Those who remember my post “Student From Hell Part One” already know the basic set up. I was stuck in an economics class where all the teacher wanted us to do was regurgitate the textbook. As a consequence, I was bored out of my mind. My only source of amusement was trying to contradict the textbook as much as possible.
In the case of this particular assignment, I was really angry that such a loaded question had been given for what was supposed to be a three paragraph answer. Or maybe it was four, I don’t remember for sure. I never wrote down any instructions except the question that we were supposed to answer.
In any case, it was obvious that we were just supposed to summarize what the textbook said about each of the competing economic theories in one paragraph. That is why you will find one paragraph tacked on at the end. I was running out of time and I had to rush to meet the bare minimum.
I should warn people that this has to be the most horrible written assignment that I ever turned into to a professor (although, since I only ever had 3 professors, that is not saying much). That could explain why this was the only (if my memory serves me correctly) assignment where I received a B.
Ironically, I had the most fun of my whole economics course while writing this piece of garbage, but not because I like to write garbage. I had so much fun doing the reading for this piece that I almost did not have time to spew anything out.
My main regret is that I brought shame on the ideas of Jean-Baptiste Say by associating him with an Ape Man’s mental barf. Really, if you were smart, you would go read some of Say’s work instead of this.
Anyway, here are the questions…..
“Compare Classical (supply side) policies, demand side policies (Keynesian) and Monetary policy for their effectiveness in ending a recession.”
Comparing Classical and Keynesian policies
I have made no secret throughout this course that I am not convinced that Keynesian theory has any value. I have searched for a way of articulating the problems I have with Keynesian theory in a manner that is consistent with the format of this discussion. In other words, I did not want to write a twenty page paper and at the same time I did not want to oversimplify my arguments.
Thus, the above question puts me in a quandary. I do not think that Keynesian policies can help end a recession, but how can I make the case without seeming like I am arrogantly ignoring the work of talented economists who would argue otherwise? If I had the time to examine all their arguments and present my own supporting views to counter them, perhaps I could show that my concerns were at least reasonable. Since I do not have that time, I fear that I will come across as one of those knee-jerk conservatives who are against Keynesian theory for the sole reason that the theory claims that the government can do something good economically.
Nonetheless, I am going to take the teacher’s admonishment to compare Classical and Keynesian theories a little more literally than he perhaps intended. I am going to compare the arguments of Jean-Baptiste Say (the classical economist whose theories Keynes was most critical of) with the arguments of modern Keynesian theorists. In particular, I am going to compare them against the backdrop of the problems that Japan is currently having. Hopefully, this comparison will help illuminate why I think that Say (and the other classical economists) were more on target than Keynes.
Before I go further, I should note that I have not read the works of Keynes himself but I am familiar with the works of his followers. In particular, I have long followed the work of Paul Krugman. It is his interpretation of Keynesian theory that I am most familiar with. (Go to http://www.pkarchive.org/ to learn more about him. I should note that all quotes that I ascribe to him can be found at that site. However, due to how the site is set up, I cannot link directly to them. I have to link to the main page.) However, I don’t think that this weakens my argument. Most of Keynes’s disciples have improved on his theory in response to criticism received from the neo-classical school of thought, among others. Thus, I think I am dealing with a stronger argument than the one that Keynes originally presented.
Even though I have read all these modern explanations of Keynesian theory that have been put out by Krugman and others, I still find the writings of Say to be more convincing. Even thought he was writing around the time of Napoleon he still has much to say that seems to me to offer a better explanation of today’s events than many modern writers do.
Let us take Japan as an example. The Keynesian theory cannot get over what a perfect example Japan is of the problems that Keynes warned about. We even see references to Japan’s problems in our textbook as being a good example of the problems that Keynes warned about. Liquidity trap, poor demand, and low investors confidence are all reportedly problems that are dragging Japan down.
These arguments all seem convincing until we consider the fact that Japan has been following textbook Keynesian theories and they have not been working. (See http://www.federalreserve.gov/pubs/ifdp/2002/729/ifdp729.pdf for the Federal Reserve working paper that I am basing that claim on.) This is in spite of the fact that Japan’s actions were more stimulating (according to Keynesian theory anyway) than actions other countries took in similar circumstances.
The authors of the paper that I have been referring to argue that Japan’s statistics were faulty and that if Japan’s policy makers had a better picture of what was going on they would have realized that the stimulus should have been a little bigger. But do you really have to get your Keynesian polices exactly right in order for them to work? Shouldn’t we see evidence of them working even if they were not executed perfectly?
I can not prove that argument right or wrong. It is impossible to say what would have happened if Japan had stimulated demand more. But I can not help noticing that whenever Keynesian theory is called upon to solve a real world problem there is always some reasonable sounding reason why it does not work. I also can not help noticing that there is very little evidence that the popularity of Keynesian theory has had an impact on the frequency of downturns in the business cycle.
It is easy to cast these types of stones at a theory. What is harder to do is to fend them off when they are thrown back. How are the problems that Japan is having consistent with Say’s theory that free economies are self stabilizing?
We can find the answer to that question in a series of letters that Say wrote criticizing Thomas Malthus’s (the same who wrote the doomsday predictions regarding population) book entitled Principles of Political Economy, considered with respect to the practical Applications. It is well worth reading these letters because Malthus had many concerns that were similar to Keynes. For example, he argued that insufficient demand would cause great damage to the British economy, although he did not phrase it in those terms. Thus, you could consider Say’s letters criticizing Malthus to be Say’s answer to Keynesian criticism (You can find Say’s letters here. I think that many of the spelling errors are due to a faulty OCR program, but without a print copy close at hand I do not dare correct them).
In Say’s first letter, right after he gets past the polite pleasantries, Say says this to Malthus,
“And, in the first place, what fixes my attention, because all the interest of the moment is attached to it, is, from whence comes that general overstock of all the markets of the universe, to which goods are incessantly carried which sell at a loss? — Whence comes it that in the interior of each state, with a want of action in unison with all the developments of industry, whence comes, I say, that universal difficulty that .is experienced in obtaining lucrative employ? And when the cause of this chronic malady is discovered, what are the means of cure? These are questions upon which the happiness and tranquillity of nations depend. Wherefore I cannot think a discussion tending to elucidate them will be unworthy your attention, and that of an enlightened public.”
In other words, Malthus had written on the problems that England was facing in the form of what we would now call insufficient demand (or as Say calls it, “Overstock”) and unemployment (or as Say calls it, the problem of finding “lucrative employ”) and Say is going to dispute some of his points. Thus, we see that Say was aware of the points that Keynes was later going to bring up.
(As a side note, it is difficult for me to understand why modern commentators think that that the Great Depression and Japan’s current problems are without explanation in classical theory. Krugman goes so far as to say that “Before the General Theory, economists could not explain how depressions happen, or what to do about them. (I’ve tried going through the pre-Keynesian business cycle literature; it’s a vast wasteland.) After 1936, they could.” This statement seems a bit disingenuous to me. I can find documents where classical economists were talking about the problems of cyclical unemployment and overcapacity written a hundred years before Keynes formulated his theories. Granted, they did not use the term business cycle. But it is unfair to say that the classical economist could not explain how a depression happens or what to do about them just because they did not use the words that we would use.)
So given that all that is true, what does Say have to say about Japan (pardon the pun, it is kind of unavoidable)? Does it upset his famous law about supply creating its own demand? A full answer to those questions demands a complete reading of Say’s works, but we can get a good idea of his approach by how he handles a complaint made against him by M. de Sismondi. He brings this complaint up in his first letter to Malthus “in order not to deprive you, Sir, of any advantage that belongs to you.” In other words, he wanted to make sure that he showed that he was aware of all the arguments that supported Malthus.
This was M. de Sismondi basic complaint,
“Examine the reports of commerce, the newspapers, and the accounts of travellers, and every where will be seen proofs of that super-abundance of production beyond the consumption, of that manufacture, proportionate, not to the demand, but to the capital employed; of that activity of merchants which induces them to go in crowds to every new settlement, and which exposes them by turns to ruinous losses in every trade in which they expected profit.”
Sismondi goes to develop his argument that there is not enough demand for all the goods that England is producing. He then goes on to make a point that could have been taken straight from Keynes. He says.
“The error into which they have fallen is entirely owing to this false principle — that the production is the same thing as the revenue. Mr. Ricardo, according to M. Say, repeats and affirms it. ‘M. Say has proved in the most satisfactory manner,’ says he, that there is no capital, however large, that cannot be employed, because the demand for produce is only bounded by production.’ No person produces but with the intention of consuming or selling the article he produces, and no one sells but with the intention of buying some other production, which may be of immediate use, or contribute to future production.
“The producer becomes therefore consumer of his produce, or buyer and consumer of the produce of some other person. “Upon this principle, it becomes absolutely impossible to comprehend or explain the best demonstrated fact in all the history of commerce, viz. the choaking up the markets.”
Here we have, over a hundred years before Keynes, someone making the complaint that the classical economist could not account for market failure. More precisely, Sismondi was arguing that excess capacity disproved Say’s law (Although I should point out that Say never said that supply created its own demand, it was James Mill summarizing Say who said that. See here). Here we have someone describing an economic problem that sounds a lot like Japan more than 200 hundred years before it happened. What was Say’s response to Sismondi?
The first thing that Say says in response to Sismondi is that the problem stems from government interference in the market. He says
“The English Government rejects, on its part, by means of its Custom Houses and Importation Duties, the production which the English might bring from abroad, in exchange for their goods, and even the necessary provisions, of which their manufacturers stand so much in need; and this because it is necessary that the English farmers should sell their wheat at above eighty shillings per quarter, in order to enable them to pay the enormous taxes. All these nations complain of the sufferings to which they have reduced themselves by their own fault. This puts me in mind of invalids who are out of temper with their sufferings, but who will not correct themselves of those excesses which are the primary cause of them. I know that an oak is not so easily grubbed up as a pernicious weed. I know that old barriers are not taken away, however rotten they may be, when they are supported by the dirt which has collected around them. I know that certain corrupt and corrupting governments stand in need of monopolies and custom-duties, to pay for the vote of the honorable majorities who pretend to be the representatives of nations. I am not sufficiently unjust to desire that one should govern with a view to the general interest, in order to obtain all the votes without paying for them; but at the same time, why should I be surprised that deplorable consequences should be the result of so many vicious systems?”
We could say the same thing about Japan. All most everyone I have ever read, including Krugman, fully admits that Japan’s government has a number of policies in place designed to prevent the outcome that market forces would bring about. Krugman and his fellow Keynesian theorists also concede that these polices are harmful to aggregate supply in Japan.
To give just one example, most of the banks that are receiving government aid have had no change in management. Thus, those who have helped bring Japan to its current state are receiving government support whereas those who have helped build up Japan are having to compete with them without government aid. Contrast that with how the US handled the failed savings and loans crises. We sold off all of the problem banks to new owners and overhauled regulations governing those institutions.
I could give many more examples of how Japan’s government has been harming aggregate supply in Japan, but I think that the problems have been reported enough in the media that I do not need to. It is almost common knowledge now that Japan is in bad need of economic and political reform. Given this, why should we be surprised “that [To quote Say] deplorable consequences should be the result of so many vicious systems?” In other words, why do so many people argue that it is Japan’s failure to correctly implement Keynesian remedies which is the primary cause of its problems, when Japan is following roughly the same Keynesian polices that other nations have followed in similar circumstances? Those other countries did not plunge into the deep depression that Japan is in. Why not look at how Japan’s government is affecting aggregate supply, an area where its policies are widely considered markedly worse than the policies of other nations?
This does not really answer the criticism directed against Say, so Say was not content to make his argument against Malthus on the basis of the failure of government policy alone. He says
“You will readily admit with me, Sir, at least I presume so, the mischief which nations do to each other by their jealousies, their sordid interest, or by the ignorance of those who set themselves up as their organisers; but you maintain that, even supposing they have had more liberal institutions, the commodities produced may exceed the wants of consumers. Well, Sir, I am ready to defend myself on this ground.”
In other words, Says is saying that his opponents would argue that even if governments did not interfere (he is using liberal in the European sense, not the American sense), market mechanisms alone could produce the same problems namely, overcapacity and cyclical unemployment (although they did not give it that name back then).
Say then goes on to give a long argument showing how the creation of goods and the consumption of goods are different sides of the same coin. You cannot create goods and services without consuming and you can not consume without creating goods and services. In other words, Say is making the argument that we do not work for money, we work for the goods that money buys. Therefore he says, we can only buy more if we produce more. Obviously, we can steal or be on the dole, but at a national level the argument holds true.
He sums up his arguments by showing how he thinks the interaction between supply and demand should be understood, saying,
“Let us figure to ourselves, producers (and under this name I comprise as well the possessors of capitals and lands, as the possessors of industrious powers,) let us fancy them advancing, to meet each other with their productive services, or the profit which has resulted from them (an immaterial quality). This profit is their produce. Sometimes it is fixed on an immaterial object, which is transmitted with the immaterial produce, but which in itself is of no importance, is nothing, in political Economy: for matter, dispossessed of value, is not wealth. Sometimes it is transmitted, is sold by one, and bought by another, without being fixed in any matter. It is the advice of the Doctor or the Lawyer, the service of the Soldier or the public Officer. Every one exchanges the utility he produces against that which is produced by others, and in every one of these exchanges, which are carried to account in a book of competition, as the utility offered by Paul is more or less in demand than that offered by Jacques, it sells dearer or cheaper — that is to say, that it obtains in exchange more or less of the utility offered by the latter. It is in this sense that the influence of the demand and supply must be understood.”
In other words, the market is an exchange between producers. There really is no such thing as a consumer as all consumers produce things or services (they have jobs or rely on tax money that was taken from those with jobs) in exchange for what they buy. In a sense, even Krugman would agree with this point. After all, it is Krugman himself who said, in the long run productivity growth is all, meaning that if we do not expand production we can not expand consumption.
Where Krugman and Say differ is in Say’s contention that the market is self-correcting and can move along the path to more and more goods and services by itself. They also differ over Keynes’s theses that an economy can operate below productive capability due to the failure of market forces.
Say was very well aware of this, saying in his second letter to Malthus,
“However, Sir, on reading again the 3rd section of your chapter 7,(10) I feel that there is still one point in which you do not agree with me. You will perhaps confess that produce is bought onlv with other produce, but you persist in maintaining that men can, putting all productions together, produce a cluantitv more than equal to their wants, and consequently — thief there will be no employ for a part of these productions — that there may be a superabundance and glut of all kinds at the same time.”
But Says attempts to prove (successfully I would say) that consumption and production are two sides of the same coin are not a diversion from his main point. Rather it was a necessary argument to support a contention that he made at the very beginning of his first letter. Namely, that goods are only exchanged for goods. Money is worthless except that it helps to transfer information about the relative value of various things. Or in Say’s words (found in the beginning of his first letter),
“I had said — As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the.more we can produce the more we can purchase. From whence proceeds this other conclusion, which you refuse to admit — That if certain commodities do not sell, it is because others are not produced, and that it is the raising produce alone which opens a market for the sale of produce.”
Here is the main point of contention between Say and Krugman/Keynes. Krugman and Keynes believe that government sponsored worthless things can lead to the full production of things with value. In Keynes’s case, it is putting people to work digging holes and filling them. Krugman is a little nicer. Instead of making the poor saps dig holes and fill them again he advocates the printing of money to stimulate demand. Say, on the other hand, argued that value of goods and services can only be measured relative to other goods and services that you can get in exchange for them. Thus the only way that an increase in production will be of any value is if that increase in production will lead to the receiving of more goods and services in exchange. Therefore Say would argue that the digging of holes and filling them will not lead to more production because they do not increase the amount of goods and services available to be exchanged. In fact, Say makes it quite clear that he does not think an increase of demand alone can increase economic production by characterizing his opponents as arguing that “instead of continually producing, one ought to mutiply barren consumptions, and expend the old capital instead of accumulating new.”
That is not to say the Say argued that the market would never make a mistake as some people like to characterize the classicalists as arguing (not without some justice, since some of them did say things like that). But he did not think that a failure of demand was a mistake that free economy would likely make. He thought that a failure of demand was about as likely as the moon crashing into the earth. What he did see happening was an overproduction of goods to the extent that they can not be exchanged for enough goods to replace the goods that were consumed in the making of them. But he thought that situation would self-correct quickly.
As he put it in his third letter to Malthus,
“I shall remark at the same time, that although the evil is great it may still seem greater than it is. The commodities which superabound in the markets of the universe, may strike the eye by their mass, and alarm commerce by the depredation of their price, and still be only a very small part of the commodities made and consumed of each kind. There is no warehouse that would not be very soon emptied, if every kind of production of the commodity contained in it was simultaneously to cease in all parts of the world.
It has been further remarked, that if the quantity sent in the slightest degree exceeds the want, it is sufficient to alter the price considerably. It was a remark of Addison, in his Spectator, (No. 200,) that when the wheat harvest exceeds by one-tenth the ordinary consumption, wheat falls one half in price. Dalrymple makes an analogous observation. We must therefore not be astonished, that a slight excess is often taken for an excessive abundance.”
In other words, the very speed and brutality with which market forces correct market failures can sometimes make it seem as if the failures are greater than they are. But according to Say, that same speed and brutality makes market failures rare and short. The only way that Say allows for a market failure to be long and prolonged is through government intervention aimed at foiling market forces.
I could go on and on, describing the point and counterpoint of the two theories. But what it boils down to is this. If Say is right, we should find that overinvestment in certain hot industries cause short and sharp corrections to markets. The only time they should be prolonged, if Say is right, is when the government intervenes to protect certain market participants from the corrective actions of market forces. If Keynes/Krugman is right, then market depressions should be frequent in the absence of government action, increasing leakages should precede downturns, and confidence should decrease before real production does.
My reading of history supports Say. With the exception of wars and natural disasters, all economic downturns seem to be preceded by heavy investment in hot sectors of the economy. Whether it is railroads in the late 1800s, electric companies in the 1920s, plastics in the 60s, conglomerates of the 80s, or the dot coms in the 90s, we can always see signs of over-investment before the crash. In those cases where the government leaves market forces alone the duration of the pain is short. In those cases where the government interferes in the market, such Hoover with his big Tariff hikes and Nixon with his price and wage controls, the problems are long and prolonged.
I see no evidence that governments with Keynsian policies suffer from less downturns than those who do not, all other things being equal. And it seems to me that consumer confidence is not a leading indicator but a following one, albeit an indicator that can be more easily measured at the time than the things that are causing moves in consumer confidence. The same thing can be said about those things that Keynes called leakages. They seem to increase after the economy is already going into a downturn.
Some Keynesian theorists would argue that overinvestment starts the downturn but low confidence and leakages will reinforce the downturn unless the government intervenes. I see no evidence for this. I think that Keynesians are simply mistaking effect for cause.
That only leaves the monetarist position to be considered. I fully accept that inflation/deflation can have an effect on an economy that is similar to government intervention. This is because inflation/deflation screws up the markets’ pricing signals at the most fundamental level. But I do not believe that a perfect monetary policy can prevent a recession or even always help shorten one (except where failed monetary policies helped cause the recession). I believe that overinvestment can occur even when momentary policies are perfectly correct.