John Fraser, Unwitting Keynesian

keynes scribblingKeynesianism: A mind-warping affliction affecting almost all economists. In its active state it induces the delusion that profligacy is the path to prosperity. In some economist it lays dormant, breaking out only when economies suffer stress. Often these economists, particularly self-confessed conservatives, do not know they have the affliction and vigorously profess their freedom from its debilitating symptoms. This can produce secondary symptoms of cognitive dissonance.

Unfortunately, though predictably enough as a 1972 economics graduate, Australia’s new Treasury Secretary John Fraser appears to have been afflicted with Keynesianism. At this stage, he appears to have only a mild case compared with, say, Ken Henry, his predecessor-before-last, whose affliction was pronounced. Nevertheless, he will not be out of place in his old stamping ground and will have a measure of commonality with Reserve Bank economists whose regular economic updates are symptomatic of full-blown Keynesianism.

Oh come on, you might say, Fraser’s speech to CEDA on February 27 has been widely lauded by conservatives. It has, too, and with considerable justification. I liked most of his speech. However, he’s a Keynesian and probably doesn’t quite know it. Cognitive dissonance is consequentially evident.

First to the good stuff in his speech, and there was lots of it. Mr Fraser was on strong ground in concentrating on the need to repair Australia’s fiscal position by reining in the growth of government expenditure. “Australia has spent its way to a structural budget problem,” he rightly said. Moreover, he earned conservative brownie points, from me at least, by rejecting public infrastructure spending as a means of boosting growth: “there is no shortage of private sector financing [for projects with] a demonstrated high rate of economic return”.

He also pointed to the effect of tighter prudential regulation of banking since the global financial crisis in constraining lending to business. He didn’t exactly say this was a bad thing but the implication was clear enough. And it was a point well made.

Banking is innately risky and can’t do its job properly without coming under pressure, and wilting, during periods of great economic stress. Serial banking crises are part and parcel of dynamic capitalism. You can’t have one without the other, whatever starry-eyed prudential regulators think. Trying to make banking too safe inevitably strangles business lending and results in economic torpor.

Equally well made were his observations that “currency depreciation is a not a badge of honour [and that] we cannot rely on a lower exchange rate to solve our growth challenges”. Visit some Third World countries to appreciate that weak economies have weak currencies. Strong economies have strong currencies.

A falling exchange rate provides a window of opportunity to change the structure of production and boost productivity. The best way government can help is to get its fiscal house in order and free the economy from restrictive labour and product market regulations. If the mission is accomplished, the exchange rate is likely to rise back up.

So, with all the good stuff, where does Fraser go wrong? In discussing the need to secure stronger growth in non-mining business investment, he said the following. “Cheap credit, lower fuel prices and the depreciation of the exchange rate will assist, although weak demand is weighing on confidence and current investment plans.” Oh dear, weak demand.

Keynesianism breaks out when you least expect it!

What demand is he talking about? He doesn’t say, but it is clear that it is consumer demand.

Fraser at this point is firmly in a Keynesian delusional mindset where the (consumer) tail wags the (investment) dog. Those consumers should stop salting all their dough under the bed and spend it at Kmart or wherever; or else max out their credit cards. That is sure to set the economy in motion. Prosperity through profligacy is the epitome of the Keynesianism affliction. Mr Micawber’s cautionary tale of overspending causing misery is out of the window.

Then he conflates consumer and investment spending and gets into an awful tangle to boot. “For the economy to operate at its productive potential at any point requires matching growth in demand. This can only be achieved if households and businesses are sufficiently confident about the future direction of the economy to increase spending and investment.” God knows, or perhaps the late Lord Keynes would know, exactly what this means.

To expand on my puzzlement: The potential of an economy is closely tied to technological progress and competitive innovation which, in turn, are brought to fruition through business investment. It is senseless to talk about “matching growth in demand”. Business investment is the wellspring of growth, as it is, at the same time, demand. It is all one. Moreover, consumers will have nothing to spend on, outside of subsistence living, however confident they are, unless there is value-adding investment.

The question is how anybody can ever think straight and properly analyse the economy with a mind warped by Keynesianism. The answer is clear. It can’t be done.

How in the world to unravel the tangle? It can’t be unravelled by remaining within a Keynesian mindset. It can only be unravelled by applying good economics. This kind of economics was common before Keynesianism afflicted the economics profession with such devastating and disastrous effect.

First, consumer demand is a product of income. Demand is contingent on income. You can’t eat the coconuts until you’ve picked them.

Consumer demand is not an independent variable whose magnitude entrepreneurs and businesses are waiting on with bated breath. Henry Ford did not wait to build cars until there were queues outside his house demanding horseless carriages. Bill Gates did not delay his development efforts until he had seen consumers wandering around demanding Microsoft software.

Second, consumer demand and business investment are not two sides of the same demand coin. Business investment is a driver. Consumer demand is a derivative. Business investment generates employment, which generates production, which generates income, which generates consumption. Get that order right and you have a much better chance of seeing the world as it is and implementing good economic policy.

Third, it is plain daft and dangerous (Keynesianism in action, in other words) to talk about the need for demand to match the productive potential of the economy. It is daft because there is never any endemic shortage of overall demand. Ask anybody whether they would find it difficult to spend another $10,000 a year. It is dangerous because it leads to a policy of boosting demand through public policy, and often through public expenditure, when economic policy should be focussed on removing impediments to increased investment and production.

Production in an economy will always be equally matched by demand provided the structure of production is right. Now a market economy is good at matching the structure of production with the structure of demand. It is not perfect. Mismatches occur. But businesses that get it wrong lose money and corrective adjustments ensue.

The key for government is not to worry about whether demand will be sufficient. The key is to run a sound fiscal policy, and to remove distorting and inhibiting regulatory barriers which interfere with the ability of businesses to change course, to develop, and to become and remain profitable.

You will note something about profitable businesses. Their products are demanded for a price which exceeds their costs of production. They face no shortage of demand. Now imagine an economy filled with profitable businesses. While nothing can be done for those too far gone, there’s a clue there for Mr Fraser and other economists who suffer only from intermittent and mild bouts of Keynesianism.

Further clues and a potential antidote for Keynesianism can be found by reading the economics of John Stuart Mill or if you want something of modern vintage Steven Kates’ Free Market Economics is particularly instructive. I could mention by own book, Bad Economics, but modesty forbids.


  • pgang

    This is off topic but I have a question Peter, that I’ve been putting out for a while now and has been generally ignored. Why do we need the Reserve Bank board to try to second guess the correct short term interest rate? Why can’t the market determine the interest rate?

    • prsmith14@gmail.com

      A short proximate response to pgang. By buying and selling short-term securities the RBA determines the availability of exchange settlement balances – and the price of them (the cash rate)- that one bank can lend to another overnight. This very short-term rate flows through the market, becoming less influential as the maturity of securities lengthen.

      The market, any market, determines price as an interaction between supply and demand. Under a gold standard the supply of gold determines the supply of base money (central bank deposits plus currency). Under a fiat standard the government controls the supply of base money. So government, via the central bank, perforce controls short-term interest rates either directly by setting a target cash rate as now and altering the supply of base cash to underpin it, or by setting a base cash supply rule (monetarism) and letting the market set rates. But either way, the central bank effectively controls short-term rates – because it controls the supply of base cash under a fiat standard. Peter

      • pgang

        Thanks very much for the reply Peter. If I am paraphrasing correctly, the Central Bank either controls supply, or it controls the price and more-or-less guarantees supply (as now).
        The monetary system seems more efficient to me. The current system has the Central Bank attempting to control demand through price fixing, rather than allowing the demand side of the equation to work itself out. So rather than reacting to price and varying supply accordingly, the Central Bank is second guessing where demand should be. Our current system seems Keynesian whereas monetarism is more Millsian.
        It seems to me that the trading banks as the customers should be free to determine their side of the price input, not the Central Bank. If they want more money they should be allowed to compete for it. If they want less then the supply becomes somewhat irrelevant anyway, and interest rates will balance out automatically. The only decision to be made then is how much to supply on the upswing to prevent a credit bubble.

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