Keynes is right; Austrians are not wrong.

July 14, 2010

So I’ve read about half of Keynes’s “The General Theory of Employment, Interest, and Money”, and I’m convinced it’s a sound theory. It’s essentially a theory of economic velocity. When velocity slows down (usually due to a rapid increase in savings or the desire to save), then employment suffers. If velocity slows down too much, then prices could fall, causing a deflationary economic death spiral.

This should become obvious to anyone who thinks about the issue long enough. You can even break it down to barter society, as Austrian theorists like to do: If the shoemaker decided to stop trading his shoes, and the breadmaker stops trading his bread, then soon the shoemaker will have too many shoes and the breadmaker too much bread. They both become “unemployed” (no need to make any more shoes or bread). And unless somebody else in the economy is still willing to trade things, then they will remain unemployed, and the breadmaker will eventually go shoeless (unless he makes his own shoes — but this is not “employment”, this is just self-sustenance), and the shoemaker eventually breadless.

Note that we could all live perfectly fine with absolute zero economic velocity — if we were all farmers, raising our own food, sewing our own clothes, building our own homes, etc, etc.

But we’re not all farmers. We all have our own specific jobs. And we don’t barter. We all use cash. Money is essentially the conversion of our specialized productivity into a generic value instrument that can be easily traded in exchange for the fruit of another’s specialized productivity.

So when money velocity slows down, it’s like the breadmakers and the shoemakers stopped trading. The result is, someone ends up unemployed.

Efficient resource allocation

The issue I’ve long had with Keynesian theory, is that it is uninterested in the notion of wealth creation or of efficient resource allocation. Resources allocated, is the only concern. It doesn’t matter if they’re digging holes and filling them back in. The only thing that matters, from a theoretical point of view, is that they are employed – meaning cash is flowing from their employer to them, and from them into the economy at large. If the cash flow (i.e. velocity) is maintained, then there is no need for unemployment. Keynes’s general prescription for an economy in contraction was to simply get the velocity flowing again. And if the private sector refuses to do it, then the public sector can take its place. It’s simple math. If the private sector won’t employ the resources, then the govt can.

I suspect that Keynes did not totally neglect the idea of efficient resource allocation (tho telling by his “bury treasury notes at suitable depths and let the private sector dig them up” idea, i can’t be completely sure). I suspect that Keynes just assumed the market would allocate resources in a way that was “efficient enough” (or maybe Keynes felt that resource allocation was too nuanced to discuss in a general theory of employment (I seem to remember he paid it some lip service, then quickly moved on)).

Perhaps a “rational” market would always allocate resources efficiently. But we don’t have rational markets. We have rational market actors, where “rational” means they will always serve their individual best interests. They have little care for the rationality of the market as a whole. In fact many actors know the market is suffering some form of irrational bubble behavior, but they’ll jump on the bandwagon anyway, trying to sneak off with a bit of pie for themselves before the whole thing collapses.

Austrians are not wrong

It is my belief, consistent with Austrian theory, that severe economic contractions are caused fundamentally by severe misallocation of resources. This misallocation usually corresponds with bubble behavior. As the bubble grows unsustainably, more and more resources are inefficiently misallocated to the bubble sectors. It’s as if the breadmakers stopped making bread and the butchers stopped preparing meat and the farmers stopped growing vegetables so they could all make shoes, because for some reason everyone wanted to buy new shoes. There was a shoe bubble, which stole resources away from other sectors, and eventually caused the prices of shoes to rise very high, while the actual wealth of the economy deteriorated (as nobody was making any more food (obviously this analogy is extremely exaggerated, but it makes the point)). Soon enough, real wealth deterioration finally reaches the shoe market, and no one can afford to buy shoes anymore. Major economic dislocation occurs, unemployment rises, uncertainty and fear rise, the economy contracts, hoarding behavior begins, economic velocity slows, and a recession ensues. Given the extent of resource misallocation, the recession could become a depression.

Yes, Keynes is right: if we’re facing contraction, then let the govt spend. Let the govt put the idle former shoemaker resources to work. This will get velocity going again and avert depression.

But what if the govt decides to pay these unemployed shoemakers to make even more shoes? Or what if the govt just buys up the toxic oversupply of shoes (in essence, paying the shoemakers)? Are we solving our economic dislocations and malinvestments? No, we’re just throwing money at them, assuming that velocity is our only problem, and assuming that any problem involving resource allocation will be worked out (rationally?) by the market.

I’ve recently read two excellent blogs that hit precisely on this point:

Hussman: Implications of a Likely Economic Downturn

Interfluidity: Preventing 2006

So as I continue my economic education, I’m fairly certain about a few things:

1. Keynesian theory is right (and wrong).
2. Austrian theory is right (and wrong).
3. Anyone who tries to bend all light thru the single lens of one theory or the other, has only one eye open. The economic world is three-dimensional, but you’ll never perceive that fact if you confine yourself to only one of these very flat, two-dimensional theories.


4 Responses to “Keynes is right; Austrians are not wrong.”

  1. Chester Says:

    Really interesting article. I agree with you mostly, but I am curious about your original analogy; why do you believe that if the bread maker stops making bread, everyone or the shoemaker will be breadless? Once the bread maker stops making bread, won’t that greatly increase demand for bread thus opening an excellent opportunity for someone else to make bread, essentially creating a new bread maker? In a free market society isn’t there always competition where there is demand, with the exception of when the government intervenes?

    And, if there was a case where there was no demand or such little demand for bread that it would not be profitable, doesn’t that mean that society has chosen that the particular good or service is not in high enough demand to justify its existence? Then if the government then produces this good or service going against the market, isn’t it doomed for failure and will result in just wasting the wealth of the society by propping up the good or service?

    Milton Friedman does a better job of explaining this than I can, in volume 2 of Free to Choose, where he compares India’s central planning approach to having the government subsidize and essentially prop up a good that the market has already decided is no longer in high demand to that of a free market where products that are not in high demand naturally dissolve[1].

    I like John Maynard and what I’ve read of his ideologies, I find them original, insightful, and very intelligent. However not only do I not believe that he ever intended his ideologies to be used for what they are today, I think he would have despised them and openly spoken out against them. I also believe the road that has been taken by adopting his economic ideologies were inevitable, and while the Austrian theory is not perfect ultimately I think it is much more safe and is ultimately much better for the economy.

    Without even discussing the negative consequences of using fiat currency from a third-party central bank which enforces an economy based upon debt; I don’t believe it is possible to sustain continously ethical government intervention without an extremely well educated and unmanipulatable general public. Even if the people that initiate government intervention have great intentions and would never abuse their power or waste one penny, the system itself creates the opportunity and incentive for future generations and/or representatives to steal, manipulate, waste the wealth of society, and even if this did not happen it would still not be efficient because no one spends a stranger’s money as carefully as they do their own.

    Also, I am not entirely against government intervention. There are many examples of governments helping economies, however on average in the long term I feel they do much more harm than good.


    • The key point to the analogy is that everyone has ceased trading. Severe economic contractions tend to increase fear and uncertainty in the market, which tends to induce hoarding behavior. The breadmaker would perhaps love to trade his excess supply of bread with others, but he can’t, because nobody will trade with him. In effect, the demand for bread (and for shoes and everything else) has fallen precipitously, due to hoarding. This is an exaggerated analogy, obviously. And it represents irrational behavior by the market participants on the whole. But in times of economic stress, the apparently rational thing to do is to hoard, because people worry that their source of income may be diminished or lost in the near future. So the shoemaker slows or stops trading his shoes for the time being, because he’s worried the leather-maker might go out of business soon, leaving him unable to make more shoes in the near future (or something like that… i’m stretching it a bit 🙂

      I share your concerns about government economic intervention. And I agree, from a theoretical point of view, that the govt should not prop up goods or services for which there is insufficient demand to make the good/service profitable in the free market (for the record, I don’t consider many public services, such as fire and police departments, and school and library systems, to fall into this category – I believe the public acknowledges their need and pays taxes “voluntarily” to support them – even if the taxes are technically exacted “by force”).

      But I also believe part of the govt’s role is to advance research and technology into the dark un-scouted unknown territories that the free market dare not go (even the most ambitious entrepreneurs). Many significant technological advances in the last half-century were pioneered by govt funding, then packaged and sold and made profitable by the private sector. I believe this is a useful and socially benefiting form of govt spending. Key areas we need to invest, imo, are energy and manufacturing productivity. We (America) need to improve our manufacturing capacity and productivity if we’re ever going to generate enough real wealth to service our ever-mounting debts.

  2. Jørgen Klaveness Says:

    Rob: Your article madea lot of sense to me.

    I’ve been saying for a long time that running an economy is a lot like skiing. Hoarding (going uphill) is hard work and it slows down the economy, but it builds strength and eventually gives us the capacity to do amazing things. Spending borrowed money is a great way to speed up the economy, just like running downhill gives us a fantastic (but temporary) thrill and sense of power.

    Every skier knows that when he’s completely stuck, it can make sense to change course in a downhill direction for a while (Keynsian stimulus). However, if he gets himself hooked on ski lifts (tax cuts, cheap Chinese manufacturing), he’ll sooner or later disciver the limits to how much credit the lift operator is willing to give him, and start regretting that he invested in heavy alpine boots and skis (malls and residential property) instead of climbing gear (better schools and more cutting-edge manufacturing capability).

    It’s weird to see people wondering about whether or not we’re going to have deflation. We already have massive deflation. It happened first in the property market. It’s starting to happen in the labour market, where people are becoming more willing to work for less. It will continue as more and more people discover they’re stuck in the bottom of the valley (maybe next to a raging stream in a ravine), begging the hoarders for a lifeline.


  3. Scott Says:

    Maybe it’s a bit late for a comment, but I appreciate your post. So many people with economic opinions are either committed Austrians or Keynesians… as if there are one-size-fits-all solutions for all situations.

    That’s why I tend to distrust Krugman, although I end up agreeing with him most of the time.

    But I wonder, do the Austrians recognize the idea of a “public good”?

    The private sector is never going to provide such a thing, and that’s the perfect thing to spend stimulus money on while at the same time putting people to work, right? So I do end up agreeing with articles like this:

    But the system of Americans spending borrowed money for cheap goods made in China isn’t sustainable… as painful as the adjustment is going to be, it’s gotta end.

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