Undue Reverence for Keynes’ Plausible Twaddle

Economics is not the kind of topic that excites the passions as does God or, say, Bruce Pascoe. The lower case ‘he’, as the inventor of Aboriginal agriculture, won’t mind the juxtaposition, I would suppose. Obviously, I can’t speak for the upper case ‘He’. But economics it is. Take it or leave it.

I am constantly struck by the ignorance of economics dressed up as expertise. It comes from federal Treasury, from the Reserve Bank and, of course, from the economics commentariat whether they are correspondents for news outlets or occupy positions in business or finance. It is not their fault. For example, people brought up in India might be Hindu or those in Egypt might be Muslim. It is a product of their environment. They can’t necessarily be blamed for following the paths they did. Choice usually didn’t enter into it.

Equally, if you are taught superficially plausible rubbish in an economics undergraduate course you might well regurgitate such rubbish. Unless, as with me, the Holy Spirit intervenes to lead you to the truth. Of course, many people might pooh-pooh my introduction of God into things. But that is what I think, and what do they know?

To my theme. I am talking not about economics in the whole but only the part called macroeconomics. Before John Maynard Keynes there was economics or political economics, as it was generally termed in the nineteenth century. The OED lists the first use of the term ‘macroeconomics’ as being in 1948 in the journal Econometrica. I believe it was used earlier than this but it matters not. The term only came into prominence in a Keynesian context; that is, post 1936 after Keynes’s The General Theory of Employment Interest and Money was published. And, now, macroeconomics is effectively Keynesian economics.

All commentary on national economic affairs, all official communiques, are Keynesian in their orientation. You will know this because you will see or hear references to the state of domestic demand or aggregate demand or just demand. They all fancifully imagine that the demand for ice creams, haircuts, steel, motor cars, and so on, can be wrapped up and represented as a single quantity. Then they image that this single quantity, depending on its size, steers the economy into states of either unemployment or non-inflationary full employment or inflation. Quite simply this is nonsensical on its face. Yet it is the conventional wisdom.

Hilaire Belloc’s The Great Heresies spring to mind. Keynesian economics is akin in the non-religious sphere to a great heresy. John Stuart Mill wrote the bible. His Principles of Political Economy formed the backbone of economics teaching throughout the whole of the second half of the nineteenth century and held sway during the early twentieth century, before the Keynesian heresy took over.

Mill was a supply-sider before his time. “Demand for commodities is not demand for labour,” he wrote. What employs labour “is the capital expended [i.e., the investment] setting it to work.” He also understood that in a well-functioning economy the demand for each product, at its prevailing price, equalled its supply.

Troubled brewed, he explained, when the supply and demand for individual products got seriously out of whack. Seriously being the operative word. Obviously, supply and demand for individual products are always moving in and out of line and prices adjust accordingly to bring them back into line. To gain perspective on what misalignments might cause economic downturns, think of the gross oversupply of houses fashioned by misguided US government policy during the lead up to the economic and financial crisis of 2008-10.

Looking at demand as a whole is wrong on two counts. First it masks what is going on in individual product markets. Second, it supposes that demand drives economic activity and accordingly that there can be too much or too little (aggregate) demand. Best to go to Mill again:

…that there may be a supply of commodities in the aggregate surpassing demand… appears to me to involve so much inconsistency in its very conception, that I feel considerable difficulty in giving any statement of it which shall be at once clear, and satisfactory to its supporters.

To bring it up to date here is Steven Hamilton, assistant professor of economics at George Washington University, writing in the AFR on May 22. Incidentally, I am not picking on Prof. Hamilton. Michele Bullock or Steven Kennedy would be in accord, quibbles aside.

Inflation occurs when aggregate demand in the economy rises without an accompanying rise in aggregate supply. The effect of policy on inflation depends on how it affects the balance between the two. By raising interest rates, the RBA reduces aggregate demand, principally by reducing households’ disposable income.

This, of course, is all complete tosh. It’s pseudo-science. It is being taught to students in Washington, as it is throughout most of the world; though not, I would suppose, in Milton Friedman’s old stamping ground of Chicago or in any school of Austrian economics. Real economic still lurks in bastions of the conservative and libertarian right. And here, with little old wine drinker me – the only person in Australia who has read the General Theory right through twice and dipped into it hundreds of times as a fan, and later as a critic when enlightened. [This claim cannot be verified.]

Let me explain what inflation is for the edification of non-economist QoL readers. Economists won’t understand it for fear of being cancelled if they do. I will go to a desert island, without loss of generality.

Some islanders climb psalms to pick and sell coconuts. Some Islanders collect shells to buy coconuts. It takes coconut sellers about one hour to pick six coconuts and shell collectors about one hour to pick twelve shells. The price of a coconut circles around 2 shells each. One day a tsunami dumps shells onto the beach. Thereafter, shell collectors pick 24 shells in one hour instead of twelve. Shell collectors bid up the price of coconuts to four shells.

Notice something. The supply of coconuts has not changed. And, decidedly, neither has the demand for coconuts changed. Moreover, the amount of work put in by those selling and those buying coconuts has not changed. Yet the price of coconuts has doubled. The only thing that has changed is the number of shells.

As the great Milton Freidman nearly said: “Inflation is always and everywhere a [shell] phenomenon.” Talking about aggregate demand and supply is misconceived, and it leads to damaging economic policy prescriptions that harm the man and woman in the street. The terms are unscientific and should be banned outright from any textbook except to illustrate error.

Economic policy should have two principal drivers. The first is to facilitate the production of goods and services in all of their variety. Here deregulation and lowering taxes is important as is ensuring there are no obstacles to resources moving between different uses according to the value they bring and the profits they generate. The second is to control and contain inflation by ensuring that the money supply does not grow excessively. All else causes mischief. The Keynesian heresy most especially.