Free Markets, Say’s Law and the Failure of Keynesian Economics – by Steven Kates

November 28, 2012

Author Articles, Economics Finance

Photo: Mark Wainwright, Creative Commons 2.0

How can we return the economy from the midst of recession to rapid rates of growth? Steven Kates explains why adopting Kenynesian policy is doomed to failure, and instead advocates classical theory based on a proper understanding of Say’s Law.

I wrote my Free Market Economics: an Introduction for the General Reader (Elgar 2011) at the very start of the financial crisis in 2009 – it was written in white heat between February to May as the text for the course I was teaching in Economic Analysis for Business. What drove the book to completion was my dismay at the return of Keynesian economic theory and policy as the guide to recovery. My assumption at the time was that my book would be one of many such texts written in response to the devastation that would inevitably be brought on by the stimulus. What is to me quite astonishing is that this book is the only book of its kind. I fear that after 75 years of Keynes, virtually no one can any longer see what the problem with modern macroeconomic theory is and why a Keynesian demand-side stimulus could not possibly have worked.

What makes this book different is that the macroeconomics is not just pre-Keynesian and not just un-Keynesian but actively anti-Keynesian. The book also explains Keynesian theory, of course, since it is impossible to teach economics without discussing modern macroeconomics as it is currently taught. Nevertheless, anyone interested in understanding the nature of the business cycle, how to return an economy from the midst of recession to rapid rates of growth, or what is needed to achieve low rates of unemployment from a classical perspective – that is, from the perspective of the free market – ought to look at this book. Let me merely note that free market does not mean laissez-faire.

On the macroeconomics side, the core concept is what has come to be known as Say’s Law which no one understands unless they have personally read the narrow and specialist literature on this fundamental concept. The one person, moreover, from whom you cannot find out its meaning is Keynes. Keynes made it his business to demonstrate that Say’s Law is wrong – the original name of Say’s Law, it might be noted, having been the Law of Markets. Keynes went about his work firstly by setting up his straw man version of Say’s Law and then by refuting a proposition no one had ever supported. Indeed, it is utterly fantastic that Keynes was ever able to convince anyone that classical economists had always assumed full employment was assured even when they were discussing recession, but that he did. This has now entered into the mythology of economic theory which is one of the reasons few economists ever look back at the economic theories that preceded the publication of The General Theory. What a mistake that is!

Since the very point of Say’s Law was to deny absolutely that demand deficiency could have been the cause of recessions even while recognising that recessions were frequent and often devastating, it can be seen just how different a non-Keynesian theory of the cycle is from virtually all versions of macroeconomics today. What my Free Market Economics does is provide a guide to the pre-Keynesian theory of the cycle which not only makes clear what causes economic crises but also why using Keynesian policy to attempt to restore growth through increasing aggregate demand is doomed to failure. Since these Keynesian policies have unquestionably failed, asking why that is ought to have become the main order of business across the economics world. It is a question that has, however, virtually never been asked.

But the book does more than recast macroeconomics in its classical form. The microeconomic sections of the book also provide a different perspective on the nature of the market, the role of the entrepreneur and the unparalleled importance of uncertainty whose significance in economic analysis cannot be exaggerated. The text wages a battle against the other major innovation of the 1930s, the diagrams associated with marginal revenue and marginal cost. Anyone who has done economic theory has been dragged through a set of diagrams that show how the price of individual products are determined according to where the additional cost of producing one more unit of output is equal to the additional revenue that would be received by producing that one extra unit of output. Maddeningly complex while simultaneously shallow, it will leave an economist almost completely unequipped to deal with the genuine questions an economy poses to policy.

This analysis has distracted economists from focusing on what is most important about entrepreneurial decision making by making it appear that profit maximisation is about getting MR to equal MC. The reality of business, however, is that the future is an absolute unknown; economic decisions are seldom about single products and never about whether one more unit of anything ought to be produced. Instead, virtually all economic decisions are based on conjectures built on the past and projected ahead into the future about which nothing can ever be known for sure, and the more distantly into the future decision makers project, the less likely they are to get right.

This, then, is how marginal analysis needs to be explained. Decision making occurs as the expected costs associated with some decision (their marginal cost) are weighed against the expected return (their marginal revenue). Such decisions have nothing to do with deciding whether to produce one more unit of output. It is about making decisions that often put millions on the line and involve years of pre-planning. The free market succeeds because there are many different projections being made by people who venture their own money and who therefore have the most intense interest imaginable in getting it right, and then correcting their errors when things go wrong, as they inevitably do. That is what marginal analysis is actually about.

The book is my update for the twentieth century of two of economic theory’s great classics, John Stuart Mill’s Principles of Political Economy published in 1848 and Henry Clay’s Economics: an Introduction for the General Reader published in 1916, and from which I adopted the title. They knew nothing of Keynesian economics other than its being a common, but at the time unnamed, fallacy that economists had to continuously refute. Keynesian economics is now, however, the mainstream. If you would like to understand what is wrong with Keynesian theory and much else, as well as understanding how to view the economy and economic issues, my book is the place to start.

Steven Kates is senior lecturer in economics in the School of Economics, Finance and Marketing at RMIT University in Melbourne. Before that he was for 24 years Chief Economist for the Australian Chamber of Commerce and Industry and subsequently a Commissioner on the Australian Productivity Commission. Free Market Economics: an Introduction for the General Reader is the most recent of his books, and has recently been given the RMIT University College of Business Best Book Award for 2012.

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