Keynesian Economics: The Beast That Won't Die

0:00It's time for our first speaker, who received his Ph.D. in Economics from the University of California, Berkeley. That's a little deceiving. Yeah, dig yourself out of that hole. He's a B.A. from the University of North Carolina in Chapel Hill. He's the editor of two books, and he is currently associate professor in the Division of Applied Social Sciences at the University of Missouri. Now, he has a forthcoming book coming out that the Mises Institute is going to publish. We don't have a title for it yet, but anybody who has a pithy title they want to suggest go ahead during the course of the day.

0:47His specialty is entrepreneurship and business organizations, but today he's speaking on Keynesian Economics, the beast that won't die. Please help me welcome Dr. Peter Klein.

1:15Thank you, Doug. It's great to be back on the West Coast. As Doug mentioned, I did my I started my graduate work at Berkeley, like Seattle, a hotbed of libertarian and Austrian sentiment. Actually, one of my professors that I was fairly close to is now President Obama's chief economic advisor, Christina Romer. A very nice person, but someone whose views are a little different from mine. I remember when I started the program, I noticed that virtually everyone else in the economics department was some kind of a left, liberal, socialist, quasi-socialist, social democrat type. And I asked, I said, well, you know, I've heard all this about diversity, are there any libertarians or conservatives or people who, you know, might have different views than the dominant view in the department?

2:07and I was told, yeah, well, we have a conservative and it turned out what they meant was there was a guy from mainland China who thought that Deng Xiaoping's reforms had gone way too far and that they should go back to the pure communism of Chairman Mao. So I guess there was some diversity at Berkeley. Now, I want to talk about Keynes today and I have I have to confess that this is, in a sense, a depressing time to be an economist. It's a very difficult time to be an economist. Now, don't get me wrong, I love my job. I love teaching and researching and studying about the free market, about the capitalist economic system, about the entrepreneur, about liberty, about human flourishing.

3:00But, you know, the last year and a half to two years, This has not been a good time for it to be sort of a sound economist think about all the things that have gone on in our economy you have the bank and industry bailouts you know this is something that that nearly every competent economist opposes okay I mean saving a particular industry with government protection or taxpayer funds is you know a classic example of what the textbooks call the fallacy of composition right the idea that something that benefits one particular group or element in society necessarily benefits the entire group. I use exactly this kind of an example when I'm teaching some of these fallacies in my freshman level courses, bailing out the Chrysler Corporation in 1980, bailing out the airline and insurance industries after 9-11 and so on. There's a great chapter in Henry Hazlitt's has its wonderful economics in one lesson called saving the X industry as an example of Hazlitt's fallacy of the broken window.

4:08Saving the X industry simply transfers resources to the X industry from the Y and Z industries and from the taxpayer and substitutes the political process for the market process in determining how resources are allocated among activities. And yet when the bailouts began, first the financial sector bailouts and then the automobile industry and other industries and so on, the wisdom of economic doctrine was almost entirely ignored. The general level of discourse on the housing crisis, the bank bailouts, the industry bailouts was not just among laypersons but among the media and among politicians and even people who should know.

4:54It was just shockingly vapid, vacuous, even by the usual standards of American political discourse, right? You know, listening to government officials and pundits and experts and so on talk about the financial crisis. It was sort of like listening to my son's second grade class discussing the nuances of postmodern French literature. Well, it's obvious the housing crisis was caused by deregulation, too much deregulation. The free market has failed yet again. Thank goodness we have the government to step in and take care of things. Then you had the bailouts of individual borrowers, right, through the Obama administration's abominable housing plan. I mean, think about it, we're in a major recession triggered by a collapse in the housing market itself, the result not only of monetary policy, but also of specific government actions, often through Fannie Mae and Freddie Mac, you know, to make sure that the wrong loans got to the wrong people so they could buy the wrong houses, okay?

6:03So the administration's remedy is not to let Fannie and Freddie die, you know, they're long overdue and merciful death, but to prop them up, to give them additional powers, and to subsidize private mortgage lenders, to extend yet more credit to more people who can't pay it back so they can buy even more property that they can't afford and to make what might have been a temporary crisis into a semi-permanent one. So this is depressing as well. Now, most depressing of all is the subject of my talk this morning, the resurrection of John Maynard Keynes and Keynesian economics, particularly in the form of the Obama administration's 800 billion plus stimulus package, the so-called stimulus package.

6:49David Leonhart wrote in the New York Times, this was a couple weeks ago, August 19th, the indispensable economist of the moment is clearly John Maynard Keynes. Keynes's prescription for financial crises, aggressive government action and by definition big budget deficits has been Washington's basic approach since the collapse of Lehman Brothers in September 2008. Leonhard is clearly right. Keynes is back in the spotlight, at least in the public eye and among most of the intelligentsia. This is the great Keynesian moment, the great resurrection of a theory, an approach to the economy that to most professional economists had long since has been dead and buried. If there are any of you economic students in the crowd, most of us were taught that the Keynesian approach, which became dominant after World War II through the 1960s, you know, was sort of beaten back by first the monetarist and then the so-called rational expectations or new classical counter revolutions in the late 1970s and 1980s.

8:07But it has come back. Keynesian economics has returned with a vengeance. Now to the Austrian economists, the Keynesian doctrine was in its original form and remains even in its fancy dressed up form today. Nothing more than a tissue of fallacies, a resurrection of long discredited under-consumptionist fallacies that no serious economist before 1936 gave The Mises-Hayek Approach to the Business Cycle The idea that there had been an unsustainable credit boom in the 1920s that had predictably burst, exposing or revealing a pattern of malinvestments that had to be liquidated for economic recovery to take place.

9:11But that Austrian understanding of the business cycle was swept aside during the Keynesian avalanche in the late 1930s. Keynes published his great book, The General Theory of Employment, Interest in Money, in 1936 and Keynes told us, no, Mises and Hayek have it completely wrong the problem is insufficient aggregate demand which is a fancy way of saying spending there's not enough total spending in the economy and this problem is easily solved, according to Keynes with cheap money and massive government expenditures and budget deficits Okay? And you know, best of all, it really didn't even matter what the government spent the money on, as long as the government spent money on something, because this new spending would have a marvelous sort of miraculous ripple effect, pulling the private economy back on its feet.

10:05As you can imagine, politicians loved it. Keynes's younger disciples mathematized it, and mainstream macroeconomics was born. Now, the Keynesian approach became dominant, especially when it was sort of popularized in the leading textbooks, Paul Samuelson's textbook, for example. The sort of Keynesian idea that the economy was a giant machine that could be fine-tuned by pulling appropriate policy levers with great precision by sort of enlightened bureaucrats and politicians and so on, always in the interest of course of ensuring full employment and sustained economic growth and stable markets and so on.

10:52That idea was so deeply ingrained among most of the profession that in 1959 a New Zealand engineer named Bill Phillips built an actual machine with tubes and pipes and levers and and Pulleys mainly operated by water to sort of simulate the economy and predict and forecast the economy. That's what people sometimes refer to hydraulic Keynesianism. I mean it literally, the idea that you could build a hydraulic machine that would replicate the economy and would give the experts all the tools they needed to engage in their fine tuning. Now things, as I mentioned, did get better in the 70s and 80s. Hayek of course won the Nobel Prize in Economics in 1974, and people began to inquire more seriously about the older Mises and Hayek approach, the pre-Keynesian Mises and Hayek approach to the cycle. And there were these other movements within mainstream economics that sort of shunted Keynes aside, and they were improvements over traditional Keynesianism I think. And to many of us, these new advances were driving the final nail in the Keynesian

12:10coffin. The Austrians had shown the essential fallacy of the Keynesian doctrine, and finally, or so we thought in the 1980s, even mainstream economists have realized that Keynesian economics has hopelessly garbled. It's sort of an incoherent mess without any logical consistency. It doesn't have any application to the economy of the real world. Now, like one of those movie vampires or zombies that keeps coming back, you know, you stab it, you kill it, and the hero or heroine turns around and then you see in the background the zombie rises up again, you know, with its weapon in hand. This monster has come back to life. You know, economy in Doldrums? No problem. All it needs is stimulus. It needs some stimulus. Turn on the printing presses. Flood the bond markets with T-bills. Spend, spend, spend. The free market won't do it, of course. It won't spend enough because, as Keynes told us, private investors are plagued by animal spirits. They're motivated by irrationality. Only the enlightened politicians and bureaucrats

13:23can make rational spending decisions. Now, if you're worried that this extra spending and money creation might lead to some problems down the road, some inflation perhaps, no problem. Listen to San Francisco Fed President Janet Yellen, a Berkeley economist by the way, who recently said, quote, I'll be the first to say that it is always difficult to get monetary policy just right, Concession, but the Fed's analytical prowess is top-notch and our forecasting record is second to none. Some of you have probably seen that little YouTube clip with all the different Bernanke remarks up through the beginning of the housing crisis about how healthy the housing market was and how there was no danger of any kind of economic problems associated with the housing market.

14:16Janet Yellen continues, with respect to our tool kit, that's the levers and so on, we certainly have the means to unwind the stimulus when the time is right. Don't worry about these things, we put the money in, we'll take it out when the time is right, we have everything under control. Robert Blumen wrote an entry on the Mises blog where he quoted this, he We keep killing this Keynesian beast time and time again and it keeps coming back. What's going on? Well, to understand why Keynesian economics won't stay dead, we have to detour just briefly into the history and sociology of science.

15:08Social Science in particular, and realize that science doesn't work the way many of us were taught in high school. Formulation of hypotheses, testing them against the data, searching for truth using the scientific method, quote unquote, leaning to these kind of incremental advances in knowledge with the old falsehoods tossed aside, new truths embraced and incorporated and so on. That's not the way a scientific discovery actually works. It doesn't work It's much more complicated and it's much more messy. Errors, once refuted, don't necessarily disappear from the scene. They hang around. Truth doesn't always win out in the battle of ideas, at least not in the short run. There are a lot of reasons why. There are institutional reasons. It has to do with finance, scientific research, financing of scientific research, incentives of researchers, personalities, and so on. It's a complicated problem.

16:08On guard against what Murray Rothbard, in his History of Economic Thought project, called the Whig Theory of Intellectual History, wrote Rothbard on analogy with the Whig Theory of History, coined in mid-19th century England, which maintained that things are always getting and therefore just get better and better. The Whig Historian of Science, seemingly on firmer grounds than the regular Whig Historian, implicitly or explicitly asserts that later is always better in any particular scientific discipline. The Whig historian really maintains that for any period of historical time, whatever was was right or at least better than whatever was earlier. The result is an infuriating, Panglossian optimism.

16:54In this view, according to Rothbard, there can be no such thing as gross systematic error that deeply flawed or even invalidated an entire school of economic thought. much less sent the world of economics permanently astray. But yet that is in fact what we find. That the Austrian School, for example, which thrived from the late, from the 1870s until about the 1920s, faded from the scene and was replaced by something much, much worse. The Keynesian approach to the macro economy, so-called macro economy, and then later the sort of contemporary neoclassical approach to microeconomics. Any trained historian of science will tell you that this naive wig approach is hopelessly inappropriate.

17:41Thomas Kuhn's famous book on the structure of scientific revolutions introducing the idea of a paradigm, and a paradigm shift, shows that scientists are not sort of completely disinterested observers of the world around them, are guided, in some sense blinded if you like, by particular preconceived notions about what is or isn't the right way to do science, the right questions to ask, and so on. So, knowledge can be lost. The great Austrian truths of the business cycle were largely lost after 1936. Theories such as Keynes, discredited theories such as Keynes' can hang around, waiting for just the right moment to return. What exactly is Keynesian economics anyway?

18:26I mean, you hear a lot of people talk about it, we talk about it in a critical way, and its proponents praise it and so on. I mean, I think you can understand Keynesian economics, you can break it down into just a few simple elements. First, a very high level of aggregation, a focus on aggregate concepts such as total spending, total income, the unemployment level, and so on. and so on. Second, the absence of any role for sort of resource allocation within these aggregates. There's no role for relative prices or the decisions of individual consumers, individual entrepreneurs, individual investors. These are all ignored. And third, no theory of capital. The Mises-Hayek approach to the business cycle was built on a particular notion of the capital structure of an economy developed by Menger and Boehm-Bawerk and their great Austrian predecessors, and that's completely absent from the Keynesian model. In the Keynesian story, fluctuations in total spending in the economy, aggregate demand, cause fluctuations in total output, aggregate output. Forget about capital and relative prices and so on.

19:39Now, you know, supposedly mainstream macroeconomics has moved beyond this very primitive, crude level of aggregation. But you'd never know it from the discussions of the last year and a half to two years. People kept saying, banks aren't lending enough. Businesses and consumers can't get loans. Firms have too many bad assets on their books. The key questions, though, are which ones? Which banks aren't lending to which consumers? Which firms have made and Poor Investments. Newsflash to the intelligentsia. A loan isn't a loan isn't a loan. Some people maybe shouldn't get a loan. Hard to understand. Not every borrower should get a loan. The relevant question is which loans weren't made to which people and why. The critical issues in other words revolve around the composition of lending. Critical issues in the housing and Crisis, the composition of lending, not the total amount.

20:45Now, Keynesian economics ignores all of this, right? It holds that only aggregates like total lending and total spending and so on matter. Government spending magically transforms into economic wealth, often at a more than one-for-one ratio, the famous multipliers of Keynesian economics. Government spending, in that sense, it's kind of free, it's a freebie, right? Right, the government spends a dollar and it boosts the economy by more than a dollar. Wow. Of course, the deficits don't matter because, as the distinguished Keynesian macroeconomist Franklin Delano Roosevelt put it, we only owe it to ourselves.

21:33What's the, what's the Keynesian critique of all, sorry, what's the Austrian The Austrian critique of all this, the Austrian critique of Keynes, well, the Austrian approach begins with the idea that resources are heterogeneous, that investments are not the same, that businesses are not the same, that consumers are not the same, that there's a great amount of variety or heterogeneity within an economy, and the critical question is to get resources allocated in the right patterns to get financial resources and other resources to the right entrepreneurs, to get entrepreneurs serving the particular consumers who desire those entrepreneurs' products, and so on. Now, you know, the sort of sophomoric or even childish Keynesianism of people like Paul Krugman and Bradford DeLong and so on, like Ben Bernanke, Timothy Geithner, etc., doesn't doesn't understand any of this but only understands aggregate concepts like national output, total employment, the price level. When was the last time the price level affected your behavior when you went out to go shop in the marketplace? No, you're concerned about the prices of the

22:47things that you buy, not some mythical statistical aggregate. When government policy generates It's an artificial boom in a particular market, such as housing. It draws resources away from other parts of the economy, and if those investments are caused by some artificial government stimulus, monetary policy, housing policy, and so on, the key to recovery is to let those resources flow out of that market and back to the other sectors or segments of the economy where it belongs. It's quite simple in terms of the housing market. House prices should be falling. It's good that home prices are falling. Interest rates should be rising. Savings rates should be going up. Debt levels should be going down.

23:36The current administration's policies, like that of its predecessor administration, are designed to do exactly the opposite, to keep the housing market from shrinking, to keep any prices from falling, to keep any firms from failing, to keep any consumers from reducing Their Consumption. A child thinks only about what he sees right in front of him. He can't see the things that don't exist because of his actions. He doesn't see the things outside his immediate range of vision that are harmed by his decisions. And that's the way many Keynesian commentators think. That's the mentality that they have. One good example is the so-called shovel-ready criterion for the allocation of stimulus spending.

24:24There's an interesting piece from an engineering professor at the University of Minnesota named David Levinson. He pointed out, he said, well in the nineteen thirties when you were literally building with shovels maybe this kind of a thing made some sense uh... this professor says that was largely unskilled labor. Today it's blue collar labor but not unskilled. The guy brushing the asphalt back and forth is unskilled, but the guy operating the steam roller isn't. And there's an assumption out there that construction workers are interchangeable between residential and highway projects. But a carpenter isn't a whole lot of help in building a road. Okay? Modern Keynesian economics, which retains its master's belief in homogeneous labor and capital, and is focused on macroeconomic aggregates, treats a worker Lending and spending, that's all that matters.

25:16It doesn't matter what is being lent to whom, it doesn't matter what is being spent on what. You simply need to lend and spend and that brings so-called idle resources into use. As Hayek famously put it, John Stuart Mill's profound insight that demand for commodities is not demand for labor. Hayek's way of saying, quoting Mill, that the total spending in the economy by consumers does not necessarily translate into a particular pattern of employment in resource markets, because consumer preferences are transmitted only indirectly and in a complicated way to particular labor markets, so boosting spending in total may not reduce unemployment in any particular industry. This insight, demand for commodities is not demand for labor, according to Hayek, Hayek, which was set in 1878 by Leslie Stephen, as the one doctrine whose complete apprehension is perhaps the best test of a sound economist, remained for Keynes an incomprehensible absurdity.

26:20Okay, so this criterion, this level of understanding that according to Hayek is the sound test, is the one test of any competent economist remained for Keynes an incomprehensible absurdity. Keynes just didn't get it. Why can't we kill this beast? Why can't we kill it? If it's wrong, if it's easily refuted, why does it keep coming back again and again? One insight comes from a 2008 book by John Wood called The History of Macroeconomic Policy in the United States. Wood notes that in the US, fiscal and monetary policy has been more or less the same over a long period, The theory is largely uninfluenced by theory. In fact, would suggest the direction of influence between theory and practice is largely from practice to theory. In other words, scholars are coming up with theories to justify the policies that already exist. And of course, That's the classic explanation for the spread of the Keynesian doctrine in the 1930s, that rather than proposing some sort of new theory of macroeconomic policy, it simply provided

27:39intellectual cover, rationalization or justification for the massive deficit spending and easy money policies that were already in place. The University of Chicago economist Luigi Zingales put it nicely in a recent article. He said, Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behavior. Medical science has established that one or two glasses of wine per day are good for your long-term health, but no doctor would recommend a recovering alcoholic to follow this prescription. Unfortunately, Keynesian economists do exactly this. They tell politicians who are addicted to spending He says, in medicine such behavior would get you expelled from the medical profession. In economics it gets you a job in Washington. By the way, this Keynesian delusion doesn't just affect policy makers, it affects professional economists as well, and you know, I've long suspected, I can't prove this, so caveat for those of you who are watching on the internet, this is just a conjecture on my part, I suspect that people like Paul Krugman for example

29:06and Brad DeLong, I suspect that for them the appeal of the Keynesian doctrine is ultimately based not really on scientific grounds, but on some kind of aesthetic grounds, they just People just like it. Deep down in their hearts, they aren't really comfortable with private property, free markets, individual choice. They don't think ordinary people are capable of making wise decisions. They think that they and people like them, the elites, should be in charge, should be running the system. They resent the fact that most people don't want their lives controlled by Berkeley intellectuals, or Seattle intellectuals, right? They resent the fact that most, sorry, all these technical arguments about the effectiveness of monetary and fiscal policy, the relationship between aggregate demand and output, what really went on in the 1920s and 1930s and so on.

30:02I think to a lot of Keynesian economists these discussions are really beside the point. It doesn't really matter. I think for people like Krugman and DeLong, the belief that markets are naturally unstable in the absence of government planning is an article of faith. It's a deeply held personal belief that no amount of argument or evidence or statistical analysis will resolve, will challenge. I should mention by the way, some of my free market and Austrian colleagues think that the Austrian approach hasn't won, hasn't won out in the marketplace of ideas because our arguments aren't good enough, because we aren't persuasive enough, our historical and empirical work isn't sophisticated enough and so on.

30:52But I strongly reject this view, not that of course our arguments can't be better, It's not that our work can't be more sophisticated, that our evidence can't be stronger. Of course, we can always do better in making our arguments, in doing our analysis, but the truth is in an interventionist economy, there will always be a strong demand for interventionist economists, interventionist theories, rationalizations of interventionist policies and so on, because they provide intellectual and moral cover for interventionism. It's as simple as that. Government officials and their supporters want to increase the size and power of the state. The enabling class of what you might call court intellectuals wants its piece of the action too.

31:41To groups like this, you know, so the allure of the Keynesian elixir, if you like, is just overwhelmingly strong. No amount of theory or evidence will persuade them otherwise. Now, of course, I'm generalizing. There are always exceptions. I'm not claiming that every economist or policymaker who subscribes to Keynesian economics is corrupt in this fashion. But I think there is a lot of truth in this. Now, one silver lining in the late unpleasantness is that there has been a rebirth of interest in the Austrian critique of Keynes. Even mainstream journalists, some mainstream economists, even government economists at places like the IMF, the World Bank, the European Commission, are going back and re-reading Mises and Hayek and saying, you know, well, since Keynes is sort of now the dominant explanation for things, maybe we ought to go back and look at some of the alternatives to Keynes. What were some of the critiques of Keynes? Did Keynes really answer them? Did Keynesian economics really address these critiques? And people are realizing that

32:53that the Keynesians didn't, okay? So there's some resurgence of interest in the Austrian tradition, which of course is a wonderful thing. Among the educated layperson, books like Tom Wood's Meltdown, and of course Ron Paul's books, and the Ron Paul Movement, Ron Paul's book on the Fed and so on, I mean the phenomenal success of these publications as a testament to how intriguing the Austrian critique of the Keynesian model really is. So, can we kill this beast once and for all? Is there a silver bullet or a dagger through the heart that will finally bring it into the grave? I don't know. But we have to try. We have to keep fighting it. We have to try to kill the beast, even if we don't succeed.

33:43Remember the words of Virgil that were adopted by Mises as his personal motto, and its little motto, do not give in to evil, but proceed ever more boldly against it. Well, now is the time for that kind of boldness. Thank you.