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Fight of the Century… Keynes vs Hayek Round 2..!

Well, i am not 100% sure this is the fight of the century, perhaps more the fight of all centuries. Another great take on the continuing battle between liberal Hayek economic theory and the Government intervention promoted by John Maynard Keynes.

This video has been put together by EconTalk‘s Russ Roberts and John Papola, and i strongly advise you get involved in the fantastic set of podcasts from Econtalk. check the website here http://www.econstories.tv.

Having balanced on the edge of the edge of a depression after the financial slump seen in 2008, there are still many questions being asked by economists and policy makers so as to speed up the recovery in many capitalist nations, as growth and employment are slow to recover than anticipated. Should we push for more fiscal stimulus, should spending be steered and from the top down or does prosperity come as green shoots from the bottom up?

Listen to this great rap video, to get a take on all these and more.

The evolution of economic theory and practice up to 2007

Classical economics has been around since the 1700s, with the likes of Adam Smith, David Ricardo, Thomas Malthus, John Stuart Mill and Alfred Marshall (amongst many others). It simply states that the economy works through no other mechanism than self interest, and that Supply ‘creates’ demand (Say’s Law). It works along the basic principle that the market will always adjust to find the equilibrium point between supply and demand, and that there is a natural adjustment to full employment. It is a brutal mechanism, concerned only with the markets and has not affection for the human impact! If the market strays from the equilibrium then the simple answer is to sit back, and wait for the re-adjustment. There is little role for governments, other than to maintain the rules and keep the markets free (ie a very laissez-faire attitude). There are certain roles for governments, such as defence etc, but that a balanced budget should be maintained at all costs (ie after the government spend of WW1, taxes were hiked and spending was cut to redress the balance regardless of human consequence). The belief was that if unemployment was high it was because wages were too high and that people were pricing themselves out of the market and that if there was inflation it was due to too large a money supply, thus fiscal contraction was required to reduce the money base. Market failure was placed very much on the shoulders of the government, and being too involved.

The Fisher Equation 

MV = PT

M = money supply
V = velocity/number of times the money changes hands
P = price
T = number of transactions

Seeing as it was believed that V and T were fairly equal/constant, it could be deduced that there was a positive relationship between the money supply and price (or inflation). Thus an increase in the money supply was seen to increase inflation and vice versa. Then the Great Depression hit, and it all changed.

Keynesian Theory Economics

This was the theory developed by John Maynard Keynes, that took force in the 1950s after the Great Depression. This is concerned with the control of aggregate demand within an economy, and that government should act to control this.

AD = C + (I-S) + (G-T) + (X-M)

for a further breakdown of this please read the following (‘How the Great Depression lead to further spending and fiscal stimulus‘).

Keynes argued that through fiscal stimulus; to include government spending and regulation of taxes; an economy could overcome the usual market cycle of boom and bust and maintain a more regular balance of growth and prosperity. It was a system that was not based on full employment, and was aware that the markets more often than not sat in disequilibrium.

After WWII, it was believed that the only road was that of depression economics. This involved currency devaluations, nationalistic agendas, increased tarifs and taxes for foreign imports. But after WWII both Theodor White and Maynard Keynes offered something new. Fixing the US exchange rate to the Gold Standard of $35 per ounce of gold meant, allowed all other nations to peg their currency to the US dollar which in turn offered the stability markets so craved. The International Monetary Fund was established to manage the currency rate and act as market stabiliser and between 1947-1971 the world’s economic waters returned to calm.

During this period it could be said that mixed market economies existed, where there was a carefully managed relationship between public and private sectors that was tied together with a fixed currency exchange rate. However in the 1980’s the exchange rate was allowed to float due to inflexible markets, and so became a floating exchange rate system.

Through this period it was apparent that the Phillips Curve, a correlation between % inflation and unemployment, existed and so fiscal control was an easy way to control the economic machine. However, in the 1980’s Stagflation set in where both stagnation and high rates of inflation were seen. This gave rise to Monetarist Economics. Monetarism was closely linked to classical economics and was  concerned with the control and supply of money. It was believed that inflation was positively correlated with the money supply, and so to reduce inflation a government should choke the money ‘drip’. However Monetarism was concerned with ‘adaptive expectations’, ie that one could look back over years of behaviour and systematically adjust policies. It blamed government intervention for inflation (going back to Fishers Equation).

There was an evolution of this, called the New Classical Economics theory which did not believe one could predict the behaviour of the people, and instead looked at the ‘instinctive adaptation‘ of leaders and building up a wealth of knowledge. This meant that responses were instant and based on principles, and that systematic errors did not occur. There was a firm belief that government spending resulted in inflation, and was an advocate for reduced government and mass privatisation. It was also called the Rational School of Thought.

Keynesian Economics has had to evolve also, and so as to counteract the forces seen in stagflation, suggested that contracts were vital so as to commit people and businesses to certain rates for a period of time. It aimed at focussing on what policies can work for governments and why.

Supply Side Economics, does just that. It returns to Say’s Law regarding supply before demand and looks at providing incentives to get back into work, promoting hard work and risk/investment. However, i have an issue with this, as i believe demand becomes before supply, and that all incentives in the world can be offered but if there is no work, there are no jobs.

In general this debate has been raging for many years, and will continue to do so for many more as there appears to be no right answer or that the right solution has not been found yet. I have not gone into the recent 2008 collapse, but will aim to get something up soon.

How the Great Depression lead to further spending and fiscal stimulus

The Great Depression began with Black Tuesday, on the Oct 29th 1929 when Wall Street lost $14 in a single day! Unemployment reached 25% and GNP fell by 50% in a year!

It was the belief of classical economists that this departure from the equilibrium of supply and demand would soon change and return itself to the natural equilibrium of the markets. However, John Maynard Keynes, asked ‘how long would the market wait before it settled back into the equilibrium point?’, and therefore challenged the fundamentals of Classical Economics.

‘the difficulty lies, not in the new ideas, but in escaping from the old ones’ – Keynes

‘capitalism holds the belief that the wickedest men will do the wickedest things for the greatest good of everyone’ – Keynes

He challenged Say’s Law, and suggested that without demand there was no market, and that markets do fail. He was adamant that the consumer was more important than the supplier. He believed that the government was required to control ‘aggregate demand’. He believed:

AD = C + (I-S) + (G-T) + (X-M)

AD = aggregate demand
C = consumption
I = investment
S = savings
G = government spending
T = taxes
X = exports
M = imports

He believed that through fiscal stimulus, ie government spending one could achieve a higher rate of investment and thus aggregate demand. This in turn would drive consumption, which would drive up taxes etc. It was his argument that this fiscal stimulus should come through Government Bonds, bought from the idle savings capital so as to increase investment, that would drive AD etc.

The original argument from the classical economist was that if you borrow all the money from the private savings then there is no money for future investment. However, this was overcome by the Multiplier effect, devised by Richard Kahn.

The monetary Multiplier, measures how much the money supply (this is the total amount of assets in an economy, including less liquid deposits and investments) is affected by a change in the monetary base (this is the total of highly liquid assets, notably coins and paper notes, in an economy).

Therefore if the money Multiplier is 5, and the government spends 100M, then the money supply will be 5 x this, and there will be 500M of actual money spent in the economy, assuming a Marginal Propensity to Save (MPS) of 0.8. Thus, within about 6 months, the original loan of 100M is paid back and there has been an additional stimulus for the economy of 400M.

This can be calculated with:

Multiplier = 1 / (1-MPS)

There are several things which can change this Multiplier affect. These include people’s willingness to save money which will depend on interest rates, and people’s willingness to spend/invest. It will also need to consider foreign investments made with this stimulus, and how not all GNI is GDP (ie some firms will remove profits to their own domestic market place).

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