Economics

What Classical Economists Knew that Modern Economists Do Not

I have a new book that has just been published which attempts to cure the economics profession of its demented allegiance to modern macroeconomic theory, which is, in essence, that economies are driven forward by aggregate demand, and that the essential ingredient in the creation of full employment and faster economic growth is the level of spending. The higher the level of spending, it is argued, the higher the number of jobs there will be. And should unemployment rise to an unacceptably high level, the cure is an increase in public spending. Sounds so obvious today, especially since every single introductory course in economic theory argues exactly that, along with virtually every macroeconomics course taught at every level today. And there is not a Treasury in the world that does not assume spending is the cure for unemployment and a slowdown in growth.

This essay appears in November’s Quadrant

Not only is this theory wrong, but it was, until 1936, universally understood by the mainstream of the economics profession to be wrong. What happened in 1936 was, of course, the publication of John Maynard Keynes’s General Theory of Employment, Interest and Money which argued that aggregate demand is the key to growth and employment. It had been argued by others before that, mostly by economists on the Left. Keynes was the first from within the citadel of mainstream economics to take the theory seriously. And from Keynes it spread so far and wide that it almost instantly became mainstream across the world, as it remains today.

Let me remind you of what I wrote in February 2009 in Quadrant (“The Dangerous Return to Keynesian Economics”) in anticipation of the stimulus packages that would be introduced to fix the downturns that had flowed from the Global Financial Crisis:

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.

That no economy did any better than sputter along following the stimulus packages after the GFC and continued to do so (other than in the US) right until the enforced slowdowns that were part and parcel of the COVID-19 lockdowns is a matter of record. Crucially important for me, however, in trying to demonstrate how badly served we are by modern macro theory, was that Quadrant article from 2009 (for which there were follow-ups published in 2010, 2014 and 2019). No one has ever challenged any of what I wrote then, in part I think because pre-Keynesian economics is so difficult to understand for an economist educated in modern economics. I have therefore written a book to explain what lay beneath these forecasts, Classical Economic Theory and the Modern Economy.

The first chapter of the book is titled, “The Purpose of this Book and Why Only I Could Write It”. Part of the reason why only I could write this book is because of Quadrant, and the role of Quadrant’s editor, Keith Windschuttle, in allowing me to write that initial article in 2009, which meant I could date-stamp with precision when I had stated that no stimulus package would bring recovery.

What also played a major role was that I had been involved from the employer side in our Australian National Wage Case proceedings from 1980 until 1994. There I had been required to contest the perennial union argument that raising wages would lead to higher employment since it would stimulate consumer demand. The refutation of this nonsensical proposition led me back into the classical economic theory of the nineteenth century whose power and insight astonished me. It has led me to write the book which has now been published.

What follows below is the opening to the first chapter of the book, which outlines both the role of Quadrant and the fact that I was practising my economics within the industrial relations system in Australia, which allowed me to discover the actual meaning of Say’s Law, the supposedly most-discredited proposition in the entire history of economics, which happens to be as valid as pre-Keynesian economists had always believed it was. The rest of this article is taken directly from the book’s opening chapter.

 The first section of the opening chapter

# My aim in writing this book is to explain why classical economics is vastly superior to modern economic theory. And in attempting to demonstrate that this is so, I will explain how a classical economist understood the operation of the economy. But in outlining the classical approach to economic analysis, I begin with the recognition that anyone who has already been taught modern economics will be virtually incapable of understanding classical economic theory.

# I will therefore start with a personal explanation of why I believe I am almost uniquely placed to explain classical economic theory and why it is important that we do so. It will be argued that the disappearance of classical economic theory has led to an enormous loss in our ability to understand what needs to be understood if we are to make sense of how an economy works.

# Modern economic theory is a labyrinth. Perhaps all theory is like that. Once one enters into its precincts it becomes virtually impossible to escape other than by accident. I will therefore explain how I accidentally found my way out as a possible way to assist others to attempt to do the same.

# And even as I begin, I will acknowledge how obscure I am within the world of economics. I have published papers and books. I have attended conferences and meetings of economic societies around the world. And in all this time, I have come across virtually no one who sees things as I do. There are a handful of others, but our numbers are trivially small. So to my story.

 

How I personally discovered Say’s Law

I was educated in the usual way, with Keynesian economics at the core of macroeconomics and marginal analysis at the core of micro. Every element of all of this instruction I accepted as plain and obvious. But in 1980, I became the economist for the Confederation of Australian Industry (CAI then, now the Australian Chamber of Commerce and Industry), which had the most profound effect on my intellectual destiny.

In Australia, there is an annual court case to determine whether there should be an adjustment made to the minimum wage, and if so, how much that adjustment should be. In 1980 I was writing the economic submission on behalf of employers and had to deal with what was already by then an antique argument from the union side: “Raising wages will stimulate economic activity and therefore increase the level of employment because it will increase the demand for goods and services.”

Keynesian though I was, I found this argument instantly without merit. If you compel employers to give employees an extra $100 by making them pay an extra $100, but without any additional output produced, prices must then rise by enough to cover the extra wage payments if job losses are not to occur. There is therefore no stimulus to demand.

Around the time I was writing this submission, I picked up a copy of John Stuart Mill’s Principles of Political Economy (available to download here), which I read purely out of interest, with no other motivation in mind. The book starts with chapter-length discussions of the factors of production, something no modern economics text now does, focusing first on labour and then on capital. I was breezing through the book, caught up in the sweep of its argument, when I came to Chapter V: “Fundamental Propositions Respecting Capital”. In this chapter, I came upon Mill’s Fourth Proposition, which instantaneously changed my understanding of how an economy works. This is the short-form version that has attracted a continuous thread of commentary from some of the greatest economists who have ever lived. This is what Mill wrote:[1] “Demand for commodities is not demand for labour.” (Mill [1871] 1921: 79)

This was not to me at that moment some ancient proposition from a long-discarded text. This was John Stuart Mill arguing along the same lines I had been arguing myself during the Wage Case. It was not identical, but similar enough that it made me read further. Where I then went next was to Mill’s second essay in his Essays on Some Unsettled Questions in Economics, “Of the Influence of Production on Consumption”, where I came upon this, which Mill obviously found patently absurd:

The man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman’s fortune. (Mill [1844] 1967: 263)

This was virtually the identical argument that I had crafted myself. Rather than it being theft, the process was a legal mandate on employers to pay higher wages which was supported with the argument that paying these higher wages would be beneficial to the businesses which had been made to pay these higher wages.

Mill’s text then went on to explain why, using modern terminology, an increase in aggregate demand would not lead to an increase in the demand for labour. The argument, which will be discussed in subsequent chapters, struck me as so obviously correct that I could not believe it was not obvious to everyone.

I recall speaking to an economics colleague in the very week I had come across this argument and saying to him something that was absolutely true: that in the very instant that I read Mill’s words I stopped being a Keynesian. More than that, I instantly understood why Keynesian economic theory was false and that a Keynesian policy would only do harm.

What I did not know, which would take a year or two to realise fully, was that what I had come across in Mill was what we today refer to as Say’s Law. I had thus discovered Say’s Law for myself.

 

Ricardo’s doctrine

Keynes muddled the definition, rendering it as, “supply creates its own demand”, which does not, on its own, make any coherent statement of economic principle. The actual economic theory Keynes was trying to refute he described in The General Theory as “Ricardo’s doctrine”:

The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. (Keynes 1936: 32; emphasis added)

On this, Keynes was absolutely correct. Ricardo, along with virtually all o f his contemporaries, denied that recessions could be due to a deficiency of demand. What he did not deny was that recessions accompanied by high levels of unemployment might from time to time occur.

That this is indeed Ricardo’s own doctrine can be seen in this reply from Ricardo to Malthus in a letter sent in 1820, just after Malthus had published his own Principles of Political Economy. Malthus had argued that the recessions that had followed the Napoleonic Wars had been caused by there being too little demand. Ricardo in his reply to Malthus therefore wrote: “Men err in their productions, there is no deficiency of demand.”

Ricardo thus does not deny there might be recessions and abnormally high levels of unemployment. How could any economist anywhere at any time deny it? What Ricardo did deny, however, along with the entire mainstream of the economics community until 1936, was that the cause of high unemployment was a deficiency of demand. And with this I had discovered a subject of such immense personal interest that although having a full-time job, I eventually made it the subject of my doctoral thesis, which was completed in 1996 and published in 1998 as, Say’s Law and the Keynesian Revolution.

 

Say’s Law is Central to Understanding an Economy

In writing this thesis, my research required me to read through a vast expanse of the classical economic literature from the time of Adam Smith through to The General Theory. And as a side note, while working on my research, rather than owning up that I was looking into the notoriously infamous Say’s Law, I would tell others I was working on the classical theory of the cycle, which ironically was absolutely true, since Say’s Law, properly understood, is an essential element in the explanation of the business cycle.

But what was of more consequence at the time was that while still the Chief Economist of Australia’s national employer association, I remained in the midst of our national debate on economic issues, beyond questions on wages policy, but involved with every aspect of economic policy of every kind. I was also, moreover, a frequent delegate at international conferences at the OECD, the ILO and other international meetings of economists. And in writing submissions and commenting on economic events and policy, I followed a strictly classical approach, in which the guiding light was my growing understanding of classical theory in general and Say’s Law in particular.

In so doing, over a period of twenty-four years I never made a single wrong call on the economy or the effects of public policy on economic outcomes both domestically or internationally. Economic events and the results of public policy, both in Australia and across the world, became so obvious that I simply became used to seeing things work out just as I thought they would, while others, using conventional economic analysis, would see these things in a completely different way. I will provide a few instances to indicate how contrary to the modern received wisdom my economic policy prescriptions were, yet how accurate they always turned out to be. For myself, understanding the grip of Keynesian theory on others, I could see what they were doing and why they thought the measures they took would succeed. But because I understood things from a classical perspective, things always looked very different to me. I will provide a number of instances that for the most part have an international dimension, so that they do not require a knowledge of Australia’s economic history.

 

Forecaster of the Year

The first example led me to become the Australian Financial Review Forecaster of the Year following the worldwide share market collapse in October 1987. The Finance Editor of the AFR spoke to economists across the economy to ask how likely they thought it was that a recession would occur due to the collapse of share market prices, since to quite a few it looked like a replay of the start of the Great Depression in 1929.

The government had gone into panic mode and behaved in perfect accord with classical economic policy. It had balanced the budget, in the same way that across the world, others had for a change acted in a sober and sensible way, proving that policy-makers really do know what needs to be done to make an economy hum. So while others rated the prospect of recession as high, I said that the likelihood was effectively zero, given how well, for a change, our economies were being managed. When 1988 turned out to be one of the best years on record economically, I was named the Forecaster of the Year, although I am not by trade a forecaster at all. The only remnant I can find on the net of my forecasting is this passage from the Industrial Review, the CAI newsletter which I wrote, which was quoted extensively in the press at the time, as for example here: “‘An Australian economic miracle, a truly Lazarus-like recovery is now a clear possibility,’ says the Confederation of Australian Industry (CAI) in a newsletter this month.” (Sydney Morning Herald 14/4/88: 4)

The economy actually ended up bursting at the seams, as did economies everywhere due to the careful economic management that occurred at the time. This unfortunately led to an overkill response across the developed world, with massive increases in official interest rates that finally drove economies around the world into deep recession that commenced two or three years later. I did everything I could to persuade our central bank, along with central banks everywhere else, not to murder this astonishing recovery in its tracks, but nothing could be done. Across the world economies were said to be “overheating” and down they would eventually crash due to a ridiculous policy of high interest rates designed to kill off economic growth to forestall an inflation that was never even remotely possible. I even said as much to Janet Yellen, during a meeting I attended at the OECD at the time, well before she became the Chair of the Federal Reserve many years later.

That recession eventually and inevitably arrived in 1991-92. In 1991, while economic conditions were still seemingly positive, the head of the OECD came to visit Australia, and came to visit us, as we were the peak employer association. I told him of our grave concerns for the economy and he, who was French, went on a quite funny rap in his charming French accent, about how employers always remind him of French farmers. You ask them one year how things are, and they complain there is too much rain. Then you ask them the next year and they complain again, but this time that there is not enough rain. You employers are just like French farmers, never satisfied, always complaining. And then the downturn came, and the very next year, when the world’s economy was somewhere near the trough, he returned to Australia, and came to see us to apologise for what he had said the year before.

 

Australian Balanced Budget on Way to Achieving Zero Government Debt

The second instance of a stand-alone policy understanding occurred in 1996 with the election of an Australian government that immediately proceeded not only to cut spending in the midst of a mild recession in order to balance the budget, but as it turned out, during what is now referred to as the Asian Financial Crisis. Moreover, the succeeding years of public sector restraint led to Australia becoming, so far as I know, the only nation anywhere since the end of the Second World War where the government achieved an entirely debt-free economy. CAI (with me driving the response) again, uniquely, supported these policies. The result was a succession of years of rapid uninterrupted growth, and a continuously falling rate of unemployment. Eventually others would subscribe to the policy, since it is hard to argue with success. But only someone with a classical non-Keynesian view of the operation of an economy could see that massive cuts to public spending in the midst of a recession would lead to a re-kindling of economic growth and a fall in unemployment. It’s obvious if you understand the classics; but mystifying if you are a student of modern macro.

Here I might append that at the start of 1993 I sat next to someone at a lunch who was a major economic official in Japan (possibly its Treasury head) just as they were about to start their reflation of the Japanese economy through a massive fiscal stimulus. I told him it would be a huge mistake to undertake this spending program, to which he replied, “Don’t you care about the unemployed?” There our conversation on economic matters ended, but the Japanese economy has been dead in the water ever since. No one understands why the Japanese economy has performed so poorly since those times, although many explanations have been cobbled together to provide one. The answers are, however, clear enough if you take your policy from a classical economics text.

 

The Response to the Global Financial Crisis

The third instance was my unrelenting public opposition to the fiscal stimulus packages that were introduced across the world following the Global Financial Crisis in 2008-09. Most supported these stimulus programs, and those who did not, focused on the likelihood that the result would be an increased and uncontrollable level of debt. Few argued that the stimulus packages would not lead to recovery and would actually make conditions worse. For myself, nothing was less likely than that large increases in public spending would lead to recovery. The following was part of an article published in Quadrant in February 2009, “The Dangerous Return of Keynesian Economics”:

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. (Kates 2009)

That all this was on the public record is also clear from this question I was asked by Senator Doug Cameron, at an Australian Senate Economic References Committee, on September 21, 2009, after I had provided testimony arguing against the introduction of a stimulus package.

Why have the IMF, the OECD, the ILO, the treasuries of every advanced economy, the Treasury in Australia, the business economists around the world, why have they got it so wrong and yet you in your ivory tower have got it so right?

That was exactly the right question. Why was I able to get it right when all others got it so wrong? That is just what my book is attempting to explain.

 

Free Market Economics: An Introduction

Beyond writing the Quadrant articles on how mistaken a public sector stimulus would be, I completely revised the introductory course in economics I had been teaching. It was a graduate course in which I had over the years re-shaped what I taught towards a somewhat more classical approach. But given the nature of every single textbook on the market, I could not shift very far from the standard macro/micro that made my students cardboard cut-outs of students everywhere else. That immediately came to a halt.

I spoke to my Head of School, the woman who was my co-teacher in the course, and to the students I was teaching, advising them that there would be no course text available in the first semester of 2009. Instead, I would write my own textbook, completing a chapter a week over the succeeding twelve weeks of the course, in which I would outline economics as I thought it ought to be taught. Because it was a graduate course, half the students had already undertaken economics as part of their undergraduate training. To those students I provided a straight-out warning, that if they thought that they could pass this course based on what they had already studied, they would be very sadly mistaken. Because, what I set out to do was write my own classical economics text for the twenty-first century right down to an inclusion of Mill’s “Four Propositions Respecting Capital”—the first time, so far as I know, they had been included in an economics text since Mill had written them himself. The first edition was published in 2011 under the title, Free Market Economics: An Introduction for the General Reader. To appreciate what the text was attempting to achieve, this is from the preface to the second edition written in 2014:

The book is my update for the twenty-first century of two of economic theory’s great classics, John Stuart Mill’s Principles of Political Economy published in 1848, and Henry Clay’s Economics: An Introduction for the General Reader published in 1916 and from which I adopted the title. They knew nothing of Keynesian economics other than its being a common but at the time an unnamed fallacy that economists had to refute continuously. Keynesian economics is now, however, the mainstream. If you would like to understand what is wrong with Keynesian theory and much else, as well as understanding how to view the economy and economic issues from a classical perspective, this book is the place to start. (Kates 2017: ix)

This is the entire preface to the third edition:

The major change made in the third edition is to introduce a model of an economy that explains the difference between the modern theory of recession on the one hand, and the classical theory of the business cycle on the other. Mainstream theory continues to revolve around demand deficiency with the resulting policies to return an economy to rapid growth and full employment dependent on increases in aggregate demand. The theory has thus maintained its place in spite of the failure of increased public spending to achieve a recovery anywhere in the world at any time in history. Aggregate demand will eventually disappear from economics, although when that will be is hard to say. Bad theory does seem to persist for an unconscionably long period of time.

The model introduced in a new Chapter 15 explains the causes of recession in relation to distortions in the structure of supply through the use of a simple graphical model. Although the explanation in this new chapter provides greater clarity, it is only a summary statement of the arguments that were already present in the first and second editions. The model is based on the economics of John Stuart Mill and Henry Clay, as is almost the entire book and as were both the first and second editions, which is why the new cover continues to display a water mill made of clay. (Kates 2017: xi)

The text is a restatement of the economics of John Stuart Mill, as best as I was able. I think of Mill’s Principles as the greatest economics text ever written. But I am also aware how difficult he is to read, with his 150-word sentences, endlessly complex examples to explain the simplest ideas, and a formality in language that has now all but disappeared. I therefore did what I could, by writing this text, to re-introduce classical economic theory to the modern world.

 

Keynesian Economics and its Failings

Beyond this text, I put together three book-length collections of specially commissioned articles to document how incompetent modern economic theory is at dealing with our economic problems. The first, published in 2010, was titled Macroeconomic Theory and Its Failings: Alternative Perspectives on the Global Financial Crisis (Kates 2010) and then a year later, The Global Financial Crisis: What Have We Learnt? (Kates 2011). There was then a third volume, What’s Wrong with Keynesian Economic Theory? (Kates 2016) which gathered together a sampling from every contemporary anti-Keynesian economist I could find, of which there are virtually none.

My assumption in all this was that the failure of Keynesian policies to regenerate growth would lead to a re-examination of modern macroeconomic theory, with these books being part of the reconsideration that would then go on. And while there has been no doubt whatsoever that, aside from the United States since 2017—a very important exception—no economy even a decade later had had the robust recovery that typically follows a downturn, no economy-wide re-evaluation has occurred. As with Japan, virtually no one blamed the anaemic recovery on the prior Keynesian policies that had been adopted to hasten the return to normal conditions. Instead, growth rates remained low, unemployment did not fall back to previous levels, while real wages growth slowed if it did not actually fall back. Ad hoc explanations were available at every turn to explain what had been an unexpected turn of events, but which were an inevitable series of outcomes if one begins from a classical economic perspective.

Steven Kates is Honorary Professor in the School of Economics, Finance and Marketing at RMIT University. His new book, Classical Economic Theory and the Modern Economy, is published by Edward Elgar.

Publications Cited in this Article

 

Books

 

Clay, Henry. 1916. Economics: An Introduction for the General Reader. 1st edn. London: MacMillan and Co.

 

Kates, Steven. 2020. Classical Economic Theory and the Modern Economy. Cheltenham, UK: Edward Elgar Publishing.

 

Kates, Steven. 2017. Free Market Economics: An Introduction for the General Reader. 3rd edition. Cheltenham, UK: Edward Elgar Publishing.

 

Kates, Steven. 2016. What’s Wrong with Keynesian Economic Theory? Cheltenham, UK: Edward Elgar Publishing.

 

Kates, Steven. (ed.) 2011. The Global Financial Crisis: Alternative Perspectives on What we have Learnt. Cheltenham, UK: Edward Elgar Publishing.

 

Kates, Steven. (ed.) 2010. Mainstream Economics and its Failings: Alternative Perspectives on the Global Financial Crisis. Cheltenham, UK: Edward Elgar Publishing.

 

Kates, Steven. 1998. Say’s Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way. Cheltenham, UK: Edward Elgar Publishing.

 

Keynes, John Maynard. 1936. The Collected Writings of John Maynard Keynes. Edited by Donald Moggridge. London: The Macmillan Press Ltd. Vol VII: The General Theory of Employment, Interest and Money.

 

Mill, John Stuart. [1844] 1967. “On the Influence of Consumption on Production.” In Essays on Some Unsettled Questions in Political Economy. Toronto: University of Toronto Press.

 

Mill, John Stuart. [1871] 1921. Principles of Political Economy: With Some of their Applications to Social Philosophy. Edited with an introduction by Sir W.J. Ashley. London: Longman, Green and Co.

 

Ricardo, David. 1951-1973. The Works and Correspondence of David Ricardo. 11 vols. Edited by P. Sraffa (ed.) with the collaboration of M. H. Dobb. Cambridge: Cambridge University Press. Volume VIII: Letters, 1819-June 1821.

 

Quadrant Articles

 

Kates, Steven. 2019. “The Dangerous Persistence of Keynesian Economics.” Quadrant. March 2019.

 

Kates, Steven. 2014. “The Dangerous Return of Keynesian Economics – a Five Year Review.” Quadrant. No. 504, Volume LVIII, Number 3, March 2014.

 

Kates, Steven. 2010. “The Dangerous Return of Keynesian Economics – a Twelve Month Review.” Quadrant March 2010

 

Kates, Steven. 2009. “The Dangerous Return of Keynesian Economics.” Quadrant. No. 454, Volume LIII, Number 3, March 2009. [The article was initially published in Quadrant Online in February]

[1] This is the full passage from The Principles:

“We now pass to a fourth fundamental theorem respecting Capital, which is, perhaps, oftener overlooked or misconceived than even any of the foregoing. What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of the labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of the capital, or other funds directly devoted to the sustenance and remuneration of labour.” (Mill [1871] 1921: 79)

1 comment
  • ianl

    Nonetheless, Keynes’ notions have the completely irresistible allure of “free” money.

    The advent of the never-ending Job Keeper programme says this in spades, irrespective of any irresponsibility. Can’t be effectively argued with where democratic votes actually count.

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