Wednesday, February 10, 2010

Six Blunders of the Current Orthodoxy

Robert Higgs, a Senior Fellow at the Independent Institute and editor of The Independent Review, describes (Pdf) six major errors of the current economic orthodoxy, which he says began with "the first edition of Paul Samuelson’s Economics (1948), the best-selling economics textbook of all time and the one from which a plurality of several generations of college students acquired whatever they knew about economic analysis. Long ago, this view seeped into educated discourse, writing in the news media, and politics, and established itself as an orthodoxy."

Higgs calls this phenomenon "vulgar Keynesianism," which he further refines this way:
I use "vulgar Keynesianism" to denote a loosely articulated belief system about economic booms and busts to which journalists, politicians, and a wide segment of the general public have subscribed since the 1950s. It is not necessarily the same thing as Keynes's own ideas or the models developed and refined by so-called new Keynesian economists, some of whom are much more sophisticated about the issues (not to say that I agree with them, but only to recognize that some of them are well informed, well educated, and serious thinkers conscious of what they are doing).
The six major errors consist of the following:

1. Aggregates, that is, "[thinking] of the economy in terms of a handful of economy-wide aggregates: total income or output, total consumption spending, total investment spending, and total net exports." Whatever complex relationships exist within the aggregates are ignored because they're irrelevant. To the vulgar, the economy produces an "output," not an endless variety of products.

Aggregate output is driven by aggregate demand, to which aggregate supply more or less responds automatically.

In truth, "producers are connected in an intricate pattern of relations . . . [C]ritical consequences turn on what in particular gets produced, when, where, and how." Economic action refers to the choices of millions of participants in selecting the actions to take and the alternatives to forgo. The orthodox model "actually excludes the very possibility of genuine economic action, substituting for it a simple, mechanical conception—the intellectual equivalent of a baby toy."

2. Relative Prices - The orthodox view ignores relative prices and their changes. There is only one price, "the price level," which is a weighted average of all the prices for which the economy's goods are sold. Seeing aggregates only, the orthodox view does not see why a sudden increase in demand in one area could be problematic. We can never have too many houses and apartments, as long as the economy has unemployed resources.

If there are unemployed skilled silver miners in Idaho, building more condos in Palm Beach is still a good thing. Aggregate output is a simple increasing function of the aggregate labor employed. Mathematically,

Q = f(L); where dQ/dL > 0

Aggregate production has only one input, aggregate labor. Do workers work without the aid of capital? It would seem so, though if questioned vulgar Keynesians will admit laborers do use capital, but it's a "given" and fixed in the short run.

And the short run is all that matters.

3. Rate of Interest - A crucial relative price, the rate of interest is the price of goods available now relative to goods available in the future. The rate of interest affects the choice between current consumption and saving.

The orthodox view ignores relative prices. Interest rates are simply the rental rate for borrowed money. The lower the rate of interest, the more people will borrow and spend. As long as at least one person is unemployed, this is always good for the economy. Since unemployment always exists, the interest rate is never low enough for the orthodox view. Some have even proposed a negative rate of interest.

4. Capital and its structure - Capital to the vulgar is an inheritance from the past; it is given, it exists already. It is "essentially an undifferentiated glob of monetary value, any part of which may be substituted perfectly for any other part of equal monetary value."

"It matters not whether firms invest in new telephones or new hydroelectric dams: capital is capital is capital."

In contrast to the orthodox, Austrian economics presents "a theory of malinvestment, which is to say a theory of how an artificially reduced rate of interest leads business firms to invest in the wrong kinds of capital, in particular the longest-lived capital goods, such as residential and industrial buildings, as opposed to inventories, equipment, and software with a relatively short life."

The boom spurred by low interest rates culminates in a bust. But the vulgar Keynesians see no need for a correction, that is, for "the bankruptcies and unemployment that necessarily attend a substantial economic restructuring." Instead, government should engage in deficit spending to compensate for lower private investment and consumption spending.

5. Malinvestments and Money Pumping - the vulgar analysts disregard malinvestments and encourage government spending in excess of its revenues. The borrowing that's needed to make up the excess of spending over revenue should be assisted by a central bank policy of "easy credit." Easy money lowers the cost of financing deficits, but to the vulgar its major value economically is the consumer spending it induces.

The vulgar ones don't sweat inflation - it can always be countered by price controls and rationing, which had some efficacy during WW II. Their biggest fear is deflation.

6. Regime Uncertainty - The vulgar Keynesians are policy hounds. Try something, and if that doesn't work, try something else. Better yet, try many things at once. Roosevelt did it, Johnson did it, and Obama is attempting to be the most trying of all. They fail to understand that extreme policy activism creates what Higgs calls "regime uncertainty." Regime uncertainty is "a pervasive uncertainty about the very nature of the impending economic order, especially about how the government will treat private-property rights in the future. This kind of uncertainty especially discourages investors from putting money into long-term projects." Long-term investing virtually disappeared from 1929 to 1946.

The "bailouts, capital infusions, emergency loans, take-overs, stimulus packages, and other extraordinary measures crammed into a period of less than a year," have created a great deal of regime uncertainty. It can only hurt.

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