March 26, 2016

Keynes and Libertarianism, Part 1

There are only two Keynesian libertarians in the world (the other is in Australia). This scarcity of our breed is easily explained by conventional wisdom, according to which both Keynesians and libertarians adamantly refute the idea that Keynesianism can be mixed with libertarianism. It is almost written in stone that if you are a Keynesian, you are either a social liberal or an outright socialist; on the other hand, if you are a libertarian you adopt Austrian theory as your guide through the world of economics. 

However attractive conventional wisdom can be as a guideline through the world of ethics, politics and economics, it does have its strict limitations. One of them is that while it may help you explain conventional phenomena, it is the unconventional parts of reality that tell real analysis from - yes - conventional wisdom. 

This is very much true in economics.
All economic theory (except Marxism) is explicitly or implicitly based on the premise that the economy has a fundamental ability to grow along a harmonious, long-term path of general equilibrium. The premise is explicit in Austrian theory, which helps explain its appeal among proponents of economic freedom. It is also explicit in mainstream, neoclassical/New Keynesian economics where traditional microeconomics plays a big role. There, the free market and its inherent ability to gravitate toward full-employment equilibrium plays an essential role as the analytical "default setting".

In plain English, this means that Austrian, mainstream and Keynesian theory all assume that unless the economy is subjected to a disturbance, it will move along at the full employment of all available resources until the next Big Bang. The free market will guarantee the best possible use of every available resource.

This does not mean that they all view the free market with the exact same analytical glasses. The microeconomic foundations of Austrian theory prescribe that people make rational choices even in an intertemporal setting: an investor can compare an investment opportunity "today" and "tomorrow" with equal confidence in the information pertaining to each case. As a result, proponents of Austrian theory are unapologetically for the free market.

I have expressed my disagreements with this core feature of Austrian theory in another article.

Mainstream economists also rely firmly on their free-market microeconomic foundations, but they make a habit out of looking for singular imperfections in the free market. These imperfections are then used to explain deviations in macroeconomic activity from its full-employment long-term path. An often-cited singular imperfection is price rigidity, where the price of either consumer products or labor (sometimes referred to as "sticky wages") does not adjust flexibly to changes in supply and demand. Delayed changes in prices, say mainstream economists, force economic activity down below the level where all resources are used to their fullest extent.

One big problem with this belief in "singularities" is that an otherwise perfectly rational, perfectly informed economic system would leave one singluar imperfection in place over the long term. This is illogical and has led me to refute mainstream economics.

Now for traditional Keynesian economics. Contrary to what most modern economists tend to believe, Keynes was no foe of the free market. He was absolutely not a socialist, and he had some rather derogatory things to say about Marxism and its practitioners. That said, he did not embrace the free market the way Austrian economists do. He saw systemic problems in it that makes his theory stand out methodologically. It also makes his theory more compelling in terms of the relations between macro- and microeconomics, but that is an issue we will have to return to later.

Keynes did not assume that the free market will always have the strength or resiliency to keep the economy at full employment. But unlike his later, self-proclaimed followers in mainstream, New Keynesian economics, Keynes claimed that the inabilities of the free market had nothing to do with price flexibility. It is a matter of entrepreneurs and consumers losing faith in the future, a less tangible but from a practical viewpoint more important variable than, say, sticky wages.

Some critics of Keynes would immediately suggest that "losing faith in the future" - or being overwhelmed with uncertainty - is irrational and therefore not of interest to economic analysis. Others would suggest that if given enough time, economic agents will recover faith in the future.

Neither category of critics is correct. The point with Keynes's "lost faith in the future" is that under certain circumstances this loss of faith is in fact the most rational act to take. Again quoting Paul Davidson from Money and the Real World: "In times of uncertainty, he who hesitates is saved to make a decision another day."

What makes Keynesianism so useful is that it incorporates this rational "hesitation" feature and still relies on the free market as its foundation. Using Keynes's original economic contributions - and some highly selective more modern amendments and expansions - we can explain not just the long-term growth path of free-market economies, but we can also explain how and why those economies fall into recessions, depressions and decade-long periods of stagnation. 

And best of all: we finally have an economic theory that works hand-in-glove with libertarianism.

Wait, what? Is not Austrian theory the home of libertarian economics? No, it is not. More on that in part 2.

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