Stumbling Blocks to Spending Our Way to Prosperity

by Guest Author Edmund Phelps

Editor’s note: These are Prof. Phelp’s opening remarks for the Keynes vs. Hayek debate produced by Reuters, 8 November 2011 at Columbia University.  James K. Galbraith led the Keynes team.  His opening remarks have been posted previouslyPictured left is John Maynard Keynes; pictured right is Friedrich August Hayek.

Keynes was a close observer of the British and American economies in an era in which their depressions were wholly or largely monetary in origin – Britain’s slump in the late 1920s after the price of the British currency was raised in terms of gold, and America’s Great Depression of the 1930s, when the world was not
getting growth in the stock of gold to keep pace with productivity growth. In both cases, there was a huge fall of price level. Major deflation is a telltale symptom of a monetary problem.

Ever since, the followers of Keynes – the Keynesians, as they are called – see every slump as monetary. They suppose that behind the slump is a shortfall of liquidity and a resulting deficiency of ‘effective demand’ – an insufficient flow of money circulating through the affected economy to support the normal level of employment. So they always call for anti-deflation measures – for a “stimulus” to “demand.”

It’s true that such a deficiency of liquidity occurred twice in recent US experience – hence an actual or incipient deficiency of aggregate demand. With the fall of Lehman in 2008, there was a rush to get into liquid assets. So the Keynesians (and everyone else) were right to urge the US central bank – the Fed – to create a
massive increase of the money supply. Then, by spring 2010, another deficiency had developed – one of the Fed’s own making.  There was clear evidence of that in the fall of the inflation rate from the customary rate of 2% per annum to 0.9% in half a year’s time. The Fed had to engage in QE2 to get the inflation rate back
up to 2% per annum.

These measures served to remedy a deficiency of liquidity and thus to forestall or remove a deficiency of effective demand.  The evidence: Inflation is running at about 2% again. The expected rate of inflation at 1.5% or so. Consequently, we do not have a “deficiency of demand” now!1 So what do we have? We have a structural slump! We are slowly coming out of a structural slump – thanks to structural forces, such as wealth decumulation and a build-up of untried ideas for innovation.

If the present slump is wholly or largely structural, Keynes’s theory of  employment, since it’s monetary, does not apply to the slump.

In contrast, the theoretical perspective of Hayek, which is non-monetary at its core and more structural, does apply! (So does my 1994 book Structural Slumps and my 1999-2001 studies with Hian Teck Hoon and Gylfi Zoega of “structural booms.”

That did not stop Keynes from arguing that suitable government measures can cure a slump. With a joke that got a lot of attention, Keynes said the government could borrow the money through sales of public debt to “dig holes in the ground,” then borrow more money to fill them up the next day.  Government purchases of capital goods, Keynes was suggesting, could return the economy to full employment – if not to good health: to a revival of private investment.  The objection was that such a program would generate an exploding public debt unless the economy is so fortunate as to return at some point to good health –
so that the government expenditure and continuing deficit are no longer needed.2

Keynes’s American disciples, mostly lacking Keynes’s fondness for an enlarged public sector, favored another kind of fiscal stimulus with its deficit-financing. They argued that the cut in income tax rates, in causing a jump of consumer demand, would lead to an increase in consumer good output and in total
employment. What about the public debt? An insightful Keynesian, Gardiner Ackley, answered that private wealth will be rising, as households save some of the increase in take-home pay brought by the tax cut; and this rising wealth will support rising consumer good demand (on top of the initial increase). In this analysis, the economy can go on recovering while tax rates are gradually
restored and the deficit tapers off as employment nears its normal level. Thus the public debt does not explode.

Hayek was skeptical. Basically he asks: If someone or even the government borrows some apples with which to buy more oranges, why should that cause an increase of total employment?  And how could it do that forever?

In the late 1960s I explored some answers to the first question.  Output and employment respond at first, I argued, because employers and workers do not realize how general and how large the increase of demand at other firms and locations is.  But once they have understood that there has been a general
increase in spending, prices and wages, employment (and the real wage) will recede from its newly increased level. There is no clear argument for believing that there will be a lasting effect.3 Like the stimulus from drugs, it wears off. (This objection was voiced explicitly by Jacob Viner, though it was implicit in Hayek’s writings.)

The Keynesians, however, continue to talk as though government borrowing is an appropriate medicine to administer even if it is not long-lasting.  Keynes replied to such concerns that “in the long run we are all dead.”  But this was too glib.  If the stimulus wears off, the deficit will be stopped, since it no longer works.  Then the increase of the tax rate back to its previous level will cause a Keynesian shock to “effective demand.”  In the Keynesian analysis, a new recession would result. This is the sort of “stop-go” cycle that came to cause exasperation in Britain
during the decades of Keynesianism in Britain.

Keynesians would reply that the tax rate would already have been restored to some degree, thanks to the growth of private wealth wrought by the deficit.  But that assumes what is to be proved – that the artificial creation of private wealth pushes up employment. The past generation of Keynesians never tested their
doubtful premise that bloated levels of private wealth were fine, even a help to employment, not a hindrance.  There is evidence against that: increases in total world public debt drive up the world real rate of interest.4

So the strategy of running deficits, even if it pulled up employment for a time, would come at a heavy toll in the future.

In the Hayekian mind, however, the economy is much more unKeynesian than that.  There is a bond market and a stock market.  And these markets will be alive even in the long run:  So present asset prices in these and other markets depend on expectations of the future prices.  And the “bond vigilantes,” at any rate, know
something about how to think about the future.

The bond market will see that, in the long run, the pile-up of government debt – and any pile-up of entitlements – will make things much worse than they would have been.  As people try to sell off some of their government bonds and shares to each other to finance higher consumption, they will cause bond prices and share prices to be depressed. In the present, the markets will anticipate these depressed bond prices and share prices in the future.  That will in turn cause share prices to be depressed in the present; and long-term bond prices to be depressed too, hence long-term interest rates to be higher.  So investment activity will be down, even if consumption-good production is up. It is very possible, then, that the near term will be worse too – not only the long run.5

Whether the near term will be worse or not depends on how large the public debt and entitlements already.  At present, the public debt and the accompanying entitlements are already enormous: about 66 trillion dollars in all – more than 4 times the annual GDP. It is irresponsible to assume that the government can pile on another 15 trillion or so over the decade without causing a collapse of asset prices.

The new-born Keynesians – most of them travelers from history and trade economics – suppose there is no reason to worry.  They seem to believe that their forerunners had tested the waters.  Or believe they possessed a truth that did not need testing.  But now there are sovereign debt crises before our eyes.  Greece went past the point of no return.  Maybe Italy will be next.  These countries’
governments artificially created private wealth by running budgetary deficits.  And they created what may be called public wealth by granting the citizenry entitlements not backed by assets.  America and France are on the watch list.

I have to say that the Keynesians have not been good disciples of Keynes.  I am sure he would not have said about today’s situation, with its towering debt and entitlements, that we can spend our way to the level of prosperity you want by the
device of tax cuts to stimulate consumer demand on top of the huge stimulus from the 66 trillion. He would have been worried about the effect of all this on entrepreneurial spirits.  He warned Franklin Roosevelt in 1934 not to endanger “confidence.”  Two months before he died, in 1945, he complained in the Economic Journal that economics had “gone silly and sour.”

What now do we do?  With some luck, the economy will “recover” through a return of investment activity to sustainable levels once some capital stocks, like houses, have been worked down.  But it will not recover to a strong level of business activity unless something happens to boost innovation.  The great question is how best to get innovators humming again through the breadth of the land. Hayek himself said little on innovation.  But at least he had an applicable theory of how a healthy economy works.

The Keynesians, sad to say, show no understanding of how the economy works. They think they can lever employment up or down by pushing buttons – as if the economy were hydraulic.  They show no grasp of the concepts that would be necessary to restore us to prosperity and flourishing.  In an old image that applies well to the posturing of today’s self-styled Keynesians, “the Emperor has
no clothes.”


1 Some Keynesians make the counterargument that downward rigidity of wage
rates prevented a big deflation from occurring in 2008-2009. And the eventual
resumption of wage and price growth at normal rates still leaves the price level
depressed in relation to the level of money rates, which (unlike the price level)
refused to move down. But in fact the price level is not depressed in relation to
the wage level. Keynesians themselves make much of the fact that wages are
depressed relative to the price level, not the other way around.

2 An MIT economist, Evsey Domar, seemed to rescue Keynes with his
argument that an economy enjoying a steady growth rate could manage a steady
deficit-to-output ratio forever. A 10% deficit with a 4% growth rate would
produce a debt-to-output ratio of 2.5. But the U.S. and U.K. have not seen
anything like 4% growth for decades. (The European Continent has hardly seen
any growth at all.)

3 In one argument, the resulting increase in buying at firms in a city will cause
local wages to be bid up. That in turn will cause some people who would
otherwise have left the city to seek better wages elsewhere to stay and accept
work there. So employment is pulled up. But once people learn that wages have
risen at other cities too, an upward push of wages and hence prices is set in
motion. It could continue to the point where the higher price level is enough to
counterbalance the increase in take-home pay.

4 I and my collaborators Hian Teck Hoon and Gylfi Zoega used standard
statistical procedures and OECD data to test some of the Keynesian beliefs in
my 1994 book Structural Slumps. The assumption that wealth is proemployment
came out particularly badly. To this day, Keynesians have not tested their policy propositions against the structuralist critique.

5 This thesis has been explored in theoretical terms by Hian Teck Hoon and me
in a 2006 paper in the Journal of Economic Theory and a 2007 paper in The
Journal of Macroeconomics. An informal discussion can be found in two op-eds
of mine appearing in the Wall Street Journal in 2004.

Related Article

Keynes:  “Banks and Bankers are by Nature Blind.” by James K. Galbraith

About the Author

Edmund Phelps is McVickar Professor of Political Economy at Columbia University and Director of Columbia’s Center on Capitalism and Society.  He was the winner of the 2006 Nobel Prize in Economics.  His career began in the corporate world followed by positions at Yale (and the Cowles Foundation) and then at the University of Pennsylvania.  He has been at Columbia since 1971.