Part 2 of a Discussion of Peter Foster’s Why We Bite the Invisible Hand Chapter 10 “The Rise and Fall and Rise of John Maynard Keynes”
Continuing on from the previous blog, we will look deeper into Keynesianism in the 20th century and what led to its fall and the rise of neoclassical economics in the 1980s.
John Maynard Keynes was a second generation academic who studied at Cambridge University where his father taught economics. He studied under Alfred Marshall, who we learned in the previous blog thought similarly as Adam Smith.
Keynes spent time in both government and academic positions over the years. He worked for the British Treasury during World War I, which provided him a front row seat to the Treaty of Versailles that saddled Germany with enormous reparation payments.
Keynes wrote a book, The Economic Consequences of the Peace, where he spelled out how the reparations were “economically flawed and politically dangerous.” (p. 205)
While history proved him right, this early work did not mean he was against heavy handed government policies in all cases.
His most influential work was The General Theory of Employment, Interest, and Money, published in 1936, in the depths of the Great Depression. In it, he refuted the Smithian notion of a self-correcting market economy. Full employment was not a natural state of affairs; thus corrective government action was essential. (p. 205)
Keynes was educated in the classical economics that still prevailed in his day, but he questioned its conclusion that the economy would necessarily right itself when there was a downturn in output and employment.
That conclusion was based on the assumption that prices would adjust to clear any imbalances. A rise in unemployment would lead to a fall in wages, which would then make it so businesses could hire more people.
Keynes thought prices, in particular wages, could be “sticky.” That is, there is resistance to wages falling. This could be due to contracts, labor unions, and people’s unwillingness to take a pay cut.
However, falling real wages is essentially what happens when we go through a recession. Hourly workers who are given less hours are essentially having their wages cut. The unlucky salaried workers who lose their jobs often find themselves getting a new job at less pay.
Keynes thought this process would be slow and incomplete so that wages would not fall to the point that unemployment was eradicated like the classical economists predicted.
Also, he captured the idea that even if it did work as classical economics said, it could take a long time, and in fact, too long, with the well known quote, “In the long run we are all dead.”
Classical economics predicted the economy would right itself in the long run, but they never said how long that could take to occur. Keynes’ work suggested a role for government spending and tax policies that could shorten the time it took to get back to full employment without waiting around for some elusive “long run” fix.
Keynesianism is not focused on the individual actors of households and businesses. It focused economists on the aggregate: Aggregate Demand and Aggregate Supply.
Thus, when a downturn hits, unemployment rises and consumption falls as people’s income falls. This is a decrease in Aggregate Demand because Keynes holds that as private spending falls, so does Aggregate Demand. However, here is his big contribution: government spending is part of Aggregate Demand.
An increase in government spending then could offset the decrease in private spending, helping to move the economy to full employment.
This is ignoring the idea of crowding out: the increase in government spending has to come from somewhere so in one way or another it is coming from the private sector.
Those more in line with classical economic thinking hold that crowding out is perfect and thus in the long run any increase in government spending is perfectly offset by a decrease in private spending.
Another problem with the overall solution of letting government spend us out of a recession is it is assuming government will spend the money better than the individual. This is getting us back to the DIYE flaw that we have an inborn bias towards thinking someone should be in charge of the economy.
Foster quotes economics journalist Henry Hazlitt criticizing this idea that government could do better than the individual. (p. 207)
“The people who have earned the money are too shortsighted, hysterical, rapacious, and idiotic to be trusted to invest it themselves. The money must be seized from them by politicians, who will invest it with almost perfect foresight and complete disinterestedness (as illustrated, for example, by the economic planners of Soviet Russia.) For people who are risking their own money will of course risk it foolishly and recklessly; whereas politicians and bureaucrats who are risking other people’s money will do so only with the greatest care after long and profound study.”
If Hazlitt was writing today, I think he would have to add /s.
Another consequence of Keynesianism is how it completely flipped the way we think about the economy. From classical economics, we had Say’s law: the income generated by past production and sale of goods is the source of spending that creates demand to purchase current production.
That means the source of demand is production. First you have to produce something worthy of being sold to have the money to buy things.
Keynes flips this idea so that consumers are the source of demand. When consumption falls, it needs to be boosted to keep the economy going.
It was Keynesianism that turned us into a consumption focused economy where we act as if we can “spend ourselves rich.” (p. 209)
Criticism of his theories fell largely on deaf ears because his theories gave policymakers exactly what they wanted.
Keynes’ main attraction for economists and politicians was that he offered an economic model that put them in charge…That was in part because he offered a seemingly scientific rationale for what politicians wanted to do, in part because he provided economists with a self-image combining the authority of technique with high moral purpose, and in part because he created an arsenal of economic concepts that proved indispensable even to those who disagreed with his particular policy prescriptions. (p. 209)
The Theory of Public Choice Disagrees
As stated in Hazlitt’s criticism above, Keynesian theory implicitly assumes that government is capable of spending money wisely.
Economist James Buchanan won the Nobel Prize in economics in 1986 for his work showing that that is not likely.
Stated simply, Buchanan’s main contribution to political economy — via the theory of public choice — was to note that political actors behaved just like economic ones: they looked out for number one. Whatever good intentions they might profess, elected representatives and bureaucrats did not pursue the “public purpose” without regard for their own benefits. Their top priorities were to get, and stay, elected, and/or to expand their political/bureaucratic empires. (p. 211)
We could have all sorts of debates about the details of Keynesianism, but to me, the above quote is the killing shot.
People are quick to say that the government should do this or that, but they never stop to think why the government could be trusted to do it.
Government is made up of the same kind of self-interested people who operate outside of government. Giving them power and money does not make them somehow more saintly that then rest of us. And it would take very little time to amass a canon of stories showing quite the opposite.
Buchanan himself did not start out thinking in the way he eventually enshrined in the theory of public choice.
Buchanan acknowledged that his own intellectual development represented a journey from reflexive left to reasoned right, from sharing a pervasive belief that business was dangerous and needed to be controlled politically, to an appreciation of free markets and a realization of the profound flaws of economic intervention and macro-management. (p. 211)
And if you are still hanging on to Keynesian thinking, I will give you one thing to hold onto. He advocated that government would spend more/tax less during recessions AND spend less/tax more during boom times.
Only half of his prescription was instituted — the half that is popular policy with the electorate. Raising taxes and cutting spending tends to make voters mad.
It seems Buchanan is right about government doing what is best for government as opposed to what is best for the economy. They only implemented the half of Keynesianism that benefitted them.
The Fall of Keynesianism
Keynesian policies were adopted widely in reaction to the Great Depression, but they started being questioned by the 1970s. The increased government spending it called for led to inflation, so really you were trading one problem for another down the road. (p. 216)
In addition, the 1970s oil shock revealed that there are two kinds of recessions. There is the “ordinary” recession that is a slump in aggregate demand, but it is also possible to have a negative shock to aggregate supply. Since Keynesian policies can only impact aggregate demand, they are not useful when there is a negative supply shock.
In the 1970s, policymakers were faced with unemployment and inflation. Their typical Keynesian response to increase spending to combat the unemployment would just make inflation even worse.
For all these reasons and more, the 1980s saw the rise of President Reagan and Prime Minister Thatcher pushing neoclassical economics, a return to some of the classical thinking Keynesian policies had supplanted.
The events of the 1970s….paved the way for the Thatcher and Reagan revolutions of the 1980s with their emphasis on deregulation, privatization, personal responsibility and breaking the more perverse aspects of trade union power. (p. 216)
Mainstream economists howled in protest as the Keynesian theories that cast them as experts were threatened. Despite the economic growth that resulted from the Thatcher and Reagan revolutions, they railed against them. In March 1981, 364 British economists signed a letter claiming Thatcher’s policies had “no basis in economic theory.” (p. 217)
Really? Sounds like an early encounter with “The Science.” Of course it has a basis in economic theory. At least an economic theory. You may hold to a different theory, but it is histrionic to say there was no theory backing it. Just ask the Austrian economists like Mises and Hayek.
While the original form of Keynesian economics fell at this time, it was set to rise again as soon as neoclassical economics faltered in the 2008 financial crisis.
However, Keynesianism had not been dispatched. It catered to too many useful misconceptions. The lessons of economics are both counterintuitive and morally suspect, and thus subject to reflexive dismissal by every new generation. (p. 217)
We will look at the return of Keynesianism in the next blog.
Reference: Foster, Peter, 2014. “The Rise and Fall and Rise of John Maynard Keynes” Chapter 10 of Why We Bite the Invisible Hand, Pleasaunce Press.
