Seduced by Keynes’ Sweet ‘Nothings’

I wrote this as a reply to someone who asked me to answer the points raised in an article at The Conversation, “Why the federal budget is not like a household budget”. I wrote the response below and then sent it off, only to be told The Conversation has fallen silent until January 5. A reply to a Keynesian never, unfortunately, goes cold, so I might have waited till then. But it’s so long away, and we are off to the beach and shutting down, so here is my reply now.

The state of economic theory today truly is a scandal. The effect of Keynesian theory on the way economists think is so disturbing that the reality is there is no likelihood anytime soon that things will begin to come good. Let me take a case in point, which comes from the article by Warwick Smith which came with the title, “Why the federal budget is not like a household budget”, which I suppose is true, but it all depends on what conclusion you therefore draw.

He also says that, “the whole deficit/surplus thing has been greatly exaggerated”, which again I am willing to accept, depending on how he follows up from this. He goes on to add that “the focus on deficits and surpluses distracts us from what’s really important in the macro economy.” OK. So just what is it that is really important? And this is his great insight:

“Inflation is the limiting factor for government expenditure, not taxes or borrowing”.

That is, governments can keep spending right up until we reach the point where prices begin to rise too much. There is therefore plenty of room for government stimulus that is not limited to the amount of spending covered by one’s revenues. Here are his words:

“A government that can create money doesn’t need your money from taxation or from borrowing in order to spend. There is no limit to how much money a sovereign government can spend, but if government spending plus private spending exceeds the productive capacity of the economy then you get inflation.”

Until the government reaches the point where the economy is at its capacity level, it can, it seems, keep spending without taxing or borrowing, and it is all to the good. The economy will keep growing and inflation will remain under control. Here is his conclusion, in his own words so you can see I am not making this up:

“Times like these represent opportunities for the government to finance productivity improving infrastructure and provide much needed services for nothing. I know it sounds too good to be true but this is the reality of a fiscally sovereign government.” (author’s emphasis)

How is it possible to believe anything like this and call yourself an economist? So here is the answer to why this is nonsense, which I hope will also help you understand why the American economy is falling to bits — and  why, if we are not very careful, ours will do exactly the same.An economy grows only by producing goods and services whose value is greater than the value of the inputs plus labour-time used up during production. There was a time every economist understood this. If you have some timber, a hammer, a few nails and some time, you can do many things with them, but only some of the things you might do will end up with a value greater than that of the lumber, nails and time used up.

The belief that a government has any idea where value-adding activities can be found is one of the dopiest notions ever concocted. Governments can certainly spend the money they create, and some of what they do is value adding, but hardly everything. To believe that what governments produce automatically has greater value than the resources they use up is so nonsensical it is hard to believe any economist would ever peddle such a notion.

Take our own Rudd-Gillard stimulus. The two major projects were pink batts and school halls. Ask me if we are better off with more and better insulated houses and a better school infrastucture, I am happy to say that, all things being equal, we are. But if you ask me whether we have seen a return of more than $43 billion on our outlay – the approximate price tag of this spending – then the answer is that we have not had anything like that amount of benefit.

You may delude yourself from now until the end of time that these benefits were provided “for nothing”, but have you not seen our own reality: the dollar is falling, our standard of living is being dragged down, unemployment is on the rise. Ah, but where is that inflation? For most, real incomes are not rising, so however small the official inflation rate may be, it is plenty high enough to erode our ability to demand. Have you tried to buy a house lately, to cite but one example?

But the real damage comes through the other mechanism by which inflation affects an economy, which is the deterioration in our capital stock. Our economy is just not being maintained, never mind allowed to grow, because the government is diverting our resources into its own projects, instead of allowing businesses to replace their capital as it erodes during production. The real side of the economy is slowly but ever so surely falling to bits.

If you don’t understand it, you are in good company, since people with economics degrees apparently don’t seem to understand it either. But even if you don’t understand the process, you can certainly feel the effects.

Steve Kates teaches economics at RMIT University. He recently published the second edition of his Free Market Economics