Economics

When Bad Economics Takes Over

Let me start by taking you to 46 Gordon Square in Bloomsbury, a well-heeled part of London, in November 1930. The drawing room is large and comfortable with numbers of armchairs and couches. An open fire roars in the hearth. Russian ballerina Lydia Lopokova is reclining on a chaise longue. John Maynard Keynes, her husband, the celebrated academic, economist and government adviser, sits opposite. A number of friends are gathered around, among them Virginia Woolf, E.M. Forster, Lytton Strachey and Keynes’s former lover Duncan Grant. The economy is spiralling down. The Great Depression is under way. Keynes has just finished an essay on the “Economic possibilities for our grandchildren”. He is holding forth.

You know, he says, we’ll be able to build enough capital so that within one hundred years what work there is to be done will have to be shared as widely as possible. “We shall once more value ends above means and prefer the good to the useful.” And, while looking around fondly at his friends: 

We shall honour those who can teach us to pluck the hour of the day virtuously and well, the delightful people who are capable of taking direct enjoyment in things, like the lilies of the field who toil not, neither do they spin.

Well, delightful people have now only another eighteen years to wait before they can be like lilies, neither toiling nor spinning. That’s something to look forward to.

An even more bullish Keynes was evident in his seminal work, The General Theory of Employment, Interest and Money, published in 1936. In the wake of the Great Depression, and with the laggard US economy still struggling, he wrote that within a single generation it might be possible to make capital so abundant that the return on new investment would fall to zero. This, he thought, “may be the most sensible way of gradually getting rid of the objectionable features of capitalism”.

I have made none of this stuff up. Not to any extent that matters anyway. Keynes’s vision of future abundance is central to his economics. I will come back to it later.

Economics matters. Bad economics is not simply an academic wrong turn. Pestilent economists, the purveyors of bad economics, are not kept quarantined behind bars in laboratories or even locked up in universities. They are set free in the public service. They affect our lives. Big and bigger government, crippling debt, entrenched unemployment, soul-destroying dependency, and even insurrections, are all products of bad economics. So, what is this bad economics?

In a nutshell, bad economics relegates the role of prices in free markets (the very heart of economics) to a mere footnote and elevates buying things above saving, investing and making things. It is the antithesis of economics as it was thought about and taught by the giants of the past; from the time of Adam Smith onwards until the dawning of the economics dark ages in 1936, when Keynes set The General Theory on the world and, seemingly, at least partially lobotomised most of the economics profession at the same time.

Of course, bad economics pre-dated Keynes. John Stuart Mill railed against it in the second half of the nineteenth century. Roosevelt put it into practice, via the New Deal, four years ahead of Keynes. He managed to keep the US economy depressed long after other economies had recovered. For that he’s been lauded as a saviour by the Left and accorded sainthood by the Democratic Party and the New York Times. Just imagine if his policies had actually worked!

So, Keynes did not invent bad economics. But before Keynes, it had lurked furtively in the shadows, in the keeping of assorted cranks. Keynes gave it theoretical and academic respectability. He brought it out of the closet. His disciples codified it. Its influence became pervasive. In 1972 President Nixon said, “We are all Keynesians now.” The policy responses to the GFC bring the story bang up to date.

Where does that leave John Stuart Mill? He was an intellectual giant. His Principles of Political Economy was the defining economics text throughout the second half of the nineteenth century. He dismissed Keynesianism by other names; and easily won the debates of his day. If Keynes was right, we have to assume Mill was wrong.

Thankfully Mill was right. It would be a pity if his reputation were tarnished. To put it kindly, Keynes may have been a trifle crack-potted; albeit in a sophisticated, intelligent, famous and erudite way. You might say: how could crack-potted economics have defined economic policy since the Second World War? I don’t know the answer. I suspect that politicians and economists have gradually become less intelligent since the end of the nineteenth century, but I can’t prove that so I’ll leave it hanging.

Keynes’s main conclusion in The General Theory was that we needed to “socialise” investment—in other words, to put the size and direction of business investment in the hands of wise and morally-upright planners. We needed this, he thought, in order to keep the economy on an even keel and to keep demand up in a world of over-saving and approaching superabundance. Now this is crack-potted stuff; hard to swallow and unworkable—what exactly does it mean to “socialise” investment? End of story, you would think. The world moves on, as it did from his earlier works.

Enter John Hicks and other economists with a fondness for elegance and simplicity. From The General Theory they extracted a pared-down theory which, apart from some bells and whistles on the monetary side of things, tied the ups and downs of economic activity to spending. This became Keynesian economics. I read somewhere that it had to be explained to Keynes. Who knows? It’s a nice story. Keynesian economics has the distinct advantage of being beguilingly simple and completely suiting the predilection of governments. Let me take them in turn.

Keynesian economics is beguilingly simple. The economy, with all of its complexity, is reduced to just a few aggregates. The most important of these is aggregate demand. This is the total of intended expenditure on goods and services right across the economy—by households, by businesses, and, importantly, by government. You must have heard the term bandied about. Keynesian economists—that means most economists and all economists in the public service—swoon at its very mention.

Now it’s a matter of record that total expenditure and total production (GDP) are equal. Why is this? Well, ignoring foreign trade, anything bought must have been produced. By definition, from an after-the-fact accounting perspective, the more total expenditure there is, in other words, the more demand there is, the more production there is. The more production there is, the more employment there is. And, critically, in the Keynesian world, that’s the direction of causation—from demand to production to employment.

If the economy falls into recession in this world it can be rescued by increasing demand. This will increase production, and thereby employment. How do we increase demand? That’s easy. We increase government spending; because government spending is a component of aggregate demand. Voila! Problem solved. How beguilingly simple is that?

It suits government. Governments like to spend. Keynesian economics gives them a blank cheque in times of recession. They can let themselves go without the least restraint or feelings of guilt, shame or remorse. In fact, they become economic saviours. Photo opportunities abound as various stimulus projects around the country get under way.

Now the simple-minded will understand and see the sense in this Keynesian economics. This should tell you that it’s probably wrong. If this doesn’t tell you that it’s wrong I will up the ante. Commentators on the ABC, the BBC and NBC universally accept it as being right; as being settled economics science. What I’d like to do is to explain why it’s not right but wrong and yet why it survives. And to go on briefly to explore how it encourages and nourishes a broader economic, political and social culture which produces great harm.

I had an article in Quadrant in September 2010 titled, “Time to Topple Keynesian Economics”. It earned me a couple of minutes of fame. Well, it was briefly noticed in some obscure quarters. For example, I was interviewed by a chap with the unlikely name of Guy Razz, who runs a program called All Things Considered on National Public Radio. NPR is a nationally-syndicated left-wing radio station in the USA. It’s very popular in California, I understand. Anyway, deeply on the political Left, Paul Krugman, Nobel Prize-winning economist and writer for the New York Times, was on the same segment. He got more time on air than I did. On reflection, I suppose that was fair enough. He is a Nobel Prize-winner. All the same, I talked sense; Krugman talked though his Nobel laureate hat. Mind you, that wasn’t the view of NPR listeners. They didn’t like me at all. Krugman, in contrast to me, was not only right but all heart. I was not only wrong but callously indifferent to the plight of the unemployed. Such is the conservative’s burden.

Krugman wanted the US government to spend another $800 billion or so; the same amount as the original stimulus. He was asked what it should be spent on. He answered that it didn’t matter so long as it were spent. In other words, he wanted another boost to aggregate demand. What particular demand he didn’t care, and he didn’t think it mattered. Why is this nonsense?

Consider how the economy works. Many thousands of businesses use their own savings or the savings of others to employ people. They pay these people to make products that they believe lots of other people will buy, and at a profitable price. When the economy is working well there is a close correspondence between the quantity of each product produced and the demand for it. Periodically things go wrong. This results in unsold stocks or in loss-making sales. Minor glitches happen all the time. They don’t matter. But, if the glitches are serious or systematic enough—like the gross over-building of houses in the USA in the decade leading up to the GFC—then they can have wide repercussions. They can lessen confidence across the whole economy. We have a recession.

As an aside, if you read accounts of the GFC you will find the silliest stuff in book after book. It was attributed to greed and incompetence among bankers; to derivative trading; and, of course, to the complete failure of capitalism. I once worked for a bank. Is anyone serious about greed and incompetence? We’d have a crisis every year if they were the cause. They had absolutely nothing to do with causing the GFC; nor did derivative trading; nor did capitalism. The meddling hands of politicians and government were all over it.

But, the GFC aside, we have to understand that market economies are dynamic and ever changing. Even without the misconceived meddling of politicians and governments, recessions occur. On balance, they are generally beneficial in the end; uncompetitive businesses are driven out, leaving room for the growth of new innovative businesses. Societies grow wealthier.

We also need to understand that once an economy is in recession it is trying to restore itself. Businesses closing down free resources for other uses. Relative prices, including wages, change to reflect changing conditions. Interest rates fall. Individuals and businesses reassess their expectations. They respond to movements in prices, wages and interest rates; to opportunities closing down and to others opening up. The clearer they begin to see the future, the more likely it is that confidence will return, and investment and growth resume. Historically, most recessions last no longer than a year.

Now overlay massive and temporary government stimulus spending on an adjusting economy—thousands of school halls, for example; roads, bicycle paths, public housing, bridges, pink batts. People and resources that would be guided by price and wage movements into productive ventures will be held occupied on wasteful stimulus projects. Businesses wanting to expand will face delays and higher building costs. Whatever the government temporarily spends money on will form no part of the array of products produced and bought in a recovered economy. The temporary influx of spending will have gone. It will have distorted market signals, kept interest rates up, and complicated recovery. This will not be evident. When economies recover, governments will claim credit for their spending policies. 

Until it was overtaken by an even greater scam, Keynesian economics easily outstripped the Piltdown Man as the greatest scam of the twentieth century. But being now only in second place should not blind us to the enormity of the Keynesian scam.

In July 2010, the US economy had lost 2.3 million jobs since the early 2009 stimulus spending on so-called “shovel-ready” jobs. The chair of the White House Council of Economic Affairs, Christina Romer (looking, to my mind, distinctly embarrassed) announced that, in fact, the stimulus had created or saved three million jobs. We were meant to believe that minus over two million jobs was really plus three million jobs. We were meant to believe the unbelievable; because we’re taken for fools. Even Goering only gave the Fuehrer licence to make two plus two equal five; not to make minus two into plus three!

Were the miraculous three million jobs actually counted? No. These jobs fell out of a model, which was built to give no other possible result. In this Keynesian econometric model—of the kind used in the USA as it is here—government spending on goods and services adds dollar for dollar to demand and therefore to GDP (and then plus some because part of each dollar spent is assumed to be spent again). And more GDP means more employment—in the model. It has as much to do with reality as does CGI in the movies.

Let’s be clear. It doesn’t matter what happens to the economy. It can grow as did the Australian economy after the GFC. It can decline as did the US economy. In both cases, the stimulus spending (of more or less the same size relatively speaking) was given credit for saving each economy. The patient gets well or relapses. It doesn’t matter. The leeches worked. The sickened patient would have died without them. It was only for the want of more leeches that the patient suffered. That’s the tall tale.

Just why would the dumping of large dollops of government expenditure on an adjusting economy help? It is treating the economy as though it were a giant amoeba. It pays no attention to the role of changes in relative prices in guiding the recovery process. It’s as though they don’t count. The world is a congealed one in which individual products and prices disappear. The sole objective is to boost aggregate demand as quickly as possible. And, as Paul Krugman told us, any old demand will do. If Krugman and Keynesians are right, then, presumably, it would have been sensible for the US government to spend money on having more houses built in 2009. It is patently and completely daft. 

Before Keynes, saving and well-directed investment and production were accorded primacy in generating economic activity. Keynesian economics gives primacy to indiscriminate spending. If you have seen the movie War of the Roses, you may recall Kathleen Turner’s character claiming ownership of their house because she’d chosen all of the furniture and furnishings to make it into a home. Michael Douglas, as her husband, takes a different view: “It’s easier to spend it than to make it, honeybun!” I don’t want to get into this domestic argument, but Douglas has a point. It’s not a point that seeps into the consciousness of Keynesian economists or into the consciousness of the great mass of people who’ve been taken in. Listen to it. Good news: consumer confidence has risen; people might start spending again.

Step back from it all. Australia can’t generate enough savings to support its capital investment. Banks and other companies source savings from overseas to make up the shortfall. And we think it is a good idea if consumers spend more and save less? It is ridiculous (unless of course you are Gerry Harvey). In the normal course, if some retailers, manufacturers and importers are in trouble, it’s because they’ve made wrong decisions. They need to reassess their business model or, perhaps, go out of business. There might well be a mismatch between some consumer goods produced and imported, and the demand for them. There is no shortage of aggregate demand. There is a mismatch. The market will sort it out; if the government doesn’t interfere too much and start bailing out selected companies, or putting obstacles in the way like onerous regulations, or imposing taxes of uncertain application and impact, like the carbon tax.

Making stuff that people want to buy makes us rich. Buying stuff is secondary. Once this is understood, saving is restored to the virtuous place it had in the scheme of things before Keynes came along. And we are on our way to understanding good economics.

To Keynes and his followers, saving is a vice. It lowers demand and therefore lowers production and employment. In fact, in the world in which we actually live, we don’t have to worry about people demanding too little. Our demands will never be satisfied. Poverty still abounds. And, poor or not, we are insatiable. New and more exciting products continually come to the marketplace and we want them. There were queues outside Apple stores to buy the new iPad. Who among us would have difficulty in spending another $10,000 a year?

Keynes’s view, which I began with, was that we’d soon be lolling around replete, with not enough to do. This is why he put demand at the centre of his economics and cast saving as the villain. Saving is not a villain. It’s a super-hero. Saving underpins capital investment. Capital investment makes us prosperous. Without saving there would be no capital investment. We would gradually become poorer and poorer.

Keynesian economics is macroeconomic folly. Unfortunately it doesn’t stop there. It is also a common-sense-destroying virus which infects the whole body politic. It has been embraced by the Left because it appears to demonstrate that the market doesn’t work and that we need government to save us.

Keynesian economics downplays the role of individual prices, and saving, and making things. From there, it is a short step from a Keynesian world to a broader socialist one. Micawber is turned on his head. Happiness comes from spending more than you earn. Of course, it isn’t put that way. But the whole edifice undermines the old virtues of working hard, self-reliance and thrift, to say that we can collectively spend our way out of problems—not only out of recessions, but out of shortages of goodies like pensions and health care, and child minding, and dental care, that we can’t personally afford.

We enter a socialist world where there is a disconnection between making things and distributing them. These aren’t the socialists of old, nationalising industries. The experience of Eastern Europe has put paid to that brilliant idea. Their method now is more insidious. They white-ant away at self-reliance among businesses and individuals, until government becomes the sole and great benefactor. These born-again socialists, hiding behind the labels of “Progressives” or “Greens”, see food on the table which they want to share around. How the food was planted, grown, harvested, transported, cooked and served is, to them, incidental. This leads them to a loaves-and-fishes mentality; albeit stripped, as you might imagine, of any religious connotation. They act as though more can be shared than is collectively produced. They’re cargo cultists without the excuse of wearing bones through their noses.

In free-market capitalist economies (and who would want to live elsewhere—certainly not Michael Moore, who unfortunately shows no inclination to migrate to the Cuba he admires so much) production and reward are tied together. They are not discrete processes. Price movements encourage resources to move to where they are best rewarded. And where they are best rewarded is where they are most productive. Disconnecting productivity from reward eventually brings down capitalism. It is as simple as that. It also confounds economics. This is essentially why a socialist economist (even a Nobel Prize winner) is a contradiction in terms. 

It is a fact of life that some people are more productive than others; and that some are extremely productive, and are, therefore, extremely well rewarded and become wealthy. Socialists of any sort don’t like this at all. Through the fog that inhabits their minds, they cannot see the advantage of leaving all that wealth in the hands of the wealthy. It is unfair. They want it spread about and spent.

I heard part of a debate on Fox News in which one Democrat commentator complained that it was no use extending (the Bush) tax cuts to the rich because they would “pocket the proceeds” rather than spend them. What do you say to people who come out with this kind of thing? Their common sense has been almost entirely eaten away by bad economics. It’s not their fault entirely. Listen to Michael Moore talking to a union crowd and weep for his lost intelligence: 

America is not broke. Not by a long shot. The country is awash in wealth and cash. It’s just that it’s not in your hands. It has been transferred, in the greatest heist in history, from the workers and the consumers to the banks and the portfolios of the uber rich.

You may recall Senator Obama telling Joe the Plumber, back in 2008 when he was running for president, that it was a good thing to spread the wealth. President Obama has clearly doubled-down on that view. If you read Wayne Swan’s recent article in the Monthly you will see that he has exactly the same view. For example, he apparently believes that the benefits of the industrial revolution in Britain all went to the rich. With due respects to the Treasurer, it is hard to imagine anything quite as silly as that being written down. It is yet another example of the corrosive effect of bad economics on the human mind.

Don’t think this is just a different view. “Some people think like this; some people think like that.” No, these people don’t think rationally or logically at all; they only feel. Thinking would bring their whole worldview crashing down. They can’t afford to think too hard because that would mean having to take consequences into account.

Adam Smith was a thinker. He understood that what the rich do, which the poor don’t to any great extent, is to save. If monetary wealth were spread about, the recipients would spend it on consumer goods and baubles. There would be little saving and therefore little investment. We need rich people to keep hold of their financial wealth. They use it to invest directly in productive physical capital and in hiring labour or, to buy stocks and bonds, to support the investment of others in productive physical capital and in hiring labour.

Adam Smith was, of course, brighter and wiser than Moore, Obama or Swan. In itself that’s not surprising; what is surprising is the gulf. Spread financial wealth around all you want. It won’t add one physical thing that people can use. Spread enough of the billions around and it will cause rising prices of consumer goods. In turn, this will trigger a change in the way resources are used. Factories will be retooled to produce more cars and boats and houses and expensive clothes and jewellery for the populace at large. The physical capital stock will run down. Inflation and then poverty will ensue.

We need to encourage demonstrations and sit-ins and occupy public buildings and parks with people with placards saying: Thank you, rich people, for holding on to your wealth. Please don’t spend or give away too much of it; or, for short, Hooray for the one per cent!

In summary, bad economics has blighted public policy. It has replaced faith in individuals and in free markets with dependence on government. It has created a delusion of power over economic events. It has caused massive interference in market processes. It has led to utopian promises which can’t be fulfilled. It has led to the entitlement society, and to massive debt and economic and social misery. Over-striding it all have been pestilent economists, who have failed to properly understand the role of market prices in rationing demand and allocating resources; and who have given primacy to buying things rather than making things.

The only benign way out of the mess in Europe, in the United States, and eventually in Australia, is to renew faith in individuals and in capitalism. Nothing else will do. The option is to gradually morph into despotic socialist utopias. Does anybody of rational mind think that the answer lies in more government? The answer lies in getting rid of crony capitalism, getting rid of much of the red, and the green, and the indigenous tape, which is delaying and stopping business development; and getting rid of the subsidisation of grossly inefficient green energy.

It also lies in governments setting credible plans to move towards balancing their budgets. How quaint is that: governments living within their means; a modern-day socialist’s nightmare. This in turn will require governments to reduce, to means-test, and to ring-fence, unaffordable pensions, and welfare, and child minding, and health care entitlements; and to get people off the public payroll. There may be scope in all of this for conservatives to join with the industrial Left, to freeze out the destructive Greens, who would drive us all back to a more primitive and impoverished age. A simple rule for governments to follow is to make it as easy as possible for businesses to produce things that other businesses or people will be prepared to pay their hard-earned cash to buy. All economic policies should be measured against this “good economics” benchmark.

This is an edited version of a talk Peter Smith gave at a Quadrant dinner on August 15 to mark the publication of his book Bad Economics, published by Connor Court.

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