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The Keynes Solution?

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10/16/2009David Gordon

[The Keynes Solution: The Path to Global Economic Prosperity. • By Paul Davidson • Palgrave Macmillan, 2009 • Ix + 196 pages]

The Keynes Solution: The Path to Global Economic Prosperity

It is not often that Paul Samuelson and Paul Krugman are indicted for lack of fidelity to Keynes, but this is exactly Paul Davidson's complaint against them. Davidson is a leading Post Keynesian, who holds that almost all economists, even professed Keynesians, have been untrue to the radical vision of The General Theory. The pseudo Keynesians attempt to domesticate Keynes by combining his theories with neoclassical economics; in fact, the two approaches are diametrically opposed.

He remarks that

Samuelson has called himself a "Keynesian" and even a "post-Keynesian" in several editions of his famous textbook. Nevertheless, it should be obvious that by his own admission Samuelson, who became the premier American Keynesian of his time, had not understood Keynes's General Theory book. (p. 171)

Krugman is also weighed in the balance and found wanting:

In a December 14, 2007, piece, [on the housing bubble] … Paul Krugman … did not suggest any remedies that government could take to relieve the distress caused by the deflating housing bubble. He wrote that the market would solve the problem by deflating housing prices until they would fall by approximately 30 percent to restore a normal ratio relative to people's income. (pp. 24–5)

Davidson's complaint about Krugman suggests the nature of the misunderstanding of Keynes that concerns him. In the view that he opposes, the price system is held to be basically in order. Government needs on occasion to supplement it: in particular, because of labor unions and the "money illusion," government spending in a depression is needed to drive down real wages.

Samuelson adopts exactly this perspective:

In 1986, 50 years after Keynes's General Theory was published, Samuelson was still claiming that "we [Keynesians] always assumed that the Keynesian underemployment equilibrium floated on a substructure of administered prices and imperfect competition." … If sticky wages and prices cause unemployment, however, there was nothing revolutionary about Keynes's analysis. After all, nineteenth-century economists had already demonstrated that if wages were rigid in a Walrasian classical theory model, unemployment would result. (p. 171)

Keynes's idea was entirely different. He denied that his analysis depended on inflexible prices and wages:

In Chapter 19 of his General Theory, Keynes specifically stated that his theory of unemployment did not rely on the assumption of wage and/or price rigidities. He claimed that his theory provided a different analysis where the cause of unemployment was related to the operation of financial markets and the public's desire to hold liquid assets. (p. 163)

To grasp Keynes's theory, one must first consider the contrasting framework, accepted down to our day by most economists, which Keynes rejected. In that view, everything is fine as long as prices and wages are flexible. If prices can adjust to changes in business expectations, why should there ever be a serious problem? Davidson contends that this way of thinking rests on a flawed assumption. Advocates of the standard model imagine that accurate markets exist, not only for present transactions, but for future contracts as well.

The assumption of accurate futures markets in turn rests on a hypothesis, which Davidson deems the crucial principle of neoclassical economics.

Since drawing a sample from the future is not possible, efficient market theorists presume that probabilities calculated from already existing past and current market data are equivalent to drawing a sample from markets that will exist in the future…the presumption that data samples from the past are equivalent to data samples from the future is called the ergodic axiom. Those who invoke this ergodic assertion argue that economics can be a "hard science" like physics or astronomy only if the ergodic axiom is part of the economist's model….The ergodic presumption is the essential foundation of classical efficient market theory. (p. 37)

Readers will not be surprised to learn that Samuelson, who evidently ranks high on the list of Davidson's villains, fervently endorses the ergodic axiom.

Keynes saw the fallacy in this assumption. The future is in fact radically uncertain.

The classical ergodic axiom, which assumes that the future is known and can be calculated as the statistical shadow of the past, was one of the most important classical assumptions that Keynes rejected… For decisions that involved potential large spending outflows or possible large income inflows that span a significant length of time, [Keynes argued that] people "know" that they do not know what the future will be. They do know that for these important decisions, making a mistake about the future can be very costly… (pp. 46–7)

Keynes, the author of A Treatise on Probability, was well equipped to make this fundamental point.

Davidson is right that Keynes has here scored heavily against neoclassical economics. But the uncertainty of the future hardly suffices to establish the validity of the Keynesian system. For one thing, Austrian economics also emphasizes the uncertainty of the future. It is constantly stressed by Mises, who goes so far as to claim that the uncertainty of the future is a praxeological law, deduced from the action axiom. Davidson never so much as mentions the Austrian School in this book. For him, only the efficient-market economists, with their false ergodic assumption, and their Keynesian rivals count.

In what way is Keynes supposed to be superior to Mises? Perhaps the answer lies in the second main assumption that Keynes made. In his view, at least in Davidson's rendition of it, a capitalist economy rests on people's ability to fulfill their contracts. To do so, they must have ready access to money.

In Keynes's view, the sanctity of money contracts is the essence of the entrepreneurial system we call capitalism. Since money is that thing that can always discharge a contractual obligation under the civil law of contracts, money is the most liquid of all assets. (p. 51, emphasis omitted)

If, owing to uncertainty about the future, people fear that they will lack liquidity, they will endeavor to increase their cash balances. Private spending and investment will then fall. Faced with falling demand, businessmen will prove even more reluctant to invest and the demand for liquidity will increase further. A spiral downwards can quickly occur.

Business firms will start reinvesting in plant and equipment only after market demand has risen sufficiently so that firms believe sales will be pressing on existing capacity. Accordingly, in a recession, we cannot expect enterprises to increase their spending on investment. (p. 56)

What is the solution? Government must come to the rescue through an increase in spending. Once businesses respond to the increased demand created by the government's spending, the economy will revive.

Accordingly, in a recession, it is just the federal government [in the United States] that is able not only to maintain but actually to increase spending on the profits of private enterprise, even if tax receipts are due to declining incomes for business firms and households. Of course, to buy more while revenues are declining, the federal government must finance these purchases by borrowing money — that is, by increasing the annual deficit and adding to the national debt… (p. 57)

An increase in government spending during a recession is precisely the opposite of what Austrian economists would recommend. But this difference does not count as an advantage for Keynes — quite the contrary. Davidson seems oblivious to the fact that money has a purchasing power. For him, what counts is the existence of a certain number of monetary units, principally so that people can fulfill their contracts. If people want more of these units to increase their liquidity, fewer units are available to purchase goods and services. The result is an economic collapse. Had he taken account of purchasing power, he would have realized that if people increase their demand to hold money, the purchasing power of money will rise. So long as prices are flexible, there need be no fall in demand for goods and services.

Davidson's odd view of money becomes evident from what he says about money neutrality. He denies that an increase in government spending is inflationary. The view to the contrary depends on a false axiom: "This neutral money axiom asserts that any increase in the supply of money into the economy will affect neither the volume of goods produced nor the level of employment in the economy" (p. 65).

Davidson, by claiming that the axiom is false, asserts that a mere increase in the number of monetary units increases productivity and, correspondingly, that a decrease in the number of monetary units curtails the volume of goods produced. Again, he disregards prices: for him, apparently, the purchasing power of money is a useless complication.

Davidson's Post Keynesian account suffers from a related problem. Against his enemies, the proponents of efficient markets, Davidson is anxious to assure us that the future is uncertain. But he nevertheless has a mechanical view of what will happen if government spending in a recession takes place as massively as he wishes. Then, he assures us, the economic doldrums will end and all will be well. How does he know that business and consumer confidence will respond so readily to the injection of government money? Evidently, the future is uncertain, but somehow this state of affairs alters when government enters the scene.

Why should we believe this? Why assume that business confidence is so rigidly determined? Is it not rather the result of many causes that, if indeed the future is uncertain, cannot be readily specified?

Davidson writes very clearly, and his readers will find it easy to grasp his account of Keynes's contributions. But he fails completely to show that these supposed discoveries represent genuine insights, and he seems to have a real gift for focusing on Keynes's worst ideas. One example must here suffice. Following the unfortunate article "National Self-Sufficiency" (1933) that even most of Keynes's followers prefer to forget, Davidson has little use for free trade. Yet he is constrained to admit,

Suppose the Chinese spent the $10 billion [savings on international earnings] on the products of American industries, instead of using their international savings to buy Treasury bonds. The result would be that (1) more products from American factories would be available in China to enhance the standard of living of Chinese workers, and (2) American businesses and their workers would earn more income and not have to borrow from the Chinese to finance their excessive import purchases of Chinese goods. (p. 124)

Why in that case the imports would be "excessive" he does not tell us; but here the advantages of international exchange do not entirely escape this eminent Post Keynesian.



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David Gordon is Senior Fellow at the Mises Institute and editor of the Mises Review.