Monday, September 5, 2011

The errors of the neo-Keynesians

The importance of observing events cannot be emphasized enough as demonstrated by the erroneous diagnoses and prognoses of the global economy by the self-proclaimed experts. So let's tease out the reasons behind their errors which typically stem from incorrect observations.

For this post, we'll deal with the neo-Keynesians since they have quite an influence on the economic thinking of most governments, especially those bent to the left. The neo-Keynesians seek to fuse the thoughts of John M. Keynes (1883-1946) with those of classical economists. They have introduced mathematical models, something which Keynes never used, to provide a semblance of rigorous veracity. As always the case, the legitimacy of models depend on the assumptions and in this the neo-Keynesians fall far short of reality.

The neo-Keynesians  argue that government intervention is needed for continual economic growth as capitalism, left to its own devices, can dislocate itself by going unnecessarily to extremes. Therefore the guiding hand of the state is needed to ensure full employment and price stability. Whereas Keynes counselled intervention during a crisis, the neo-Keynesians support intervention on a continuing basis. Keynes also stated that an economy's output in the short run was determined by the aggregate demand, that is, the total spending of households, businesses and government. So Keynes's advice for the government to spend heavily during the Great Depression of the 1930s was right but it was only right for that time and under the conditions prevailing then.

It's easy to see where the neo-Keynesians have misunderstood Keynes. They have placed demand as the solution to recessions and economic slowdowns for all times. Now if we weigh this against the 4C framework, it is obvious that the neo-Keynesians have ignored both Capacity and Communication, and placed little importance on Currency. Their obsession has always been with Consumption. Till today, Paul Krugman, the popular public face of the neo-Keynesians, stubbornly insists on major government deficit spending to stave off the depression, not realising that such a move only buys time. It's a counter-measure, not a solution since there is no solution.

Now let's tackle their theoretical underpinning, that is, the IS-LM (Investment Saving - Liquidity Preference Money Supply) model (see left charts from The Economist). This model works only in a closed economy and as low cost producers started to compete with American goods in the 1970s, the model began to give way.

The model has two curves, the IS and the LM. The IS charts the different combinations of output and  interest rates at which demand equals supply (or saving equals investment). It marks the real (goods and services production) part of the economy and therefore used as the basis for fiscal policy. It is negatively sloped because as interest rate goes down, output (synonymous with income or demand) increases. The neo-Keynesians believe government can shift this curve to the left (by reducing spending) or the right (by increasing spending), thus reducing or increasing income. With an open economy, a shift to the right may not result in increased income if the income is siphoned off by the foreigners. The other failing is that with increasing technology use, the income is not shared by all as a few producers become very efficient leaving many others without jobs and income.

The LM curve on the other hand charts the different combinations of output and interest rates at which the demand for non-interest bearing money equals its supply. It is positively sloped because as output increases, the demand for holding money increases thus pushing up interest rate. It forms the basis for monetary policy. The government, it is thought by the neo-Keynesians, can shift this curve to the right (by printing money) or the left (by issuing bonds to mop up the money). The intersection between the IS and LM curves represent the equilibrium point for goods production and money holding. In reality, it's doubtful whether there is such a state.

The events post 1973 rendered the IS-LM  irrelevant. As oil prices began to rise after 1973, the recycled petrodollars from the inflating oil prices pushed money supply up through bank lending. The Fed had to jack up the fed funds rate to almost 13 percent in 1974 to suppress inflation. Although inflation did indeed fall briefly to 4.9 percent in 1976, it was achieved at the cost of high unemployment. Energy had become a constraint on capacity as new oil fields, now explored as a result of the high prices, took some time to enter production. Only by the mid 1980s, did oil prices fall. Consequently much of the late 1970s and early 1980s was characterised by high inflation and high unemployment, a phenomenon known as stagflation.

As the neo-Keynesians were baffled by this turn of events, Milton Friedman of the monetarist school came up with his NAIRU (non-accelerating inflation rate of unemployment) which posits that there's a natural rate of unemployment below which inflation will rise.

We can now prove that both schools are wrong. The neo-Keynesians and the monetarists have been using the unemployment rate as the yardstick for measuring capacity utilisation. High unemployment, in the neo-Keynesians' views, reflect high slack capacity and therefore the economy could do with some monetary expansion to increase output with no impact on inflation. However had they studied the 4C's Capacity, they would have realised that capacity is much more than unemployment; energy, materials and technology play a much bigger role. With so much automation in the factory even as far back as the 1970s, labour was no longer a key factor in determining the economy's capacity utilisation. Actually unemployment now has no relations to capacity utilisation as we now have surplus capacity but high unemployment. As for Milton Friedman, his views were always naive but the fact that he could influence so many policymakers to this day is a reflection of the low acumen of those to whom we surrender our fate.


  1. The standard view of the economics profession is that Keynes was a brilliant, intuitive, non-rigorous innovator who was unable to apply formal mathematical analysis in his work. These essays show that Keynes backed up his “intuitions” with a rigorous mathematical and logical supporting analysis which has been overlooked by the economics profession for 70 years.

  2. Thanks for highlighting this. If we refer to the works of Alfred Marshall, who was Keynes's teacher, he used mathematics not as an engine of enquiry, as practised by the current generation of economists, but to enable him to support his findings in layman's terms. Keynes surely would've used the same approach.