Kirzner on Austrian Business Cycle Theory

In “An Interview with Israel M. Kirzner,” Austrian Economics Newsletter (vol. 17.1, 1997), Kirzner makes some very fascinating remarks on Austrian business cycle theory (ABCT). In the extract below, AEN (Austrian Economics Newsletter) stands for the interviewer:

AEN: You’ve never thought of providing a systematic critique of the Austrian business cycle theory, for instance?

KIRZNER: No, I’ve never had too much interest in the Austrian business cycle theory. I’ve never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn’t see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it’s not really Austrian. It goes back to the Currency School and Knut Wicksell. It’s certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don’t believe that to be an Austrian you have to buy into the Hayekian view of business cycles.

AEN: Are there any aspects of Hayek’s business cycle theory that you regard as Austrian?

KIRZNER: I recently wrote a paper to accompany the facsimile German edition of Prices and Production. I identified what seemed to me to be elements of Hayek’s later work on coordination, miscoordination, and knowledge. I argued that the germs of his later ideas can be traced to this volume, especially his description of the upswing stage of the cycle. This is a phase during which some decisions are out of sync with other decisions. Current investors are making decisions which anticipate the decisions of others down the road, which are in fact not there. Leaving the exact mechanism aside, that is the kind of thing Hayek taught us to look for in analyzing the market process. In that respect, it's Austrian.

AEN: And the rest of the theory?

KIRZNER: Otherwise, the Austrian theory of the business cycle is a macro theory. It’s an equilibrium theory. And it treats capital in an objective sense rather than a subjective sense. It treats time as somehow embedded in the capital goods themselves. So I’ve always had a certain reserve about that particular theory, however brilliant it may be. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912.

AEN: Do you accept the idea that interest-rate manipulation by the central bank can cause distortions in the structure of production?

KIRZNER: Certainly the Austrian cycle theory showed brilliantly how this can happen. But it’s one thing to develop a theory which could explain a downturn. It’s quite another to claim that historically every downturn is to be attributed to that particular theory. That does not necessarily follow. If one were asked, does this theory necessarily explain each and every cycle, I would say no.

Mises used to poke fun at those who criticize the Austrian theory of the business cycle as being too simple. He said that still doesn’t tell what’s wrong with it. That’s correct, as far as it goes. Perhaps many market aberrations are of this kind. But that can only be a question of historical understanding. We must be able to look at every case to see just what is happening.

A number of points emerge from this:

(1) Kirzner never felt “that the Hayekian business cycle theory was essentially Austrian.”

(2) Hayek’s version of ABCT contains “aspects” that are “non-Austrian.”

(3) Austrians do not even need to adhere to ABCT, as it is not some fundamental idea of Austrian economics.

(4) Hayek’s development of ABCT was not “quite consistent with the way Mises laid it out in 1912.”

(5) Kirzner did not even think that all recessions could be explained by ABCT.

You have to wonder, then, what Kirzner would think of modern Austrians desperately trying to use ABCT to explain every recession that has ever happened. And, moreover, for the moderate subjectivist Austrians who agree with Kirzner, a question occurs: what recessions in their mind aren’t explained by ABCT?

FURTHER POINT

The commentator Iain below alerts me to another issue. Kirzner argues that “the Austrian theory of the business cycle is a macro theory. It’s an equilibrium theory.”

How strange it is, then, to see Austrians denying the validity of macroeconomics or macro concepts, particularly when Roger Garrison, one of the leading neo-Austrian moderate subjectivists in the tradition of Hayek, has devoted himself to creating an Austrian macroeconomics (Garrison 1984 and 2002). Furthermore, Steve Horwitz notes how Hayek’s work in the 1930s was essentially in macroeconomic theory and what its legacy was:

“Hayek’s ‘pre-Keynesian’ macroeconomics was not left to die on the vine. Although not much discussed in self-consciously Austrian books, there is an Austrian macroeconomics that is alive and well. There are three distinct issues that Austrian macroeconomists have been pursuing in the post-revival years. First are the extensions of the Mises–Hayek theory of the trade cycle ... . Second is the recent interest in the idea of ‘free banking’ .... Third, and arguably even less explicitly Austrian, is the work of Leland Yeager, Axel Leijonhufvud, and Robert Greenfield that has tried to revive interest in the pre-Keynesian monetary disequilibrium theorists...” (Horwitz 2000: 2).

J. E. King gives a further explanation of ABCT and macroeconomic and equilibrium theory:

“In the 1930s, however, Hayek had formulated an influential theory of the trade cycle, which he explained as the result of mistaken government policy. Excessive monetary expansion in the upswing pushed the rate of interest below its ‘natural’ value, encouraging a short-lived boom in investment that extended the average degree of ‘roundaboutness’ of production beyond its sustainable level. In the ensuing depression the appropriate capital structure was restored by means of a decline in the level of investment expenditure. Hayek interpreted the reduction in output and employment in the downswing as the unavoidable consequence of the initial policy error (Hayek 1931). His analysis of money and capital was heavily criticized at the time [Sraffa, 1932; Kaldor 1937]. It not only proved to be vulnerable to the Cambridge capital critique ..., but also appeared to rely upon concepts of equilibrium (the ‘natural rate of interest’, for example) that were inconsistent with the broader principles of Austrian economic theory” (King 2002: 229–230).

It appears that Kirzner in the comments above is pointing to precisely this issue.

BIBLIOGRAPHY

Garrison, R. W. 1984. “Time and Money: The Universals of Macroeconomic Theorizing,” Journal of Macroeconomics 6: 197-213.

Garrison, R. W. 2002. Time and Money: The Macroeconomics of Capital Structure, Routledge, London.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Mises Did Not Predict the US Stock Crash of 1929

I see that someone has dragged up a stupid myth about Mises in one of the comments.

The claim is that Mises predicted that US stock market crash in 1929 and (presumably) the later depression. The source of this nonsense is a story by Fritz Machlup that can be conveniently found in Skousen (2009):

“As his assistant in the university seminar which met every Wednesday afternoon, I [i.e., Fritz Machlup] usually accompanied him home. On these walks we would pass through a passage of the Kreditanstalt in Vienna [one of the largest banks in Europe]. From 1924, every Wednesday afternoon as we walked through the passage for pedestrians he said: ‘That will be a big smash.’ Mind you, this was from 1924 onwards; yet in 1931, when the crash finally came, I still held some shares of the Kreditanstalt, which of course had become completely worthless” … In the summer of 1929, Mises was offered a high position at the Kreditanstalt bank. His future wife, Margit, was ecstatic, but Lu surprised her when he decided against it. ‘Why not’ she asked. His response shocked her: ‘A great crash is coming, and I don’t want my name in any way connected with it’ … (Skousen 2009: 295–296).

In the world of Austrian apologists, this prediction of the failure of one Austrian bank is transformed into the prediction of US stock market crash in 1929. Mises is alleged to have warned his future wife that “a great crash” was coming, but I have seen no evidence to suggest he was referring to America or a global depression, or anything other than the Kreditanstalt bank with that statement.

The only other evidence one can find is Mises’ introduction to the English version of his The Theory of Money and Credit published in 1934, where he claims that Austrians had “foreseen” the crisis, even though the depression had been going on for years at that point. You don’t need to be a genius to “predict” something years after it actually happens.


BIBLIOGRAPHY

Skousen, M. 2009. The Making of Modern Economics: The Lives and Ideas of the Great Thinkers (2nd edn.), M.E. Sharpe, Armonk, N.Y.

Some Quick Thoughts on Austrian Economics

Someone has made the following comment:

You’ve essentially dealt with Rothbardian economics. No big blows have been dealt to the modern Mises/Kirzner/Hayekian branch, or the Lachmannian branch.

On the contrary, I have already dealt with Mises and his praxeology:

“Mises’ Praxeology: A Critique,” October 1, 2010.

“Was Mises a Socialist?: Why Mises Refutes Himself on Government Intervention,” October 7, 2010.

“Rothbard on Mises’ Utilitarianism: Why the Systems of Mises and Rothbard both Collapse,” October 8, 2010.

“Mises on the Ricardian Law of Association: The Flaws of Praxeology,” January 25, 2011.

As I have pointed out before, the Lachmann radical subjectivists have ideas in common with the Post Keynesians, and there might well be scope there for mutual constructive dialogue – and that is why I have not attacked them. There are certainly ideas in various strands of Austrian economics that Post Keynesians can agree with, such as:

(1) money is not neutral;
(2) capital goods are heterogeneous;
(3) we face fundamental uncertainty in economic life, uncertainty in the sense of Knight and Keynes which is not measureable risk;
(4) expectations are subjective.

For example, one important similarity between the Lachmann radical subjectivists and Post Keynesians is the view that expectations are subjective:

“The natural extension of the subjectivist concept from preferences to expectations implies that Austrian views on human action and market processes and Keynesian theory on the instability of investment are complementary. Within the Keynesian understanding Shackle did much to ensure consistency and clarity in the Keynesian understanding of the role of subjective expectations. Lachmann did the same for Austrian economics. Because both Lachmann and Shackle were open to the views of subjectivists from other schools, the result is a large measure of similarity in (some) Austrian and post-Keynesian theories on the role of expectations. The similarity is such that Lachmann (1978: 15) considered Shackle an Austrian even though Shackle considered himself a Keynesian” (Burger 2003: 104-105).

Indeed, the Austrian school is itself split between the Lachmann-wing and the moderate subjectivists who have not dealt with the consequences of radical uncertainty and subjective expectations:

“Kirzner initially saw his project as improving neoclassical economics and providing a ‘story’ as to how markets adjust, whereas the kaleidic Lachmann-inspired wing (including Shackle and Loasby) seems to have been reaching out to Post keynesians such as Davidson. Indeed, in their debate with Davidson [1989, 1993] both Prychitko (1993) and Torr (1993) acknowledged the tension between the kaleidic wing of Lachmann, Shackle and Boulding, with their stress on divergent and disequilibrating expectations, and the more dominant, market-as-an-equilibrating-process axis of Mises, Hayek and Kirzner” (Dunn 2008: 136).

Subjective expectations and the instability of investment are factors that destroy the myth of equilibrating markets that return to what neoclassicals call full employment equilibrium. These factors also destroy the basis of the neoclassical view from loanable funds theory that, if there is an increase in saving, then the rate of interest would fall, which will stimulate investment in production by an equal amount. This idea that an increase in saving due to a fall in consumption would not decrease aggregate demand because there is a corresponding increase in investment in capital goods to compensate for the fall in consumption is an assumption underlying Say’s law, from which it is concluded that aggregate demand will remain the same and only its composition will alter. But subjective expectations in the investment decision destroy any such automatic process to create the necessary investment.

It seems to me that Austrian business cycle theory (ABCT) as (for example) described in Garrison (1997), which also relies on loanable funds theory, makes a similar mistake: ABCT assumes a mythical “natural rate of interest” that occurs when increased savings in loanable funds (and not fiduciary media or fiat money created by the central bank) lowers the interest rate and that money is borrowed by business in a “sustainable” growth path. But what guarantee is there that business will even use those increased savings in capital goods investment under subjective expectations? If those increased savings are not borrowed for investment, you have a failure of aggregate demand. ABCT also makes the mistake of assuming an economy running at full capacity and full employment (a false assumption clearly in Garrison 1997), when in reality there are many periods when capitalist economies have very significant idle resources.

To return to the other Austrians: as for the moderate subjectivists like Kirzner or even O’Driscoll and Rizzo, I think Paul Davidson has already dealt with them:

“The Economics of Ignorance or Ignorance of Economics?,” Critical Review (1989) 3.3/4: 467–487.

“Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3 (1993): 423–444.

I have always enjoyed Gerald P. O’Driscoll and Mario J. Rizzo's The Economics of Time and Ignorance (1st edn, Oxford, UK, 1985), though I don’t agree with its conclusions. Furthermore, I have always said the ThinkMarkets blog is well worth reading.

In particular, O’Driscoll and Rizzo made some favourable comments about Post Keynesian economics:

“[i]t is evident that there is much more common ground between post-Keynesian subjectivism and Austrian subjectivism …. the possibilities for mutually advantageous interchange seem significant” (The Economics of Time and Ignorance, Oxford, UK, 1985, p. 9).

That is why they stand out in my mind, as opposed to the frankly crude, ignorant and often idiotic line up of other Austrians and their supporters on the internet.

BIBLIOGRAPHY

Burger, P. 2003. Sustainable Fiscal Policy and Economic Stability: Theory and Practice, Edward Elgar, Cheltenham, UK.

Davidson, P. 1989. “The Economics of Ignorance or Ignorance of Economics?,” Critical Review 3.3/4: 467–487.

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3: 423–444.

Dunn, S. P. 2008. The ‘Uncertain’ Foundations of Post Keynesian Economics, Routledge, London.

Garrison, R. W. 1997. “Austrian Theory of Business Cycles,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 23–27.

Lachmann, L. 1978. “An Austrian Stocktaking: Unsettled questions and Tentative Answers,” in L. M. Spadaro (ed.), New Directions in Austrian Economics, Sheed Andrews and McMeel, Kansas City. 1–18.

O’Driscoll, G. P. and M. J. Rizzo, 1985. The Economics of Time and Ignorance (1nd edn), Oxford, UK.

Prychitko, D. 1993. “After Davidson, who needs the Austrians: reply to Davidson,” Critical Review 7.2/3: 371-380.

Runde, J. 1993. “Paul Davidson and the Austrians: reply to Davidson,” Critical Review 7.2/3): 381-397.

Torr, C. 1993. “What can Austrian Economists learn from the Post Keynesians? Reply to Davidson,” Critical Review 7.2/3: 399-406.

Say’s Law Presupposes Aggregate Demand as a Meaningful Concept

It never ceases to amaze me to see certain Austrians and pro-free market libertarians making statements like this:

“When Krugman uses ‘demand,’ he means ‘aggregate demand,’ which economically speaking is a nonsensical term. There is no such thing as ‘aggregate demand’ …”

In fact, the concept of aggregate demand is presupposed by Say’s law, and if aggregate demand is a “nonsensical term,” “not meaningful” or if “there is no such thing,” then Say’s law utterly collapses with it.

In modern formulations of Say’s law, there are two main variants:

(1) Say’s Identity
According to Baumol (1977: 146), this

“is the assertion that no one ever wants to hold money for any significant amount of time, so that, as a result, every offer (supply) of a quantity of goods automatically constitutes a demand for a bundle of some other items of equal market value.”

(2) Say’s Equality
Again, according to Baumol (1977: 146), Say’s Equality

“admits the possibility of (brief) periods of disequilibrium during which the total demand for goods may fall short of the total supply, but maintains that there exist reliable equilibrating forces that must soon bring the two together.”

Say’s equality asserts that, in a given time period (say a year), total factor payments from production (= aggregate supply) will be spent on consumption or capital goods/business investment in new commodity output (= aggregate demand), and this either will be equal or tend to be equal to the value of aggregate supply in the short run. How can anyone seriously deny that the total demand for final goods and services in an economy is not a fundamental and meaningful concept here?

If we turn to Thomas Sowell (1994: 39–41), one of the supposed experts on Say’s law, we can see his summary of what the Classical economists meant by the expression:

“(1) The total factor payments received for producing a given volume (or value) of output are necessarily sufficient to purchase that volume (or value) of output [an idea in James Mill].

(2) There is no loss of purchasing power anywhere in the economy. People save only to the extent of their desire to invest and do not hold money beyond their transactions need during the current period [James Mill and Adam Smith].

(3) Investment is only an internal transfer, not a net reduction, of aggregate demand. The same amount that could have been spent by the thrifty consumer will be spent by the capitalists and/or the workers in the investment goods sector [John Stuart Mill].

(4) In real terms, supply equals demand ex ante [= “before the event”], since each individual produces only because of, and to the extent of, his demand for other goods. (Sometimes this doctrine was supported by demonstrating that supply equals demand ex post.) [James Mill.]

(5) A higher rate of savings will cause a higher rate of subsequent growth in aggregate output [James Mill and Adam Smith].

(6) Disequilibrium in the economy can exist only because the internal proportions of output differ from consumer’s preferred mix—not because output is excessive in the aggregate” [Say, Ricardo, Torrens, James Mill] (Sowell 1994: 39–41).

As we can see, propositions 3 and 4 above require aggregate demand as a fundamental concept. If there is no such thing as aggregate demand, how could these propositions even be true?

BIBLIOGRAPHY

Baumol, W. J. 1977. “Say’s (at Least) Eight Laws, or What Say and James Mill May Really Have Meant,” Economica n.s. 44.174: 145–161.

Sowell, T. 1994. Classical Economics Reconsidered, Princeton University Press, Princeton, N.J.

More on “Taxation is Theft”

Consider this statement:

“The institution of taxation is one in which one party uses force to demand payment from another.”

As I have pointed out, there is considerable empirical evidence that the majority of people do not regard paying taxes as immoral or as theft, but as the right and proper thing to do as a citizen.

If the threat of force or use of force invalidates everything, then we are left with a very strange situation indeed. For example, the law employs the threat of force or use of force. Is that any reason to abolish the law?

It is the law that you cannot park in an ambulance zone in front of a public hospital, and the threat of force or actual force can be seen as restricting your “freedom” to park where you want. If you park your car there, the car will be forcibly removed and you will be fined, yet most people freely choose not to park their cars in these zones, and they think this behaviour is moral and right. Why? When pressed, I suspect, most people would give a utilitarian argument: parking your car there could have very bad consequences indeed for sick people arriving in ambulances, if they can’t get in quickly and easily.

If this silly argument above against taxes were valid, under such an argument, no action made illegal by the state is avoided by anyone “voluntarily”.

In other words, it’s like saying that the reason why everyone doesn’t go out now and commit a crime spree is that people are being “coerced” by the “evil” state from committing theft, arson etc. etc. Do we seriously think that people don’t commit theft only because there is a threat of force by the state to arrest and try them, if they in fact do commit it? That in fact it is only coercion that stops everyone from breaking the law?

No, it is because most people think theft is immoral and unacceptable, and refrain from it voluntarily, and the threat of force by the state is not what makes most people adhere to the law. It is the same with taxes: most people pay taxes because they think it right and fair. Some people are indeed coerced, but I have already dealt with that issue.

Bibliography on Austrian Economics

This is another of my bibliographies, and, like the others, it is a work in progress. And, no, I haven’t converted to Austrian economics, but I believe in actually reading what the opposition think. I want to concentrate here more on recent literature, though I have included some older work by Mises, Rothbard and Hayek.

BIBLIOGRAPHY

Boettke, P. J. (ed.), 1998. The Elgar Companion to Austrian Economics, Elgar, Cheltenham, UK.

Boettke, P. J. (ed.). 2010. Handbook on Contemporary Austrian Economics, Edward Elgar, Cheltenham.

Butler, E. 2010. Austrian Economics. A Primer, Adam Smith Institute, London.

Caldwell, B. J. and S. Boehm, 1992. Austrian Economics: Tensions and New Directions, Kluwer Academic, Boston and London.

Ebeling, R. M. (ed.). 1991. Austrian Economics: A Reader, Hillsdale College Press, Hillsdale, Mich.

Faber, M. P. (ed.) 1986. Studies in Austrian Capital Theory, Investment, and Time, Springer-Verlag, Berlin and New York.

Garrison, R. W. 1991. “Austrian Capital Theory and the Future of Macroeconomics,” in R. M. Ebeling (ed.), Austrian Economics: Perspectives on the Past and Prospects for the Future, Hillsdale College Press, Hillsdale, MI. 303–324.

Garrison, R. W. 1997. “The Lachmann Legacy: An Agenda for Macroeconomics,” South African Journal of Economics 65.4: 459–481.

Garrison, R. W. 2002. Time and Money: The Macroeconomics of Capital Structure, Routledge, London.

Gloria-Palermo, S. 1999. The Evolution of Austrian Economics: From Menger to Lachmann, Routledge, London and New York.

Grassl, W. and B. Smith (eds), 1986. Austrian Economics: Historical and Philosophical Background, New York University Press, New York.

Hagemann, H., Nishizawa, T. and Y. Ikeda (eds), 2010. Austrian Economics in Transition: From Carl Menger to Friedrich Hayek, Palgrave Macmillan, Basingstoke.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Hayek, F. A. von, 1935. Prices and Production (2nd edn), Routledge and Kegan Paul.

Hayek, F. A. von, 1939. Profits, Interest and Investment, Routledge and Kegan Paul, London.[1973-1979]

Hayek, F. A. von, 1944. The Road to Serfdom (2nd edn), Routledge and Kegan Paul, London.

Hayek, F. A. von 1973–1979. Law, Legislation and Liberty: A New Statement of the Liberal Principles of Justice and Political Economy, Routledge & Kegan Paul, London.

Hayek, F. A. von, 1983. Knowledge, Evolution, and Society, Adam Smith Institute, London.

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Huerta de Soto, J. 2006. Money, Bank Credit and Economic Cycles (trans. M. A. Stroup), Ludwig von Mises Institute, Auburn, Ala.

Huerta de Soto, J. 2008. The Austrian School: Market Order and Entrepreneurial Creativity, Edward Elgar, Cheltenham, UK.

Hülsmann, J. G. 2001. “Garrisonian Macroeconomics,” Quarterly Journal of Austrian Economics, 4.3: 33–41.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Keizer, W., Tieben, B. and R. van Zijp (eds), 1997. Austrian Economics in Debate, Routledge, New York.

Kirzner, I. M. 1982. Method, Process, and Austrian Economics: Essays in Honor of Ludwig von Mises, Lexington Books, Lexington, Mass.

Kirzner, I. M. 1994. Classics in Austrian Economics: A Sampling in the History of a Tradition, William Pickering, London.

Kirzner, I. M. 1996. The Meaning of Market Process: Essays in the Development of Modern Austrian Economics, Routledge, London.

Kirzner, I. M. 2000. The Driving Force of the Market: Essays in Austrian Economics, Routledge, New York.

Koppl, R. (ed.). 2008. Explorations in Austrian Economics, JAI, Bingley, UK.

Koppl, R., Horwitz, S., and P. Desrochers (eds), 2010. What is So Austrian About Austrian Economics?, Emerald Group Publishing Limited, Bingley, UK.

Lachmann, L. M. 1973. Macro-economic Thinking and the Market Economy: An Essay on the Neglect of the Micro-foundations and its Consequences, Institute of Economic Affairs, London.

Lachmann, L. M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54-62.

Lachmann, L. M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. by W. E. Grinder), Sheed Andrews and McMeel, Kansas City.

Lachmann, L. M. 1978. Capital and its Structure, S. Andrews and McMeel, Kansas City.

Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London.

Lewin, P. 1999. Capital in Disequilibrium: The Role of Capital in a Changing World, Routledge, London and New York.

Meijer, G. (ed.), 1995. New Perspectives on Austrian Economics Routledge, London and New York.

Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.

Mises, L. 1977. A Critique of Interventionism (trans. H. F. Sennholz), Arlington House, New Rochelle, N.Y.

Mises, L. 1996. Human Action: A Treatise on Economics (4th rev. edn), Fox and Wilkes, San Francisco.

Murphy, R. P. and A. Gabriel, 2008. Study Guide to Human Action: A Guide Tutorial of Ludwig von Mises’s Classic Work, Ludwig von Mises Institute, Auburn, Ala.

O’Driscoll, G. P. and M. J. Rizzo, 1996. The Economics of Time and Ignorance (2nd edn), Routledge, Oxford, UK.

Oakley, A. 1999. The Revival of Modern Austrian Economics: A Critical Assessment of its Subjectivist Origins, Edward Elgar, Cheltenham.

Parsons, S. D. 2003. “Austrian School of Economics,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 5–10.

Rothbard. M. N. 1951. “Mises’ ‘Human Action’: Comment,” American Economic Review 41.1: 181–185.

Rothbard, M. N. 1998. The Ethics of Liberty, New York University Press, New York and London.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2008 [1985]. What has Government done to our Money?, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. 2009 [1969]. Economic Depressions: Their Cause and Cure, Ludwig von Mises Institute, Auburn, Ala.

Shand, A. H., 1984. The Capitalist Alternative: An Introduction to Neo-Austrian Economics, New York University Press, New York.

Skousen, M. 1990. The Structure of Production, New York University Press, New York.

Skousen, M. 2005. Vienna & Chicago, Friends or Foes?: A Tale of Two Schools of Free-Market Economics, Capital Press/Regnery Pub., Washington, DC.

Spadaro, L. M. (ed.), 1978. New Directions in Austrian Economics, Sheed Andrews and McMeel, Kansas City.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Coercion and the “Taxation is Theft” Argument

I see one of the latest responses to one of my previous posts is this:

“You statists simply refuse to analyze human activity as voluntary on the one hand or the result of hostile force and/or fraud on the other, the Rothbardian test. That is because unsophisticated people understand the difference quite well and would see what a nest of theft and fraud the Keynesian program is.”

I am well aware of the difference between forced and voluntary behaviour, and the simple truth is that you cannot live in a world without some degree of reasonable force and coercion (the operative word being “reasonable”). For example, your wife or child is about to walk in front of a speeding car, and there is no time to yell a warning. Do you:

(1) Use coercion to stop them from being killed or injured by grabbing them, or

(2) Do nothing because coercion is always wrong.

If you do what any normal, moral human being does, you do (1), and that course of action can be defended as a moral and right thing to do on many ethical theories. If you choose (2), on the grounds that nobody can be subject to involuntary coercion at any time, you are revealed as an utterly immoral idiot, to my mind. The crucial point is that when coercion occurs it must be justifiable. To say that coercion is reasonable is to say that it is justifiable in a convincing way, on some grounds.

We are told by some Austrians (perhaps not the more intellectually sophisticated ones) that nobody should be subject to involuntary coercion at all, and usually they appeal to natural rights arguments and nature. But I doubt whether such libertarian concepts really are consistent with nature. Take this libertarian insistence that we must be free from any coercive authority, done without our consent. This is a radical violation of one fundamental part of human nature: the relationship of parents to children. How can you raise children without using coercion without their consent? You can’t. The alternative is letting children run wild. Reasonable coercion is necessary, in so far as it does not conflict with the legal rights that all human beings are given under the law.

But to return to the comment above, it is a typical version of the “taxation is theft” argument.

First of all, how would Austrians know that all people who pay taxes regard this as theft? It is natural to dislike paying taxes, but evidence suggests that many people – a majority – think it is the moral thing to do:

“The IRS Oversight Board conducted an independent poll in 2005 that found 96 percent of the respondents agreed ‘it is every American’s civic duty to pay their fair share of taxes.’

The Pew Research Center in a similar study in 2006 found 79 percent of the respondents said that cheating Uncle Sam was ‘morally objectionable.’

Certainly, Americans pay they taxes because they have to: ever since 1945, taxes have been automatically withdrawn from pay-checks. But people also comply because they think it is fair. Polls show that most Americans think only ‘a few’ people cheat on their taxes. Paying taxes, just like leaving a tip, is a social norm” (Maxwell 2000: 146).

Yes, Americans might dislike paying tax, but it appears a majority think it is both fair and right, just as you might dislike looking after a troublesome, obnoxious teenage child, even though you recognise that this is the right thing to do and the law says you must do so as a parent.

With regard to modern taxes which pay for public goods, it appears to me that it is the Austrians/libertarians who are in the minority. But, of course, just because a majority of people think something is moral, this does not necessarily make it so. You need a defensible moral theory to justify some action as right. This issue cuts right to questions about philosophy of ethics.

If two people (a libertarian and Keynesian, say) wanted to seriously debate, they would have to ask:

(1) Is there an objective theory of ethics?

If one person does not believe in objective ethics, then the debate collapses into whether ethics is objective or subjective. Also, anyone who believes that morality is subjective can just appeal to David Gauthier’s Morals by Agreement and come up with some contractarian theory in which, if a majority of people assent to living by certain rules, then this is perfectly defensible ethics. If one takes David Gauthier’s Morals by Agreement as a method for ethics, then modern social democratic states already have a majority that supports basic principles like progressive taxation, so it appears to have ample justification.

But the statement “taxation is theft” seems to require that some objective ethical theory is true, however, so:

(2) If both people agree that ethics is objective, then what ethical system is true?

Our morality cannot be justified by an appeal to nature: that is why most natural rights/natural law based ethics collapse, and why natural rights ethics in the Rothbardian or Randian tradition won’t fly.

In my opinion, the workable objective theories of ethics that are not obviously flawed are Rawl’s human rights ethics, or rule consequentialism/utilitarianism (as in Brad Hooker, 2000, Ideal Code, Real World, Oxford University Press, Oxford). Some claim that a modern form of Kantian ethics is defensive, though I have my doubts.

Since taxes are levied to provide public goods and services (e.g., universal health care in all industrializied nations except the US), it is not difficult to justify them morally under Rawl’s human rights ethics or rule consequentialism.

Also, since in every ethical system some values will conflict, where does human life and the preservation of human life rank in these systems?

The belief that taxation is theft obviously implies that property rights are absolute or at least high in value. But why on earth should property rights rank above human life? Under rule consequentialism even the initiation of force involved in taking wealth might be perfectly justified, e.g.,

(1) If a village of 100 people has one well which is in the possession of one man, who suddenly refuses to give water to anyone else, and there is no rain or any other water and people are dying of thirst, can the dying people use force against the man (but not kill or wound him) to take what water they need just to survive? (leaving him of course with his proper share).

If a person said “no,” I would conclude that the person is morally bankrupt (since I regard rule consequentialism as defensible theory). If “yes,” then it is obvious that rule utilitarianism allows the use of reasonable force to take some reasonable amount of property, if people's lives or welfare are at stake.

In fact, utilitarianism as a moral theory was also held by Ludwig von Mises, who rejected natural rights, and used utilitarianism to justify a minimal state and limited interventions like fire regulations:

“There is, however, no such thing as natural law and a perennial standard of what is just and what is unjust. Nature is alien to the idea of right and wrong. “Thou shalt not kill” is certainly not part of natural law. The characteristic feature of natural conditions is that one animal is intent upon killing other animals and that many species cannot preserve their own life except by killing others. The notion of right and wrong is a human device, a utilitarian precept designed to make social cooperation under the division of labor possible. All moral rules and human laws are means for the realization of definite ends. There is no method available for the appreciation of their goodness or badness other than to scrutinize their usefulness for the attainment of the ends chosen and aimed at” (Mises 1998 [1949]: 716).

“Economics neither approves nor disapproves of government measures restricting production and output. It merely considers it its duty to clarify the consequences of such measures. The choice of policies to be adopted devolves upon the people. But in choosing they must not disregard the teachings of economics if they want to attain the ends sought. There are certainly cases in which people may consider definite restrictive measures as justified. Regulations concerning fire prevention are restrictive and raise the cost of production. But the curtailment of total output they bring about is the price to be paid for avoidance of greater disaster. The decision about each restrictive measure is to be made on the ground of a meticulous weighing of the costs to be incurred and the prize to be obtained. No reasonable man could possibly question this rule” (Mises 1998 [1949]: 741).

Perhaps is time for Austrians to attack Mises as an “evil” statist who advocated using coercion to enforce fire codes?

Progressive taxes and Keynesian macroeconomic management of an economy are justifiable on utilitarian grounds. As for the libertarian minority who disagree, there is no reason why a minority of people with a debased sense of morality should not pay their share.


BIBLIOGRAPHY

Maxwell, S. 2000. The Price is Wrong: Understanding What Makes a Price Seem Fair and the True Cost of Unfair Pricing, John Wiley & Sons, Hoboken, N.J.

Mises, L. 1998 [1949]. Human Action: A Treatise on Economics, Ludwig von Mises Institute, Auburn.

William L. Anderson Flunks Keynesian Economics 101

William L. Anderson runs a site dedicated to criticising Paul Krugman, called Krugman-in-Wonderland, one of the various Austrian blogs I read. His latest post is here:

William L. Anderson, “Is it Austerity, or Reality?,” May 23, 2011.

Anderson pretty much demonstrates to us all how little he understands about Keynesian economics. He asserts that

“Keynesians really believe that spending money is what creates wealth, and that governments can create wealth out of thin air simply by cranking up the spending.”

It’s no wonder Austrian economics will never be taken seriously by voters or governments.

Money is (1) means of payment, (2) unit of account, (3) medium of exchange and (4) store of value, and, when it is spent by (1) government in a Keynesian stimulus or (2) by private businesses or individuals, this spending creates the demand that causes the private sector to create wealth (i.e., commodities we consume), either by increasing production through using unutilized capacity or by new capital goods investment. When government employs people directly, these workers will still buy whatever commodities they desire to satisfy their wants, and, if they don’t want commodity a, b, or c, the producers of those commodities will go bankrupt. Malinvestments will clear even in a Keynesian system.

Just as in private transactions, money is a means by which these things are facilitated. Keynesian stimulus is about getting the private sector to create wealth by increasing capacity utilization and using idle resources (including labour), just as private investment, bank credit, and payment of wages to workers by a business can create the private spending that does the same thing.

Post Keynesians are also well aware that the capital stock is heterogeneous and not perfectly malleable. In fact, the Post Keynesians had a massive debate with the neoclassicals in the 1950s and 1960s called the Cambridge capital controversy, and were arguing precisely that capital goods are not homogenous. They won that debate, but the neoclassicals typically acted like nothing had happened.

William L. Anderson (in his comments section) in response to my earlier comment asks:

“By the way, why didn’t this [sc. Keynesian stimulus] work in Argentina or Zimbabwe?”

I am not quite sure what period he is talking about in Argentina, but, as for Zimbabwe, that was hit by massive output contraction after 2000, because of Mugabe’s disastrous land reforms (and natural disasters contracted output too), and, if Anderson knew anything about Keynesian economics, he would know in those circumstances, a demand contraction, not some huge, ridiculously large stimulus, is necessary, as is carefully explained by Bill Mitchell to the unenlightened:

“Zimbabwe for Hyperventilators 101,” Billyblog, July 29th, 2009.

You don’t stimulate an economy when its capacity to produce output has been severely diminished or damaged, or external supply shocks mean you cannot obtain the necessary factor inputs for production. Nor do you stimulate a booming economy. That is a basic Keynesian policy.

Anderson’s rather feeble question demonstrates that in fact he has no proper understanding of Keynesian economics. No big surprises there: it’s a common failing of Austrian ideologues, and Robert P. Murphy is in the same boat too.

Herbert Hoover’s Budget Deficits: A Drop in the Ocean

The meme that Herbert Hoover was some type of big spending Keynesian seems to be an especial favourite of Austrians, and some examples of this idea can be seen here:

Stefan Karlsson, “Again Herbert Hoover Was No Deficit-Cutter,” Thursday, March 11, 2010.

Robert P. Murphy, “Did Hoover Really Slash Spending?” Mises Daily, May 31, 2010.

Typically, once such claims are examined they collapse like a house of cards.

It is of course true that Hoover often gets unfairly blamed as an advocate of the extreme liquidationist solution to the Great Depression, a solution which was actually recommended by Andrew Mellon (US Treasury Secretary from 1921–1931). In truth, Hoover rejected extreme liquidationism, and attempted to fight the onset of Great Depression with a number of limited interventions, including increased government spending.

But the idea that Herbert Hoover’s small budget deficits could ever have stopped the Great Depression remains absurd, and Herbert Hoover ran a federal budget surplus in fiscal year 1930, the first year of the devastating contraction that occurred from 1929–1933. A significant cause of his budget deficits in fiscal years 1931, 1932, and 1933 was the collapse in tax revenues, and his stimulative discretionary spending increases in the budget in fiscal years 1931 and 1932 were a stone in the ocean compared to the massive collapse in US GDP.

Far from disproving Keynesian economics, Hoover’s policies reinforce the basics of Keynesian deficit spending, and also show how financial crises and bank collapses need to be prevented, if one wants to arrest an economic spiral into depression.

In particular, Austrians and other libertarians refuse to properly understand basic Keynesian concepts, such as:

(1) Potential GDP,
(2) the Keynesian multiplier and
(3) the appropriate level of discretionary spending increases that actually bring about Keynesian stimulus and positive GDP growth.

To begin with, we need to understand some basic facts about the US budget, the fiscal year and Depression history:

(1) In the US, the fiscal year before 1976 ran from July 1 to June 30 in the next year. So in the relevant years the actual fiscal years were as follows:

Fiscal 1929: July 1, 1928 – June 30, 1929
Hoover inaugurated March 4, 1929
Fiscal 1930: July 1, 1929 – June 30, 1930
Fiscal 1931: July 1, 1930 – June 30, 1931
Fiscal 1932: July 1, 1931 – June 30, 1932
Fiscal 1933: July 1, 1932 – June 30, 1933
Roosevelt inaugurated March 4, 1933.

(2) Since Hoover did not become president until March 4, 1929 he was not essentially responsible for the budget in fiscal year 1929. Hoover was responsible for fiscal years 1930, 1931, 1932, 1933. Roosevelt was not responsible for fiscal year 1933, even though was inaugurated in March 1933.

(3) In fiscal year 1930, tax receipts were $4.1 billion. By fiscal year 1933, tax receipts had fallen to $2 billion. In other words, government tax revenue fell by 51.21%. The budget deficits that emerged were the result, to a very great extent, of the collapse in tax revenue, not because of huge increases in spending.

(4) The first contractionary phase of the Great Depression in America ran from August 1929 to March 1933. Thus, when Roosevelt came into office, a recovery was just starting to happen. The aftermath of the severe contraction from 1929 to 1933 was what neoclassicals would call a suboptimal equilibrium with high involuntary unemployment.

(5) The size of US government spending in 1929 was very small. As Herbert Stein notes:

“In 1929 total federal expenditures were about 2.5 per cent of the gross national product (GNP), federal purchases of goods and services about 1.3 per cent and federal construction less than .2 per cent. In 1965, for comparison, these figures were 18 per cent, 10 per cent and 1 per cent” (Stein 1966: 189–223).

Thus Hoover’s increase in federal spending of 30.25% in fiscal year 1932 is deeply misleading, because total federal spending as a percentage of GDP was very small in these years, and just 2.5% of GDP in 1929.

(6) We can the list the state of the US budget and federal spending, including Hoover’s budget deficits, below:

Government Spending
Coolidge (August 2, 1923–March 4, 1929)
Fiscal 1927: July 1, 1926 – June 30, 1927 – $2.857 billion
Fiscal 1928: July 1, 1927 – June 30, 1928 – $2.961 billion (3.64% increase on 1927)
Fiscal 1929: July 1, 1928 – June 30, 1929 – $3.127 billion (5.60% increase on 1928)
Hoover (March 4, 1929–March 4, 1933)
Fiscal 1930: July 1, 1929 – June 30, 1930 – $3.320 billion (6.17% increase on 1929)
Fiscal 1931: July 1, 1930 – June 30, 1931 – $3.577 billion (7.74% rise on 1930)
Fiscal 1932: July 1, 1931 – June 30, 1932 – $4.659 billion (30.25% rise on 1931)
Fiscal 1933: July 1, 1932 – June 30, 1933 – $4.598 billion (1.31% fall on 1932)

Budget Surplus or Deficit
Fiscal 1930 – $0.7 billion surplus
Fiscal 1931 – $0.5 billion deficit
Fiscal 1932 – $2.7 billion deficit
Fiscal 1933 – $2.6 billion deficit

As noted above, Roosevelt was not inaugurated until March 1933, so Hoover was responsible for the budget in fiscal year 1933 as well.

Hoover actually ran a budget surplus in the fiscal year 1930, not a deficit. Hoover’s first deficit was in fiscal year 1931, when the US economy had already begun contracting severely. He also cut spending in fiscal year 1933, and introduced the Revenue Act of 1932 (June 6) which increased taxes across the board and applied to fiscal year 1932 and subsequent years. These were highly contractionary measures, and these two policies are the very antithesis of Keynesianism!

An antidote to the conservative nonsense about Hoover can be found in Bruce Bartlett, “The Real Lesson of the New Deal,” Forbes.com, 2.13.09.

In order to understand whether deficit spending is truly stimulative, we need to understand the following terms: the output gap, potential GDP, actual GDP, and the Keynesian multiplier.

Bartlett shows that once the output gap is calculated and we have a rough estimate of the multiplier in the 1930s (possibly as high as 4) it can be shown that Hoover’s budget deficits and discretionary spending were woefully inadequate. Far from disproving that Keynesian stimulus doesn’t work, Hoover’s spending demonstrates that too little spending in the face of an economic catastrophe is a recipe for disaster.

US GDP was $103.6 billion in 1929. It can be estimated that potential GDP during the first years of the 1930s was about $100 billion.

For the moment, let’s ignore the impact of state and local budgets (though, as we will see below, that is in fact an important factor). In 1931, US GDP collapsed by $14.7 billion dollars, in a debt deflationary spiral with bank failures and a collapse in employment and investment. If we assume a multiplier of 4 (which is very high), then Hoover’s spending increase of $257 million dollars might have generated at most $1.028 billion of GDP in fiscal year 1931. But GDP fell by $14.7 billion dollars! Only an complete idiot or ignoramus would seriously argue that Hoover’s increase in spending in fiscal year 1931 could have prevented the depression, by effective stimulus to offset such a catastrophic fall in GDP.

In 1932, US GDP collapsed by $17.8 billion dollars. If we assume a multiplier of 4 again, Hoover’s spending increase of $1.082 billion dollars might have generated $4.32 billion of GDP in fiscal year 1932. But that was not even remotely enough to stop a collapse in GDP of $17.8 billion dollars. In 1933, Hoover cut spending, a very clear contractionary and anti-Keynesian policy.

Now the figures above are based on federal spending. Does anything change if we look at total (local, state, and federal) government spending in these years? Indeed it does. In fact, total US government spending gives us an even more accurate picture of fiscal policy. The figures for total government spending (federal, state and local) can be found here:

US Government Spending Fiscal Years 1910 to 1960.

You can see the collapse in GDP for every year from 1930 to 1933 above, and the increases in government spending. The only real difference is the total US government spending did increase in fiscal 1930 and 1933, but by small amounts, not even remotely large enough (even with a multiplier of 4) to arrest the collapse in GDP. What is also apparent in the figures above is that state and local austerity counteracted Hoover’s spending increases in 1931 and 1932. In particular, what looks like a large increase in federal spending of $1.082 billion dollars in fiscal year 1932 was reduced to just $0.26 billion by state and local austerity. What is also noticeable is that total government spending was significantly increased in fiscal years 1935 and 1936 under Roosevelt, and these were years of strong GDP growth.

The myth that Hoover attempted a Keynesian countercyclical policy designed to reverse the collapse in 1929–1933 is one of the most stupid things spouted by Austrians and libertarians.

Murphy on “Did Hoover Really Slash Spending?”: A Critique

Over at Mises.org, we have a perfect example of type of absurdity I point to above:

Murphy, R. P. “Did Hoover Really Slash Spending?” Mises Daily, May 31, 2010

Murphy is of course perfectly correct that Hoover increased spending in 1930, 1931, 1932, but in no sense does that refute Keynesian economics, as he claims at the end of his essay.

Let’s examine some of worst statements in his essay below:

“But the point is that the Fed had implemented record ‘easy’ policies from November 1929 through September 1931, some 22 months after the onset of the Great Depression.”

Murphy makes a great deal of the fact that the Fed lowered the discount rate from 1929 to 1931, which is true. He seems blissfully unaware that Keynesian economics tells us that monetary policy in times of severe economic contraction and depression will be ineffective. The old Keynesian dismissal of monetary policy in these times was summed up in the expression “pushing on a string”, which means that cheap money and low interest rates just don’t create significant aggregate demand when the economy is shocked. It is not remotely surprising that monetary policy did nothing to counteract the depression.

“Today’s Keynesians love to point to history to ‘prove’ the efficacy of their remedies. In particular, they adore Hoover’s budget cuts of 1932, and the Fed’s rate hikes of October 1931, as proof positive that ignorant conservatism caused the Great Depression. But prior to these turnarounds in policy, the federal government and central bank operated in a Keynesian fashion”

This is perfectly absurd. The aim of a Keynesian policy in a downturn is stimulate the economy so that GDP contraction is reversed and positive growth returns. If we assume a multiplier of 3 in 1930, to counteract the Great Depression, the US government would have had to increase spending by $4.13 billion in fiscal year 1930. Instead, the total government spending (local, state and federal) increase in 1930 was a miserable $240 million.

Again, if we assume a multiplier of 3 in 1931, to counteract the contraction that year, the US government would have had to increase spending by $4.9 billion in fiscal year 1931. Instead, the total government spending increase in 1931 was a feeble $260 million.

“If the Keynesians were right, the economy should have been in a tepid recovery by mid-1931, and yet it was in fact still freefalling.”

Murphy is perfect ignoramus. He hasn’t a clue about basic Keynesian concepts and how to apply them. The idea that the tiny spending increases in 1930 and 1931 could have stopped the depression is pure madness.

And even Hoover’s larger increase in 1932 was counteracted by state and local austerity, as we have seen above.


BIBLIOGRAPHY

Barber, W. J. 1985. From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921–1933, Cambridge University Press, Cambridge and New York.

Bartlett, B. 2009. “The Real Lesson of the New Deal, Revisiting the 1930s,” Forbes.com,
http://www.forbes.com/2009/02/12/stimulus-depression-deficits-opinions-columnists_0213_bruce_bartlett.html

Cary Brown, E. 1956. “Fiscal Policy in the 'Thirties: A Reappraisal,” American Economic Review 46.5: 857–879.

Karlsson, S. 2010. “Again Herbert Hoover Was No Deficit-Cutter,” Thursday, March 11, 2010.

Murphy, R. P. “Did Hoover Really Slash Spending?” Mises Daily, May 31, 2010.

Stein, H. 1966. “Pre-Revolutionary Fiscal Policy: The Regime of Herbert Hoover,” Journal of Law and Economics 9: 189–223.

Stein, H. 1969. The Fiscal Revolution in America, University of Chicago Press, Chicago.

Temin, P. 1989. Lessons from the Great Depression, MIT Press, Cambridge, Mass.

Economic Systems are Best Conceptualized on a Continuum

Of the various ways of organizing economic systems, one can see two extremes: anarcho-capitalism and communist command economies. Anarcho-capitalism would privatise everything and abolish the state. A communist command economy would abolish most private property and plan production of commodities centrally. In the middle, we have the modern mixed economy, where there is a very large space for private production of commodities and private property, but where regulation restricts production and property rights, and where the state intervenes with monetary and fiscal policy, as well as social security and other public goods.

The modern neoliberal/neoclassical system we have had since the early 1980s would be to the left of centre. I would put the neoclassical synthesis Keynesian system many countries had from 1945–1979 in the middle. A Post Keynesian system would probably be slightly right of centre.

Some nations like Japan, South Korea and Taiwan after 1945 had a higher degree of planning than even mixed economies, through their highly successful industrial policy, and would be even more to the right of the centre on the line below.

Hayek on Mises’ Apriorism

There is an obvious conflict between Mises and Hayek on the proper methodology for economics. In fact, the two Austrians had quite different, even conflicting, views on methodology, as follows:

(1) Mises adhered to aprioristic praxeology with deduction, and
(2) The methodology of Hayek, which rejected pure a priorism and admits a role for empirical evidence and is closer to Popper’s falsificationism.

It is now well known that Hayek disagreed with Mises on the role of empirical evidence. In a letter that Hayek wrote to Terence W. Hutchison dated 15 May, 1983, Hayek stated:

“I had never accepted Mises’ a priorism .... Certainly 1936 was the time when I first saw my distinctive approach in full clarity – but at the time I felt it that I was merely at last able to say clearly what I had always believed – and to explain gently to Mises why I could not ACCEPT HIS A PRIORISM” (quoted in Caldwell 2009: 323–324).

In fact, in 1937 Hayek had published an article called “Economics and Knowledge” where he criticised Mises’ apriorism, and appears to have moved closer to Popperian ideas on methodology in later years:

“I became one of the early readers [sc. of Karl Popper’s Logik der Forschung, 1934]. It had just come out a few weeks before …. And to me it was so satisfactory because it confirmed this certain view I had already formed due to an experience very similar to Karl Popper’s. Karl Popper is four or five years my junior; so we did not belong to the same academic generation. But our environment in which we formed our ideas was very much the same. It was very largely dominated by discussion, on the one hand, with Marxists and, on the other hand, with Freudians. Both these groups had one very irritating attribute: they insisted that their theories were, in principle, irrefutable. Their system was so built up that there was no possibility – I remember particularly one occasion when I suddenly began to see how ridiculous it all was when I was arguing with Freudians, and they explained, “Oh, well, this is due to the death instinct.” And I said, “But this can’t be due to the [death instinct].” “Oh, then this is due to the life instinct.” … Well, if you have these two alternatives, of course there’s no way of checking whether the theory is true or not. And that led me, already, to the understanding of what became Popper’s main systematic point: that the test of empirical science was that it could be refuted, and that any system which claimed that it was irrefutable was by definition not scientific. I was not a trained philosopher; I didn’t elaborate this. It was sufficient for me to have recognized this, but when I found this thing explicitly argued and justified in Popper, I just accepted the Popperian philosophy for spelling out what I had always felt. Ever since, I have been moving with Popper” (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 18–19).

One wonders what Hayek would have thought about the hordes of ignorant and “pop” Austrians on the internet today, claiming that the inferences of praxeology are irrefutable and praxeology has no need for empirical evidence (which is a distortion of what even Mises believed). If Hayek were alive today and gave an honest answer to this, he would have to class such vulgar Misesians as talking nonsense on a par with Marxism and Freudian psychology.

The recognition that the pure deductive method and apriorism are not valid methods for economics appears to have been accepted by modern Austrians like O’Driscoll and Rizzo. As John Pheby says

“… O’Driscoll and Rizzo, following Hayek, seem to envisage a moderate role for empirical tests in establishing whether or not particular interpretative theories are applicable to specific real-world situations …”, John Pheby, New directions in post-Keynesian economics, p. 65.

In support of this, Pheby cites O’Driscoll and Rizzo’s The Economics of Time and Ignorance (Oxford, UK, 1985), chapter 2.

It also surprises me how often vulgar supporters of Austrian economics on internet blogs haven’t the foggiest idea who O’Driscoll and Rizzo are, or their contributions to Austrian economics.

BIBLIOGRAPHY
Caldwell, B. 2009. “A Skirmish in the Popper Wars: Hutchison versus Caldwell on Hayek, Popper, Mises, and methodology,” Journal of Economic Methodology 16.3: 315–324.

Hayek, F. A. 1937. “Economics and Knowledge,” Economica n.s. 4.13: 33–54.

Nobel Prize-Winning Economist: Friedrich A. von Hayek. Interviewed by Earlene Graver, Axel Leijonhufvud, Leo Rosten, Jack High, James Buchanan, Robert Bork, Thomas Hazlett, Armen A. Alchian, Robert Chitester, Regents of the University of California, 1983.

Richard Koo on Balance Sheet Recessions

Richard Koo is a Taiwanese economist working in Japan, and appears to be influenced by Post Keynesian economics, particularly Hyman Minsky’s financial instability hypothesis. Richard Koo’s research has focussed on balance-sheet recessions and credit cycles.

I have posted a very interesting video below where Richard Koo is essentially explaining the process of deleveraging and how to avoid debt deflation. He also explains how Japan narrowly avoided a debt deflationary disaster in the 1990s during the lost decade.

Koo makes the point that Japan and now the US are not in an inventory recession or a recession caused by a central bank trying to control inflation by monetary tightening where the underlying economy is strong: this is a balance sheet recession with excessive private debt, falling asset prices, and deleveraging.
Japan in the 1990s was prevented from a catastrophic depression and the full effects of debt deflation (e.g., the type of collapse in the US from 1929-1933) by stop-and-go use of fiscal policy: but the effectiveness of that fiscal policy was undercut by fiscal conservatives who demanded austerity and budget balancing during the lost decade, most notably in 1997-1998.

Now GDP is determined by the following:

GDP = private consumption + gross investment + government spending + (exports − imports).

In a balance sheet recession, where deleveraging is going on, households are paying down debt and reducing consumption, and business are also repaying debt and reducing gross investment.

This means that private consumption and gross investment collapse in GDP, causing a failure of aggregate demand. Unless you can massively increase exports to make up for this (impossible for most countries), then government spending must step in to fill the shortfall. But for Keynesian stimulus to work effectively, excessive and unsustainable private debt must be written off or restructured and the financial system must be cleared of bad assets and non-performing loans. In Japan, and now as we see in the US and other nations, deleveraging and the poor state of private balance sheets can cause the malaise to go on for years.

Without these measures and additional, larger fiscal stimulus, the US and possibly the UK will most likely experience a lost decade in the 2010s, and now Joseph Stiglitz thinks that the European Union itself will be in for a “lost half-decade” too. Whether the US and European nations will slip into outright deflation again as austerity is implemented is difficult to know. Possibly high energy and commodity prices will keep inflation moderate to high in coming years.

But if serious austerity takes hold in the US a lost decade for America, with a double dip recession, is a real concern. The US may well be the new Japan, so it seems.



Finally, there is further analysis of these issues here from the perspective of MMT:

Bill Mitchell, “How fiscal policy saved the world,” Billy Blog, October 9th, 2009.

Bill Mitchell, “Balance sheet recessions and democracy,” Billy Blog, July 3rd, 2009.

The Swedish Solution: Sweden’s Bank Bailout versus Japan’s and the US’s

Asset bubbles are a perennial curse in unregulated or poorly regulated financial markets. They are a plague on modern capitalism. But such bubbles, especially ones financed by excessive private debt, were minimized in the period from 1945–1979 when most countries had an effective system of financial regulation.

With the advent of neoliberal/revived neoclassical financial deregulation and liberalization over the past 30 years, asset bubbles and debt deflation have become serious problems again all over the world.

The first major victim was Japan, where ill-advised financial deregulation in the 1980s set Japan up for its massive property bubble that burst in 1991, leading to the lost decade. The US and other countries have now been hit by a similar disaster: bursting housing bubbles financed by high private debt, and leading to debt deflation and private sector balance sheets in a terrible state.

The bailouts in 2008 in the US and the UK and other nations have been widely criticised, and a far better type of bailout was employed by the Swedish government for its financial crisis in 1992. In Sweden, financial deregulation in the 1980s caused a flurry of real estate lending by Swedish banks, and when the bubble finally popped in 1991 and 1992 there was a major economic contraction. Bank failures and a financial crisis occurred. The Swedish solution? Here it is as described in the New York Times:

“Sweden told its banks to write down their losses promptly before coming to the state for recapitalization … later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years …. By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again …. Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country.”
Carter Dougherty, “Stopping a Financial Crisis, the Swedish Way,” New York Times, September 22, 2008.

This type of bailout and cleaning of the financial system was far superior to Japan’s failed bailouts in the 1990s and the US bailout of 2008.

More information on this can be found here:

Peter Thal Larsen and Chris Giles, “Self-assembly solution,” FT.com, March 18, 2009.

Leijonhufvud on Broken Financial Systems and Excessive Private Debt

There is an excellent paper by Leijonhufvud brought to my attenion by a comment on the last post here:

Axel Leijonhufvud, “Wicksell, Hayek, Keynes, Friedman: Whom Should We Follow?,” conference paper, Special Meeting of the Mont Pelérin Society Conference, 2009.

At the end of the paper, Leijonhufvud makes some very insightful remarks about debt deflation and the lost decade in Japan, noting how Japan’s failure to clean its financial system led to the malaise of the 1990s. The model for fixing broken banks after an asset bubble is clearly Sweden’s bank reforms in the early 1990s. I particularly like Leijonhufvud’s description of debt deflation as causing “financial sinkholes in private sector balance sheets” (p. 9) that need to be repaired before deficit spending will work effectively.

This is almost exactly what a Post Keynesian would say on these points, which is further proof that Leijonhufvud’s “coordination Keynesianism” is compatible with Post Keynesian thought.

Axel Leijonhufvud and the Post-Walrasians

I see someone has brought up the topic of Axel Leijonhufvud’s theories in a comment on a previous post.

Axel Leijonhufvud is a so-called “Post-Walrasian” (or disequilibrium Keynesian/coordination Keynesian), and – like Post Keynesians – he is critical of neoclassical synthesis Keynesianism based on neo-Walrasian theory. The leading economists in the Post-Walrasian movement are Don Patinkin (1922–1995) and Robert W. Clower (1926–2011), as well as Axel Leijonhufvud. What is most fascinating is that Robert M. Barro and Herschel I. Grossman made contributions to early Post-Walrasian thought, but moved away from it and became members of the New Classical school.

Leijonhufvud presented a bold new interpretation of Keynes’s General Theory and a critique of the neoclassical synthesis in On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory (New York and London, 1968).

Both Clower and Leijonhufvud became heterodox macroeconomists after the 1970s, and seem to share these common ideas:

(1) they criticise neo-Walrasian theory, and in particular the supposed market clearing mechanisms summed up in the metaphor of the “Walrasian auctioneer” who clears all markets;

(2) a dynamic disequilibrium approach to economics and interpretation of Keynes’s theory;

(3) the recognition that incomplete information of economic agents prevents market clearing mechanisms;

(4) we have an economic world of slow price adjustments and sometimes false price signals: the Walrasian assumption of instantaneously or near instantaneously adjusting prices is a myth, and once it is rejected we see there is no guarantee at all that decentralised market systems will coordinate economic activity to create full employment, and

(5) the idea that what is needed today is a reconstructed “Post Walrasian macroeconomics” which is derived from Marshallian microfoundations, not Walrasian microfoundations.

All in all, that is not a bad critique of modern economics, and there is a great deal here Post Keynesians can agree with. The Post-Walrasians believe that market economies can lead to unemployment equilibriums and that there are no automatic mechanisms for fixing this. They think that Keynes’ theories, properly understood, will have an important place in a future macroeconomics.

In the previous comment on my last post, I am told that if I “read more Axel Leijonhufvud” my blog would be much improved. I frankly think that most of what Leijonhufvud says is also said by Post Keynesians, but Post Keynesians do it better. For example, Leijonhufvud’s view on what causes recessions:

Leijonhufvud rejects interpretations based on wage rigidity, and he rejects explanations of depression that depend on monopolies, labor unions, and the like. These interpretations of involuntary unemployment imply that “if ‘competition’ could only be restored, ‘automatic forces’ would take care of the employment problem” ... Leijonhufvud notes that Keynes was critical of such explanations (Meltzer 1988: 267).

A very good discussion of the similarities and differences between Leijonhufvud’s thought and the Post Keynesians can be found in Littleboy (1997). In short, Leijonhufvud errs in thinking of the money supply as exogenous, and pays insufficient attention to uncertainty in the Keynesian/Knightian sense.

Finally, we can hear from the man himself. Here is an interesting interview with Leijonhufvud held at the Central European University (Budapest) during the Institute for New Economic Thinking conference (held from September 6–8, 2010). I note that Leijonhufvud’s comments on the poor state of private sector balance sheets at the moment (from 10.35) seem to approach the Post Keynesian concern with debt deflation.





BIBLIOGRAPHY

Leijonhufvud, A. 1968. On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory, Oxford University Press, New York and London.

Littleboy, B. 1997. “On Leijonhufvud’s economics of Keynes,” in G. C. Harcourt and P. A. Riach (eds). A ‘Second Edition’ of the General Theory (vol. 2), Routledge, London.

Meltzer, A. H. 1988. Keynes’s Monetary Theory: A Different Interpretation, Cambridge University Press, Cambridge.

Keynes on the Special Properties of Money

Keynes in the General Theory (1936) showed that fiat money and even commodity money have special properties:

“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).

Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

Even under the gold standard, when money was a type of producible commodity, production of gold or silver in significant quantities was severely limited to certain countries and brief times. For example, if the UK was hit by a deflationary depression in the 1880s, with a rising purchasing power for money as demand for it increased as a hedge against future uncertainty (that is, a rise in its value due to deflation), could UK businesses just hire unemployed workers to “produce” gold in the UK? They could not.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

A further point is that money and financial assets have zero or near zero elasticity of substitution with producible commodities:

“The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).

The gross substitution axiom is a fundamental assumption of neoclassical economics and the Austrians appear to tacitly assume the axiom as well. But the gross substitution axiom is wrong, and all inferences made from it in economic theories are also wrong.

This is also one of the reasons why Say’s law, in its various forms, does not work.

BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

Why Are So Many Economists Wrong?

The question is posed by a commentator on the last post, with respect to the New Keynesian N. Gregory Mankiw. The answer is that he, like the New Classical and monetarist economists, starts from fundamentally wrong assumptions about the world and the economy. In fact, these assumptions are basically the following axioms:

(1) the ergodic axiom
(2) the neutral money axiom (at least neutral in the long run)
(3) the gross substitution axiom.

These axioms are all wrong. A mainstream economist would have to reject them and start from scratch to come to the same conclusions independently as Keynes or Post Keynesians.

For why these axioms are wrong, see Paul Davidson, Financial Markets, Money, and the Real World (Cheltenham, 2002), p. 43ff.

As I noted in the last post, these are the traits of real world capitalist economies:

(1) a monetary production economy,
(2) fundamental uncertainty;
(3) subjective expectations;
(4) contracts which do not normally allow flexibility if economic variables change;
(5) inflexible or “sticky” wages;
(6) money with a zero or very small elasticity of production, and
(7) money and financial assets with zero elasticity of substitution with producible commodities.

If someone starts from principles that do not describe the real world, then one’s deductive arguments will go badly wrong and will not apply to the real world.

Skidelsky on “The Relevance of Keynes”

Robert Skidelsky has a very good essay on Keynes’s thought and how it applies to the financial crisis of 2008 and the state we find ourselves in today:

Robert Skidelsky, “The Relevance of Keynes,” January 17, 2011, www.skidelskyr.com.

This has also been published as an article:

Robert Skidelsky, “The Relevance of Keynes,” Cambridge Journal of Economics 35.1 (2011): 1–13.

Skidelsky is Keynes’s biographer and his interpretation of Keynes is in fact very close to that of the Post Keynesian school, which is why his work is important. The interested reader looking for something more substantial can also read Skidelsky’s new book Keynes: The Return of the Master (Allen Lane, 2009). A reasonably good summary can be found here:

Keynes: The Return of the Master, Wikipedia.org.

The reaction to this book shows us the schism that runs through modern New Keynesian macroeconomics. First, we have quite positive reviews of Skidelsky’s book by the liberal New Keynesians Krugman and Stiglitz:

Paul Krugman, “Keynes: The Return of the Master by Robert Skidelsky,” Guardian, 30 August 2009.

Joseph Stiglitz, “The Non-Existent Hand,” London Review of Books 32.8, 22 April 2010.
(this also has a letter by the Post Keynesian Paul Davidson clarifying Keynes’s views on uncertainty).

In contrast, we have the conservative New Keynesian N. Gregory Mankiw in a remarkably cold review in the Wall Street Journal:

N. Gregory Mankiw, “Back In Demand,” Wall Street Journal, September 21, 2009.

Mankiw asserts that Keynesianism “is based in part on the premise that wages and prices do not adjust to levels that ensure full employment.” In fact, Keynes also showed that even if wages and prices were flexible, there would still be involuntary unemployment and failures of aggregate demand. The so-called New Keynesian tradition developed by Mankiw and others (which is rather different from the New Keynesianism of Krugman and Stiglitz) is actually a travesty of Keynes’ thought, and part of the problem plaguing modern economics.

Post Keynesians Reject the Liquidity Trap

As I have pointed out before, Keynesianism comes in 3 forms:

(1) Neoclassical synthesis Keynesians (= Old Keynesians);
(2) New Keynesians;
(3) Post Keynesians.
See “Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review,” July 7, 2010.

Post Keynesian economics is what this blog advocates, and most people do not understand that Post Keynesianism rejects the neoclassical synthesis idea of the liquidity trap. In the original formulation of the concept, a liquidity trap is the existence of an infinitely elastic or a horizontal demand curve for money at some positive level of interest rates.

It should be noted that the expression “liquidity trap” is also used loosely or in a weak sense by New Keynesians like Krugman to mean that interest rates cannot fall below zero and that monetary policy can become impotent in some situations, which is perfectly true. That rather different definition of the “liquidity trap” is not objectionable. But it is the original neoclassical synthesis concept I am talking about here.

Keynes’ General Theory of Employment, Interest and Money (1936) gives us a theory of real world capitalist economies, where we have a monetary production economy, fundamental uncertainty, subjective expectations, contracts, inflexible or “sticky” wages, and money with a zero or very small elasticity of production, and money and financial assets with zero elasticity of substitution with producible commodities. But in fact Keynes did not regard the original liquidity trap idea as a real world phenomenon. Paul Davidson explains:

“…Old Keynesians claimed that, at some low, but positive, interest rate, the demand curve for speculative money balances become infinitely elastic (horizontal). This horizontal segment of the speculative demand curve was designated the liquidity trap by Old Keynesians such as Paul Samuelson and James Tobin. These mainstream Old Keynesians made the liquidity trap the hallmark of what Samuelson labeled Neoclassical Synthesis Keynesianism. If the economy is enmeshed in the liquidity trap, then Old Keynesians argued that the Monetary Authority is powerless to lower the rate of interest to stimulate the economy no matter how much the central bank exogenously increased the supply of money. This view of the impotence of monetary policy was succinctly summarized in the motto ‘you can't push on a string.’ The liquidity trap implied that monetary policy would be powerless to stimulate the economy if it fell into recession. These Old Keynesians, therefore, proclaimed that deficit spending fiscal policy was the only policy action available to pull an economy out of a recession. This faith in deficit spending as the only solution for recession became the policy theme for ‘Keynesians’, even though Keynes's speculative motive analysis denies the existence of a ‘liquidity trap’....
In the decade after the Second World War, econometricians searched in vain to demonstrate the existence of a liquidity trap (that is, a horizontal segment of the speculative demand for moment) where monetary policy could not affect the interest rate. In a stunning volte face of the history of economy thought, Milton and his followers who accept the neutrality of money as an article of faith used this failure of econometricians as an attack on Keynes’s theory. Friedman’s motto ‘Money matters’ became an anti-Keynesian weapon. This may have been an effective argument against Old Keynesians who followed Samuelson’s lead in accepting the neutral money axiom. Keynes, however, explicitly declared that in his analysis money was never neutral, that is, that money matters in both the short run and the long run in the real world” (Davidson 2002: 95).

Keynes also conceived the speculative demand for money as a rectangular hyperbola (Davidson 2002: 94–95), and we can turn to the General Theory to confirm that Keynes did not think the liquidity trap existed in the real world:

“There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest” (Keynes 2008 [1936]: 187).

The reason why monetary policy can be impotent and ineffective in recessions, depressions or periods of high involuntary unemployment where expectations have been shocked is that we have an economy with endogenous money, subjective expectations and shifting liquidity preference. A government can massively increase the private banks’ excess reserves by quantitative easing (QE), as seen in Japan from 2001 to 2006, and in the US and the UK from 2009, but that will not increase investment, spending or employment significantly, unless that money is injected into the economy by private debt. But it is precisely the collapse of expectations and confidence that destroys the demand for credit and the willingness of banks to extend credit. Banks may prefer to hold their excess reserves, and private individuals, households and businesses may be deleveraging (especially after an asset bubble and excessive private sector debt), and unwilling to take on new debt, while the economy is hit by debt deflation. The impotence of monetary policy in such circumstances is indeed a reality and the remedy is fiscal policy. But the neoclassical synthesis Keynesian idea of the liquidity trap is simply not needed to explain this phenomenon.

QE was a radical monetary policy justified by mainstream economics. It is the New Consensus macroeconomics, monetarism and conservative New Keynesianism that emphasises the use of monetary policy, while neglecting the role of fiscal policy. In contrast, liberal New Keynesians and Post Keynesians emphasise the role of fiscal policy and the ineffectiveness of monetary policy.


BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

Keynes, J. M. 2008 [1936]. General Theory of Employment, Interest and Money, Atlantic Publishers, New Delhi.

Hayek vs. Keynes Round 2: Amusing Rubbish

This video called “Hayek vs. Keynes, Round 2” by Russ Roberts (George Mason University) and the producer John Papola seems rather popular at the moment:



First, let me say: if this is supposed to be a frivolous attempt at entertainment, then that’s all well and good. I must confess there are several moments in it where a broad smile came to my face and I burst out laughing. Good entertainment can be fiction.

On the other hand, if people think there is anything really serious in it, they will be sorely disappointed. This video presents a caricature of Keynesian thought.

I address some of the more important points below.

I. Hayek’s influence is overrated.
The first point is that the fight over economic policy today has little if anything to do with Hayek. Today’s debates are essentially between New Keynesians versus New Classicals/monetarists. All of them are neoclassicals, and the free market New Classicals and monetarists are not Austrians.

Secondly, back in the 1930s and 1940s there were epic debates between Keynesians and Austrians like Hayek: and the Austrians lost those debates.

In fact, a good many of Hayek’s bright students at the LSE in the 1930s like Abba Lerner and Nicholas Kaldor simply abandoned his theories once they came to understand Keynes’ ideas. The defeat of Hayek and the Austrians was rather spectacular, as the world converted to Keynesian economics, and Austrians like Hayek and Mises were relegated to outer darkness.

When neoclassical synthesis Keynesian came under attack in the 1970s, it was not Austrian economics that overthrew it, but Milton Friedman’s monetarism and then the revived New Classical macroeconomics.

Furthermore, one of the major debates between Hayek and the emerging Keynesians in the 1930s and 1940s was over Hayek’s business cycle theory. One can note that even the Marshallian neoclassicals found his business cycle theories dubious, even before Keynes published the General Theory in 1936. The following anecdote illustrates this:

Immediately before giving his early 1931 lectures at LSE, which were his introduction to the school, Hayek gave a one-lecture to the Keynes-dominated Marshall Society at Cambridge. Richard Kahn, one of Keynes’ followers and later his literary executor, described the scene. Hayek had “a large audience of students, and also of leading members of the faculty. (Keynes was in London.) The members of the audience—to a man—were completely bewildered. Usually a Marshall Society talk is followed by a lively and protracted barrage of discussions and questions. On this occasion there was complete silence. I felt I had to break the ice. So I got up and asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ said Hayek. ‘But,’ pointing to his triangles on the board, ‘it would take a very long mathematical argument to explain why’” (Ebenstein 2003: 53).

It is no wonder that by the late 1930s Hayek’s LSE students were deserting him in droves.

Lest you think I am exaggerating, let Hayek speak for himself:

“At about the same time [viz., 1946], I discredited myself with most of my fellow economists by writing The Road to Serfdom, which is disliked so much. So not only did my theoretical influence decline, most of the departments came to dislike me, so much so that I can feel it to the present day. Economists very largely tend to treat me as an outsider, somebody who has discredited himself by writing a book like The Road to Serfdom, which has now become political science altogether. Recently—and Hicks is probably the most outstanding symptom—there has been a revival of interest in my sort of problems, but I had a period of twenty years in which I bitterly regretted having once mentioned to my wife after Keynes's death that now Keynes was dead, I was probably the best-known economist living. But ten days later it was probably no longer true. At that very moment, Keynes became the great figure, and I was gradually forgotten as an economist” (Kresge and Wenar 1994: 127).

II. A command economy is not a mixed economy, and Keynesian stimulus is not about war.

From 3.00 to 4.00 in this video, there is a truly stupid attempt to paint Keynes or Keynesians as supporters of war as a method of stimulus, in the comments on the Second World War.

And the producers of this video can’t even understand the nature of Western economies in WWII. Of course, the US and other nations did have huge government spending in WWII, but they also had moderate command economies in these years, with price controls and rationing. I say “moderate” because the US command economy was certainly not as extreme as that of the Soviet Union.

Other nations like the UK, Canada, and Australia also had moderate command economies during WWII.

The real lesson from WWII that is devastating to Austrian and other libertarian buffoons is that advanced capitalist nations showed that their type of command economy was extraordinarily successful – in fact they won the war for us. We owe our freedom from German and Japanese fascism to central planning of production and the way the economy was run in those years. The experience in WWII refuted the Austrian idea that government can never plan production on a large scale. If that were true, how on earth did any government produce anything in these years, let alone win the war? Of course, the WWII was a horrific disaster and any wartime economy is brutal and wasteful military spending.

None of the comments above is, in any way, an endorsement of war or a reason to re-establish command economies today – they are just statements of fact. I don’t personally support a command economy, nor do Keynesians, and it is not in doubt that rigid, communist command economies in backward nations were grossly immoral, brutal systems that faced severe problems and, in the long-term, serious inefficiencies.

But Keynesians do not advocate a command economy; they support a mixed economy, a very different thing from a command economy. Modern capitalist economies are mixed economies, where there is a vast space for private production of commodities and private enterprise.

In a Keynesian system, we can stimulate the economy into full employment without war or military spending. You can give a huge Keynesian boost to the economy by (1) large infrastructure spending, social spending, education spending, or increased R&D. Alternatively, you can also give a stimulus by (2) simply cutting taxes without cutting spending, which is also a classic Keynesian method.

These are the two methods of stimulus preferred by every Keynesian I know, not war.

III. Hayek recanted his views on “secondary deflation”.

Towards the end of his life, Hayek basically recanted his earlier view on the role of deflation in 1929–1933:

“There is no doubt, and in this I agree with Milton Friedman, that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation! So, once again, a badly programmed monetary policy prolonged the depression” (Pizano 2009: 13).

Hayek argued that a secondary deflation had negative effects on the US economy after 1929 and admitted that his earlier views had been wrong:

“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

In saying that he agreed with Milton Friedman, Hayek presumably would have accepted a monetarist solution of stabilizing the money supply by open market operations and other interventions (some claim that Hayek also supported limited fiscal policy actions, but I have yet to see evidence of this).

In other words, even the Hayek in this video is a travesty. By the end of his life, he moved closer to a monetarist position on “secondary deflation,” and approved of “evil” state interventions to stabilise the money supply.

IV. Hayek and Keynes shared some important ideas on economics.

As I have pointed out before, there are some interesting similarities in the thought of Hayek and Keynes:

“Hayek and Keynes: Not So Far Apart?,” April 19, 2011.

This involves the issue of methodology and the role of econometrics. Even Hayek himself noted Keynes’ negative views on econometrics:

“But Keynes himself did not think very highly of econometrics, rather to the contrary. Yet somehow his stress on aggregates, on aggregate income, aggregate demand, encouraged work in both macroeconomics and econometrics. So, very much against his own wishes, he became the spiritual father of this development towards the mathematical econometric economics. Now, I had always expressed my doubts about this, and that didn’t make me very popular among the reigning generation of economists. I was just thought to be old-fashioned, with no sympathy for modern ideas, that sort of thing”(Kresge and Wenar 1994: 127).

BIBLIOGRAPHY

Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago, Ill. and London.

Hayek, F. A. 1975. A Discussion with Friedrich A. Von Hayek, American Enterprise Inst., Washington.

Kresge, S. and L. Wenar (eds). 1994. Hayek on Hayek: An Autobiographical Dialogue, University of Chicago Press, Chicago.

Pizano, D. 2009. Conversations with Great Economists, Jorge Pinto Books Inc., New York.