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.

An Overview of the Major Schools of Economics

The major approaches to economics can be divided into

(1) neoclassical theories and
(2) non-neoclassical or heterodox schools.

The neoclassical schools include Supply-side economics, Monetarism, New Classical economics, and New Keynesian economics.

The mainstream and orthodox approach to economics is the New Consensus Macroeconomics, which is a synthesis of the main neoclassical approaches. But the mainstream neoclassicals do not agree on all issues: at the higher level they can be found in different groups like the monetarists, New Classicals, and New Keynesians.

There are three major heterodox, or non-neoclassical traditions: Austrian economics, Post Keynesian economics, and Marxism (and Marxism has more in common with Classical economics/Classical political economy, an older economic theory).

These divisions can be seen in the chart below (please open it in a new tab or window to see a larger version).

On the development of the Keynesian schools, I have already written a post called “Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review,” July 7, 2010.

After 1945, there were two Keynesian traditions:

(1) the neoclassical synthesis and
(2) the Cambridge Keynesians, who were the founders and progenitors of the Post Keynesian school.

Post Keynesian economics has no need for, and rejects, the IS-LM model of Hicks, the Phillips curve, and the empirically unsupported notion of the liquidity trap (Davidson 2002: 95). It is a more radical development of Keynesian theory, true to Keynes’ fundamental ideas (if not to all his more conservatively-minded policy recommendations), and has always rejected the foundational neoclassical axioms (namely, the gross substitution axiom, neutrality of money axiom, and the ergodic axiom).

The New Keynesians emerged after the collapse of neoclassical synthesis Keynesianism in the 1970s, but even modern New Keynesianism can be divided into conservative and liberal/progressive wings. Both Paul Krugman and Joseph Stiglitz are outstanding liberal New Keynesians. By contrast, George W. Bush took advice from the rather more neoliberal or economically conservative Republican New Keynesian N. Gregory Mankiw, who was chairman of Bush’s Council of Economic Advisors from 2003 to 2005. Despite the name “Keynesian”, there is a good deal of false and questionable neoclassical theory in New Keynesian economics, and in many ways it is inferior to the Post Keynesian tradition. Indeed, some of the worst writings of the conservative New Keynesians can actually be regarded as a travesty of Keynes’ thought. In its best, progressive forms, New Keynesian theory parallels Post Keynesian thinking.

The various types of libertarians are discussed in “The Types of Pro-Free Market Libertarians,” January 30, 2011.

Compared to the Austrians, the monetarists and New Classicals in fact support numerous state interventions, and their economics is derived from a revived neo-Walrasian general equilibrium theory. In fact, many Austrians are hostile to the mainstream monetarists and New Classicals, and there are very significant differences between their economic ideas.

As we can see, not all economists who support extreme or strong free markets are libertarians. I have not included monetarists as libertarians, but of course there is some overlap between the two sets. Although it is true that some supply-siders, monetarists, New Classicals, and Republicans think of themselves as “libertarians” in some way as well, many in fact do not. Modern conservatism or conservative economics comes in many forms, and by no means can it all be simply labelled as “libertarianism”.

Perhaps a better division of extreme or strong pro-free market ideologues would be as follows:

(1) Libertarians, including Austrians (Anarcho-capitalists, Misesians, Hayekians, moderate subjectivists, radical subjectivists) and non-Austrian libertarians (Randians, Robert Nozick’s libertarianism, David D. Friedman’s anarcho-capitalism, and non-Austrian neoclassical libertarians), and

(2) Mainstream neoclassical theorists, including Supply-siders, Monetarists, New Classicals, and conservative New Keynesians.

This can be shown in another chart below.

There is a blue line that divides the New Keynesians into conservatives on the left and liberals/progressives on the right. It is unfair to characterise the liberal/progressive New Keynesians as strong pro-free market ideologues, so they should be excluded from the other groups. The libertarians outside the black box (i.e., the Austrians and Randians) are non-neoclassicals but pro-free market. Those libertarians inside the black box are neoclassicals or influenced by neoclassical theory.

Now over the past 65 years (since about 1945) we have had two different economic systems based on two different macroeconomic theories:

(1) neoclassical synthesis Keynesianism and Cambridge Keynesianism/Post Keynesianism from 1945 to about 1979;
(2) revived neoclassical macrotheory from the late 1970s.

The revival of neo-Walrasian neoclassical theory was done mainly by (1) Milton Friedman and (2) the New Classicals at the University of Chicago in the 1970s, including John F. Muth, Robert Lucas, Thomas J. Sargent, Robert J. Barro, Neil Wallace, Robert M. Townsend, Robert E. Hall, Edward C. Prescott and Finn E. Kydland. In many ways, the New Classicals are the worst of all the revived neoclassical theories, because they have been one of the most powerful schools, with considerable influence.

While Neoclassical synthesis Keynesianism had its theoretical problems, derived from the mistaken attempt to wed it to fundamental neoclassical ideas, it provided a far better system than the one that we have seen since about 1979.

The new neoclassical orthodoxy that emerged in the 1980s can be called “neoliberalism,” the “Washington consensus,” or “globalization.”

Reaganomics and Thatcherism were blends of the various new neoclassical ideas. In particular, Reaganomics was a strange blend of monetarism and supply-side economics, with a type of military Keynesianism brought in via Reagan’s huge budget deficits. Thatcherism was a more doctrinaire neoliberal ideology influenced by Milton Friedman, with a tinge of Austrian rhetoric, via Friedrich von Hayek.

While forms of monetarism and supply-side economics rather quickly fell from favour amongst policy-makers (indeed I think that forms of monetarism or quasi-monetarism in fact failed rather spectacularly), the New Classical economics emerged as the dominant neoclassical theory, and, through its arguments with the New Keynesians, the resulting synthesis lead to the New Consensus Macroeconomics by the early 1990s. It is this modern consensus that has come under severe attack in the wake of the 2007–2009 global financial crisis and great recession.

It is clear that the New Consensus Macroeconomics has failed. The question is whether some of the more intelligent New Keynesians can escape from the death-grip of neoclassical economics and develop a better macroeconomic theory, purging it of its unnecessary, mad and bad neoclassical ideas. If that happens, my money is on Post Keynesian economics to be the new economic paradigm.

BIBLIOGRAPHY

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