They got it wrong

Why Did Policy Makers Get it So Wrong?  

In an editorial page article in the Weekend edition of the Australian Financial Review the other week (October 10-11) there was this: 

At a recent Senate inquiry into the merits of the Rudd government’s fiscal stimulus, some academic economists questioned the efficacy of it all. After hearing one university economist critique the big-spend strategy, senator Doug Cameron declared that the witness’s comments merely confirmed in his head that one should never let an ‘academic economist run the economy’. 

Cameron thundered at the witness: ‘Why have the International Monetary Fund, the Organisation for Economic Cooperation and Development, the International Labour Organisation, the treasury of every advanced economy, the Treasury in Australia, the business economists around the world got it so wrong and yet you in your ivory tower have got it so right?’ The witness replied that Keynesian economics ‘had been one of the greatest catastrophes for economic theory in the West’.

The university economist in question is none other than myself and the question from Senator Cameron is indeed a good one. And when it is put in quite that way, it is even perplexing to myself. How have they all got it so wrong? 

And the thing that is most bewildering for others is that my critique of these Keynesian policies has a definite plausibility about it while the approaches taken by the IMF, the OECD, the ILO, the treasuries of every advanced economy around the world including our own, and all of those business economists from everywhere have a look of desperation and uncertainty about them. From what has unfolded so far, there is no obvious reason to believe I have it wrong, and there are many reasons for thinking I may even be right. 

Senator Cameron raised the same issue with the Secretary of the Treasury, Ken Henry, when he provided his own testimony to the Senate. This was the relevant exchange: 

Senator CAMERON – We have had lots of academic economists come before us and argue, I suppose, their academic bias in terms of some of these issues. We have had lectures on Say’s Law, we have had lectures on the evils of Keynesianism and why we should be looking at Hayekian economic approaches. I am just wondering if all that lecture we got was really relevant in terms of the practical circumstances that governments and treasuries around the world face. Have you got any view on that? I am sure you have looked at some of the commentary and analysis that has been put to the committee. We have got to weigh all of this up, I suppose. 

Dr Henry – I used to be an academic economist myself. It is easier to be an academic economist. 

Senator CAMERON – Are you going to leave it there? 

Dr Henry – No, look, the issues that have been raised in testimony before the committee, on my brief reading of them – and I have not read them perhaps as closely as I might have in answering this question – it is not that the issues that have been raised should be entirely discounted in all circumstances; certainly not. But, whilst being very aware of those issues for many years, I can tell you that, confronted with the crisis that the world has been dealing with these past 12 months or so, those few quibbles with the use of expansionary fiscal policy – or expansionary monetary policy for that matter – or other actions of government to prop up credit markets are not ones that I considered should detain us for too long. They were rather quickly put aside. 

Now here, too, it is myself that has been obliquely referred to. I am the academic economist who provided the “lectures on Say’s Law”. And let me also just accept here in passing that it is easier to be an academic economist than the Secretary of Treasury. The responsibility must be unbearable for anyone of conscience, as Ken Henry most assuredly is. He possibly more than anyone else in Australia wants to get this right. 

My worry is that he along with the IMF, the OECD, the ILO, the treasuries of every advanced economy, and all of those business economists do have it wrong. That we will find ourselves in a year or two wondering how we ever got into the mess we will then be in, and worrying for quite a number of years after that about how we are going to get ourselves out, is exactly what I think. 

Say’s Law sounds like an archaic principle since it is named after J.-B. Say who wrote the first edition of his treatise on economics in 1803. He did not, in fact, invent this theory but what is most important in dealing with Say’s Law is that it is this principle that Keynes made it his purpose to see removed from economic discourse. It had been the basis for the theory of the cycle right up until 1936, accepted till then by every economist across the world. 

By invoking Say’s Law, I have some of the greatest economists who have ever lived most decidedly on my side. But from virtually the day that Keynes’s General Theory was published in February of that fateful year, Say’s Law has completely vanished from economic discourse. No one teaches it, no one studies it. Yet if one understands this principle, it would be impossible to see anything other than folly in the economic policies that have now been put together everywhere to deal with the present downturn. 

Let me therefore give you an analogy that might make clear what I see wrong with the stimulus packages we find supported by this vast array of economic judgement. 

Suppose there were a mining town in some remote region of Australia that had been mining some particular mineral for a hundred years but for some reason the demand for this particular mineral had completely fallen away. Here in this mining town are thousands of people, most of them going about their lives doing nothing related to the mining industry itself. There are shops and transport, schools and banks. If it were then decided that what needed to be done was to maintain town life through a stimulus spending program through outlays on a series of government-chosen projects – school assembly halls, say, or insulating people’s homes – most of us, I think, would see that as a phenomenal waste of public funds. Worse would be if that expenditure was concentrated on a series of outlays not one of which would themselves generate a positive economic return but were chosen as just an expedient to pump money into the town. We would find anything like that bizarrely unacceptable. 

And the reason we would reject such expenditure would in part be because it would delay the necessary adjustment process as the townspeople come to recognise that their futures lie elsewhere in undertaking different kinds of work, and in part because we would recognise that the debts accumulated in paying for the stimulus will not in any way be financed by the returns generated by the projects themselves. They will just add to our level of debt. 

This is what we have done in Australia, in America, in Europe, in Asia. These are the expenditures that have been endorsed by just about every major economic institution in the world and by economists from almost every branch of the profession. In my view, they simply do not know any better. This is all they know because since 1936 that is all they have been taught. 

I, however, come from a different school of thought that was founded on an understanding of Say’s Law, classical economic theory and the theory of the business cycle. From this perspective, what has been done is totally indefensible, will do incalculable damage, weaken our economies and prolong unemployment. Which is why I presented the testimony to the Senate that I did. 

This is what academic economists do. They think about things and put their views forward as part of the general debate on what ought to be done. I do think I am right about this and I do think that those who see recovery based on deficit finance are dangerously wrong. But everyone thinks their own beliefs are true so there is no virtue in any of that. 

Over the next few years, however, we will find out just who was right and who was not. If everything turns out all right, well I can find something else to write about for the rest of my career. But should it happen that this Keynesian stimulus has been the international disaster I think it is, then reading what I have written might make clear what needs to be done instead, and what should happen the next time our economies enter recession as they inevitably must, just as I think the current recession will end one day, as it inevitably must. 

I will finish with an excerpt from a review of my book, Say’s Law and the Keynesian Revolution, which I spoke to the Senate about in defence of my own views. This book discusses the history of Say’s Law and also as it happens explains the origins of the General Theory more accurately than can be found in any other account found anywhere else. Don’t believe me? Well read the book yourself. And you will see why the reviewer in The Economic Journal, one of the oldest economic journals in the world and amongst the most prestigious, wrote this: 

The original classical formulators of Say’s Law never said what Keynes claimed they said. On the contrary, far from dismissing slumps as impossibilities, they stressed their occurrence. They differed from Keynes only in denying that demand failure could be the cause…. A convincing and authoritative account. 

Economies are very subtle creatures and fully understood by no one. And as much as anything, it is Keynesian economic theory that is on trial for its life. To repeat what I said at the Senate, Keynesian economics has been one of the greatest catastrophes for economic theory in the West. In the next year or so, we may all find out just how true that is.