The blindness of modern economists

There actually was a theory of the cycle before Keynes  

Robert Samuelson’s article on the editorial page in the Financial Review last week (29 June) was almost the beginning of wisdom. What his article most assuredly did was betray total bewilderment at the way economic conditions have turned out and demonstrated an absence of any idea where to turn next to find answers. 

All the major macro schools of the moment – he mentions Keynesianism, monetarism and rational expectations – seem to let him down. Everything is a puzzle. 

In looking at the first of these schools, the most important, he writes, “the Keynesian logic seems airtight. If consumer and business spending is weak, government raises demand through tax cuts and spending increases.” 

What kind of person would describe the Keynesian logic as “airtight”? It has had failure after failure, with the latest set of failures only being the latest in a long line. 

Keynesian economics is airtight if that is all you know and mere spending is all it takes. If all it ever required to get economies growing was more spending, no recessions would ever happen and every country would be rich. 

Unfortunately, what is actually required is production. And not just the production of valueless useless make-work projects but real value adding activity which lead to the production of things other people would actually pay real money to possess and in which the collective payments of all the buyers taken together cover all of the costs of production. 

Spending on what does not create value only piles up debt. 

A private sector firm would also just pile up debt if it could not sell what it had produced. Why it should be thought that governments can spend on what no one will buy and not end up with masses of debt with no additional economic demand across an economy is beyond me. 

All of this ought to have been obvious from the start but it clearly is not. It certainly ought to be the kind of thing that economists should be there to tell the public, but that will only happen if economists understand these things themselves. 

Indeed, Samuelson goes farther, quoting a study he finds utterly incomprehensible. 

Economists Alberto Alesina and Silvia Ardagna, he writes, found “budget cutbacks in wealthy countries often had an expansionary effect when spending reductions, not tax increases, were emphasised.” 

That is a result no one brought up on Keynesian economics – that is, virtually every economist alive today – can even begin to understand. Like Samuelson, they were taught spending will raise the level of employment and output while cuts to spending will bring them down. 

Yet before Keynes, it was understood that such spending could not work. It was understood that buying things does not add value and therefore does not increase employment. 

I will quote myself from a book published in 1998, well before our recent rounds of stimulus spending began. 

Stimulating demand will do the unemployed no good. Raising consumption may, in fact, lower the ability to employ rather than increase it, if it consumes capital that might otherwise have been diverted into payments to labour. The cure for unemployment does not occur through actions taken on the demand side, but through actions which raise production.

This is me summarising one of the least understood propositions in the history of economics. Yet in its time it was said of this proposition that its “complete apprehension is, perhaps, the best test of a sound economist”. How many today would pass this test? 

Keynesian economics has meant that someone of sound mind and good will, someone like Robert Samuelson, cannot see what was once commonly understood by economists but which is now incomprehensible across the profession. 

Before our very eyes, right now in the world we live in, we are therefore witnessing events economists find hard to make sense of because of the frame in which they view events. 

It is classical economics – the economics that existed before Keynes wrote his General Theory – that actually can and does make sense of the economic problems we now face. 

There was once a theory of the business cycle that was the macroeconomics before Keynes. It understood that recessions and unemployment occurred because of structural problems in an economy, not too little demand. 

It understood that economies will end up in recession from time to time, just as any finely tuned mechanism will break down from time to time. But it also understood that to generate recovery, the answer was not to raise wasteful public spending but to allow the economy to go through the restructuring process. 

Policies that help an economy adjust – lower levels of taxation, wage restraint, removing unnecessary regulation, cutting back on government waste, ensuring interest rates reflect the availability of savings – are the kinds of steps that will bring a return to faster growth and higher employment. 

The instincts amongst those with the responsibility for managing our economies is now towards doing the right thing. They are finally seeing that the way forward is to reduce public spending and get our economies back into fiscal balance. 

But they are doing so without the guidance of economic theory which, as now constructed, can offer almost no assistance in finding our way back towards a path to recovery. 

I merely remind you that there was a theory of the cycle before Keynes. It is there you will find not all of the answers, but you will certainly find more than in a modern macroeconomics text . Strange times indeed.

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