Monday, December 31, 2012

Refuting Keynes

Like everybody else, Keynes made mistakes. A lot of people who accepted his ideas also have made mistakes. His core ideas, the ones that have provided the the subject of innumerable policy debates, are a critique of Neo-classical economics with the follwing key elements (Wikipedia):

Keynes' theory was significant because it overturned the mainstream thought of the time and brought about a greater awareness that problems such as unemployment are not a product of laziness, but the result of a structural inadequacy in the economic system. He argued that because there was no guarantee that the goods that individuals produce would be met with demand, unemployment was a natural consequence. He saw the economy as unable to maintain itself at full employment and believed that it was necessary for the government to step in and put under-utilised savings to work through government spending. Thus, according to Keynesian theory, some individually rational microeconomic-level actions such as not investing savings in the goods and services produced by the economy, if taken collectively by a large proportion of individuals and firms, can lead to outcomes wherein the economy operates below its potential output and growth rate.

Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem. Keynesians therefore advocate an active stabilization policy to reduce the amplitude of the business cycle, which they rank among the most serious of economic problems. According to the theory, government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation.

Keynes argued that the solution to the Great Depression was to stimulate the economy ("inducement to invest") through some combination of two approaches:

A reduction in interest rates (monetary policy), and

Government investment in infrastructure (fiscal policy).

There is no doubt, by the way, that these two prescriptions are not the cure for every variety of economic ill. Penicillin was a wonderful drug in its day, but it couldn't cure cancer or old age or anything viral.

It does drive me nuts though, when somebody like Cochrane claims something like 1946 as a failure of Keynes theory when in fact nothing about 1946 met the conditions for Keynes intervention strategy. There was no depression. There was no failure of aggregate demand. True enough, some Keynesians expected that there might be, but there wasn't.

On the other hand, the situation today in Europe, especially Southern Europe fits Keynes rather well - but nobody (OK, Germany) will permit giving his ideas a try.