Wednesday, December 03, 2008


Most of us view the ‘dismal science’ of economics as a study of mainly financial matters. Economists, on the other hand, consider it to be more a study of interrelationships between humans — a rational study of why humans make the choices they make.

Noted economist Friedrich Hayek took a somewhat different view when he notably said, “The curious task of economics is to demonstrate to men how little they know about what they imagine they can design.” Hayek is one of the most famous economists from the Austrian School of economic thought.

Austrian economic thought differs sharply in several key areas from the Keynesian School of economics, which is much more mainstream. Most of our nation’s politicians and economic scholars align closely with Keynesian theory when it comes to macroeconomics, while adhering to neoclassical theory in microeconomics.

Macroeconomics focuses on regional, national, or global matters, while microeconomics considers how individuals, households, firms, and small political entities “make decisions to allocate limited resources.” While the term ‘neoclassical theory’ was originally coined to define microeconomic thought differing from that of the Austrian School, it has since come to encompass a hodge-podge of thought extracted from a wide variety of economic schools, ranging from Marxian to Austrian and everything in between.

Thus, today the area of economics where the most significant differences exist is in macroeconomics. The orthodox Keynesians and the heterodox Austrians regularly snipe at each other. Keynesians argue that Austrians are laissez faire anarchists; Austrians say that Keynesians are big government socialists that have never seen a deficit they didn’t like. While there is a grain of truth to each of these statements, both are somewhat straw man arguments.

Unlike some of the rank and file in these schools of thought, some of the leading scholars in each school are fairly open to thought coming from outside their own school. These leaders don’t think they’ve got all the answers.

Harvard economist Greg Mankiw considers himself a New Keynesian. Keynesians usually favor a significant government role in the economy, including deficit spending and centralized banking. But in the face of the current economic disaster, Mankiw argues in his Dec. 1 blog post, “Any economist approaching the subject should bring an ample dose of humility.”

Keynesian theory suggests that fiscal policy can be tinkered with to cause people in the economy to act in ways the government believes is best. Austrian theory says that the government’s role is not to manipulate the economy, but rather to ensure a level playing field. Indeed, Austrians suggest that almost any public manipulation of the economy will produce mischievous effects.

Keynesian thought also posits that deficit spending by government will stimulate the economy. In his post, Mankiw cites studies that have found that the actual outcomes of this type of fiscal policy “are not consistent with standard Keynesian theory.” Among these findings are “that both increases in taxes and increases in government spending have a strong negative effect on private investment spending,” and that “a surprise deficit-financed tax cut is the best fiscal policy to stimulate the economy.”

While Mankiw says that this does not conclusively mean that the Keynesian model is in error, he also says, “At the very least, these puzzles should give us reason to pause when using the Keynesian framework for policy analysis.”

While Mankiw doesn’t quite yet sound like Hayek, his admonition of humility is welcome indeed. And that would be just fine if “policy analysis” was the only thing Keynesians were doing. But they’re not. They are actually implementing public policy and they’re doing it on the fly. As Holman W. Jenkins, Jr. notes in this WSJ article, they are doing “an objectively crummy job.”

To be fair, serious scholars on the Austrian side, such as Don Boudreaux and Russell Roberts at their Café Hayek blog have also admitted being somewhat flummoxed by the current crisis. However, the more research they do the more they are convinced that government meddling played a significant role in causing the crisis, and is continuing to play a big role in making matters worse rather than better.

Since non-Keynesian thought has little traction in political circles, we are today engaging in deficit spending on a scale never previously imagined. Elected officials have given unelected officials unprecedented power to use borrowed funds to play god in the national economy. Each passing day brings new policy shifts, injecting massive uncertainty into the market, as noted here.

Our modern gods of finance and central banking sit atop their Mount Olympus wondering why the mortals below aren’t scurrying about using the gifts they have so benevolently bestowed on them to engage in risk and trade. The mighty ones seem oblivious to the fact that these gifts are among the sources of uncertainty that are diminishing the incentive for risk taking. So they assay to endow even more borrowed largesse, thinking that they simply haven’t done enough yet. They end up incentivizing exactly the type of bad behavior that precipitated the mess in the first place. The political climate provides no incentives for the gods to pay attention to the Fates.

Like most other Keynesian acolytes, our politicians and elected officials seem to have no clue that “increases in government spending have a strong negative effect on private investment spending.” They seem oblivious to the fact that uncertainty is the enemy of a robust market. (Consider this post and related links.) Thus, they engage in spending that harms private investment while simultaneously creating new uncertainty non-stop, all under the auspices of doing something about the problem.

The chicken with its head cut off analogy would be useful here if only the activity being undertaken produced as little harm as a headless chicken could inflict.

Like Mankiw, I am not saying that Keynesian thought is conclusively wrong. But I am saying that there is enough uncertainty about the correctness of certain Keynesian theories that we should not be actively using those theories as a basis for substantial public policy. There is a term for insisting otherwise: hubris.


Tom said...

One of the great things about being in an MBA program is that I have a chance to eavesdrop on a whole bunch of intelligent conversations.

Just yesterday some students were discussing some of the problems with the recent bailouts. One made a rather interesting point: a successful bailout is one that creates value in the economy by increasing productive output. In contrast, much of the recent bailouts have simply been substitutes for paper losses, a solution that does increase the supply of money (and, perhaps, reduces some risk) but fails to increase work effort or productive output. Thoughts?

I've enjoyed your mini-tutorials on economics. Keep it up.

Reach Upward said...

The whole idea of a bailout is that government must take action to pump taxpayer money into something that taxpayers left to their own devices are unwilling to spend their own money on.

The unwillingness of people to invest in something is a market signal that its behavior has been sufficiently poor to destroy confidence that it is a worthy investment. The only options are to work to develop good behavior (which may require new management, selling off pieces, etc.) or to cease functioning.

Or rather, these would be the only options if it were not possible to lobby government to use taxpayer funds to allow the continuance of bad behavior (or at least functioning without sufficiently good behavior).

Exactly why is it that it is OK for government to force taxpayers to invest in something that they judge to be an unworthy investment on its own?

Government should be strong enough to fulfill its necessary roles, but it should be restrained enough to refrain from (however well intended) subsidizing or developing ownership in private business.

While your classmate's thoughts sound good on the surface, we do not in fact have many real examples where government putting money into private business has created a better situation than otherwise would have been achieved without government intervention. And don't use the line that FDR did so with the WPA, CCC, etc. Economist Eric Rauchway successfully blew away that myth in his book The Great Depression and the New Deal.