Friday, 12 December 2014

How to Promote a Global Economic Recovery? The Keynesian vs. Free Market approach

What are the best economic policies to promote global recovery? Steven Kates, Associate Professor of Economics at RMIT University, tries to persuade Louis-Philippe Rochon, Associate Professor at Laurentian University and Founding Co-editor of the Review of Keynesian Economics, that Keynesian theory just makes economic problems worse.

Painter Duncan Grant with economist John Maynard Keynes. Wikimedia Commons.


Dear Louis-Philippe,
There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.
The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.
“In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work.” (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.
“What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.” (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.
In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.
And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.
You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.
If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:
“If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.
There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.
The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.
A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.
Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.
But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.
Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.
The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.
The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.
Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.
In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.
What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.
No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.
That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.
Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader. There is literally nothing else like it anywhere.
Best wishes,
Steve
Bibliography
Akerlof, George and Shiller, Robert. 2009. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton, NJ: Princeton University Press.
Kates, Steven. 2009. “The Dangerous Return to Keynesian Economics.” Quadrant.
2014. Free Market Economics: an Introduction for the General Reader. 2nd edition. Cheltenham, UK: Edward Elgar Publishing.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.

Temin, Peter and Vines, David. 2014. Keynes: Useful Economics for the World Economy. Cambridge, MA: MIT Press.
You can follow the reply and the following correspondence on Elgar Blog, where this was originally published. 

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