Keynes vs. the Classics, circa 2010

The debates between John Maynard Keynes and those who do not accept his views are just as fresh today as they were in the 1920s and 30s. That is both a testament to the power of Keynes' ideas and a damning indictment of Economics' claim to be a science. Two cases in point:

(1) Recent fears that inflation is just around the corner, coupled with skepticism about the effectiveness of last year's fiscal stimulus. From Keynes' "A Programme of Expansion," May 1929:

"The suggestion that a policy of capital expenditure, if it does not take capital away from ordinary industry, will spell Inflation, would be true enough if we were dealing with boom conditions... But we are far, indeed, from such a position at the present time. A large amount of deflationary slack has first to be taken up before there can be the smallest danger of a development policy leading to Inflation. To bring up the bogy of Inflation as an objection to capital expenditure at the present time is like warning a patient who is wasting away from emaciation of the dangers of excessive corpulence."

"The whole of the labour of the unemployed is available to increase the national wealth. It is crazy to believe that we shall ruin ourselves financially by trying to find means for using it and that "Safety First" lies in continuing to maintain men in idleness. It is precisely with our unemployed productive resources that we shall make the new investments."

"Negation, Restriction, Inactivity - these are the Government's watchwords. Under their leadership we hav been forced to button up our waistcoats and compress our lungs. Fears and doubts and hypochondriac precautions are keeping us muffled up indoors. But we are not tottering to our graves. We are healthy children. We need the breath of life. There is nothing to be afraid of. On the contrary, the future holds in store for us far more wealth and economic freedom and possibilities of personal life than the past has ever offered."

(2) The infamous Lew Rockwell links to the David Gordon reviewing Hunter Lewis' book on Keynesian economics:

Defenders of Keynes, such as the recent convert Bruce Bartlett, often claim that he supported capitalism... His interventionist measures had as their aim not the replacement of capitalism by socialism or fascism. Rather, it is alleged, Keynes aimed to save the existing order. The unhampered market cannot by itself recover from a severe depression or at best can do so after long years of privation and unemployment. Keynes discovered a way by which the government, through an increase in spending, can restore the economy to prosperity... Hunter Lewis convincingly shows the error of this often heard line of thought. Keynes, far from being the savior of capitalism, aimed to replace free enterprise with a state-controlled economy run by "experts" like him. His prescriptions for recovery from depression do not save capitalism: they derail the price system by which it functions...

Further, Keynes ignored the significance of a fundamental fact. The rate of interest is also a price. It reflects the preferences of consumers for present over future goods: the greater the time preference, the higher the rate of interest. Keynes principal aim in economic policy, not only to combat depressions but more generally, was to keep the rate of interest low: ideally, it should be done away with entirely. To do so flies in the face of consumer preferences. If the rate of interest is forced below what it would have been on the unhampered market, then people are being compelled to invest more than they wish. The point holds altogether apart from the Austrian theory of the business cycle, which Lewis fully accepts. That theory tells us that forcing the rate of interest below the natural rate may lead to an unsustainable boom. But even if this theory were mistaken, interference with interest rates would still distort the economic system. "Businesses depend on prices to give then 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. "

Of course a careful reading of the General Theory and Keynes' other works makes it clear that he was not in favor of government control of the economy. Government should manage the aggregate amount of spending through fiscal and monetary policy, but leave the allocation of investment spending to the private sector. When Keynes argues for the "socialization of investment" in the General Theory he is talking about the creation or expansion of semi-public institutions like "Universities, the Bank of England, the Port of London Authority, even perhaps the Railway Companies" and even throws in corporations whose management is insulated from the short-sighted demands of shareholders and are therefore free to take up social responsibilities (see "The End of Laissez-Faire," 1926). He approved not the free-wheeling capitalism we now have, nor something like the "commanding heights" program of the post-war Labor governments in the UK, but a system in which a critical mass of private enterprises were structurally insulated from the vagaries of the market.

It's entertaining to imagine how Keynes would have responded to each of Gordon's (and by implication Lewis') critiques of Keynes' theory. I'll take just one, the meaning of the interest rate. Keynes argued that

"It should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period." (GT, chapter 13)

Capital, Keynes argued, earns a rate of return (equal to the rate of interest) not because it is productive, but because it is scarce. Thus the solution to our problems in the long-term is to lower the rate of interest and flood the world with capital. It's an interesting, provocative argument that I'm not sure I agree with, but it's ludicrous to claim that Keynes policy prescriptions are based on his having "ignored" the "fact" of the true determinants of the rate of interest.