The god who failed

Keynes Versus the Classics – the True Story 

The word is getting out that Keynesian economics is worthless as a guide to policy. Criticisms of public spending are found more and more frequently and the deficits we now face are recognised as major impediments to a robust return to higher rates of growth and rising real incomes. 

Here in Australia, the growth in GDP is, of course, in part an artefact of the Government’s expenditure programme. We were anyway not as badly placed as most others, and in many ways we are beneficiaries of China’s own stimulus package. 

Whether we have permanently dodged recession is still an unknown although given the definition of recession we use, we probably have. The ridiculousness of choosing two successive negative quarters of GDP growth as the definition of recession is quite good for governments since it puts the bar on bad economic management at an astonishingly low level. 

There was a time when growth rates under three per cent per annum meant recession. Now we can have an increase of 0.1 per cent and everyone is grateful to see the economy continue to grow. 

Nonetheless, what we have definitely done is create the impression of economic growth since public spending goes straight into the national accounts at cost. We shall see which hollow logs the government will start looking to for more cash as the bills come due in the years ahead. 

Deficits must be paid for so unless future growth is so strong that tax revenue just naturally rises to pay off our debts, we will see raids on every part of the economy to find the money the government needs to repay what they have now blown in one useless project after another. 

What remains unfortunate is that there is still no apparent recognition just where the problem lies with the Keynesian apparatus that is now the common language of macroeconomics. 

To understand the nature of the problem, one must go back to 1936 – the year the General Theory was published – and look at, really look at, the economics that Keynesian theory replaced. Part of Keynes’s genius was to set up an utterly false caricature of “classical theory” – the term he took from Marx to describe the economic theories of his predecessors – which he could then ridicule as an entirely inappropriate framework in which to understand how economies work. 

Keynes thus not only sold the entire economics community on his own new theory (which was in fact a very old and much discredited theory which had been rejected time and again for more than a hundred years before the General Theory was published). But also while presenting his own theory of recession, he wrote into the history of economics his own version of what economic theory had been before he had developed his own. 

He thus created a version of classical economic theory that has now been accepted across the economics world as the genuine article. And straw man though it is – indefensibly wrong in almost every detail – wherever the story of the Keynesian Revolution is told, this is almost invariably the version of pre-Keynesian economics that is taught. 

The phrase that matters in understanding Keynes’s ability to discredit his predecessors was this: that if classical economic theory is valid, “there is,” as he put it, “no obstacle to full employment”. That is, anyone who accepts classical theory is really accepting that unemployment is a theoretical impossibility. Such economists, he argued, cannot account for what was actually happening before their eyes. 

There was, Keynes wrote a “category of unemployment, namely ‘involuntary’ unemployment in the strict sense, the possibility of which the classical theory does not admit.” So far as economic theory is concerned, he argued, no one is ever unemployed against their will. 

Therefore, as he quite logically concluded from his wildly inaccurate characterisations, since “the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment”. That is, it is fallacious to apply classical economics to any problem related to the kinds of unemployment that had existed during the Great Depression, or which exist in economies around the world today. 

It is something of an open question, even today, whether Keynes knew much at all of the economics of his own time or whether he lied outright to gain attention for his own approach. Because whatever else economists did or did not have in 1936 when Keynes’s own theory was published, what they most certainly did have were theories that explained the causes of recession and why high levels of unemployment frequently occurred. 

The very idea that economics could have been developing since the late eighteenth century – with recessions and mass unemployment amongst the most visible aspects of the economy – without economists having written major theoretical works to explain what everyone sought to understand, is an example of the overpowering role of authority in overriding common sense. 

And what is even more astonishing, it was those very classical theories which had been applied by the British Treasury to bring the Great Depression to its end. 

Classical works on unemployment and depression were banded together under the heading of the theory of the business cycle. It is this theory that, with the coming of the Keynesian Revolution, has for all practical purposes disappeared from within mainstream economic thought. 

Today, following Keynes, economists almost always begin their analysis of recessions from the premise that the downturn has been caused by some kind of fall in demand. And clearly, once you start from there, the solutions that will inevitably come to mind will centre around doing things that will restore the demand that has somehow been lost. 

It is for this reason that economists have almost no collective understanding of how recessions begin or what to do about them when they do. Lack of demand followed by more spending by governments is what they know. And what they know does far more harm than any conceivable good. 

It is an understanding and further development of the classical theory of the cycle that will restore some kind of sense to a macroeconomic theory that has gone dangerously wrong and is causing so much damage.