134

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government price fixing 248 government role 137–8 government spending 135, 147 government spending boost simplistic version of Keynes’s message 237 “Government spending is taxation” 176 government spending on employment targeting of 159 government spending rise, US 174 government spending, speedy 135 government stimulus expenditure 244 measures 138–9 spending, important policy instrument of Keynesianism 175 government-supported union 21 government transfer payments 178–9 Great Depression 99, 126–8, 136, 165, 167, 220 in the United States 8 mid-1930s 78 severe unemployment 221 share market crash, 1929 124 worst eras in US economy 179 worst period in American economy 175 Great Inflation, 1970s and 1980s deficit spending 8 Great Moderation 62 Great Recession 62, 165 second worst period in American economy 176 worst eras in US economy 179 Great Recession, 1980s 166 Great Recession in late 2008 44 Great Recession of 2008 and 2009 global impact 62–3 greenhouse gases level reduction 132 gross business spending (B2B) 227–8 gross domestic product (GDP) 220 Gross Output (GO) 232 a measure of “make” economy 227 from input–output tables of Leontief 227 quarterly data 227 spending measures 226–30

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Index ­267

Hayek, Friedrich A., Austrian economist 13, 119, 144, 226–7 business cycle theory 208 Federal Reserve policy 93, 98, The Pure Theory of Capital (1941) 111 Hazlitt, Henry 6 The Failure of the New Economics (1959) 2 Heath, Edward, PM Conservative Government 57 Hicks–Hansen IS–LM analysis 235 high birth rate more consumer desire 185 high inflation 154 low growth 129 higher prices on aggregate demand effect 155 higher rate of inflation increase in aggregate demand 155 hire purchase 50 hoarding 153, 191 Hollande, François, French President quoting Say’s Law 146 homebuilding integral facets of total economy 168 homeownership integral facets of total economy 168 household net worth 45, 65 houses qualities and quantities 188 housing market 171 US economy 168 housing sector meltdown in US 131–2 human psychology boom driver 96 Hume, David, eighteenth-century philosopher 212 Hutt, William 2–3, 6, 7 “hydraulic Keynesianism” 203 idle resources 92 IMF, see International Monetary Fund implications of self-organization 212–13 inappropriate formalism 206 income 46 income deposits 49 income effects in an economy 178

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income-expenditure analysis 44, 45 approach of Keynes, 1940 articles 69 circular flow 65, 67, 74 model 45–7, 115 Keynesian 113 New Palgrave 54 increasing demand for entrepreneur’s products 35 incumbent businesses 157 “industrial circulation” 49 and circular flow 50 industrial output 231 annual rate of growth of output 211 “industry” 49 inflation, expected and unexpected 155 inflation check control of prices and wages 57 inflation rate changes distortions in real wage rate 154 inflationary “cure” more market problems 89–90 inflationary monetary expansion 89 inflationary process 88–9 input–output analysis 159 insufficiency of demand for product 30–31 interest rate 15, 16, 18–19, 154 adjustments 20, 171 as determinant of investment 154 high, 1920s 95 lower 112 manage aggregate demand 203 mechanism 114 microeconomics of the interest rate, Austrian approach 116–17 policies 94 policy-infected 98 rise 21 spread 231 theory, Austrian 14–19 International Monetary Fund (IMF) 45, 63, 75 advice to Japanese, 1998 130 “fiscal policy” figures 65 international trade 133 interpretations, conflicting, of Keynes’s message 103 intertemporal coordination 114 structure of production 112–17

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268

What’s wrong with Keynesian economic theory?

intertemporal discoordination and the business cycle 117–18 “investment” commitment of funds to a financial asset 51–2 investment uses up economic value 248 investment, active 47 investment and savings 115 relationship between 108 investment, employment, consumption downward co-movements 96 investment goods 113–14 investment in securities 14 “investment opportunity” for capital goods 187 investment–savings equilibrium 115 Ireland 2014, fast rate of economic growth 205 draconian fiscal tightening to 2013 205 iron ore scarcity 198 IS–LM model balance between saving and investment 154 IS curve 115 interest rate movements 100 Japan, 1990s large spending packages, deep recession 129 Japanese downturn 9 Japanese economic stimulus, 1990s 9 Japanese Recovery Program 129–31 Japanese slump, 1990s 13 jigsaw puzzle capital goods as puzzle pieces 117 meaningful pattern and picture 119 no final picture 117–19 pieces used in right way 119 job creation 157 job creation, meaningful 159 job loss, drop in demand 163 Job Openings and Labor Turnover Survey (JOLTS) US 159 jobs create spending 156 JOLTS data 162

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Kates, Steven Free Market Economics: An Introduction for the General Reader (2011) 2 Kennedy, John F., President of United States tax cuts to stimulate growth 129 key concepts in Keynesian textbooks 44 Keynes, John Maynard economist most influential and revolutionary of twentieth century, 219 The General Theory of Employment, Interest and Money (1936) 11, 49, 78–9, 92, 96–7, 107, 110, 124, 134–5, 202 The General Theory, preface 101–3 influence 183 monetary economist 93 A Treatise on Money (1930) 49, 92, 107–12 Keynes, John Maynard, model “aggressive effective demand” 219 Keynes’s view of capital and differences with the Austrians 110 Keynesian aggregate level 83 Keynesian aggregates misdirection for understanding monetary and cyclical processes 77 Keynesian aggregation problem 150 Keynesian consumption function 156 Keynesian demand-deficiency model 123, 132–3 “Keynesian” economic theory 6 signature equation 2 Keynesian Economic Theory and its Critics 1 Keynesian economics 1, 201 conclusive fault line 235 economy to grow from demand side 202 problem 136–7 Keynesian economics failure major reassessment across profession 139 Keynesian economists failures of common sense of 165

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Index ­269

Keynesian Episode, The (1979) 244 Keynesian framework, weakness “negative multiplier” in recent US data 162 Keynesian income-expenditure analysis discrediting 44 Keynesianism how prevalence over Austrianism? 101–3 PSST alternative 160 “Keynesianism” intellectual con trick 199 Keynesianism, removal 218 “Keynesianized”, characterizing US economy 102 Keynesian liquidity trap Austrian critique 11 Keynesian macroeconomic analysis 39 Keynesian macroeconomics 4, 7 replacement need 218 Keynesian Revolution, main tenets 12, 202–3 Keynesians’ ignorance of role of capital in economic system 195 Keynesian theory 5 no deep recession, twenty-five years after war 129 overturning of self-imposed restraints 126 Keynesian theory’s historic failures 7–8 Knight, Frank H. 2 knowledge distribution 215 known demand 28 labor force, composition changes 162 labor in each production sector resources, capital equipment 84 Labour Government, UK, budget, 2008 fiscal stimulus, one per cent of GDP 204 language, self-organizing process 212 Latin America highest growth rates, saving and investing 231 Latin American countries economic growth improvement 214

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Lawson, Nigel, Chancellor of the Exchequer policy decision 61 leads and lags in determining outcomes 213 leakages 51 leakages from financial circulation 54 significance for forecasting 55–63 Leamer, Edward discrepancy between statistical theory and econometric practice 161 level of abstraction 206 level of aggregate demand, increase 5 level of demand modern macroeconomics 131 life insurance policies 52 liquidation of unsound investments 195 liquidity preference 12 or demand for money 14 theory of interest 22 liquidity trap 12, 21, 22 market forces 19–22 loan rate and natural rate 21 loan rate of interest 14, 17–18, 20, 22 natural rate of interest 19 loanable funds theory 112–13 loan-market signals 93 falsified 93 policy-tainted 93 long hours 184 low interest rates 120 interest-rate sensitive production processes 93 low interest rates in UK 208 low taxes “general” theory of economy 219 Lucas, Robert (1976) instability of macroeconomic model 161 new classicism 99 Lucas Critique 161 machinery, view of 184 machines’ work less work for people 184 macro-aggregate approach failure 86

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270

What’s wrong with Keynesian economic theory?

macro-aggregates “total demand” and “total supply” 85 macroeconomic analysis 136 data 160–62, 161–2 data, inadequacy 162 demand management 12 equilibrium 68 outcomes 44 policies 203–6 policy for Latin America 214 relationships 92 stability, UK economy after Second World War 57 theory 6 variables, constant composition 207 macroeconomics 238 “back-of-an-envelope” economics 206 Hicks–Hansen IS–LM analysis 235 Keynesian approach 99 short life 240 university teaching 46 macroeconomics dominance since 1930s 139 magnitudes, changes 98 mainstream macroeconomic thinking undermining 203 major error spending way to prosperity 134 make-work projects 102 malinvestment 120 Malthus, T.R. Principles of Political Economy (1820) 143 mandated price ceilings 21 manipulation of aggregate demand 201 Marget, Arthur W. on monetary and related theory 80 “marginal revolution” 242 marginal tax rate reductions 172 marginalist revolution in economic theory in 1870s William Stanley Jevons 77 market anticipations Keynesian assumptions 86 market clearing 156 market-directed economic growth 93

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market economies 211–12 progress and prosperity 242 market economy, developed institutions, entrepreneurships, introduction of new goods and services 207 market economy, inherently unstable 219 Keynesian myth 218 market prices 111 market, reliance on lasting solution 134 markets, unbalanced 131 Marshall, Alfred 219 Marx, Karl 219 mathematics in economic theorizing 213 meaningful patterns 118 measure of austerity, 2009–13 against measure of economic growth 205 measuring economic progress not by unemployment 119 Menger, Carl 219 mercantilism, influence 183 microeconomic adjustment processes 108 microeconomic interactions 207 microeconomic level 82 microeconomic policy 2002 Hartz Commission 214 micro-foundation monetary theory and Keynesian avalanche 78–9 micro-foundational theories 78 micro-foundations 240–41 Middle Ages execution by king 170 Mill, James 142 Mill, John Stuart 144–5, 219 “Demand for commodities is not demand for labour” 144 Principles of Political Economy (1848) 241 minimal regulations 180 Minsky, Hyman P. 219 consumer spending drives the economy 225 Mises, Ludwig von Theory of Money and Credit (1912) 93

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Index ­271

Modigliani paper, 1944 49, 58 monetarism 13 monetary aggregates 62 monetary contraction weakness in aggregate domestic demand 56 monetary disequilibrium 68 monetary economy 246 monetary expansion effect on market activities 88 monetary inflationary process, “Austrian” Friedrich Hayek, on 88 Monetary Policy Committee Bank of England 62 monetary policy, depressions 13 monetary policy, power and importance Keynes mistaken in disparaging 223 monetary policy relation real interest rate effect 155 monetary policy to target inflation 132 monetary theory and monetary policy tenuous links broken 201 money growth 62 accelerations or decelerations 55 money growth deceleration, late 1990 63 money hoarding price falls 21 “money matters” 223 money spending, a virtue 190 money supply and aggregate price level 163 and interest rates, impact on business cycle 223 mortgage loan, fixed-rate 171 mortgages 171 financial derivatives 132 mortgages, supply increased by low interest 165 multi-equation, multiple regression techniques in US economy 161 multiple regression techniques 161 multiple specificity of capital goods 120 multiplier concept 44 multiplier “process” 47

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Napoleonic Wars England in 1807 142 national expenditure 46, 47 national income 47 National Institute of Economic and Social Research (NIESR) 45 advocacy of fiscal reflation 58 national output 46 natural experiments microeconomists 161 natural medicine, power of 180 natural rate monetary rate of interest 16 natural rate of interest 16–17, 20 Keynesian macroeconomics 60 natural scientists, in 1970s interdependent variables 212 neoclassical economics, Milton Friedman business confidence strengthening 210 “net” acquisition of financial assets 52 “net” in “net lending” 52 net sales of assets 68 network of self-organizing processes 212 net worth changes motivation for volatile leakages 65 net worth figure 75 New Classical Macroeconomics 12 New Classical Revolution (1977) 12 New Deal high levels of public spending 8 New Keynesianism 102 NIESR, see National Institute of Economic and Social Research 56 Nobel Prize winning adherents Keynesian economics 245 no business cycle of boom and bust 221 no business errors 221 no liquidity trap 221 no “new economics” of Keynes 221 Norman, Montagu Governor of Bank of England in 1920s 95 no separation of AS and AD Milton Friedman 221 notional demand 236

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272

What’s wrong with Keynesian economic theory?

Obama, Barack fiscal stimulus 204 Obama stimulus package of 2009 237 objective “price level” statistical illusion 84 observational studies 161 oil price rise and fall in 132 “oil shock”, 1973–74 154 Organisation for Economic Co-operation and Development (OECD) 63 OECD countries 205 Osborne, George, UK Chancellor severe rate of fiscal tightening 209 overfunding of budget deficit 60 over-production 39 of one good 40 parasitism 189, 191 source of general prosperity 191 partial glut 39 pathology of the miser 190 pattern predictions 212 patterns of specialization, new 157 patterns of sustainable specialization and trade (PSST) 157–9, 163–4 patterns of trade, unsustainable 157 pay for non-work increases amount of work 165 PDI, see personal disposable income pebble dropping into water ripples and rest, more pebbles need 87 pension programs for retired government employees in US 224 personal disposable income (PDI) 59 personal income tax rate, highest 172 personal sector assets 58 Phillips Curve Friedman, Milton (1967) 154 Phelps, Edmund (1970) 154 Phillips-curve-like relation inflation 155 Phillips-curve theory 162 physical capital, destruction of 110 point predictions 212 policy-driven economic boom in US, 1920s 94–5

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policy-induced boom, 1920s 93 policy-induced boom–bust episodes versus vacillations in slack economy 95–7 policy prescriptions 244–9 political theory Keynesian economics 245 politicians short-term political considerations 120–21 politicization of stimulus spending 121 politics and economics self-organizing process 212 Post-Keynesians “effective demand” notion 248 popular Keynesianism 150 not intuitive 153 post-Global Financial Crisis 140 postwar recovery conversion to Keynesian theory 128 post-war recovery, after 1945 8 poverty 185, 186 practical policy, Keynes’s approach 93–5 pre-Keynesian economics “classical economics” 141 prescriptions for prosperity higher tariffs 173 present consumption over future consumption 15 present money 15 pre-war exchange rate of $4.87 to the pound 95 price adjustments 242, 246–7 price and wage rigidities 238, 243 price-cost difference in different markets 207 price distortions and malinvestment 208 price falls 243 price level and aggregate wage 163 general definition by Benjamin Anderson 84 what it is 84 “price-level” statistically constructed objections to 90 price lowering 21 price manipulation Federal Reserve System 170

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Index ­273

price mechanism 111, 152, 247 price rise predictions 212 prices of long-life assets 243 prices fall 195 rising in mass unemployment 198–9 role 242–3, 249 price system 249 pricing system improving working of 244 primacy of demand instead of production 249 principles rather than rules for economic theories 214 private bonds 171 private investment expenditure 246 private sector activity 247 problems with Keynesianism Austrian capital theory view 106 production and demand 241 production and investment before consumption 228 production costs 30, 34–5, 41 production decisions opportunity costs 108 production expansion in nineteenth century 183–4 production limiting consumption 186 production of economic value 27 production process 28–9 productionist views 186 importance of consumer desires 187 productive resources 39 productive resources, scarcity 31 productivity and investment, crisis in 231–2 productivity of labour 83 profit 28 profitability of investments 18 of specific production process 29 profit and loss 117 coordinating role 17 profit function 29 profit opportunity of entrepreneur 29–30 profit return 17 progressive taxation policy prescriptions 218

KATES 9781785363733 PRINT.indd 273

pro-Keynesian view of World War II revision by historians and economists 222 propensity to consume, value of 47 prosperity dependence on absence of wealth 185 protectionism Keynesian model 219 PSST, see patterns of sustainable translations and trade public spending 129 combined with budget deficits 126 public spending increases 135–6 public works expenditure creating employment 244 purchasing power 236 purchasing power raising 35 pure rate of interest 17 Quadrant, Australian magazine 123, 124, 135 quantity of money 44, 54 quoted securities 50 rate of interest fluctuation 97 rates of interest, rising braking action of 100 rates of profit 207 rational expectations 240 assumption of 239 Reagan, Ronald, President of United States 165 spending restraint years 179–80 tax cuts to stimulate growth 129 Reagan era 1977–88 high personal income tax rate 173 Reagan recovery 166 Reagan supply-side years cuts in tax-rates 166 dollar appreciation 166 government spending under control 166 sound monetary policy 166 “real balance” effect 202 real-world forecasting 54 Reason Foundation expert on roads and infrastructure 223

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274

What’s wrong with Keynesian economic theory?

recession free market economy 243 recession and inflation 8 recession causes 143 recession ending not from increased levels of public spending 126 return to sound finance and fiscal discipline 126 recession fighting massive deficits, interest rates, low 219 recession, potential causes not demand failure 125–6 recessions, none 125 recessions problem 131, 238 absence of demand 125 absence of demand for output 143 deficiency of aggregate demand 125 fall in consumption spending and investment 137 recovery of the private sector 134 reduction in propensity to consume new demands for scientists, technicians 114 retail clerks employment reduction 114 reduction of interest rates slashing public sector wages, 1931 127 regulation of markets 134 relation between costs and prices rate of profit 111 resources, unemployed 246 resource-using costly production process 33–4 retail sales 231 retail store, luxurious dilapidated roads, alongside, in US 231 revolutionary technology 39 Ricardo, David, economist 219 no deficiency of demand 143–4 rich to poor, redistribution 165 rigidity of prices from government intervention 21–2 rigid money-wage policy 92 rigor-seeking Keynesianism 150–2, 154 roads and infrastructure in America substandard 223

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“Roaring Twenties” 165, 167 massive cuts in tax rates 173 spending restraint years 179–80 Roosevelt, Franklin Delano deficit finance 8 New Deal with “Keynesian” prescription, 1933 127, 248 Röpke, Wilhelm 2 Royal Economic Society 69 Rueff, Jacques 2 saving not spending for purposes of consumption 192 saving and hoarding 192 saving, frequently bad Keynesian myth 218 saving, investing, capital formation main ingredients of economic growth 231 saving ratio fluctuations 63 saving ratio increase, 1990–92 63 “savings” income minus consumption 51 “savings” and “investment” 52 coordination 113 dependence on psychological factors 153 Keynes’s denial of link between 114 savings decisions, individual self-defeating consumer demand, down 241 savings-investment identity 51–3 savings leading to reduction in employment 114 savings leading to reduction in total income Keynesian results 114 savings ratio 63 fluctuations in 52–3 Say, Jean-Baptiste 219 greatest French economist, early nineteenth century 146 “Law of Markets” 83 Say’s Law 125, 140–42, 218, 228, 244 comment from James Mill, economist 142–3 correctly understood 142 economists’ taught to reject 124–5 full employment guaranteed by

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Index ­275

market operation, Keynesian myth 124 “general” theory of economy 219 Keynes’s misunderstanding, 143–4 meaning “supply creates it’s own demand” 141 “supply creates it’s own demand” 125 Say’s Law and policy 147 Schumpeter, Joseph A. 219 creative destruction 157, 158 on Austrian inflationary way 88 Schwartz, Anna J. Monetary History of the United States, 1867–1960 (1963) 99 “The Great Contraction” 220 scientific procedure self-organizing process 212 self-correcting market economy 13 self-organizing processes in human societies significance of 212 self-organizing system 212 Senate, Australia, inquiry on stimulus 123 on Keynesian economics 141 report extract 138–9 share market prices across world plunge in 132 Shaw, George Bernard Keynes’s letter to 102 “shock” expenditure 47 short-term focus modern politics, modern economics and business 224 short-termism justification 218 short-term processes higher interest rates 18 “skilled” labor or “unskilled” labor 81 skills of unemployed 158 Smith, Adam 156, 212–13, 219 first principles for promoting economic growth 213–14 Smoot–Hawley Tariff legislation, US 173–4 snapshot view 27 social aspect to production 31 social security benefits, US 224

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Social Security/Medicare unfunded liability 224 sound money 180 Southeast Asia highest growth rates, saving and investing 231 special case, 1970s, huge increase in cost of oil 129 rapid growth in wages 129 UK’s economic prospects, dark, 1974 58 specialization and trade, patterns 150–51, 156–7 speculative demand 14–15 speculative demand for money liquidity trap 19 “Spending creates jobs and jobs create spending” 151–2, 156 spending for production 192 spending for recovery catastrophic 123 spending, lack of 152 spending newly created money 190 spending over saving Keynesian model, 219 spending restraint 180 spending, wasteful and profligate easy and common 135 stabilization policies, counterproductive 98 “stagflation” of 1970s downward spiral of economies 129 “stagflation” of 1970s, US 162 standard macroeconomic model 135 standard macroeconomics 4 static and dynamic accounts of the multiplier, 1930s 47 static equilibrium analysis 26–7 static equilibrium model 211 Stephen, Leslie “best test of a sound economist” (1876) 144 sterling selling falling exchange rate 209 stimulus check 176 stimulus model, Keynesian, failure 121 stimulus packages 177, 195 drain on the economic system 197 more loss of capital 196–7 should be stopped 198

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276

What’s wrong with Keynesian economic theory?

stimulus program 178 stimulus spending 245, 246 stimulus spending by the Keynesians 119, 121 stock market advance 1986 60 stock market index 212 stock prices 93, 231 structural unemployment wine and cloth 163 structure of demand Keynes recessions 131 subsidization by government of sector of economy 36 substantial unemployment Keynesian economics 246 substitution effects 178 incentives reduction 179 substitution effects in an economy 178 supply 81 supply and demand for different commodities 83 supply chain of goods 156 supply curve constraint mortgages 170 “Supply really does create demand” (François Hollande) 146–7 supply-side economics 172, 176 supply, value-adding 147 sustainable patterns of trade 157 tariffs, increase in 173–4 tax cuts 129, 173 tax cuts in Japan 130 tax cutting corporate business and investments 232 tax policies Keynesian periods, 1929–39 172 supply-side periods, 1921–29, 1981–89 172 tax rates corporate income for Great Depression and Great Recession years, 1929–39 and 2004–14 172 for capital gains 172 for personal income 172 taxing work increases amount of 165

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tax-rebate plan President Gerald Ford, 1970s 178 technological advances in nineteenth century accumulation of capital goods 189 technological change 48 technological errors 28 technological progress 189 new uses for capital goods 185 technological progress, lack of no increase in capital goods 188–9 technological progress value 187 technology and capital goods 187–8 Template Letter 3 temporary idle resources, 89 Thatcher government “monetarist” policy 60 theory of aggregate demand 7–8 time-consuming temporal production process 33–4 time dimension 47 time paths of consumption 94 time preference present consumption over future consumption 15 time preferences 18 Total Output 227 consumers on consumption goods 137 Total Output and Employment 79 “trade cycle” boom and bust 98 trade cycles boom phase 96 trade needs, accommodation 100 transfer payers 177 demand reduction 179 transfer payment check Summers’s logic 176 transfer recipients 177 spending more 179 transfer resources and spending power 179 Troubles Asset Relief Program (TARP) 223 Truman, Harry S., American President no fiscal stimulus to American economy 128

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unemployment, 89, 92, 150, 239 unemployment benefits 21 unemployment compensation, generous 102–3 unemployment countering “print money”, spend, borrow 244 unemployment, growing 194 unemployment increase 157 unemployment problem job loss, options available 157–8 unemployment rates, double-digit 78 unemployment rates in United States, UK and Australia, 1929 to 1938 127 unemployment situations Keynesian economics relevance 244–5 unfunded liabilities in America 224 unit trust units purchase 52 unitary rate of interest 16 United Kingdom Blue Book 52 United Kingdom Clearing House Automated Payment System (CHAPS) 50 United Kingdom fiscal policy tightening 67 United Kingdom Payments Administration Ltd payments settlement 48 United Kingdom savings ratio, 1963 to 2015 63 United States Bureau of Economic Analysis 226–7 United States economy investment-driven, not consumption-driven 228 United States employment rate 160 United States stock market companies buying back own shares 208 value and production glut 33–6 value creation 36 sale at profit 34

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value-creation process on consumers’ terms 41 value creation through production 42 value destruction sale at a loss 34 value of transactions significance 47–50 value productivity not physical productivity 110 Vietnam War 129 virtues of thrift “general” theory of economy 219 Wage Level 79 wage rates, lower cost and prices, lower 195 wage rates, sticky-downward 92 wage restraint during 1973 58 Walrasian general equilibrium 239, 242 wars, natural disasters beneficial to Keynes 196 Washington Consensus John Williamson 214 waste workers in industries 163 weakness in an industry 159 wealth, spending one’s way to 165 websites delivering news 157 welfare state 218 welfare state, slow development postwar period 129 “wholesale financial” transactions 50 Wicksell, Knut, Swedish economist rising prices, 1898 86 Wicksellian model nature of capital 109 World Bank world output value, 2013 48 World War II benefits of massive deficit spending 222 world’s economies, instability carbon emissions limitation 132

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