Where Keynes Went Wrong

From Chapter 1: Commonsense Economics

What would a commonsense economics look like? What would it have to say about the Crash of 2008, the ensuing economic slump, or the best policy response for a crisis of this kind?

We might begin by addressing this question to Timothy J. Kehoe, distinguished professor of economics at the University of Minnesota. He is a self-described "lifelong Democrat and Obama voter." He tells us that "if you postpone short-term pain, you end up with long-term pain."

He is thinking in particular of the Bush administration's bailout of banks, a giant insurer, and two auto companies: "[The] money disappeared; it was scandalous....Unproductive firms need to die."¹

This is hard advice, but it does sound commonsensical. Is it not better for sound companies to buy cheap assets from failed companies and put them to productive use?

We might next turn to Kenneth Rogoff, professor of public policy at Harvard and former chief economist of the International Monetary Fund. He says, in regard to the 2008 economic crisis and its aftereffects, "we borrowed too much, we screwed up, so we're going to fix it by borrowing more."² Rogoff is, of course, being ironical. He may also be trying to inject an element of commonsense into the economic policy discussion.

Consider this background. During the 1980s, the 1990s, and the 2000s, the US economy grew, but the amount of new debt grew much faster, especially during the housing bubble. Economist Marc Faber drew the commonsense conclusion: "When debt growth vastly exceeds nominal GDP [gross domestic product] growth, sooner or later something will have to give."³

Given this background, is it not defiant of commonsense for the US government to start up another and even bigger round of printing money, lending, and borrowing? This does sound suspiciously like trying to cure a hangover with more alcohol.

Wait a moment. We need to address an important question. Does commonsense actually have any relevance for national or global economic policy?^A If an individual, family, or business has been living for the day without regard for the morrow, spending more than it makes, buying what it does not need, saving nothing, making foolish and reckless investments, and borrowing more than it can repay, we do not prescribe more of the same. We counsel abstinence. But societies and governments are different, are they not? Has economics not taught us that the rules applying to an individual do not apply to society as a whole?

* * * * *

Where Keynes Went Wrong has been written in five parts, this introduction being Part One. Part Two attempts to summarize what Keynes really said, frequently relying on exact quotation. This part is not meant to be a "hatchet job." It is meant to present Keynes honestly, wherever possible speaking for himself.

The aim has been to be fair, but also to be clear. Keynes himself is often obscure, even at first glance self-contradictory. In some cases, very close examination reveals that Keynes was not actually contradicting himself. Often he was simply being sloppy, although sometimes he seems to be intentionally opaque, rather like former US Federal Reserve Chairman Alan Greenspan used to be when testifying to Congress. Opacity has its uses in politics, especially when there is a logical difficulty to obscure or evade.

Keynes's arguments are presented without interruption in Part Two, because that is the fairest way to present them, and also the best way to understand them. The same arguments are repeated in Part Three, sometimes verbatim but usually in condensed form, so that they can be dissected, reviewed, discussed, and rebutted. A reader who does not want to read Keynes's ideas in full and without interrruption can skip Part Two and go directly from Part One to Part Three. Conversely, a reader interested only in what Keynes said can skip Part Three.

Part Four tells us more about Keynes, especially his methods of persuasion. Part Five explores the paradoxical nature of Keynesian economics and also explains why it has so much potential for harm.

From Chapter 10: "Drive Down Interest Rates" (and Reap a Whirlwind of Inflation, Bubbles, and Busts)

1a. Keynes: Interest rates are too high.

The rate of interest is not self-adjusting at a level best suited to the social advantage but constantly tends to rise too high. . . .¹

1b. Comment: This is a frontal assault on the entire price system.

Keynes does not define any of his terms. He does not say what the "social advantage" is. He does not tell us how we will know when interest rates have fallen far enough. Nevertheless, he has told us something important—that the price system cannot be trusted.

It is important to keep in mind that interest rates are a price, the price of borrowed money. They are not only a price; they are one of the most important prices in an economy. All prices are interconnected, but this price in particular affects all other prices.

Businesses depend on prices to give them the information with which to run the economy. If the price system for interest rates is broken, no part of the price system is unaffected. If the price system is hobbled, it is a very serious matter because attempts to replace market prices with government-imposed prices have not generally been successful. As Oysten Dahle, a Norwegian oil executive, said about the Soviet Union, "[It] collapsed because it did not allow [market] prices to tell the economic truth."²

As a rule, we should be extremely wary of any argument that begins by throwing the market price system out the window, but for the moment we will withhold further judgment and see where Keynes is going.

* * * * *

8a. Keynes: By continually lowering interest rates, we can abolish slumps and enjoy a state of perpetual quasi-boom.

It may appear extraordinary that a school of thought should exist which finds the solution for the trade cycle in checking the boom in its early stages [before problems arise] by a higher rate of interest. . . .²⁰ The remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.²¹

8b. Comments:

i. As we have seen, this is a formula for creating inflations, bubbles, and crashes.

Is it possible to abolish slumps and live forever happily in a state of quasi-boom? US Federal Reserve Chairman Alan Greenspan experimented with this idea in the 1990s and 2000s and just produced bubbles.

Paul Krugman, Nobel Prize winning economist and fervent Keynesian, agrees that it should be possible to avert slumps, and if necessary to cure them, by running the government's printing press to reduce interest rates, and thereby to increase the demand for loans. He writes that "to many people it seems obvious that massive economic slumps have deep roots. To them, [the argument] that they can be cured by [the government] printing a bit more money seems unbelievable."²²

In reading this, we should pay close attention to the words "a bit more money." If printing "a bit more money" will "cure" a "massive economic slump," then only the tiniest amount of newly printed money should be needed to keep a boom going. But this has not proved to be the case. In fact, larger and larger amounts of new money are needed to keep a bubble from popping. Eventually all the debt associated with the new money becomes too great a burden for the economy and everything collapses.

ii. There is a diminishing return to taking on debt.

In the United States, we have operated on Keynesian principles since World War II. The government has printed money. Debt levels have grown. We have not only gotten inflations and bubbles. We have also gotten less and less growth for each increment of debt.

During the decade 1950–1959, we added $338 billion in debt, and we got 73¢ in economic growth (increase in gross domestic product) for each $1 in new debt. For the decade 1990–1999, we added $12.5 trillion in debt, but got only 31¢ of growth per dollar of debt. For the seven plus years 2000–2008 (1st quarter), we added $24.3 trillion in debt, but got only 19¢ in growth for every dollar of debt.²³ It thus required more and more debt to generate further growth.

iii. Eventually the return on debt becomes negative.

By the end of 2007, the debt machine shuddered and threatened to fail. Fed Chairman Bernanke immediately reduced interest rates to emergency levels. Wall Street took one last gulp of cheap credit. But it did not work. The crash came anyway.

What is actually happening here? Henry Hazlitt again explains:

If one truth concerning economic crises has been established . . . it is that they are typically brought on by cheap money—i.e., low interest rate policies that encourage excessive borrowing, excessive credit expansion, imprudent speculation, and all the distortions and instabilities in the economy that these finally bring about. . . . A policy of perpetual cheap money [produces] boom and bust, [not the perpetual quasi-boom that Keynes promised].²⁴

From Chapter 14: Government for Sale (A Digression to Discuss "Soft" US Political Corruption in the Context of the Housing Bubble and the Drug and Auto Industries)

In the prior chapter, we considered Keynes's claim that government could do a better job of investing than private enterprise. We evaluated this in terms of the potential threat that it posed for the economy. We have not yet considered what is arguably more important: the threat posed to our democratic institutions by allowing government to become completely mixed up with the world of money and business.

Historian Doris Kearns Goodwin observed that a degree of financial corruption has always existed in American government, but that it grew exponentially after the Civil War.¹ Why? Because business and government became so closely involved with each other. Sometimes it was the "hard" corruption of outright bribery. More often, it was the "soft" corruption of selling laws, tax breaks, rules, and decisions for campaign contributions, electioneering help, jobs, or other favors.

Government's job is to guard and protect us. But who will protect us from the guardians themselves, once they become corrupted? There is no certain recourse against a corrupt government.

In Russia today, a holding company, Basic Element, run by the financial oligarch Oleg Deripaska, owes $650 million to Alfa Bank, led by fellow oligarch Mikhail Fridman. Fridman presses Deripaska for repayment. Deripaska speaks to the Russian president, Dimitry Medvedev. The president calls in Fridman and the loan is magically deferred.²

Russia, having abandoned Communism, has embraced age-old principles of mercantilism. The state does not own the private sector as it once did. But there are really no boundaries between private and public. When businessmen need political favors, they know whom to call. When politicians need money, they also know whom to call. The crony capitalists and politicians are clever; they keep most of it concealed behind closed doors.

The world's most developed countries have not reached this point—yet. But day by day they are edging closer to the Russian model. The United States is a case in point.

From Chapter 19: Keynes Speaking

Keynes was a virtuoso of the spoken word. He could out-talk and out-debate anyone, and he knew it.

Bertrand Russell, fellow Cambridge professor, world famous philosopher and mathematician, and by common agreement one of the keenest minds of the 20th century, knew Keynes intimately. He said of their relationship, "When I disagreed with him, I felt I took my life in my hands and I seldom emerged without feeling something of a fool."¹

Contemporaries described Keynes as brilliant, quick-witted, ingenious, clever, dazzling, expansive, dramatic, lively, vivid, ironic, witty. He was a master both of exposition and of repartee. He could shift mood and mode of expression with lightning speed. Moreover, he always seemed to be "on," able to draw upon deep stores of nervous energy. As the art historian Kenneth Clark observed, "He never dimmed his headlights."²

From Chapter 20: Keynes Writing

Device Eleven: Misuse of Math

In chapter 15, we saw how Keynes wrote N = F (D), which means that employment, denoted N, is a function of demand. Demand however is defined as expected sales, not actual sales. We noted that expectations are not a measurable quantity and thus do not belong in an equation.

Much of Keynes's math is like this. As Henry Hazlitt has pointed out,

A mathematical statement, to be scientifically useful, must, like a verbal statement, at least be verifiable, even when it is not verified. If I say, for example (and am not merely joking), that John's love of Alice varies in an exact and determinable relationship with Mary's love of John, I ought to be able to prove that this is so. I do not prove my statement—in fact, I do not make it a whit more plausible or "scientific"—if I write, solemnly,

let X equal Mary's love of John,

and Y equal John's love of Alice,

then Y = f (X)

—and go on triumphantly from there. Yet this is the kind of assertion constantly being made by mathematical economists, and especially by Keynes.²⁷

Given the Alice In Wonderland quality of The General Theory,^BBB it should not surprise us that Keynes interrupts his own misuse of math to tell us that he (apparently) agrees with Hazlitt:

To say that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth [is] a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and nonquantitative concepts as the basis of a quantitative analysis.²⁸

He also warns of

symbolic pseudo-mathematical methods . . . of economic analysis.²⁹

After some of his own algebra he adds that:

I do not myself attach much value to manipulations of this kind.³⁰

It is quite typical of Keynes now to attack, now to disarm, now to shout, now to whisper, now to qualify his mathematical claims, now to ignore, even blatantly ignore, the same qualifications. On occasion, Keynes was even capable of a crude bluff. Writing a private letter to Montagu Norman, Governor of the Bank of England, he said that his theories (the same theories that would later appear in The General Theory) were a mathematical certainty, [not] open to dispute.³¹

Keynes certainly knew better. Some of his disciples did not. Economist Wilhelm Röpke noted in 1952 that

The [Keynesian] revolutionaries [take a stance of] . . . vehement self-assertion and barely veiled contempt, such as are habitual to the "enlightened" in dealing with those who remain in the dark. They seem to regard themselves as all the more superior in that they can point with obvious pride to the difficulty of their literature and to the use of mathematics, which lifts the "new economics" almost to the lofty heights of physics.³²

From Chapter 21: Upside-Down Economics: What Keynes Would Have You Believe

In Chapter 1, we suggested that Keynesian economics defied common sense.

Keynes, as usual, seemed both to agree and disagree. On page 349 of The General Theory, he extolled commonsense and pilloried "orthodox" economists for lacking it. Perhaps he forgot that on page 16 he had argued for an economics transcending simple observation and logic, the elements of commonsense, and had pilloried orthodox economists for being too simple.

Whatever Keynes may have thought about common sense, he was not a commonsense economist. As we have seen, his stock in trade was to take a commonsense proposition, for example that savers are more likely to get rich than spenders, turn it on its head, present it as a profound new insight....

From Chapter 22: What Is Really Wrong Here: The Central Paradox of Keynesianism

The central paradox of Keynesianism is that it attempts to "fix" the price and profit system—by subverting it. No free price or profit relationship is left untouched.

Does this sound exaggerated? Consider the following direct or indirect government price controls that comprise the Keynesian Policy Prescription:

A. Price controls

1. Interest Rate Controls

As we have previously noted, interest rates are some of the most critical prices. All prices are interrelated to a degree, but interest rates especially influence other prices. In the Keynesian system, followed by all world governments, interest rates are supposed to go in only one direction, down. If they rise, it is supposed to be for short periods only.