Recycling Discredited Ideas
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men who believe themselves to be quite exempt from any intellectual influences are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
—John Maynard Keynes, 1936.
Unless they have taken a course in economics most people probably have never heard the name John Maynard Keynes. To his contemporaries this English economist, statesman, and general all-around charismatic intellectual was a household name. And to generations of economics students after World War II, he was a hero.
He was the man who invented macroeconomics, the man who revealed to the world how to avoid another Great Depression, the man who made it respectable for governments to target unemployment and to worry about balancing the economy, not the budget. He taught us that it is unnecessary to worry about the long run because “in the long run we are all dead.” He taught us that government leadership was necessary to safeguard us from the possible and likely instabilities of the market system. Capitalism was ok. It was the best system we had to ensure economic growth peacefully and democratically. But it needed to be bolstered by enlightened governmental intervention at crucial moments. Most of this came packaged in his book The General Theory of Employment, Interest, and Money, published in 1936. It became the basis of the new conventional wisdom.
Teaching a New Generation Old Tricks
To be sure, Keynesian ideas were around before Keynes—but they were mostly associated with quacks and crackpots. Economists before Keynes dismissed the idea that governments could “create jobs” by simply putting people to work on “public works” using money created by the central bank (inflation). After all, if resources were employed in public works they would be unavailable for anything else. Society would have to forgo the alternative product of these resources—that was their opportunity cost. Governments could not simply “create” jobs where none existed before. They could only redistribute jobs away from the private sector into the public sector. And there was no reason to presume that the latter jobs were more valuable to society than the former. An understanding of economic history and of the market process suggested the opposite—namely, that private market decisions in pursuit of profit would tend to produce the most valuable jobs for the most people.
Keynes secured acceptance for his ideas because of who he was, when he was, and what he was. He was a very powerful personality (to say the least) who came to prominence at the time of the worst economic depression the world had ever faced. He was also the head of the most prestigious university economics department (Cambridge) in the world. He was uniquely placed to take these hitherto dismissed ideas and not only make them respectable but present them as the new revealed truth.
Keynes packaged these ideas in convoluted intellectual garb but he asked some legitimate, penetrating, hard-to-answer questions about how the market works. He suggested that the “dark forces of time and ignorance” made it implausible to suppose that private, mortal entrepreneurs could be relied on to anticipate the future demand for goods and services in any detail. This being the case, Keynes asked, how can we rely on the market to put to work the savings of millions of private individuals? Savings is the sacrifice of present consumption spending for the option to consume in the future. But what guarantee is there that increased saving today could and would be translated into increased consumption tomorrow? After all, increased saving today means less consumption today, and this is likely to discourage entrepreneurs from producing for the future. This is why we need the government to undergird the economy and prevent it from falling into a downward spiral due to the pessimism that could arise from underconsumption (however caused). In a modern monetary economy, private savings do not automatically get translated into private investment. Thus private investment needs to be supplemented and nudged by government investment—and if necessary, it would seem, also by government consumption.
Blasphemy from Chicago and Austria
The Keynesian message is appealing and intuitive, and it has sold very well. In fact, it testifies to the power of ideas in history. In the postwar period first the academic economists, then the other social scientists, and then the public at large became converts. From the time of John Kennedy onwards American economic policy became self-consciously Keynesian. But there were pockets of strenuous resistance to the new creed—most notably at the University of Chicago (the economists of the Chicago School) and also among many individual economists around the world—notably those trained in the Austrian school of economics. The most prominent Austrians of that period were Ludwig von Mises (then at New York University) and Friedrich Hayek (at the London School of Economics and later at the University of Chicago). The most famous Chicago economist in this context was Milton Friedman—perhaps America’s most well-known economist ever. It was Friedman’s relentless work (together with his students and colleagues) that paved the way for a sober reconsideration of the new Keynesian orthodoxy and its subsequent overthrow.
My own personal odyssey coincided with that broader cultural shift. I arrived at the University of Chicago in September 1972 to pursue my Ph.D. in economics as an informed and enthusiastic Keynesian. This despite studying in South Africa under Ludwig Lachmann, an adherent to the Austrian School, and in spite of a detailed knowledge of Milton Friedman’s monetary theory. Between 1972 and 1976, while I was immersed in a detailed and rigorous examination of market economics, the American economy was being put to the test. Friedman had long been preaching against Keynesian macroeconomic policies (tax, inflate, and spend) and in his presidential address to the American Economic Association (1968) had warned that such policies would lead ultimately to simultaneous inflation and unemployment. By the mid-to-late 1970s this is exactly what happened—a new American word, stagflation, was coined to describe it. High levels of both inflation and unemployment emerged, seemingly impervious to the stimulatory actions of government economic policy.
In fact, people now began to suspect what Friedman (and Mises and Hayek and countless others) had been saying for years—that government policy was responsible for the mess, that government policy, far from being the solution, was itself the problem—could be true. People began to suspect that the pre-Keynesian economists were right in thinking that the market was not inherently unstable (as Keynes has asserted) and that government intervention to improve on market outcomes actually succeeded in destabilizing the market much further. By the end of the 1970s people were ready for a change. It was in this climate of opinion that Ronald Reagan and Margaret Thatcher were elected. When I left Chicago in 1976 I was convinced that Keynesian economics was a fraud, and I have never seen reason to change my mind. I naively thought that my own passage from illusion to enlightenment was characteristic of the public in general and that Keynesianism (at least in its naive form) had been put to bed forever. I had thought that we now understood that inflation and unemployment were not alternatives and that any temporary stimulus achieved by money inflation would be short-lived and would itself cause a boom-bust cycle. The Keynesians had scrambled to put together an even more convoluted version of the story, but I had thought their efforts were basically seen as unsuccessful—at very least by the majority of trained economists.
Don’t Call it a Comeback
Clearly not. The current financial crisis has fueled a frenzied recycling of discredited Keynesian ideas. We are hearing again of the need for “public works,” of the need to “stimulate” the economy. The Federal Reserve is frantically inflating the supply of money. We are laying the groundwork for a disaster reminiscent of the 1970s—if not worse.
To understand this we need to look at some of the details of the current crisis. The conventional wisdom blames our plight on an over-reliance on the free market, on “too much deregulation.” The truth is exactly the opposite. The current debacle is the result of multiple overreaching government regulations and interventions. At the very base of the problem is the Federal Reserve, which has attempted to fine-tune the economy and guide it delicately through ups and downs. The Fed has always been reluctant to be the party pooper that brings any boom to an end. Thus the “natural” end of the dot-com boom was postponed by a reluctance of the Fed to allow interest rates to rise, thus allowing the supply of money to expand to fuel the necessary credit for continued expansion into ever more risky and unsustainable business ventures. When the bust came it came with more pain than necessary. The related housing bubble that followed played out along similar lines.
But the matter is more complicated than simply too much credit for overexpanding sectors of the economy. The housing crisis is the result of a systematic, hardheaded social policy aimed at increasing the number of homeowners in America. Using the politically charged notion that minorities were suffering from discrimination in the mortgage industry (a notion that has been discredited; see, for example, Stan Liebowitz, “A Study that Deserves No Credit,” Wall Street Journal, September 1, 1993, http://tinyurl.com/8bsjb3 [pdf]), some Democratic politicians made it their mission to rewrite the standards for mortgage approvals and ensure they became the reigning procedures for the industry. In this they were assisted by the quasi-government mortgage-packaging institutions, Fannie Mae, Freddie Mac, and Ginnie Mae. The result was a massive expansion of the production of new houses, an increase in housing prices, and an increase in the proportion of Americans owning their own homes.
The rise in housing prices in turn encouraged creative speculation in financial securitization based on mortgages. It also encouraged speculation in home ownership whereby, with very little or no money down, people could buy multiple homes and profit from the run-up in prices. When housing prices finally started to fall—an inevitable outcome—many people found themselves owing more than the houses were worth and simply walked away from them. Others found themselves facing mortgage payments they could not afford—because of the systematic dumbing-down of mortgage standards. (For a comprehensive, penetrating examination, see Stan Liebowitz, “Anatomy of a Trainwreck: Causes of the Mortgage Meltdown,” http://tinyurl.com/3m4bzv [pdf].)
In short, we have had a distortion of the economic structure toward the production of items whose value did not justify their production in the first place. This is a structure that cannot be sustained. Resources are “misemployed” and need to be redeployed—a process that is necessarily painful. (The same story characterizes the travails of the auto industry over a much longer period.)
Pay Now or Pay More Later
Against this background one can see that attempts to solve the crisis by simply providing more liquidity or “stimulating” the economy won’t work. In fact they will make things worse by creating the illusion that the distorted production structure can be preserved. We have a choice: pay now or pay more later. The Obama administration came into office talking about a nearly $800 billion program, in addition to the $700 billion already available for bailouts and mortgage cleanup, to stimulate consumption. This presumably was in anticipation of a precipitous fall in consumption spending—reminiscent of the Great Depression of the 1930s—that was expected to result from massive capital losses produced by the financial and housing price meltdowns. As bad as things are now, we are as yet nowhere near the situation of the Great Depression, and one hopes we never will be.
This massive expansion of money is occurring at a time of great uncertainty. So the money is not circulating through the economy very rapidly (as people are reluctant to lend and even to borrow). The time will come, however, in the not-too-distant future when this excess liquidity will inevitably result in general price inflation and all the negative side effects that this always brings.
The stimulus package and the other varied and unpredictable government initiatives that we have witnessed recently—like the “bailout” of Citigroup and AIG—are unlikely to do any good at all, except for those who are directly subsidized by these actions at the taxpayers’ expense. We know from the logic of basic economics and from history that such initiatives are unlikely to work. And we know that, at very best, they will postpone the necessary reallocation of resources that must take place before the economy can recover. Most likely they will seriously exacerbate the misallocation of resources and make the recovery ultimately more difficult.
What is most alarming to me personally is the enthusiastic recycling—indeed apparent wholesale resuscitation—of discredited Keynesian ideas. The false prophet of the public purse is back.
Comment by Pawel on 5 April 2009:
The PDF file with new The Freeman doesn’t work. I can’t open it at my computer.
Comment by Just Joe on 11 April 2009:
How can there be only one comment so far on this outstanding article — are there a bunch of dormant surfers out there ?? Even Glenn Beck has made some references to this concept .. the opening two sentence paragraph is really powerful and the last line is totally scarry !!
Comment by Patrick on 19 April 2009:
Should anyone be surprised by the resurgence of Keynesianism when, A.) A large number of Americans are totally ignorant of the subject of economics (American Idol is heating up after all!) and B.) A somewhat smaller but still sizable portion of America looks to Uncle Sucker for a handout. It’s a deadly combination.
This leaves the ruling elite to do as they please and the Ivy League background of these folks screams in their brains for them to have the government “Do Something” in a voice that sounds strangely like Paul Krugman’s.
Comment by Daniel Shapiro on 28 May 2009:
Unfortunately the people that need to read this are the least likely to do so. The necessity of coersive state intervention in all human affairs for economic stablization, justice, and humanitarian purposes is an old traditional belief that appeals to many and seems to make “common sense”. Well so does the belief that the earth is stationary and sits at the center of the universe. So much for common sense.
Comment by David on 25 September 2009:
Good post Peter and good comments Daniel and Patrick. Its about time some old philosophies of truly “free” economies are re-examined, and people like Keynes and CH Douglas have certainly proposed some far better alternatives than we have today. I’m certainly no economist, but i do have the common sense to see whats being done and where things are going with our current economic system and the potential for prosperity which could exist without it as well.
To break this down into simple terms, today’s economy exists to serve the interests of the banks. They have been given control of our currency and credit by corrupt politicians from both major parties, have managed to assassinate the two presidents we have had who would have taken away their power to control same (no proof of this that would stand up in court obviously, but its a simple thing to figure out who stood to gain from their assassinations). Then through party manipulation and media control, prevented the only one who was not owing his political career to them from having any chance at all in the past presidential election, even though he was coming in with more than twice the popular support of any of the other candidates in the initial straw poles, and would have won the presidential election with a landslide if his party had given him a chance to run.
Since the banks exist as parasites, and contribute absolutely nothing of any tangible value to any of us, the only way they can maintain their existence is by establishing political power which must eventually lead to socialism as they must remove any freedom or means that the people might have to get rid of them, before they figure out that they would be better off without them and do so. The end result of our current economic system can accomplish nothing but this if its allowed to continue.
Since the greatest part of our national budget is going toward paying interest on the deficit, and since most people in this country are by now working 3 weeks out of each month in order to pay interest on their mortgages and other credit, we have already become virtual slaves to them and once they remove our political freedom as well there will be absolutely nothing left. I’ve seen this happen already where i came from and if something isn’t done it will happen here, and soon. When it does, America will cease to exist and become like all the other miserable places in the world, where the purpose of the individual is to serve the state (hence the banks), instead of the state existing (at least in theory) to serve the individuals comprising it.
I’ve made more extensive comments regarding this topic in response to another post on this site, but to put this in very simple terms, the 13 colonies provided us with the perfect and simplest example of what needs to be done prior to the American Revolution, and every complex problem is always solved by a simple solution. Since King George had simply forgotten to provide them with money, the colonial governments simply printed their own on behalf of the people, and put and kept enough in circulation to pay for what the people could produce. It wasn’t even an officially sanctioned form of currency but simply script to which people attributed a certain value and used to trade with each other, and this is the single and only purpose which money should have as well. The people were in control of it through their representatives, and it was created and issued for their own benefit and could not be used as a means to power for private interests. At the time the 13 Colonies were the most prosperous place in the world with a standard of living many times that of the mother country. Then when the British banks found out about this, got King George to outlaw the colonial script and replace it with the British pound, they went from this to 75 % unemployment overnight. This is something they’ve managed to keep out of most of the common history books, but anyone even vaguely familiar with American history is aware of this, and it was this, and not a tax on tea which was the primary cause of the American Revolution as well.
Now, if you take the combined annual profits of America’s Banks, as compared to the national budget, and you figure in the fact that most of the people in this country who are actually producing something and contributing to the benefit and well being of their fellow citizens are having 60 – 80 % of what they produce consumed by the banks in interest, it should become obvious that without them the American people as a whole could experience prosperity far greater than any of their wildest imaginations. Further to this, simply regulating the currency in a sensible and beneficial manner in order to make sure there was always enough of it to pay for what we could produce would increase our production capacity to many times what is is today with what we already have, and produce an exponential growth in that production capacity in the years to come. Again the only possible outcome of this, is the average person would have many times more then they have today with the same amount of effort going into earning it, as we would be working to feed ourselves and not the interests of the parasites who are bleeding off the vast majority of what were producing now. I expect we would also be able to exist without taxes as well as the state should have more than enough means to finance its operations simply by putting the currency into circulation required to make up for the increase in our production capacity that having enough would generate on a year to year basis.
The problem is that as Patrick stated, the vast majority of the population is absolutely terrified of having to think for themselves and they want to be told what to do. As a result they are simply too damn stupid and ignorant to realize whats being done to them or what they could have were this not the case. Since the banks have the money which they have stolen from us, and consequently the power to control our political system and media, and tell them what to think and do they blindly follow and obey, as sheep being led to their own slaughter.
This is also a problem which will not be solved through our democratic process, as in the case of both Lincoln and Kennedy the banks will simply assassinate any president or politician we elect who would pose a threat to their power and the continued enslavement of the American population. If this is going to happen, it will take a second American Revolution as the banks and their control of our political system will have to be removed by the people by force of arms, and the threat to our freedom and prosperity will not cease to exist until each and every one of the individuals in charge of our banking system has been executed and their 100 % assets seized by the population as well.
The single and only thing that give me any hope for America at this point, is that the people seem to be currently preparing for exactly that. Since the last Presidential election they have been buying up every firearm and round of ammunition as fast as it can be produced, before the current government can pass laws eliminating their ability to do so. In view of this, i do expect that the banks will engineer some limited relief to the current economic crisis, as both they and the Obama administration are living in absolute terror of the American population at this point, and i expect the people will once again be foolish enough to settle for what they give them instead of taking what should be rightfully theirs. The simple fact is though that the arms and ammunition will be in place, and since they inevitably must try to remove any and all political freedom in order to enforce the continued denial of our economic freedom, this does increase our chances of success against them later on as well. The problem will be that if it does come to the people going to war to defend their political freedom, will enough of them realize the source of the threat they are defending against and do something about that to prevent it from becoming a threat again ?. If they come to realize that it’s not so much Bush or Obama, but the people who put them in power and dictate their actions that are the threat then they will have a chance.
Thanks; Dave
Pingback by It Is Now Mathematically Impossible To Pay Off The U.S. National Debt - Video Game Forum & Tech Forum | Gaming + Tech News on 21 April 2010:
[...] TARP as 'Huge Rip-Off' – WSJ.com Recycling Discredited Ideas | The Freeman | Ideas On Liberty Recycling Discredited Ideas | The Freeman | Ideas On Liberty Bad Regulation Drives Out Good | The Freeman | Ideas On Liberty Bad Regulation Drives Out Good | [...]
Comment by Peter Lewin on 21 April 2010:
Mike, I only now saw this. Hence the very long delay.
The way out is simple. Fiscal responsibility. The way in was provided by regulation that caused market signals to malfunctbetwion, making houses seem more affordable than they really were. The way out is to pay for our mistakes and allow the reallocation of resources to sustainable projects. My article implied as much in pointin to the economics of Friedman, Hayek and Mises.
War “between the haves and the have-nots”, what war? What does this mean? I hope it doesn’t mean that because someone thinks that the resentment of those who feel themselves deprived of the riches of others need to be placated by having the state (Federal Government) do what they would like to, but legally cannot. Leadership, wisdom and courage will indeed get us out of this. Forcibly redistributing wealth from some who have more to those who have less is neither wise nor courageous and is certainly not the kind of leadership we need.
Pingback by Atlas Sound Money Project » Blog Archive » Peter Lewin to Speak at the University of Texas at Dallas! – Oct. 12 & 14, Nov. 17 on 13 October 2010:
[...] Lewin will be presenting on the ideas given in his 2009 Freeman article, found here. *Peter Lewin is Clinical Professor of Finance and Managerial Economics in the University of Texas [...]
Comment by David Willson on 29 April 2011:
Thank you for posting this. Having been on the financial intermediary side of this mess for the last 5 years I have come to the conclusion – Keynesian Economics = false prophecy. During the initial stages of the visible collapse (July 2007) I had thought that government intervention was going to be key to a “soft landing” in the housing market. However, it is clear that a politician does not a good economist make. We are now clearly observing that government interference can cause a situation that is even worse than the initial problem. I guess the market will just have to do in the meantime.
Comment by Rich Robison on 5 May 2011:
This is a very poignant article. I never thought Keynesianism was completely dead, but I had certainly thought the economic conditions of the late 1970s had left a big enough impression on most to make it dormant. I was worried about the resurrection of this flawed philosophy when Obama was elected, but I took some small amount of solace in the fact the he had spent a little time at the University of Chicago and maybe some of the econ department had rubbed off on him.
Knowledge is not the issue though. The problem with our political climate, and maybe human psychology in general, it that people want immediate fixes to their problems. We certainly see this in the medical and most other fields. The Chicago/Austrian view is one of the long term. Sure, there’s pain now, but trust us, it will get better… Eventually. That last word is what most have a problem with. In a 2/4/6 year election cycle, politicians just don’t have the luxury for “eventually”, even if they know it’s right. Their political futures are on the line and “decisive action” will always sell better than “decisive inaction”.
The answer, of course, is to take the power out of government, leaving less on the line for politicians’ futures, so they then can do what is right for the economy instead of what is right for them.
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