The economic
theories of British economist John Maynard Keynes, made popular during the
1930s Great Depression when his General
Theory was published, and the theories of a school of economists he has
inspired known as the Keynesians, have proved damaging to the cause of economic
freedom. Luckily for the defender of the free-market order, Keynesian theories
of the economy are based on a number of untenable assumptions that serve as the
intellectual fatal flaws of Keynesianism. We will discuss these flaws, and
through them why Keynesianism is unsound, in the following post.
1. Failure to treat the interest rate as a market price, and
failure to recognise its economic significance as the price of time:
According to John Maynard Keynes, the
interest rate is determined by ‘liquidity preference’, the interest rate being
the ‘reward for parting with liquidity (command over cash)’. This explanation
is superficially plausible; after all, when one loans money at interest, it is
at the price of giving up control over liquid cash assets temporarily. It
becomes less plausible though when we realize, as Henry Hazlitt pointed out in
his book dedicated to refuting Keynes’ General
Theory, that the price of every commodity in a monetary economy could be
explained as being determined by ‘liquidity preference’. Thus, if someone buys
a movie ticket for $14, one could say that the ‘reward for parting with
liquidity’ in this case is movie tickets, at the rate of one ticket for $14 of
liquid cash given up.
The more relevant question is: what
determines whether a person decides to buy a movie ticket with his $14 or
instead, whether he decides to lend his $14 out at interest? The answer is that
if he buys the movie ticket or any other consumption good, the person shows
that he wishes to use the $14 for present consumption, while if he lends at
interest or otherwise invests his savings, the person shows that he wishes to
use the $14 to invest in the production structure in some way, with the hopes
of increasing his disposable wealth when the loan is returned with interest
payments added on or returns are made on the investment. What, then, determines
the interest rate? It is determined by the degree of future-orientedness of all
market participants involved in the loan/time market. If our individual is
quite future-oriented, perhaps a 2% interest rate is enough to induce him to
hold off consumption, while for a less future-oriented person, perhaps only a
10% interest rate would be high enough. If the general market interest rate,
tending towards a rough uniformity as all market prices do and determined by
the degree of future-orientedness of all market participants involved in the
time market, is 5%, than the first person will invest the $14, while the second
person will not and will choose to consume it instead.
Thus, the interest rate is really the
price for selling time, a crucial factor of production in every economy above
the ultra-primitive. Austrian economists call the degree of future-orientedness
of market participants their individual time-preferences,
with a lower time-preference meaning more future-oriented, and thus they
say that the general interest rate on the market is determined by the
time-preferences of market participants, not by their ‘liquidity preferences’.
It should also be noted that time is
not just sold on the loan market, but is involved in every act of investment.
Thus, all of the factors of production necessary to produce a certain consumer
good, say a car, are going to be worth less than the final product, not just
due to entrepreneurial profit, but also because there is an implicit time
transaction involved. It takes time for the factors of production to be
combined into the final product and then sold, thus the person who advances the
money to buy the factors of production in exchange for ownership of the final
product, no less than the person who lends money to the car manufacturer, are
selling time and will tend to be compensated at the market’s roughly uniform
interest rate, whether they are lending money or investing in factors of
production.
The lower the market interest rate,
the more, other things equal, time-consuming processes of production market
participants will be able to profitably engage in. These more time-consuming
processes are often more productive, or can produce things otherwise impossible
to produce, than less time-consuming processes. Thus, imagine if someone with
no personal savings wanted to produce a car from scratch. Starting from the
mining of the iron ore from the ground and the raising of cows for leather,
going all the way through to the final assembly of the car, this production
process would take a very long time if started from scratch. Someone with no
personal savings would have to be able to borrow money for a very long-time in
order to complete the car (probably longer than a life time in this case, but
luckily in the real world we already have a complex economy where many of the
necessary factors of production are constantly being produced, with the time
element already factored into their prices). If the interest rate were too high,
the necessary price that the man would have to charge to make a profit on the
completed car would probably be too high for most consumers, and hence the car
would probably not be produced. With a lower interest rate, it would be
possible for the car to be profitable though, as the crucial factor of
production, time, wouldn’t be as
prohibitively expensive in this case.
Creating a car absolutely from scratch
is admittedly a far fetched example, but it points to the crucial role of time
in the production processes of our modern economy, and to the interest rate as
the price of time as a factor of production, which pervades the modern economy.
The Keynesians, with their mistaken
theory of interest, ignore most of this. They don’t tend to treat the interest
rate as the market price of the factor of production/consumer’s good time, and the rate as determined by the
time-preference of market participants, but as some ‘macroeconomic variable’
that government officials have to manipulate to keep the economy on course.
During economic depressions, they call on the government and the central bank
to ‘reduce the rate of interest’ by printing money and throwing it on to the
credit markets first, not realizing that the interest rate is a market price
like any other, set by suppliers and demanders of time through mutually beneficial transactions.
2. Disregard of Austrian Business Cycle Theory:
This brings
us to the second fatal flaw of the Keynesians: their disregard of Austrian
Business Cycle Theory. Briefly, Austrian Business Cycle Theory (ABCT)
postulates that when fractional-reserve banks or a government monetary
authority (the central bank) extends credit via the creation of money that had
not existed before, the market interest rate is temporarily reduced below what
it would have been without the money creation, because the new money starts as
credit on the time markets and only later flows through the rest of the economy
and raises prices all-around. There is nothing inherently wrong with low
interest rates, in fact, if achieved without money creation they would mean
more rapid capital accumulation leading to a more capital-intensive economy
that could engage in longer and more productive production processes, which
would become more prosperous all-around as a result. The problem with the
inflation-induced low interest rates is that they are not achieved through a
lowering of time-preferences (more future-orientedness) among market
participants and the corresponding increased saving of resources to be invested
in longer production processes. There is no reason to believe that more
resources have been saved up as a result of the inflation, and in fact there
are compelling reasons to believe that fewer resources have been saved up.
Inflation, by inducing people to mistakenly believe that they are richer than
they actually are, and by undermining less risky investments such as low-yield
bonds, actually tends to lead to more consumption and possible capital
consumption, even though the initial dose of the new money starts out by
masquerading as saved funds in the loan/time markets.
Thus, we
have a situation where business entrepreneurs, through the lower market
interest rates, are induced to act as if more saved up resources are available
and engage in more time-consuming production processes, while there is no
reason to believe that there actually are more saved up resources, and
compelling reasons to believe that there are less as a result of the inflation.
In Austrian terminology, during this ‘boom’ period, the genuine saved up
resources are invested unsuitably, malinvested,
in an unsustainably long, time-consuming structure of production, while through
inflation, people are led towards overconsumption,
the opposite of what would be necessary to make the structure of production
the investors are trying to build up sustainable. Something has to give, and
does when the fractional-reserve banks and/or the central bank is forced to
stop inflating as quickly due to the foreseen risk of a catastrophic
hyperinflation leading to the destruction of the currency. Without the
inflationary monetary steroids, the structure of production is revealed to be
unsustainable, and thus many of the investments and businesses must be
liquidated, making it vital that the resources and the labor they were using be
shifted and repurposed to build up a more realistic and sustainable structure
of production, not based on artificially low interest rates. This is what Austrians
call ‘the bust’, and what everyone knows as a recession or a depression.
The
Keynesians, due largely to their neglect of capital theory and their faulty
theory of interest, disregard this theory, either ignoring it or, like Paul
Krugman, contemptuously rejecting it through snarky, superficial, unscholarly pot-shots
at it. This, as well as other flaws in their thinking, leads Keynesians to
advocate inflationary credit expansion to get the economy out of
recessions/depressions. But credit expansion is the cause of the unsustainable
boom followed by the painful bust in the Austrian Theory, and if the Austrian
Theory is correct (which I think it is), than the Keynesian remedy is just a
policy of attempting to kick the can down the road, causing damage to the economy
as they do. Thus, in 2000, when the dot-com bubble collapsed and the US economy
entered recession, the central bank followed a Keynesian policy of printing
money to foster credit expansion and artificially lowering the interest rate.
The result was a more serious bubble in the form of the housing bubble that
developed and an even more painful bust in 2008, just as the Austrian Theory
predicted. Given this, there can be no reconciliation between the theory
schools of thought. If one thinks that there is any plausibility to the
Austrian Theory, than the Keynesian ‘remedies’ must be rejected as silly and
counterproductive. Pretending that such things as an economy’s capital
structure and structure of production don’t exist, and pretending that the
interest rate isn’t a real market price but can be manipulated with no negative
consequences by bankers and government officials, and ignoring the Austrian
Business Cycle Theory as a result, is very dangerous if you like economic
prosperity and fear recessions and depressions.
3. Assumption that a harmful ‘Deflationary Spiral’ could
occur:
A key aspect
of Keynesian thought is its benign view of monetary inflation and great fear of
monetary deflation. Its fear of monetary deflation is largely based on the
construction of a nightmare scenario known as the ‘Deflationary Spiral’. According
to Keynesians, if the money supply, largely through the contraction of the
outstanding loans or the actual bankruptcy of fractional-reserve banks during a
recession or depression, should be reduced, a vicious ‘Deflationary Spiral’
will set in unless it is counteracted by central bank inflation. When the money
supply is reduced, the money that remains will tend to be able to buy more
goods, or increase in purchasing-power, as, other things equal, less supply
tends to lead to a reduction in price (in this case the goods-price of money,
the same thing as an increase in the purchasing-power of each monetary unit).
So far so good, this is all true. But now, the Keynesians and other
deflation-phobes contend, people, seeing that money is growing in value while
their investments are turning sour or being revealed as riskier than they
thought, will be led to stop investing in productive assets and start hoarding
money for speculative purposes instead. Even once the money supply has
physically stopped being reduced; money will continue to increase in
purchasing-power as more people increase their demand for money for speculative
purposes, leading to more and more people piling into money. Consumption and
productive investment will stagnate, and the economy will be stuck in a vicious
spiral of poverty.
The first problem with this nightmare
scenario is that nothing like it has ever been observed in the recorded history
of humanity. There have been serious monetary contractions before, but rampant speculative
hoarding leading to a prolonged period of rapid deflation (increase in money’s
purchasing-power) has never been the result. What tended to happen was that
after the physical monetary contraction had stopped, people didn’t keep piling
into money but started using it to consume and invest again, and the economy
recovered from its temporary slump. This was the pattern of most recessions and
depressions in 19th century America, where fractional-reserve banks,
favoured by government privileges, were in a position to engage in inflationary
credit expansion and thus set in motion the boom and bust cycle, but there was
no central bank to rapidly ‘reinflate’ the money supply, as Keynesians would
prescribe, in the depression period. These recessions were typically
short-lived, the worst usually being over in about six months to a year after
the initial ‘Panic’.
These
empirical results can be explained theoretically. The main thing to realize is
the incredible risk someone would be taking by dropping his investments and
piling into a money which was increasing in value only based on other people’s
speculation, after the physical monetary contraction was over. If people were
really desperately dumping investments to pile into money as the ‘Deflationary
Spiral’ scenario assumes, the value of money, due to all the extra speculative
demand, would increase at a very steep rate, very rapidly, as everyone tried to
get their hands on a limited supply. After a short period of this, it is almost
guaranteed that a bunch of savvy investors would realize that the value of
money has increased far beyond what people really want to hold in their cash
reserves if they weren’t holding it speculatively, and would move to cash in on
their gains before everyone else did. They would use their high-valued money to
invest in a lot of real productive assets or to buy luxurious consumer goods
that they couldn’t afford before their speculation. As soon as enough people
started catching on and doing this though, the speculative demand pushing up
the value of money would vanish, and the demand for money would fall back to
the level of the purchasing-power that people and businesses actually wanted to
hold as cash reserves. Latecomers in the speculative stampede that the
‘Deflationary Spiral’ predicts would lose really big, as they traded their real
investments for a money that received a substantial portion of its great value
only from the speculative demand of people who thought that the money would
continue increasing in value solely based on other people’s speculative
demands. When that value collapsed, these people would suffer great losses. The
risk of these great losses would be the primary thing that would prevent such a
speculative stampede from getting out of hand in the first place.
Indeed, if
the ‘Deflationary Spiral’ myth were true, one should have seen it play out in
the recent rapid rise in gold prices. Gold, while not currently money, used to
serve as such and is not a perishable commodity, thus making it suitable for
long-term speculation. In the last few years, its value has been raised
tremendously, but then it stopped rising in value once it reached a certain
point. Even Jim Rogers, an investor famous for his bullish views on hard
commodities and gold and silver, eventually came to be of the opinion that the
gold price had reached as high as it would go for the new future, and ceased
buying it as a result. What happened was that people, due to a fear of fiat
money inflation and currency instability, piled into gold, and then more people
piled into gold because they saw its price rising rapidly. But this process was
over in a short period of time. Once the price had risen to a certain level,
investors cooled down their enthusiasm because they realized that enough was
enough, and that the fundamentals simply did not support a higher price for
gold at the moment. The same would happen in a free-market monetary system,
probably one where gold was the main currency, and no ‘Deflationary Spiral’
would occur, even if fractional-reserve banks and government intervention
succeeded in creating a boom-bust cycle in the first place.
It should of
course be noted that in a free-market monetary arrangement, characterized by the
separation of fractional-reserve banking from the money supply and the
prevalence of 100% reserve banking instead, and characterized by a gold
standard, a money that governments wouldn’t have the power to inflate, the
chances of serious contractions in the money supply would be severely
curtailed. This is because money would be gold, and unless people had a strange
penchant for hurling gold into the deep sea, there would be no particular
reason why the physical money supply of gold should ever contract significantly.
The loan-policies and financial stability of fractional-reserve banks would
not, as they do currently, be able to affect the growth or contraction of the
money supply.
Of course,
if people wanted to keep generally higher cash reserves for non-speculative and
non-depression-related purposes, they could increase their demand for money,
leading to an increase in its purchasing-power. But this would not tend to be
very dramatic or sudden, and would certainly not set off the speculative
stampede that the ‘Deflationary Spiral’ fear-mongerers warn about.
The purchasing power of money, in a
free-market system, would generally increase on the goods-side, due to
increased production of goods which must be able to be bought with the same
supply of money, as happened in the US in the late 19th century. But
this would certainly not lead to a surge in speculative demand for money for
the simple reason that interest rates would not need to be reduced in the face
of such a ‘growth deflation’, as ‘growth deflation’ does not lead to a reduction
in general sales revenues, and hence does not make it any harder to pay off
debts as a monetary contraction deflation would. Thus, the interest rate
received by the creditor would just be added on to the increasing
purchasing-power of money that he would be paid back in, thus not reducing the
attractiveness of investing in real assets.
Without the ‘Deflationary Spiral’
myth, the deflation-phobia that characterizes most Keynesians, and many other
economists as well, appears more groundless.
4. Assumption that prices, and especially wage rates, are
rigid downwards, and that it is impossible to do anything about it:
This
Keynesian assumption is another reason why they fear deflation, but it is just
as groundless as the first. They assume that prices, especially wage rates,
will not adjust downward in the face of a deflation caused by monetary
contraction or increased demand for money for holding, thus leading to
unemployment and the stocking up of excess inventories. Their assumption that
prices will not adjust downward in the face of less monetary demand and lead to
unsold inventories piling up does not accord with reality, where money prices
are constantly reduced to get rid of excess inventories whenever a ‘Sale’ is
held. Whether it’s in a deflationary environment where everyone must eventually
reduce his prices or a non-deflationary environment when some retailers must
due to a drop in demand that they did not anticipate for their particular
product, sellers are typically ready and willing to reduce their prices in
order to get rid of excess inventory.
The rigid
wage rate hypothesis is a bit more plausible, but only because we live in an
interventionist age. Minimum wage laws and the coercion that unions are
permitted to employ to maintain artificially high wages for their members serve
to introduce institutional wage rigidity into the economic system. If wage
rates are not allowed to fall in a deflationary scenario, there will indeed be
problems of unemployment. This happened historically in the Great Depression.
But rather than fearing deflation and advocating inflation, with all of its
associated problems, to solve this issue, why not just remove the institutional
rigidities that create the problem in the first place? It is disingenuous for
an economist to take a certain economic policy that results in wage rigidities
(often supported by Keynesian economists themselves!) as a given, and tailor
their analysis of other issues around this given. Why should an economist
accept an economic policy as a given, when it is precisely his task to support
or not support certain economic policies based on his analysis? Without the
economic policies resulting in rigid wage rates, workers would just have to
accept that in a deflationary environment, where the prices of the consumers
goods they want their wages to be able to buy anyway are being reduced, they
would just have to accept nominal wage cuts at times, which would just mean a
retention of the same real wage as before.
5. Failure to really consider the differences between
government and private resource-use when making policy prescriptions:
Chances are
that if you’re a Keynesian, you have at one point in your career come out in
favour of some government ‘stimulus’ program or another, where the government,
through inflation or through amassing more debt, usually both, spends money to
‘stimulate’ a depressed economy. But the Keynesians do not fully consider the
implications of this policy, so focused are they on their (faulty) remedies for
getting out of a depression via inflation. They do not tend to stop and
consider the vital differences between government resource-use versus private
resource-use. Government resource-use has many disadvantages over private
resource-use in most economic fields, disadvantages which I discuss in the
first section of the following post: http://thinkingabouthumansociety.blogspot.ca/2013/04/dissecting-leftist-statism.html
This neglect
leads Keynesians to tragically underestimate the economic disadvantages of
their proposed remedies. Of course, one could make the argument that most
Keynesians have socialistic leanings anyway, as exemplified by Keynes’ call for
the ‘euthanasia of the (private) rentier’ and call for the ‘socialization of
investment’. But, unlike the socialists, Keynesians do not usually even attempt
to make the case for why government resource-use will be better than private
resource-use outside of the government’s role in ‘stimulating’ the economy,
which is based on the faulty premises outlined above anyway.
6. Lack of understanding of the vital importance of savings
and the capital accumulation/capital maintenance that they lead to, and the
vital roles these play in economic growth and prosperity:
It would not
be an exaggeration to say that Keynesians almost never call for people to save
more, but routinely call for people to consume more, again, to ‘stimulate the
economy’. This hatred of thrift stems from their non-existent capital theory and
faulty theories of interest discussed above, and their refusal to recognize
that before one can invest resources, one must first save them, and without
this savings-investment, any production process beyond the ultra-primitive hand
picking of berries would be impossible. For more on the importance of capital,
see Tip 27 here: http://thinkingabouthumansociety.blogspot.ca/2013/03/how-to-think-about-human-society-tips.html
Note: For the reader interested in finding more critiques of
Keynesianism, I would recommend the following:
1. Henry Hazlitt’s Failure
of the “New Economics”, available for free here: http://mises.org/document/3655/Failure-of-the-New-Economics
2. This excerpt from Murray Rothbard’s America’s Great Depression, where he defends Austrian Business
Cycle Theory against Keynesian criticisms and provides his own critique of
Keynesianism in the process: http://mises.org/rothbard/agd/chapter2.asp
3. Robert Higgs’ critique: http://mises.org/daily/5216/Six-Fundamental-Errors-of-the-Current-Orthodoxy
4. Jonathan Finegold Catalan’s critique: http://mises.org/daily/4578
5. George Reisman’s critique: http://mises.org/daily/3424
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