It depends on what you mean by created, saved, and jobs.

It is certainly true that the federal government gave money to the states and localities, and some of that money was used to pay teachers, police officers, and firefighters. However, to say that this “saved” those jobs implies that they really would have vanished without federal money. In some cases, state and local politicians might have been engaging in fear-mongering. It’s been done before. But even if they weren’t, we would have to assume that if the federal money hadn’t materialized, those politicians wouldn’t have found other things to cut in order to keep paying the teachers, officers, and firefighters — the perhaps bloated administrative bureaucracy, for instance. We’ll never know because they were relieved of the necessity –mother of invention — of making “the tough choices” they always say they were elected to make.

What about other kinds of jobs? Two studies demonstrate that many jobs “created” were filled by hiring people away from jobs they already held. Some will claim that this is fine because the vacated jobs were available to the unemployed. But that implies that highly skilled people were sitting around waiting for jobs, and this is not the case. Companies losing employees had to incur high search and training costs to refill those jobs. See this previous post, “Labor Is Not Fungible,” for more discussion. Also see “No Such Thing as Shovel Ready”: ”[H]iring people from unemployment was more the exception than the rule in our interviews”; and “Did Stimulus Dollars Hire the Unemployed?” Both papers are by Garett Jones and Daniel Rothschild of the Mercatus Center. (Summary here.)

Finally, in economics a job is employment that creates value by helping to transform resources from a less- to a more-useful condition. In the market, prices, consumer behavior, and profit-and-loss sheets tell us if that criterion is met. A job is not merely exertion for which someone is paid. In the case of government and government-financed jobs, where resources are acquired by force and there is not market pricing at every stage, we can’t be sure that people who “work” actually create value rather than destroy it. They may sweat, but they that doesn’t mean they have jobs.

Finally, let’s remember that government can’t actually stimulate the economy; that is, it cannot inject something from outside the economy, like a defibrillator transfers electricity to a body to jump start a heart. Any money the government appears to inject was already in the economy and is just moved around. So, as Russ Roberts says, government’s stimulating an economy is like taking water from the deep end of a pool and pouring it into the shallow end.

In recent months – or has it been years? – Paul Krugman and Brad DeLong have been saying, in effect, “We told you so – the stimulus was not enough. Look at the sluggish economy and high unemployment rate.”

They are arguing that the problem with the fiscal stimulus is that it was not enough. The idea was right but the quantity was wrong.

Let it pass that at ThinkMarkets it was predicted that this is what the stimulus advocates would say in the event that the economy did not improve as much as they wanted.

The basic problem with the quantitative claim is that it skirts some real problems in the analysis.

The rest is here and definitely worth reading.

This massive money injection is supposed to work as follows: buying up Treasury bonds will make their prices rise, and their yields—hence long term interest rates in general—fall. (Recall that previous monetary stimulus has already pushed short-term rates close to zero.) Lower interest rates mean investment capital will be even cheaper than it already is, pushing idle investment money “off the sidelines” and into productive, labor-demanding business activity. And because all the fresh money starts its life as bank reserves, banks will be in a position to extend new loans six ways from Sunday.

Keynesians insist that this kind of massive stimulus is the only weapon the monetary authorities have left in their struggle to cure unemployment. This is a short-term fix, mind you; all economists realize that printing money does not call new goods or services into existence, and not even Keynes himself would tell you that straight-up money printing is a recipe for long-term prosperity. But can printing money induce entrepreneurs to expand output? Can it make unemployed resources suddenly employable? The answer depends on why those resources became unemployed—“underutilized” in Fedspeak—in the first place. This is precisely the question that Austrian economists are asking: What exactly went wrong in the economy such that so many resources are now not being utilized? By addressing this crucial question, only the Austrian perspective can adequately dissect the very concept of “underutilization” and offer a coherent critique of this mad-hatter monetary stimulus.

Let’s deconstruct this notion of resource “underutilization.” Resources are only resources to the extent that they have value, or usefulness, to somebody. Resources, properly speaking, are components of a broader plan of entrepreneurial action that brings more and better goods into existence, which people can use to improve their lives. Not all things are resources—things that can’t be used to enhance life aren’t resources, just objects; things that used to be resources but are now worn out, obsolete, or otherwise have lost their usefulness aren’t resources. They’re just junk.

Context matters when we’re talking about resources. The mere fact that a good was produced at some point and sold for some price does not mean it is still as valuable as originally anticipated. For example, if I took the trouble to fatten 100 steers in hopes of selling 50 tons of beef, only to later discover that everyone has become a vegetarian in the meantime, the beef I produced, economically speaking, would not be a resource. Nor would the beef-producing equipment, tools, and knowledge I invested in have the same value to me once I found out the true state of people’s dietary preferences. While some cattle-raising equipment could be converted to other uses, much of it—like the squeeze chute used for medicating and branding cattle—was highly specific to beef production and would be worth no more than its scrap-metal value in a world where nobody wanted to consume beef. My plan to be a cattleman turned out a big mistake entailing a loss on investment. Losing investments mean economic waste has occurred—to some degree, resources have been turned into junk.

This example may be ridiculous, but is it really that far-fetched? It is highly unlikely that people’s preferences would change so drastically or that entrepreneurs would be so clueless at forecasting market trends. But a strong enough outside influence might induce enough entrepreneurs into misreading the true state of the market such that they become overoptimistic and invest too much. If, for instance, politicians were dedicated to stimulating the beef industry and promoting beef consumption, and built policy on policy to that purpose over the decades—a labyrinthine mixture of subsidies, tax breaks, and cheap credit—they just might generate an investment boom in beef production. The boom, however, would be destined to end as soon as the policy changed or, more likely, the oversaturation of the market became evident.

At this point, with declining beef prices and (now-apparent) excess capacity in beef production, market forces would oust marginal producers from the industry and induce even the large, established operators to scale back production. As for the now “underutilized” resources, it would take some time and a lot of extra work to melt down those excess squeeze chutes, to convert cattle pasture into other crops, and for the reluctant surplus cowboys to eventually accept city jobs mopping floors, answering phones, ringing up sales, and so on.

The value of capital—both capital equipment, or physical capital, and people’s knowledge, experience, and training, or human capital—is critically dependent on how well it can fit into the structure of actual consumer demands and the structure of existing complementary capital (both physical and human). It is precisely this kind of interconnectedness among different kinds of resources that mainstream economists tend to disregard. Yet the extent of economic losses revealed by the recent financial crisis and recession is making the malinvestment (waste) of resources hard to ignore. Even at the Fed, some people show signs of understanding the relevance of the structure of capital resources, as opposed to sheer quantities or supposed dollar values. As Naranya Kocherlakota, president of the Minneapolis Fed, recently stated: “[T]he Fed does not have a means to transform construction workers into manufacturing workers. . . . Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.”

In other words, no amount of money-printing will change the real relationship of any particular object to its economic context. But the term “mismatch” implies mistakes have been made—entrepreneurial error—and raises the question: What went wrong to cause such massive mistakes in the first place? Again, Austrian capital theory provides the answer: The Fed itself, with its cheap money, along with a host of government “affordable housing” policies, severely overstimulated the housing construction market in the years of the boom.

Entrepreneurs always have many options for how to employ their time, labor, and capital. During the housing boom the amazing increase in home prices relative to construction costs made projects like new home construction and even flipping condos seem an obvious profit opportunity. Following the price signals, people expanded their investments appropriately: Young entrepreneurs learned about real estate and construction management, and new workers learned construction trades; building companies were started and existing companies expanded, purchasing more new equipment like nail guns, Skilsaws, and pickup trucks; upstream suppliers similarly expanded investment in things like cement plants, timber plantations, sawmills, and the like.

Regardless of whether these workers and entrepreneurs were cognizant of the temporary, cheap credit- and subsidy-induced nature of the boom, the lure of high prices and high profits proved irresistible. In retrospect it is easy to see how the Fed’s cheap money policy, along with a host of government subsidies to homebuyers and lenders, set the stage for an unsustainable boom—a boom that did not match well the actual, long-term consumer demand and for which the credit that financed it was not fully funded by actual savings. (For an excellent explanation of the government’s role in the housing boom and bust, see Peter Boettke and Steven Horwitz’s FEE publication “The House That Uncle Sam Built” [PDF]). Nonetheless, the slew of political interventions into the housing market led these entrepreneurs on for years before the inevitable market correction occurred. The net result was that too much investment capital went into home building, and not enough into other economic activities—a mistake of grand proportions.

The housing bust revealed that many of the capital investments of the boom period—from concrete trucks on up to skilled construction tradesmen—were actually malinvestments whose value turned out to be less (in some cases much less) than anticipated. The capital resources created to build houses are, to varying degrees, ill-suited to other tasks. They will necessarily be underutilized relative to the boom era, precisely because they have lost value (usefulness) in light of the new economic reality. Indeed, economic reality in the bust indicates that many of these resources will have to find other ways to be productive, as attested by the overbuilt housing market. (According to National Association of Realtors figures, there were between 1.02 and 1.77 million “excess” homes as of September. Supply was converted into excess units on the basis of six-to-eight months’ supply representing “normal” conditions.)

But this adjustment takes time, and the more specialized the resource, the longer the wait. Some excess concrete trucks can be sent overseas or converted to other industrial uses, but many will simply sit, awaiting the next boom or the scrap heap. Indeed, in some cases, when a particular resource loses its usefulness, leaving it idle can be its optimal “use.” Likewise, the surplus low-skilled construction laborers can perhaps get jobs washing dishes, but skilled tradesmen, engineers, and jobsite managers must retrain to find different jobs that match their boom-era earnings. Not surprisingly, some choose to wait (and take unemployment benefits) rather than risk retraining. For those who have thrown in the towel on a construction career, retraining and reemployment can take years. No amount of money-printing can change this reality.

Political efforts to “stimulate” economic activity will necessarily alter the capital structure of the economy. Government-based stimulus for industry Z necessarily detracts from what the market would have provided industries A through Y. Even a nonspecific stimulus, if such a thing is possible, will only stimulate the investment fad du jour; there is no such thing as neutral government policy. The key policy implication of Austrian capital theory is that any attempt to stimulate the economy will, by spurring malinvestment, doom some resources to superfluousness. From a statistical standpoint this may look like underutilization; from an economic standpoint, however, it’s simply the waste that results from too many investment plans gone bad. Attempting to undo the waste by further stimulus will only exacerbate the problem: more stimulus, more malinvestment, more wasted resources.

So what should the wise and munificent monetary central planners do? Ironically, the optimal monetary policy is not to have one, but to let the competitive market process function for money and credit the way it does for countless other goods. If we must have central banking, the ideal policy is simply this: First do no harm.

So why don’t they apply the same logic to the economy as a whole? The only tenable answer is that they are under the spell of the economic miseducation inflicted on the minds of economists and many among the general population by John Maynard Keynes. They believe that consumer spending drives the economy, without having stopped to consider from where consumers get the means to spend.

Consumption Doesn’t Need Stimulation

On their own—that is, in the absence of government handouts in the form of welfare payments or unemployment compensation (funded by taxpayer money)—people acquire the means to spend by earning income from producing and selling goods and services or directly selling their labor services. If they borrowed the money to spend, it must be from someone else who has earned income from production. And as Adam Smith long ago noted in The Wealth of Nations, “[C]onsumption is the sole end and purpose of all production. . . . The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it.”

Why else does anyone work other than to acquire the means to purchase goods and services? That is why consumption spending does not need stimulating. What we currently save out of our incomes is to enable us to smooth out our consumption spending over time or to acquire the means to increase consumption and/or our income-earning capacity in the future.

Such household investments may take the form of bank accounts or bonds to earn interest income, stocks to earn dividends, or educational skills to earn higher future wages and salaries. The only part of our unconsumed income that we do not devote to increasing our future capacity for increased consumption spending is cash hoarding; cash does not earn interest or dividends. But in normal times, when we are not too scared to keep our savings in bank accounts or to purchase stocks or bonds, cash hoarding constitutes a very minor part of our unconsumed income. Meanwhile, what we save is spent by borrowers of our savings, mostly producers of goods and services.

On the basis of these fundamental truths about how people manage their financial affairs and drawing on the wisdom of Adam Smith, Jean-Baptiste Say constructed the thesis now named after him, Say’s Law of Markets, in his 1803 Treatise on Political Economy. It is from production that people earn incomes to purchase those goods and services they themselves don’t produce:

Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have [acquired] this money itself by the sale of productions of our own. . . . It is then in strict reality with their productions that [people] make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands.

The law simply says that “productions can only be purchased by productions” (Say, Letters to Malthus, 1821).

Regarding the need for savings rather than consumption spending to promote economic growth, Say noted that:

The public interest is . . . not served by consumption, but it is served and served prodigiously by saving, and though it seems extraordinary to many persons, not being any the less true as a consequence, the labouring class is served by it more than anyone else. These persons think, perhaps, that the values which the wealthy save out of outlays on their personal pleasures in order to add to their capitals are not consumed [spent]. They are consumed; they furnish markets for many producers; but they are consumed reproductively and furnish markets for the useful goods that are capable of engendering still others, instead of being evaporated in frivolous consumption.

Failing to understand all this, Keynes made a fetish of consumption spending as the engine that drives an economy during the 1930s, especially in his famous book The General Theory of Employment, Interest, and Money (1936). He argued that Say’s Law applies only to an economy in which there is no unemployment or one in which money is not used as a means of exchange. Neither claim is true. However, many an economist has been hooked on Keynes’s miseducation ever since. In macro models legislated unemployment compensation is listed among “automatic stabilizers.” The thinking is that paying the unemployed so they would keep spending will sustain the economy’s so-called aggregate demand. Even if proponents of that view recognized that the government would have to pay the unemployed from its tax revenue (or borrowed funds), they still do not realize that total spending would not change. But unless the government borrowed the additional funds from outside the domestic economy, what it takes from purchasers of its bonds will not be available for private borrowers to spend on investment projects or for their own consumption. Put differently, variations in the level of government spending, besides the portion funded by external borrowing, do not change total spending in the domestic economy.

The Need for New Production

As for stimulating economic activity, it is not the level of consumer spending but new directions in production that make the difference. Entrepreneurs conceiving of new ways to meet economic necessities or desires in the marketplace create new incomes with their positive ripple effects in the economy. Meeting such needs requires that entrepreneurs find the savings, or loanable funds, to acquire the resources to engage in production. Of course, followers of Keynes’s mistaken 1937 view—“The investment market can become congested through the shortage of cash. It can never become congested through the shortage of saving. This is the most fundamental of my conclusions within this field”—do not recognize the necessity of savings to fund investment expenditures. But the fact is that the government’s taxing the employed or borrowing the community’s savings to pay people who are unemployed does not help entrepreneurs in their socially useful task of new wealth creation. This is also how we should recognize the failure of the $787 billion so-called stimulus of February 2009, the subsequent Cash for Clunkers program, and the first-time home purchasers’ subsidies of 2010 to stimulate economic recovery. The money to fund such programs has to be taken from the economy: There is no injection of new money by the government; it effects only a transfer.

Specialization and Trade

Adam Smith in The Wealth of Nations made the salient point: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” The prudence is in the fact that households typically do not aim to be their own tailors, shoemakers, wine makers, homebuilders, or producers of all the numerous things they need, but rather specialize in those things they can produce at the cheapest cost and buy the others in the marketplace—the advantage of specialization and trade. That’s how Smith came to urge nations to adopt the wisdom of households in the management of their production and consumption activities and to reject mercantilist restrictions on trade and opt for free trade instead.

We can apply the same wisdom of households to the question of paying the unemployed. Just as no household would expect that giving money to any of its members to spend would stimulate wealth creation for the household, so it is for the economy as a whole. An economy is little more than the collective activities of households. It is ultimately the aggregation of household production and consumption expenditures that is called gross domestic product, GDP.

We also can learn from the experience of Europe. Its greater “generosity” in unemployment compensation does not produce less unemployment and greater economic growth but higher levels of unemployment and relatively poorer economic growth than in the United States. Extending the period of unemployment insurance compensation only assures that the unemployment rate stays permanently higher than the 4 to 7 percent range within which it fluctuated over the last 20 years or so until 2009. Arguing about the ballooning deficit may help stop the extensions, but that really is a side issue. The real point is that paying people who are unemployed simply discourages them from seeking and/or accepting alternative job offers quickly. And such payments do not change total spending in the economy.

It is truly a pity that followers of Keynes’s mistaken understanding of how a monetary economy works now claim the relevance of his ideas to our current economic situation and are implementing some of his misconceived policies.

This massive money injection is supposed to work as follows: buying up Treasury bonds will make their prices rise, and their yields — hence long term interest rates in general — fall. (Recall that previous monetary stimulus has already pushed short-term rates close to zero.) Lower interest rates mean investment capital will be even cheaper than it already is, pushing idle investment money “off the sidelines” and into productive, labor-demanding business activity. And because all the fresh money starts its life as bank reserves, banks will be in a position to extend new loans six ways from Sunday.

Keynesians insist that this kind of massive stimulus is the only weapon the monetary authorities have left in their struggle to cure unemployment. This is a short-term fix, mind you; all economists realize that printing money does not call new goods or services into existence, and not even Keynes himself would tell you that straight-up money printing is a recipe for long-term prosperity. But can printing money induce entrepreneurs to expand output? Can it make unemployed resources suddenly employable? The answer depends on why those resources became unemployed — “underutilized” in fedspeak — in the first place. This is precisely the question that Austrian economists are asking: What exactly went wrong in the economy such that so many resources are now not being utilized? By addressing this crucial question, only the Austrian perspective can adequately dissect the very concept of “underutilization” and offer a coherent critique of this mad-hatter monetary stimulus.

Underutilized, or Simply Useless?

Let’s deconstruct this notion of resource “underutilization.” Resources are only resources to the extent that they have value, or usefulness, to somebody. Resources, properly speaking, are components of a broader plan of entrepreneurial action that brings more and better goods into existence, which people can use to improve their lives. Not all things are resources — things that can’t be used to enhance life aren’t resources, but just objects; things that used to be resources but are now worn out, obsolete, or otherwise have lost their usefulness aren’t resources but just junk.

Context matters when we’re talking about resources. The mere fact that a good was produced at some point and sold for some price does not mean it is still as valuable as originally anticipated. For example, if I took the trouble to fatten 100 steers in hopes of selling 50 tons of beef, only to later discover that everyone has become a vegetarian in the meantime, the beef I produced, economically speaking, would not be a resource! Nor would the beef-producing equipment, tools, and knowledge I invested in have the same value to me once I found out the true state of people’s dietary preferences. While some cattle-raising equipment could be converted to other uses, much of it — like the squeeze chute used for medicating and branding cattle — was highly specific to beef production and would be worth no more than its scrap-metal value in a world where nobody wanted to consume beef. My plan to be a cattleman turned out a big mistake entailing a loss on investment. Losing investments mean economic waste has occurred — to some degree, resources have been turned into junk.

This example may be ridiculous, but is it really that far-fetched? It is highly unlikely that people’s preferences would change so drastically, or that entrepreneurs would be so clueless at forecasting market trends. But a strong enough outside influence might induce enough entrepreneurs into misreading the true state of the market such that they become overoptimistic and invest too much. If, for instance, politicians were dedicated to stimulating the beef industry and promoting beef consumption, and built policy on policy over the decades — a labyrinthine mixture of subsidies, tax breaks, and cheap credit — they just might generate an investment boom in beef production. The boom, however, would be destined to end as soon as the policy changed or, more likely, the oversaturation of the market became evident.

At this point, with declining beef prices and (now-apparent) excess capacity in beef production, market forces will oust marginal producers from the industry and induce even the large, established operators to scale back production. As for the now “underutilized” resources, it will take some time and a lot of extra work to melt down those excess squeeze chutes, to convert cattle pasture into other crops, and for the reluctant surplus cowboys to eventually accept city jobs mopping floors, answering phones, ringing up sales, and so on.

The value of capital — both capital equipment, or physical capital, and people’s knowledge, experience, and training, or human capital — is critically dependent on how well it can fit into the structure of actual consumer demands and the structure of existing complementary capital (both physical and human). It is precisely this kind of interconnectedness among different kinds of resources that mainstream economists tend to disregard. Yet the extent of economic losses revealed by the recent financial crisis and recession is making the malinvestment (waste) of resources hard to ignore. Even at the Fed, some people show signs of understanding the relevance of the structure of capital resources, as opposed to sheer quantities or supposed dollar values. As Naranya Kocherlakota, president of the Minneapolis Fed, recently stated: “the Fed does not have a means to transform construction workers into manufacturing workers.… Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.”

In other words, no amount of money-printing will change the real relationship of any particular object to its economic context. But the term “mismatch” implies mistakes have been made — entrepreneurial error — and raises the question: What went wrong to cause such massive mistakes in the first place? Again, Austrian capital theory provides the answer: The Fed itself, with its cheap money, along with a host of government “affordable housing” policies, severely overstimulated the housing construction market in the years of the boom.

The Housing Boom and Idle Resources

Entrepreneurs always have many options in which to employ their time, labor, and capital. During the housing boom the amazing increase in home prices relative to construction costs made projects like new home construction and even flipping condos seem an obvious profit opportunity. Following the price signals, people expanded their investments appropriately: Young entrepreneurs learned about real estate and construction management, and new workers learned construction trades; building companies were started and existing companies expanded, purchasing more new equipment like nail guns, Skilsaws, and pickup trucks; upstream suppliers similarly expanded investment in things like cement plants, timber plantations, sawmills, and the like.

Regardless of whether these workers and entrepreneurs were cognizant of the temporary, cheap credit- and subsidy-induced nature of the boom, the lure of high prices and high profits proved irresistible. In retrospect it is easy to see how the Fed’s cheap money policy, along with a host of government subsidies to homebuyers and lenders, set the stage for an unsustainable boom — a boom that did not match well the actual, long-term consumer demand and for which the credit that financed it was not fully funded by actual savings. (For an excellent explanation of the government’s role in the housing boom and bust, see Peter Boettke and Steven Horwitz’s “The House That Uncle Sam Built” [pdf].) Nonetheless, the slew of political interventions into the housing market led these entrepreneurs on for years before the inevitable market correction occurred. The net result was that too much investment capital went into home building, and not enough into other economic activities — a mistake of grand proportions.

The housing bust revealed that many of the capital investments of the boom period — from concrete trucks on up to skilled construction tradesmen — were actually malinvestments whose value turned out to be less (in some cases much less) than anticipated. The capital resources created to build houses are, to varying degrees, ill-suited to other tasks. They will necessarily be underutilized relative to the boom era, precisely because they have lost value (usefulness) in light of the new economic reality. Indeed, economic reality in the bust indicates that many of these resources will have to find other ways to be productive, as attested by the overbuilt housing market. (According to National Association of Realtors figures, there were between 1.02 and 1.77 million “excess” homes as of September. Supply was converted into excess units on the basis of six-to-eight months’ supply representing “normal” conditions.)

But this adjustment takes time, and the more specialized the resource, the longer the wait. Some excess concrete trucks can be sent overseas or converted to other industrial uses, but many will simply sit, awaiting the next boom or the scrap heap. Indeed, in some cases, when a particular resource loses its usefulness, leaving it idle can be its optimal “use.” Likewise, the surplus low-skilled construction laborers can perhaps get jobs washing dishes, but skilled tradesmen, engineers, and jobsite managers must retrain to find different jobs that match their boom-era earnings. Not surprisingly, some choose to wait (and take unemployment benefits) rather than risk retraining. For those who have thrown in the towel on a construction career, retraining and reemployment can take years. No amount of money-printing can change this reality.

Implications for Monetary Policy

Political efforts to “stimulate” economic activity will necessarily alter the capital structure of the economy. Government-based stimulus for industry Z necessarily detracts from what the market would have provided industries A through Y. Even a nonspecific stimulus, if such is possible, will only stimulate the investment fad du jour; there is no such thing as neutral government policy. The key policy implication of Austrian capital theory is that any attempt to stimulate the economy will, by spurring malinvestment, doom some resources to superfluousness. From a statistical standpoint this may look like underutilization; from an economic standpoint, however, it’s simply the waste that results from too many investment plans gone bad. Attempting to undo the waste by further stimulus will only exacerbate the problem: more stimulus, more malinvestment, more wasted resources.

So what should the wise and munificent monetary central planners do? Ironically, the optimal monetary policy is not to have one, but to let the competitive market process function for money and credit the way it does for countless other goods. If we must have central banking, the ideal policy is simply this: First do no harm by abstaining from continually tinkering with interest rates and the money supply in an attempt at perpetual stimulus. Despite the seductive logic of the Keynesian physicians, printing money is patent-medicine quackery that stands to do the patient more harm than good.

The need to rationalize the likes and dislikes which, for lack of anything else, must guide the planner in many of his decisions, and the necessity of stating his reasons in a form in which they will appeal to as many people as possible, will force him to construct theories, i.e., assertions about the connections between facts, which then become an integral part of the governing doctrine.

The problem is that when unforeseen circumstances arise, as they always do, that force the planner to significantly alter her plans, she must justify her actions by appealing to new facts and theories while at the same time downplaying or ignoring what was carefully laid out before.

An Orwellian World

George Orwell, who read and evidently liked parts of The Road to Serfdom, illustrated this brilliantly in his novel Nineteen Eighty-Four.  (The parallels between the two books, published at about the same time, are striking.)

Winston Smith, the central character in Orwell’s classic, works in the Ministry of Truth.  His job is to erase all historical references to facts that contradict current government policy.  If the Party announces that the nations of Eurasia and Oceania, which yesterday were loyal allies, are today at war with each other, Smith’s Ministry gets busy deleting from the record all evidence that any alliance ever existed and replaces it with evidence that they were and always had been sworn enemies.  Or when a popular official is purged from the Party, Winston makes sure that that person disappears from history — so thoroughly in fact that even he himself wouldn’t be able to find any proof that the former official was even born.

Facts contradicting government policy are swept swiftly into the dustbin of history – the “memory hole” — to be just as swiftly replaced by a new set of “facts.”

Doublethink

The really frightening aspect of this is the role it plays in the Orwellian concept of “doublethink” – the ability to hold two contradictory thoughts in one’s mind at the same time.  Those who can perfectly recall that the ousted official was, just the day before, popular and high-ranking in the Party, have nothing to support what they know to be the case.  Since no evidence exists to corroborate anyone’s memory of that fact, and since all are expected to spout the Party line, everyone eventually comes to believe in the new set of “facts” and must suppress any thought that contradicts it.  That goes even for high-ranking officials themselves.

Truth in a totalitarian state is highly inconvenient.  And, as Hayek argues, surrendering to the belief that truth is an illusion, that expediency disguised as principle should guide action, pulls the rug from under any basis for morality.

Fast-Forward to 2010

Although both Hayek and Orwell were writing about the consequences of totalitarianism, it’s frightening how easy it is to find instances of this phenomenon in the political discourse in our own interventionist mixed economy. Of course, no one would be surprised that success in politics does not depend on telling the truth, but one must at least appear to be doing so.

Observe the following diagram, which has appeared in several places.  (This version comes from a website called Brainshavings.)

(Click to enlarge.)

It tracks the official measure of the rate of unemployment from 2007 to the present, and projects it to 2014.  The Obama administration in 2008, in arguing for the $700 billion “stimulus” bill that was passed in early 2009, warned that unemployment would climb from 6.5 percent to just over 9 percent by mid-2010 without the stimulus.  That is the light-blue line in the middle.  The dotted line represents where unemployment actually went after the bill was passed, hovering around 10 percent.

So, according to the administration’s own estimate, the unemployment rate would have been significantly lower had the government not passed the stimulus bill (the “do-nothing” option that President Obama emphatically said was not an option).

My point is not that the administration was wrong and refuses to admit it. It’s rather that so few among both supporters and even detractors of the stimulus seem to even care that the administration was wrong or demand an explanation for why it was wrong and why its recent calls for even more stimulus would be any more successful than the earlier package.  Few seem to remember or bother trying to remember what was said so loudly only two years ago.  The government hasn’t wiped history clean of its earlier assertions.  The scary thing is that it hasn’t had to.

Admitting error and correcting course based on that admission is the real “third rail” of politics.

The second camp has people like Peter Schiff and the Austrians claiming that “stimulus” spending by government will only make things worse and that the government risks creating conditions that can bring about massive inflation and runaway gold prices.

So which is it? Is the stimulus a disaster because it does not involve enough spending, or has the government gone too far and created dangerous economic conditions that will explode later?

Krugman clearly believes his argument has won the debate. Pointing to the fact that interest rates currently are low and that the possibility of deflation exists, he writes:

[T]hat framework [of the “liquidity trap”] has held up very well. That basic framework led me to conclude that the Obama stimulus was much too small; that the huge increase in the monetary base wouldn’t be inflationary; that interest rates would stay low as long as the economy remained depressed, despite huge government borrowing. All this has turned out to be true.

Now, there’s no virtue in sticking with a model if it fails the reality test; but in this case the model — unlike the economy — has performed well.

In other words, we should look at results. Where is the hyperinflation? Where are the sky-high interest rates? Haven’t the so-called bond vigilantes been wrong?

I am in the second camp, but the current Austrian claim that “hyperinflation is just around the corner” is not an acceptable answer. The inflation wolf may well be at the door, but we need to do a better job of explaining not only why the stimulus is not working – and actually making things worse – but also why the current situation exists. Furthermore, we need to better elucidate why we believe inflation is a real danger in our economic future.

The short Keynesian answer to why the current situation exists is that “aggregate demand” is weak, which is why we supposedly need more “stimulus” spending through government. According to Krugman, if the government spends enough, then the economy will gain “traction” and the economy will operate as though on automatic pilot. However, Keynesians argue, if government spending does not fill the gap left by the drop in consumer spending, the economy will implode into the black hole of depression. Krugman argues we are well on the way to that point unless government spending picks up rapidly.

What Next?

How, then, can this current scenario suddenly morph into hyperinflation? Some economists point to the huge increase in the monetary base created by the Federal Reserve System, but unless that base (which is found in bank reserves) turns into a blizzard of loans, it remains out of circulation and has little effect on prices.

There is a way, however, for this current situation to turn into an inflationary mess, and it is related to the stimulus. Most countries where we have seen outright hyperinflation have had large government-owned sectors of the economy, and governments simply printed the money to pay the workers, who then quickly spent the new money.

While new money in our economy comes through bank loans, if in the future the Fed and the banks aggressively purchase U.S. short-term bonds to finance current spending increases, that effectively would be like printing money and certainly would quickly force up prices. Furthermore, such a scenario would not be far-fetched should Washington become desperate enough with an imploding economy.

There is a way out, however. In my column next week I will show the way to an economic recovery and explain why increased government spending has not worked. While it is doubtful that Washington is in a mood to listen, nonetheless the Austrians really do have the answers. No. they don’t involve yet another “stimulus” and the accompanying threat of inflation.

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 less as 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.

According to the Associated Press:

Vowing to find new ways to stimulate the sputtering economy, President Barack Obama will call for long-term investments in the nation’s roads, railways and airports that would cost at least $50 billion, administration officials said.

The infrastructure investments are one part of a package of targeted proposals the White House is expected to announce in hopes of jump-starting the economy ahead of the November election.

The $50 billion in “front-loaded” spending likely means Obama will direct money quickly to those states and congressional districts where the Democratic incumbents are in trouble. Furthermore, since it was a Labor Day announcement, no one should be surprised that this new money is aimed at employing people who are part of organized labor: “In a Labor Day interview on CBS’ ‘Early Show,’ Labor Secretary Hilda Solis said the plan Obama was to unveil Monday would ‘put construction workers, welders, electricians back to work … folks that have been unemployed for a long time.”

While this initiative clearly is political, it is nonetheless important to take a harder look at this whole infrastructure argument. On the surface it seems to make some sense. Good roads, bridges, water, public transportation (including new passenger rail lines), and sewer systems would seem to benefit commerce wherever these things exist. How could these things be malinvestments if they appear useful?

Proponents claim that such aggressive infrastructure programs create win-win scenarios since they create present employment and they leave something useful behind. Only a skinflint (or an Austrian economist) can be against that.

Austrian analysis, however, should prompt us to question such projects, which lead to lower standards of living even as the government claims to create prosperity. Leaving aside whether projects like these should be undertaken by private enterprise, one easily can make a case that, as President Obama conceives them, they are little more than boondoggles that would use scarce resources in wrongheaded ways.

First, as pointed out, the bulk of this new spending would like be aimed at buying votes in districts where incumbent Democrats could lose in the November elections. The projects won’t be selected by economic criteria  — even if they could be. Forcing wealth transfers to create political benefits for others is standard practice with politicians, and this latest initiative seems to be right in that category.

Second, while government-created roads and bridges around the country really are in dangerous disrepair, the economy is not in peril because of that. It is in peril because the government, having created boom-and-bust conditions, now refuses to permit the necessary economic liquidations to occur while piling debt, bloated military spending, and other politically oriented expenses on top of any remaining healthy economic entities. So-called infrastructure spending does not begin to address this very real issue; it only adds to the economic burden.

Furthermore, we have an example of vast sums spent on infrastructure to stave off recession and failing miserably: Japan. The New York Times (whose editorial board, ironically, calls for such programs here) reports:

Japan’s rural areas have been paved over and filled in with roads, dams and other big infrastructure projects, the legacy of trillions of dollars spent to lift the economy from a severe downturn caused by the bursting of a real estate bubble in the late 1980s. During those nearly two decades, Japan accumulated the largest public debt in the developed world — totaling 180 percent of its $5.5 trillion economy — while failing to generate a convincing recovery.

Unfortunately, the wrong lessons are being learned. American officials are claiming that Japan’s example is proof that infrastructure funds should be better targeted. Once again we see that those who refuse to learn the lessons of history are doomed to repeat them.

Yet with literally trillions of dollars spent, the rate of unemployment hovers around 10 percent, many banks remain in a precarious state, and a meaningful economic recovery is as elusive as ever. On one side the Keynesians claim that had the government not spent these huge sums, the economy would have collapsed even more.

On the other side, however, are the members of the Austrian school of economics, who say that the very rush of government spending, along with the expansionary monetary policy of the Federal Reserve, has made the economy weaker not stronger. Obviously, the differences between the Austrian and the Keynesian views are fundamental, so if I am to point out why Austrians do not support government “stimulus” efforts, I need to supply something other than the usual political rhetoric.

Of the two economic viewpoints, the Keynesian one is easier to explain and appeals to the sentiments of ordinary people. As long as individuals spend all their income on consumption goods and do it quickly, the economy will hum along. However, if people get nervous and save some of their money, the economy will slip into the doldrums and only can be rescued by government spending.

In the Keynesian viewpoint, an economy is a circular-flowing mechanism that simply needs enough money to keep the wheels greased. Nothing else matters, just as long as the money keeps flowing.

The Austrian View

Austrians hold to a much different viewpoint. Here I wish to deal with what Austrians call malinvestments and explain what they are and why they lead to recessions. While Keynesians believe that the only thing which matters is spending on consumer goods (with all factors of production, including labor and capital, simply following whatever spending patterns arise), Austrians understand that the structure of production matters.

The production structure is the mix of factors that are used to produce goods over time, and in a market economy the value that consumers place on the final, or consumption, goods will be imputed to the various factors. For example, during the housing boom, a number of factors went into that line of production, from building materials to real estate agents. While the government directed new credit into the housing market, the economy boomed as owners of the factors gained new income.

However, the market could not sustain the housing boom as home prices increased at much faster rates than individual incomes and home sales fell. Furthermore, the financial instruments created to help finance the boom also lost value as it became obvious the boom could not continue.

In the Keynesian view the housing boom did not need to end; all that was needed was for the government to throw even more money into it and have the Federal Reserve purchase at face value the financial paper that had lost real value.

Austrians, however, hold that there were massive malinvestments in housing, and that the malinvested factors needed either to be liquidated or transferred to other uses that would reflect the directions of consumer choices.

Austrians believe that once an unsustainable boom begins, a bust is inevitable, and further attempts to sustain the boom only pull the structure of production into more distorted and unwieldy shapes. Thus the “stimulus” spending, according to Austrians, has not sustained the economy, but rather has further disfigured it, guaranteeing more disruptions in the future.

There is no way to reconcile these two viewpoints. To Keynesians an economy is a homogeneous mix of goods that needs only more money to be sustained. Austrians, however, know better. They understand an economy is complex and full of heterogeneous factors. Government stimulus, they realize, only makes things worse.