The Clash of Economic Ideas (part 2)

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Chapter 5 of Lawrence White’s book is devoted to “The Great Depression and Keynes’s General Theory.” I will also incorporate some ideas from later chapters that are relevant to Keynesian economics.

Keynes and Hayek disagreed fundamentally over the ability of the market economy to sustain full employment and economic growth without deliberate government stimulus. Hayek believed that the income generated by economic production would automatically stimulate further production, because the income would either support consumption or new investment. Either consumer goods or capital goods would be produced. Keynes, on the other hand, did not believe that income that people saved rather than consumed would necessarily support new investment. An increase in what he called the “propensity to save” might just reduce consumption without increasing investment, resulting in a lack of “aggregate demand” and a reduction in production and employment. Some Keynesians would say that a big reason for an excess of saving and a lack of demand is an income distribution favoring rich savers over lower-income spenders, but that argument was not essential to Keynes’s original theory. His point was simply that production didn’t necessarily create the demand needed to generate further production.

Keynes understood the Great Depression as a vicious circle of low demand and low production, with no short-run market solution. Hayek saw economic slumps as self-correcting as long as central banks properly managed the money supply. “Despite the reservations and objections of orthodox (often older) economists, Keynes’s theory quickly caught on among younger economists and completely eclipsed Hayek’s theory.” Keynesian theory dominated economic thought in Great Britain and the United States until the 1970s.

According to Keynesian economics, government spending in excess of taxes could increase aggregate demand and stimulate the economy. Only if the economy were already operating at full employment would that spending merely replace other kinds of spending with no net gain in aggregate demand and national output. At less than full employment, government spending would lead to a net gain in GDP (the size of which could be expressed by the “multiplier” ΔY/ΔG–the ratio of the change in GDP to the change in government spending). Keynesians rejected the classical economic view that running a deficit is as foolish for a nation as it is for a household. Otto Eckstein argued that a national debt is different from a household debt because “we owe it to ourselves.” In theory, we can repay it out of the larger income that deficit spending generates. This argument was more convincing before other countries began financing a large portion of our debt.

Critics of Keynesian economics such as James M. Buchanan argued that government spending had to burden either current or future taxpayers, and that the theory encouraged fiscal irresponsibility: “Keynesian economics has turned the politicians loose; it has destroyed the effective constraint on politicians’ ordinary appetites. Armed with the Keynesian messages, politicians can spend and spend without the apparent necessity to tax.”

Keynesian economist Paul Samuelson provided an additional rationale for government spending in his theory of “public goods.” As described by White, “the theory…views government as a faithful agent hired by the citizenry to provide desired goods and services having characteristics such that the market economy provides too little of them.” This elaborated on an idea already present in the writings of classical and neoclassical economists. Private entrepreneurs may not find it in their self-interest to produce something even if the public values it enough to pay for it. For example, they may not be able to make a profit financing basic research or general intellectual activity (as opposed to applied research to develop specific products), and yet the public may well wish to finance universities with their tax dollars. The problem for the entrepreneur is to “capture all of the potential gains from production and trade,” which is hard to do for ideas that spread freely. The failure to do so is a type of market failure known as a “Pareto inefficiency,” named for the Italian economic Vilfredo Pareto. Arthur Pigou related the problem to the concept of externality discussed in the previous post. Just as markets sometimes reward individuals for doing things that have negative externalities (social costs), they also fail to reward individuals for doing things that have positive externalities (social benefits). Public goods theory says that the government has a responsibility to discourage the first type of behavior and promote the second.

Critics of public goods theory have tried to show how goods and services that are commonly regarded as public could conceivably be provided by markets under the right conditions. In 1960, Ronald Coase argued that externality problems are often property rights problems, and the solution is often to expand the rights of producers to make sure they profit from socially useful activity. In the classic case he studied, radio broadcasting could become a profitable activity only when broadcasters owned the frequencies on which they broadcast so they were free of interference. The argument can be extended to justify many forms of privatization. On the other hand, some goods seem irrevocably public. Maintaining a favorable global climate requires public action, since no business can own the climate enough to have a profit motive to protect it.

Non-Keynesian economists, especially James M. Buchanan and Gordon Tullock, have tried to counter public goods theory with “public choice” theory. It questions the very idea that government spending can work for the benefit of all. What is more likely to happen is that:

 …[I]ndividuals can use the powers of government for special-interest programs, or “rent-seeking,” gaining benefits for some at the expense of others….On an issue where the taxpaying majority is poorly organized, a well-organized special interest group may use plausible arguments (and campaign contributions) to persuade legislators to grant it monopolistic privileges or to tax the general public for the group’s benefit.

This is reminiscent of Adam Smith’s criticism of mercantilist government, favoring some economic interests over others instead of letting the market decide what’s best. Of course, a public goods theorist would question the assumption that what is most profitable is really best for society.

White concludes his treatment of public choice theory with the observation, “By rebuilding the intellectual case for the limited-government constitutionalism of the American founders, Buchanan and Tullock might today be called patron saints of the constitutionalist wing of the Tea Party movement.” This remark dramatizes the close association between economics and politics. Is the Tea Party trying to restore limited government and economic freedom, or is it trying to render government too impotent to stand up to powerful private interests and carry out needed economic reforms?

Continued

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