April 2, 2016

On the Proper Role of Government

One of the most persistent myths about Keynes is that he was some kind of statist, even a socialist. Nothing could be further from the truth. Ideologically, Keynes dwelled somewhere in the free-market main stream of the 1920s and 1930s. Scholarly, his work was solidly planted in free-market capitalism, a system that he studied and analyzed at great length and with increasing sophistication throughout his career.

What sets Keynes apart from other economists of his time - and frankly from most modern-day economists - is that he had an unrelenting interest in understanding the limitations of the free-market system. Working part of his career inside the realm of politics and public policy, Keynes had a pragmatic understanding of how the economy actually worked, and his research aimed to provide an economic theory that had real-life applicability in a way that was not the case with dominant economic theory of that time (during and between the two depressions in the Intebellum years).

Inevitably, his research came to focus on what role government could and could not play in the economy. It is probably the part of his writings that is least satisfactorily developed, both in his original contributions and in contemporary research tracing its roots straight back to his work. Keynes himself never had (or gave himself) enough time to explore the potentials and limitations of government in the economy, leaving students of his work to assess his views for the most part based on rhetorical writings rather than scholarly contributions.

Contemporary practitioners of Post Keynesian economics are the most loyal of today's economists to Keynes's legacy. Sadly, among them it is very difficult to find any deeper interest in the actual role of government. An overwhelming majority of Post Keynesian economists are of left-leaning ideological convictions, motivating them to take for granted that government plays a big, natural role in Keynesian economics.

This is, ironically, a mistake they share with some of their adversaries on the stage of economics, namely New Keynesians. In the latter case the conclusion that government has an active role to play in the economy is derived from an erroneous yet systemic analysis of the workings of a modern economy. Post Keynesians, again, tend to assume an active role of government based on ideology, not scholarly analysis.

This is not universally true. The unrelenting Paul Davidson is a bright exception, a man whose scholarly contributions have filled many important holes in traditional Keynesian economics. During my years as a graduate student, even though I never took a class from him, I learned more from Davidson than from any other professor I had the privilege of knowing.

On the other side, though, are a slew of left-leaning economists whose endeavor primarily is to use Keynes's works to give credibility to their own political ambitions. Others yet have lost themselves in high economic theory and methodology that pulls Keynesianism away from real-world applicability - quite the contrary of what Keynes himself wanted to accomplish. (It is in these circles one finds academics whose major research contributions fall into the category of conceptual masturbation. While appearing impressive, this kind of "economics" often serves as an escape pod from the grueling demands on economists to make a difference for the better in this world.)

It is important to have this as a background when one asks what role government really plays in Keynesian economics. Economists are expected to dispense advice on economic policy based strictly on scholarly analysis, yet their recommendations are all too often tainted by their ideological views. In most cases the economists themselves do not understand this; left-leaning Post Keynesians clearly fall into this category. Theory and ideology have merged to the point where they are indistinguishable to the practitioner of that brand of economics.

New Keynesians can more easily motivate a presence for government in the economy by means of their own analysis. To see why we need to quickly repeat the distinctions between mainstream microeconomics and the microeconomic analysis that underpinned Keynes's original contributions:

Mainstream microeconomics assumes...

-Perfect foresight, in other words that all economic agents can perfectly predict the future outcomes of all their actions;
-Instantaneous response in prices to shifts in demand and supply, meaning that a gallon of milk can cost ten cents one day and $5 the next day;
-that economic agents are fully able to adapt to fully flexible prices, move money and resources in and out of markets without any meaningful cost, the reason being that they have perfect foresight;

Therefore, mainstream microeconomics concludes that...

--The free market, if left alone, will always operate at the full employment of both capital and labor.

This seems to be a ridiculous theory, and for all practical purposes it is ridiculous. However, it does fulfill an analytical role in that it explains some of the mechanics of an economy that leads to the formation of prices. For this reason it is important that students of economics learn to master it, but it is also important that they learn its limitations. 

For more advanced practitioners of economics, it is important to understand the deeper implications of this theory. In terms of economic policy and what societal organization we ought to strive for, mainstream microeconomics has two implications. First, it tells us - again - that the free market is the superior means of allocating resources in the economy. This implication is indisputable, but imperfect as we will see when we get to Keynesian microeconomics. 

Secondly, the conclusion that the free market is our best allocative system also implies that if the economy is left alone by government it will, at the macroeconomic level, always operate at full employment. Already back in the 1920s European liberals - ideologically roughly in line with today's moderate Republicans - drew the conclusion, based in part on the ideas put forward in mainsteam microeconomics, that there really was something called eternal growth. The modern industrialized economy was destined to grow ad infinitum, and all politicians had to do was to remove imperfections and make minor adjustments along the way. 

Interestingly, statists - typically known as social democrats in Europe - came to the same conclusion. They saw the economy, as explained by mainstream economists, as a machine capable of producing higher and higher levels of prosperity. However, unlike liberals they also drew the conclusion that government could enter the economy, reallocate income and products and get a different distributional outcome without any risk to the performance level of the economy. So long as the resources going out in the form of taxes funding the redistributive system - a.k.a., the welfare state - were similar at the macroeconomic level as the resources going back into the economy, the theory was that the path to perennial prosperity would not be disturbed. 

Needless to say, classical European liberals and social democrats reached different conclusions as to the size and role of government in the economy. However, they shared a common belief in the economy as an independent growth machine, and they did it because they had adopted the message from mainstream economics of permanent, full employment of all economic resources.

Marxists, notably, disagreed with this view. Their interpretation of the free-market economy was that it would be destabilized and eventually destroyed by unrelenting accumulation and concentration of capital. How fast that process was depended on what the individual Marxist believed regarding the tendency of the profit ratio to decline over time.

Keynesian microeconomics also disagrees with its mainstream counterpart, saying that...

-there is no perfect foresight;
-the default setting for all economic activity is fundamental uncertainty;
-unless we take active steps to reduce uncertainty, it will prevent us from making any informed decisions regarding the future.

As I explained in a recent article on Keynes and libertarianism, the consequences of these premises are that:
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. 
Here is where Keynesian theory opens the door for government to play a role in the economy. Before I explain that part, though, let me point out that my conclusion regarding what role government can play is a conclusion based on studying economic theory and its applications, not following my ideological preferences. The role that government can play in the economy partly refutes the role that my libertarian philsophy says it should play.

It is important to point to this discrepancy, because it is very common both in academia and in the think tank industry that people adapt their economic thinking to match their ideological preferences. This is not just a problem among Keynesians - it is just as common among libertarians who believe in Austrian theory.

So, then, what are the proper roles of government according to original Keynesian economic theory?

a) Independent arbiter of contract disputes, enforcer of contracts and property rights. This classic role is recognized universally among even moderately sensible economists. It is derived from the first point above about contracts.
b) Enforcer of antitrust laws, preventing artificial concentration of market power. This is important as an instrument to allow market-based "flock behavior" to move markets in one direction or another.
c) Guardian against macroeconomic uncertainty.

This last part is essential. What sets Keynesian macroeconomics apart from other macroeconomic theories is that it recognizes that:

1. There is something called fundamental uncertainty, and
2. This fundamental uncertainty can overwhelm the vast majority of people.

The consequence is that nobody wants to take any chances; everybody wants to hold on to their money so that they will have a chance to support themselves in the future. When, under fundamental uncertainty, nobody wants to spend any money, the economy freezes at an abysmal rate of economic activity.

This is precisely what happened during the Great Depression. We saw a somewhat milder version of it unfolding during the first couple of years of the Great Recession.

But what exactly does this mean regarding actual economic policy? What should government do to play its role of guarding the economy against macroeconomic - or fundamental - uncertainty...?

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