The Peter (Smith) Principle

It was a great privilege to have launched Peter Smith’s Bad Economics at the Quadrant dinner on Wednesday night (Aug. 15). Peter’s book is in large part about Keynesian economics, but that is hardly all that it’s about. I was reminded of his other great theme by listening to the questions he was asked. It is a problem on all sides of the debate how hopes and wishes invade the common sense that economic theory ought to systematically provide but often does not.

What economic theory is supposed to do is explain. In part it is, like astronomy, supposed to explain why things happen the way they do without necessarily providing a basis for policy, but it is also designed to explain what to do if you are interested in a particular economic outcome. In both of these, there is often a very heavy dose of what people wish were true that overrides what actually is.

Suppose you would like to achieve objective D. A good economic theory will tell you that to achieve D, you must first do A, B and C. If it is good economics, the theory will lay down what must be done to get the outcome you were looking for. But at the same time, good economics will also explain that there are a number of possibly undesirable side effects, Y and Z. Those who must decide have to weigh up the advantages of D against the downsides represented by Y and Z. And then there are also the unknown and unexpected side effects, the mysterious X factors that no one can or does predict.

But what you often find, and I fear that there was an element of that on the night, is the wish-fulfillment side of policy. Peter Smith was trying to explain why good economic theory ought to have deterred policy from introducing the stimulus, and even if it had not, there ought by now have been at least the beginnings of a shift towards theories that will show why these policies had not worked and what ought to be done instead.

Instead, we find that Keynesian theory — an utter failure if ever there has been one — is wrapped up in a desire to do good and be seen to do good, even if it does harm and is recognisably harmful. Amongst the lay public, it may be too hard to understand why such a policy cannot work. But why should it be amongst economists as well.

Increased employment depends on an increase in the production of goods and services other people would be willing to buy with the money they have themselves earned. Oh yes, occasionally governments hit on something that is value adding and productive so they too can sometimes increase real output and employment. But past the usual basics, such as schools, roads and hospitals, it is rare for a government to create value in production. It is therefore rare for a government to be the source of increases in the demand for labour. Government employment is almost invariably due to the private sector on whose tax payments that employment depends.

Do economists not know this? If they don’t, then they might as well be the man in the street since they are ignorant of what they need to know if they are going to provide useful advice. If they do know it but still argue that a fiscal stimulus can do some good, they are then deceiving the public.

The point that Peter tries to make in his book is that good economics is about recognising the hard facts about what is required to make an economy prosper. It is because so many continue to be misled by the economics of wish fulfillment that so many of our problems persist when good economic advice would and could cause them to diminish.

Dr Steven Kates teaches economics at the RMIT University in Melbourne