Sunday, 6 December 2009

Keynesian nonsense

As we enter the week of the pre budget report, I have decided to post a rather long essay I scripted several months ago.  It is heavily detailed, and can seem quite boring and dry, but it puts to bed the myth that governments can successfully 'prime the pump'.  Keynesian deficit spending has been shown by history to be completely useless, and over the week, I shall be writing several articles, refuting the basic tenets of Keynesian theory.  I just hope I have more than 10 readers by then to read it!

The Labour Party has initiated a Keynesian stimulus programme in order to restore growth to our battered economy. Gordon Brown has said this is the only way to proceed, and that ‘’savage’’ Conservative cuts will deepen the recession, and ‘’cause more debt, more deficits, more unemployment…’’ This is wrong, and based on a deeply flawed theory. Governments love Keynesianism because it gave them an economy theory that justified them surreptitiously taking greater control over our lives and the free economy.

The most famous example of a Keynesian stimulus is FDR’s New Deal. Contrary to popular belief, Herbert Hoover was a fiscal expansionist. Notable public works programmes under Hoover include the Hoover Dam, the San Francisco Bay Bridge, the Los Angeles Aqueduct. Hoover remarked ‘’No president before has ever believed that there was a government responsibility in such cases . . . we had to pioneer a new field.’’ Hoover also wasn’t Laissez Faire, as commonly believed. He introduced various protectionist measures, including the Smoot Hawley Tarriff Act. He also increased federal spending.

FDR increased federal spending by 106% between 1933 and 1940. Yet unemployment continued to rise, never falling below 14% of the population between 1933-39. Other examples of Keynesian stimulus programmes include Gerald Ford’s tax rebate programme, equalling $12 billion, in what Time Magazine dubbed ‘’Ford’s risky plan against slumpflation.’’ The economy did not improve. George W Bush gave out rebate cheques in 2001 and 2008 to stimulate the economy. Whilst tax cuts under any occasion are to be lauded, they didn’t solve the problem. President Bush also legendarily increased federal spending, yet we have had the biggest bust in history. Japan is also a notorious case of fiscal stimulus gone bad. Between 1992 and 1995, Japan tried six spending programmes that totalled 65.5 trillion yen, and they cut income taxes during 1994 and they cut taxes again in 1998 by 2 trillion, and in April that year, they unveiled a fiscal stimulus programme worth approximately 17 trillion yen, with 50% of their money allocated for public works. In November 1998, a fiscal stimulus worth 24 trillion yen. A year later in November 1999, Japan announced another fiscal stimulus worth 18 trillion yen. In October 2000, another stimulus was announced, worth 11 trillion yen. During the course of the ‘’lost decade,’’ Japan implemented 10 fiscal stimulus packages worth over 100 trillion yen. National debt as a proportion of GDP exceeded 100%, an extraordinary figure for peacetime.

The Keynesian economic theory is very flawed upon close analysis. Keynes believed that monetary policy is impotent during a recession, which was of course nonsense, as proved by Milton Friedman in his classic ‘’A Monetary History of the United States.’’ Keynes believed that when private sector investment collapses, the government must step in, using fiscal policy to boost aggregate demand. Keynes didn’t believe in the classical economy position that unemployment would be restored to full equilbrium on its own, and believed that high unemployment in the Depression was due to ‘’sticky’’ wages. However, in an article by Timothy Fuerst, called ‘’Perils of Price Deflation: An Analysis of the Great Depression,’’ he showed that wages actually fell during the Depression.

Another massive flaw in Keynesian theory is fiscal stimulus. There is nothing ‘’stimulating’’ about taking money from one section of the economy to boost another part. Overall money supply remains the same. If you really want to end a depression, you don’t offer temporary tax cuts or rebates. The Rational Expectations theorists completely discredited what I call paleo-Keynesianism, and it led to the development of New Keynesianism, as expounded by people like Paul Krugman and Greg Mankiw. The Rational Expectations theorists stated that people make careful economic decisions based on future expectations. They cannot be fooled by government, and as Gordon Brown’s investment vs. cuts strategy has shown, people expect future tax rises and spending cuts if debt and borrowing is sky high. In the halcyon days of Keynesianism, economists believed there was a long run trade of between inflation and unemployment. The massive inflation and unemployment completely destroyed this view. Inflation expectations play a greater role now, and if people believe a Keynesian stimulus programme will lead to higher inflation, they will adjust their behaviour accordingly. A University of Chicago economist, John Cochrane stated last year that fiscal stimulus ‘’is taught only for its fallacies.’’ Thomas Sargent of New York University stated ‘’ the calculations that I have seen supporting the stimulus package are back of the envelope ones that ignore what we have learned in the last 60 years of macroeconomic research.’’ Greg Mankiw, the doyen of the New Keynesians, has criticised the stimulus plan, and Stanford University economist John Taylor stated, ‘’the theory that a short run government spending stimulus will jump start the economy is based on old fashioned, largely static Keynesian theories.’’ You can’t manipulate the business cycle in the short term.

You actually cut government spending and permanently cut taxes, though of course a government that truly supports free market capitalism won’t be taxing much anyway. The perfect example of this is the 1921 recession in America. It was one of the most severe contractions since the emergency of the trade cycle, but it was also one of the shortest, and the economic rebound was one of the strongest in history. President Warren Harding followed a laissez faire strategy. He cut federal spending and cut taxes. And guess what, the recession ended in under one year. The Great Depression continued for nearly a decade despite massive fiscal injections. But a ‘’do nothing’’ approach ended the 1921 depression very quickly. There was no monetary stimulus, as the monetary base actually fell. The economic recovery was extremely strong, and led to the ‘’roaring twenties.’’ Of course, some believe the roaring twenties led to the bust. Personally, I believe it was the Fed, who encouraged a boom, and then when the banking system needed liquidity desperately, the Fed contracted the money supply by a 1/3. The historian, Thomas Woods, in his book ‘’Meltdown,’’ stated ‘’episode because it suggests government intervention is not required in such "crises.’’ The crisis proved that the free market is better at restoring equilibrium, adjusting prices and supplies much better than central government, because, as Friedrich Hayek so eloquently argued in his essay, ‘The Use of Knowledge in Society,’ a centrally planned economy could never match the efficiency of free and open markets because an individual knows only a small fraction of what is known, and as a consequence, a free market economy is complementary towards the decentralised nature of information throughout society.

Although I am an advocate of the Austrian School of Economics, I am also a realist, and realise that central banks and governments are here to stay, so here is what I believe should be done. Quantitative Easing is not inflationary. As the crisis hit Britain, M4 growth exceeded 15% a year. The velocity of circulation has collapsed. The monetary multiplier, which measures how the money supply increases as a consequence of a change in the monetary base, was running at 1.6 during the last decade. It has collapsed by half to 0.893. Despite Japan’s misguided fiscal policies, it increased the money supply during the lost decade without stimulating inflation. Indeed, the Japanese economy was crippled by deflation. As Ambrose Evans Pritchard has pointed out, capacity utilization is on average running at 50-60%. This will put the lid on any inflationary pressures. If the government is to cut taxes, it should cut spending even more, which means a deficit decrease and a tax cut. If one believes the Laffer Curve, in the long run we will generate more income. As Edmund Conway pointed out on Thursday, our budget deficit is forecast to be so huge because of a dramatic fall in tax receipts. The new 50% tax will drive entrepreneurs away. Brown and Darling like to say ‘’it wasn’t an easy decision to make,’’ or ‘’It was one of the tough decisions we have made to get the deficit under control,’’ but everyone knows it is Labour returning to their class warfare routes.

The government consumes. It doesn’t produce. The government exists because we pay taxes. It can’t generate wealth. The government should cut its budget dramatically, and heavily cut income and corporation taxes. This will enable our businesses to expand, employ more people, which creates more taxpayers, which equals more revenue. This will lead to further expansion and the cycle continues. And we should have a more pro-active monetary policy because in the real world, we will never abolish central banks.


A Monetary History of the United States 1867-1960 by Milton Friedman and Anna J Schwartz

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