A Spectator’s Guide to the Economy

At the end of 2008, at the height of the global financial crisis, when I could no longer bear the thought of teaching Keynesian economics ever again, I began to write a book, Free Market Economics: An Introduction for the General Reader, which has just been published. This was just as the stimulus programs were being introduced in one country after another to deal with the higher unemployment that the GFC had caused.

There were, and are, no other books that say what I wanted to say, so I decided to write my own book that would discuss economics in a way that would appeal to what I think is true about how economies work. And this was about far more than just Keynesian economics. Economics has been misconceived from top to bottom in its approach, in how it is taught and in what it actually tries to explain. My response to Keynesian theory was the stimulus for what I wrote, but there was quite a good deal more about the way economic theory is conceived and taught that I found myself dissatisfied with. Just how much that was the case I did not really appreciate until I read the book I had written.

Not a book that was planned and carefully designed, it was instead written at white heat. There are twelve weeks in a semester so in essence I had to write a chapter a week to stay ahead of the students who took the course. My Monday classes would be given a handout of the overheads for a text that had just been put up on the website half an hour before. Had I had the time to craft the book more carefully, I am not sure it would have come out as it has.

Instead, I have produced something that in not one chapter is it mirrored by a chapter in any other book I know. Whether others like what it says I will find out when they have read it. But for myself, what satisfies me is that having polished it up over the next four semesters, I am content that it says what I wanted it to say. But in every way it is a reflection of the way in which it was originally written, where I wrote down as rapidly as I could my beliefs about the general subject of whichever chapter I happened to be writing.

And while my stimulus had been the way Keynesian economics had returned with a vengeance, the book is not about Keynesian economics. While it is a large part of the story, in many ways it may not be the most important part of what I think this book has to offer. It is about how the whole of economics is conceived and the way in which the subject is taught to those who are being initiated into the subject.

Not that I ignore Keynesian macroeconomics. My book is the first attempt in forty years to reverse our understanding of what is known as Say’s Law of Markets and to reintroduce the associated concepts into the mainstream of economic theory. At the introductory level, this may be the first time this has been attempted for three-quarters of a century.

Say’s Law, as the book explains, was economic theory’s law of gravity before Keynes’s General Theory was published in 1936 to become the single most influential book on economic theory written in the last hundred years. My book is the first attempt, certainly the first full-scale attempt since the 1970s to rid economic theory of the Keynesian perspective on Say’s Law, a perspective that can only create havoc every time it is applied, as it did in prolonging the Great Depression in the United States during the 1930s, as it did during the Great Stagflation of the 1970s and just as it did during the “lost decade” of the 1990s when the attempt by the Japanese to spend their way out of recession led to a downturn in economic activity that has not been brought to an end even now. The stimulus packages following the GFC are in the long tradition of abject Keynesian failure, with not a single peacetime success.

Keynesian theory aside, nothing in my book is outside the bounds of economics as it is generally understood. Most of it is straightforward and largely within the normal bounds of how economists think about economies. But the problem is we don’t usually explain it this way. In many respects what the book deals with is how economies work in a world in which there are no facts about the future everyone is busily planning for. 

Uncertainty  

There is first uncertainty, which in economics is a technical term with a serious meaning. The example I give to explain what it means is of travellers on a train in a foreign country they have never visited before, sitting with their back towards the engine. All they can know is what they see outside the window, and everything they see has already passed.

In the world we live in, nobody knows what will happen next, so even as decisions are made, there is a recognition that things may not work out. The reason that businesses fail are similar to the reasons that people buy shares which then fall in value. Things go wrong. They do not turn out as expected.

The riskiness of business—of all economic activity—exists because of the uncertain nature of the world. The phrase repeated over and over in the book is that all decisions are made in the present, and that is as true for every decision that has ever been made in the past as it is for the ones being made at this very moment. The present now known was once the unknown future. Every decision, both good and bad, that has affected the present was made in a present that has now disappeared. 

The entrepreneur  

The existence of the unknown and unknowable future is why the book focuses on the entrepreneur. Most books, if they mention the entrepreneur at all, do so in a paragraph or two and then go on to other things. How much more misleading is it possible to be?

Moreover, this entrepreneur is not the entrepreneur of fabled innovation and change, although it could be. This is the entrepreneur who exists in every business who is the person with the ultimate decision-making role in the enterprise. From the largest businesses to the tiniest, from Microsoft to the seamstress working at home, there is someone in charge who is responsible for deciding what that business will do, from production decisions to the purchase of inputs to what prices to charge. Every business must have someone to make these decisions. This person is the entrepreneur of that firm.

The existential risks and uncertainties of life are therefore focused on the fact that a business decision is made by a particular individual. Every business is the way it is because of the decisions that were made in the past by someone.

Why then do we have entrepreneurial-driven economies? Why are the only successful economies those built around entrepreneurial decision-making? Because it is only these kinds of economy that embed self-interest into a structure where that self-interest acts for the benefit of others. An entrepreneur in a profit-oriented business is interested in knowing what someone else would really like in a way that almost no one else ever is.

The entire business firm is therefore oriented towards working out what others want and then providing it as cheaply and efficiently as possible. Moreover, no one else can possibly know what needs to be known at the level of the single individual business. No one else will ever care as much about the success of a firm as the person who owns and manages it. No one else besides the person in the firm will have the perspective, never mind the incentive, to work out what ought to be done at any moment.

There is a role for governments but the essence of that role is to ensure that there is a legislative and regulatory environment that allows entrepreneurs to find their way to creating value added. 

Value added  

If there is one issue that truly matters in understanding how an economy works it is the issue of value added. It is almost never discussed, yet without a firm grasp of what value added means it is impossible to have a solid grounding on how an economy works or how it is supposed to increase our prosperity.

Wasting resources is easy. Governments do it all the time. But using $900,000 worth of input and turning it into $1,000,000 worth of output is very hard. And this is what must happen if economies are to grow and the population experience a rising standard of living. It does not happen automatically and almost never happens if the control of those resources is in the hands of government. It is because the aim is to create value-adding activity that entrepreneurial decision-making is as crucial as it is. Only entrepreneurial-directed economies are driven to add value to resources, since it is only by adding value that profits can be earned.

The book not only discusses value added, it devotes an early chapter to explaining its meaning and significance. Without value added, nothing about how an economy functions can ever be understood with clarity. This book, surprisingly, is near unique in explaining just what value added is and why it matters. 

No cosmic forces in an economy  

In a typical discussion of an economy things just happen with no clear reasons given for why they do. There are apparently cosmic forces at work, often given the name “supply and demand”. They come like the gods on Mount Olympus, where a change in some underlying factor decrees some kind of outcome in the world in which we live. Curves will move left or right depending on some changed underlying condition with an automatic change in the price and the equilibrium level of production. Human intervention is there vaguely if at all. It is just market forces that have been in play, not a decision-maker deciding what to do in the face of the uncertainties that come with any decision to do something different.

In reality, and as explained in the book, little in a dynamic market is known, particularly the number of units that could and would be sold at different prices. There is no demand curve known to anyone, and so far as the industry is concerned, there is no supply curve either. Although the underlying conditions have changed in some way, and these appear to have affected the level of sales, what has happened, how long these new conditions will persist, how others will react and what they will do, are matters of judgment and conjecture.

But nothing is known. Everyone is groping their way in the dark towards what they think will be the optimal solution for themselves. There is no equilibrium of any kind as millions of individual decisions are processed through the ongoing adjustments of an economy as new circumstances arise.

The traditional approach to supply and demand, where one of those “all other things being equal” conditions change and the market equilibrium shifts along with them, provides no genuine insight into the way events actually unfold. The information contained in those supply-and-demand curves economists so confidently draw is never known to anyone. What actually exists are buyers facing a phenomenal array of goods and services offered to them by those who have put those products up for sale.

We are no longer thinking in terms of how the price of paper clips is determined. We are instead brought into a world where there are individuals who are trying to find satisfaction through selecting from amongst the different goods and services put up for sale by sellers, by those entrepreneurs. While on the other side there are those sellers trying to make a living by working out what buyers would like to buy and then producing what they believe they can sell at prices high enough to cover every cost. Reducing the whole of the market mechanism to the supply and demand for single existing products reduces the entire nature of a market economy to a shadow of what is actually important about the free market and the role of prices in determining relative costs. 

Marginal revenue and marginal cost 

To my surprise there were no end of flaws in the standard theory that I found I had stored away. Since I had in the past just taken some pre-existing text and taught it, I had not really dwelt on my dissatisfaction with the way that the standard microeconomic theory is presented. But as I wrote the book, thoughts that were buried not all that deeply came to the surface.

Most importantly, it was the concepts surrounding marginal analysis and especially marginal revenue (MR) and marginal cost (MC) that I found so pernicious. If you go to the book you will find an appendix in the chapter on marginal analysis which is the first draft I did at the start, which contains the normal way MR and MC are taught. But the more I revised the more I found myself totally dissatisfied with the way these issues are approached.

To be specific, in the way these things are almost always taught we say profits are maximised when MR = MC. Approximately one student in a hundred works out the point, but even if they do, there is not much value in knowing it. It amounts to saying that businesses will do what gives them the greatest profit but uses a set of brutally abstract diagrams containing information no one in business can ever know.

The real point is to argue that when a major decision is being made, there are an incredible number of considerations that must be weighed up. To reduce this to an apparatus that talks about comparing the addition to revenue from selling one more box of toothpicks (the marginal revenue) with the addition to costs of selling that one extra box of toothpicks (the marginal cost) reduces the value of this part of economic thinking to a nullity.

There is real insight into how economies work through understanding marginal analysis properly. It is merely unfortunate that the way it is universally taught makes it near on impossible for almost anyone to work out just what those insights are. 

Macroeconomics and Keynes  

What did lead me to write this book was my disgust with modern macroeconomics, which is thoroughly Keynesian in every way. With the GFC at its peak and stimulus programs being implemented in one economy after another, I found I could no longer teach the Keynesian macroeconomics that is a feature of just about every text on macroeconomics today. They are all based in one way or another on the proposition that recessions are caused by a deficiency of aggregate demand and that the most direct and rapid means to overcome the unemployment that accompanies such recessions is to raise the level of public spending.

No one who studies economics fails to be taught the fundamental equation of Keynesian theory: Y = C + I + G. Output (represented by the letter “Y”) in an economy (in this case, for simplicity, without international trade) is made up of the sum of consumer goods produced (C), the total level of private sector investment (I) and the goods and services bought by governments (G). So if you are in a recession where C and I have fallen, if you follow a Keynesian prescription you raise public spending, G, to compensate.

So clear, so simple, so wrong. But because of the way they are taught, there would hardly be an economist in the world who would have understood that these stimulus packages could not possibly have worked.

Even now, with the failure of every single stimulus package staring us in the eye, there is still no general understanding of just what it was that went wrong. That the stimulus package would fail was as obvious to me as anything in economic life can be. You never know with economies whether some outside event might have saved us from the fate that the stimulus package would lead to. But in an article in the March 2009 Quadrant when the GFC was at its peak, this is what I said:

Just as the causes of this downturn cannot be charted through a Keynesian demand-deficiency model neither can the solution. The world’s economies are not suffering from a lack of demand and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.

Quite a few have claimed credit for predicting the downturn, although how difficult it was, given how far in advance it had been telegraphed, is hard to say. But while there was a distinct minority who opposed increased levels of public spending, few said, at the height of the GFC, that the Keynesian stimulus would with near inevitability turn out to be a disaster, that increased public spending could in no circumstances do any good, that it would do only harm. While there were a number of sound reasons for opposing the stimulus, those who understood that you cannot create demand without first creating value-adding supply were too few in number and largely without policy influence.

I write in this way because I wish to draw attention to the theory that makes all of this obvious. The theory is not my invention. It was the standard “macroeconomics” common to all economists before Keynes’s General Theory became the shared collective wisdom of virtually the entire economics community. Almost every economist before 1936, and certainly the whole of the mainstream, would have foretold the kind of outcome we have seen in just the way I have described. No economist educated in the Keynesian tradition can see it today.

Even now there is no appreciation of just how misconceived these Keynesian policies were. But what is in its way even worse is that there is almost no understanding of why these policies did not work. Economists, and therefore just about everyone else, are conditioned to believe that economies are driven by demand. They therefore are conditioned to believe that all of these increased public forms of spending will improve things. They cannot see how it could possibly be otherwise. 

Keynesian economics is designed to increase deficits and debt  

Sure we have built up deficits and debt. That was by design. That was the very aim of policy. That is what a Keynesian policy does. The specific mechanism to overcome recession and lower unemployment is to create deficits and increase the level of debt.

The real question is: Why didn’t the stimulus pull our economies out of recession? Why did it not create the jobs it was supposed to? Why was unemployment not contained? Where are the successes from the fantastic amounts of money that have been spent?

The most compelling example of the failure of Keynesian economics has been found in the United States. So confident was the Obama administration of the effectiveness of their Keynesian policies that they published forecasts showing the difference that the stimulus would make. These forecasts have been monitored since they were issued, to the great embarrassment of those who made them.

The graph has become notorious. The administration forecast that with no stimulus package, unemployment would reach a peak of around 9 per cent in early 2010, then steadily decline, but that with the stimulus package, unemployment would reach 8 per cent in early 2009 before steadily declining. The actual unemployment rate rose to just under 10 per cent in 2009 and has not declined.

So we have debt, but why no jobs? Why, in fact, has there been no momentum towards recovery of any kind? The only fallback answer has been that it would all have been much worse without the stimulus. But against these forecasts and subsequent statistics, it is an argument that has worn very thin. 

Say’s Law  

The red thread that sits under the entire text of this book is a classical proposition now known as Say’s Law but which was generally referred to as the law of markets before Keynes included the phrase “Say’s Law” in his General Theory. Because of Keynes, all economists are not just taught that demand deficiency is the principal cause of recessions, but they are also instructed that Say’s Law is totally and absolutely wrong. Therefore no economist learns what Say’s Law is other than the version handed down to us from Keynes.

There are many strands to a proper understanding of Say’s Law. But in a single sentence, this is near enough to capturing what Say’s Law meant:

You can only add to the demand for goods and services by first adding to the supply of goods and services that people will actually pay for with their own money.

Much of the needed complexity is missing by putting it just this way. But if you took this principle as your own, you would never make the kinds of mistake about economic policy that were made during the GFC, nor would you have been in any doubt about the consequences of a huge increase in wildly wasteful public spending. You would not, for example, have believed that the series of non-productive projects that went with the stimulus could ever have led to higher demand and therefore to recovery and a return to prosperity. What you would have understood is that the kinds of outcomes that did happen were the kinds of outcomes that would happen. 

The classical theory of the cycle 

Amongst the utterly untrue statements Keynes made about Say’s Law was that if you believe Say’s Law is true then you have no explanation for recessions and involuntary unemployment. His version of Say’s Law was that “supply creates its own demand”. We have all been taught this as economists along with its Keynesian interpretation. If you accept Say’s Law as valid, wrote Keynes, then you believe that everything produced will with certainty find a market, demand deficiency can never occur and therefore involuntary unemployment cannot in theory exist. There would be, as Keynes wrote, “no obstacle to full employment”.

The idea that any economist would ever have believed any such thing, never mind the whole of the profession for more than a century, is ludicrous. Yet so powerful has Keynes’s authority been that this is what has been taught for three quarters of a century about the whole of the economics profession before the General Theory was written. And this is in spite of there having been a theory of the business cycle that had developed over the previous 150 years in which a multitude of theories of the cycle had been developed.

So where the most fantastic irony of all occurs is that Say’s Law, rather than having been an obstacle to clear thinking about the causes of recession, was in fact the very basis for the classical theory of recession. Recall my definition of the law of markets, which was expressed by classical economists as “demand is constituted by supply”. Produce what people wish to buy and there is no possibility there will be too little demand for what is produced. This proposition thoroughly rejected Keynesian economics, which was part of its very purpose (there having been many “Keynesians” before Keynes).

The most obvious characteristic of a recession is that the goods and services that have been put up for sale cannot find a market. Keynes said that it was because people chose to save and not spend. His classical predecessors said it was because businesses had chosen for some reason to produce an array of goods and services that could not find a market. The structure of production had gone wrong. There were many possible reasons for these errors in production but they frequently but not invariably centred on problems in the financial system. But one way or another, large-scale errors in the economy had taken place that distorted market signals and led to an economy that was misshapen so far as the direction in which productive decisions were made.

Think of the GFC itself. Which makes more sense as an explanation: that there was a sudden fall off in demand for some reason because there was suddenly a desire to spend less? Or that the GFC was caused by distortions in the housing market in the United States that subsequently affected the entire financial system of the world through those bundled-together sub-prime mortgages? On these matters, there is no contest. The Keynesian approach is utterly devoid of insight into the causes of the downturn and therefore into the proper means to use to return our economies to strong rates of non-inflationary growth.

My book therefore discusses the classical theory of the cycle. It explains how the business cycle was understood before the General Theory. If you are interested in why there are recessions, and what a government really ought to do when an economic downturn occurs, then this is what the book allows you to understand.

It is a book about the economic organisation of a free community. What makes a market economy a free market economy is the political and personal freedom that surrounds it. Without such personal freedom no prosperous economy can ever come into existence. But far more important is this: without a market economy, personal freedom itself cannot come into existence. This is what is at stake and it is this that the book in the final analysis is really about.

Dr Steven Kates’s book Free Market Economics: An Introduction for the General Reader, is published by Edward Elgar Publishing. His 2010 Ludwig von Mises Memorial Lecture, “Why Your Grandfather’s Economics was Better than Yours”, can be seen at www.youtube.com/watch?v=rIgkbdT5V6w.