Keynes and Libertarianism, Part 2

The question that we left hanging at the end of the first part of this article is: how can traditional Keynesian economic theory be a better companion to libertarianism than Austrian theory?

As mentioned in the first part, both Keynesianism and Austrian theory are built upon a microeconomic foundation of free markets. That foundation is more pronounced in Austrian literature - or, to be exact, less pronounced in Keynesian literature. The reason for this is that most modern Keynesians are of some sort of some kind of American liberal conviction, which by illogical implication also means that they regard the free market not as a virtuous institution, but as a necessary bad.

Again for illogical reasons they disregard much of the free-market related components of Keynesian economics, giving many modern readers of economic literature - and especially economic-policy material - the impression that Keynes was some kind of collectivist.
That is far from the truth, as some honest Keynesian economists have tried to point out. Unfortunately, liberals and socialists are not alone in presenting Keynes as a leftist economist: the prevailing opinion among libertarians in general, and public-policy active libertarians in particular, is that Keynes was a big-government socialist.

As an economist, Keynes was not a proponent of big government. He also did not like the ideas of a planned, Marxist-based economy. In fact, the over-arching theme of his scholarship is that he wanted to identify the systemic elements of a free-market economy that kept it from performing as it was intended to do.

In a nutshell: you do not become a socialist just because you point out that a free-market economy on its own cannot maintain full utilization of all economic resources at all times.

It is precisely in his studies of the imperfections of the free market that Keynes becomes the best ally for us who want to preserve a free-market based economy. However, unlike, e.g., the New Keynesians and mainstream economists, Keynes suggested that these imperfections are inherent to the system and therefore not removable - only manageable by participants in the free market.

The first imperfection is related to human decision-making. Unlike the theory of the free market derived from the Walrasian system (today represented as standard microeconomics in introductory economics textbooks) where individuals make rational decisions under perfect foresight of the future, the Keynesian decision-maker has a strictly limited set of information about the future. Because of time constraints he has to make a decision at some point based on any given set of information.

Here is where the Keynesian microeconomic foundation substantially differs from mainstream microeconomics. People always make economic decisions at vaying levels of confidence; to improve their chances of success in making the right decision, they use three tools:

1. Contracts. Repetitive behavior is helpful for predicting the success of tomorrow's actions. Contracts that confirm either a new, or a repeated economic transaction in the future, vastly help remove uncertainty regarding the payoff of tomorrow's actions.

2. Flock behavior. In many markets there are some sellers whom others consider "leading indicators" in the market. If a leading competitor decides to, say, invest in a new production facility or hire more people, then that is taken as a sign of confidence by weaker competitors who then repeat the market leader's behavior.

3. Animal spirit. One of Keynes's major points about decision making under varying degrees of uncertainty is that on occasion, the information saying "go for it" and the information saying "don't do it" weigh equally. At this point a decision maker relies on his "gut feeling", which Keynes refers to as the "animal spirit". Savvy entrepreneurs will make a leap of faith where others may refrain from doing anything. 

Together, these three points have important implications for how we understand the free-market economy. I will probably return to them later; what matters here is how these three points make Keynesianism the preferred theory for libertarians.

Here is how it works. Because Keynesian theory explicitly puts the individual economic decision maker in a context of uncertainty, it not only represents reality better than theories based on Walrasian "perfect foresight" theory, but it also gives a meaningful reason why government shall protect and provide mechanisms for the enforcement of contracts. Without the ability to take a contract dispute to court, individual decision makers are subject to a much stronger impact of uncertainty on their economic activities.

The second and third points about economic behavior imply that government shall refrain from preferential treatment of economic agents. One form of such preferential treatment is often referred to as "corporate welfare", others are known as regulations raising the bar for businesses to enter a market (certification requirements, etc) or leave (bankruptcy laws). In order for a market to produce the kind of "flock behavior" that helps smaller businesses make decisions based on the behavior of larger ones, we have to be absolutely certain that the larger business has not gained any artificial advantages. This goes toward the "animal spirit" point as well: government can help some businesses make a decision under uncertainty in a way that gives them an unfair advantage over others - and for precisely that reason government shall refrain from picking winners and losers.

In other words, Keynesian microeconomics provides a meaningful foundation for contract and property-rights enforcement as well as a blanket non-interference rule for government. In addition to a ban on corporate welfare and other means of preferential treatment, this means no "too big to fail" programs for irresponsible banks and no tax breaks for struggling businesses.

But does not Austrian and mainstream economic theory lead to the same conclusions? No. Both these theories are based on the same "perfect foresight" paradigm that was born with the Walrasian model for the free market. Under this model, in the long run the free market always operates at full employment of all resources. In order to be able to do so the model necessitates that individual economic agents - entrepreneurs as well as investors and households - make their economic decisions with perfect foresight of the future. 

The problem is that perfect foresight does not exist. In a later article I will explain why, using the "cat tail" example. The point here is that if entrepreneurs have perfect foresight, they do not need a government to help them enforce contracts - they will know beforehand whether or not the contract will be honored by the opposite party. Nor do we need a ban on government preferential treatment of businesses; we will know beforehand what businesses will fail and which ones will succeed. 

Now, choosing Keynesian theory over its Austrian or mainstream competitors also has consequences for the macroeconomic level. There, the conclusion regarding absence of government is not as clear cut. This presents the libertarian with a challenge - but so does Austrian economics. Alas, the plot for another article! That will be a stand-alone piece, though, because it will deal with macroeconomics.