Tuesday, 12 March 2013

The Errors of Keynes's Critics

Guest post by Steven Kates

An important understanding is taking hold, that the road to unwind Keynesian economics travels through Say’s Law. Keynes himself could not have been clearer about the significance of Say’s Law to the entire structure of his argument. Keynes emphasized, over and over again, in The General Theory (TGT) that he was reversing the conclusions of those who believed Say’s Law to be true.* Thus, there are two things that need to be done if you are going to refute Keynes. First, you have to know what Say’s Law is. Then you have to show it is valid.

keynes_stupid_buttonThere is a huge problem that must be overcome in order to make any headway in refuting Keynes and revitalizing Say’s Law. All economists are brought up on Keynesian demand side theory and, unless corrected, it infuses every aspect of their thought. Even while recognizing that it is the structure of demand that is key, they still hang onto the level of demand as an integral part of how they approach economic problems.

Classical economists have explained Say’s Law by arguing that “a general glut is impossible”; there can never be a deficiency of demand. This is axiomatic, you must know it in your bones if you are to understand the Classical theory of the trade cycle. Hoarding never causes a recession. Too much saving is never the problem. An economy never suffers from demand deficiency. After a recession begins people become tentative because of a lack of confidence, this is a common view everywhere on the Classical side of the Keynes-Classical divide, but that was not the point being made by Keynes. He was trying to prove that demand deficiency was, of itself, the nature of the recessionary problem and that public spending was the necessary answer to bring recessions to an end.

With this in mind, let me take you to a book review discussing Say’s Law, and criticising Keynes, that gets it wrong:

Let’s have a look of some of [the book’s] arguments, beginning with Keynes’s famous critique of Say’s Law. Keynes’s distorted version of Say’s Law in his General Theory states that supply creates its own demand. [The book’s author, Juan Ramón Rallo] vindicates Say’s Law in its original version: In the long run, the supply of a good adjusts to its demand. Ultimately, goods are offered to buy other goods (money included). One produces in order to demand, which implies that a general overproduction is impossible [in the long run].
    Say’s Laws leads us straight forward to the most innovative argument in Rallo’s book that addresses the old argument against hoarding. Even harsh critics of Keynes, for example from the monetarist or neoclassical camp, admit that Keynes was at least right in that hoarding is a destabilizing and dangerous activity.
    Rallo however proves and emphasizes the social function of hoarding. To demand money is not to demand nothing from the market. Hoarding is the natural response of savers and consumers to a structure of production that does not adjust to their needs. It is a signal of protest to entrepreneurs: “Please offer different consumer and capital goods! Change the structure of production, since the composition of offered goods is not appropriate.” [Emphasis and additional text by Kates]

The book, and the review, thus attempts to controvert Keynes by confirming everything he wrote. People really do hoard, the book argues, and store money rather than spend; there really is a deficiency of demand in the short-to-medium term that may finally work itself out in the long run, in three-to-five years perhaps; overproduction is impossible, but only “ultimately,” and in the meantime it can occur; involuntary unemployment does apparently occur because of some problem on the demand side of the economy due to hoarding. However, rather than this “deficiency of demand” being a bad thing, it’s a good thing, since the hoarding allows business to think about what to do next. But if you are Keynesian such as Krugman, it also licenses the government to come to the rescue with a stimulus package that will short-circuit this delay. Here is the example from the review to show how hoarding can work:

Hazlitt, Henry

In a situation of great uncertainty, it is even prudent to hoard and not immobilize funds for the long run. [The book] provides us a visual example. Let’s assume that uncertainty increases because people expect an earthquake. They start to hoard, i.e., they increase their cash balance, which gives them more flexibility. This is completely rational and beneficial from the point of view of market participants. The alternative is to immobilize funds through government spending. The public production of skyscrapers is not only against the will of the more prudent people; it will also prove disastrous if the earthquake is realized.

A government should not build skyscrapers when everyone expects an earthquake! Does one need economic theory to make such an argument? But if the economy has gone quiet and there are useful things a government can do—perhaps reinforcing existing buildings against future earthquake damage—why wouldn’t that make sense within the terms of this argument? It’s a metaphor that doesn’t hold up, it doesn’t explain why Keynes is wrong, and it would certainly never convince a Keynesian.

Let me get to the problem expressed in this paragraph in the review:

As [the book’s author] points out in contrast to The General Theory, it is not aggregate supply or aggregate demand that is important, but their composition. If, in a depression with a distorted structure of production, in a liquidity trap situation, aggregate demand is boosted by government spending, the existing structure cannot produce the goods that consumers want most urgently. The solution is not more spending and more debts, but debt reduction and the liquidation of malinvestments to make new and sustainable investments feasible. [Emphasis mine]

I absolutely agree with him that the solution is to leave recovery to the private sector as they find their way toward profitable outcomes. But to use “aggregate demand” in the same sentence as “structure of production” must leave the argument confused. Even more certainly, to include mention of “a liquidity trap” will bar entry to the world of Classical economics. Demand is constituted by supply; according to Say’s Law, supply is demand. Aggregate demand and aggregate supply are not two separate entities. There is no such thing as an independent force that can be described as aggregate demand.

If you want to get to the essence of Say’s Law you must never think in terms of aggregate demand and aggregate supply. Just drop it from all conceptual discussions of the economy and I think, although I can’t be sure, you will find yourself necessarily thinking about issues in the same way as the Classical economists. As I have argued in my Say’s Law and the Keynesian Revolution (Elgar 1998), if you want to defeat Keynesian economics, you need to wage war on the very notion of aggregate demand. Nothing else will do.

* * * *

Photo of Steven    KatesDr Steven Kates currently teaches economics at the RMIT University in Melbourne, but spent most of his working career as the Chief Economist for Australia’s national employer association, the Australian Chamber of Commerce and Industry, and as a participant on Australia’s Productivity Commission. If he has a mission in life, it is to see Keynesian economic theory disappear from our textbooks and the return of the classical theory of the cycle as the guide to economic policy. He is the author of Free Market Economics: an Introduction for the General Reader which explains what economic theory looks like if the entrepreneur is placed at the centre of microeconomic analysis and in which Say’s Law is brought back as the core of macro; Says Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way, arguing that Keynes was not simply wrong about the classics, but in making legitimate the concept of aggregate demand failure—and quite parentless Say’s law of markets—the consequence of Mr Keynes has been ruinous for theory and policy alike..

* * * *

* Keynesian follower Paul Sweezy declared in 1947 about Keynes and his General Theory … that the “Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say’s Law is assumed” (p. 105). Thus, it was important that Keynes and his followers “discredit” Say’s Law.

Keynes’s “refutation” of Say’s Law was the most influential of the twentieth century. Yet as Henry Hazlitt (1959) points out, Keynes “refuted” Say’s Law by taking a passage from Mill in which he states that
the means of payment for commodities is simply commodities. . . .

Could we suddenly double the productive powers of the country, we should double the supply of commodities in every in every market; but we should, by the same stroke, double the purchasing power. (Quoted in Hazlitt, 1959, p. 34)

Keynes targets that passage as being false on its face because it allegedly declares that every good produced automatically will find a buyer and, thus, recessions are impossible, writing:

Thus Say’s Law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussion concerning the volume of aggregate employment are futile. (Keynes, p. 26 )

Harrington also makes a similar statement, declaring, “Say’s Law maintains that if business can produce products, it can sell them. The Great Depression discredited Say’s Law” (p. 31). Thus, Mill’s chapter that was written to explain what did not cause business recessions has been turned into something that was not written at all: that classical economists claimed “full employment” always was the norm.

Yet, as Hazlitt points out, Mill (1848) himself in the very next passage explains the context of his previous statement in which he says, “It is probable, indeed, that there would now be a superfluity of certain things” (Hazlitt, 1959, p. 35). Thomas Sowell (1974, p. 43) quotes Mill (1844) elsewhere saying that “production is not excessive, but merely ill-assorted.” Likewise, on that same page, Sowell quotes Ricardo who says that “it is at all times the bad adaptation of the commodities produced to the wants of mankind which is the specific evil, and not the abundance of commodities.” Ricardo added,

Men err in their productions (but) there is no deficiency of demand.

In other words, the same people who recognized and agreed with Say’s logic also recognized that business recessions were a possibility and that they themselves had observed them. As Hazlitt (1959) puts it:

If you had presented the classical economists with “the Keynesian case”—if you had asked them, in other words, what they thought would happen in the event of a fall in the price of commodities, if money wage-rates, as a result of union monopoly protected and insured by law, remained rigid or rising—they would have
undoubtedly replied that sufficient markets could not be found for goods produced at such economically unjustified costs of production and that great and prolonged unemployment would result. (p. 36)

Thus, the critics of Say’s Law have claimed that it is absurd on its face, and that it denies something that has been observed many times in history: the business recession. Yet, as those who support Say’s Law might ask, “How could a chapter that acknowledges the presence of a business recession then deny that such a recession actually was taking

Indeed, Say’s Law is not about the denial of recessions or even a partial overproduction of goods relative to demand; it is about dealing with the claims that a recession occurs because of a general overproduction of

[Footnote adapted from William L. Anderson’s “Say’s Law and the Austrian Theory of the Business Cycle”]

No comments:

Post a Comment

1. Commenters are welcome and invited.
2. All comments are moderated. Off-topic grandstanding, spam, and gibberish will be ignored. Tu quoque will be moderated.
3. Read the post before you comment. Challenge facts, but don't simply ignore them.
4. Use a name. If it's important enough to say, it's important enough to put a name to.
5. Above all: Act with honour. Say what you mean, and mean what you say.