The Conceits of the Keynesians

The Keynesian revolution turned careful economic thinking on its head, giving policymakers delusions of grandeur.

The economic distresses of the Western industrialized world today clearly indicate that something has gone wrong. The Keynesian orthodoxy that has dominated economic theory and policy in the post-World War II era promised full employment, price stability, and rapid economic growth. Instead, we now face high unemployment, accelerating inflation, and stagnation.

The question that is being asked with ever more urgency is, "Where did Keynesian economics go wrong?" Various answers have been suggested.

Some argue that the problem lies in errors in the technical details of Keynesian economics. These critics point out that Keynesians are at least partly wrong in claiming that the demand for money is unstable, that wages and prices are rigid, that consumption is a stable function of disposable income, and that investment is unstable because irrational entrepreneurs periodically exercise their "animal spirits."

Other critics attack Keynesian economics in broader terms. "The economy," they point out, is really individuals producing, buying, and selling goods and services, but the Keynesian overemphasis on aggregates has led to an almost total lack of consideration of the role of the acting individual. Closely related to this overemphasis on aggregates is an understatement of the difficulties associated with government attempts to manipulate or "fine tune" a national economy. And in recent years an increasing number of economists have zeroed in on a fact ignored by Keynesians—that inflationary policies almost always look attractive to politicians, and Keynesian economics, whereby the balanced-budget rule and the gold standard came to be ridiculed and discarded, has destroyed all the old restraints on engaging in such policies.

All of these criticisms have considerable merit, but there is yet another, and important, flaw that they miss. For the Keynesian revolution wrought a disastrous alteration of thinking processes within the economics profession.

THE PATIENT ECONOMIST From the time Adam Smith published The Wealth of Nations in 1776 until John Maynard Keynes published The General Theory in 1936, almost all economists had continually emphasized the importance of patient, sophisticated reasoning tracing out all the indirect, often obscure, unintended consequences of human action. Why give painstaking attention to these consequences? Precisely because they are unintended and obscure. Since it would always be very difficult for the general public and the politicians to recognize and appreciate such consequences, the economist was to bring his expertise to this process and thus at least partly discourage the use of measures that seem to offer direct, obvious benefits.

Of course, there was a long tradition even before Adam Smith that economists should apply this reasoning process. Smith, however, was the first to spell it out so thoroughly in his "invisible hand" concept, which is simply an explanation of the indirect, obscure, unintended benefits accruing to the whole society from the self-interested actions of individuals in a market economy.

Smith's explanation of the "invisible hand" was a powerful defense of the market. It depended entirely on patient, sophisticated reasoning, which led to conclusions that seem absurd unless obscure, unintended consequences of human action are traced out. The first impression given by the market is that it is a system of greed in which each person makes himself better off by making others worse off, a system in which the rich capitalist can and does oppress the poor worker. Smith demonstrated how totally misleading is this impression, how voluntary exchange inevitably makes both parties better off, how self-interest leads each individual to produce those goods most desired by others, how a market system functions to make not only the rich capitalist richer but the poor worker less poor as well, how the capitalist can become rich and stay rich only by serving and continuing to serve the desires of consumers in an efficient manner.

All of these conclusions, which profoundly influenced both economic theory and economic policy, were possible only because Smith carried out the careful, involved analysis through which he was able to explain the indirect, obscure, unintended consequences of human action. And since the market system is subtle and complex, it can only be defended through such reasoning.

The great macroeconomic principle culled from the same patient, sophisticated reasoning Adam Smith had used in The Wealth of Nations is Say's Law—the idea that "supply creates its own demand." It is certainly not obvious that it does so. Again, the principle can be defended only by ferreting out the less obvious consequences of human action. The fact that an increase in saving is not a withdrawal from demand but rather a change in time preference that will shift the structure of production toward more capitalistic methods is not easily understood, to say the least. The fact that a general glut of output or a surge in unemployed workers will be cleared up by individual actions altering price and wage decisions is also not easily comprehended. But the understanding of such concepts was essential to the economic defense of the market as a stable, self-sustaining method of economic organization.

There were some who strayed from this central tradition in economics—the mercantilists with their notion that the road to wealth is the direct, obvious action of accumulating gold; Thomas Malthus with his direct, obvious explanation of the possibility of general gluts: deficient demand. But the arguments of these wayward economists were completely rejected by all the great economists, who realized the errors of such unsophisticated reasoning.

ECONOMIC DARK AGES Then came The General Theory, and all this changed. We are now in the Age of Keynes, an era characterized by impatience and lack of sophistication in reasoning and in policy. Economic analysis has been returned to the Dark Ages by a shift in emphasis to the direct, obvious consequences of action and to governmental attempts to improve the performance of the economy by producing consequences intended by government policymakers.

The lesson of Adam Smith had been the necessity of engaging in abstract reasoning to fully understand the implications of any action. The lesson of Keynes has been the desirability of taking obvious, direct action to solve any problem, while ignoring or at least deemphasizing any indirect, obscure, unintended consequences. This change of emphasis has engendered drastic, and in the long run disastrous, changes in economists' policy recommendations.

First, Say's Law has been rejected and replaced by Keynes's Law—"demand creates its own supply." By Keynesian lights, people produce because they expect the product to be purchased, so if production falls and unemployment rises, all that has to be done is to increase total spending. Thus, discretionary fiscal and monetary policies are used to manipulate aggregate demand and supposedly to assure full employment. Keynes's Law is popular with businessmen, the general public, and politicians because it is the result of direct, obvious reasoning. It seems to be unquestionably true.

And this is the key to the success of Keynesian economics—it tells the public and the politicians what they want to hear. It justifies these policies that seem obviously desirable. All the sophisticated reasoning behind Say's Law is ignored or explained away because the implications of Say's Law are inconvenient. But unintended consequences accompany even Keynesian policies. When individuals know that government is going to manage aggregate demand to assure full employment, they change their behavior. And all these changes and their unintended consequences are ignored in the simplistic Keynesian analysis.

Second, as a stabilization tool, government taxing and spending (fiscal) policies have been designated as preferable to government money-supply (monetary) policies because of their more direct, obvious link to total spending. Continuing the same reasoning, government spending increases are considered preferable to tax cuts, which require that people spend the money and thus have a less direct effect on aggregate demand. Finally, carrying the Keynesian argument to its logical extreme, a program providing government jobs for the unemployed is the best policy of all: since the purpose of manipulating spending is to increase employment, why not just act on employment directly?

Again, the indirect, obscure, unintended consequences of such government action are ignored or explained away. Sophisticated analysis clarifies the fact that government spending must be financed. If it is financed by tax increases or bond sales, private spending and employment are reduced. If it is financed by new money, inflation results. But these inconvenient conclusions have been discarded by Keynesian economists.

THE "VISIBLE HAND" Third, Keynesians analyze monetary policy in terms of its direct, obvious, intended effects on interest rates and thus investment. The more sophisticated but less obvious analysis of the effect of monetary policy on liquidity and thus on spending tends to be ignored. Much more important, the complex, unintended effects of additional money on relative prices and the structure of production are usually not even considered.

Fourth, this continued emphasis on direct, obvious effects again leads inexorably to a simplistic solution to inflation—wage and price controls. Why not stop inflation by making it illegal? The devastating unintended effects of such controls on the efficiency of the price system, the freedom of individuals, and the likelihood that the politicians will find inflationary policies irresistible while controls create a short-run illusion of the absence of inflation—these are all too obscure for proponents of such controls to recognize or seriously consider.

Finally, and potentially most devastating of all, national economic planning rears its superficially beautiful head. After all, in order to get the right goods produced by the right methods at the right time and place, what better method than to have government tell everyone what to do? What could possibly be more direct and obvious than government orders? Any problems—such as how the central planners are to accumulate the necessary information to guide an economy that depends on highly decentralized information, what will prevent politicians from emphasizing short-run political goals over long-run economic goals, and what will restrain the power of special interest groups—are to be dealt with only after the planning system is established. After all, how could the "visible hand" of government fail to be better than the "invisible hand" of the market?

And so it goes. The obvious solution to poverty is to take money from middle- and upper-income individuals and give it to the poor. The obvious solution to the "energy crisis" is a $10 billion Department of Energy. The obvious solution to deterioration of the central cities is a massive government building program. Keynesian economics has set the politicians loose, and they are having a ball!

This Keynesian reasoning has set economics, let alone human progress, back hundreds of years. Dressing up feeble, unsophisticated reasoning in the form of complex models with elaborate empirical tests to defend them does not alter the nature of the reasoning. The never completely successful attempt by economists to restrain the general public and their political representatives from their tendency to accept direct, simplistic solutions to every problem has collapsed completely as the economics profession has joined the other side. The inevitable result is more and more government domination of the entire economy.

RETURNING TO OUR SENSES The only bright spot on the horizon is the gradual movement of many economists away from Keynesian economics. The first evidence of this was the surging popularity of Monetarism in the 1960s and early 1970s. The Monetarists have opposed the use of such direct, obvious actions as fiscal policy, wage and price controls, and national economic planning; but they suffer from deficiencies of their own—an excessively narrow concentration on the money supply and an almost exclusive concentration on aggregates. These and other failings have led to at least a leveling off if not a fall in the popularity of Monetarism.

In the second half of the 1970s, the most exciting trend occurring in economics is the revival of the Austrian viewpoint. Austrians, among all economists, have been most consistent in sticking with the ideas of Adam Smith and extending them further. Their emphasis is always on individual action and the indirect, obscure, unintended consequences of such action. They still constitute only a small minority of the profession, but they offer the best hope for the future.

Even if the battle within the profession is won, we still will have the much more difficult task of convincing the general public and the politicians. It may be that we will have to experience wage and price controls, national economic planning, and public service employment to a substantially greater extent than we have done so far in order for economists and the public to experience the disastrous results of such policies. Then, perhaps, it will be possible to return to a more rational, patient, sophisticated view of economic theory and policy.

William Field is an associate professor of economics at Nicholls State University in Louisiana. He has himself moved from Keynesianism through monetarism toward Austrian economics.