Editor’s Note: This column first appeared in September 2010.

One of F. A. Hayek’s most accurate, and oft-repeated, lines about John Maynard Keynes comes from a review of Keynes’s 1930 book, A Treatise on Money.  Hayek wrote: “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.”  That Austrian macroeconomics rests firmly on the microeconomic “mechanisms of change” that ultimately comprise economic activity remains a crucial reason why that insight can better explain both the mistakes of the boom and the way out of the bust.

The Austrian insight is relevant to both capital and labor.  In standard Keynesian models (as well as most other macroeconomic models), capital is understood as an undifferentiated mass.  The Keynesian model also assumes that interest rates do not equilibrate the supply of savings and the demand for investment funds.  Thus when people save more, there’s no signal transmitted to investors that they should build more for the future.  As a result, the decline in consumption that accompanies the increase in savings causes firms to invest lessas their inventories pile up without any offsetting increase in investment elsewhere due to the lower interest rate.

In the Austrian view investment cannot be treated at this high a level of aggregation.  The production process that leads to consumption goods comprises a number of stages, starting with the “early” stages of research and development and raw materials, and finishing with the “later” stages, such as wholesaling or inventory management, which are closer to the final consumer purchase.  Looking at the structure of production this way enables Austrians to note that when saving increases and causes interest rates to fall, resources will indeed be drawn away from the late-stage investments in inventory, but they will be drawn toward investment in early stages of production, as the interest lower rate makes longer-term production processes involving more stages relatively less costly.  Over time, savings promotes those longer-term processes, which are more productive and provide us the capital base for economic growth.

By disaggregating investment, the Austrian model also reminds us that different kinds of  capital goods have to “fit together” to be productive.  This is most clear when central banks try to inflate to generate growth.  In this case, the lower interest rates produced by excess money lead to increased investment in those same early stages.  However, unlike the first story, where that increased investment is financed by reduced investment in the later stages, inflation also increases consumption as the lower interest rate reduces savings.  The credit expansion creates no new resources but leads to more investment at both the very late and very early stages of production. This is the boom of the business cycle.

However, like a railroad being built, misaligned, from two directions, the plans of both sets of investors are unsustainable and the capital projects are left unfinished.  We have a recession.

Labor Too

All that is true of capital here is also true of labor.  Most Keynesian models also treat labor as an undifferentiated aggregate, speaking of “the” labor market and “the” wage rate.  Once we look at the microeconomic processes underlying the structure of production, we see that each of these stages has its own labor market.  Thus when resources move from one stage to another, the demand for labor will shift also, leading to changes in each wage rate.  Growing sectors will attract labor, and shrinking ones lose it.

During an inflation-generated boom, labor, like capital, is misallocated across stages.  And when the boom turns to bust, workers will lose their jobs as the projects they were working on are abandoned.  Unemployment results as we enter the recession.  However, that unemployment, like the misallocation of capital, will not be evenly distributed across the economy.  To see the real costs of inflation-generated business cycles, we need to get behind the aggregates to see the fundamental mechanisms of change.

Being too focused on Keynes’s aggregates can also mislead us as to the best ways to get out of the recession once we’re in it.  It may look as if all we need more is investment or more jobs. But once we understand that the “fundamental mechanisms of change” have to do with the boom’s microeconomic misallocation of capital and labor, we see that what is needed is a reallocation of resources not just more of them.  Capital needs to move out of unproductive lines and back toward productive ones, and the same is true of labor.

Stimulus spending, bailouts, and extension of unemployment benefits only prevent the fundamental mechanisms of change from doing their work in unwinding the errors of the last decade.  The cure for macroeconomic discoordination is freeing up the entrepreneurial market process to reallocate and coordinate resources.  But 80 years after Hayek first made the point, the fascination by economists and politicians with Keynes’s aggregates continues to conceal the fundamental mechanisms of change, and in so doing, also continues to block the processes through which a sustainable recovery can take place.

Economics and business reporter David Warsh is getting much attention for suggesting that F. A. Hayek, far from being one of the two most prominent economists of the 1930s – the other being Keynes – is rather more like the woman who was thought to have won the Boston marathon in 1980 when in fact she had joined the race, mostly unnoticed, a half-mile from the finish line.

Hayek’s fans “have jumped a caricature out of the bushes late in the day and claim that their guy ran a great race,” Warsh writes. “. . . But the fact remains that Hayek just didn’t contribute very much to the development of technical economics,” he continues.

Warsh, whom we may judge by the fact that he calls The Road to Serfdom “an embarrassment,” nonetheless does have some positive things to say about the 1974 Nobel Prize laureate: “With the publication of ‘The Use of Knowledge in Society’ in the American Economic Review in 1945, he essentially won on the ‘calculation debate,’ conducted with Ludwig von Mises and Oscar Lange, concerning the possibility of central planning.”

Considering how many respectable economists favored central planning – essentially the abolition of spontaneous competitive markets — until fairly recently, that would seem to be no mean feat. And there’s more:

[I]t is pleasing to think that Hayek himself may yet turn out to have been a very great economist after all, far more significant than [Gunnar] Myrdal or [Joan] Robinson, when seen against the background of a broader canvas.  The proposition that markets are fundamentally evolutionary mechanisms runs through Hayek’s work. [Bruce] Caldwell, of Duke University, notes that, starting with the Constitution of Liberty, “the twin ideas of evolution and spontaneous order” become prominent, especially the idea of cultural evolution, with its emphasis on rules, norms, and decentralization.

These are today lively concepts in laboratories and universities around the world. ‘It could have been that Hayek was running a different race, and the fact that he didn’t do well in the [mainstream] Walrasian race was that he wasn’t running in it — he was running in the complexity race,’ says David Colander, of Middlebury College. Hayek may yet enter history as a prophet of evolutionary economics, a discipline dreamt of since the days of Thorstein Veblen and Alfred Marshall in the late nineteenth century but not yet forged, whose great days lie ahead. [Emphasis added.]

In other words, maybe Hayek’s critics judge him by an inappropriate standard. We’ll get back to this.

Krugman Pile-on

As Jacob T. Levy surmises, not everyone eager to dismiss Hayek as a lightweight read Warsh’s post to the end. Take Paul Krugman, ever ready to trash anyone who doubts that Keynes was the fount of all wisdom:

David Warsh finally says what someone needed to say: Friedrich Hayek is not an important figure in the history of macroeconomics.

These days, you constantly see articles that make it seem as if there was a great debate in the 1930s between Keynes and Hayek, and that this debate has continued through the generations. As Warsh says, nothing like this happened. Hayek essentially made a fool of himself early in the Great Depression, and his ideas vanished from the professional discussion. . . .

[T]he Hayek thing is almost entirely about politics rather than economics. Without The Road To Serfdom — and the way that book was used by vested interests to oppose the welfare state — nobody would be talking about his business cycle ideas.

Hayekians Strike Back

The Hayekian wing of the blogosphere (which really has nothing to do with the right wing) has responded in force, and properly so. A common theme is that Hayek furnished the grounds for a proper skepticism about macroeconomics, the branch of economics launched by Keynes that treats large statistical aggregates (demand, unemployment, and so on) as though  they were concrete entities that interact with each according to fixed quantitative rules rather than historical “summations” of individual purposeful actions in a particular institutional context. As Hayek wrote,  “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” (See Steven Horwitz’s “Mr. Keynes’s Aggregates.”)

George Mason University professor (and FEE trustee) Peter Boettke at Coordination Problem wrote:

Hayek’s influence in modern economics is ubiquitous, even if sadly modern economics is not as Hayekian as I would like it to be.  Information economics, theories of dynamic competition, equilibrium theory of the business cycle, and complexity theory all owe a debt to Hayek’s economic contributions.  The work on legal origins owes a debt to Hayek’s work on law and political-social philosophy as well.  Hayek impacts the DNA of economics and political economy to such an extent that many are unaware of the pervasive influence. . . .

The final problem I have with both Krugman and Warsh is that they don’t actually consult the historical record and the accounts of those who were there in the 1930s when the battle was engaged or the direct citation evidence from post-WWII thinkers. . . . Instead they rely on impressionistic accounts from their education and discourse communities, and cherry pick from recent journalistic histories of economics.

Back with a Vengeance

And there’s this from GMU professor Alex Tabarrok at Marginal Revolution:

It is true that many of Hayek’s specific ideas about business cycles vanished from the mainstream discussion under the Keynesian juggernaut but what Krugman and Warsh miss is that Hayek’s vision of how to think about macroeconomics came back with a vengeance in the 1970s. . . .

Hayek was an important inspiration in the modern program to build macroeconomics on microfoundations.

Tabarrok notes that “in an interesting exercise David Skarbek finds that Hayek is cited by other Nobel laureates in their Nobel talks more than any other Nobel laureate with the exception of [Kenneth] Arrow.”

GMU’s Russ Roberts responded this way at Café Hayek:

Was Hayek an important macroeconomist? I would argue that the macroeconomic skepticism of the later Hayek is more valuable than the macroeconomic theorizing of the early Hayek. But he wasn’t an important macroeconomist in the mainstream sense of the title. So what? That’s a badge of honor. He was merely a great economist, without any prefix.

Rejecting the Rules

There are others, but I will close with a post from New York University’s Mario Rizzo at ThinkMarkets, one of the most perceptive people I know. Remember the remark above that “It could have been that Hayek was running a different race”? That’s Rizzo’s take.

I think the real issue is this. Hayek’s approach attacks, root-and-branch, the macroeconomic way of thinking. It is not simply a challenge to a particular theory of the determinants of mass unemployment, inflation, business cycles and the like. Hayek is not accepting the rules of the game or the parameters of the sub-discipline of modern macroeconomics. . . .

In short, he does not want to focus on aggregate spending and aggregate consequences. Hayek’s approach says: Let us pierce the veil of aggregates and look at the distortive effects on relative prices and relative output produced by boom-time credit expansions. Let us look at the distortive effects that booms leave us as we work our way through a recession. . . .

Suffice it to say this greatly erodes the intellectual capital of a field of economics – although one not noted for its successes. It mocks the claim that Keynes was a true revolutionary in economic thought. It opens the possibility that he was muddled, inconsistent and unaware of the contributions to monetary and business cycle theory made by the “classical economists” on the eve of the General Theory.

(By cutting out many details, I have not done these blog posts justice. Follow the links for the particulars.)

Hayek was important politically for demonstrating the practical social necessity of individual freedom. But he is just as important for what he taught us about markets: namely, that they provide the only way for human beings to overcome their individual deficiencies in knowledge, which would otherwise keep them from flourishing through social cooperation and the division of labor.

A recent contribution to this genre is Kenneth R. Hoover’s Economics as Ideology. A political science professor at Western Washington University, Hoover wants to find out what made Harold Laski a socialist, F. A. Hayek a proponent of free-market liberalism, and John Maynard Keynes, well, a Keynesian.

Laski was one of the most prominent and influential advocates of socialism in Great Britain in the decades from World War I to the early 1950s. His writings and political activities helped move his country in the direction of central planning and the welfare state. Hoover concludes that Laski’s ideology and politics were driven by a falling out with his businessman father and the Orthodox Judaism of his family. His whole life was supposedly a revolt against the chains and apparent social insensitivity of religious and cultural conservatism.

Keynes was the product of a British intellectual elite and a generation at the beginning of the twentieth century that was determined to break free of Victorian morality. A focus on the pleasures of the moment and a probabilistic theory of uncertainty concerning the future resulted in Keynes discounting many of the long-run consequences from short-run policies. In Hoover’s account, his homosexual adventures as a young man and his failure to father children after he married also made him think a lot less about the future impact of present policies.

Hayek, on the other hand, resented the rules and regulations that come with greater government control of social and economic affairs because of a bad marriage he entered into when he was a young man and a difficult divorce immediately after World War II. Untangling himself from an unwanted marriage, according to Hoover, supposedly is the key to understanding Hayek’s desire for a society with fewer restraints on the choices of individuals.

The difficulty with taking all such psycho-ideological analyses seriously is that they can be used to explain almost anything, and therefore explain nothing. There have been Jews who renounced their religious and cultural ancestry and became classical liberals. There have been free-spirited homosexuals who became social and political conservatives. And there have been people trapped in bad marriages and difficult divorces who became radical socialists.

An equally crucial weakness in Hoover’s book is his failure to come to grips with many of the important issues and arguments that separated these three protagonists in the decades between the two world wars. He gives the clearest analysis when critically evaluating Laski. He shows that Laski could not reconcile a desire for participatory democracy and greater human freedom with his ideal of economic planning. Hoover points out that as the years went by, the argument for centralized government control increasingly replaced Laski’s defense of personal liberty. And he explains that Laski never attempted to seriously grapple with the practical difficulties of centrally planning the production and consumption activities of tens of millions of people.

But in many ways Hoover’s discussion of Laski is a sideshow to his central purpose: to argue that Keynes and his political-economic views represented the level-headed and moderate course that was relevant in the 1920s and 1930s, and is still important and relevant today. In making this case, Hayek becomes a foil, the extreme “right-wing” opponent of reasonable government action, blinded by a near-irrational hatred of political power applied for good social purposes.

Through all the details of Keynes’s and Hayek’s personal lives and academic activities in the period between the wars, Hoover devotes practically no time to an exposition of their competing theories of what caused the Great Depression or how to get out of it. Hayek is merely portrayed as the advocate of “do-nothingism” in an epoch of massive unemployment, while Keynes was designing practical policies to save society from want and waste.

The shallowness of Hoover’s understanding comes out most clearly in his discussion of Hayek’s critique of socialist planning. Hayek argued that the division of knowledge that inevitably accompanies the division of labor precludes any group of central planners from being able to integrate all the information required for central planning to succeed. Only the system of competitively generated market prices can coordinate the activities of multitudes of interdependent human beings.

Without any detailed discussion of the types and qualities of the knowledge used in a market society (which Hayek spent a good deal of time explaining in many of his writings), Hoover merely asserts that he sees no reason for thinking that most if not all such knowledge and information could not be absorbed and used by intelligent regulators and planners. And he conveys an unbelievably naïve conception of democracy as a forum for inclusive social participation, which suggests a total unawareness of the Public Choice literature about the actual special-interest-group workings of the political process.

In a nutshell, Hoover’s book is another rear-guard action by one who wishes to rationalize the continuation of the interventionist-welfare state and the presumed ability of an intellectual elite to guide the economic affairs of others—all for their own good, of course.

Despite the widespread acceptance of this narrative, there are many reasons to question whether it accurately portrays the motivations and hopes of some Progressive-Era reformers. In a 2005 article in the Journal of Economic Perspectives, “Eugenics and Economics in the Progressive Era,” the economist Thomas C. Leonard offered a completely new historical account of the sources of Progressive-Era labor legislation and the intentions of its supporters. Leonard’s work, including an important 2009 article coauthored with legal scholar David E. Bernstein for Law and Contemporary Problems, “Excluding Unfit Workers: Social Control Versus Social Justice in the Age of Economic Reform,” indicates that lurking behind what many people see as humanitarian reforms was something much uglier.

Leonard and Bernstein argue that some of the most prominent of the Progressive reformers were “partisans of human inequality.” They supported interventions as ways to forward their eugenic goal of a purer (that is, whiter) human race by eliminating the opportunities for the “unfit” to get meaningful work. The “unfit” here included not just nonwhites (especially African-Americans) but also the “insane,” immigrants (especially from central and eastern Europe), and in a somewhat different way, women.

In other words, what we today think of as the unintended consequences of laws supported by today’s well-meaning but economically uninformed Progressives were actually the intended goals of some of their intellectual ancestors a century ago. Early Progressive economists understood the effects of these interventions, but they thought those effects were desirable.

The Progressive economists of the late nineteenth and early twentieth centuries saw social science not merely as a means of inquiry and understanding but as a guide to social management and control. The advent and broad acceptance of Darwinism in the late nineteenth century, combined with a more general belief in the power of science and scientific management to solve social problems, led to a fascination with eugenics and the possibility of using public policy to ensure the “survival of the fittest” and the purity and strength of the human race. In the hands of many thinkers at the turn of the twentieth century, Darwinian theory became a rationale for using the power of government to weed out the “undesirable” and “unfit” in much the way that the new understanding of evolution was changing agriculture and animal husbandry. Eugenics clubs and societies grew rapidly and many of the leading intellectuals of the early twentieth century, including a number of well-known economists (such as John Maynard Keynes and Irving Fisher, perhaps the most famous American economist of the time), were active in these groups and saw their work through the lens of eugenics.

Eugenics and Intended Consequences

We look back on the eugenics movement with proper horror. Yet the same ideas that led to forced sterilization also led to restrictions in the workplace, because labor markets were one place where eugenics-oriented economists could combine their two interests. They recognized early on that legislation which  excluded the “unfit” from labor markets would advance their eugenic goals. Most of these laws were enacted at the state level during this period, but the New Deal era saw many of the same arguments applied at the national level.

Consider minimum wage laws, for example. Today we tend to think people support them because they believe a minimum wage is a free lunch that will help the poor. Classical-liberal economists have long criticized such regulations, arguing they are a perfect example of the law of unintended consequences and of the disconnect between intentions and outcomes. In a competitive labor market any worker who can produce value is hirable at some wage up to that value. Even workers with limited skills are employable. What the minimum wage and other mandated benefit laws do is create a minimum productivity criterion for hiring, closing off the labor market to workers whose productivity is too low to justify that cost.

Leonard’s work shows that some advocates of the minimum wage, including many giants of the early days of the economics profession, such as John R. Commons and Richard T. Ely, understood exactly what minimum wage laws would do and liked it. In addition, various Progressives and socialists who were not economists, such as Eugene Debs and Beatrice and Sidney Webb, also supported minimum wage laws and other interventions into the labor market precisely because they would weed out those who were deemed too stupid or lazy to compete in a market economy—in particular, women, immigrants, and blacks.

Leonard writes, “the progressive economists . . . believed that the job loss induced by minimum wages was a social benefit, as it performed the eugenic service ridding the labor force of the ‘unemployable.’” He quotes the Webbs’ statement that “this unemployment is not a mark of social disease, but actually of social health.” Further, he quotes Henry Rogers Seager of Columbia University, who suggested that minimum wages were necessary to protect workers from the “wearing competition of the casual worker and the drifter.”

A. B. Wolfe, who would one day be a president of the American Economic Association, wrote in the American Economic Review in 1917 (quoted in part by Leonard and Bernstein): “If the inefficient entrepreneurs would be eliminated [by minimum wages,] so would the ineffective workers. I am not disposed to waste much sympathy upon either class. The elimination of the inefficient is in line with our traditional emphasis on free competition, and also with the spirit and trend of modern social economics. There is no panacea that can ‘save’ the incompetents except at the expense of the normal people. They are a burden on society and on the producers wherever they are.”

In the context of the early twentieth century this group largely included nonwhites, immigrants, and women, as well as white males with physical or mental disabilities—the very same groups the Progressive eugenicists thought were diluting the quality of the human gene pool. Unlike their modern successors, these supporters of minimum wage laws were under no illusion about the effects of their proposed policies; they understood and intended the negative consequences that economists now go to great lengths to argue will be the outcomes of the policies favored by contemporary Progressives. A great irony of the Progressive movement for a minimum wage is that while it aimed at eliminating the “unemployable,” it in fact created a group of “unemployables.”

Leonard’s research shows that even professional economists, including some for whom distinguished prizes and lectures are named today, engaged in a manner of thinking about issues like minimum wages that was profoundly—even obscenely, given their explicitly racist goals—anti-economic. According to some Progressives, wages were determined not by marginal productivity but by the living standards to which a particular worker was accustomed. Competition from women, children, and members of “low-wage races” threatened the dignity of white male heads of households, the robustness of the white genetic stock, and ultimately the social fabric. Leonard and Bernstein quote sociologist Edward A. Ross, who wrote that “the coolie, though he cannot outdo the American, can underlive him.” If society was to endure, white male breadwinners needed protection from outside competition.

Economists today sometimes argue that subsidies or expansion of negative income tax programs like the earned income tax credit are far more efficient ways to help the poor than policies like minimum wages. Leonard and Bernstein point out that according to Progressive economist Royal Meeker, wage subsidies were undesirable precisely because they would create more employment, particularly among “unfortunates.” The virtue of the minimum wage was that it increased the supposed dignity of white labor while separating “unfortunates” and “defectives” from jobs they would have otherwise had. Minimum wages were supported by explicit racists seeking explicitly racist ends.

Fast-forward a few decades and the results are still the same even if the intentions are more noble. In a recent paper, “Unequal Harm: Racial Disparities in the Employment Consequences of Minimum Wage Increases,” William Even and David Macpherson argued that in states fully exposed to the most recent minimum wage increases, the law cost young African Americans more jobs than the recession has. We should judge policies by results, not intentions. As the economist Thomas Sowell might say, whether a policy is deemed “compassionate” or not should depend on its effects rather than the stated goals of its advocates.

Other Labor Market Interventions

Eugenics provided an allegedly scientific pretext for protectionist legislation—specifically, restrictions on immigration. The eugenicists supported immigration restrictions because they believed that members of “low-wage races” would compromise not only whites’ living standards but also whites’ genetic stock through miscegenation. According to them, immigrants and other outsiders (read: African-Americans) would degrade the labor force and debauch the species. The Progressives proceeded on a model of society in which a (white male) breadwinner earned a “family wage” sufficient to support a (white) wife and (white) children. Women were to fulfill their roles as “mothers of the race,” and children were to be trained to do the same in the following generation.

In his 2005 article Leonard pointed out that restrictions on child labor were enacted specifically to prevent the lower classes from putting their children to work. Presumably this would then cause them to think twice about procreating as well as limit their incomes.

The Progressives used the same techniques to reduce the labor market opportunities of women. Women were seen both as fragile—in need of protection from the rigors of the workplace—and as having a special role in bearing children and managing the household as “mothers of the race.” This was in contrast to the perceived “overbreeding” of nonwhites and immigrants from places like eastern and southern Europe. Progressive reformers tried to keep women out of the labor force by enacting a variety of “protective” legislation at the state level, including maximum hours and minimum wage laws for women, both of which were set differently from those for men. Such laws made women less desirable and more expensive employees, which limited their labor force participation—precisely the goal of the reformers.

The perils of the 1930s provided an opening for additional burdens on the labor market designed to exclude “unfit” workers. Leonard and Bernstein report that the Davis-Bacon Act, for example, was “passed with the intent of preventing itinerant African American workers and others from competing with white labor unionists for jobs on federal construction projects.” The amplification of interest-group politics was evident in the relatively transparent attempts by New Deal Progressives to protect special interests from low-wage competition from the South—from African-Americans and other “low-wage races.”

In the 1930s U.S. Rep. John Cochran (D-Mo.) said he had “received numerous complaints in recent months about southern contractors employing low-paid colored mechanics getting work and bringing the employees from the South.” Rep. Clayton Allgood (D-Al.) joined in: “Reference has been made to a contractor from Alabama who went to New York with bootleg labor. This is a fact. That contractor has cheap colored labor that he transports, and he puts them in cabins, and it is labor of that sort that is in competition with white labor throughout the country.”

The disemployment effects, for example, of the National Industrial Recovery Act (NIRA) were stark. Leonard and Bernstein cite one estimate that the NIRA’s “wage provisions directly or indirectly led to the dismissal of 500,000 African American workers.” They also write that “the American Federation of Labor took credit for the failure of the FLSA [Fair Labor Standards Act] to provide for a lower minimum wage in the South,” preventing southward capital flows.

The Progressives, the Modern Left, and the Dismal Science

This history can be read as the American version of what happened earlier in England. David Levy has shown that economics became known as the “dismal science” because classical-liberal economists (such as J. S. Mill) favored racial equality in a free labor market. Reactionary, elitist British Romantics such as Thomas Carlyle and John Ruskin argued that the free market, with its underlying assumption of equality, would eliminate racial hierarchies and bring a “dismal” future of racial mixing. It was the classical-liberal economists who were providing the intellectual support for that future.

The moral of the story is that, despite the modern left’s continued claim that the pro-market philosophy is racist, sexist, and xenophobic, history demonstrates that classical liberals/libertarians were proponents of equality and opponents of racism, and that those who viewed the races as unequal were likely to seek backing from the State, particularly in labor markets. The historical record of the left on these counts is much more mixed than it is willing to acknowledge.

Despite their odious views on race and the use of the State to enforce their eugenically informed vision of the future, Progressive-Era reformers were ahead of their modern liberal counterparts in one important way. They understood that free markets, especially free labor markets, are the enemy of racism.

In response to questions by U.S. Senator Jack Reed (D-RI), Bernanke joined in the chorus of those predicting skyrocketing interest rates in the United States and abroad if the federal government defaulted on its debt obligations because Congress did not raise the debt ceiling. It was not a given that the federal government would have defaulted if the ceiling had not been raised. But ignoring that fact, Bernanke argued that the “loss of investor confidence [following default] could potentially raise interest rates quite significantly. . . . But if interest rates rise, that’s clearly going to reduce investment, uncertainty will rise, that will reduce the abilityness [sic] of firms to hire and invest. . . . So I can only conclude that this would be very bad for—for jobs.”

Did the person supposedly in charge of determining interest rates in the United States through Federal Reserve credit creation really say that? What was the rationale for QE1 and QE2 (quantitative easing) if not to lower interest rates and promote economic prosperity? And who inspired that mistaken thinking? John Maynard Keynes, of course.

Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or lendable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall had explained. Therefore, in Keynes’s view, it is the responsibility of a central bank to increase its supply of money enough to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments. That is, money should become so plentiful that no one would be obliged to pay interest to borrow it. (Of course, Keynes here confuses money with savings or wealth.)

The money (cash) supply-and-demand theory of interest rates was the predominant view among Mercantilist thinkers from the sixteenth to eighteenth centuries. It was to correct that mistaken view that Hume, in his essay “Of Interest,” explained that although interest rates may be influenced temporarily by the abundance or scarcity of money, they are permanently determined by the flow of savings relative to their demand:

High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce [hence the desirability of demanding more loans]: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver [money]. Low interest, on the other hand, proceeds from the opposite circumstances: A small demand for borrowing; great riches to supply that demand; and small profits arising from commerce: And these circumstances are all connected together, and proceed from the increase of industry and commerce, not of gold and silver.

Hume’s elaboration on that point was the basis of subsequent classical writers’ explanation of interest-rate determination by the supply and demand for savings. Keynes, on the other hand, denied all such explanation and declared in his 1939 preface to the French edition of the General Theory that, in arguing that interest rates rather are determined by “the demand and the supply of money, that is to say [by] the demand for liquidity and the means of satisfying this demand [he is] returning to the doctrine of the older, pre-nineteenth century economists. Montesquieu, for example, saw this truth with considerable clarity—Montesquieu who was the real French equivalent of Adam Smith, the greatest of your [French] economists, head and shoulders above the Physiocrats in penetration, clear-headedness and good sense (which are the qualities an economist should have).”

Has Bernanke now abandoned his adherence to Keynes’s money, or liquidity supply-and-demand, theory of interest rates, or was he merely participating in the debt-default scare to further the federal government’s agenda of raising the debt ceiling to accommodate its profligate spending?

After all, Bernanke also acknowledged to Senator Reed that besides the Chinese, the Fed is “the largest holder of our Treasury debt.” Why wouldn’t the Fed simply cancel the Treasury’s debt and purchase some more to save the federal government from its predicted default? To support the political-posturing view of Bernanke’s statements, one could legitimately cite his similar proclamations in fall 2008 that without the Troubled Asset Relief Program (TARP), giving the Treasury secretary $700 billion to purchase “toxic assets” mainly from investment banks, businesses could not meet their payrolls. The claim wasn’t true. Businesses borrow from commercial banks, not investment banks, to meet payroll. And commercial banks rely mainly on the public’s deposits to lend to businesses. The public would not have stopped making deposits with banks had TARP not passed. Besides, then-Treasury Secretary Hank Paulson didn’t initially use the money for the bill’s stated purposes. But the scare worked to push Congress to vote for the legislation.

More likely Bernanke simply employed the common-sense view of interest-rate determination through the supply and demand for financial assets (interest rates thus being inversely related to the price of financial assets), which is the classical economics view, in contradiction to Keynes, but without consciously intending to be anti-Keynes. Buyers of such assets (IOUs) are the savers while sellers of financial assets are the borrowers. Clearly, many U.S. Treasury bond holders would be inclined to sell them should a default occur. Such selling would reduce their price and thus raise their yield (interest). Therein lies the contradiction of Keynes and the affirmation of the classical principle he denied—namely, that the supply and demand for savings are the principal or permanent determinants of interest rates. Bernanke couldn’t deny the obvious, even as he exaggerated the consequences of a government default.

So what if the U.S. defaulted on its debt obligations and the yield on its debt rose? Must all interest rates rise as a result of the nonzero default risk on Treasuries? Not necessarily. There would simply be a narrowing of the risk premium between U.S. government bonds and other private-sector securities. Treasury securities would lose their default-risk advantage over other securities but retain their liquidity-risk advantage, given the Federal Reserve’s readiness, hence commercial banks’ readiness, to redeem Treasury securities on sight. There is no reason that the default risk of the bonds and stocks of such corporations as Apple, Microsoft, Google, or Walmart should rise just because that of the U.S. government has risen. Thus the yield on private securities may decline (as investors flee Treasuries) while that on U.S. government securities rises, leaving the average unchanged.

Savers are constantly looking for instruments (financial assets) through which they can earn returns on their savings. There may be some diversion of savings into gold, driving up its price further. But investors in gold also know that, like all other commodities, the bubble created by current fears about Treasuries will also burst in due course. Thus the predicted skyrocketing of worldwide interest rates from a possible U.S. government debt default was an exaggeration. If interest rates rise it will be the result of a contraction in the rate of savings worldwide.

Besides, high interest rates, as Hume explained in his 1752 essay, are not necessarily injurious to a high rate of economic growth. It is high interest rates resulting from a contraction in savings that reduce economic growth. One easily can verify this from the level of interest rates in the United States during the economic boom from 2003 to the fall of 2008. The yield on a one-month Treasury rose steadily from 0.91 percent in May 2004 to 5.16 percent in June 2006 while the unemployment rate declined from 5.6 to 4.6 percent. On the other hand, the one-month rate stood at 0.02 percent in June 2011 because of the Fed’s massive injection of credit while the economy has continued to be mired in anemic growth and the unemployment rate has risen to over 9 percent.

Raising taxes to balance the federal budget would not necessarily lower interest rates. Rather, higher taxes would reduce disposable income and thus the flow of savings. The high level of government spending—financed either by debt or high taxes—would put pressure on interest rates to rise. It also would divert more savings from private-sector investments that would otherwise promote sustained employment and economic growth. These are the insights of classical macroeconomics that Keynes failed to appreciate and his modern followers continue to miss.

Current low U.S. interest rates are unsustainable. They are going to rise with or without an increase in the federal government’s debt ceiling. Savers will not forever endure the current negative real interest rates. Cutting federal spending is the surer path to resumption in robust economic growth and reduction in the rate of unemployment. As David Ricardo acutely observed in his 1810 pamphlet, “The High Price of Bullion”:

To suppose that any increased issues of the Bank [of England] can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, . . . is to attribute a power to the circulating medium [money] which it can never possess. Banks would, if this were possible, become powerful engines indeed. By creating paper money, and lending it at three or two per cent. under the present market rate of interest, the Bank would reduce the profits on trade in the same proportion; and if they were sufficiently patriotic to lend their notes at an interest no higher than necessary to pay the expences of their establishment, profits would be still further reduced; no nation, but by similar means, could enter into competition with us, we should engross the trade of the world. To what absurdities would not such a theory lead us! Profits can only be lowered by a competition of capitals not consisting of circulating medium. As the increase of Bank-notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest [permanently].

Experience around the world repeatedly has confirmed Ricardo’s warning against the belief in a central bank’s money creation as the engine of economic growth instead of the pursuit of policies that encourage increased private savings.

I have devised a simple plan for improving Americans’ health by drastically reducing everyone’s weight, thereby significantly increasing longevity and reducing medical costs. All we need to do is revalue the pound. Instead of a pound being 16 ounces, it will now be 32, cutting everyone’s weight in half. We adjust our bathroom scales, our weights drop, and our health is improved.

Of course this “solution” rests on two fallacies. First, it conflates measurement with what is measured. Adjusting my bathroom scale does not change my weight, only my perception of my weight.

Second, the solution confuses cause and effect. My weight is not necessarily the cause of my health or lack thereof; in fact my weight may be caused by my ill health—an injury that keeps me from exercising or a thyroid condition, for example. More commonly, good health is the result of acting responsibly for many years: moderating calorie and alcohol intake, eating the right foods, engaging in regular exercise, getting quality dental and medical care. Such actions are likely to result in both moderate weight and good health. But I can no more make myself healthy by adjusting my bathroom scales than a doctor can cure a child’s cold by adjusting the thermometer he uses to measure her fever.

The two fallacies are so obvious that no one could possibly fall for them, right? Sadly, no. Many brilliant people have fervently believed in nearly identical fallacies for decades and are even now basing our country’s monetary policy on them.

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760–1830:

If we seek—it would be wrong to do so—for a single reason why the pace of economic development quickened about the middle of the eighteenth century, it is to low interest rates we must look. The deep mines, solidly built factories, well-constructed canals, and the houses of the Industrial Revolution were the productions of relatively cheap capital.

John Maynard Keynes, making this same observation years before, concluded that simply by manipulating a country’s money supply and financial markets to artificially produce low interest rates, “deep mines, solidly built factories, well-constructed canals and houses” would spring into being. But Keynes confused “cheap capital” with easy money. Capital—inventories, pre-consumer goods, and the methods and means of production—cannot be conjured into being by manipulating interest rates. They can exist only through production and saving (deferred consumption).

Capital goods can be relatively cheap only if they are relatively plentiful. Increasing capital, all else equal, will lower interest rates. But interest rates are more than just a measure of capital availability; they also reflect lending risk. Risk in turn can be affected by such things as inflation and the reliability and efficiency of transportation, communication, and capital markets.

A lender would hardly agree to make a $100 loan unless he could reasonably expect to get at least $100 in purchasing power in return. If the government is debasing the currency, loans will be made only if interest rates are higher than the anticipated rate of inflation.

Costs and Lending Risks

Transporting goods by human or animal power is slow and costly. Sailing ships can carry far more goods far more quickly. Steam-powered ships are faster and more efficient still. Transportation costs, then, are inversely proportional to the level of technology. But costs also depend on the rule of law. When local chieftains can block mountain passes and extort steep tolls, or when highwaymen and pirates can exact their own tolls with impunity, transportation becomes risky and expensive. Conversely both transportation costs and lending risks are reduced if private property rights are respected and enforced.

Efficient capital markets foster trade by reducing transaction costs. Such markets depend on property rights and laws of exchange and on fast and reliable methods of communicating information such as prices, weather, and changing market conditions. Like transportation, communication depends on the level of technology.

Low capital costs are the result of a lot of people acting responsibly for many years: sound currency, institutions protecting private property and preserving the rule of law, inventors devising new and useful products, entrepreneurs bringing those products to market and finding ever-more-efficient ways to satisfy customers, and individuals producing more than they consume and saving for the future.

False Signals

Artificially low interest rates signal the existence of capital goods that were never actually created. While these low rates may spark investment bubbles, the bubbles must eventually burst when competition for scarcer-than-expected capital goods, services, and labor drives prices up.

Manipulating markets through monetary policy devalues a nation’s currency, destroys rather than secures property rights, and does nothing to sustain the rule of law constraining both the rulers and the ruled.

The costs of fooling ourselves can be high. By readjusting my bathroom scale I disable an indicator that might warn me when I need to change my eating and exercise habits. By overriding market money prices we similarly deny ourselves important data about the country’s fiscal health. Our weight and the real price of money are both valuable pieces of information providing vital feedback on our actions. Manipulating that feedback destroys the value of the information and, rather than giving us control, gives us only the illusion of control.

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.

How an Economy Grows and Why It Crashes is Peter Schiff’s most recent effort in that regard. Bypassing the academic crowd and avoiding an eye-glazing academic approach, Schiff and his brother Andrew have tried to grab readers’ attention with an amalgam of allegorical storytelling and current events. They aim to promote real economic comprehension.

The book’s introduction starts with a lucid explication of the key elements of Keynesian economics—showing how John Maynard Keynes, by making “something simple seem hopelessly complex,” paved the way for acceptance of “some very stupid ideas about what makes economies grow.” In chapter 1 the authors shift into allegorical mode, weaving a tale about a Crusoe-type economy based on fishing. Here they introduce the reader to the rudiments of capital theory. The story progresses logically from there. The use of capital leads to both greater wealth and income inequality. Then comes a cogent discussion of the counterproductive effects of forced income redistribution.

Next they turn to the role of saving—how it serves as the source of credit and a cushion permitting people to get through emergencies and how, contra Keynes, it is the true key to economic growth. In addition the authors correct the common misinterpretation of deflation—not as the disaster depicted by Ben Bernanke and his ilk, but as a key channel through which prosperity spreads. They proceed to describe the benefits of free trade, dissecting the canard that it is a job-killer and pointing out that “it is not the aim of an economy to simply provide jobs, but to create jobs that maximize labor productivity.”

Notable in their discussion of government is an endorsement of restricting voting to those who pay taxes, an idea going back at least to John Stuart Mill. They argue that retreat from this stipulation accelerates a nation’s downward trajectory into an inflationary welfare state. The Schiffs elucidate the unaccounted-for implications of the many popular policies dragging economies down this path. Included among those are the replacement of a commodity standard with fiat money, subsidization of loans to politically favored sectors of the economy, and so-called “stimulus” spending—all central elements of Keynesian monetary and fiscal policy.

They finish their allegory with the inevitable upshot of those policies (given the lack of political will to incur the short-term pain that would stave it off): the decision of our international creditors to cease enabling our profligate ways by redeeming our dollars, unleashing massive price increases, and pushing our standard of living off a cliff.

It’s well argued, but I wonder if the book is written at the right level for its intended audience. It is clearly not aimed at academics, which is too bad because many of them could use it the most. Rather it is aimed at noneconomists. Yet for the totally uninitiated I fear that it may throw too much at them too fast, without sufficient explanation. One can only hope they will be interested enough to seek the requisite explanations from other sources rather than throwing up their hands in frustration.

Also, I found the pervasive fish metaphor tiresome—not to mention that fish are too perishable to ever be used as a monetary commodity. (On p. 159 the Schiff brothers do mention the advantages of precious metals as money.) While I realize this is an allegory in which some literary license is permitted, the cost of this aspect of the story in reader confusion and lack of credibility may be high.

On the other hand I do like the way each allegorical chapter is followed by a takeaway that uses the principles presented to shed light on real-world events. Knowing that the authors of this book wrote it to share the economic insights that enabled them to predict the onset of our current recession, I hope my misgivings are unfounded because the lessons are ones all of us need to master.

Regardless of how political actors in the 1960s might have sought to exploit economic analysis to gain a plausible public-interest rationale for their proposed programs, the most prominent body of economic analysis in those days—the sort taught by the leading lights at Harvard, Yale, Berkeley, and the other great universities—virtually cried out to be exploited in this way. During the mid-1960s the so-called Neoclassical Synthesis achieved its greatest hold on the economics profession.

This term “synthesis” refers to the combination of a microeconomic part, which contains the theory of individual markets that had been developed over the preceding two centuries, and a macroeconomic part, which contains the ideas about national economic aggregates advanced by John Maynard Keynes in his landmark 1936 book The General Theory of Employment, Interest, and Money and further developed by Keynes’s followers during the three decades after the book’s publication.

On the microeconomic side, the Neoclassical Synthesis incorporated the so-called New Welfare Economics that had been developed during the 1930s, 1940s, and 1950s. In this form microeconomic theory advanced a general-equilibrium theory of the economy’s various markets, identified the conditions for the attainment of equilibrium in this idealized system, and demonstrated that various “problems”—springing from external effects, collective goods, less-than-perfect information, and less-than-perfect competition, among other conditions—would cause the system to settle in a state of overall inefficiency: The value of total output would fall short of the maximum that would have resulted from systemic efficiency, given the economy’s available resources of labor and capital and its existing technology.

Attainment of such an inefficient state was characterized as a “market failure,” and economists expended enormous effort alleging the existence of such market failures in real-world markets and in proposing means (mainly taxes, subsidies, and regulations) by which the government might, in theory at least, remedy these failures and thus maximize “social welfare.”

Had economic theorists rested content with using the microeconomics of the Neoclassical Synthesis strictly as a conceptual device employed in abstract reasoning, it might have done little damage. However, as I have already suggested, this type of theory cried out for application—which, in practice, was nearly always misapplication. The idealized conditions required for theoretical general-equilibrium efficiency could not possibly obtain in the real world; yet the economists readily endorsed government measures aimed at coercively pounding the real world into conformity with these impossible theoretical conditions.

Closely examined, such efforts represented a form of madness. As the great economist James Buchanan has observed, the economists’ obsession with general equilibrium gives rise to “the most sophisticated fallacy in [neoclassical] economic theory, the notion that because certain relationships hold in equilibrium the forced interferences designed to implement these relationships will, in fact, be desirable.”

Great Society measures such as the Elementary and Secondary Education Act (1965), the Higher Education Act (1965), the Motor Vehicle Safety Act (1966), and the Truth in Lending Act (1968), as well as many of the consumer-protection and environmental-protection laws and regulations, found ready endorsement among contemporary neoclassical economists, who viewed them as proper means for the correction of purported market failures.

The assumptions that underlay these economic interpretations and applications, however, could be sustained only by wishful thinking. Economists presumed to know where general equilibrium lay, or at least to know the direction in which the quantities of various inputs and outputs should be changed in order to approach general-equilibrium efficiency more closely. But neoclassical economists cannot move the earth with a mathematical lever because they have no place to stand—no “given” information about (presumably fixed) property rights, consumer preferences, resource availabilities, and technical possibilities. What neoclassical economics takes as given is, in reality, revealed only by competitive processes.

If the microeconomic side of the Neoclassical Synthesis fostered government measures to remedy a variety of putative market failures, its macroeconomic side endorsed government measures to remedy the greatest alleged market failure of all—the economy’s overall instability and its recurrent failure to bring about a condition known as “full employment.”

The supposition that mass unemployment constitutes or reflects a market failure came easily to economists who had reached maturity during the Great Depression. By the early 1950s Keynesian ideas had entrenched themselves among the leading lights of the mainstream economics profession. Since then, some species of Keynesianism has been either in the professional saddle or clamoring to get there.

In the 1960s few economists disputed this general framework of analysis. Even critics such as Milton Friedman accepted it, arguing only that certain second-order aspects of the model differed from what the Keynesians assumed.

Few macroeconomists looked to monetary-policy changes as important means of pushing an economy out of what they viewed as a mass-unemployment equilibrium. For the typical macroeconomist of those days, fiscal policy—changes in government spending, taxing, and borrowing—held the key to keeping the economy on a steady growth path. By employing these instruments policymakers could effectively select from a menu of inversely related rates of inflation and unemployment, a tradeoff schedule known as the stable Phillips Curve. As if to certify the completeness of Keynesianism’s conquest, in December 1965 Time magazine put an image of Keynes on its cover and featured a long, laudatory article titled, “We Are All Keynesians Now.”

The Great Society programs, whether for microeconomic remedy of alleged market failures or for macroeconomic fine-tuning, had an important element in common: the presumption that technocrats possessed the knowledge and the capacity to identify what needed to be done, to design appropriate remedial measures, and to implement those measures successfully. In short, the Great Society amounted to social engineering—or worse, to sheer, groping social experimentation—on a grand scale. People ought not to have been surprised when its attainments failed to match its pretensions.

There is always an easy solution to every human problem – neat, plausible, and wrong. –H. L. Mencken

I have devised a simple plan for improving Americans’ health by drastically reducing everyone’s weight, significantly increasing longevity and reducing medical costs.  All we need to do is revalue the pound.  Instead of a pound being 16 ounces, it will now be 32, cutting everyone’s weight in half.  We adjust our bathroom scales, our weight drops, and our health is improved.

Of course this “solution” rests on two fallacies.  First, it conflates measurement with what is measured.  Adjusting my bathroom scale does not change my weight, only my perception of my weight.

Second, the solution confuses cause and effect.  My weight is not necessarily the cause of my health or lack thereof; in fact, my weight may be caused by my health – an injury that keeps me from exercising or a thyroid condition, for example.  More commonly, good health is the result of responsible actions taken over many years: moderating calorie and alcohol intake, eating the right foods, engaging in regular exercise, getting quality dental and medical care.  Such actions are likely to result in both moderate weight and good health.  Conversely, I can no more make myself healthy by adjusting my bathroom scales than a doctor can cure a child’s cold by adjusting the thermometer he uses to measure her fever.

Brilliant Fools

The two fallacies are so obvious that no one could possibly fall for them, right?  Sadly, no.  Many brilliant people have fervently believed in nearly identical fallacies for decades and are even now basing our country’s monetary policy on them.

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760 – 1830 (9-10):

If we seek – it would be wrong to do so – for a single reason why the pace of economic development quickened about the middle of the eighteenth century, it is to low interest rates we must look.  The deep mines, solidly built factories, well-constructed canals, and the houses of the Industrial Revolution were the productions of relatively cheap capital.

John Maynard Keynes, making this same observation years before, concluded that simply by manipulating a country’s monetary supply and financial markets to produce artificially low interest rates, “deep mines, solidly built factories, well-constructed canals and houses” would spring into being.  But Keynes is confusing “cheap capital” with easy money.  Capital – inventories, pre-consumer goods, and the methods and means of production – cannot be conjured into being by manipulating interest rates.  They must be produced through saving, that is, deferred consumption.

Capital goods can be relatively cheap only if they are relatively plentiful.  Increasing capital, all else equal, will lower interest rates.  Interest rates are a measure of capital’s availability. Dictating low rates will not improve a nation’s fiscal health any more than manipulating my bathroom scale will improve my physical health.

But low interest rates depend on more than just the availability of capital goods.  They are also a function of the risk in lending.  Risk in turn can be affected by such things as the reliability and efficiency of transportation, communication, and capital markets.

Transporting goods by human or animal power is slow and costly.  Sailing ships can carry far more goods far more quickly.  Steam-powered ships are faster and more efficient still.  Transportation costs, then, are inversely proportional to the level of technology.  But costs also depend on the rule of law.  When local barons can block mountain passes and extort steep tolls, or when highwaymen and pirates can exact their own tolls with impunity, transportation becomes risky and expensive.  Conversely, both transportation costs and lending risks are reduced if private property rights are respected and enforced.

Efficient capital markets foster trade by reducing transaction costs.  Such markets depend on property rights and laws of exchange and on fast and reliable methods of communicating information such as prices, weather, and changing market conditions.  Like transportation, communication depends on the level of technology.

Doing the Right Thing

Low capital costs are the result of a lot of people doing the right things for a lot of years: institutions protecting private property and preserving the rule of law, inventors devising new and useful products, entrepreneurs bringing those products to market and finding ever more efficient ways to satisfy customers, individuals producing more than they consume and saving for the future.

Artificially driving interest rates down cannot raise a nation’s level of technology, magically bringing railroads or fax machines into being.  Manipulating markets through monetary policy destroys rather than secures property rights and does nothing to establish rules of law that constrain both the rulers and the ruled.

The costs of fooling ourselves can be high.  By readjusting my bathroom scale I disable an indicator that might warn me when I need to change my eating and exercise habits.  By overriding market money prices we similarly deny ourselves important data about the country’s fiscal health.  Our weight and the real price of money are both valuable pieces of information providing vital feedback on our actions.  Manipulating that feedback destroys the value of the information and, rather than giving us control, gives us only the illusion of control.