One of the greatest intellectual and political debates of the last century is commonly referred to as the “Classical versus Keynesian controversy.” This great dispute arose as a result of the work of the famous economists Adam Smith and John Maynard Keynes. Generally speaking, the focal point of their disagreement was over their competing theories on how economies exit recessions. Smith argued for Laissez-faire capitalism in his famous book The Wealth of Nations, and Keynes argued for an interventionist economic policy which later became known as “Keynesian Economics.”
Smith contended that as a given economy enters a recession and the means of production fall out of use, property holders will reduce the price of the capital they control, until investors are incentivized to reinvest in their money into capital they can afford. In short, the economy reacts, balances, and ultimately pulls itself out of a recession without assistance from the government.
Keynes actually agreed with Smith that economies can pull themselves out of recessions, he just thought the market moved too slowly to effectively respond to a recession. He proposed an alternative solution, arguing that when the economy enters a recession, the government should cut taxes and increase government spending by running a deficit, both of which have stimulatory effects. Keynes argued this would lead to increased aggregate demand and economic growth, consequently causing the economy to exit the recession. Once the economy exits the recession, Keynes argued the government should decrease its spending to lower the deficit and raise taxes so that the economy would not grow too rapidly. Many brilliant libertarian economists have responded to Keynes’ proposal to note its flaws, and I will briefly discuss four of their arguments in this article.
Nobel Prize winning economist James Buchannan argued that Keynesian economics will not be successful because democratically elected officials are not incentivized to consistently follow Keynesian principles. Here’s why. Imagine the economy enters a recession. The government decides to cut taxes and spend more money on government programs, borrowing or printing the money to finance their spending. Congress’s approval ratings skyrocket, and the economy is booming, after all, who doesn’t like lower taxes and free stuff? Once the economy grows to the point that congress considers far enough, are they really going to raise taxes and stop spending money? Their constituents will be furious! Buchannan argued that members of congress would never follow Keynesian theory all the way through, because of how unpopular raising taxes and decreasing spending is. Buchannan was dead on. Congress has run a deficit for at 45 out of the last 50 years, and has no plan to decrease it.
Another Nobel prize winning economist, Milton Freidman, highlighted a different issue with Keynesian theory. He actually won his Nobel prize for his published response to Keynesianism called “Crowding out Theory.” More specifically “crowding out of investment expenditures by government spending.” Keynes argued that increasing government spending stimulated one of the factors of aggregate demand (the measure of the sum total of goods and services in the economy represented by the equation C + I + G + (X-M)). From right to left those variables stand for Consumption Expenditures, Investment Expenditures, Government Spending and Exports minus Imports. Increasing (or stimulating) any one of these factors results in economic growth, by definition. Keynes wanted to increase government spending, represented by “G” in the equation.
Friedman’s response was genius. He claimed as Keynes increases government spending, the government borrows through bonds or prints money to fund their spending. By flooding the market with bonds or printing fiat money, the government drives interest rates up, resulting in decreased private sector investment expenditures, represented by “I” in the aggregate demand equation. This is problematic for two reasons. First, investment expenditures are the most important element of aggregate demand, and decreasing them has an exaggerated effect on the economy when compared to the other factors of aggregate demand. Secondly, this reality retards the effectiveness of government stimulatory efforts, as increasing government spending has strong downward pressure exerted on it by falling investment expenditures. Therefore, at best, any legislative body wishing to apply Keynesian theory has to deal with strong downward pressure on their attempts to stimulate the economy, and at worst, potentially regressive pressure that negates or even reverses the intended effect of their policy. It’s like being in a rowboat and having the wind push you back two feet for every three feet you paddle, or possibly even the other way around.
The great French libertarian economist Frederic Bastiat told a famous story called “the parable of the broken window” in his 1850 publication That Which is Seen and That Which is Not Seen. In this story, a shoemaker’s son carelessly breaks a pane of glass in his father’s shop. The shoemaker pays a local glazier six francs to repair the pane for him. A group of onlookers observing both the window breaking and the exchange of goods and services that resulted in a repaired pane and a wealthier glazier conclude that breaking windows is a good thing, since it provides services for the glaziers of Paris to generate wealth with, and stimulates the local economy. Bastiat objects, by arguing that destroying goods does not generate wealth. Rather, the shoemaker’s son robbed him of six francs he intended to use for some other purpose (his disposable income), and the shoemaker’s loss is equivalent to the glaziers gain resulting in no net increase in wealth. This argument may not have been intended as a response to Keynesian economics, but proves the point nonetheless. By robbing the taxpayers through increased taxes, or decreasing the value of their currency by printing money with central banks, Keynesians who wish to stimulate the economy by increasing government spending are not generating any wealth. They are like a snake eating itself, or a crowd of Frenchmen smashing every window in Paris to stimulate the local economy. According to Bastiat, it just doesn’t work.
Not only are there theoretical problems with Keynesian economics, but practically speaking, the government cannot respond to a recession in time. Recessions are normally determined by statistical indicators like the value of GDP, a numerical representation of the Gross Domestic Product (the sum of all goods and devices) in the economy. The value of GDP is a lagging indicator, meaning it can establish long term trends with good accuracy, but cannot predict them because it is calculated by economists on a quarterly basis after the economy has already reacted. This means that by the time the government notices the economy is in a recession, its already three months into it. Once congress gets its act together if they wish to respond with Keynesian theory, they have to come up with a plan, and send it through the meandering legislative process. And after two to four months of bickering maybe congress gets a plan passed to address the situation.
Once the plan passes, it more than likely takes three to six months to actually get enforced and affect the economy. That means that assuming accurate indicators, a prepared and efficient congress and excellent enforcement, any plan to address a recession at best takes effect 8 months after the recession hits the economy, and at worst over a year after the recession hits. This is an ironic reality, because Keynes claimed his proposal to exit a recession was more efficient than Lassiez-faire Capitalism. But, as all good capitalists know, the government is an inherently inefficient agent of change when compared to the market. When you look at the real world requirements for Keynesian economics to be successful, the numbers just don’t add up.
Needless to say, the problems with Keynesian economics are many. No body of legislators will actually hold to its principles, it is subjected to strong downward and possibly regressive pressure, it behaves as a snake infinitely consuming itself, and is many times slower than normal market reactions. These basic arguments should give you some weapons to fight against the Keynesians out there. But please remember these are highly compacted and simplified arguments that are merely representations of lifetimes of research and thought from some of the greatest economic minds the world has ever known.
If you enjoyed this article, I am pleased beyond words and hope to see you again on Liberty Hangout. But if you wish to understand these arguments in their full context, please go to authoritative sources and study for yourself. Keep fighting for liberty!
- It would be deeply unfair to not recognize my economics professor Dr. Anton Eff for his considerable contributions to my limited understanding of macroeconomics. While I cannot technically site him as source material (per MLA regulations) it is because of his research and teaching that I was able to compile this article. If you wish to read his published works or contact him personally he can be found at his website.
- On James M. Buchanan and the incentives of congress
- On Milton Friedman and “crowding out of investment expenditures by government spending”
- On Frederic Bastiat and “the parable of the broken window”
- On time lags associated with Keynesian economics
- On deficit spending