Elgar Debates: How to Promote a Global Economic Recovery? “Markets… have been the single most liberating institution in possibly the entire history of the human race”

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What are the best economic policies to promote global recovery?  In the third letter of our new Elgar Debates series, Steve Kates challenges Louis-Philippe Rochon’s proposed strategy for economic stimulus, and suggests that the market is the best tool to develop recovery.

To follow this debate, begin at the bottom of the page by reading Steve’s first letter, and then Louis-Philippe’s reply.

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Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

 

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

 

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction.

 

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

 

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

 

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

 

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

 

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least we can agree, that the world’s economies are in a mess: consumers deep in debt, savings eaten away by low productivity, government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things worse. You describe what I see, but I expected things to end like this from the start.

You only began to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, that the problem is not enough government spending.

 

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

 

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding production. You must do more than build brick walls, you must build where what is built actually contributes to prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And if we were looking to make matters worse, it’s hard to go past items 1-3 of your program for recovery:

 

First, we must replace private debt with public debt.

 

Second, we must put job creation above all other goals.

 

Third, we must deal head on with the problem of income inequality.

 

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Kind regards

Steve Kates

——

 

Louis-Philippe’s Reply to Steve’s First Letter – published on 20th November 2014.  Steve’s letter is below.

Samuel_Johnson_by_Joshua_Reynolds_2

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked.   In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!   When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

 

 

Steve Kates’ First Letter, which began this debate – published on 13th November 2014

 

GrantKeynes

 

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

 

This is what I wrote at exactly the same time.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. (Kates 2009)

 

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

 

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

 

Y = C + I + G

 

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader. There is literally nothing else like it anywhere.

 

Best wishes,

Steve

Bibliography

Akerlof, George and Shiller, Robert. 2009. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton, NJ: Princeton University Press.

Kates, Steven. 2009. “The Dangerous Return to Keynesian Economics.” Quadrant.

2014. Free Market Economics: an Introduction for the General Reader. 2nd edition. Cheltenham, UK: Edward Elgar Publishing.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.

Temin, Peter and Vines, David. 2014. Keynes: Useful Economics for the World Economy. Cambridge, MA: MIT Press.

 

 

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