The tragic failure of Keynesian economics
This is the tragedy of modern macroeconomic theory and of economists in general. Economists simply do not know any better. They automatically prescribe increased public spending during recessions because that is what they have been taught for something like four generations. An important part of the reason for the economic mess we are in is due to the failings of economic theory itself.
Aggregate demand is the conceptual contaminant that has permeated the subject, and no amount of policy failure appears capable of making a difference. Neither the stagflation of the 1970 nor the lost decades of Japan since the 1990s seem to have made the slightest dent. One can only hope that the looming macrofailures of the current series of stimulus packages now being applied across the world will help lift the fog of unknowing about the dangers that this Keynesian legacy has left behind.
Until Keynes came along, economics was decidedly supply side. Creating value was the aim of economic activity and it was understood to be immensely difficult. Value adding activity was therefore largely left to the business community. Market forces were recognised as a trial and error system in which those who could create more value than was used up in production were allowed to continue in business. Those who could not were encouraged to find some other way to make a living. Free markets and competition were amongst the most important institutional elements designed to reward success while removing from the direction of capital those who could not use the nation’s resources in a productive way.
This form of understanding has now been replaced by a theory which places demand at the centre of macroeconomic activity. It is buying that supposedly drives an economy forward, not producing. It is from stimulating demand that recovery is expected to find its way, not from encouraging value adding production. Thus, instead of recognising the necessity for the painstaking efforts required to craft a business enterprise, so that the value of output is greater than the value of the resources used up during production, we now pretend that we can get the same result by governments just spending money on whatever seems to be most politically convenient.
Only one in a hundred, if that, can run a truly successful business. On the other hand, anyone can spend from now until the end of time if given the licence to tax or print money. We now appear to believe that governments spending money will stimulate growth when in times past it was perfectly well understood that it was almost entirely the management of successful business enterprises that pulled an economy forward.
Here is the fundamental error of Keynesian economics. In the domestic economy there are three elements of demand identified by macroeconomic theory: consumption (represented by the letter “C”), private investment (I) and government spending (G). The equation found in economic texts round the world is that output equals the total of C+I+G. To increase output, therefore, what is required is to increase any one of C, I or G.
From the theoretical point of view, it makes no difference whether money is spent by consumers on final goods and services, by governments on politically driven wasteful expenditures, or by businesses on value adding forms of investment. All provide demand and therefore all are equivalent so far as macro theory and policy are concerned.
There was a time when we knew better, and economists were there to say so. But that time is long gone. Until that Keynesian incubus is finally removed, macroeconomic theory will remain incapable of reliably providing the kinds of sound advice needed. A large proportion of the economics community will, instead, continue to recommend expenditure on one dubious project after another until the dead weight costs of such spending finally force governments into doing what they ought to have been doing from the start.
To paraphrase Margaret Thatcher, the trouble with Keynesian economics is that eventually you run out of other people’s money. By waiting until that day of reckoning, we postpone the inevitable. But as the very meaning of the word clearly implies, the inevitable inevitably arrives. And when it does, not only does the original problem need to be repaired, repairs are also needed for the Keynesian non-solutions that were attempted first.
We now not only have a crisis in our economies, there is also one in economic theory as well. Unless we fix the problems embedded within our prevailing theories, fixing the problems of our economies will be far more difficult than it should ever need to be. And so long as we continue to rely on Keynesian prescriptions, the remedies chosen will themselves cause a quite extraordinary amount of damage along the way. The evidence for these failings is there to be seen in any direction you might now care to turn.
Dr Steven Kates is Senior Lecturer in Economics at the RMIT University in Melbourne, Australia.