Consolidators versus Stimulators

All intellectual systems rely on assumptions that do not need to be spelled out because all members of that particular intellectual community accept them. These “deep” axioms are implicit in economics as well, but, if left unscrutinized, they can steer policymakers into a blind alley. That is what is happening in today’s effort, in country after country, to slash spending and bring down budget deficits.

The chief task that John Maynard Keynes set himself in writing his General Theory of Employment, Interest, and Money was to uncover the deep axioms underlying the economic orthodoxy of his day, which assumed away the possibility of persistent mass unemployment. The question he asked of his opponents was: “What must they believe in order to claim that persistent mass unemployment is impossible, so that government ‘stimulus’ to raise the employment level could do no good?” In answering this question, Keynes reconstructed the orthodox theory – and then proceeded to demolish it.

Today, despite the Keynesian revolution, the same question demands an answer. What do people who demand rapid “fiscal consolidation” amid heavy unemployment need to believe about the economy to make their policy coherent?

This question is not trivial, because the fiscal hair shirt has become the favored article of policy clothing among those who now dictate economic affairs. Prestigious bodies like the G-20, the IMF, and the OECD join the “markets” and economic columnists in demanding that governments liquidate their deficits. Any other course, they say, spells disaster; balancing budgets as soon as possible is the only way back to prosperity.

A few Keynesian economists stand against this stampede to retrenchment – Paul Krugman, Joseph Stiglitz, and Brad DeLong in the United States; Martin Wolf, Samuel Brittan, Danny Blanchflower, and I in the UK; and Paul de Grauwe and Jean-Paul Fitoussi in continental Europe. But we are a small minority.

Indeed, all Western governments, with the exception of the Obama administration, are committed to retrenchment – and Obama cannot get a new stimulus package through Congress. The question is: what must the cutters and slashers believe to justify their policies?

When I ask this question, I never get a coherent answer; so let me retrace Keynes’s steps.

The first of the implicit assumptions of orthodox theory that Keynes identified was Say’s Law, the doctrine that “supply creates its own demand.” This means that all money earned is bound to be spent, and therefore that at no point in time could there be a “general glut” of commodities.

Keynes pointed out the fallacy here: while the income derived from production is, by definition, equal to the value of production, it does not follow that all this income will be spent. Some part of it may be “hoarded,” in which case demand may fall short of supply. Specifically, Keynes denied that saving is simply deferred spending. In a well-known passage, he wrote: “An act of saving means…a decision not to have dinner today. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence…Thus it depresses the business of preparing today’s dinner without stimulating the business of making ready for some future act of consumption.”

“Getting to that realization,” says Krugman, “was an awesome intellectual achievement.” Yet Say’s Law is alive and well among new classical macroeconomists like John Cochrane and Eugene Fama. It amounts to claiming that the factors of production will always be fully employed, and that, in Cochrane’s words, “if the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment.”

The second classical postulate Keynes identified was that the “real wage is equal to the marginal disutility of labor.” This means that, in a competitive labor market, real wages will always be instantly adjusted to changes in conditions of demand. In other words, there can never be involuntary, or unwanted, unemployment.

Keynes denied that real wages are set in the labor market. Workers bargain for money wages, and a reduction in their money incomes might leave total demand too low to employ all those willing to work. Yet today most economists model unemployment as “voluntary” – a rational preference for leisure rather than work. This reinforces the idea that “stimulus” cannot do any good, since workers have as much employment as they want.

Keynes thought that the chief implicit assumption underlying the classical theory of the economy was that of perfect knowledge. “Risks,” he wrote, “were supposed to be capable of an exact actuarial computation. The calculus of probability…was supposed to be capable of reducing uncertainty to the same calculable status as certainty itself…”

For Keynes, this is untenable: “Actually…we have as a rule only the vaguest idea of any but the most direct consequences of our acts.” This made investment, which is always a bet on the future, dependent on fluctuating states of confidence. Financial markets, through which investment is made, were always liable to collapse when something happened to disturb business confidence. Therefore, market economies were inherently unstable.

Today’s “efficient market theory” restored to economics the assumption of perfect knowledge by claiming that all risks are correctly priced. This means that the “underpricing of risk worldwide,” which Alan Greenspan identified as the root cause of the banking collapse of 2007-08, is impossible. Yet it happened.

The classical view of the economy, which Keynes set out to demolish, is not only alive, but in recent years has been dominant, feeding the belief that competitive markets can be left to regulate themselves, will always provide as much employment as is wanted, and are immune to large-scale collapse. This also fuels opposition to government intervention, and to “stimulus” policies, which are supposedly redundant, if not harmful, since the events that require them cannot happen (but do).

Unless we start discussing economics in a Keynesian framework, we are doomed to a succession of crises and recessions. If we don’t, the next one will come sooner than we think.