By Alasdair Macleod – Re-Blogged From http://www.Silver-Phoenix500.com
As we lurch through successive credit crises, central bankers and economists believe they learn valuable lessons every time, and that the ultimate prize, the suppression of business cycles through monetary policy, will be achieved. Enormous effort is put into computer models to enable economists to predict the future, and no doubt, the modellers are now working with artificial intelligence to improve their accuracy.
We saw, over Brexit, how wrong the Bank of England’s and the UK Treasury’s models were, and these errors were also evident in the OECD’s model. Brexiteers smelled conspiracy, but in the absence of evidence, perhaps we should give them the benefit of the doubt and assume the errors were genuine. If so, all computer economic modelling has been a waste of time.
Then there’s the old mantra of garbage in, garbage out, which is certainly true. However, the problem goes deeper than the models, and is rooted in the rejection of classical economic theory. This rejection dates from Keynes’s General Theory, published in 1936, which forms the basis of today’s macroeconomics. Even though macroeconomics began to evolve during the depression years, Keynes’s book really marked the birth of it becoming mainstream.
The failures are manifest and multiple. And while we have no knowledge of the counterfactual, there is good reason to believe the errors made by following macroeconomic theory are far greater than if we were still basing government policy on classical economics. Admittedly, this is a broad statement that does not allow for differences of opinion between the classical economists of yesteryear, and differences of opinion between economists post-war. But there are some fundamental distinctions between the two disciplines that can be agreed.
The most fundamental is of approach. Classical economists agreed that demand is subordinate to supply. In other words, the time-line of goods and services acquired by the individual is that his demand for them must be successfully anticipated before being produced and supplied. The reasoning is unarguable. It therefore must follow that a recession cannot be the result of a lack of demand. It is the result of goods being produced in error, either unwanted or too expensive for the market, and that error not being corrected by the efficient reallocation of capital. This is just one of the important conclusions of what came to be called Say’s law, and it is not revealed by Keynes’s incorrect definition of it, that supply creates its own demand.
This five word phrase, accepted by the mainstream, has perhaps done more economic damage than any other definition. Keynes compounded his error two pages further on, by stating that,
Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output is equivalent to the proposition that there is no obstacle to full employment.
The obfuscation is deliberate, dressing up a statement to make it both innocuous and indeterminate. Note how Keynes tries to turn his earlier inaccurate statement into an equation, and then connect it to his assumption. As we all know, equations must balance, and this equation’s balance has an obvious element of doubt. The seeds of doubt can then be made to grow in the reader’s mind. It is no more than simple prestidigitation.
Keynes may as well have said that Say’s law is the equivalent to saying that there is no obstacle to the totally efficient use of capital. But that would have exposed the weakness of his argument. We should know that the division of labour, which is just a part of the capital allocated to production, is a dynamic process of success and failure. It is not the static representation that Keynes describes. This has nothing to do with refuting a very simple process: we produce to sell to buy what we want and need.
Since the whole of his General Theory is based on the refutation of Say’s law, and these are the only passages referring to it, you would think its readers would smell a rat. Many did when it was published. Before, this sort of stuff was the preserve of eccentrics. After, it was the classicists who were out of step.
More correctly, supply anticipates demand. The importance of, and therefore the purpose for Keynes’s error becomes obvious when one realises that demand can be temporarily stimulated by the introduction of new money into the economy, which is where neo-Keynesian economics has taken us. It is far less easy for governments to stimulate production and maintain a constructive role in the economy, because that requires successful entrepreneurial decision-taking, for which governments are not equipped. A government entering commercial operations is practising communism, and we know only too well that that fails.
Before Keynes, there had been only two notable attempts to bring demand stimulation into consideration. In 1807, William Spence suggested that the loss of trade from the Napoleonic Wars could be remedied by encouraging the landed aristocracy to increase their spending. The idea has superficial attractions. The next attempt to promote demand stimulation was in 1820, with the publication of Thomas Malthus’s Principal of Political Economy. Malthus argued that over-saving reduced demand and led to a general glut of unsold goods.
David Ricardo refuted Malthus by pointing out to him that the problem was the manufacture of unwanted or unprofitable goods. If, for whatever reason, entrepreneurs failed in their plans, goods unwanted at the price demanded will remain unsold. Therefore, it cannot be the result of insufficient demand. The disproof of Malthus’s approach emerged over time, when he had incorrectly forecast that agricultural production could not keep pace with population growth, leading to starvation, wars, and the rest. Malthusian logic is consistent with the erroneous belief that demand stimulates production. It ignored entrepreneurial anticipation of demand for food, which has not only satisfied and outpaced the demand that arose, but has even released labour for employment in other production.
It is impossible to prove, other than circumstantially, whether Keynes simply failed to understand the errors made by Spence and Malthus, or whether he was merely pursuing his own agenda. He was, after all, primarily an establishment man, a believer in government, and in the fallibility of free markets. His psyche was to despise the idle rich, who he pejoratively termed rentiers, but whose accumulated capital is central to the working of free markets.
His argument, simplified, was that if the free market fails, the government can surely intervene to put things right. All that had to be worked out is the theory behind how to do it. That’s when Keynes came up with the concept of aggregate demand, consisting of the sum of consumption, investment, government spending, and net exports. Mathematically, and Keynes was first and foremost a mathematician, a shortfall in any of the others can be made up by an increase in government spending. And by dismissing classical economics, this would be made possible by giving money a greater role than implied by Say’s law.
In effect, Keynesianism has blurred the line between the real economy and money. No economist today thinks first and foremost about the economy in any other terms but money-totals. Even followers of Austrian economics rarely appear to think otherwise, routinely talking of economic growth measured in gross domestic product, instead of economic progress, which cannot be measured. The reason the distinction is barely understood is all economists are trained in Keynesian macro theory first, and if they subsequently discover classical or Austrian economics, they still retain a money-side approach.
The Credit Cycle
Ricardo’s refutation of demand as the cause of recessions correctly identified the problem as being a failure of production. But in his letter to Malthus (referred to above), he does not go into why there should be a failure of production sufficient to cause a recession. He mentions that with an abundance of capital and a low price of labour, “there cannot fail to be some employments which would yield good profits”. He makes the case that production must be relevant to demand. All this is true, but it equally applies to the continual evolution of an economy where producers randomly fail and succeed, and on its own is not an explanation of a more general increase in unsold goods.
There was a sharp slump at the time of Ricardo’s letter. Britain had moved from a war economy, financed by monetary inflation. Post-war, the government cancelled contracts, leaving industry to adjust, and had an eye on returning to the pre-war gold standard, which meant reducing the money quantity. The combination of changes in money quantities and government spending overrode the otherwise random process of failures and successes of production, and resulted in high unemployment.
Subsequent discoveries by the Austrian school identified the origins of economic disruption as arising from variations of money and credit, to which we can obviously add the disruption caused by quantitative changes in government spending. Both were present during and after the Napoleonic wars. Fortunately for Britain, wise heads somehow prevailed, and despite enormous political difficulties and radical change, Britain emerged over the rest of the century to become the world’s economic powerhouse.
Contemporary politicians also face enormous economic challenges, but without the benefit of classical economics. In that sense, their task is made even more difficult today.
The Keynesians, by turning their backs on classical economics, became managers of demand. The dissidents, while they retained most of their monetary and mathematical mind-set, came to be called supply-siders. Supply-siders woke up to the futility of stimulating demand, and effectively fell into line with Say’s law, at least insofar as it defined the sequence of events as produce something first, sell it for money, then buy another product.
As soon as the primacy of production is realised, the shortcomings of a consumption-focused approach becomes apparent. This is now particularly relevant, given that President Trump is trying to pursue his own version of supply-side economics by introducing tax cuts as a means of stimulating the US economy.
President Trump appears to believe that if he cuts tax rates, the economy will be sufficiently stimulated to raise tax income overall, and thereby close the budget deficit. Note, there is no attempt to reduce the destruction of capital that results from taxation and government spending. And note further, there is no attempt to stop the Fed from using the expansion of money and credit to manipulate demand. In short, the White House’s economic policy is severely confused.
The classical approach is to withdraw government from the overall economy as much as possible, and allow ordinary people making things to do so with minimal intervention. It means allowing people to be motivated to accumulate personal wealth and to keep it. It means rescinding government regulation of commercial activities. It means allowing the failures to fail. It means withdrawing welfare support from all but the neediest cases. It means reintroducing the certainty that comes with sound money.
A modern politician is only interested in the next election. A statesman thinks about future generations. A statesman considers how he will carry his electorate with him towards a better future, and is successful only if he manages to steer them in the right direction. But what is the direction, and what is that future?
Unwinding the distortions brought about through macroeconomic fallacies is going to be a monumental task. It means abandoning those fallacies, and realising that people, not governments, facilitate economic progress. It means accepting the destruction of the post-war economic order, including, most likely, the end of state-issued currencies in their current unbacked form. It means dismantling most of the monetary apparatus, downsizing the central banks. But what makes the task almost impossible is the fact that everyone who has studied economics, and has any credibility in the discipline, started from and cannot abandon that Keynesian mind-set.