Tuesday, August 23, 2011

The Failure of Keynesian Economics

Stephen Moore wrote an editorial in Friday's Wall Street Journal decrying the current administration's wholesale, unquestioned embrace of Keynesian macroeconomics. He began his piece with these passages,

"Consider what happened last week when Laura Meckler of this newspaper dared to ask White House Press Secretary Jay Carney how increasing unemployment insurance "creates jobs." She received this slap down: "I would expect a reporter from The Wall Street Journal would know this as part of the entrance exam just to get on the paper."

Mr. Carney explained that unemployment insurance "is one of the most direct ways to infuse money into the economy because people who are unemployed and obviously aren't earning a paycheck are going to spend the money that they get . . . and that creates growth and income for businesses that then lead them to making decisions about jobs—more hiring." "

If you stop and think about Carney's response, it's a lot like Keynes' own suggestion that, if necessary, pay men to dig, then fill holes, in order to 'prime the pump.'

If economics were a so-called hard science, like physics or biology, these theories would have been carefully tested to determine their veracity, and, if so, under what conditions or constraints.

But since economics is considered more of a social science in actuality, but taught and beheld by many politicians as a hard science, Keynes' theories gained credibility without real tests.

Over the years that I've written this blog, I've reviewed articles in the Journal by eminent economists and near-economists concerning the lack of evidence that Keynesianism ever worked. For example, recently, I wrote this post discussing Richard Rumelt's recent Journal piece reminding us, via facts, that FDR's domestic spending during the Depression didn't rescue the US economy. Neither did WWII. It was the forced savings during the war, via rationing and bond drives, that led to the subsequent economic growth from all that savings and pent-up demand which was forcibly denied during WWII.

Earlier, in this post, I cited Alan Reynolds' empirical survey of analyses of government spending and recessions. A quote from Reynolds in that post is appropriate here,

"A 1999 study in The Journal of Economic Perspectives by Christina Romer (now head of the Council of Economic Advisers) found that "real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe." Ms. Romer also noted that "recessions have not become noticeably shorter" in the era of Big Government. In fact, she found the average length of recessions from 1887 to 1929 was 10.3 months. If the current recession ended in August, then the average postwar recession lasted one month longer—11.3 months. The longest recession from 1887 to 1929 lasted 16 months. But there have been three recessions since 1973 that lasted at least that long.

In the late 19th and early 20th centuries, nobody thought the government could or should do anything except stand aside and let the mistakes of business and banking be fixed by those who made them. There were no Keynesian plans to borrow and spend our way out of recessions. And bankers had no Federal Reserve to bail them out until 1913. Yet recessions after the Fed was created soon turned out to be much deeper than before (1920-21, 1929-33, 1937-38) and often more persistent.

It's clear that U.S. history does not support the theory that Big Government means shorter and milder recessions. In reality, recessions always ended without government prodding, long before anyone heard of Keynes and long before the Fed existed. What's more, recessions ended more quickly before the New Deal's push for Big Government than they have in the past three decades. The economy's natural recuperative powers before the 1930s proved superior to recent tinkering by Big Government economists, politicians and central bankers."

With those examples in mind, here are the later passages from Moore's Friday editorial,

"How did modern economics fly off the rails? The answer is that the "invisible hand" of the free enterprise system, first explained in 1776 by Adam Smith, got tossed aside for the new "macroeconomics," a witchcraft that began to flourish in the 1930s during the rise of Keynes. Macroeconomics simply took basic laws of economics we know to be true for the firm or family—i.e., that demand curves are downward sloping; that when you tax something, you get less of it; that debts have to be repaid—and turned them on their head as national policy.

As Donald Boudreaux, professor of economics at George Mason University and author of the invaluable blog Cafe Hayek, puts it: "Macroeconomics was nothing more than a dismissal of the rules of economics." Over the years, this has led to some horrific blunders, such as the New Deal decision to pay farmers to burn crops and slaughter livestock to keep food prices high: To encourage food production, destroy it.

The grand pursuit of economics is to overcome scarcity and increase the production of goods and services. Keynesians believe that the economic problem is abundance: too much production and goods on the shelf and too few consumers. Consumers lined up for blocks to buy things in empty stores in communist Russia, but that never sparked production. In macroeconomics today, there is a fatal disregard for the heroes of the economy: the entrepreneur, the risk-taker, the one who innovates and creates the things we want to buy. "All economic problems are about removing impediments to supply, not demand," Arthur Laffer reminds us. "

I highlighted Art Laffer's comment because it seems useful to me to focus on the true fundamental nature of man's economic problem: scarcity. Economics has always been, at root, about how to allocate scarce resources for the production of goods and services to satisfy a population's demands, at prices which satisfy both producer and consumer.

I may be one of the very few Americans to have read a slim volume on economics from the 1939 entitled The Theory of Idle Resources by W.H. Hutt. It was a response to Keynes' General Theory of Employment, Interest and Money (1935), which I have also read in full.

Keynes' basic ideas seem sensible, until you read Hutt's rebuttal. Particularly Hutt's scathing rebuke of Keynes' notion of MPP (the marginal physical product of labor). Hutt studied economics at the LSE and taught in Cape Town all of his professional life. The jacket of my copy of the book contains an approving accolade from no less than Von Mises, attesting that Hutt was "not contested by any competent critic."

Prior to Keynes, the classical theory of macroeconomics correctly equated PQ and MV, or the price of goods and services produced, multiplied by quantities, and the money supply multiplied by its velocity. But nobody believed that macroeconomic forces could or perhaps should be forcibly altered by government action. No economic theorists were that vain and egotistical to believe that they could counsel government on how to prevent economic cycles.

I have always found it ironic that neo-Keynesian Paul Samuelson (father-in-law of the current administration's economic maven, now departed, Larry Summers) won his Nobel prize for a theory, the 'accelerator-multiplier,' which actually explained why the classical approach of macroeconomic non-intervention would allow economies to pass through their various cycles without interference.

Of course, Samuelson and his followers instead used his theory to argue for government intervention in order to magically short-circuit recessions. Something that, as Reynolds noted, even citing another current (also now departed) administration economic advisor, Christine Romer, has never actually occurred.

I shudder every time I hear new-Keynesians and their followers decry classical economics as some hoary pre-Enlightenment sort of faith-healing. Though Keynesian proponents can offer not one credible shred of evidence for the actual effectiveness of government debt-financed spending as a tonic for economies in recession, they seem to appeal to human nature's desire to believe that doing something is better than simply allowing the large, complex and difficult- if not impossible- to control entity that is a modern developed nation's economy to experience the natural cycles it must. Patience is hardly a modern virtue, either, so that's another basis on which classical economics seems to be judged guilty by modern Keynesians.

But the reality is that without naturally-occurring cycles in economies which clear out failure, re-allocate resources and allow new growth, you don't get constant economic expansion with low inflation. Instead, you get politically-allocated resources borrowed on behalf of taxpayers, along with the recession that was promised to be ended sooner and more mildly than without the deficit spending.

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