Recession
and Recovery
Six Fundamental Errors of the Current Orthodoxy
by
Robert Higgs
by Robert Higgs
As the recession
has deepened and the financial debacle has passed from one flare-up
to another during the past seven or eight months, commentary on
the economy's troubles has swelled tremendously. Pundits have pontificated;
journalists and editors have reported and opined; talk-radio jocks
have huffed and puffed; public officials have spewed out even more
double-talk than usual; awkward academic experts, caught in the
camera's glare like deer in the headlights, have blinked and stumbled
through their brief stints as talking heads on TV. We've been deluged
by an enormous outpouring of diagnosis, prognosis, and prescription,
at least ninety-five percent of which has been appallingly bad.
The bulk
of it has been bad for the same reasons. Most of the people who
purport to possess expertise about the economy rely on a common
set of presuppositions and modes of thinking. I call this pseudo-intellectual
mishmash vulgar Keynesianism. It's the same claptrap that has passed
for economic wisdom in this country for more than fifty years and
seems to have originated in the first edition of Paul Samuelson's
Economics
(1948), the best-selling economics textbook of all time and the
one from which a plurality of several generations of college students
acquired whatever they knew about economic analysis. Long ago, this
view seeped into educated discourse and writing in the news media
and in politics and established itself as an orthodoxy.
Unfortunately,
this way of thinking about the economy's operation, particularly
its overall fluctuations, is a tissue of errors of both commission
and omission. Most unfortunate have been the policy implications
derived from this mode of thinking, above all the notion that the
government can and should use fiscal and monetary policies to control
the macroeconomy and stabilize its fluctuations. Despite having
originated more than half a century ago, this view seems to be as
vital in 2009 as it was in 1949.
Let us
consider briefly the six most egregious aspects of this unfortunate
approach to understanding and dealing with economic booms and busts.
Aggregation.
John Maynard Keynes persuaded his fellow economists and then
they persuaded the public that it makes sense to think of the economy
in terms of a handful of economy-wide aggregates: total income or
output, total consumption spending, total investment spending, and
total net exports. If people remember anything from their introductory
economics course, they are most likely to remember the equation:
Y
= C + I + G + (X – M).
Sometimes Q
• P is equated to the variables on the right-hand side of the equation.
So, the idea is that aggregate supply (physical output times the
price level) equals aggregate demand equals the sum of four types
of money expenditure for newly produced final goods and services.
This way
of compressing diverse, economy-wide transactions into single variables
has the effect of suppressing recognition of the complex relationships
and differences within each of the aggregates. Thus, in this
framework, the effect of adding a million dollars of investment
spending for teddy-bear inventories is the same as the effect of
adding a million dollars of investment spending for digging a new
copper mine. Likewise, the effect of adding a million dollars of
consumption spending for movie tickets is the same as the effect
of adding a million dollars of consumption spending for gasoline.
Likewise, the effect of adding a million dollars of government spending
for children's inoculations against polio is the same as the effect
of adding a million dollars of government spending for 7.62 mm ammunition.
It does not take much thought to conceive of ways in which suppression
of the differences within each of the aggregates might cause our
thinking about the economy to go seriously awry.
In fact,
"the economy" does not produce an undifferentiated mass we call
"output." Instead, the millions of producers who bring forth "aggregate
supply" provide an almost infinite variety of specific goods and
services that differ in countless ways. Moreover, an immense amount
of what goes on in a market economy consists of dealings among producers
who supply no "final" goods and services at all, but instead supply
raw materials, components, intermediate products, and services to
one another. Because these producers are connected in an intricate
pattern of relations, which must assume certain proportions if the
entire arrangement is to work effectively, critical consequences
turn on what in particular gets produced, when, where, and
how.
These extraordinarily
complex micro-relationships are what we are really referring to
when we speak of "the economy." It is definitely not a single, simple
process for producing a uniform, aggregate glop. Moreover, when
we speak of "economic action," we are referring to the choices
that millions of diverse participants make in selecting one course
of action and setting aside a possible alternative. Without choice,
constrained by scarcity, no true economic action takes place. Thus,
vulgar Keynesianism, which purports to be an economic model or at
least a coherent framework of economic analysis, actually excludes
the very possibility of genuine economic action, substituting for
it a simple, mechanical conception, the intellectual equivalent
of a baby toy.
Relative
prices. Vulgar Keynesianism takes no account of relative prices
or changes in such prices. After all, in this framework, there's
only one price, which is called "the price level" and represents
a weighted average of all the money prices at which the economy's
countless actual goods and services are sold. (There's also the
rate of interest, which is treated as a price in a limited and misleading
way; about which I say more later.) If relative prices change, which
of course they always do to some extent, even in the most stable
periods, these changes are "averaged out" and affect the calculated
change, if any, in the aggregate price level only in a shrouded
and analytically irrelevant manner.
So, if
the economy expands along certain lines, but not along others, in
response to a change in the configuration of relative prices, the
vulgar Keynesians know that "aggregate demand" and aggregate supply"
have risen, but they have no idea why or in what manner they have
risen. Nor do they care. In their view, the economy's aggregate
output, the only output they treat as worthy of notice, is driven
by aggregate demand, to which aggregate supply responds more or
less automatically, and it matters not whether only the demand for
cucumbers has risen or, to cite an example Keynes himself used,
only the demand for pyramids has risen. Aggregate demand is aggregate
demand is aggregate demand.
Because
the vulgar Keynesian has no conception of the economy's structure
of output, he cannot conceive of how an expansion of demand
along certain lines but not along others might be problematic. In
his view, one cannot have, say, too many houses and apartments.
Increasing the spending for houses and apartments is, he thinks,
always good whenever the economy has unemployed resources, regardless
of how many houses and apartments now stand vacant and regardless
of what specific kinds of resources are unemployed and where they
are located in this vast land. Although the unemployed laborers
may be skilled silver miners in Idaho, it is supposedly still a
good thing if somehow the demand for condos is increased in Palm
Beach, because for the vulgar Keynesian, there are no individual
classes of laborers or separate labor markets: labor is labor is
labor. If someone, whatever his skills, preferences, or location,
is unemployed, then, in this framework of thought, we may expect
to put him back to work by increasing aggregate demand, regardless
of what we happen to spend the money for, whether it be cosmetics
or computers.
This stark
simplicity exists, you see, because aggregate output is a simple
increasing function of aggregate labor employed:
Q
= f (L), where dQ/dL > 0.
Note that this
"aggregate production function" has only one input, aggregate labor.
The workers seemingly produce without the aid of capital! If pressed,
the vulgar Keynesian admits that the workers use capital, but he
insists that the capital stock may be taken as "given" and fixed
in the short run. And – which is highly important – his whole apparatus
of thought is intended exclusively to help him understand this short
run. In the long run, he may insist, we are, as Keynes quipped,
"all dead"; or he may simply deny that the long run is what we get
when we place a series of short runs back to back. The vulgar Keynesian
in effect treats living for the moment, and only for it, as a major
virtue. At any given time, the future may safely be left to take
care of itself.
The
rate of interest. The vulgar Keynesian may care about the rate
of interest, but only in a restricted sense. For him, the rate of
interest is the "price of money," that is, the price paid for borrowing
money. Such borrowing is always good, and more of it is better,
because individuals use borrowed money to purchase consumer goods,
thereby "creating jobs." Hence, the lower the rate of interest,
the more people will borrow and spend, and the better the economy
will function, again so long as any unemployment exists anywhere
in the country. Because some unemployment always exists, the vulgar
Keynesian always wants the rate of interest to be lower than it
is. If it can be lowered artificially by central-bank action, he
strongly favors such action.
He does
not understand what the rate of interest really is. He fails to
comprehend that it is a crucial relative price – namely,
the price of goods available now relative to goods available in
the future. Remember: he does not think in terms of relative prices
at all, so it is entirely natural that he fail to recognize how
the rate of interest affects the choice between current consumption
and saving (that is, making possible more future consumption by
not consuming current income). In a free market, a reduction in
the rate of interest reflects a desire to shift more consumption
from the present to the future.
A free
market would comprise private suppliers and demanders of loanable
funds, and the prevailing market rate of interest would be that
at which the amount demanders want to borrow equals the amount suppliers
want to lend. Both borrowers and lenders, however, are making their
choices in the light of their "time preference," which is to say,
the rate of which they are willing to trade present goods for future
goods. People with a "high rate of time preference" are keen to
consume now, rather than later, and to induce them to give up present
consumption, borrowers must compensate them by paying a high rate
of interest for the use of their funds.
Although
vulgar Keynesians recognize that a lower rate of interest will spur
business firms to borrow more money and invest it, they imagine
that business investment plans are naturally volatile and essentially
irrational – driven, as Keynes said, by the entrepreneurs' "animal
spirits." Hence, the degree to which investment responds to a change
in the rate of interest is small and may be more or less disregarded.
For them, the importance of the rate of interest is that it regulates
the amount that individuals will borrow to finance their purchases
of consumer goods. Those purchases, in the vulgar Keynesian view,
are the essential element in the determination of how much firms
want to produce and how much they want to invest in expanding their
capacity to produce. Again, in this framework, it matters not what
kind of investment takes place: investment is investment is investment.
Capital
and its structure. As noted already, the vulgar Keynesian views
the capital
stock as "given." If he thinks about it at all, he considers it
a sort of massive inheritance from the past and assumes that nothing
that might be added to or subtracted from it in the short run will
change it enough to warrant concern. But if he gives little thought
to capital, he gives none at all to its structure: the fine-grained
patterns of specialization and interrelation among the countless
specific forms of capital in which past saving and investment have
become embodied. In his framework of analysis, it matters not whether
firms invest in new telephones or new hydroelectric dams: capital
is capital is capital.
Because
the structure of the capital stock is disregarded – even sophisticated
economists, such as Frank Knight, have insisted that the capital
stock is essentially an undifferentiated glob of monetary value,
any part of which may be substituted perfectly for any other part
of equal monetary value – no attention is given to how changes in
the rate of interest bring about changes in the structure of the
capital stock. After all, what possible difference can it make?
This willful blindness has caused many economists, including the
most recent Nobel laureate, Paul Krugman, to misinterpret the Austrian
theory of the business cycle as a theory of "overinvestment," which
it definitely is not.
Instead,
the theory pioneered by Ludwig von Mises and F. A. Hayek in the
first half of the twentieth century – a theory that fell into near-oblivion
after the Keynesian Revolution in macroeconomics – is a theory of
malinvestment, which is to say, a theory of how an artificially
reduced rate of interest leads business firms to invest in the wrong
kinds of capital – in particular, in the longest-lived capital
goods, such as residential and industrial buildings, as opposed
to inventories and equipment with a relatively short life. Thus,
in the Austrian view, Fed-induced low rates of interest, like those
between 2002 and 2005, lead firms to overvalue longer-term capital
projects and to shift their investment spending in that direction,
producing, for example, booms in building construction. This shift
would make economic sense if the interest rate had fallen in a free
market, thereby signaling that people wish to defer more consumption
by saving more of their current income. But if people have not in
fact changed their preferences in this way and continue to prefer
present consumption relatively as much as before, then businesses
will make mistakes by choosing these kinds of investment projects,
which are, in effect, attempts to anticipate future demands that
will never eventuate. When the projects ultimately begin to fail,
the boom that artificially lowered interest rates set in motion
will collapse into a bust, with attendant bankruptcies and unemployed
labor, as unsustainable projects are liquidated and resources shifted,
painfully in many cases, to more viable uses.
Because
the vulgar Keynesian is blind to these micro-distortions and to
the need for their correction in the wake of an artificially induced
boom, he will fail to see any need for bankruptcies and unemployment.
He supposes: if only the government stepped in and used its own
deficit spending to make up for the reduced private investment and
consumption spending, then business would be restored to profitability
and workers reemployed without any economic restructuring.
It comes
as no surprise, then, that people who think along such lines are
currently working to continue a policy that contributed greatly
to producing the unsustainable boom of 2002–2006, namely, subsidized
lending to would-be homeowners who cannot meet normal commercial
qualifications for receiving such loans. It does not occur to the
vulgar Keynesians that too many resources have been directed into
house and condo construction and that lending to homeowners who
can afford to purchase homes only if subsidized to do so signals
an uneconomic use of resources at the expense of the taxpayers who,
directly or indirectly, finance these subsidies.
 Malinvestments
and money pumping. With their great, simple faith in the efficacy
of government spending as a macroeconomic balance wheel, vulgar
Keynesians disregard malinvestment, past and future, and support
government spending in excess of the government's revenues, the
difference being covered by borrowing. Of course, they favor central-bank
actions to make such borrowing cheaper for the government. In fact,
they chronically prefer "easy money" to more restrictive central-bank
policies. As noted previously, they prefer easy money not only because
it lowers the cost of financing the government's deficit spending,
but also because it induces individuals to borrow more money and
spend it for consumption goods – such increased consumption spending
being viewed as always a good thing, notwithstanding the recent
near-zero rate of saving by individuals in the United States. Reflecting
on the vulgar Keynesian attitude toward Fed policy, I keep recalling
an old country song whose refrain was: "older whiskey, faster horses,
younger women, more money."
Vulgar
Keynesians do not spend much time worrying about potential inflation;
on the contrary, they are obsessed with an irrational fear of even
the slightest hint of deflation. If inflation should become an undeniable
problem, we may count on them to support price controls, which,
they are convinced on the basis of sketchy knowledge of such controls
during World War II, can be made to work well.
 Regime
uncertainty. Vulgar Keynesians are nothing, if not policy activists.
Like Franklin D. Roosevelt, they believe that the government should
"try something," and if it doesn't work, try something else. Better
still is that the government try a bunch of things at once, and
if they don't turn the trick, then pour more money into them and
try something else, to boot. The eras they esteem as the most glorious
ones in U.S. politico-economic history are Roosevelt's first term
as president and Lyndon B. Johnson's first few years in the presidency.
These periods witnessed an outpouring of new government measures
to spend, tax, regulate, subsidize, and generally create mischief
on an extraordinary scale. The Obama administration's ambitious
plans for government action on many fronts fill vulgar Keynesians
with hope that a third such Great Leap Forward is now beginning.
The vulgar
Keynesian does not understand that policy activism itself works
against economic prosperity by creating what I call "regime uncertainty,"
a pervasive uncertainty about the very nature of the impending economic
order, especially about how the government will treat private property
rights in the future. This kind of uncertainty especially discourages
investors from putting money into long-term projects. Such investment,
which almost disappeared after 1929, did not recover until after
World War II. More than one observer has commented in recent weeks
that regime uncertainty has arisen recently from the government's
frenetic series of bailouts, capital infusions, emergency loans,
takeovers, stimulus packages, and other extraordinary measures crammed
into a period of less than a year, many of them into the past six
months. With the commencement of the Obama administration, prospects
appear favorable for a continuation of this kind of frantic policy
activism. It cannot help, and it may hurt a great deal.
March
6, 2009
Robert
Higgs [send him mail] is
senior fellow in political economy at the Independent
Institute and editor of The
Independent Review. He
is also a columnist for LewRockwell.com. His
most recent book is Neither
Liberty Nor Safety: Fear, Ideology, and the Growth of Government.
He is also the author of Depression,
War, and Cold War: Studies in Political Economy, Resurgence
of the Warfare State: The Crisis Since 9/11 and Against
Leviathan: Government Power and a Free Society.
Copyright
© 2009 Robert Higgs
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