Thinking Things Over November 12, 2011
Volume I, Number 17: What if Economists Are Trying to End This Slump Using the Wrong Model? (Part 1 of 3)
By John L. Chapman, Ph.D. Washington, D.C.
In 1633 Galileo faced the Roman Inquisition for committing the heresy of challenging the geocentric view of the universe, in place since Ptolemy and the Biblical writers more than 1500 years earlier. Galileo had supported Copernicus and Kepler in arguing that the earth revolved around the sun, thus disputing the “empirically obvious fact” that the earth was the center of the universe. For challenging the Biblically inerrant canon, Galileo was threatened with execution, forced to recant, and placed under house arrest until his death in 1642.
Galileo represented a threat to the Church’s teaching of what was thought to be inerrant doctrine, and had formed the basis of an existential worldview for centuries. The Copernican view of a heliocentric universe – which destroyed this received doctrine at its core — didn’t seem to fit what was so plainly obvious via casual observation. But Galileo had forged ahead regardless, in this case at the threat of forfeiting his life, because he had deduced a new “model” of reality.
This story comes to mind as we consider the plight of current economic policy: what if the “model” through which policymakers are viewing the world is the wrong one? Indeed, this is the case, and like the old axiom from the computer world, “garbage in, garbage out”, the results are not only poor, but indeed are slowly making matters worse. Understanding why this is so can lead to a change of course.
The economics profession is dominated by the macroeconomic theories of John Maynard Keynes (1883-1946), who in turn studied under Alfred Marshall (1842-1924) at Cambridge. Marshall was the father of modern economic analysis of industrial markets through what came to be known as price theory, or the determination of output, prices, and the distribution of income using the tool of supply-and-demand. Keynes later took Marshall’s supply-and-demand framework and applied it to the entire economy (via aggregates such as total consumption spending, total investment spending by business, and government expenditures); the synthesis of the two has formed the core of economic theory ever since.
To understand the complexity of reality, Marshall and his followers developed theoretical constructs, or “models” of competition, necessarily abstracting from the complex world via simplifying assumptions. For example, in the model of “perfect competition”, as it came to be known, it is assumed that (1) there are an infinite number of buyers and sellers, so that no one has market-moving power; (2) all goods and all capital are homogenous – that is to say, all the firms produce the exact same product, and all capital goods are completely interchangeable; (3) transaction costs are zero – all market activity (including exchange) is costless, and hence money is not in the model as there is no need for it; (4) actors have “perfect information” – there is no erroneous understanding or uncertainty about the future; (5) there is no taxation, which complicates any real-world analysis (and is therefore a nuisance to try to model); (6) economic profit = 0, as price is equal to marginal cost in all markets; and (7) there are no entrepreneurs (since there is perfect knowledge, there is no profit that accrues to successful entrepreneurial activity, and it is costless to transact on the market in any case, rendering entrepreneurship moot). All of this implies, for this perfectly competitive model, that the market is always in “perfect equilibrium”; that is to say, there are no unsold inventories, no idle resources, and no entrepreneurial error that causes either of these, since there are no entrepreneurs.
This is the core of the Marshallian industry model that Keynes learned, and indeed, all professionally-trained economists to this day absorb. Keynes of course was confronted with a depression in the 1930s in which most every industry suffered from idle resources and unsold inventory; he assumed this was so because of the capriciousness of investors, and he asserted there was never any reason why the economy would be in equilibrium at full employment. Hence it was the function of government to fill in any gaps in aggregate demand to ensure full employment.
While most Keynesian economists would certainly insist (or, protest) that they understand and account for the unrealistic nature of the model’s assumptions above, the problem is that after so many years of having this “neoclassical” model embedded in their subconscious, they become wedded to it at some level, to the point that its unrealistic aspects seep into their thinking – and their policy recommendations.
Examples abound to show this, but a glaring specific instance is the Antitrust Division of the U.S. Justice Department. When Microsoft (MSFT) was deemed to have “too big” a market share in 1998, the Clinton Justice Department sued the software firm and attempted to pursue a “remedy” that would have broken up the firm into three parts. Microsoft at the time had (literally all of) a 5% share of the global software market at the time, but in the narrow desktop sector, it dominated, and the federal government wanted to break up the firm because of this.
Among other expert witnesses for the government was M.I.T. economist Franklin Fisher, a Harvard-trained Keynesian proponent of federal activism and longtime advisor to Democratic politicians. Mr. Fisher’s testimony was straight from Marshall’s theory: the software industry did not conform to the textbook definition of a competitive market per the assumptions above, its market power was “too great” and profits “too high” as a quasi-monopolist, and it had to be broken up in the name of expanding consumer welfare. Never mind that “monopolists” who have real market power raise prices and restrict output, and need not bother wasting money on R&D or innovation, since they “own” the market (think, for example, of public education, which has changed little in its basic delivery platform in the last 150 years). As an advertisement by the Independent Institute in the New York Times on June 2, 1999 put it:
Consumers did not ask for these antitrust actions — rival business firms did. Consumers of high technology have enjoyed falling prices, expanding outputs, and a breathtaking array of new products and innovations. … Increasingly, however, some firms have sought to handicap their rivals by turning to government for protection. Many of these cases are based on speculation about some vaguely specified consumer harm in some unspecified future, and many of the proposed interventions will weaken successful U.S. firms and impede their competitiveness abroad.
Indeed, Microsoft throughout its history had then, and continues to now, repeatedly lower prices and spend billions every years in delivering new innovations, products, and services to enhance its offerings. Rather than behave like a power-wielding monopolist, the firm appears to behave in hyper-paranoid fashion. And in any event, the firm was not broken up, but settled with the Justice Department via Consent Decree after four years and hundreds of millions in litigation costs. Seen from the vantage point of a decade later, the lawsuit was a giant exercise in taxpayer dollar waste in support of an errant textbook model of what a competitive industry should look like. But it had unambiguously harmful effects on Microsoft and its shareholders.
Keynesian modeling errors in economy-wide policy are harder to spot because they are broader and more pervasive. As such, however, they are more harmful. But Keynes made the same mistakes that his disciple Franklin Fisher made, in becoming wedded to a false theoretical construct: indeed, there are three critical errors (and several more minor ones) in the Keynesian framework, as adapted from Marshall’ assumptions above, that lead to errors in policy:
(1) Obliteration of entrepreneurial function – There is, literally, no room for entrepreneurship in the Keynesian model, and hence no role in policy. Keynes thought entirely in “aggregates”, such as “total consumption” or “total output”, and lost sight of the crucial role played by entrepreneurs in discovering and promoting advancements in markets, technology, and business methods, all of which raise productivity and improve standards of living. Keynes in fact argued in favor of the “socialization” of investment in his 1936 book, asserting that government planners were smarter and better able to make decisions than the timid legion of anonymous entrepreneurs.
This alone belies the Keynesian pretense of understanding of how a market economy functions. For entrepreneurs — and entrepreneurial initiatives undertaken by existing businesses who put risk capital to work in the face of an uncertain future — are the veritable driving force of a market economy. But the inevitable end of this mindset is the situation we have today in the United States: a stunning drop-off in entrepreneurial pursuits led by a sharp decline in private equity and venture capital investing, alongside a fall-off in corporate investment and $2 trillion in corporate cash on the sidelines. And, in this same business and investment community, there’s now genuine fear of an ever-expansive federal government which is now deep into “socializing” investment, from Solyndra to GM.
(2) No appreciation of the role of money in an economy – Keynes wrote a great deal about monetary matters across his career, but by the time of his 1936 book he was back to the Marshallian model’s ignoring it as a critical institutional feature. A well-functioning monetary system permits – literally – the development and advance of civilization, first in rising above barter subsistence, and over time in permanently expanding specialization and the division of labor through monetary exchange. A stable money also permits for calculation of profit and loss, as well as accurate pricing, both of which serve to signal producers and consumers to economize on scarce resources and invest where demand is most urgent. But for Keynes this is all trivially assumed away in favor of government manipulation of money and credit in order to support the socialization of investment and fiscal spending Keynes preferred, all controlled by the central government.
(3) No role for capital – The Keynesian theory is, as Auburn University’s Roger Garrison calls it, a “labor-based” story; capital, a homogenous and ever-present resource in Marshall’s model, is similarly ignored by Keynes. Indeed, Keynes (and, sadly, his disciples to this day) so misunderstood the nature of capital that he asserted that spending for consumption (and led by the government) would induce the saving after the fact that led to needed capital accumulation. Indeed, Keynes bragged that he had repudiated J.B. Say and his famous dictum on this point (Say’s Law holds that production is the source of demand): for Keynes, it is a truism that “demand creates supply”, the corollary of which is that capital is not scarce.
This is a catastrophic error in mindset, which has promulgated harmful policies leading to capital decumulation for decades now. For in fact, consumer spending is an effect of economic growth and productive output, and not a cause of it. We produce in order to consume, and can only consume once something has been produced, and income generated. Capital, which in the real world consists of a heterogeneous mix of machines, tools, and other productive assets, may not be analytically tractable for the modeling exercises of Keynesian economists, but is crucial in its role of wealth creation. To ignore it, and indeed, to pursue spending policies which are antithetical to its formation, is to guarantee a future with a lower standard of living.
Space does not permit a full accounting of the errors in Keynes’ thinking. But one need not be a psychologist to understand, after a thorough reading of his works, how deeply embedded the artificial constructs of his teacher Marshall were in his own mind – a mindset from which he could not fully escape when trying to formulate real world policy.
Like the Ptolemaic system discredited by the Copernican, the Keynesian policy mix of central bank-generated inflation in the supply of money and credit, socialization of investment directed by the central government, and industry regulation to support government-desired behavior all lead to far poorer outcomes than would be the case with a more correct view of how the economy works. Next week in this space we will describe in further detail problems with the Keynesian paradigm, and then the following week offer an alternative economic model that views the world correctly, that of the Austrian school.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at email@example.com.
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