I first suspected something was seriously wrong with a lot of peoples understanding when the retired broker I use to work for said, “I believe in Austrian economics”. When I asked, “What’s that?” He said, “Much less government intervention in the economy”.
Folks, Austrian economics is hardly anything more than classical economics. For the purpose of this lesson, Austrian economics and Classical economics are the same thing.
Classical economics is what the U.S. had before the Great Depression.
Keynesian versus Classical economics is really a dispute over how an economy adjusts during a recession and finds its way back to full employment.
Conservatives/Republicans tend to favor Classical economics. Democrats/Liberals tend to favor Keynesian economics.
Republicans tend to favor Classical economics because a central belief is that the market will adjust and recover from a recession on its own without any government intervention.
Democrats tend to favor Keynesian economics because a central belief is that changes in government fiscal and monetary policies are necessary to recover from a recession.
A more accurate truth that escapes many Republicans and Democrats alike is that economics is a constantly evolving science that has elements of both Keynesian and Classical economics in it. There is only one school of economics and that is what we are currently using. It’s not Keynesian, Classical, Austrian, New Classical, Laissez-Faire, or any other one economic school. It’s all of them. For example, Keynesian economics as practiced today uses diminishing marginal utility which comes from Austrian economics, so what does that make it? Also, Keynesian economics today is really nothing like what John Keynes first wrote about. In fact, if you were to sit down tonight and read John Maynard Keynes’s famous little book, The General Theory of Employment, Interest and Money, you would find little in that book resembling today’s basic textbook Keynesian model. Keynes’s arcane prose was transformed into an easily-understood algebraic and graphical model by professors Alvin Hansen and Paul Samuelson. Again economics is constantly evolving with the U.S. currently at the top of the world because, in part, of its superior economic model. In reality there is only one living, breathing, and constantly adapting and evolving model of economics that takes a little of what has worked from all economic schools before it.
Economist John Maynard Keynes
John Maynard Keynes was born in 1883, the son of a British economist famous in his own right, John Neville Keynes.
John Maynard Keynes was by all accounts a genius who made millions as a stock market trader.
He was also a distinguished patron of the arts. A faculty member at Cambridge University, and a key appointee to the British Treasury.
Keynes’ General Theory
In 1936, with the global economy flat on its back, Keynes published The General Theory of Employment, Interest, and Money.
In that book Keynes flatly rejected the classical economics model of a self-correcting economy that would solve unemployment through adjustments in wages and prices.
Keynes argued that patiently waiting for the eventual recovery was fruitless because, “in the long run, we’re all dead”.
Keynes believed that under certain circumstances a recessionary economy would only not naturally rebound, but even worse, fall into a deep spiral.
To Keynes, the only way to get the economy moving again was to prime the economic pump with massive government expenditures.
Keynes’ An Economic Heretic
From an historical perspective, it is important to emphasize that, at the time Keynes’ approach was economic heresy.
Indeed, the Keynesian prescription was initially rejected by the entire economics profession.
Far worse, Keynes and his followers were branded as socialists or even communists for advocating such an activist role for the central government.
To his credit, Keynes stuck to his guns and, as the Depression wore on, his teachings gained in popularity.
While the Classical economists made a powerful theoretical argument, as to why a recessionary economy should always adjust back to full employment, the reality of the Great Depression in the 1930’s resulted in a search by the world’s political leaders for an alternative economic solution.
That solution turned out the be Keynesian economics.
Why Classical Economics Failed
Here is the mathematics behind Classical economics.
Step 1: The economy is at full employment, Q1 where AS1 intersects AD1 at a price of P1.
Step 2: The economy suffers a demand shock, shifting the aggregate demand back to AD2. For example, 911 in the U.S., the collapse of the banking system during the Global Financial Crisis, or repeated interest rate hikes by the Federal Reserve, that causes consumers to reduce there spending and businesses to reduce there investment. The new equilibrium is a recessionary output of Q2 at a price of P1, and the result is a recessionary gap equal to Q1 minus Q2.
Step 3: Wages, prices and interest rates fall, as a result of the recession. This causes aggregate demand to move downward, along the aggregate demand curve, through the wealth, interest rate and net export effects.
At the same time, the supply curve shifts out to AS2, as firms hire more workers, and expand output. Together, these price and wage adjustments drive the economy back to full employment at Q1, and close the recessionary gap, but at a new and lower price, of P2.
The Classical Price Adjustment Failed During the Great Depression
Of course we now know that for whatever reasons, this classical price adjustment mechanism did not work to lift the economy
out of the Great Depression.
Republicans who bring their political ideology into their economic analysis (never go full retard) claim that the economy was starting to improve on its own during the Great Depression because they have to claim that in order to make their view of the economy fit their politics. The truth is that the economy never did improve. For the previous 5 recessions, the Classical economics theory of price adjustments auto-fixing the economy did work. The Great Depression changed everything.
I spent three days pondering why the Classical economics model of price adjustments as shown above didn’t work. I wanted to see if I could come with the same conclusion Keynes did about the fault of such a system. Keynes really was a genius and I failed at coming up with an answer for why the Classical model doesn’t always work. The answer is so elegantly simply and obvious that it escapes detection.
To John Maynard Keynes, the problem with classical economics was not the price adjustment mechanism that it relied on but rather Keynes believed that before such a mechanism had time to work, it would be dwarfed by a much more powerful and deadly income adjustment mechanism.
The Income Adjustment Mechanism
When an economy sinks into recession, peoples’ incomes fall. This fall in income causes them to both spend less and save less, while businesses respond by investing and producing less.
This reduction in consumption, savings, investment and output in turn drives the economy deeper into recession rather than back to full employment.
While eventually income will fall far enough so that savings and investment return to equilibrium, the economy will be at a level well below full employment with no way to get out, stuck in a rut with a glut of goods, just as Thomas Malthus predicted in his original critique of the Classical model.
Modern economics incorporates both Keynesian economics and Classical economics as I stated earlier. In thinking about the aggregate supply curve, it is useful to identify three distinct ranges in the curve, as illustrated in this figure.
The horizontal, or Keynesian range, represents a range where increasing output will not lead to any inflation. In this range, the economy is likely to be either in a severe recession or a full-blown depression, thus large amounts of unused machinery and equipment, and unemployed workers, are available for production. In such a case, putting these idle resources back to work, can be done with little or no upward pressure on the price level. It follows that in this Keynesian range, prices are for all practical purposes, fixed. Hence the flat portion of the curve, and fiscal policies such as increased government expenditures, can be used to stimulate the economy without any fear of inflation.
This is illustrated in the figure above where an increase in aggregate demand caused for example, by expansionary government policies, shifts output from Q1 to Q2 but the price level remains the same.
In contrast, in the vertical or classical range the economy has reached its absolute full capacity level of real output at Q sub C. In this range any attempt to increase production further will not increase real output, but only cause a rise in the price level, just as the Classical economists quantity theory of money predicted.
In this Classical range, expansionary fiscal and monetary policies will clearly not be effective.
The ineffectiveness of expansionary policies in the classical range is illustrated in this figure.
Here, an increase in aggregate demand, from AD5 to AD6 does not increase Q sub c, but only the price level from P5 to P6. This is demand pull inflation because shifts in aggregate demand are pulling up the price level.
Finally, there is an intermediate range between Q sub U and Q sub C, where any expansion of real output is accompanied by a rising price level. Here, the problem is that the economy is comprised of numerous product and resource markets, and as it moves to full employment, movements in all these markets may not occur simultaneously. For example, as the economy expands in the intermediate range, auto and steel workers may still be unemployed, but the high-tech computer industry may begin to experience shortages in skilled workers. At the same time, raw material shortages, or bottlenecks in production, may begin to appear in other industries. This situation is illustrated in this figure.
Here, real GDP begins at Q sub 3, but it is below the full employment output of Q sub 4. In this case, stimulating aggregate demand through expansionary fiscal policies, will move the economy to Q sub 4. However, it will also result in demand-pull inflation, as the price level rises, from P3 to P4.
Unified Macroeconomics Theory
As you can see both Keynesian and Classical economics are now largely unified in modern macroeconomics. There will always be people who try and be divisive in order to gain a cult like following. Galatians 5:15 says, “If you keep on biting and devouring each other, watch out or you will be destroyed by each other”. Is it really necessary to quarrel so much? Some will say that Classical economics is right. Others will say Keynesian economics is right. Both of these groups fight along political ideology lines. However, the truth is that both of these economic models are right at different times during the economic cycle. There is a time for Keynesian economic fiscal and monetary policies, and there is a time for Classical economic fiscal and monetary policy (or lack thereof). When you hear someone who follows classical economics like Peter Schiff rail on about the wisdom of less government intervention, just remember, there will be a time in the economic cycle, a stage, where that will be correct. There will also be a stage in the economic cycle where that is incorrect. Now you understand why an intelligent person like Peter Schiff can be so right some of the time, and grossly wrong at other times. The Bible tells us in Roman 12:18, “Do all that you can to live in peace with everyone”. After this lesson, I hope you will find it easier in your heart to do just that.