What Neo-Keynesianism Has Wrought

Here is Keynes’s own version of pre-Keynesian economics: Economies never go into recession because aggregate demand always equals aggregate supply.

Having invented this total fiction, Keynes then argued that in spite of what his predecessors had said, economies actually could go into recession. He received wild applause for this supposed insight into economic reality which had apparently evaded the entire economics profession for the previous 150 years. Indeed, he went further; he provided his own explanation for recessions, arguing that they were caused by too little demand. Things weren’t selling because people weren’t buying.

Based on this premise, Keynes proposed his own remedy: When economies slowed, governments should make up for the missing demand by spending because the private sector clearly was not.

And from his day to this, both his description of classical economics and his theory of recession have been taught to economists, and for the vast majority of the economics profession this is all they can be expected to know. Almost no economist in the modern world is taught the classical theory of the cycle.

Here instead is the real version of pre-Keynesian economics: Economies frequently go into recession, which is why the business cycle is an inevitable part of economic life. 

The theory of the cycle was an integral part of pre-Keynesian economic theory. And as far as pre-Keynesian economists were concerned, it was the specific preserve of economic cranks to argue that recessions were caused by too little demand.

A pre-Keynesian economist perfectly well understood that while there were a number of steps that could and should be taken to hasten recovery, public spending in recession could at most add a small counterweight to the forces pulling the economy down, but the cycle being cyclical, an upturn would come in due course. Public spending, especially when poorly directed, would almost inevitably make things worse, not better.

The classical view was almost perfectly stated by Winston Churchill when he was Chancellor of the Exchequer in 1929:

The orthodox Treasury dogma, which is steadfastly held, that whatever might be the political or social advantages, very little additional employment and no permanent additional employment can, in fact, and as a general rule, be created by State borrowing and State expenditure.

There was thus, once upon a time, a clear understanding amongst economists that public spending added almost nothing to employment during recessions and whatever might be its short-term effects, in the long term such expenditure would add nothing at all to the number of people employed. This is an understanding that has disappeared almost entirely from within the economics profession. If there is a Treasury dogma today, it is almost precisely the opposite of the dogma that was held in Churchill’s time.

Over the past seventy years, strange as it might be to say, there has been a regression of economic theory. The advice now provided by economists during recessions is worse than the advice that would have been offered seventy years ago.

Looking Back Twelve Months

Twelve months ago, in Quadrant’s March 2009 issue, I discussed the difference it makes whether one looks at recessions as a Keynesian or instead sees things through classical eyes. Twelve months later, the first returns are coming in and it is not very good news for those of a Keynesian persuasion. Only if they compare Keynes with his straw-man classical version do they come out ahead. Comparing Keynesian theory with the actual fully developed classical theory of the cycle leaves the Keynesians in the dust.

As I discussed in my article then, recessions in classical times were seen to occur because of structural problems. Large parts of the economy would, for one reason or another, find that they had produced goods and services which could not be sold at a profit. The cause of the downturn was always different, but the differences were variations on a theme based on structural imbalances in the economic system as a whole.

On this occasion, the most important of these structural problems occurred in the United States, where at one and the same time, the housing industry, the car industry and the banking industry all found themselves in the midst of major contractions. These were not due to a fall in demand—it would be ridiculous even to suggest any such thing—but were due to faulty legislative programs, poor regulation and a series of bad business decisions in each sector. The result was a massive decline in output and a major increase in the level of unemployment, which was transmitted across the world partly through a global infection of the world’s financial system and partly through a massive loss in business confidence. All of this was well within the compass of the classical theory of the cycle, and none of this can be coherently explained using a Keynesian model.

Given the nature of the downturn, the absolute first priority was to stabilise the financial system, which was undertaken in a series of emergency measures in just about every economy where the banks were under threat. Here in Australia the most important step was to guarantee deposits in the major trading banks, but other smaller steps were taken as well, with the most notorious being the OzCar scheme for financing automotive dealers after credit lines had become frozen. Other measures could have been taken, and in some cases were taken, such as lowering interest rates and, in some overseas economies, also lowering business taxation.

The one set of actions that should have been avoided, as any good classical economist could have told you, were increases in unproductive forms of public spending and in particular, large increases in the budget deficit. Not only were these unnecessary, they would also themselves in time become an addition to whatever existing problems there were, not in any way a solution. The world’s economies have now stabilised, but where a Keynesian solution has been applied—that is, in those economies where public spending and large budget deficits were at the centre of the policy response—the result has been the arrival of a potentially far more intractable set of problems than the problems such spending was intended to fix. These problems will remain with us for a very long time.

In both the USA and the UK, the wrongness of Keynesian expenditure policies are obvious. There was a time, perhaps in the middle of 2009, that the notion that things would have been worse had all this spending not taken place had a kind of plausibility, but such a time has long gone. It is now clear that the expenditure programs in the USA and UK have created no economic momentum whatsoever and have left a large number of additional problems in their wake.

Disappearance of Recession

But what is more to the point is that irrespective of what was done in any economy, the worst of the recession has ended—absolutely ended. Sometime around the middle of 2009 economies everywhere stabilised, the panic ended and a trough of some kind was reached.

It did not matter what policies the local government had followed, it did not matter whether that government had laid on an expenditure program of many percents of GDP, or whether it had cut taxes, or whether it had done nothing at all, the downturn simply stopped. So far as the ending of the fall into the abyss was concerned, the rapid deterioration just went away. Nowhere across the entire globe is there a single economy still experiencing the kind of rapid deterioration that had been the common experience at the start of 2009.

For someone who looks at the business cycle in pre-Keynesian classical terms, this is exactly what one would expect. There would be a crisis of some kind, there would be a rapid worsening of economic conditions, and then a low point would be reached from which an upturn could be expected to build momentum.

This is not Keynesian economics in action. This is the classical pre-Keynesian theory of the business cycle describing exactly what one should expect. As I wrote in these pages as long ago as Quadrant’s April issue last year, in a text which was written in February when global uncertainty was at its peak:

“What the present recession will share with all of its predecessors is that one day, and not all that long from now unless we really do mismanage the downturn, even this current recession will also be a creature of the past while everyone busily gets on with re-building their wealth.”

There were certainly important steps that were needed, the most important one being the actions taken to stabilise the banking system, which I discussed in my article a year ago in March. As I then wrote:

Certainly there are actions that governments can take to relieve some of the problems of recession but they are limited. Sure, this is a better time than most to build infrastructure. Absolutely, there need to be measures taken to assist the unemployed.

Yes, the central bank should be lowering interest rates and ensuring the viability of the banking sector. All such steps are mandatory and largely non-controversial.

The technicalities of what needed to be done so far as the banking system is concerned are high-level matters. Post-mortems will be conducted for years to determine whether the actions were optimal or whether other steps might have better succeeded. But whatever might one day be decided on what ought to have been done, the emergency was then. Focusing on the banking system was an absolute essential and once that had been done, the downward momentum stopped and the storm clouds lifted so that we were merely left with the wreckage caused by the recession along with the additional wreckage caused by increases in the deficit and debt.

That is what is expected, or at least ought to be expected, from time to time in any economy. Once such ideas were common knowledge. These are the words of Margaret Thatcher, trying to get others to understand the nature of a free enterprise economy and the business cycle:

Since its inception, capitalism has known slumps and recessions, bubble and froth; no one has yet dis-invented the business cycle, and probably no one will … [What are] called the “gales of creative destruction” still roar mightily from time to time. To lament these things is ultimately to lament the bracing blast of freedom itself.

If you want to understand what happened during the last quarter of 2008 and the first half of 2009, the one place not to look for answers is in a standard Keynesian text. You will make little sense of anything if you do.

The Australian Story

Here in Australia, one might, if one did not know any better, think that the stimulus package has actually done some good. The Rudd government has made such a fetish of having avoided recession by first basing its definition of recession on there being two consecutive quarters of falling GDP, and then on having pumped spending into just the right sort of places so that the national accounts only ended up falling for a single quarter and not two.

Let me therefore point out what did happen to the growth rate in Australia’s GDP, using both the trend and seasonally adjusted figures for the relevant quarters.

Quarterly Growth Rate in GDP

                                      Trend         Seasonally


                                         %                   %  

September 2008                0.1                  0.1 

December 2008               –0.1                –0.9 

March 2009                      0.1                  0.5 


Total                                 0.1                –0.3 

Source: ABS—Australian National Accounts (5626.0)

I will leave to the technicians the debate over whether Australia was ever in recession but this was recession enough for me. Thus, with a stimulus expenditure of $43 billion—around 4 per cent of one year’s GDP—we avoided having a “technical” definition of recession by 0.2 percentage points. With a reduction of 0.2 percentage points in either the trend or seasonally adjusted figures for September 2008, Australia would have had a technical recession to go along with the actual recession we really did have. The money spent to keep GDP in positive territory may well have been the most expensive marketing campaign in the history of the Commonwealth.

It’s also worth looking at some other stats to remind us about the nature of the economy we are actually in, the most revealing being the figures on hours worked across the economy.

Hours Worked—Trend Data

                            Total Economy   Market Sector    

                                       %                        % 


September 2008             0.1                      –0.1 

December 2008            –0.5                      –0.9 

March 2009                 –0.7                      –1.2 

June 2009                    –0.6                      –1.0 

September 2009           –0.4                      –0.7 


Total Sept to Sept        –2.2                      –3.7 

Source: ABS—Australian National Accounts (5626.0)

Unless there has been some massive productivity improvement that occurred just when the economy went into recession and just when private and public sector investment went into decline, it is truly hard to reconcile a falling number of hours worked with an actual improvement in the level of economic activity.

This is all the more so since with private sector hours falling by a greater percentage than the total number of hours worked, jobs during the year shifted to the public sector and away from the private. There is not the slightest chance that the Australian economy produced more in real terms in the last twelve months than in the previous twelve months.

The reality is that the Australian economy went backwards over the past year irrespective of what the GDP figures might say. If fewer people were working and fewer hours were being worked, we were not producing a greater amount than we had produced when more people had been employed.

The stimulus did not give us an increase in the real level of economic activity. It did not give us much of an improvement in employment, assuming it gave us any at all. What it gave us was an increase in the measured level of GDP, which is a long way indeed from giving us an increase in the actual level of production. The reality, whatever the stats may say, is that the Australian economy contracted in 2009.

Unfortunately, with the stimulus package having been put in place, ending the downturn is no longer where the problems finish. Now on top of everything else we need to add in the problems created by the stimulus package itself. The massive debt we have built up in spending on non-productive assets will be a dead-weight cost to the economy for years to come. The expenditures on school auditoriums and roof insulation will radically diminish the government’s ability to cut personal taxes or increase productive spending in other areas. Year by year, after-tax incomes will fall in real terms as inflation eats away at our purchasing power. Our brief binge-spending program will carry with it austerity, possibly for years on end.

Misleading Ourselves with Statistics

It is, in spite of the technicalities involved, also worth looking at how the national accounts are constructed to have some idea of the dangers we now face of misleading ourselves about the nature of economic outcomes.

In dealing with matters such as the stimulus, we tend to think only about job creation and have almost totally divorced workplace effort from productive output. We spend literally billions on producing goods and services providing no net economic value, which deprive the community of all of the useful forms of output we might have produced instead. But if it creates jobs, good enough; that now seems to be the only political coin of the realm.

GDP is the measure of wealth creation but is an entirely artificial construct. Not one in a hundred who quote the fact that GDP has risen have much of an idea about what it is that has actually gone up.

Flaws abound in the construction of the national accounts, but there is one that is of particular importance because it can lead to the impression that growth has occurred when the economy has actually gone backwards. For the private sector, what is included in the GDP statistic is the money value of goods and services sold on the market after adjustment for movements in the price level.

But for most of the public sector, no such money value exists, since what was produced was never actually put up for sale. What is therefore done instead is that the actual amount outlaid by governments for whatever they purchase is simply included “at cost”. That is, the amounts spent by governments are just added in without making any attempt to work out whether the economy is in any way better off.

In the private sector, expenditure is only recorded after a business goes to all the effort of production and has then found someone to purchase what has been produced. For the private sector, a buyer is a necessary element if the national accounts are going to show that output went up.

In the public sector, things are different. In the public sector, whatever the government spends, on whatever it happens to buy, is put straight into the accounts without making any adjustment to determine whether there has actually been an increase in the community’s wealth.

A stimulus package will therefore create jobs, at least in the short term, and lead to a rise in the measured level of GDP. But whether the community is economically better off is an unknown. Given the movement in hours worked, it is almost certain that on this occasion while the measured level of GDP increased, the level of value-adding production went down.

Jobs and Growth

What has astonished me more than anything else about the community’s reaction to the stimulus has been the ready acceptance of any old expenditure as equivalent to the private sector generation of jobs. I would have thought that the undoubted waste of billions of dollars on school auditoriums and insulation would have led to some serious questioning about priorities. So far as I can tell, the only issue, to the extent there has been any discussion at all, has been about deficits and debt, which are issues enough. But as for the direction of spending, aside from a handful of commentators, this has been no issue at all.

More or less, constituencies across the world seem to have accepted that governments are better than the market at directing our resources. The unit of account is the job; whether an expenditure adds value seems to make no difference. The political overlay on spending is now so widely accepted that even to raise this as an issue will seem almost incomprehensible to many.

The market economy finds the cheapest way to produce the greatest amount of economic value. Governments become involved for various reasons because they believe they represent some kind of collective demand. And there are some things that only governments can do, and these are generally known, and the government’s role is generally welcomed.

But does anyone seriously believe that having the government run anything that could be run by private sector firms will mean it is meeting communal demands more cheaply, directly and efficiently? Does anyone seriously believe that the government’s priorities should have precedence over the community’s own desires? Unfortunately, the answer to both questions is a definite yes. Many seem to believe exactly that.

The global warming debate has been quite instructive. Public spending by governments has destroyed hundreds of billions of dollars of value across the world. There was a recession which destroyed an enormous amount of wealth in its own right, but the stimulus recovery programs may have destroyed even more. (Technically speaking, recessions do not destroy any wealth at all but merely expose what had been hidden from view, which is that a significant proportion of the output previously produced had not actually created any net value even though those who had produced these goods and services had believed that they would earn themselves a profit from their economic activities.) 

The world is less wealthy than it was, and its wealth is continually being depleted by government spending programs everywhere. The unit of account is not wealth, but jobs. It is not how much value we can create but how many jobs we can create. The value added per job created seems to be the last thing on the minds of those who pursue government spending programs.

The fall in living standards that will follow the introduction of any serious form of cap-and-trade or carbon taxation will be a wonder to behold. Even if such programs are necessary to save the planet, as so many claim, they are not going to come cheap. The cost will come with an astounding fall in living standards. I would be more willing to applaud the self-sacrifice of those calling for climate action if I thought they had the slightest idea just how great the sacrifice would actually be.

Centrally Managed Economies

But what is more to the point, what we would then be dealing with would be a government-managed economy where the direction of almost anything of importance would be in the hands of people without much clue about how and where to create value.

Think of the mechanics of the stimulus package and other such programs. The government merely announces that it is going to undertake some populist form of expenditure, say school auditoriums or a broadband network. It has no idea, in doing these sorts of things, how much timber is needed or metres of copper wire. The new socialism is for governments to direct where final output ends up and lets the intermediate steps, the producers of the hundreds and thousands of inputs, run their firms on the traditional principles of profit maximisation. It may look like the capitalist system but it is not. 

Whether in the longer run there are more jobs is very much to be doubted. But as to whether in the longer run living standards can be raised to any significant degree with greater and greater government direction of our economic activity, of this I have no doubt whatsoever. It cannot be done.

What is perhaps the final irony is that it is the capitalism of the West that has made our communities rich enough to enable many within them to disdain the wealth our economic system has created. We as a community have created a monster by allowing governments to direct so many of our resources into areas of their own choosing because there is the belief that it will create jobs and growth. It will do neither, but once the process begins in earnest, it is hard to see how it could ever be brought to an end.

Dr Steven Kates will be delivering the Ludwig von Mises Lecture on “Why Your Grandfather’s Economics was Better than Yours” at the Austrian Scholars Conference at the Mises Institute in Auburn, Alabama, later this month. He teaches Economics at RMIT University in Melbourne.

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