Against the Tide

XI

Keynes and the Revolution in Economics: Economics Old, New, and True*

With the possible exception of Protestant theology, there is hardly a branch of learning today that, like economics, is split into two almost irreconcilable camps with almost no dialogue passing between them any more. This split has its origin in an exceedingly bold revolution in economic thought dating back fifteen years and, perhaps by an unjust simplification, associated with the name of the late Lord Keynes, who died in 1946.

THE REVOLUTION IN ECONOMICS

Radical rethinking is not alien to other disciplines. To take theoretical physics as an example, we all know how far quantum mechanics and the theory of relativity have deflected that science from Newton’s classical tradition. But this revolution in the physical concept of the universe has not created a rift between the “old” and the “new” schools. As and when the new theories asserted themselves by irrefutable proof or empirical probability, they became the common property of science, and there was no sound of venomous dispute, all the less so as the practical applications of physics in everyday life were not affected by this palace revolution in theory. The revolution in economics, on the other hand, has so far essentially done nothing but shock and divide. It originated in a theory that combines provocative radicalism with far from fully convincing argumentation, with a precision that proves to be apparent rather than real and throws up problems of the most confusing kind. Furthermore, thanks to its influence on actual economic policy in our time, it has become a force that has a decisive bearing on the life and interests of every individual, indeed of whole nations and classes and, with the mere term “full employment,” has furnished both one of the most seductive and one of the most dangerous slogans to the political life of the mid-twentieth century. As a result, economics is today split into two camps apparently without prospect of reconciliation, and it would be hard to find a parallel to this split in the whole history of the science.

HEALING THE RIFT

The adherents of the Keynesian School, or of the “new economics,” as it is widely called, are, like all revolutionary leaders, inclined to regard the victory of their doctrine as complete. The idea of so serious and genuine a rift offends their sense of domination. But if the rift is to he healed—and to do so is a task that is gaining in urgency but perhaps steadily losing in difficulty—the first step must be to acknowledge its existence and full implications.

It is probably still not generally realized just how deep is the rift and how critical, therefore, the inner predicament of economics. One of the most distinguished of contemporary economists, whom I met again recently after many years, said to me that he was not prepared to enter into a discussion of the last ten years’ literature, which, because it was essentially inspired by Keynes, he regarded as useless, not worth reading, and stultifying, and I frankly confess that while I would not make this temperamental judgment my own, I would far sooner see him in charge of a central bank or an economic government department than any of the authors of the literature he condemns. As eminent a mind as Professor F. H. Knight, of Chicago, not long ago described the “new economics” of Keynesian origin as the worst of the fashion crazes that from time to time afflict our science and as a return to the dark Middle Ages, and Schumpeter, to name another master, remained to his dying day in hardly less vehement opposition, no matter how politely elegant the style in which he couched it.

RIGID FRONTS

The revolutionaries’ answer to these legitimists of economics is vehement self-assertion and barely veiled contempt, such as are habitual to the “enlightened” in dealing with those who remain in the dark. They seem to regard themselves as all the more superior in that they can point with obvious pride to the difficulty of their literature and to the use of mathematics, which lifts the “new economics” almost to the lofty heights of physics. A leading Keynesian in the United States, to give an example, recently dismissed one of Hayek’s books with the contemptuous remark that there was no breath of the “new economics” in it and that the author had thus behaved like an astronomer who failed to take account of the Copernican revolution. The columns of this very publication were recently the scene of the tragi-comic spectacle of a reviewer’s (V. Muthesius) thinking he was lavishing special praise upon an English book by stating with relief that the author had not fallen victim to the Keynesian School, which remark, in turn, called forth the protests of adherents of the “new economics,” who clearly felt the object of the reviewer’s praise needed to be defended against such an insult. They seemed anxious to counter any impression that there might be a dissenter among England’s ranking economists by suggesting that, at any rate in that country, the “new economics” had permeated everywhere—not reflecting, perhaps, that if the theory’s domination really were as absolute as all that, the chronic crisis of the British economy is not much of a recommendation for it. Conversely, if the Germans compare the economic developments of their beaten country with those of the victor’s, they have reason to note with some satisfaction that at any rate they victoriously withstood the onslaught of the Keynesians.

But enough of this description of a conflict and opinions and theories that is so sharp that one cannot but agree with Professor J. M. Clark, of Columbia, when he declares that the Keynesian revolution has split economics into two spheres of logic, where the sense of one is nonsense in the other. It can easily be imagined what disastrous consequences this disintegration of traditional economic theory has had for economic policy in practice. The remarkable advances of economics, in research, organization, and external influence alike cannot obscure the cracks that have appeared in its foundations and that certainly signify an extremely serious retrogression in comparison with the “old economics.” …* There can surely be no doubt that the disintegrating and confusing influence of the “new economics” must be taken into account by anyone wishing to gain a serious and unbiased understanding of the agonizing economic history of the last ten years, with its “repressed inflation,” its ad hoc experiments, and the Sisyphus labor of international reconstruction failing over and over again.

EXPEDIENT INTO DOGMA

This is a depressing state of affairs, a clear view of which is continually obstructed by the fact that it is not easy to say just what is the essence of Keynesian economics and what constitutes the revolution it brought about. What did Keynes want, and what have his disciples—typically overzealous like all adepts—learned from him?

To put it in a nutshell and, hence, inevitably in simplified terms: Quite rightly, the Great Depression of the 1930’s had appeared to Keynes as a gigantic circulatory disturbance marked by a series of deficiencies of income and demand, which, regardless of their original cause, kept entailing others; he considered it as basically due to a breakdown in the mechanism that should ensure that the decision of some individuals to save, and thereby forgo spending their income, finds its normal compensation in the decision of others to invest. Whereas the “old economics” had focused attention on the ordering and guiding mechanism of the system of individual prices and wages and had viewed the economic process mainly as one of continuous readjustment of production and of redistribution of factors of production in response to this guiding mechanism, the world was now faced with a situation that could not be interpreted in terms of that theory. It was a disturbance to be explained no longer as the result of wrong prices or wages, as an expression of a wrong distribution of factors of production; rather, it was to be explained only as a disproportion between the economic aggregates of the circular flow (saving and investment, income and expenditure, decline and renewed creation of purchasing power), and the cure lay in removing that disproportion. In other words, it was a case where a deficiency of “effective demand” was the true cause of mass unemployment and as such had to be removed by a policy that, in bold reversal of sound economic thought, put the main emphasis on “spending,” on boosting “effective demand,” and, in taking this course, on neither being frightened by the danger of inflation nor waiting for prior savings.

Had Keynes stopped there, he would have done no more than the rest of us, who at that time advised a policy beginning with the “spending” end. He would have secured for himself only a modest little nook in the Valhalla of economics, but, on the other hand, no one could have said of him that he did more harm than good. But the crucial point is that he did not stop at calling for extraordinary means in an extraordinary situation. He went much further. He declared the method of thinking in aggregates to be the only valid one, now and in the long run. And together with the method, he elaborated its results—his diagnosis of an extraordinary situation and the treatment accordingly prescribed—into a general theory in which “deficiency of demand” is always around the corner, and economic policy must always be poised to close this “gap” in order to ensure eternal “full employment.” It is only with this that he really brought into economic thought a revolution that thrusts aside the previously ruling method and puts an opposite one in its place, literally standing on its head most of what theory and sound common sense have so far considered right and proven. That is the calamity, and that is the reason that the adherents of the “old economics” cannot be reconciled with those of the “new economics” so long as this torrent of exuberant destruction has not been forced back into its bed.

A BIASED APPROACH

This is not the place to demonstrate in detail why, for all its seductive brilliance and elegance, the chain of thought that led Keynes to these bold conclusions does not hold. Our main concern on this occasion is with the result of this revolution for economic theory and policy. A whole generation of economists (especially in the Anglo-Saxon countries, but likewise wherever else it is thought important to be in the swim) was so one-sidedly brought up to operate with economic aggregates that it forgot the things that until then were the real content of economic theory and that never should be forgotten: namely, that the economic order is a system of moving, and moved, prices, wages, interests, and other magnitudes. Keynes’s aggregative functions made the plain mechanism of prices look outdated and uninteresting, and we witnessed the development of a sort of economic engineering with a proliferation of mathematical equations.

This new method was one part of the training of the new generation of economists and economic policy makers; another was the idea that saving is, at best, unnecessary (since investment takes care of saving afterward via the multiplier and the marginal propensity to save) and, at worst, harmful. It follows that a policy measure is good when it increases effective demand and bad when it threatens to diminish effective demand.

THE DANGER OF INFLATION UNDERESTIMATED

The danger of inflation was reduced to a remote theoretical possibility; the thing to be feared constantly was what was described as deflation. Budgetary deficits, leveling taxes that diminish both the ability and the willingness to save, “cheap money policy,” a combination of growing popular consumption and investment stimulation, expenditure and credits on all sides, mercantilist foreign-trade policies with the twin purposes of mitigating the effects of those other policies on the balance of trade and of creating export surpluses as a further stimulant for the domestic money flow—all of these practices now received the blessing of economic science.

NOT WITH IMPUNITY . . .

Years ago, in an obituary of Keynes in the Neue Zürcher Zeitung, I wrote that while it is legitimate to think that there exist times when a resolute increase in the money supply averts trouble, it is not with impunity that a man of outstanding intelligence may give the blessing of his authority to the inflationary inclinations of government, which are strong enough as it is. It is legitimate to think that in certain circumstances the growth of the public debt is the lesser evil, but not with impunity may this be turned into a maxim. It may happen that mass unemployment cannot be quickly removed by any means other than an increase in effective demand by means of credit expansion, but not with impunity may the proven rules and institutions be flouted with barely veiled contempt, lest, without these long-run guardians of an orderly economic process, the economy become subject to permanent inflationary pressure. There may be some previously overlooked problem to discover in the process of saving, but not with impunity may people be deprived of the feeling that they are doing the right thing by saving and setting aside from their income a reserve for themselves and their children instead of spending as long as the money lasts, and then, when there is none left, relying on help from the state, which is accumulating debt upon debt. Just as a ship in distress may have to cut away its masts and jettison its cargo, so there may be hurricanes in economic life that force us temporarily to neglect the principles of sound economic and monetary policy, but not with impunity may these principles be declared as outdated just because they are inconvenient for the full employment policy rigidly pursued after the shock of the Great Depression.

“TO THE TROPICS WITH THE EQUIPMENT FOR A POLAR EXPEDITION”

We ought not to forget that this is the seed that Keynes has sown. No honest person can overlook how abundantly it is bearing fruit. There is no other explanation for the utterly wrong postwar orientation of the Western world, which, taught only to fear and combat deflation, followed the banner of “full employment” right into permanent inflation. In spite of all the warnings of the old-style economists, the danger was recognized too late, so that it has become exceedingly difficult to face about and abandon the wrong position. As I wrote some years ago, it was like a man going to the tropics with the equipment for a polar expedition, and I was pleased to see in a recent article by Professor Erich Schneider, of Kiel,1 that he took up the simile with a slight variant.

It is time to admit honestly and openly that such is the nature and such are the effects of the Keynesian approach, the last manifestation of which was the United Nations Experts’ Report of December, 1949, soon thereafter recognized as untimely and quietly shelved.

There is not much to be gained by pointing out that Keynes was a man of genius to whom we owe remarkable and fruitful stimulation. There are few who would deny it, and I myself in my above-mentioned obituary have compared him with Adam Smith, albeit with strong reservations. Nor is it much help that Keynes himself at the end of his life was troubled and tried to restrain the excessive zeal of his followers, and that, flexibly open-minded as he was, he himself, had he lived to do so, might well have written the most effective correction of Keynesian economics. What for him was intellectual working capital with a rapid turnover has been turned by the less agile into fixed investment capital, the productivity of which is defended by all means, including monopolistic protection. Keynes cannot be absolved from the reproach that in the exuberant vitality of his mind he did not make sufficient allowance for this.

KEYNES AND THE MARKET ECONOMY

Finally, it is cold comfort that Keynes himself always regarded himself as a liberal, professing his belief in the freedoms of the bourgeois world and meaning to serve them after his own—in our view, strange—fashion. The desire to reconcile his theory with the market economy is laudable, but practical experience has proved that this theory has instead become one of the supporting pillars of an opposite economic policy of the collectivist and inflationary kind. It can be shown that there are profound reasons why one could hardly expect it to be otherwise. And has not Keynes himself in his magnum opus outlined this development clearly enough, as proof of how little he was in earnest about the market economy? If the countries of Europe are today grouped according to the style of their economic policy, there are those with a market economy on one side, and those with a collectivist, inflationary, full-employment policy on the other. It is the latter that cause most concern, even to the more impartial representatives of the “new economics.” It really seems grotesque that recently a French author, J. Cros, in a study entitled “Le Néo-Libéralisme,” contrasted Keynes as “le véritable néo-libéral” with such muddle-headed writers as Lippmann and Röpke.

IDEOLOGY AND ANALYTICAL TECHNIQUE COMBINED

The developments of the last ten years have in fact so compromised the Keynesian approach, and compromised it so openly, that it is easy enough to understand the attempt to water it down and present it as a mere analytical technique, which can now, with disinterested impartiality, be switched from the struggle against deflation to that against inflation. When, however, this attempt is combined with the claim to illuminate us with the pure light of Keynesian theory, then the legitimists among the rest of us economists will be forgiven for displaying some surprise at such agility. After we have spent years warning the adherents of the “new economics” of precisely those dangers that have materialized, we have some difficulty in getting used to their now stealing our thunder in the name of the selfsame “new economics.” At the very least we shall, no doubt, be permitted a few words on the subject.

First of all, we have to admit that the use of the Keynesian analytical technique in combating today’s inflation in the full-employment countries is in a way quite legitimate. We do, after all, use it ourselves when we say that these countries “live beyond their means,” in the sense that the sum of consumption and investment releases more purchasing power upon the economy’s goods than can be satisfied at current prices, so that inflationary pressure develops and with it a deficit in the balance of payments. We could, of course, have learned that from the “old economics” as well, but we do not deny that the technique of thinking in flow aggregates has been refined by the “new economics.”

But if we concede that much and thus make a step toward reconciliation, it would not be unfair to expect that the adherents of the “new economics” in their turn should frankly admit two things: first, that in fact a passionate ideology has been turned into a mere analytical technique, and second, that if this technique has now to be applied to a situation exactly opposite to Keynes’s assumptions, this has not happened, to put it mildly, entirely without the help of the Keynesian ideology. They might even be expected to admit that the fact that it is so desperately hard to deflect the full-employment countries from their inflationary course is not least to be ascribed to the firm hold gained in the meantime upon public opinion in those countries by the Keynesian ideology, with its sole emphasis on the fear of deflation, full employment at any price, expansion and reckless spending—so much so that some pessimists doubt whether the task can be achieved without grave social and political upheavals.

A BRAKE AGAINST INFLATION, BUT …

This alone throws light on the great difficulty of applying the analytical technique of the “new economics” with fine impartiality to inflation or deflation in turn, according to the situation. A number of serious objections may be raised against the possibility of such symmetry. It is bound to be heavily lopsided insofar as the Keynesian approach at best always remains latent inflationism. This inflationism at once becomes virulent in the presence of any disturbances, including those which, because they are accompanied by unemployment and a shrinking volume of business activity, look like “deflation,” even though they are to be interpreted, not according to the “new economics” as a disproportion of the economic aggregates, but according to the “old economics” as a result of wrong values (prices or wages) and a wrong distribution of the factors of production. What happens then? What happens when excessive wage increases cause unemployment? And, above all, how about the difficulty that disinflation in a full-employment situation tends to be associated with such pseudo-deflationary symptoms?

The point is that even though the “new economics” is reduced to a mere analytical method of a neutral kind and in the present situation agrees in its conclusions with those of the “old economics,” the desired synthesis will be a good deal more difficult than meets the eye. It will hardly be possible at all unless the exponents of the “new economics” make up their minds to surrender their method’s and their theory’s claim to domination and to evacuate a good many more positions than they have already given up.

The idea of continuous manipulation of aggregates with a view to counteracting now an inflationary, now a deflationary, tendency, as the case may be, is indeed most seductive. It is not, of course, the sole privilege of the “new economics” but has always been a guideline of sensible economic policy. But it remains a dangerous idea so long as it is not purged of all Keynesian vestiges far more radically than has been done so far. Keynesian analysis will always look at the danger of inflation through a diminishing glass and at the danger of deflation through a magnifying glass, and in matters of economic policy, to change the metaphor, will always limp with the inflation leg. So long as the analysis remains spellbound by the “new economics” to the extent of working only with aggregates, its underlying models are bound to misrepresent the nature of inflation and even more so of “deflation.” Nothing-could be better proof of the inner bias of the whole approach than the fact that it took so much time and persuasion, and the present inflationary tendencies had to grow to such massive proportions, before at least the more circumspect among the champions of the “new economics” bowed to the evidence and changed over from an anti-deflationary to an anti-inflationary course. The analytical machine worked out with so much ingenuity by Keynes and his disciples does indeed possess a brake against inflation. But the machine is so constructed that this brake comes into play only at breakneck speed and, moreover, has the awkward habit of cutting out again immediately after the first effect.

A HIGHLY UNMATHEMATICAL CIRCUMSTANCE

This is one of the main reasons why the Keynes-inspired theory of continuous anti-deflationary and anti-inflationary compensation, brought about chiefly by means of what is known as compensatory fiscal policy, has not so far proved its worth in practice. Expansion causes no trouble, but when it comes to the contraction demanded in the boom, which, in compensatory fiscal policy, implies swinging the budget from deficit to surplus, it has never worked, not in the United States, nor in Switzerland, nor anywhere else. “Under the ’compensatory’ theory,” we read in the Guaranty Trust Company’s Guaranty Survey of September, 1952, “the last twelve years should have witnessed an unbroken series of substantial budgetary surpluses. The contrast between this and the actual record would be amusing if it were not so tragic. Experience so far indicates that what is in theory a two-sided influence actually operates on one side only—the inflationary side—and that the inflationary effects tend to be strongest at times when they are least desired.” The reason lies not only in the lopsided character of the philosophy underlying this compensatory theory. It lies also in the damnably unmathematical circumstance that one cannot talk Parliament and public opinion into saving and economical management, by exceptionally praising them as virtues, if all the rest of the time they are reviled as folly and sin, not to speak of modern mass democracy’s built-in obstacles. This is something that has not been accorded the attention it deserves, thus giving away the theory as a typically intellectual construction that forgets the social reality behind the integral calculus.

* Universitas, December, 1952, pp. 1285–1295.

* There follow a few lines of quotation from Professor Sir Roy Harrod, the source of which is not identified and the original text of which cannot now be traced, even by their author.—Ed.

1 Frankfurter Allgemeine Zeitung, September 4.