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Friday, March 2, 2018

In Defense of Keynesian Economics, Part 1

One of the most popular pastimes among libertarians is to bash Keynes and Keynesian economics. This is deeply unfortunate, because libertarians - like myself - have a lot to learn from Keynes. 

In fact, Keynesian economics, correctly understood, is a superior foundation for fiscal and monetary policy. To get there, though, we have to address some mistakes that are all too often made by critics of Keynes, especially on the political right.

The most recent example - among many - is provided by Ivan Jankovic, contributing writer with the American Institute for Economic Research (for which I too did a stint as contributing writer, full disclosure).
I will use Jankovic's piece on Keynes and the supposed fallacy of Keynesian economics as an example of how Keynes is being castigated by libertarians for somehow being the well from which the modern evil of big government has sprung.

This does not mean Jankovic is alone in this anti-Keynesian endeavor. As we will see in later installments of this defense of Keynesian economics, he is just one of many voices. However, his blog article is a good summary of how uninformed Keynes critics think. This is particularly important keeping in mind that Jankovic, like almost every other libertarian economist I have encountered, has made Austrian economics a main research field and apparently his scholarly home turf.

Jankovic starts off with a quote attributed to Keynes:
“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” 
Of all the Keynes quotes one can find floating around on the internet, this is one of the most widely used. As so many other quotes of famous people, this one is almost always torn out of its context. Keynes had decades-long debates with other academic economists, with Arthur Cecil Pigou and Friedrich von Hayek as two of many examples. This quote is a reflection of how Keynes felt that some academics won undeserved influence over public policy.

Unlike most of his opponents and contemporary critics, Keynes was a prolific public policy writer. This leads to one of three mistakes that Keynes's modern critics often make.

Jankovic makes this first mistake. Here is how he uses the aforementioned Keynes quote to build a case against Keynesian economics:
This is how John Maynard Keynes described the relationship between original thinkers, on the one hand, and second-hand dealers in ideas—journalists, activists, and politicians—on the other. People usually believe that they are just espousing common sense, when what they are actually doing is unwittingly parroting the peculiar ideological orthodoxies of some professor in the past. It is a rich irony of history that the said “madmen of authority” and “practical men” of today’s world, when it comes to economics at least, for the most part are the slaves of late Keynes himself. 
Keynes carefully separated his policy writings from his academic endeavors. Books like Treatise on Probability (in modern parlance, his thesis on microeconomics), Treatise on Money and The General Theory of Employment, Interest and Money (his foundational piece on macroeconomics) represent a solid line of scholarly work on economic theory and its real-world implications. At the same time, Keynes penned dozens of volumes of essays and articles dealing with practical policy issues. 

His essays are not always informed by his academic work, especially not in terms of macroeconomics; General Theory was published in 1936, after which Keynes was out of the game for health reasons for about three years. Alas, between his macroeconomic masterpiece and his untimely death in 1946, he did not do very much to explain how his work would change economic policy.

When Jankovic and others quote Keynes like this, they associate his scholarly work with his polemic - and often brilliantly witty - public policy writings. In other words, the quote that Jankovic shares really has nothing to do with the application of Keynesian theory of modern-day economic policy. 

The second mistake that Keynes's critics make is one of associating interpretations of Keynes's contributions with - yes - Keynes's contributions. Jankovic again:
One of his main assertions, which is more difficult to kill than a zombie in sci-fi movies, is that there must be a trade-off between inflation and unemployment. Inflation goes up, employment goes down. If there is full employment and wages start going up, the thinking goes, that’s a sure sign of impending inflation, that the economy is “overheating” and consequently it has to be cooled down by the central authorities through increased taxes and tighter monetary policy. However, if unemployment is low, then the government has to shift the printing press in sixth gear and finance a budget stimulus to “warm up” the economy. 
I would kindly ask Jankovic, and every other Keynes critic who associates this so-called Phillips Curve with Keynes, to please show where Keynes himself defines this relationship between unemployment and inflation. The truth is, they can't, because contrary to what Jankovic says in the first sentence of this quote, Keynes never formulated the Phillips Curve. It was the work of a statistician from New Zealand, a certain A W Phillips, developed after Keynes's death. 

It is understandable, however, that Jankovic makes this mistake. As he himself points out, using the Keynes quote, many people listen to the wrong authority when trying to formulate their own thinking. The Phillips Curve has become attributed to Keynes primarily because it was included in a package of so-called Keynesian economic theory in macroeconomic textbooks during the 1950s and 1960s. The main "culprit" here is Paul Samuelson, whose economics textbooks were probably the most successful of the 20th century. Using an assortment of sources, including but not limited to J R Hicks's precursor to the IS-LM model, Samuelson built the formal narrative of Keynesian economics that was not in Keynes's own works, but was attributed to him by virtue of what was taught in countless macroeconomics classes around the globe.

The Phillips Curve itself has been elevated far and above its own analytical merits. It described accurately a trade-off between inflation and unemployment for about a quarter century in the mid-1900s, but it was never Phillips's intention that it be used as a tool for generalized economic laws. The unfortunate introduction of algebra and econometrics into macroeconomics in the 1950s compounded the problem by yet again undeservedly elevating the Phillips Curve: it made for a neat one-liner in a recursively soluble macroeconomic equation system. 

In other words, if you want to criticize the Phillips Curve and any fiscal and monetary policy decisions informed by it, talk to Paul Samuelson, not Keynes.

Perhaps it is worth noting that the death of the frenzy over the Phillips Curve is long overdue. Jankovic again: 
This Keynesian thermodynamics is thoroughly absorbed, almost by osmosis, by journalists, intellectuals, and even economic analysts. It’s everywhere. Over the last couple of weeks, a breathless chorus of Keynes’s adherents in the media have been sounding the alarm from the rooftops about economic “overheating.” The economy is doing too well, it’s almost at full employment, and wages are growing. Rising wages will lead to inflationary expectations, these expectations to Fed rising interest rates, and all of this to recessionary pressures. 
Here is another myth, often dispensed by Keynes's critics. Truth is, Keynes never developed any "thermodynamics" of economic policy. This myth is, again, attributable to how his scholarly contributions were "algebrized" into what modern macroeconomics books presented as IS-LM and AD-AS equation systems. 

Keynes was not a business-cycle economist. He was a depression specialist. His entire General Theory is a response to the Great Depression, a tutorial, if you will, for politicians on how to deal with a macroeconomic situation where the private sector is stuck in abundant pessimism. The book is not a policy manual; in fact, with one exception Keynes is notably vague on the applications of his theory. Instead, the book explains why an economy gets stuck in a depression and why the private sector cannot get out of it on its own. 

The one exception to Keynes's policy vagueness is his prescription that government help activate the economy. This is the latch that all his critics grab hold of - and all his misinformed leftist supporters cling to when they prescribe government spending right, left, up and down throughout every recession that comes along. 

I will devote the second part of this series to a more detailed account of Keynes's anti-depression policies. For now, let us make clear that when Keynes sees an active role for government in lifting the economy out of a depression, it does not mean that he has the same recipe for fiscal policy in a recession. 

Jankovic, like so many other Austrian economists, fails to separate recessions from depressions. The reason seems to be buried deep within the layers of Austrian economics itself, but appears to boil down to the idea that there is no economic downturn that the private sector cannot cure, if it is just left to fend for itself. 

As a libertarian, I am philosophically inclined to agree with this viewpoint. Beyond the protection of life, liberty and property, there is no role for government in the economy. However, as I explained in my doctoral thesis a long time ago, especially in the under-appreciated third part, there is a conflict between libertarian philosophical thought and macroeconomic reality. 

Austrian economics gives libertarians a pass on reality. Keynesian economics forces them back out there.

The third mistake Keynes's critics make relates to wages and prices and the conditions under which they are determined. Jankovic, sharing in this mistake, pins it on Keynes to have defined inflation as a wage-driven phenomenon. This, in turn, is a misunderstanding of the role of price contracts in the economy, one that harks back to the big difference between Walrasian prices and what is best thought of as "uncertainty pricing". 

Austrian economists are closely tied to Walrasian price theory, which has consequences for how they view the economy and its self-healing ability. I recently wrote a conference paper on this, and I will return to the price theory side of Keynesian economics in the third installment of this series. For now, the point is that those who criticize Keynes for somehow endorsing - or even relying on - sticky wages as an explanation of recessions, have not understood the role of time and uncertainty in Keynesian theory.

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