Franklin Roosevelt recognized that the war only provided a short-term fix for the economy—and a very costly one at that. What would happen after the war—when 12 million troops came home and the strong demand for guns, bullets, tanks, and ships ceased?

Roosevelt envisioned a New Deal revival. He had created the National Resources Planning Board (NRPB) in 1939 and urged it during the war to plan for peacetime. The NRPB leaders believed that government planning was necessary to promote economic development. They consciously (and sometimes unconsciously) followed ideas popularized in 1936 by John Maynard Keynes in his bestselling book, The General Theory of Employment, Interest and Money.

Capitalism was inherently unstable, Keynes argued, and would rarely provide full employment. Therefore government intervention was needed, especially in recessions, to spend massive amounts of money on public works, which would create new jobs, expand demand, and rebuild consumer confidence. Yes, government would need to run large deficits, but economic stability was society’s reward. If government planners could manage aggregate demand through public works, the boom-bust business cycle could be flattened and economic development could be managed in the national interest. No more Great Depressions. Man could indeed be master of his economic future.

Before and during the war Keynes’s ideas swept through the United States and first transformed the universities, then the political culture of the day. With statistics in hand and a near reverence for government, the Keynesians were the new generation of planners. They wanted to remake society. Not entrepreneurs, but economists were needed to gather data, plan government programs, and regulate economic development. Paul Samuelson, for example, a 21-year-old economics student, was cautious at first, but then euphoric after Keynes’s book was published. “Bliss was it in that dawn to be alive, but to be young was very heaven,” Samuelson wrote. Other economists soon accepted Keynes, and by the 1940s his ideas dominated the economics profession. In 1948, Samuelson would defend Keynes by writing the best-selling economics textbook of all time.

Planning for Peace

Those on the NRPB were among the excited disciples of Keynes and economic planning. The war itself seemed to be evidence that government jobs had pulled the U.S. economy out of the Depression. Now the economists and planners needed to take the nation’s helm to plan for peace.

According to Charles Merriam, vice president of the NRPB, “[I]t should be the declared policy of the United States government, supplementing the work of private agencies as a final guarantor if all else failed, to underwrite full employment for employables. . . .” That idea launched what Merriam and the NRPB dubbed “A New Bill of Rights.” FDR would call it his Economic Bill of Rights. Included was a right to a job “with fair pay and working conditions,” “equal access to education for all, equal access to health and nutrition for all, and wholesome housing conditions for all.”

New Bill of Rights

FDR viewed this Economic Bill of Rights as his tool for guaranteeing employment for veterans (and others) after World War II. But it was more than a mere jobs ploy; it had the potential to transform American society. The first Bill of Rights, which became part of the Constitution, emphasized free speech, freedom of the press, and freedom of religion and assembly. They were freedoms from government interference. The right to speak freely imposes no obligation on anyone else to provide the means of communication. Moreover, others can listen or leave as they see fit.

But a right to a job, a house, or medical care imposes an obligation on others to pay for those things. The NRPB implied that the taxpayers as a group had a duty to provide the revenue to pay for the medical care, the houses, the education, and the jobs that millions of Americans would be demanding if the new bill of rights became law. In practical terms this meant that, say, a polio victim’s right to a wheelchair properly diminished all taxpayers’ rights to keep the income they had earned. In other words, the rights announced in the Economic Bill of Rights contradicted the property rights promised to Americans in their Declaration of Independence and in the Constitution.

FDR promoted his Economic Bill of Rights in his State of the Union message in 1944, but he died before the war ended. Shortly before his death, Senator James Murray (D-Mont.) introduced a full-employment bill into the Senate for discussion. The bill committed the government in a general way to provide jobs if unemployment became too high. Many leading Democrats and economists supported Murray’s bill. “In this session of Congress,” The New Republic reported, “one of the first bills to be introduced will no doubt be the full employment bill of 1945, designed to carry out item number one in the Economic Bill of Rights.” The Nation joined The New Republic in endorsing the full-employment bill. “Mr. Roosevelt’s program,” it concluded, “is squarely based on the best economic authority available. It is entirely consistent with the economic doctrines of the distinguished British economist Lord Keynes.”

On September 6, 1945, President Harry Truman gave a major speech in which he supported the Economic Bill of Rights, especially a full-employment bill. Most congressmen, however, rejected both. Rep. Harold Knutson (R-Minn.) said, “Nobody knows what the President’s full employment bill will cost American taxpayers, but the aggregate will be enormous.”

Instead, Knutson and many other congressmen favored cutting tax rates and slashing the size of government as the best measure to restore economic growth. Senator Albert Hawkes (R-N.J.) even argued that “the repeal of the excess-profits tax, in my opinion, may raise more revenue for the United States than would be raised if it were retained.” Hawkes proved to be prophetic. After vigorous debate Congress scrapped the Economic Bill of Rights and cut tax rates instead. American business then expanded, revenues to the Treasury increased to balance the federal budget, and unemployment was only 3.9 percent in 1946 and 1947. The Great Depression was over.

But wait. Only 3.5 million jobs? Why so few? It’s not like creating jobs is difficult.

Egypt built more than 100 pyramids beginning sometime in the third millennium B.C. to house the corpses of the pharaohs and their significant others. Think of all the jobs that project created. I’ll bet the unemployment rate was something any pharaoh could have proudly campaigned for reelection on—if he faced election, that is. Pyramid-building is one heck of a public-works project.

Pyramids, Earthquakes, Wars

Its economic significance was not lost on that great advocate of full employment through public works, John Maynard Keynes. The British economist, so in vogue today, famously wrote in The General Theory on Employment, Interest, and Money (1936), “Pyramid-building, earthquakes, even wars may serve to increase wealth.”

In fact, pyramids are even better than the usual government project. Keynes said: “Two pyramids . . . are twice as good as one; but not so two railways from London to York.”

Ancient Egypt’s success has many applications today. We could have full employment overnight if the government simply outlawed machines. Today’s 8 percent unemployment rate would vanish.

Again, we find an endorsement in Keynes’s General Theory: “‘To dig holes in the ground,’ paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.”

Exhibit B is Franklin Delano Roosevelt. I don’t mean his public-works projects, like the Civilian Conservation Corps. I’m talking about his most serious job-creating operation: the draft.

If You Can’t Employ ‘Em, Draft ‘Em

In September 1940 Roosevelt signed the Selective Service Act, which ordered all males 21–35 to register for military service. “Of the 16 million persons who served in the armed forces at some time during the war, 10 million were conscripted, and many of those who volunteered did so only to avoid the draft. . . .” writes Robert Higgs in Depression, War and Cold War.

The draft marked the beginning of the end to the double-digit unemployment that had plagued America for a decade. Two years earlier, Roosevelt’s treasury secretary, Henry Morgenthau, lamented, “[A]fter eight years of this administration we have just as much unemployment as when we started.” The draft was the answer they had sought all that time.

So creating jobs is not difficult for government. What is difficult for government is creating jobs that produce wealth. Pyramids, holes in the ground and war do not produce wealth. They destroy wealth. They take valuable resources and convert them into something less valuable.

Instead of iPods, great art, cures for diseases and machines that replace back-breaking work, we get the equivalent of digging holes and filling them up.

Under President Obama’s “stimulus” plan, jobs will be created to weatherize buildings, construct schools and wind turbines, and repair roads and bridges. But outside the market process, there is no way to know whether those are better uses of scarce capital than whatever would have been produced had it been left in the private economy.

Since government services are paid for through the compulsion of taxes, they have no market price. But without market prices, we have no way of knowing the importance that free people would place on those services versus other things they want.

So although we’ll see the government putting people to work and even some new schools and bridges, we won’t be able to calculate how much wealth we’ve lost because scarce resources were misallocated by the politicians.

Nevertheless, we can be sure we will have lost. If the government’s projects were truly worthwhile, they would be undertaken by private efforts, and in their quest for profits, entrepreneurs would handle them more efficiently.

Remember this when President Obama begins to boast about how successful his stimulus plan is.

Klein received the Prize in 1980 for what the Nobel committee called his contributions to econometric modeling for purposes of directing economic policy. What is less well known today is that immediately after World War II he was one of the great popularizers of the “new economics” of John Maynard Keynes, especially in his widely read book, The Keynesian Revolution, published in 1947.

In The General Theory of Employment, Interest, and Money (1936) Keynes had argued that the market economy was inherently unstable and susceptible to wide and unpredictable swings in output, employment, and prices. Worse yet, he asserted, the market could get stuck in a prolonged period of high unemployment and idle resources. Only judicious government monetary and fiscal policy could assure a return to sustainable full employment.

In the decade following publication of The General Theory Keynes’s ideas captured the hearts and minds of a growing number of economists. The book was soon translated into a variety of foreign languages, including German; that edition appeared in the autumn of 1936. Addressing himself to the Nazi economists of Hitler’s Germany in the preface to the German-language edition, Keynes declared that his theory of “aggregate demand” management by government was more easily adapted to a totalitarian economy than a relatively free-market system:

The theory of aggregate production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state, than . . . under conditions of free competition and a large degree of laissez-faire. . . . Although I have, after all, worked it out with a view to the conditions prevailing in the Anglo-Saxon countries where a large degree of laissez-faire still prevails, nevertheless it remains applicable to situations in which state management is more pronounced.

While it would be wrong to suggest that Keynes had any direct sympathy for totalitarianism or the Nazi system, he understood clearer than many of his followers that the more the government controlled the economy the easier it would be to implement what soon became known as Keynesian-style policies.

Klein’s The Keynesian Revolution represented the growing consensus of the time among economists and government-policy advocates on how monetary and fiscal tools should be used to manipulate the economy. The book was widely assigned to college students in their economics classes, thus further spreading Keynes’s message.

In the final chapter Klein outlined what would be necessary from government if the Keynesian “insights” were to be fully applied for the “social good.” In a world guided by Keynes’s ideas Americans would have to accept a greater degree of government regimentation than they had in the past. Should they be afraid of this? No, Klein assured his readers: “The regimentation of unemployment and poverty is infinitely more severe than the regimentation of economic planning.” He was sure the American people would “quickly come forth with support” for the required regimentation of economic planning.

The “economic planners” would have to have “complete control over government fiscal policy so that they can spend when and where spending is needed to stimulate employment and tax when and where taxation is needed to halt upward price movements.” The traditional congressional budget process would have to be put aside. Klein was sure that “It is inevitable that the Congressional debating techniques will be much too slow and cumbersome to provide the flexibility needed for fiscal policy in a full-employment program.” In its place:

We must have a planning agency always ready with a backlog of socially useful public works to fill any deflationary gap that may arise [through discretionary government deficit-spending powers]; similarly, we must have a price-control board always ready with directives and enforcement officers to wipe out any inflationary gap that may arise. . . . Government spending should be very flexible and subject to immediate release or curtailment, in just the precise amount which will maintain full employment, no more and no less. . . . This is the road to the kind of full employment that we need.

From where would come the money that the government would need for all this fiscal activity? Don’t worry, Klein said, the government can just borrow and borrow and borrow. But would it not have to be paid back? Wasn’t this merely imposing a higher tax burden on the citizenry in the future? We need have no concern, he declared, since, after all, “public debt can never be a burden, because we owe it to ourselves.”

At the same time, government would have to keep individuals from saving too much and spending too little, since excessive savings would diminish the “aggregate demand” on which “full employment” depended. This would require, Klein said, income redistribution from rich to poor because the rich have a higher marginal propensity to save.

To reinforce this objective the motive for personal saving would have to be undermined by the government’s taking greater responsibility for such things as retirement planning. “The people acting on individualistic principles do not know their own best interests,” he said.

Once discussing some of the implications of his own ideas, Keynes said that in a world consistent with his policy prescriptions, “customary morals, conventions and traditional wisdoms” would have to be set aside. As Klein clearly showed, this included the American tradition of constitutional government and financial self-responsibility.

For the last hundred years constitutionally limited government has been slowly but surely eroded in the United States and around the globe. Governments have grown in discretionary power over the lives and fortunes of the citizenry everywhere we look. Restraints on government have been loosened so those in political authority can do more to the people in the name of “for the people.”

The traditional purpose of constitutions has been to restrain and specify the powers of government. The presumption is that government is the enemy of liberty and prosperity. Unbridled government threatens to enslave the people through controls, regulations, and prohibitions. Unlimited government power to tax and spend undermines the ability of the people to plan their own lives and peacefully interact with their fellow citizens for mutual improvement.

Keynesian economics and popularizers of its policy prescriptions like Lawrence Klein were major contributors to our continuing trend toward larger and ever-more intrusive government. They persuaded more than a generation of students and economists that the free market is untrustworthy of supplying either jobs or justice. They rationalized the need for unbounded political power in the name of economic stability and distributive fairness. They weakened the belief in the importance of constitutional limits on power.

Even today, after the supposed counterrevolution against Keynesian economics that began during the “stagflation” of the 1970s, those ideas still have their hold over the minds of too many economists, policy makers, and opinion molders. If freedom is to be restored, part of the task will have to be a thorough overthrow of the Keynesian concepts that have been so deeply imbedded into public thinking by people like Lawrence Klein.

In the process Keynes helped undermine what had been three of the essential institutional ingredients of a free-market economy: the gold standard, balanced gov­ernment budgets, and open competitive markets. In their place Keynes’s legacy has given us paper-money inflation, government deficit spending, and more politi­cal intervention throughout the market.

It would, of course, be an exaggeration to claim that without Keynes and the Keynesian revolution inflation, deficit spending, and interventionism would not have occurred. For decades before the appearance of Keynes’s book, the political and ideological climate had been shifting toward ever-greater government involvement in social and economic affairs, due to the growing influ­ence of collectivist ideas among intellectuals and policy-makers.

But before the appearance of The General Theory, many of the advocates of such collectivist policies had to get around the main body of economic thinking which still argued that in general the best course was for gov­ernment to keep its hands off the market, maintain a sta­ble currency backed by gold, and restrain its own taxing and spending policies.

The classical economists of the eighteenth and nine­teenth centuries had persuasively demonstrated that government intervention prevented the smooth func­tioning of the market. They constructed a body of eco­nomic theory which clearly showed that governments have neither the knowledge nor the ability to direct economic affairs. Freedom and prosperity are best assured when government is, in general, limited to pro­tecting people’s lives and property, with the competitive forces of supply and demand bringing about the neces­sary incentives and coordination of people’s activities.

During the Napoleonic wars of the early nineteenth century, many European countries experienced serious inflations as governments resorted to the printing press to fund their war expenditures. The lesson the classical economists learned was that the hand of the government had to be removed from the handle of that printing press if monetary stability was to be maintained. The best way of doing this was to link a nation’s currency to a com­modity like gold, require banks to redeem their notes for gold on demand at a fixed rate of exchange, and limit any increases in the amount of such bank notes in cir­culation to additional deposits of gold left in the banks by their depositors.

They also concluded that deficit spending was a dan­gerous means of funding government programs. It enabled governments to create the illusion that they could spend without imposing a cost on society in the form of higher taxes; they could borrow and spend today, and defer the tax cost until some tomorrow when the loans would have to be repaid. The classical econo­mists called for annually balanced budgets, enabling the electorate to see more clearly the cost of government spending. If a national emergency, such as a war, were to force the government to borrow, then when the crisis passed, the government should run budget surpluses to pay off the debt.

These were considered the tried and true policies for a healthy society. And these were the policies that Keynes did his best to try to overthrow in the pages of The General Theory. He argued that a market economy was inherently unstable, open to swings of irrational investor optimism and pessimism, which resulted in unpredictable and wide fluctuations in output, employ­ment, and prices. Only government, he believed, could take the long view and rationally keep the economy on an even keel by running deficits to stimulate the econ­omy during depressions and surpluses to rein it in dur­ing inflationary booms. He therefore attacked the notion of annual balanced budgets; instead, government should balance its budget over the “business cycle.”

To do this job, Keynes said, governments could not be hamstrung by the “barbarous relic” of the gold stan­dard. Wise politicians, guided by brilliant economists like himself, had to have the flexibility to increase the money supply, manipulate interest rates, and change the foreign-exchange rates at which currencies traded for each other. They required this power so they could gen­erate any amount of spending needed to put people back to work through public-works projects and gov­ernment-stimulated private investments. Limiting increases in the money supply to the quantity of gold would only get in the way, Keynes insisted.

Keynes believed not only that the market economy could not keep itself on an even keel, he also believed that it would be undesirable to allow the market to work. He once said that to have the market determine prices and wages to balance supply and demand was to submit society to a cruel and unjust “economic jugger­naut.” Instead, he wanted wages and prices to be politi­cally fixed on the basis of “what is ‘fair’ and ‘reasonable’ as between the [social] classes.”

The level of wages imposed by trade unions, for example, was to be viewed as sacrosanct, even if many workers were priced out of the market because the level was higher than potential employers thought those workers were worth. The government, instead, was to print money, run deficits, and push up prices to any level needed to make it again profitable for employers to hire workers. In other words, perpetual price inflation was to be the means to assure “full employment” in the face of aggressive trade unions.

No Check on Spending

In addition, when the balanced-budget rule was over­thrown there was no longer any check on govern­ment spending. As James M. Buchanan and Richard E. Wagner pointed out in Democracy in Deficit (1977), once government is freed from the restraint of making tax­payers directly and immediately pay for what it spends, every conceivable special-interest group can appeal to the politicians to feed their wants. The politicians, desir­ing votes and campaign contributions, happily offer to satisfy the gluttony of favored groups. At the same time, the taxpayers easily fall prey to the delusion that gov­ernment can give something for nothing to virtually everyone at no cost to them.

Indeed, politicians can now play the game of offer­ing more and more dollars to special interests, while lowering taxes. The government simply fills the gap by borrowing, imposing a greater debt burden on future generations. Either taxes will have to go up in the years ahead or the government will turn to the printing press to pay what it owes, all the while claiming that it’s being done to generate “national prosperity” and fund the “socially necessary” programs of the welfare state.

In one of the most famous passages in The General Theory, Keynes said that “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 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.”

Seventy years after the appearance of The General Theory, many practical men of affairs and politicians in authority remain the slaves of defunct economists and academic scribblers. The tragedy for our times is that among the voices they still hear in the air as they cor­ruptly mismanage everything they touch is that of John Maynard Keynes.

Keynes (1883–1946)² had a acquired an international reputation shortly after World War I, when he published The Economic Consequences of the Peace, a biting criticism of the Treaty of Versailles that formally ended the war.³ In the 1920s he was a leading critic of the gold standard and a vocal proponent of a government-managed currency to maintain full employment. In his 1924 book, A Tract on Monetary Reform, Keynes declared that gold was a “barbarous relic” and that governments should use their control over the money supply to maintain a stable domestic price level even if this required abandoning a stable foreign exchange rate between the British pound and the other currencies of the world.⁴

In 1930 Keynes published A Treatise on Money, a two-volume work that he expected would establish his reputation as the leading monetary theorist of his time⁵. Instead, the book was savaged by reviewers, including many of the most prominent economists in Great Britain and the United States. The most devastating criticisms were made by a young Austrian economist named Friedrich A. Hayek, who in a lengthy two-part review demonstrated the logical confusions and theoretical misunderstandings that ran through the entire work.⁶

For the next five years Keynes devoted his time to devising a new theory for his argument that a free-market economy was inherently unstable and that only the guiding hand of government could assure full employment in the face of the economic disaster being experienced during the Great Depression of the early 1930s. This work finally appeared in February 1936 under the title The General Theory of Employment, Interest, and Money. ⁷

Except for some of Keynes’s young protégés at Cambridge University, most of the reviewers of the book were highly critical of many of its theoretical “innovations,” as well as its inflationary prescriptions for unemployment.⁸ Even some economists who later became proponents of Keynes’s “new economics” were initially highly critical of his work. For example, Alvin Hansen, who was one of the leading advocates of Keynesian economics in the United States in the 1950s and 1960s, wrote in late 1936 that The General Theory “is not a landmark in the sense that it lays the foundation for a ‘new economics.’ . . . The book is more a symptom of economic trends than a foundation stone upon which a science can be built.”⁹

Yet within a few years, and most certainly by the end of World War II, Keynes’s ideas had virtually pushed aside every other explanation of the causes and cures of economic depressions.¹⁰ Keynes’s book became the foundation stone for the new “macroeconomics.” His face even appeared on the cover of the December 31, 1965, issue of Time magazine. The feature article, titled “We Are All Keynesians Now,” stated:

Today, some 20 years after his death, his theories are a prime influence on the world’s free economies, especially America’s. . . . Now Keynes and his ideas, though they still make some people nervous, have been so widely accepted that they constitute both the new orthodoxy in the universities and the touchstone of economic management in Washington. . . . Now even businessmen, traditionally hostile to Government’s role in the economy, have been won over. . . . They have begun to take for granted that the Government will intervene to head off recession or choke off inflation, [and] no longer think that deficit spending is immoral.¹¹

Keynes argued in The General Theory that the free-market economy contained no built-in mechanism to assure full employment. The crucial weakness, he said, lies in the relationship between savings and investment. People tend to consume more as their incomes go up, but the increase is not as great as the increase in income. In other words, they also save a portion of their higher income. The problem, he insisted, is that saving is “non-spending” and if people do not spend all the extra income they earn, businessmen may not have the incentive to invest enough to employ all those who want to work at prevailing wages.

As a result, a large portion of the labor force may be left unemployed because the private sector has failed to create enough jobs. The economy, therefore, may be stuck for a prolonged period in what Keynes called an “unemployment equilibrium.” Couldn’t workers improve their prospects by accepting lower money wages? No, Keynes insisted, because workers suffer from a “money illusion”—even if prices were falling and a cut in wages would make them no worse off in real buying-power terms, workers would refuse to accept less money.

Rather than demand that workers accept lower pay, Keynes favored raising the general level of prices so employers could make profits without cutting wages. In other words, Keynes’s solution to unemployment was price inflation.

Deficit Spending

Government deficit spending would provide additional market demand, pushing prices up and stimulating more hiring. Public-works projects would “prime the pump.” This policy would continue until “full employment” was attained. But since, in Keynes’s view, businessmen were usually shortsighted and irrational in their fears about investment prospects, the private sector would always lag behind in creating jobs. The government would have to be constantly at the monetary and fiscal controls, injecting spending into the economy to prevent it from sinking back into unacceptable levels of unemployment.

In Keynes’s conception of the world, governments guided by his ideas would be wise and farseeing, assuring that the mass unemployment of the 1930s never happened again. Government would manipulate interest rates, the level of prices, and the amount and direction of investment to assure that society had high employment, socially beneficial investment, and general economic stability.

There were critics of Keynesian economics in the 1940s and 1950s, but they were virtually ignored by academic economists and policymakers.¹³ Some mainstream macroeconomists also took Keynes to task. But many of their criticisms were couched in terms clearly meant not to antagonize their Keynesian colleagues.

Then in 1959 came Henry Hazlitt’s The Failure of the “New Economics”.¹³ What was unique about Hazlitt’s exposition was his chapter-by-chapter dissection of the arguments in Keynes’s General Theory.¹⁴

Central to Keynes’s theory was his insistence that “Say’s Law” was wrong in claiming that “supply creates its own demand.” Just because people supply goods on the market does not mean they will demand what others are selling. They may abstain from spending by holding idle cash balances. Thus there could be a general glut of goods on the market.

Say’s Law

Hazlitt showed that Keynes had misunderstood what the Jean-Baptiste Say and other nineteenth-century economists meant. Goods can virtually always find buyers if prices are sufficiently attractive. The pre-Keynesian “classical” economists never denied that goods can go unsold and labor unemployed if suppliers fail to adjust their prices and wages to match existing market demand.

Furthermore, Hazlitt explained, many of the classical economists, especially John Stuart Mill, understood that individuals could “hoard” money rather than immediately spend it. But this was most frequently due to the temporary uncertainties of an economic crisis, usually caused by a prior, unstable inflationary boom.¹⁵

The central flaw in Keynes’s thinking, Hazlitt insisted, was his unwillingness to acknowledge that the high unemployment in Great Britain in the 1920s and the United States in the 1930s was caused by government intervention, including the empowering of labor unions, that made many prices and wages virtually “rigid.” Political and special-interest power prevented markets from competitively re-establishing a balance between supply and demand for various goods. Hence, the market was trapped in wage and price distortions that destroyed employment and production opportunities, resulting in the Great Depression. (Hazlitt did not deny that the contraction of the money supply in the early 1930s increased the degree to which prices and wages had to fall to re-establish full employment.)

Hazlitt considered Keynes’s inflationary “fix” crude and dangerous. First, Hazlitt pointed out that Keynes’s focus on macroeconomic “aggregates” concealed the microeconomic relationships among a multitude of individual prices and wages. The price level, wage level, total output, aggregate demand, and aggregate supply were all statistical fictions that had no reality in the actual market. Thus the wage level could not be too high relative to the general price level. But in the 1930s many wages for different types of labor were out of balance with the prices of individual goods sold on the market. What was needed to restore full employment was an adjustment of numerous individual wages and resource prices to the lower prices of many consumer goods. The extent to which any individual money wage or resource price might have to adjust downwards depended on the distinct supply and demand conditions in each of the individual markets.

An inflationary policy attempts to bring some individual price-wage relationships back into balance by pushing prices up throughout the economy, Hazlitt explained.

Because Keynes, with his lump, aggregate thinking, is opposed to restoring employment or equilibrium by small, gradual, piecemeal adjustments . . . we must achieve the same result by inflating the money supply and raising the price level, so everybody’s real wages are slashed by the same percentage. . . . The Keynesian remedy, in short, is like changing the lock to avoid changing to the right key, or like adjusting the piano to the stool instead of the stool to the piano.¹⁶

Second, Hazlitt pointed out that workers and labor unions are aware of how rising prices affect the real value of money wages. There is certainly no “money illusion” in an upward direction. An increasing cost of living due to rising prices soon brings worker and union demands for higher pay to make up for lost purchasing power. But if workers and unions demand the same real wages they had before the inflation, then the Keynes solution to unemployment must fail.

Finally, Keynes’s macroeconomic approach also concealed the fact that beneath the aggregate rising price level, inflation distorts many of the relative price relationships, including the rate of interest. This inevitably brings about misdirection of resources, capital, and labor across different sectors of the market that will eventually require a reshuffling of supply and demand once the inflation ends. Thus the inflationary “cure” for unemployment brings in its wake an eventual new bout of unemployment when workers have to shift jobs and readjust their wage demands in the post-inflationary period.

Indeed, in a series of chapters, Hazlitt clearly showed that Keynes was confused about the actual relationships among savings, investment, and the rate of interest. The core of his theory was founded on a bundle of errors and mistakes. This resulted in Keynes’s failure to comprehend that saving, investment, and capital formation—not government-stimulated increases in aggregate consumer demand—are the foundations of sustainable employment and rising standards of living.¹⁷

Hazlitt also took Keynes to task for advocating increasing government control and direction of investment decision-making. Keynes clearly believed, Hazlitt sarcastically observed, “that there exists a class of people (perhaps economists very much resembling Lord Keynes) who are completely informed, rational, balanced, wise, who have means of knowing at all times exactly how much investment is needed and in exactly what amounts it should be allocated to exactly which industries and projects, and that these managers are above corruption and above any interest in the outcome of the next election.”¹⁸

If The General Theory had so many fundamental flaws, how did it become, in the words of one of his most enthusiastic followers, “the Keynesian bible”?¹⁹ Hazlitt offered some possible reasons in his introduction to his edited volume, The Critics of Keynesian Economics, which appeared a year after his own book. He suggested that Keynes’s theories rationalized the politics of special-interest groups that desired to reap the benefits of an inflation. Also, while much of The General Theory is written in difficult language, Keynes could dazzle the reader with literary imagery and wit that hid his central logical flaws. Keynes used the “technique of obscure arguments followed by clear and triumphant conclusions,” Hazlitt said. And finally, Hazlitt conjectured that the success of the book may have had a lot to do with its appearing to overthrow the existing orthodoxy in favor of radical and fashionable ideas about social engineering. “But whatever the full explanation of the Keynesian cult,” Hazlitt concluded, “its existence is one of the great intellectual scandals of our age.”²⁰

The monolithic domination that Keynesian economics once had over all macroeconomic policy has been broken for more than two decades. While too many of Keynes’s misconceptions still underlie how economists think about inflation, recession, and unemployment, the original and primitive Keynesian thinking has been more or less overthrown. To a great extent this is because of the thorough and brilliant demolition that Henry Hazlitt performed more than 40 years ago.

Notes

1. Henry Hazlitt, The Failure of the “New Economics”: An Analysis of the Keynesian Fallacies (Princeton: D. Van Nostrand, 1959), reprinted by the Foundation for Economic Education in 1995.
2. The most comprehensive biography of Keynes is Robert Skidelsky, John Maynard Keynes: Hopes Betrayed, 1883–1920 (London: Macmillan, 1983), John Maynard Keynes: The Economist as Saviour, 1920–1937 (London: Macmillan, 1992), and John Maynard Keynes: Fighting for Britain, 1937–1946 (London: Macmillan, 2000); in addition, see, Roy H. Harrod, The Life of John Maynard Keynes (London: Macmillan, 1951), and D. E. Moggridge, Maynard Keynes: An Economist’s Biography (London: Routledge, 1992). All of them are highly sympathetic to Keynes as an economist and policy advocate.
3. John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace, 1920); see the critical analysis of Keynes’s arguments about the peace treaty by Etienne Mantoux, The Carthaginian Peace, or The Economic Consequences of Mr. Keynes (New York: Charles Scribner’s Sons, 1952).
4. John Maynard Keynes, A Tract on Monetary Reform (New York: Harcourt, Brace, 1924); see the critical analysis of Keynes’s arguments by Benjamin M. Anderson, “The Gold Standard vs. ‘A Managed Currency,’” Chase Economic Bulletin, March 23, 1925, p. 39.
5. John Maynard Keynes, A Treatise on Money, 2 vols. (New York: Harcourt Brace, 1930).
6. Friedrich A. Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica, August 1931, pp. 270–95, and February 1932, pp. 22–44; reprinted in Bruce Caldwell, ed., The Collected Works of F. A. Hayek, vol. 9: Contra Keynes and Cambridge: Essays, Correspondence (Chicago: University of Chicago Press, 1995), pp. 121–97, which also includes Keynes’s reply after the appearance of part I of Hayek’s review and Hayek’s rejoinder.
7. John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York Harcourt, Brace, 1936); he earlier presented an outline of his prescriptions for an “activist” government policy in The Means to Prosperity (London: Macmillan, 1933).
8. Some of these reviews, especially those by Frank Knight and Jacob Viner, were published together many years later in Henry Hazlitt, ed., The Critics of Keynesian Economics (Princeton: D. Van Nostrand, 1960); there were many others not included in this excellent anthology, especially the reviews and essays by Henry Simons, Joseph Schumpeter, Dennis Robertson, Arthur C. Pigou, Bertil Ohlin, Erik Lindahl, and Carl Landauer, which were highly critical and insightful about fundamental errors in Keynes’s ideas.
9. Alvin H. Hansen, “Mr. Keynes on Underemployment Equilibrium,” Journal of Political Economy (October 1936), p. 686. Hansen later wrote one of the most widely read popular expositions of Keynes’s ideas; see his A Guide to Keynes (New York: McGraw-Hill, 1953).
10. For a detailed exposition of the alternative “Austrian” analysis of the causes and cures for the Great Depression compared to the Keynesian perspective, see Richard M. Ebeling, “The Austrian Economists and the Keynesian Revolution: The Great Depression and the Economics of the Short-Run” in Richard M. Ebeling, ed., Human Action: A 50-Year Tribute (Hillsdale, Mich.: Hillsdale College Press, 2000), pp. 15–110.
11. “We Are All Keynesians Now,” Time, December 31, 1965, pp. 64–67B. The quotations are from pp. 64–65. Four years later, Milton Friedman appeared on the cover of Time (December 19, 1969, pp. 66–72), with the magazine now saying that “Friedman, a 57-year-old economics professor at the University of Chicago . . . has reached the scholar’s pinnacle: leadership of a whole school of economic thought. It is called the ‘Chicago School,’ and its growing band of followers argues that the money supply is by far the most important and fastest-acting of the economic regulators at the Government’s disposal. . . . [M]ost economists now consider themselves . . . hybrid . . . ‘Friedmanesque Keynesians’” (p. 66).
12. Among the strongly anti-Keynesian critics who took his ideas to task in some detail were W. H. Hutt, The Theory of Idle Resources (London: Jonathan Cape, 1939); Arthur W. Marget, The Theory of Prices: A Re-Examination of the Central Problems of Monetary Theory, 2 vols. (New York: Augustus M. Kelley, 1966 [1938 and 1942]); Benjamin M. Anderson, “The Road Back to Full Employment” in Paul T. Homan and Fritz Machlup, eds., Financing American Prosperity: A Symposium of Economists (New York: Twentieth Century Fund, 1945), pp. 9–70; L. Albert Hahn, The Economics of Illusion: A Critical Analysis of Contemporary Economic Theory and Policy (New York: Squier Publishing, 1949), and Common Sense Economics (London/New York: Abeland-Schuman Ltd., 1956); Philip Cortney, The Economic Munich (New York: Philosophical Library, 1949); and Hans Mayer, “John Maynard Keynes’ ‘Neubegründung’ der Wirtschaftstheorie” [“John Maynard Keynes's ‘New Foundation' for Economic Theory”] in E. Lagler and J. Messner, eds., Wirtschaftsliche Entwicklung und soziale Ordnung [Economic Development and Social Order] (Wien: 1952), pp. 39–55.
13. Four years later another detailed critical study of Keynes-ian economics appeared: W. H. Hutt, Keynesianism: Retrospect and Prospect: A Critical Restatement of Basic Economic Principles (Chicago: Henry Regnery, 1963); it later appeared in a revised edition under the title The Keynesian Episode: A Reassessment (Indianapolis: Liberty Press, 1979); see also W. H. Hutt, A Rehabilitation of Say’s Law (Athens: Ohio University Press, 1974).
14. Hazlitt, The Failure of the “New Economics, p. 4: “I know of no single work that devotes itself to a critical chapter-by-chapter or theorem-by-theorem analysis of [The General Theory]. It is this task that I am undertaking here.”
15. Ibid., pp. 361–71; see John Stuart Mill, “Of the Influence of Consumption on Production” [1844] in Hazlitt, ed., The Critics of Keynesian Economics, pp. 24–45.
16. The Failure of the “New Economics,” pp. 280–81; on the degree to which inflexible money wages relative to the prices for finished consumer goods raised the real cost of employing workers in the early 1930s, and therefore resulted in rising unemployment, see Richard K. Vedder and Lowell Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America (New York/London: Holmes & Meier, 1993), pp. 79–95.
17. See also Henry Hazlitt, The Conquest of Poverty (New Rochelle, N.Y.: Arlington House, 1973), pp. 217–28.
18. The Failure of the “New Economics,” p. 324; on the arrogance in Keynes’s thinking about an elite who are wise and good enough to macro-manage the economy, and the harmful real world consequences, see also James M. Buchanan and Richard E. Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes (New York: Academic Press, 1977).
19. Seymour E. Harris, “About this Book,” in Seymour E. Harris, ed., The New Economics: Keynes’ Influence on Theory and Public Policy (New York: Alfred A. Knopf, 1948), p. 9.
20. Hazlitt, “Introduction” in The Critics of Keynesian Economics, pp. 9–10.

They had come to this attractive French city south of Lake Geneva to discuss the problem of business cycles and their effect on the world economy. Little agreement was reached over the three days during which these leading economists met. But there was a single consensus among the attendees. One of the other participants at the conference, Gottfried Haberler, had set an example and standard for how research on the subject of business cycles should be undertaken. According to the official summary of the conference:

There was throughout the whole conference one matter which secured the wholehearted support of all those present, namely the new technique in research which has been followed during the last two years in the study of the theory of the business cycle by Dr. Haberler. It will be recalled that he was appointed to a special post on the staff of the Economic and Financial Section of the League [of Nations] . . . . He was charged with the duty of examining the present state of knowledge in the theory of the business cycle and was to draw up a report on this subject . . . . [T]here can be no doubt that everyone present was greatly impressed by the very valuable results that had been achieved by the procedure followed in the case of Dr. Haberler’s work. Indeed, “Haberler-like methods” became a catch-phrase of the entire conference.^[1]

Haberler had spent two years carefully researching and consulting on the various competing theories of the causes and consequences of business cycles and formulated a “synthetic” alternative, the result of which was published in early 1937 under the title Prosperity and Depression: A Theoretical Analysis of Cyclical Movements.^[2] For over 60 years it has been considered the classic summary and critical evaluation of the literature on this subject. Indeed, Joseph A. Schumpeter referred to it as a “masterly presentation of the modern material” for which he had the greatest “admiration.”^[3] And one of America’s leading Keynesian economists, Paul A. Samuelson, hailed it as “the definitive study of business cycles, both pre- and post-Keynesian.”^[4] Austrian economist E A. Hayek drew attention to Haberler’s “excellent exposition” criticizing some of the fundamental assumptions and concepts of Keynesian economics.^[5]

But this work was only one of Gottfried Haberler’s many important contributions to economic theory and policy. In an economic career that spanned seven decades in the twentieth century, he made original contributions to monetary theory and policy, the theory of wages and union power, international trade theory, and the theory of economic development and growth.

Haberler was born on July 20, 1900, in Purkersdorf, near Vienna, Austria; the centenary of his birth offers the opportunity for an appreciation of his writings and his defense of the free market.

Early Studies

Haberler studied at the University of Vienna with three of the leading figures of the Austrian school of economics in the years immediately after the First World War: Friedrich von Wieser, Ludwig von Mises, and Hans Mayer. At the university his closest friends were three other students who, like himself, were to become internationally renowned economists in the decades to come: Hayek, Morgenstern, and Fritz Machlup. After Haberler earned his degrees in political science (1923) and law (1925), Mises helped arrange for him to receive a Spelman Fund (later Rockefeller Foundation) grant that enabled him to have two years of further study in the United States and Great Britain.

After returning to Austria, Haberler became a privatdozent (an unsalaried lecturer) at the University of Vienna, teaching a joint seminar with Hayek and Morgenstern. Mises arranged a paid position for him in the library at the Austrian Chamber of Commerce, where Mises was employed as a senior economic analyst. Haberler was a visiting professor of economics and statistics at Harvard University in 1931-1932. In 1934, he accepted the two-year appointment with the League of Nations in Geneva, Switzerland, that led to the publication of Prosperity and Depression. In the autumn of 1936, Haberler began a professorship in economics at Harvard University that lasted until his retirement in 1971. He also served as an economic consultant with the Board of Governors of the Federal Reserve System from 1943 to 1947. From 1971 until shortly before his death on May 6, 1995, at the age of 94, he was a senior scholar at the American Enterprise Institute in Washington, D.C.^[6]

Many of Gottfried Haberler’s writings in the 1920s and 1930s were devoted to problems in monetary and business cycle theory. Like other Austrian economists during this time, especially Mises and Hayek, Haberler focused his attention on price-level stabilization and monetary stability. In the 1920s the argument was made that a monetary policy that stabilized the general price level through changes in the money supply would assure economy-wide economic stability. In a series of articles and in his book The Mean of Index Numbers: An Inquiry in the Concept of the Price Level and the Methods of Its Measurement (1927), Haberler challenged the fundamental assumptions of a price-level stabilization policy.^[7]

He argued that in fact there is no way to strictly measure and determine the general value of money through the use of index numbers of various types. The only precise definition of the value of money is that it is represented by the network of individual exchange ratios between money and all of the individual goods against which it trades. Every general index of prices is necessarily constructed by selecting some prices (various consumer or producer prices) as representative of the subgroup of goods under study. They are weighted according to their proportion of purchases, summed together, and mathematically averaged to create a statistical composite that is then tracked through time.

Thus every price index is “arbitrary,” in that it depends on the types of goods or industries the economic analyst is interested in studying, the choice made concerning the weights to assign and the averaging method chosen to calculate their mean value, and the assumption that what is taken to be “constant” does not significantly change over the period during which the selected “price level” is being tracked.

Furthermore, Haberler argued, precisely because a price-level index is an average of the set of individual market prices from which it is constructed, it may hide all the significant individual relative price changes beneath its statistical surface. “The relative position and change of different groups of prices are not revealed, but are hidden and submerged in a general index,” said Haberler. “Not the movement of the general price level, but the chronological succession of special price and price combinations . . . are regarded as significant for the waves of business life . . . . Such a general index rather conceals and submerges than reveals and explains those price movements that characterize and signify the movement of the [business] cycle.”^[8]

Also, Haberler maintained, a focus on an average price level tends to distract attention from the underlying microeconomic causes that result in a tendency for prices in general to move in one direction or another. And like his fellow Austrians, Haberler reasoned that a price-level “deflation” due to technological improvements and increased output resulting from lower costs of production is not a symptom suggesting a tendency toward a depression in the market economy. Instead, falling prices from those causes represent the market’s method of bringing about an increase in people’s real standard of living.

Austrian Business Cycle

Building on this reasoning, Haberler delivered one of the clearest expositions of the Austrian theory of the business cycle at a conference at the University of Chicago in 1932.^[9] He explained that in the process of increasing the money supply sufficiently to prevent prices in general from declining owing to lower costs and greater output, a monetary expansion through the banking system pushes interest rates below the market level that would have been established by actual savings and investment demand in the economy. In the 1920s, this policy induced long-term investment projects in excess of real savings in the market, resulting in an imbalance that finally manifested itself in the economic downturn and depression that began in 1929 and intensified in the early 1930s.

During the 1930s Haberler took a view different from either Mises or Hayek about the solution to the Great Depression. His Austrian colleagues argued that the market had to be freed of government intervention, for supply and demand, and savings and investment to re-establish their own new equilibrium. Haberler reached a conclusion closer to that of Wilhelm Röpke, that once begun, the economic downturn of the early 1930s had increased to such an intensity that a “secondary depression” had set in, having little to do with any healthy correction from the mal-investments created by the Federal Reserve’s monetary policy of the 1920s.^[10] Rigid costs resistant to downward adjustment, bank panics and failures that caused an actual contraction in the supply of money and credit, and pessimistic expectations on the part of the investment community generated a situation in which only a government-initiated stimulus of spending and “effective demand” could bring about a reversal of the depressionary forces.^[11]

While Haberler’s anti-depression policy perspective might seem to have shifted him into a position similar to that advocated by John Maynard Keynes and the emerging Keynesian economics that came to dominate the economics profession beginning in the 1940s, that conclusion would only be partially correct. He did think that Keynes had made a number of valuable and influential contributions to economic understanding.^[12] But in general, Haberler considered Keynes’s “new economics” to be inferior to the traditional body of economic and monetary theory.

A cornerstone of Keynes’s argument had been that even if market prices and money wages were flexible and adjusted downward during a depression, there was no guarantee that this would result in a return to economic balance and full employment. Haberler argued in the 1939 revised edition of Prosperity and Depression, as part of his critical evaluation of Keynes’s The General Theory of Employment, Interest and Money, that Keynes had failed to appreciate what has become known as the “real cash balance effect.”

Even if people were reluctant to spend in the depression because of pessimism and a desire to hold their wealth in a more liquid form, as prices and wages decreased, the real value and purchasing power of their money assets would be increasing, since each unit of money at lower prices could now buy more. A point would be reached at which people would find it advantageous to start spending again, at which time prices and wages would no longer have to fall and all those desiring employment would find employers willing to hire them to satisfy this renewed demand for goods and services. Haberler did not argue that an economic policy that fostered or permitted prices and money wages to fall during a severe depression until they found their own market level was necessarily the most desirous one. But he did insist that Keynes was wrong in stating that falling prices and wages could not restore equilibrium to the market.^[13]

Inflation Opponent

Throughout the post-World War II era, Haberler was a vocal and forceful opponent of Keynesian-inspired inflationary policies to maintain full employment. He insisted that this was an economically dangerous path to follow, that it merely reinforced the very market rigidities that were causing any persistent and significant levels of unemployment in the economy. Neither private business practices nor powerful unions could bring about a permanent and continuing rise in prices in the market. If the money supply was not increased, prices or wages pushed above their market-clearing levels could only result in unsold inventories and unemployment. In the 1950s, 1960s, and 1970s, Haberler argued that any problem of prolonged and high unemployment was caused by anticompetitive trade union practices that priced a portion of the work force out of the market through money wage demands set above what market employers considered labor to be worth.^[14]

Any prolonged price inflation had its origin in expansionary monetary policy. Government inflationary policies could temporarily reduce the unemployment generated by union wage demands only by creating enough money in the economy so that employers could afford to pay higher money wages. But this was only a short-run solution, since unions would then demand even higher money wages for their members to compensate for the lost purchasing power resulting from the higher prices caused by the monetary expansion. Equally counterproductive and harmful was the imposition of wage and price controls in 1971 by the Nixon administration, Haberler insisted. This not only failed to deal with the real source of the inflationary problem—the monetary policy of the Federal Reserve System—but it inevitably created more distortions and imbalances by preventing prices and wages from adjusting to changing conditions of supply and demand.^[15]

In the late 1970s there developed the strange phenomenon of both rising prices and rising unemployment, a mix of inflation and unemployment that seemed to defy the standard Keynesian ideas of the time. Haberler explained that “stagflation,” or an “inflationary recession,” was a frustrating but easily understood combination of events. Unions and other special-interest groups had become so used to inflation that they now demanded money wage and price increases in expectation of future price inflation. When the actual increasing rate of price inflation turned out to be less than expected, greater unemployment resulted because money wages had been pushed above even what the expanding money supply was able to validate. And Haberler was doubtful that even the most “rational” of expectations could ever assure that such mismatches did not occur.^[16]

In an analysis of what the best of economic policy worlds should be, Haberler said that the federal government should run a budget surplus and pay off the national debt so the funds could be rechanneled into productive, private-sector investment and capital formation; taxes should be significantly lowered to enhance work and investment incentives; monetary policy should be limited to a low, steady increase in the money supply equal to the annual average rise in real gross domestic product; and deregulation should be the order of the day, eliminating the various privileges, restrictions, protections, and subsidies that restrain or prevent an open, competitive market from more fully functioning. The same rules applied to the international economic order as well.^[17]

Opportunity Cost and International Trade

Gottfried Haberler’s other main contribution to economic theory and policy in the twentieth century was in the field of international trade and economic development. Beginning in the late nineteenth century, the Austrian economists, along with William Stanley Jevons and Leon Walras, had radically changed the foundations of economic theory by developing the theory of marginal utility in place of the labor theory of value championed by the classical economists from Adam Smith and David Ricardo to John Stuart Mill. But in the theory of international trade it was still common to demonstrate the benefits from the division of labor among nations on the basis of the labor theory of value. Comparing the relative costs in labor time for different countries to manufacture various goods showed the comparative advantage that different nations might have for specialization of production.

Haberler helped revolutionize the foundations of international trade theory by restating the theory of the international division of labor on the basis of the Austrian theory of opportunity cost. The relevant cost was not the labor time to produce something, but the alternative end that has to be forgone. Haberler demonstrated the logic of this principle by being the first to construct that simple diagram that is now found in every principles of economics textbook: the production possibilities frontier, which depicts the trade-offs that an economy faces between producing, say, one of two products. The members of that economy can produce either one of the goods or some combination of the two. The curve shows the additional amount of one good that can be obtained by forgoing a particular quantity of the other.

Haberler explained that even when one of two countries is absolutely more efficient in producing both goods, each country should still specialize in manufacturing and trading those commodities in which it has relatively greater efficiency. In developing and consistently applying this reformulated theory of the benefits of international specialization, he was able to prove the continuing superiority for a policy of free trade over protectionism or autarkic self-sufficiency.^[18]

In the years following World War II, Haberler argued forcefully against various forms of international trade restriction and protectionism, including artificial foreign exchange-rate regulations and manipulation, import and export quotas, and tariffs. While admitting that a number of hypothetical exceptions to the free trade doctrine can be formulated, in the real world both the theoretical and practical case for the greatest degree of international freedom of trade remains the benchmark for any serious economic policy discussion.^[19]

Finally, Haberler insisted that the underdeveloped countries of the “Third World” were moving in the wrong direction by turning to planning, controls, and protectionism in the name of economic development and growth. He reasoned forcefully that international trade would not create either permanent underindustrialized dependency on Western industrial nations or worsening terms of trade. Nor would government-induced domestic production either create real industrial efficiency or raise the standard of living of the people in those countries, in comparison to participation in the international division of labor. The best policy for all nations remains the freest exchange of goods and capital for economic improvement and rising living standards for the greatest number of participants in the global marketplace.^[20]

As Gottfried Haberler once ended one of his essays, “The conclusion is obvious. The task of freeing the market economy from as many of its fetters as possible, and of promoting free competition, is of paramount importance.”^[21] His long, productive professional life was a testament to this goal.

Notes

1. “The Proceedings of the Conference called by the Rockefeller Foundation to consider the Desirability and Feasibility of Encouraging Co-ordination of Fundamental Economic Research upon Problems of Economic Change,” Annecy, France, July 3-5, 1936 (anonymous, mimeographed), p. 14.
2. Gottfried von Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (Geneva: League of Nations, 1937, revised and enlarged editions, 1939, 1941, 1958).
3. Joseph A. Schumpeter, History of Economic Analysis (Oxford: Oxford University Press, 1954), p. 1123.
4. Paul A. Samuelson, “Gottfried Haberler as Economic Sage and Trade Theory Innovator,” Wirtschaftspolitische Blätter, No. 4 (1990), p. 310.
5. F. A. Hayek, The Pure Theory of Capital (London: Macmillan, 1941), p. 395.
6. See, “Between Mises and Keynes: An Interview with Gottfried von Haberler (1900-1995),” Austrian Economics Newsletter, Spring 2000; this previously unpublished interview was conducted in 1979 by Richard M. Ebeling and Joseph T. Salerno.
7. Gottfried Haberler, Der Sinn der Indexzahlen. Ein Unter-suchung über den Begriff des Presissniveaus und die Methoden seiner Müssung (Munich: J. C. B. Mohr, 1927); “Critical Notes on Schumpeter’s Theory of Money: The Doctrine of the ‘Objective’ Exchange Value of Money” [1925], in Anthony Y. C. Koo, ed., Selected Essays by Gottfried Haberler (Cambridge, Mass.: MIT Press, 1985), pp. 531-52; “A New Index Number and Its Meaning” [1928], in Anthony Y. C. Koo, ed., The Liberal Economic Order, Vol. II: Money Cycles and Related Themes by Gottfried Haberler (Brookfield, Vt.: Edward Elgar, 1993), pp. 107-17; and The Different Meanings Attached to the Term ‘Fluctuations in the Purchasing Power of Gold’ and the Best Instrument or Instruments for Measuring Such Fluctuations (Geneva: League of Nations, F/Gold/74, March 1931).
8. Haberler, “A New Index Number and Its Meaning,” pp. 113-15.
9. Gottfried Haberler, “Money and the Business Cycle,” in Quincy Wright, ed., Gold and Monetary Stabilization (Chicago: University of Chicago Press, 1932), pp. 43-74; reprinted in Koo, ed., The Liberal International Economic Order, Vol. II, pp. 160-74, and Richard M. Ebeling, ed., The Austrian Theory of the Trade Cycle and Other Essays (Auburn, Ala.: Ludwig von Mises Institute, 1996), pp. 37-64.
10. See, Richard M. Ebeling, “Wilhelm Röpke: A Centenary Appreciation,” The Freeman: Ideas on Liberty, October 1999, pp. 19-24.
11. Haberler, Prosperity and Depression (1941 edition), pp. 323-44. For his mature evaluation of the Great Depression and policy choices during the 1930s, see “The World Economy, Money, and the Great Depression, 1919-1939” [1976] and “The Great Depression of the 1930s—Can It Happen Again?” [1980], in Koo, ed., Selected Essays, pp. 363-427.
12. Gottfried Haberler, “The General Theory: Five Views,” in Seymour E. Harris, ed., The New Economics: Keynes’ Influence on Theory and Public Policy (New York: Alfred A. Knopf, 1947), pp. 161-80; and “The General Theory After Ten Years” (1946) and, “Sixteen Years Later” (1962) in Robert Lekachman, ed., Keynes’ General Theory: Reports of Three Decades (New York: St. Martin’s Press, 1964), pp. 269-296.
13. Haberler, Prosperity and Depression (1941 edition), pp. 242-44; 403—04; 498-503; and “The Pigou Effect Once More” [1952], in Koo, ed., Selected Essays, pp. 573-80. The positive effect from falling prices and money wages on the real value of cash balances as a method for restoring full employment became known in the economics profession as the “Pigou Effect,” after the Cambridge University economist Arthur C. Pigou, who developed the argument, but only several years after Haberler’s formulation in 1939. See Arthur C. Pigou, “The Classical Stationary State,” Economic Journal December 1943, pp. 343-51, and “Economic Progress in a Stable Environment,” Economica [1947], reprinted in Friedrich A. Lutz and Lloyd W. Mints, eds., Readings in Monetary Theory (New York: Blakiston, 1951), pp. 241-51.
14. Gottfried Haberler, “Wage Policy, Employment and Economic Stability,” in David McCord Wright, ed., The Impact of the Union (New York: Harcourt, Brace, 1951), pp. 34452; “Wage Policy and Inflation,” in Philip D. Bradley, ed., The Public Stake in Union Power (Charlottesville, Va.: University of Virginia Press, 1959), pp. 63-85; and, “Wage-Push Inflation Once More,” in Erich Streissler, Gottfried Haberler, Friedrich A. Lutz, and Fritz Machlup, eds., Roads to Freedom: Essays in Honour of Friedrich A. von Hayek (New York: Augustus M. Kelley, 1969), pp. 65-73.
15. Gottfried Haberler, Inflation: Its Causes and Cures (Washington, D.C.: American Enterprise Institute, 1961; revised and enlarged ed., 1966); Incomes Policies and Inflation: An Analysis of Basic Principles (Washington, D.C.: American Enterprise Institute, 1971); Incomes Policy and Inflation: Some Further Reflections (Washington, D.C.: American Enterprise Institute, 1972); “The Phenomenon of Worldwide Inflation,” in David I. Meiselman and Arthur B. Laffer, eds., The Phenomenon of Worldwide Inflation (Washington, D.C.: American Enterprise Institute, 1975), pp. 13-25; Some Currently Suggested Explanations and Cures for Inflation (Washington, D.C.: American Enterprise Institute, 1976).
16. Gottfried Haberler, “The Problem of Stagflation,” in William Fellner, ed., Contemporary Economic Problems (Washington, D.C.: American Enterprise Institute, 1976), reprinted in Koo, ed., Selected Essays by Gottfried Haberler, pp. 349-62; Stagflation: An Analysis of its Causes and Cures (Washington, D.C.: American Enterprise Institute, 1977); The Problem of Stagflation: Reflections on the Microfoundations of Macroeconomic Theory and Policy (Washington, D.C.: American Enterprise Institute, 1985); Notes on Rational and Irrational Expectations (Washington, D.C.: American Enterprise Institute, 1980); Koo, ed., Selected Essays, pp. 603-17.
17. Gottfried Haberler, Economic Growth and Stability: An Analysis of Economic Change and Policies (Los Angeles: Nash Publishing, 1974); The Challenge to the Free Market Economy (Washington, D.C.: American Enterprise Institute, 1976); and, “An Overview of Economic Policy: ‘A Positive Program for a Benevolent and Enlightened Dictator,’” [1985] in Richard J. Sweeney, Edward Tower, and Thomas D. Willett, eds., Judging Economic Policy: Selected Writings of Gottfried Haberler (Boulder, Colo.: West-view Press, 1997), pp. 21-43.
18. Gottfried Haberler, “The Theory of Comparative Costs and Its Use in the Defense of Free Trade” [1930], in Koo, ed., Selected Essays, pp. 3-19; The Theory of International Trade, with Its Applications to Commercial Policy (London: William Hodge, 1936 [1933]); A Survey of International Trade Theory (Princeton: Princeton University Press, 1961).
19. Gottfried Haberler, “The International Economic Order in Historical Perspective” [1979], in Anthony Y. C. Koo, ed., The Liberal Economic Order, Vol. I, Essays, on International Economics by Gottfried Haberler (Brookfield, Vt.: Edward Elgar, 1993), pp. 349-70, and several other essays in this volume.
20. Gottfried Haberler, “International Trade and Economic Development” [1959], “Terms of Trade and Economic Development” [1961], and “Integration and Growth of the World Economy in Historical Perspective” [1964], in Koo, ed., Selected Essays, pp. 453-527; “Liberal and Illiberal Development Policy” [1987] and “Liberal and Illiberal Trade Policy: The Messy World of the Second Best” [1988], in Koo, ed., The Liberal Economic Order, Vol. I, pp. 371-413; and “Trade and Development Policy,” in Sweeney, et al., Judging Economic Policy, pp. 173-227.
21. Haberler, The Challenge to the Free Market Economy, p. 18.

—Paul A. Samuelson^[1]

“Higher saving leads to faster growth . . .”

—N. Gregory Mankiw^[2]

The two quotations above dramatically demonstrate the stark contrast between the “old” Keynesians and the “new.” Samuelson and the old-style Keynesians start with the “general” theory of unemployment equilibrium and end with the classical model of full employment as a “special” case. As long as there are unemployed resources—which, according to the old Keynesians, is most of the time—thriftiness is bad and expansionary monetary and fiscal policy (i.e., inflation and deficit spending) are good. For 50 years, this “demand-management” model has been the standard approach in college economics.

The New Keynesian Revolution

Now along comes a new generation of economists, known as “new” Keynesians, who have wisely changed their way of thinking. In the most popular textbook on macroeconomics, author N. Gregory Mankiw reverses the standard Keynesian pedagogy. Mankiw, you may recall, is the young Harvard economist who was paid a $1.4 million advance last year to write the next “Samuelson” textbook. (See my column, The Freeman, October 1995.)

His mammoth advance was due, in part, to the success of his previous textbook on macroeconomics, last published in 1994. Macroeconomics may be a harbinger of what’s to come. In a brilliant move, he begins with the classical model and ends with the Keynesian model, just the opposite of Samuelson & Company. Mankiw states in the preface, “in the aftermath of the Keynesian revolution, too many economists forgot that classical economics provides the right answers to many fundamental questions.”

Under Mankiw’s long-run “general equilibrium” model, what are the effects of an increase in government spending? Crowding out of private capital. “The increase in government purchases must be met by an equal decrease in investment. . . . Government borrowing reduces national saving” (p. 62).

Economic growth is discussed up front, not at the end, as most textbooks do. Using the Solow growth model, Mankiw takes a strong pro-saving approach. He maintains that “the saving rate is a key determinant of the steady-state capital stock. If the saving rate is high, the economy will have a large capital stock and a high level of output. If the saving rate is low, the economy will have a small capital stock and a low level of output” (p. 86). What is the effect of higher savings? It’s positive. “An increase in the rate of saving raises growth until the economy reaches the new steady state,” although the law of diminishing returns suggests that “it will not maintain a high rate of growth forever” (p. 86). Mankiw writes favorably toward those nations with high rates of saving and capital investment, and even includes a case study on the miracles of Japanese and German growth (examples virtually ignored in Samuelson’s textbook). He supports efforts to increase the rate of saving and capital formation in the United States, including the possibility of altering Social Security from a pay-as-you-go system to a fully funded plan, though he does not discuss outright privatization (pp. 103-4).

The cause of unemployment? Relying on the “natural” rate of unemployment hypothesis, Mankiw suggests that unemployment insurance and similar labor legislation reduce incentives for the unemployed to find jobs (pp. 121-5). He provides evidence that unionizing labor and adopting minimum-wage laws increases the unemployment rate (pp. 127-30). He offers a case study on Henry Ford’s famous $5 workday as an example of wages determined by productivity.

He approvingly quotes Milton Friedman on monetary theory: “Inflation is always and everywhere a monetary phenomenon.” Mankiw uses numerous examples, including hyperinflation in Interwar Germany, to confirm the social costs of inflation (pp. 161-9).

Figure 13-5

Inverse Relationship between Taxes and Savings

Source: Edwin G. Dolan and David E. Lindsey, Economics (The Dryden Press, 1988, Perspective 11.1)

Sins of Omission

Not all is right with Mankiw, however. In Mankiw’s model, tax cuts have the same effect as deficit spending—by raising consumption, it “crowds out investment and raises the interest rate,” he says (p. 64). However, he fails to realize that tax cuts also stimulate savings, as the graph (below) from Dolan and Lindsey clearly demonstrates. Not all tax cuts will be spent on consumer goods.

Further more, Mankiw apparently assumes that government spending remains the same when tax cuts are put into effect, thus raising the deficit. He repeats the common historical error that the Reagan tax cuts enlarged the deficit, and thereby raised interest rates and lowered national savings. (p. 65) In fact, while marginal tax rates declined, tax revenues rose during every year of the Reagan presidency. Tax cuts didn’t cause expanding deficits, excessive federal spending did.

The second half of Mankiw’s textbook introduces all the standard tools of Keynesian modeling—aggregate supply (AS) and aggregate demand (AD), the multiplier and accelerator, and IS-LM model. The author presents real business cycle theory, wage rigidity, money neutrality and the Ricardian Equivalence Theorem, all in a bewildering effort to explain economic fluctuations “in the short run.” Although he includes a section on Robert Lucas, Jr., and the Rational Expectations School, he has virtually nothing to say about the supply-siders and the Austrians, a major omission. These two schools could have cleared up a lot of confusion about macroeconomic theory and policy.

Still, free-market economists should celebrate in knowing that the profession is slowly moving in the right direction— toward fundamentally sound economics.

That’s quite a feat for a man (Mankiw) who named his dog “Keynes.”

1.   Paul A. Samuelson and William D. Nordhaus, Economics, 15th ed. (New York: McGraw Hill, 1995), p. 357. Similar anti-saving statements have existed in all previous editions of Samuelson’s Economics.

2.   N. Gregory Mankiw, Macroeconomics, 2nd ed. (Worth Publishers, 1994), p. 86.

Source: Edwin G. Dolan and David E. Lindsey, Economics (The Dreyden Press, 1988, Perspective 11.1)

In the beginning was Say’s Law—supply creates demand. But that was the “old economics.” Now, glory be, we’re blessed with the “New Economics”—demand creates supply—thanks to the “new” dazzling 1936 paradigm of The General Theory of Employment, Interest and Money by John Maynard Keynes. Lord Keynes stood Say’s Law on its head, and so the business cycle has been mercifully repealed once and for all, of course.

Imagine, jobs for virtually everybody all the time. All central governments everywhere have to do is maintain “national income” at the level of “full employment.” No big deal. Fine-tuners merely have to apply Keynes’ equation (Y = C + I + G) and make sure macrodemand sustains adequate macrosupply through the magical “G” in the formula. G stands for government outlays, for economic—and political—paradise. So as Marx was a god in the nineteenth century, Keynes became a god in the twentieth.

Hazlitt devastates the “New Economics.” G, says Hazlitt in a backcast and forecast of persistent inflation and recurrent recessions, leads but to “a constant race between the money supply and the demands of the trade unions—but it does not lead to long-run full employment.”

Hazlitt warns the Keynesians against their forgetting that everybody’s income is somebody else’s cost, against their cavalier downplaying of excessive wage rates as a key cause of unemployment, against their temptation of deploying cheap money and deficit spending to even out the business cycle. But do the Keynesians and their friends in high places listen, even at this late date?

“The AS/AD model . . . is seriously flawed . . . a model of the worst type—a model that obscures, rather than clarifies.”^[1]

—David Colander

Finally, a major academic economist has repudiated the dangerously flawed macro model used in all standard textbooks—the so-called Aggregate Supply (AS) and Aggregate Demand (AD) curves. David Colander, well-respected economics professor and author, has written a devastating critique of AS-AD macroeconomics in the latest issue of the prestigious Journal of Economic Perspectives, an official journal of the American Economic Association. What is more remarkable is that he considers himself a Keynesian “and proud of it,” yet he is in the forefront of revamping the way economics is taught.^[2]

The teaching of macroeconomics needs a new approach on college campuses. A million and a half students study economics each year and they are receiving a heavy dose of bad economics, especially in the macro sections. The AS-AD model currently in vogue in virtually all textbooks^[3] is a fatally flawed assault on free-market economics. To understand why, see the standard diagram of AS-AD analysis at the top of the next page.

The Fatal Flaw in Macroeconomics

What’s wrong with this model of the economy? First, it is rooted in the Keynesian theory that the free market cannot guarantee full employment. The diagram illustrates how the economy can allegedly be stuck forever at a high level of unemployment and recession. Note that point E, where aggregate demand and supply meet, is at less than full employment. By implication, increased government spending (the Keynesian prescription) can stimulate economic activity and push the AD curve forward until full employment is achieved, where the AS curve is vertical.

However, most economists now recognize that this old-fashioned Keynesian view of stagnation is fallacious. The free market will always achieve full-employment equilibrium as long as wages and prices are flexible and the government doesn’t engage in perverse monetary/fiscal policies.

Another problem with the AS-AD model arises when the economy reaches the point of full employment (where the AS curve is vertical). The model suggests that further deficit spending or inflating the money supply will only drive up prices without affecting real output. Yet numerous studies of countries suffering from runaway inflation demonstrate that inflation causes real output to fall also.

These are just a few of the many problems with the AS-AD model.

Professor Colander doesn’t address any of the criticisms mentioned above, however. Instead, he focuses on the inner- contradictions in the AD and AS curves themselves. Essentially, Colander shows how AS-AD analysis is internally inconsistent because it relies on contradictory assumptions. The supply relationships packed into AD are at war with the supply relationships underlying AS. Moreover, the textbook model implies that supply and demand are totally independent of each other in the aggregate economy, a theory that contradicts all common sense.

So what to do? Many of Colander’s colleagues favor complete banishment. Reuven Brenner, an economist at McGill University, not only dismisses textbook macro as “pseudo-science” but considers astrology as its closest allied field!^[4]

Needed: A New Macro Model

Yet Colander is afraid to scrap AS-AD entirely, and opts to salvage the faulty model in his current textbook, not because he is academically dishonest, but because he doesn’t have a legitimate alternative. A bad theory won’t disappear until you have a good theory to replace it with.

The problem remains: What can replace the AS-AD model? Austrian economics comes to the rescue! The stages-of production model developed by Ludwig von Mises and Friedrich Hayek offers an excellent alternative. My own four-stage macro model provides a graphic representation of the whole economy. It incorporates the two most important variables in the aggregate economy—what Roger Garrison, economics professor at Auburn University, labels “time and money.”^[5] Professor Garrison and I are among those free-market economists attempting to develop the graphics of a new macroeconomic model. Stay tuned.

2. Professor Colander has been directly involved in two popular studies, The Making of an Economist, co-authored by Arjo Klamer (Westview Press, 1990), and Educating Economists, co-authored by Reuven Brenner (University of Michigan Press, 1992), both of which are damning critiques of the economics profession.

3. Paul Heyne’s Economic Way of Thinking (Macmillan, 1994, 7th edition) is the only exception, and it is regarded primarily as a micro text.

4. Reuven Brenner, “Macroeconomics: The Masks of Science and Myths of Good Policies,” Educating Economists, pp. 123-151.

5. Garrison has developed a fascinating graphical technique linking Keynesian and Austrian economics with a production- possibility curve. See Roger Garrison, “Linking the Keynesian Cross and the Production Possibilities Frontier,” Journal of Economic Education (Spring, 1995). For a full exposition of my 4-stage model, see my work, The Structure of Production (New York University Press, 1990), Part 2. This book also introduces an alternative form of aggregate supply and demand curves.

Once under way, inflation sets in motion powerful special interests which demand its continuance. For it benefits some groups of the population at the expense of all the rest. Inflation is a tax—the cruelest and most wanton of all taxes. Under it, all creditors are systematically swindled.

Cynical Defense

“He that would hang his dog,” says an old proverb, “gives out first that he is mad.” He that would swindle a creditor must first give him a bad name. The late Lord Keynes did this by calling him the “rentier.” He implied that the rentier was simply an idle plutocrat who lived on unearned interest at the expense of the struggling workers. In his General Theory (page 376), Keynes spoke of “the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest today rewards no genuine sacrifice.”

But who in the modern world are the creditors, the “rentiers”? They include, in addition to the holders of mortgages and corporate bonds, the thrifty, the small people who put their money in savings deposits or life-insurance policies, and all the owners of government bonds, who were induced to take these bonds for patriotic reasons. And who are the debtors who are being relieved of the allegedly dreadful burden of having to pay interest and repay capital in currency units of the same value as those they borrowed? They include the big corporations, the big holders of common stocks, and the speculators who have learned how and when to jump in and out and exploit the value of a depreciating currency.

I append a table compiled by Franz Pick for his forthcoming 1956 edition of Pick’s Currency Yearbook. This shows the depreciation of 53 currencies in the ten years from 1946 to 1955, as measured by each government’s owncost-of-living index. This table, it will be noted, shows that the U. S. dollar, the world’s monetary pivot, shrank 27 per cent in buying power over the past decade. The British pound sterling lost 35 per cent; the French franc 66 per cent. The currency units of Chile, Paraguay, Bolivia, and Korea had their purchasing power practically wiped out.

Currency Units

Loss of purchasing power (percent), 1956-55

Portuguese       0
Dominican       2
Egyptian       2
Haitian       3
Indian       10
Pakistan       10
Ceylon       11
Lebanese       16
Belgian       19
Swiss       19
German       22
Honduran       24
Irish       24
Italian       24
Guatemalan       25
Costa Rican       27
Danish       27
Ecuadoran       27
U. S.       27
Canadian       28
Netherlands       29
Norwegian       29
Iranian       30
Venezuelan       30
S. African       31
Spanish       31
Swedish       31
 El Salvador       32
Turkish       32
Hong Kong       33
Thailand       33
Malayan       34
New Zealand       34
British       35
Colombian       46
Uruguayan       46
Iceland       48
Mexican       48
Nicaraguan       49
Australian       50
Finnish       52
Austrian       54
Peruvian       59
Brazilian       60
Greek       61
French       66
Japanese       67
Israel       68
Indonesian       69
New Taiwan       85
Chilean       91
Paraguayan       91
Bolivian       95
Korean       99

      Some of the countries whose currencies suffered worst, such as Formosa and Korea, were struggling with special war or defense problems. But this was obviously not true in Chile, Paraguay, or Bolivia. The truth is that this shocking swindle by governments of their own citizens was brought about in most cases by deliberate monetary or credit inflation. And it was all done under the pious calamity visited on a country by calamity visited on a country by malevolent outside forces, which the politicians and monetary managers profess to be incessantly combating. []

Newsweek, June 25, 1956

As money is the sinews of every business, the introducing of a doubtful medium—and forcing it into currency by penal laws—must weaken and lessen every branch of business in proportion to the diminution of inducement found in the money.

Pelatiah Webster, Strictures on Tender Acts, 1780