Living in the Age of Keynes

The path to prosperity

In 1935 John Maynard Keynes wrote to his friend George Bernard Shaw: “I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years – the way the world thinks about economic problems.”

That book, The General Theory of Employment, Interest and Money, published the following year, would go on to fully realise Keynes’s expectations. After World War Two, following Keynes’s analysis, policy makers and economists around the world used fiscal and monetary tools to pursue the goal of ‘full employment’. Keynes gave his name to both the economics and the age itself.

It is conventionally said that this Keynesian Age was brought to an end by the Stagflation of the 1970s. To the extent that responsibility for ‘economic management’ was simply transferred from politicians with primarily fiscal tools to central bankers with monetary tools this can be argued. But there is another sense in which we never left the Age of Keynes.

The first substantive chapter of The General Theory is chapter two, ‘The Postulates of the Classical Economics’. Here Keynes ridicules a set of beliefs which he ascribes to an ill-defined group of ‘Classical economists’. For these Classicals income was either spent on consumption or saved. These savings, as capital, were invested with the two quantities, savings and investment, being equilibrated by the interest rate. As Keynes’s Classical mentor Alfred Marshall put it:

“[I]t is a familiar economic axiom that a man purchases labour and commodities with that portion of his income which he saves just as much as he does with that he is said to spend. He is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labour and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”

Keynes, by contrast, saw no such essential unity between savings and investment. In The General Theory he wrote that the “decisions which determine Saving and Investment respectively are taken by two different sets of people influenced by different sets of motives, each not paying very much attention to the other”.

It was possible, Keynes argued, that investors driven by mercurial “animal spirits” could become so pessimistic that the Marginal Efficiency of Capital (the expected return on their investment) could plunge below the interest rate (the cost of funding that investment) so that no investment would take place. The Marginal Efficiency of Capital could, indeed, sink so low that nominal interest rates couldn’t offset it, giving rise to the ‘liquidity trap’ and monetary impotence. Marshall’s link would be broken and aggregate demand would fall.

For Keynes, the way to guarantee the continued investment which not only guaranteed aggregate demand in the present but also increased prosperity in the future, was for the government to underwrite the profitability of investment by acting as spender of last resort, via fiscal stimulus, to prop up the Marginal Efficiency of Capital.

This was the polar opposite of the Classical view. Whereas Keynes believed that spending made you rich enough to save, the Classicals believed that saving made you rich enough to spend. Though Keynes would have agreed with the father of the Classicals, Adam Smith, that “Consumption is the sole end and purpose of all production”, they took totally different routes to get there.

This stems from a striking difference in attitudes to saving. Adam Smith, anticipating Marshall, wrote, “What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people…by labourers, manufacturers, and artificers”. Keynes, by contrast, said that “whenever you save five shillings, you put a man out of work for a day”.

Is it Smith or Keynes’s attitude towards consumption and saving which animates western policymakers today? Since 2008 we are supposed to have seen ‘The Return of the Master’. In truth he never went away. We’ve been living in the Age of Keynes for decades.

This article originally appeared at The Commentator

John Maynard Keynes, in the long run

John Maynard Keynes, 1883 – 1946

“In the long run we are all dead”. So said John Maynard Keynes, born 120 years ago on Wednesday, in one of the most misquoted phrases in economics.

It comes from Keynes’s Tract on Monetary Reform, from 1923, in a discussion about the economic long and short run. If a factory closes you can say that in the long run its workers will find jobs somewhere else but in the short run there may be considerable unemployment and it was this that Keynes was concerned to tackle. Thus, the full quote is: “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.”

Indeed, Keynes thought much about the long run. One of his most celebrated pieces of writing was an essay titled The Economic Possibilities for Our Grandchildren (1930) and he was one of the architects of the post-World War II Bretton Woods monetary system.

But this isn’t to say that Keynes had any coherent idea about the long run. He didn’t. In The Economic Possibilities for Our Grandchildren he observed that, since the Industrial Revolution, “the average standard of life in Europe and the United States has been raised, I think, about fourfold” and predicted that “the standard of life in progressive countries one hundred years hence will be between four and eight times as high as it is today”. In large part he attributed this, correctly, to “the accumulation of capital which began in the sixteenth century”.

But this capital accumulation was simply assumed by Keynes, not analysed. In The General Theory of Employment, Interest and Money (1936) he speculates on the future possibility of “a society which finds itself so well equipped with capital that its marginal efficiency is zero and would be negative with any additional investment”, blithely asserting that it would be “comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero”. The Solow growth model theorists are derided for their characterisation of technological change appearing exogenously as “manna from heaven” but that is exactly how Keynes conceptualised the accumulation of capital and capital goods.

In fact financial capital is that part of income not spent on current consumption; saving, in other words. Capital goods have to be produced and maintained. If they had no value, as Keynes posits in his Utopia, they would not be produced. Include the cost of maintaining them and they would be even less likely to be produced.

This lack of understanding of the process of capital accumulation, which he himself put front and centre of his theory of increasing wealth, was a constant in Keynes’s writings. In The Economic Consequences of the Peace (1919) Keynes wrote that, during the 19th century, which he later characterised as an “epoch of enormous economic progress”,

“There grew round the non-consumption of the cake all those instincts of puritanism which in other ages has withdrawn itself from the world and has neglected the arts of production as well as those of enjoyment. And so the cake increased; but to what end was not clearly contemplated. Individuals would be exhorted not so much to abstain as to defer, and to cultivate the pleasures of security and anticipation. Saving was for old age or for your children; but this was only in theory,—the virtue of the cake was that it was never to be consumed, neither by you nor by your children after you.”

This is drivel. The cake was consumed, not least by Keynes himself who wrote of the pre-1914 era that “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he may see fit, and reasonably expect their early delivery upon his doorstep”. And while Keynes was a-bed, per capita consumption of milk, meat, butter, sugar, and tea all rose between 1860 and 1913. The grandchildren and great grandchildren of those who had flocked to Milton’s “dark, satanic mills” in the early days of the Industrial Revolution were beginning to consume such soon-to-be-household names as Oxo, Lipton, Rowntree, and Pears.

The end, even if Keynes couldn’t see it, was to extend to the inhabitant of Stepney the opportunities enjoyed by the inhabitant of Bloomsbury. This was made possible, as Keynes recognised, by “the accumulation of capital” which came, as Keynes failed to recognise, from saving. Keynes, aping his friend Lytton Strachey, derided the Victorians for not consuming the cake in its entirety but they understood better than Keynes that it was out of those leftovers, those savings, that they would bake a bigger cake tomorrow.

Keynes was concerned about the long run but he had no conception of how we would get there. He simply extrapolated past trends into the future without stopping to consider what factors were at work behind those trends. To paraphrase, economists set themselves too easy, too useless a task if they simply tell us the ocean will be flat tomorrow without checking the forecasts.

By consuming the whole cake today without regard to the provision of tomorrow’s dinner, in Keynes’s long run we’d all be hungry.

This article originally appeared at The Commentator

First principles on wealth and economic growth

Shanghai – Before and after

In all human history there have been just four ways of securing the goods, services, or the wealth to purchase them, required to maintain life or a desired standard of living.

First, we can receive them freely from others as gifts or charity. Second, we can take them from others as theft or tax. Third, we can borrow them from others with the promise of repayment in the future. And fourth, we can receive them freely in exchange for a good and service we provide in return.

It is clear that the first and second methods depend entirely on someone else producing the good or service in the first place. You cannot be gifted or steal what doesn’t exist. These methods are purely redistributive and add nothing to the available stock of goods and services, the increase of which is the essence of economic growth and increasing wealth.

Method three, borrowing, is fine as long as it is used for investment to increase the stock of goods and services out of which it will be repaid. The fourth method, free production and exchange, is best of all. People secure the goods and services needed or desired by exchanging those they produce for those produced by others. People’s desire to consume more induces them to produce more. The stock of goods and services available, society’s wealth, increases.

All societies engage in a mixture of these methods, different sections of those societies relying on different methods at different times. But it is clear that societies which rely to a greater extent on the first and second method are, at best, shuffling round a stagnant stock of goods; not creating wealth but merely redistributing it.

Societies using more of the third method could be acting wisely if they are borrowing to invest, but if they are just borrowing to fund current consumption then they will be paying this back out of the same (or smaller) stock in the future. Societies more reliant on the fourth method will be increasing their wealth unambiguously.

So we can say that if the aim of society is to increase wealth it ought to be utilising lots of the fourth method, the third method only to fund investment, and the first second method as little as possible.

This throws stark light on the shift in relative wealth going on in the world today. Wealth is increasing in Asia in part because relatively large proportions of their populations are producing things people want to buy. And, in part, the wealth of the western economies is stagnating or declining because, relatively, we have a greater share of our populations receiving the goods and services they need and desire (or the wealth to purchase them) as transfers from others. We see ever more borrowing to finance current spending and ever more redistribution of wealth at the expense of its creation.

If a country has a great many goods and services available it is wealthy. If individuals are able to command a great deal of goods and services they are wealthy. The nature of increased wealth is an increased number of goods and services. The more people we have producing them and increasing this number, as in Asia, the wealthier we will be.

This article originally appeared at The Commentator

Britain’s productivity paradox

In 2012 the British economy created 580,000 new jobs yet output stagnated; more work produced the same amount of stuff. Indeed, British workers were producing 2.6 percent per hour less in Q3 2012 than in Q1 2008. Labour productivity is now 12.8 percent below its pre-recession trend.

This phenomenon, of increasing inputs producing an unchanged or decreasing amount of output, which has been christened Britain’s ‘productivity puzzle’, is one of the most perplexing in current economic debate. Indeed, even Nobel laureate Paul Krugman recently declared himself stumped.  

It’s an important debate both politically and economically. Politically, because Labour can point to grim GDP figures and claim the coalition is failing while the coalition can point to impressive job growth and claim they are succeeding. Economically, because increasing productivity, producing as much with less or more with as much, is the root of increasing wealth.

The Institute for Fiscal Studies recently offered three explanations for this decline in labour productivity. First, the fall in real wages thanks to inflation has seen firms retain and/or take on more labour. Second, business investment remains 16 percent below the pre-crash peak giving workers fewer tools to work with. Third, record low interest rates and forbearance on the part of banks is propping up inefficient enterprises.

There is a grain of truth in all these explanations but we might be missing the wood for the trees. Perhaps the actual explanation for the productivity puzzle is both simpler and more profound. Labour productivity is determined by two things: the skill of labour, and the quantity and quality of the capital at the disposal of that labour. On both fronts Britain has done pretty poorly.

Britain’s labour force is losing its qualitative advantage over others, notably in East Asia, thanks to a hideously dysfunctional state education system. According to the Programme for International Student Assessment which compares students across countries, in 2000 Britain ranked 7th in reading, 8th in maths and 4th in science. By 2008 it had slumped to 17th in reading, 24th in maths, and 14th in science. Any measures which can improve this dismal performance could be expected to improve British labour productivity in the longer term.

It is a similar story regarding the capital available to its workers. In 2001 it was estimated that a British worker had 25 percent less capital to work with than an American worker, 40 percent less than a French worker, and 60 percent less than a German worker. Why is capital so vital and how might we get more of it?

There are two types of goods: capital goods and consumption goods. Consumption goods are those that immediately meet our needs, what Carl Menger called “goods of first order”. Capital goods, what Menger called “goods of higher order”, are those which meet our needs indirectly. Bread is a consumption good, the flour and the milling stone (among others) are capital goods.

If our need is to eat we can satisfy it immediately via the labour intensive method of picking apples from trees or berries from bushes. Obviously this source of food would sustain very many less people on much more monotonous diets than we have today. We are able to eat more and better because we have capital which enables us not only to produce and consume more but also to produce and consume things we couldn’t have before with purely labour intensive methods.

Thus, to borrow Murray Rothbard’s example, Robinson Crusoe could pick 20 berries per hour from a bush by hand but could shake 50 berries out in an hour with a stick. Alternatively Crusoe could make the milling stone, grind the flour, and undertake the other capital production needed to make a loaf of bread. He could enjoy something he couldn’t enjoy in any quantity at all previously.

But making the stick or the milling stone will take time, time we cannot spend either picking berries or relaxing. We must forgo an act of consumption, either of berries or of leisure. We must save, in other words. This is the essential truth of capital accumulation; it comes from saving.

So does maintenance of the capital stock. To borrow from Rothbard again, a truck with a working life of fifteen years which makes 3,000 trips can be said to be using up 1/3,000 of itself each time it participates in the transformation of bread from ‘higher order’ wholesale to ‘first order’ sandwich. If saving is not undertaken to allow for the replacement of the truck at the end of the fifteen years this production process will cease. The capital, the truck, will have been consumed in every loaf it carried on those 3,000 journeys.

This is why countries that grow rich are those that save; they accumulate the capital per worker which enables them to produce ever greater amounts. In the late 18th century British textile workers earned six times what Indian textile workers earned because they had the capital goods to make them six times more productive. This is why we see saving nations in the Far East becoming wealthier as we wonder how our current standard of living will be maintained.

Britain, meanwhile, has some of the lowest savings rates even in the generally savings-averse developed world. We are seemingly attached to the Keynesian idea that consumption, rather than something we do when we are rich, is something we do to become rich. We have a government which can hand out leaflets on budget day telling savers they are on their side while turning a blind eye to quantitative easing and 0.5 percent base rates.

The result is that by deskilling and capital consumption we have become a lower productivity, lower wage economy. There is only a puzzle because we are reluctant to face this grim truth. Greece was recently reclassified as an emerging market. Might Britain be on its way to joining her?    

This article originally appeared at The Commentator

Heavens on Earth: Exploiting human ingenuity

The social sciences provide few controlled experiments; there is no Cern Laboratory for sociology or economics. But the 20th century provided something rather close.

The impoverished, war-torn Korean peninsula was split in two, the North trying communism and the South opting for capitalism. After 60 years South Koreans are on average three inches taller than North Koreans and live 12 years longer.

Germany and its capital city were split down the middle in 1945, the west going capitalist and the east going communist. The architects of the Workers’ Paradise in the east had to build walls to stop the unappreciative proles escaping to the west to be exploited. And then the Workers’ Paradise collapsed.

The results of these experiments have proved problematic for statists. In recent years the economist Ha-Joon Chang has become popular on the left for arguing that the economic success of West Germany and South Korea relative to their eastern and northern neighbours is not because of a lack of state intervention but because they had just the right kind of intervention in just the right amount. For Chang there is nothing inherently wrong with a Gosplan, you just have to make sure you have the right boffins drawing it up.

In his new book, Heavens on Earth, JP Floru utterly rejects this argument. He takes eight case studies, from Britain’s Industrial Revolution of the 18th and 19th centuries to Singapore’s journey to prosperity, and argues that the spectacular results achieved came from the release of market forces. Where Chang prescribes intensive government involvement in the economy, Floru recommends that politicians and bureaucrats set up a solid legal framework then get out of the way.

Economically speaking, the source of the increase in wealth these countries experienced was increasing productivity, the production of as much with less or more with as much. The increase in the quantity of goods and services available for consumption which this permits is the essence of increasing wealth.

The Theory of Comparative Advantage, outlined by David Ricardo 200 years ago, extends this worldwide. As a unit a country will grow rich if it produces goods or services for which the inhabitants of other countries are willing to exchange the goods and services they have produced. And countries will see their terms of trade improve the more efficient, or productive, they are.

Floru’s argument echoes that of Douglas Carswell’s recent book The End of Politics, its central feature the ‘Hayekian Knowledge Problem’. Economics is, as Alfred Marshall wrote, “a study of mankind in the ordinary business of life. It examines that part of individual & social action  which is most closely connected with the attainment and with the use of material requisites of well-being”.

It is not, as much mainstream neo-classical economics would suggest, the study of the allocation of given resources among known ends via some identified production function. It is, in fact, the study of the process of the discovery of all these things; resources, ends, and means.

The knowledge of how best to produce cars, linen, or financial services does not exist in some one place where one of Ha-Joon Chang’s Platonic philosopher kings can simply go and get it prêt-à-porter. It is lurking somewhere, probably dispersed, in the vast collective brain made up of each individual in the wider economy, and it has to be discovered.

A free market economy is far better at tapping this collective brain and efficiently discovering and coordinating the hidden, dispersed information it contains than a state command system which relies on the brains of a handful of experts. That is the lesson of Korea and Germany.

There is an incredible amount of economic gloom as debts rocket, growth stagnates, and incomes fall in the developed world. But, as the United Nations recently reported,

“The world is witnessing a epochal ‘global rebalancing’ with higher growth in at least 40 poor countries, helping lift hundreds of millions out of poverty and into a new ‘global middle class’. Never in history have the living conditions and prospects of so many people changed so dramatically and so fast”.

Thanks to free market capitalism more people are living better than ever before.

Since at least 1798, when Ricardo’s friend Thomas Malthus predicted a destiny of misery for mankind, there have been people warning of an imminent end to our material progress. But whatever the situation with regard to his material resources, one truly inexhaustible resource man possesses is his (or her) ingenuity, or human capital in the economists’ terminology. A system which allows for the maximum exploitation of this ingenuity, of its discovery and coordination, remains humanity’s best hope for the ever more prosperous future which is on offer.

In 1776 Adam Smith wrote that “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice”. JP Floru’s excellent new book performs the vital service of reaffirming this fundamental lesson.

This article originally appeared at The Commentator