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Keynesianism - an ongoing (flawed) science experiment

I am posting an essay I wrote yesterday for an online Econ course I am taking this summer as a prerequisite for a Master's in IR this fall. Its a bit sloppy, but I wanted to see what some austrians thought of it. I worry I might offend my progressive professors and classmates, but this is just the way I see the world. Thanks in advance for any comments.

I entered this course with certain preconceived ideas about the application of economics within society, yet lacking a full understanding of the science to back up my feelings. My ideas were based in part on my experiences working in the finance industry in New York and Shanghai, on my fondness for classical liberalism, and on a personal belief that it is the duty of every free-thinking individual to maintain some level of skepticism of the government. In some weekly responses those themes may have been apparent. 

The unbelievable story of the global financial crisis peaked my interest in the ways in which political leaders attempt to direct the economy and my biggest goal in this course was to try to understand the scientific principles that promote the development and enactment of prescriptive economic policies in a society. I am practically enamored by the positive scientific aspects of economics; the principle of price discovery through market equilibrium of supply and demand is beautifully clear. It might be too obvious to say, but in contrast, I find the debates over prescriptive practices, the unintended consequences of economic policies, the centralized control over monetary policy, and the tendency of governments to run up large debts, all to be quite confusing and troublesome economic issues mired in the influence of politics and business. 

Just as the study of biology and the application of biological science are different concepts, so too is this the case with economics. The science is factual, tested through repeated observations. The application of science in society is based on the scientific knowledge, but contains all of the complex issues of the variability of nature. A good example would be genetic engineering. Based on generations of accumulated scientific discovery, biologists now have the capability to alter genes, turn on and off certain genes that will change the characteristics of an organism. It can be done based on what we have discovered about how genetics work. Hypotheses can be made that this science can be applied to cure disease, improve longevity, grow bigger food, grow transplant organs, and such extremely questionable practices as the cloning of whole organisms, humans, etc, etc. Scientists have acquired this power, but the actual outcomes of pursuing experiments in this arena remain unknown and there is always an ethical question over how to proceed with this powerful knowledge. 

I bring up natural sciences because I believe the analogy holds true to Economics as well. This dichotomy between descriptive understanding of natural mechanisms and the human application of understanding to affect a desired outcome is where I find the most trouble in economics. While hypotheses regarding application of natural sciences can be tested in a controlled enviornment, economic hypotheses cannot. Therefore, the prescriptive application of macroeconomic knowledge can only be tested in real time in the real economy, and these applications are, in effect, based on the best guesses of the particular economists employed to make those decisions. 

This brings me to two basic concerns; one being the ever-present likelihood of unintended consequences from taking particular economic measures. But furthermore, when vast sums of wealth can be created or destroyed based on the outcome of economic policy decisions, it is hardly a stretch to consider the possibility of corruption within the practice of economic decision-making. 

Thus, I have been keen to develop a better understanding of the application of economic policy and to investigate as many criticisms and supporting arguments of various policies as possible. I discovered that the Classical or Austrian School of Economics provides very compelling arguments against monetary intervention in an economy. The basis of the Austrian school is rooted in the inimitable mechanism of free market price discovery and makes the critique that expansionary policies meant to stimulate aggregate demand are in fact a form of price fixing on interest rates. Rather than allowing interest rates, ie the price of money, to fluctuate freely in the market, monetary policy favors low interest rates to stimulate aggregate demand. Lower interest rates natural stimulate investment, but artificially low interest rates stimulate investment without providing an accurate measure of risk, making riskier investments look more attractive than they actually are. Mal-investments are made as a result, and as inflation from monetary expansion sets in, the investments do not pay out as expected. This is, in a nutstell, the Austrian explanation for asset bubbles. Low interest rates lead to an over-extension of credit, an over-stimulated economy, bad investments made en masse, and eventually a painful recovery period. 

I first discovered this critique from popular outspoken critics of the Federal Reserve System, namely Ron Paul and Peter Schiff, both of whom predicted the US housing bubble and collapse years before it occured, and attributed the causes of the bubble to artificially low interest rates put in place by Alan Greenspan to correct the recession of the early 2000s that followed the collapse of the dot com bubble, 9/11, and the Enron and Worldcom accounting scandals. Austrian economists would argue that Greenspan should have taken no action and allowed the economy to correct itself after the five year period of “irrational exuberance” as Greenspan famously called it. Instead, Greenspan lowered interest rates and the US Government used fiscal policy, tax breaks, to stimulate demand. Well, the low interest rates encouraged borrowing, and much of that borrowing went into the real estate market. Real estate prices skyrocketed, consumer spending increased (on mostly foreign products), savings declined, and the effect compounded for six years. When the bubble popped, credit recoiled, interest rates rose, lending stopped, housing prices plummeted. All of the aggregate wealth stored in housing equity evaporated overnight. The demand for housing was never real, it was nominal, it was based on the artificially low price of borrowing. 

The controversy and variety of opinions surrounding the financial crisis inspired me to investigate these ideas further, reading various authors from the Austrian school, such as Von Mises, Rothbard, Hazlitt, and Hayek. The Austrian school provides well-conceived, though often times very simple, critiques of prescriptive practices of Keynesianism. They seem to concern themselves primarily with real values, and dismiss nominal values as illusions. 

It was against this backdrop that I entered this course, and from the course I believe I have found evidence that supports these ideas.

One of the most valuable pieces of support for this idea that I have gained has been the explanation of the Classical Dichotomy, and the acknowledgement that short run monetary policies can stimulate aggregate demand in the short term, but in the long run the economy reverts to its normal state based on the levels of real savings. In the discussion of the effect of inflation on unemployment it is also acknowledged that policy is only a short-term solution. If a little bit of inflation stimulates aggregate demand and reduces unemployment past the natural level for a temporary period, there will always be a political incentive to encourage a slowly increasing rate of inflation. Even though, as we learned, the real natural level of unemployment and output are based on real terms, and real growth requires real savings. 

If an increase in the money supply is acknowledged as a temporary boost to employment and output, which will return to their natural level, while increasing prices and eventually requiring a readjustment period of higher unemployment and lower output to bring inflation back to zero, it would seem that an over-reliance on monetary expansion to stimulate aggregate demand by creating artificially low interest rates and easy credit, ironically contributes or possibly creates the very booms and busts these policies seek to alleviate. Was the Great Depression a severe period of rebalancing output and employment after a protracted boom period based on expansion of the money supply? I'm not sure, but I intend to pursue this idea further in my studies of economics.

The Federal Reserve has targeted low interest rates to stimulate aggregate demand since 2001 and we experienced a massive boom and a bust that has now been buffered by even stronger monetary expansion. Data has reflected significant rises in consumer prices in America and across the globe without the expected improvement in unemployment numbers that would go along with monetary injection, meanwhile average time unemployed has doubled. 

So, I suppose, we may be looking at the limits of what Keynesianism can achieve. Keynes’ most prolific quote is “In the long run, we are all dead.” I understand the way he intended it, but one could easily interpret it differently, as a dangerous political philosophy of pushing short-run economic policies to the limit when politicians get stuck in a vicious cycle of using monetary and fiscal policy as quick fixes to maintain aggregate demand in an economy that is declining in real terms. 

I guess the debate over economic policy is always going to be when to use it, how much, and for how long. Economics is a relatively young and imperfect science, Keysianism has only been around for 84 years. The best conclusion I can reach from what I have learned is that we are living through an ongoing experiment in economic manipulation that will provide a ton of fodder for economists to study for centuries to come.

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reedr3v's picture

I'm hoping many young econ. students

will do similar independent research and challenge the prevailing economic paradigm. Let us know how your prof. and other students respond!