Greg Hill versus Steve Horwitz: A Keynesian–Austrian Debate

The Austrian Steve Horwitz and the Keynesian Greg Hill had a debate on the pages of Critical Review as follows:

Hill, Greg. 1996. “The Moral Economy: Keynes’s Critique of Capitalist Justice,” Critical Review 10: 411–434.

Horwitz, Steven. 1996. “Keynes on Capitalism: Reply to Hill,” Critical Review 10.3: 353–372.

Hill, Greg. 1996a. “Capitalism, Coordination, and Keynes: Rejoinder to Horwitz,” Critical Review 10: 373–387.

Horwitz, Steve. 1998. “Keynes and Capitalism One More Time: A Further Reply to Hill,” Critical Review 12: 95–111.

Hill, Greg. 1998. “An ultra-Keynesian Strikes Back: Rejoinder to Horwitz,” Critical Review 12: 113–126.

While I will not cover every detail of the debate, two important aspects of it were the issues of (1) the coordination of saving and investment, and (2) loanable funds theory.

Hill notes that, as Keynes argued, the decision not to spend one’s income today on goods or services does not entail that the money will be spent in the future on goods or services (Hill 1998: 114).

Horwitz appeals to a loanable funds model, in a rather idealised form, in his critique of Hill. Under the loanable funds theory, when people reduce consumption, the resulting savings add to loanable funds and this is supposed to lower interest rates and induce more capital investment in production of goods that will be available at some point in the future. The hidden assumption here is that an individual’s increased saving will necessarily increase total saving, for it is total saving that must be increased to reduce the rate of interest (Hill 1996a: 374). But even if we assume that the money saved by a potential consumer is made available for capital goods investments, the money not spent by the consumer reduces the income and savings of a business where he or she would have spend the money, and the income and savings of the business’s employees and suppliers. Therefore the addition to business savings and savings of those who earn income from the business will be prevented by loss of income from the first act of saving of the consumer, and the total amount of savings need not be higher (Hill 1998: 116). When such a process occurs throughout an economy, in the aggregate there need be no increase in saving, but reduction in demand deposits, and reduction in the broad money stock. Therefore the interest rate need not fall, and the supposed inducement of more investment will not happen. Thus an increase in current savings need produce “no inducement to expand future output in the absence of an order for future delivery” (Hill 1998: 115).

Austrians might claim that a lower interest rate – or a lower price of credit – will induce greater investment when interest rates fall, but this does not necessarily follow in a world where business faces uncertainty, where expectations are subjective, and where demand for investment credit can collapse or be stagnant.

And there is also a fundamental flaw in the whole loanable funds model: the fact that a great deal of what we call “saving” is spending of money on secondary real asset markets and, above all, on secondary financial asset markets. The decision not to spend money on consumption goods today does not mean the money is necessarily transferred to banks that finance capital goods investments. Often, especially in the case of the rich and very rich, the money is used to buy financial assets, and may be diverted to exchanges between buyers and sellers of such financial assets for significant periods of time. The purchase of a stock, bond, or financial instrument on a secondary financial asset market does not make that money available for capital goods investments per se; nor does it lower interest rates. In other words, there is a devastating flaw running through the whole loanable funds model: the assumption that money not spent is going to be simply put in a financial institution that lends the money for real investment.

The blogger MGM on the short-lived “Austrian Economics” blog expresses a crucial observation on this point:

“… savings find their way into the financial sector, because financial assets possess a great deal of liquidity. And depending on one’s appetite for risk, one can attempt to sacrifice a little liquidity for the possibility of capital gains (speculation); but because most financial assets have orderly markets, it is relatively easy to sell these assets for money. Capital goods, however, are not easily resalable (liquid).

For Post Keynesians, the financial sector is very different from the industrial sector. The financial sector deals principally with liquidity, and aims to provide people with liquidity (savers). The industrial sector, on the other hand, deals with real tangible (not easily substitutable) capital goods. These goods do not provide liquidity, because they cannot easily be sold. People who deal with capital goods must therefore look to its prospective yield and not its liquidity properties. These people are generally capitalists, and not savers.”
“The Horwitz and Hill Debate: Or, Why the Austrians are Wrong about Financial Markets,” Austrian Economics, March 27, 2011.

Moreover, the banking and monetary system is endogenous, which means that it generates new money in response to the demand for (1) credit or (2) demand deposit money. Hill is absolutely right to stress that modern banking systems create credit in excess of savings and prior monetary saving is not needed to back investment (Hill 1996a: 381). Assuming resources are available, new monetary saving is therefore not even necessary for increased credit creation and investment. In a world of vast international trade, industrial sectors with unused excess capacity, and idle resources, even at a high level of employment, capitalist systems can still provide elasticity of production of many goods without serious inflation.

But the demand for investment credit is still dependent on many things other than a crude supply and demand curve for money, such as expectations of future profit, the level of demand, sales volume, expectations of future sales and orders, and so on.

Horwitz also thinks that flexible wages and prices will prevent, or at least be the solution for, unemployment when saving exceeds investment. Here Hill notes that Horwitz misunderstands Keynesian theory, because Keynes in fact argued that, even if wages and prices were perfectly flexible, involuntary unemployment would exist (Hill 1996a: 377). The most devastating response Hill has to Horwitz’s flexible wages and prices model as the cure for unemployment is the disastrous debt deflation that results from wage and price reductions (Hill 1996a: 378).


Links
Robert Vienneau, “Steven Horwitz and Post Keynesians,” Thoughts on Economics, June 1, 2008.

“The Horwitz and Hill Debate: Or, Why the Austrians are Wrong about Financial Markets,” Austrian Economics, March 27, 2011.

Dan Kervick, “Do Banks Create Money from Thin Air?,” New Economic Perspectives, June 3, 2013.


BIBLIOGRAPHY
Hill, Greg. 1996. “The Moral Economy: Keynes’s Critique of Capitalist Justice,” Critical Review 10: 411–434.

Horwitz, Steven. 1996. “Keynes on Capitalism: Reply to Hill,” Critical Review 10.3: 353–372.

Hill, Greg. 1996a. “Capitalism, Coordination, and Keynes: Rejoinder to Horwitz,” Critical Review 10: 373–387.

Horwitz, Steve. 1998. “Keynes and Capitalism One More Time: A Further Reply to Hill,” Critical Review 12: 95–111.

Hill, Greg. 1998. “An ultra-Keynesian Strikes Back: Rejoinder to Horwitz,” Critical Review 12: 113–126.