Is Keynes to Blame?

When evaluating the theory of John Maynard Keynes in the context of current monetary and fiscal policies in the United States, Austrians are quick to bash Keynes and blame his theory for most of the mess we are in today. I find myself engaging in this kind of general accusation all too frequently. But, while I think some of these accusations are well deserved by Keynes himself, a lot of the blame lies elsewhere. Let me explain.

There are undoubtedly massive problems with Keynesianism. Fundamental issues such as the broken window fallacy, the assumption of the irrational behavior of consumers (animal spirits), and the homogeneous structure of capital create giant holes in his theory. Unfortunately, many of these crucial snags are overlooked by the mainstream economics establishment in academia, and therefore by our policy makers as well. For decades now, organizations such as the Mises Institute, the Foundation for Economic Education, the Institute for Humane Studies, The Koch Foundation, and many others have worked to expose these fallacies not only in academia, but also to undergraduates, high school students, and the population as a whole. Progress is definitely being made, especially through efforts in new media via Facebook and YouTube targeting our small-attention-span culture.

But, Keynes still reigns supreme—or that’s what one would assume. In reality, that is not true. One huge omission is made to Keynes’ theory when he is cited consciously and subconsciously by congressional leaders, presidents, and central bankers: the importance of balancing deficit and surplus spending over the business cycle, and establishing a monetary policy that coincides with that goal.

Keynes made it very clear that while deficit spending could be used to combat a recession and help bring the economy back to natural output, government surpluses were necessary during economic booms to fund that deficit spending. This would ultimately lead to a fluctuation between deficits and surpluses from year to year, but over the entire business cycle would lead to a balanced budget and prevent the accumulation of massive sovereign debt. This of course is assuming the budget is balanced in respect to tax revenue, social programs, and defense spending in the absence of the need for economic stimulus. Since fiscal and monetary policies go hand in hand, the central bank must follow suit by cutting interest rates in times of recession and raising them again in times of expansion to smooth out the harmful effects of the business cycle.

What we see in reality is a complete deviation from this theory.

Looking back in history, we have seen the federal government consistently run larger and larger deficits while maintaining a fairly predictable easy credit monetary policy. This completely disregards Keynes’ call for monetary retraction and budget surpluses during expansionary periods. Honestly, I don’t find it surprising that this distortion has occurred. When you give the government the power and justification (legitimized by academia) to spend other people’s money with the guise of ensuring economic stability, they will do so without restraint. There always seems to be some need for fiscal and monetary stimulus, both in relatively prosperous economic times and in economic crises. For example, after the Dot-com bubble burst at the turn of the century, the Federal Reserve lowered interest rates to 1%. President Bush passed tax cuts that were supposed to act as fiscal stimulus as well. As the years went on, the stock market started to boom, and housing prices shot up, creating the mortgage-backed-security market as well as prevalent house flipping. At this point, Keynes would have called for the brakes to be applied; to take advantage of the new expansion and balance the budget deficit created by the tax cuts, and increase interest rates to pull money out of the system and prevent against inflation. Unfortunately, the brakes were not applied. The bubble finally burst, and recessionary conditions returned. As output fell dramatically and enormous amounts of wealth were erased overnight, the federal government and Federal Reserve acted quickly and took bold action to hopefully ease the effects of the oncoming recession by spending trillions of dollars in the name of stimulus and cutting interest rates even further to practically zero percent.

And the same cycle will continue. National debt just hit $15 trillion. The Fed is now meddling with the long-term bond market to bring long-term yields down because short-term yields can’t go any lower. The constant disrespect for a critical part of Keynes’ theory is fueling this behavior.

So when we cite Keynes as being the source of our absurd economic policies, we need to keep in mind that politicians and central bankers aren’t even adhering to the basic tenants of Keynesianism! I think he is rolling in his grave watching the world completely misinterpret what he was trying to say. I find myself always referring to politicians and central bankers as Keynesians, but in reality, they can’t even get his theory remotely correct.

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~ by rfreeland on November 20, 2011.

7 Responses to “Is Keynes to Blame?”

  1. obviously you do not understand the basics of macroeconomics. Such things as crowding out (broken window) only occurs when the labor market is at full employment.

    • The Broken Window fallacy is not “crowding out”. It is a fallacy that is consistently cited as a reason why destruction is an opportunity for economic expansion. Viewing the economy as a flow instead of a stock is the fundamental problem underlying the Broken Window. When capital is destroyed, people are worse off.

    • Also, in response to your accusation that I do not understand the basics of macroeconomics:

      You are correct. I do not understand mainstream macroeconomic theory in the sense that I do not understand how very intelligent academics, scholars, and politicians continue to accept and spread the lies that form the foundation of neoclassical economics. When micro and macroeconomics are separated and treated as independent animals, I know there is a problem. My understanding of macroeconomics comes from a microeconomic foundation — which I don’t think neoclassicals can maintain.

      The foundation of economics is individual human action. We all make individual choices in the market place. This fundamental value is overlooked when economic variables are over-aggregated, analyzed, and policies are prescribed for the entire economy. People are not just pawns on a chess board, subject to the whims and “infinite knowledge” of central planners. Knowledge is dispersed amongst the millions of people making up an economy, and that knowledge can only be tapped through the free market where prices accurately reflect supply and demand and allocate capital to where it is truly valued. When we have governments that act on the assumption that capital is homogenous, capital is directed toward items that we do not value as individuals. This in turn leads to price distortions, wrong economic signals for investors, and eventually the creation of the increasingly destructive business cycles we see today.

      So you may continue to affirm that I do not understand economics, but maybe taking a step back from all the neat models of neoclassicism and evaluating the fundamentals of economics that truly drive the economy would be rewarding to you in your quest to understand the world better.

  2. The Parable of the Broken window is often cited as an example of crowding out. Furthermore, the Parable of the broken window isn’t necessarily true in many situations. For example whenever the labor market is experiencing a high rate of unemployment, or if the velocity of money is decreasing. Finally a good economic statement isn’t one that relies on being universally correct. This is because a good economic statement is normally one that is conditional.

  3. Finally I would like to point out that vector-auto regression models suggest that central banking policy may have played a very small role in producing this economic crisis. Instead the focus should be more on changes in laws and long term interest rates.

  4. First of all, I would like to thank you for finding my blog and taking the time to respond to my latest post. I am always open to a fruitful discussion.

    When looking at our latest crisis, it is important to figure out why the market crashed and what caused the recession: a misallocation of capital that creates the need for market correction. This market correction, as we have seen in the housing market over the past few years, is not deflation. It is the process of moving misallocated capital from where it is currently not in demand to sectors where true demand lies. The Fed’s easy money policy throughout the early 2000s, combined with federal lending initiatives that encouraged banks to lend to risky buyers (because they guaranteed all the mortgages and therefore caused moral hazard) propped up the housing market artificially. The logic that house prices could rise forever is ridiculous.

    After the collapse, the Fed cut interest rates even more, and now is meddling in the long-term bond market because their over-aggregated models tell them this will stimulate economic growth, and it may in the short term. But, that artificially low-priced money will find its way into another bubble.

    It’s rather funny to watch congress, the President, and the Fed all continue to use the same policies and expect different results. What we need is true market prices acting as signals in the money market, and ideally, all other markets as well. As painful as it may be, we can’t continue propping up the housing industry. Prices must be allowed to bottom out. This is the only way we will see recovery, not through spending trillions of dollars and inflating our currency away.

  5. Fluctuations in the business cycle are primarily caused by changes in the money supply and a change in technology(innovation). During the early-middle 2000’s it became quite obvious that our central banking system would eventually start increasing interest rates, and by 2005 the prediction was fulfilled when the overnight lending rate settled at 3-5%. Despite the apparent trend that interest rate policy may have been changing, such things as CDS, Mark-to-Mark accounting, ARM’s, had been growing at a geometric rate since the late 90’s, and their growth continued despite recent interest rate policies. Henceforth, asset speculation continued to occur throughout the decade despite changes in interest rate policy. Furthermore, these interest rate policies may have indeed caused a change in the money supply. This is derived from the fact that the velocity of money started to decrease in 2005, but housing prices still increased until 2007. In brief some key indicators imply that monetary policy in the 2000’s may have had very little impact in fostering the housing bubble, and therefore the primary culprit should be the speculation that was fueled by financial innovation.

    The idea that the expectations of investors can be motivated even in the absence of low interest rate monetary policy isn’t surprising. For example the Tulip Bubble of the 17th century, and the comic book bubble of the 1990’s was most likely driven by this kind of thinking.

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