Friday, July 15, 2011

Keynes vs. Samuelson's Keynesianism

Yesterday Russ Roberts posted a prediction from Paul Samuelson to show the disconnect between Keynes and reality. Today, Roberts adds comments explaining how Samuelson's forecast failed to predict the post-World War II increase in private employment and spending that created an economic burst. Roberts also highlights and addresses a reader’s opposing response. The response makes the case that while Samuelson's forecast was wrong, Keynes' theory was not (I agree). Roberts defends his case, returning to a "flaw in Keynesianism." By changing the argument back to Keynesianism, Roberts slyly ignores the commenter’s main point.

Keynesianism is the attempt, largely by Samuelson, to merge portions of Keynes' theory with classical economic models. Keynes believed that when private demand (spending) was too weak to support economic growth, governments should increase deficit spending to maintain aggregate demand at an expansionary level. When private demand (spending) returned and unemployment was reduced, Keynes actually suggested the need to reduce deficit spending  or risk generating inflation that would ultimately destabilize the economy.

Roberts appears to assume that the post-war reduction in government spending caused increased private demand. Only a couple hours after this post, a co-contributor on Cafe Hayek, Don Boudreaux, posted a quote from Hayek's 1974 Nobel Prize lecture (Quotation of the Day…). Hayek points out the limitations of economics, specifically drawing attention to the risks associated with only accepting explanations for which there is quantitative evidence.

Prior to World War II, the US and most of the developed world were mired in depression. War efforts provided temporary employment and income to a significant number of Americans. The allied victory probably created confidence in the future that had been lacking in the prior decade. Even Roberts notes the removal of rationing and price controls, which would not have involved government spending yet raised prices of goods and subsequently lowered demand. An inability to quantify these effects should not render their potential impact meaningless.

Roberts may be correct that the reduction in government spending helped increase private spending and employment. Based on Keynes, the reduction more likely held down inflation and prolonged the post-war economic boom. Where I believe Roberts, and current theory, errs is in believing that reductions in government spending will cause growth in private spending and employment. Peripheral EU countries have largely accepted austerity only to witness further deterioration in private employment and economic growth. To answer one of Robert’s questions, the reason a change in private sector spending would not occur is due to its already over-leveraged state. Currently the private sector needs to repair its balance sheet by saving more, which means public deficits must be greater. Countless options exist for reducing government control without cutting spending. Many other options are available to make government spending more efficient.  Contractionary fiscal policy will probably be, well, contractionary. Hopefully the US does not fall for this fallacy.

From Russ Roberts at Cafe Hayek

Keynes vs. Reality-2

In this earlier post, I noted this 1943 Paul Samuelson prediction:

When this war comes to an end, more than one out of every two workers will depend directly or indirectly upon military orders. We shall have some 10 million service men to throw on the labor market. We shall have to face a difficult reconversion period during which current goods cannot be produced and layoffs may be great. Nor will the technical necessity for reconversion necessarily generate much investment outlay in the critical period under discussion whatever its later potentialities. The final conclusion to be drawn from our experience at the end of the last war is inescapable–were the war to end suddenly within the next 6 months, were we again planning to wind up our war effort in the greatest haste, to demobilize our armed forces, to liquidate price controls, to shift from astronomical deficits to even the large deficits of the thirties–then there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.

From Paul Samuelson, “Full Employment after the War,” in S.E. Harris, ed., Postwar Economic Problems, 1943.

Samuelson was wrong. When the war ended, there was massive demobilization of the armed forces and a large reduction in government spending. Yet the economy thrived, unemployment remained very low and there was a huge expansion of private sector employment.

One defense of Samuelson is that this quote is mainly about the dynamics of the labor market–it doesn’t say much about aggregate demand. It doesn’t focus particularly on the drop in government spending. But if you go back to the original article (which you can find by taking a line or two and using Google books–I hope to post more on this later) you will find other passages that make it clear that he saw this as a problem caused by a sudden drop in aggregate demand.

There were a number of interesting comments on the post. Some noted the drop in GDP after the war but forgot that wartime price controls and large amounts of government output made measuring of GDP during the war quite difficult. There was a mild recession in 1945–during the war. The most dramatic change was the one I highlighted–a large expansion of private sector employment with very little unemployment. It was an incredible transition achieved with surprising speed.

I’d like to highlight one comment by Daniel Kuehn:

Samuelson was wrong in forecasting. Keynes wasn’t wrong in theorizing.

Why did Samuelson end up being wrong? Have you ever thought that through?

Because post-war demand was substantial and he didn’t expect that.

High levels of private sector demand and a full employment economy… where the hell do you get “Keynes vs. Reality” from that? That has Keynes written all over it.

All you’re demonstrating is that Samuelson didn’t have a crystal ball. That isn’t exactly a news flash.

This defense of Keynes unintentionally highlights a flaw in Keynesianism at least as practiced by Daniel but I don’t think he’s alone or I wouldn’t single him out. (And I would add that I usually appreciate Daniel’s comments, particularly their tone in the face of criticism from the rest of you.) One, would an economist presume that a change in government spending would have no effects on other types of spending? If government spending shrinks and there is suddenly more resources available to the private sector, why would you not foresee a change in private sector spending? Secondly, the fact that full employment corresponds to high levels of spending (regardless of their source) is very close to a tautology. The challenge is to understand causal linkages and the direction of causation.

In the last few sentences of the previous paragraphs, I had originally referred to private demand. I changed it to private spending. I don’t know what private aggregate demand means, or the phrase “pent-up” demand. The usual way that Keynesians explain the post-war expansion despite the huge cut in government spending is to say, well of course the economy boomed, there was a lot of pent-up demand. What does that mean? There is always pent-up demand in the sense there is a stuff I wish I could have but can’t. But the standard story is that people couldn’t buy washing machines or cars during the war–they were rationed or simply unavailable or unaffordable. So when the war ended, and rationing and price controls ended, people were eager to buy these things. But the reason these consumer goods were rationed or unavailable is because all the steel went into the tanks and planes during the war. So when the war ended, there was steel available to the private sector. That’s why cutting government activity can stimulate the private sector. Fewer resources are being commandeered by the public sector. As the Hayek character says in the Fight of the Century when answering the Keynesian claim that WWII ended the Great Depression:

Wow. One data point and you’re jumping for joy
the Last time I checked, wars only destroy
There was no multiplier, consumption just shrank
As we used scarce resources for every new tank

Pretty perverse to call that prosperity
Rationed meat, Rationed butter… a life of austerity
When that war spending ended your friends cried disaster
yet the economy thrived and grew faster

This earlier post where I discuss Krugman’s claims about rationing and the austerity of the early 1940′s may also be of interest.

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