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November 21st 2010 print

Steven Kates

Keynesian economics is dead

Finding some kind of straw man version of economic theory to pin the downturn on may be very soulful for those dwindling number of Keynesians out there but the fact remains that recovery will not happen until we again find private sector activity on the rise.

Ross Gittens wrote an article in The Age last week and I wrote a reply which has not been published. Gittens wrote about how original Keynesian ideas were when first put forward by Keynes in 1936.

I suppose newspapers are not really a forum for the history of economics but it nevertheless does make quite a bit of difference where ideas come from and their ancestry as well.

The origins of The General Theory is, as it happens, part of my contribution to economics and without putting too fine a point on it would make the claim that I know more about how that book was written than just about anyone else alive. If you doubt this, google the name Harlan McCracken and see what you get. It was McCracken, however, that coined the phrase “supply creates its own demand” that ended up in The General Theory as Keynes’s own definition of Say’s Law. Ask an economist where the phrase comes from and my guarantee is that they will not know. Now you do, but they don’t. Anyway, this was my response to Gittens. 

OK. So Ross Gittens knows nothing at all about the history of economics. That puts him on par with everyone else in the profession. But at least the rest of the profession has the good graces to keep quiet about what they know so little. 

What does one do with something so completely out of touch as this: “There aren’t many new ideas in economics, just old ideas tarted up. Keynes’s ideas were new, however.” 

New, as in which way? New, as in never been said before? New as in novel for the time? Or do we mean new as in Ross Gittens had never heard these ideas before he heard them from Keynes? 

Demand deficiency and oversaving was the most common fallacy in economic theory until it became the mainstream. Today, rather than it being seen as fallacious, it is the core theoretical mode in all of macroeconomics. But Keynes was hardly the first to try to bring such ideas into the mainstream. 

How far back do we want to go to find some precursor for this bit of nonsense. Well, let us go to Robert Malthus’s Principles which was published in April 1820. I always prefer to go back to Malthus’s version since it was because Keynes was reading Malthus in late 1932 that the idea of demand deficiency even entered his head. 

But there were plenty of others before Malthus who had these ideas and there were plenty afterwards. What made the Keynesian version so potent was that he was at the time the most famous economist in the world (as was Malthus in his) and the Great Depression had just ended and many economists, almost entirely those under the age of forty, were looking for something new. 

Well they got something new but it has been painfully and notoriously useless in every recession it has ever been put to the test. The New Deal never ended the Depression in the US, just as the stimulus of the early 1990s has left the Japanese economy almost moribund every since. 

We pretend here that this Keynesian stimulus made all the difference to our relative return to prosperity in Australia. The reality is that our apparent success was built on Treasury wildly overestimating the negative consequences of the GFC which made the economic outcome here look like a success story of some kind. 

And then there was the massive stimulus in China which fed into our resources sector that has helped us sustain reasonable rates of growth although a recession we did indeed have along the way. 

Meanwhile, back in the real world, in the United States in particular, the effect of the Keynesian stimulus has been exactly what we non-Keynesian economists said would happen right from the start. The US is mired in a recession from which a return to strong rates of growth and low unemployment appears years away. 

And in the midst of high unemployment and low private sector growth, even Barack Obama is beginning to see the necessity for fiscal restraint and a reduction in the deficit. No more Keynesian stimulus there. 

Whatever you might say about the thirty years before this fiscal catastrophe, the Keynesian policies of the past two years have discredited the very idea of deficit finance and public spending as the way out of recession. Whatever the textbooks might say, it will be at least a generation before anyone even thinks of trying such policies again. 

As for the notion that market economies can be kept out of recession, Keynesian theory replaced what was known as the theory of the cycle. Everyone once upon a time knew that recessions were an inevitable part of economic life. Does Gittens really think neo-classical economists even today deny that recessions can occur? 

Now, because of the predominant Keynesian model, demand deficiency is almost invariably seen as the probable cause of recession and when they come, theory tells us they can be cured by public spending. 

Let us instead look at what really happened. The GFC was an infection that began in the housing market in the United States due to the prevalence of subprime mortgages that had been forced on the banks by the American Congress. 

The contagion was spread across the financial system through a series of badly priced financial assets that almost froze the payments system of the world. 

These are the elements of a classical structural recession. This is a recession that cannot be explained by a Keynesian model in which economies contract because of a fall in aggregate demand. Demand surely fell, but something else was the cause. 

Keynesian economics is dead. Finding some kind of straw man version of economic theory to pin the downturn on may be very soulful for those dwindling number of Keynesians out there but the fact remains that recovery will not happen until we again find private sector activity on the rise.