“It works in practice, but does it work in theory?” – The Quantity Theory of Money and Classical Economics
By John Saudino
1 August 2019
The title is a quote from a speech by Senator Al Franken in the Senate. After demonstrating the effectiveness of Keynesian (consumer demand based) economic policy citing extensive empirical evidence, he said the following: “Now the question for my Republican colleagues is, It works in practice but does it work in theory?”. The implication of course is the fact, as elucidated in this article, that the so-called “supply side economics” advocated by the Republicans in fact only works in theory and has been, in practice, an unmitigated disaster.
Within the theoretical social sciences economics no doubt enjoys a very special status. This is because in contrast to sociology, anthropology, psychology, etc., economics, once known as political economy, represents a point of interaction with the real world through which social science and philosophy are not mere academic pursuits but rather have a genuinely profound impact on our daily lives. Whereby a social science like sociology describes the world, the science of economics also prescribes. It prescribes the economic policy in our society that creates the world in which we must live, work and survive. Economic policy creates our world in that it provides the framework for the juridical superstructure and at the same time governs the substructure embodied in the material conditions of production upon which this superstructure is built. [1]
In contrast to the deterministic and historicist approaches taken by many vulgar Marxists to this relationship between superstructure and substructure, that view the superstructure, the entire complex of laws and political ideologies guiding society, as being determined mechanistically by the material conditions of production themselves, it is quite clear to the more perceptive among us that theory in fact takes on a much more active role than this simplistic determinist view would suggest. When one takes a more dialectically materialist approach, i.e. one that takes into account the reciprocal causation acting between the two levels, it becomes obvious that the realm of theory, which is the product of autonomous human thought, has a much more decisive effect on social and historical processes than this simplistic materialist analysis would indicate. It is the fruits of such theories in the form of laws and policy decisions that feed back into the causal nexus to create the framework that governs the economy. In this codetermination process the theoretical social science of economics is both the effect and the cause of our social reality.
Given this key role it is all the more crucial for this theoretical social science to be based on and also to facilitate an understanding of an accurate and true version of the world outside itself. In other words it is of utmost importance that the science of economics in fact be a science. The methodology, possibility or even desirability of making the social sciences more scientific is a difficult and controversial field of inquiry within the philosophy of science. Although of all the social sciences economics is the one most dominated by mathematics and hard statistics, it remains a social and not a natural science. As such it deals with the behavior of millions of autonomous individuals, who act both individually and collectively in myriad and complex ways. The causal linkages in such a vast and complex system make a truly objective and conclusive analysis, in the spirit of natural sciences like physics, quite elusive.
In addition to the sheer scale and complexity of the object studied there is the fact that the most basic questions in economics trigger profound epistemological and methodological questions. There is the problem of sorting out the connection between the individual and the aggregate level of analysis, subjective or objective evaluations. There can be essentialist or nominalist approaches, collectivist or individualist approaches, a priori or a posteriori approaches, inductivist or deductivist approaches. The key question here is: what is the theory’s relationship to the concept of truth? In other words does it succeed in or even attempt to reflect the reality outside of itself, or is it an unfalsifiable instrumentalist or conventionalist theory that employs immunizing strategies to protect itself from the scrutiny of empirical analysis?[2]
Saying that a theory respects the notion of truth is not the same as saying that it is the truth or that it is in any way a perfect representation thereof or that it is any kind of final theory that is so well conceived that it will remain unchallenged in perpetuity. Those who believe that maintaining the concept of truth would require such a perfect theory are confusing the concept of truth with the concept of certainty. A theory that maintains a respect for truth would be one that did not claim certainty for itself; it would demonstrate the necessary epistemic humility that all scientific theories must have and maintain the veracity to allow and even encourage the necessary conditions for its own falsification. The proponent of such a theory would be on constant lookout for proof that the theory he or she adheres to is wrong and to explore new theories with more explanatory power than the old one. Such a scientist or, in this case economist, wouldnot be selectively doctoring data to “prove” the favored theory right and wiggling out of attempts at falsification like an eel slipping through one’s fingers, with a slimy skin that is lubricated with immunizing strategies that blame the data, adjust only a trivial aspect of the theory, declare the “exception” irrelevant, falsify premises to justify conclusions, etc. A “scientist” for whom a favored theory is more important than the pursuit of knowledge, or who views some a priori principle to be more real than the evidence of his or her own senses is not behaving like a scientist at all, but far more like a clergyman, and a theory so maintained is far more like a religion or at the very least an ideology than a genuine science.
The only kind of economics that could possibly improve the lives of human beings rather than destroy them would have to be one that is a genuine science in the way I have described. Any other kind would risk the danger of propelling an entire country or economic block into its own unsustainable parallel universe with the inevitable collapse, perhaps of an entire civilization, just around the corner.
It is my contention that for far too long much of what we call economics has not been scientific in the way I have described and that for the sake of ideological biases that are based on class loyalties, I would argue, there is an ideological and doctrinaire rigidity to much theory that leads economists to cling to old outdated paradigms and to ignore very plain facts even when they are staring them in the face.
I will argue that one particularly egregious case of ideological rigidity of this kind is to be found in classical and neo-classical economic theory and, by implication, in the very current reawakening thereof, which is to be found in the form of the monetarist theory emanating from the Chicago School espoused by Milton Friedman. Some variant of this theory has been the dominant policy driving theory in England and the United States since roughly 1980. The resulting economic regime generated by this theory is commonly referred to as neoliberalism, which is also a political ideology for which members of the Austrian School of Economics, particularly Hayek and Mises, have been central figures.
I would like to focus primarily on one aspect of the classical theory, one of its twin sacrosanct doctrines known as the quantity theory of money (QTM). This, however, will take on the quality of a common thread more than an exclusive focus as it is crucial to focus on the meaning and impact of classical economic theory as a whole.
The Quantity Theory of Money, one of the two pillars of the classical economics
Say’s Law and the Quantity Theory
Before getting into the specifics of the quantity theory I think it appropriate to first mention its corollary, the first pillar upon which the edifice of classical economic theory rests, namely Say’s law. First formulated by Jean-Baptiste Say in his principal 1803 work A Treatise on Political Economy, Say’s law holds that “supply generates its own demand”. That is to say the act of producing goods will necessarily generate a demand for the goods of others. This is because the producer, who is specializing in his or her expertise at producing a particular product, will neither produce for no reason, nor simply fill a warehouse full of goods, but rather will endeavor to either sell or trade them on a market thereby generating demand for the goods of others who have specialized in producing other products.
The logic behind this is clear enough in a barter economy, however because even in Say’s time both metallic money in the form of precious metals and gold-backed[3] notes existed as a medium of exchange, and the industrial revolution was starting to replace manufacturing enterprises with factories that employed salaried workers, it became necessary to posit a corollary to Say’s law in order to explain how it would be maintained in an industrial economy. This corollary was the quantity theory, which posited, among other things, that even in the case of mass production the money earned by workers and entrepreneurs alike would not remain idle in bank account balances, but rather would be promptly spent and therefore generate demand as Say’s law had maintained. The other aspect of the quantity theory is the notion that “money is a veil” or rather merely a medium of exchange so that increases in the money supply will have no net effect on real wages, real prices or output. Such measures will only generate inflation.[4]
In the course of this paper I will attempt to demonstrate that both corollaries of this theory are not only outdated, but have been in large part virtually obsolete for well over a hundred years and that the dogged determination on the part of classical economists and monetarists to hold on to both principles in spite of the evidence demonstrates either shocking ignorance or deliberate obfuscation.
Say’s Law and the Industrial Revolution
As I pointed out above it was maintained by classical economists that in spite of the fact that through mass production factories had replaced the sole proprietorships of the past, and in spite of the fact that the vast majority of producers, industrial workers, no longer traded the products of their labor on the market themselves but rather received a salary, it was nonetheless the case that production continued to generate an equal demand, and thus the economy would naturally return to full employment. Before examining how the quantity theory plays a role here, let us contemplate what the reality of the situation actually was in early industrial Europe.
The average wage of a worker in Paris towards the end of the 19th century ranged from of $1.06 a day in 1870 to $1.33 a day in 1898 and in Belgium it never reached $0.67 a day over the same period.[5] How in the world were these producers, who had no control of the means of production and were living on such low subsistence wages, ever supposed to generate a demand commensurate with the volume of output they themselves were producing? The answer is of course “never”. This fact can be confirmed by the long series of at least fifteen severe financial crises that took place from the downfall of Napoleon to 1896, the year that marked the end of the so called “long depression” that had lasted for 23 years.[6]
The anatomy of such a crisis had been successfully and thoroughly analyzed by Karl Marx for all to read, if they had bothered to. He called this kind of market failure a “crisis of overproduction”. The mechanism is quite easy to grasp. Due to the universal availability of similar plant, equipment and knowhow, the general quality of factory-produced goods was roughly similar between factories. This creates a situation in which each and every entrepreneur is compelled, because of the ensuing price competition with other producers, to pay his or her own workers as little as possible, ideally just enough to keep him or her or even the children coming to work and producing for another day. The “reserve army of unemployed” provided by the masses of dispossessed farmers forced off their land by industrial farming would always enable the entrepreneur to drive down wages and to swiftly replace any worker who had asked for a wage hike or who had had the temerity to simply die of exhaustion. With wages constantly driven down and productivity constantly driven up it is clear that the workers as a whole would never be able to absorb their own excess production. The rapid growth in inventories would of course force the factory owners to start firing workers. Without unemployment insurance to keep people from becoming completely destitute, consumer demand would begin to disappear causing more layoffs and factory closings driving consumer demand even lower. After the crisis is over and the economy starts the bounce back, the smart capitalist who had had the foresight to ignore the quantity theory, that is to say, to act according to what Keynes called the “liquidity preference”, which is quite rational in this situation, would have the large reserve of “idle cash” free to buy up the plant equipment and customer base of his now bankrupt competition. This meant that after the crisis even more of the means of production has been concentrated or consolidated into even fewer hands. The former smaller capitalists who had gone bankrupt have been “precipitated into the proletariat” where they too will now produce goods as workers for their former rivals and likewise not be able to generate demand for these goods. Furthermore the consolidation would provide the surviving entrepreneur with new economies of scale that would make him more resistant to competition because he could easily underbid or even dump products so as to prevent new companies from entering the market. This monopolistic or quasi-monopolistic position would of course allow him the power to depress wages even further. The whole process would then repeat itself but in an even more dramatic form each time as the income inequality and consolidation gets more and more extreme and the ratio of owners to workers gets even more lopsided.[7]
It is clear in all of these crises of overproduction that production did everything but “generate its own demand”. Given the phenomena of these ever intensifying economic crises in which the specter of overproduction, a generalized glut, was staring in the faces of classical economists, and given the fact that the process causing it was well explained and understood by 1894 (publication of Das Kapital, Band III) at the very latest, it seems unfathomable that most serious economists continued to hold on to the dogma of Say’s law well into the early 20th century.[8] The “ad hoc […] adoption of certain auxiliary hypotheses”[9] or immunization strategy here consisted in an application of the corollary to Say’s law, the quantity theory.
The Quantity Theory of Money as Immunizing Strategy or “Let’s assume a can opener”[10]
There were various ways of explaining away the existence of this general glut and the long term unemployment and recession that accompanied it. One way of trying to save Say’s law was the quantity theory that insisted that there was no rational reason for people to maintain idle cash. According to this view even if it is the case that the money is almost entirely in the hands of the owners of the factories, it does not matter because they will also choose to make that money work for them or spend it rather than leave it in an idle balance. The idea that income distribution is irrelevant for the health of an economy, because those with great wealth will spend and invest their money so as to stimulate innovation and demand and output is an outgrowth of the quantity theory that still haunts macroeconomic policy today. In the early 1980s it took the form of “Reaganomics” or the so-called “Trickle Down Theory”. It was used and still is used as a justification for the massive tax cuts to the rich that have been continually expanding the US budget deficit since 1980, with only a brief slowdown in the process under Bill Clinton. (See Appendix B p. 22) I will investigate the effects and implications of this policy later on in this article.
There are two important factors that this theory ignores, both of which were discovered by John Maynard Keynes. One is the marginal propensity to consume, which is much higher in lower income brackets and the other is the marginal efficiency of capital.
The higher marginal propensity to consume in lower income brackets is due to the fact that working and middle class consumers spend a great deal more of what they earn on necessities. One can see this if one considers the example of tax cuts. If the government cuts one million dollars from its revenue from income taxes and this cut goes to a billionaire, the extra disposable income will not have the same multiplier effect as the same money in the hands of those in lower income brackets. A purely speculative endeavor like the buying of, and potential warehousing of, an apartment house would even represent a net loss to the economy in reduced living space. We see this kind of purely speculative “investment” going on many major cities (see the chart below showing the development of real-estate prices in London).
Other forms of speculative investment that do not or do not efficiently stimulate demand are investments in existing stocks of the type that inflate stock prices far above the market value of the corporation they represent. Real-estate investments, along with the many toxic investments like derivatives, play a big role in forming speculative bubbles that eventually burst. The ensuing crash vaporizes trillions of dollars in equity and ruins the economy. Disposable income in the hands of the working/middle class is much more likely to go into consumption and thus stimulate real output. The extra million in the hands of one billionaire taxpayer may of course also be consumed, but the purchasing of luxury items does not stimulate the economy nearly as much as the purchasing of consumer items. The purchase of one Ferrari for one million will not even come close to stimulating aggregate demand and output like the purchase of 100 Mazdas, which would represent the purchasing power of that one million distributed over 100 middle/working class families. Add to this the fact that many wealthy people have the ability to hide money in offshore accounts, which takes money completely out of the system and deprives the government of future revenue, and you get a general picture that shows that the quantity theory certainly does not guarantee that cash balances, regardless of who has them, will flow one-to-one back into the economy.
The idea that the owner of a large enterprise would automatically reinvest his cash assets simply because he possesses them is simply untrue. An investor is only motivated to invest in new plant, equipment and production, actions that would stimulate employment and output, when he sees a realistic and relatively imminent possibility for a positive return on his investment, something that is not at all the case during an economic downturn. The desire to invest will be stimulated by a favorable marginal utility of capital (the difference between market price and supply price of a good) and on the general outlook or prospect for success in his assessment of the economic situation, something Keynes called “animal spirits”. Keynes showed that this prospect for success and the general level of output depended much more on aggregate demand than on aggregate supply (which clearly does not generate its own demand for the reasons I have outlined).
One of the classical economists who endeavored to preserve Say’s law and the quantity theory was the Swedish economist Knut Wicksell (1851-1926). Wicksell made a detailed analysis of the so-called “real capital market” i.e. the bond market and its relationship to investment and prices. He detailed how the bond market functions to circulate money back into the economy. His simplified model only dealt with bonds, not with stocks, and excluded a whole slew of institutions such as “life insurance companies, savings banks, savings and loan associations, pension funds, investment trusts and so on.”[11] One could very well question the utility of constructing such an economy so far removed from reality in order to preserve a pet theory, but let us allow him the benefit of the doubt and see what he is getting at. The long and short of it is simply that the bond market regulates interest rates and, unlike the “irrational” and “barren” cash account balance, it also transfers money back into the economy. This is because even if someone is buying an old bond, the act of buying provides liquidity for the seller which either goes into consumption by means of spending or to further investment in the bond market, which will either lead to investment if it is a newly issued bond or pass on liquidity to the seller of an old bond. According to Wicksell “so long as no one desires to hold idle balances”[12] the quantity theory would hold true. When full employment and output does not return, it is, according to Wicksell and others, because of one of the other central ad hoc hypotheses of the classical economists. That is to say that the theory is always correct, i.e. immunized, because their model assumes fully flexible wages, prices and interest rates, the latter being of specific importance for Wicksell.[13]
Besides the obvious fact that a market with fully and immediately flexible prices, wages and interest rates exists only in the theoretical model of a classical economist, there is yet another reason why their theory does not work even given their own unrealistic assumptions. The reason is the negative effects of deflation. The theory is that if there is a downturn in production that causes unemployment, it will only be temporary, because nominal wages and prices will fall simultaneously, maintaining real wages, and as soon as prices are low enough, entrepreneurs will invest and hire more workers and the economy will return to full employment. However, deflation of prices has been shown to have a very negative effect both on consumption and investment. As prices fall both investors and consumers will hold on to their cash and the economy will shrink further. This is because they are waiting to see how far prices will fall so they can avoid paying too much. This and the general negative prognosis for the near future with falling demand will depress investment and prolong unemployment.
Arthur Cecil Pigou went even further in doubling down on classical economics in that he believed that a truly instantaneous wage adjustment downward would eliminate unemployment altogether. He even posited that there would be a so-called “Pigou Effect” that would turn deflation into economic recovery because it would increase real balances and stimulate demand.[14]
The fact that workers are unwilling to have their wages lowered so often and so instantaneously in concert with declines in demand seems quite logical, however. This is because the falling prices of the commodities they produce may very well not be reflected in other commodities, like, for example, the agricultural products that they need to survive, which come from a different branch of the economy. There will be significant lag times between wage cuts and the resulting decline in demand that will depress prices and the difference will have to be absorbed in the interim in the form austerity on the part of the workers and their families.
The inadequacies of classical economics were no secret to economists before Keynes; after all, prolonged gluts and severe periods of unemployment had been commonplace all along, and the constant attempt to explain them away with ad hoc hypotheses as either merely a partial phenomenon or the result of sticky wages, prices and interest rates had worn quite thin. Wicksell did much to point the way towards a more aggregate analysis by means of his examination of the real capital market, though he insisted on maintaining the quantity theory. It was not until the work of John Maynard Keynes that an entire unified theory could explain where the classical economists had gone wrong.
Keynes and the Quantity Theory
Keynes achieved something like a “Copernican revolution” analogous to that of Immanuel Kant, in that he changed the entire point of departure from which the economic activity and prosperity of a market should be analyzed. For Keynes the economy did not revolve around supply but around demand. It was aggregate demand that determined supply, and not supply that determined demand, as maintained by the classical economists and Say’s law. The myriad ways in which Say’s law does not hold I have in part explained above. The focus on demand rather than supply, however, opened up many possibilities especially when one jettisons the corollary of the defunct supply principle, namely, the quantity theory.
By analyzing factors like the marginal propensity to consume and the liquidity preference, and by showing that the maintenance of “idle” cash balances is indeed rational in many circumstances, he took direct aim at the quantity theory. Not only was it rational for individuals to have a liquidity preference and thus to not spend every penny they had right away, but the effect of the money supply, either through tax policy or through the buying up of bank bonds by the central bank, was anything but neutral with regard to real output and employment. He also showed the advantages inherent in a sound fiscal policy of direct government investment, the kinds of measures so despised by classical economists, monetarists and Austrian economists alike. By analyzing the marginal propensity to save and the marginal propensity to invest, and by emphasizing demand rather than supply, his theory was also a better way of understanding the causes of private investment and hence provided insight into possible measures to strengthen it.
With regard to the neutrality of money as postulated by the quantity theory, which said that the real economy would be untouched by increases in money supply, Keynes showed that on the contrary there are several multipliers that would not only increase income once but be recycled back into the economy to actually end up creating more real income and output greater than the initial government outlay or boost to the money supply.[15]
The key factor so gleefully ignored by classical economists, “Supply side” economists and monetarists alike is the marginal propensity to consume, which is much higher in lower income brackets. Hence, whether the initial cash for the multiplier is a tax cut, a subsidy or an increase in the money supply, it is not so important where the money is coming from as where it is going and what is going to happen with it. Keynes also saw that an improvement in consumer demand, “animal spirits” or what we would call today “consumer confidence”, is a great deal more crucial to encouraging investment than the real interest rate that people like Wicksell were so concerned with. Furthermore, if we compare the Keynesian approach to the classical one, we see that by breaking the taboo of fiscal policy the state, acting in the public interest and duly elected to do so, can apply the multipliers in a much more precise way. It can choose to build infrastructure that provides construction jobs that act as a multiplier while at the same time increasing the “capital stock” of the country as a whole, potentially increasing the marginal utility of labor and hence employment and output on a permanent basis. If one compares this to the watering can, or better said, fire hose of Federal Reserve money supply that courses through the banking system into private hands of any and all kinds and might end up even hurting the economy by merely financing another speculative bubble, one sees how foolish the generalized hostility towards fiscal policy actually is.
The extreme laissez-faire tendencies of the classical economists and of the Austrian School economists like Hayek and Mises are understandable in historical retrospect. The classical economists were eager to slay the dragon of mercantilist aristocracy, the system by which absolutist tyrants like Charles I and Louis XIV had converted their entire country into their own repressive divine-right piggy bank. The Austrian economists were staring down the throat of an even more ferocious dragon, namely Soviet and Nazi statist totalitarianism. It is no wonder that Mises was so doctrinaire about his individualism that he safeguarded his theories against the left by a conventionalist a priori approach that could not be questioned. It is also not surprising that Hayek would take time at the height of World War II to write a treatise like The Road to Serfdom that condemned Socialists and Nazis alike as “collectivists” who would demolish civilization with their misguided enthusiasm for central planning.
As noble and profound as these thinkers are as representatives of classical liberalism and the centrality of individual rights, one cannot help but realize two very crucial things: 1) The subsequent synthesis of socialism and capitalism that we call social democracy, “Soziale Marktwirtschaft” or simply the “mixed economy”, does not pose the kinds of dangers that these thinkers were concerned with, and at the same time guards against the kind of social stratification that contributes to the kind of radicalism that led to the rise of those totalitarian systems in the first place; and, 2) The modern disciples of these thinkers, the “neoliberals”, in their complete and dogmatic rejection of any real role for government, have in a very real sense “thrown the baby out with the bath water”. Even Hayek admits in The Road to Serfdom that minimum sustenance and a national health care system are not inconsistent with a free society:
There is no reason why, in a society which has reached the general level of wealth ours has, (the certainty of a given minimum of sustenance) should not be guaranteed to all without endangering general freedom; that is: some minimum of food, shelter and clothing, sufficient to preserve health. Nor is there any reason why the state should not help to organize a comprehensive system of social insurance in providing for those common hazards of life against which few can make adequate provision.[16]
To a modern day ideologue of neoliberalism, to a “pundit” or “journalist” like Sean Hannity or Glenn Beck, or to a member of the so-called Tea Party Caucus like Marco Rubio, the words of Friedrich Von Hayek here would be tantamount to Stalinism if not National Socialism, which Ronald Reagan once maintained was only possible because the Germans had made the mistake of accepting a national health care system… the necessary first step to Nazism!
All these absurdities aside, it will be the aim of the next section to point out the very real and catastrophic harm that has been done by neoclassical economics and the neoliberal ideology to the United States and, by extension, much of the world.
Conclusion: Classical Economics and Neoliberalism, 1980 to the present
The takeover of American and British politics by the far right, by Ronald Reagan in 1980 and Margaret Thatcher in 1979, marked a watershed in political and economic policy and the development of western liberal democracy. Like far right takeovers both past and present, this one was made possible in part due to a crisis situation before the elections. The crisis situation in the case of the United States was the poor economy under the Carter administration. In the 70s the United States was plagued by the twin specters of rising unemployment and high inflation simultaneously, a situation known as “stagflation”. According to Keynesian economics unemployment and inflation are supposed to be tradeoffs. Increasing aggregate demand generated either by fiscal or monetary policy will not start to generate inflation until full employment is reached and the extra dollars are chasing capacity that cannot be bought because the economy is at full output. The natural consequence of course is demand-pull inflation. Bonds will have to be sold until the rise in interest rates slows the money supply and cools off the inflation. But here there was high unemployment and high inflation. I am old enough to remember the Carter Administration and the slogan or rather expression of outrage of “double digit inflation!”, which was everywhere to be heard. I even remember a caricature of Carter holding a “new gasoline coupon”, a one dollar bill, which was a horrendously high price for gasoline at the time.
Something had obviously gone wrong with this post-Watergate democratic presidency. This situation gave the so-called “New Right” a chance to strike. They had been building up their base of ultra conservatives and evangelicals using the, at the time, new technology of computer generated mailing lists. Before that point the notion that an actor and politician who was as extremely right-wing as Ronald Reagan could actually become president was unthinkable.
The bad economy, or more specifically, the phenomenon of stagflation, gave another right-wing movement the opportunity to strike. Milton Friedman and his monetarist Chicago School along with long-time Ayn Rand disciple, Alan Greenspan, entered the stage. The fact that the now “debunked” Keynesianism supposedly could not explain stagflation, while monetarism “could”, gave Friedman a legitimacy that he otherwise would not have achieved.
On closer examination, however, it becomes clear that this whole ascendance of monetarism was a fraud. It was a fraud because the reason for the stagflation was not any deficiency in the Keynesian model at all. The inflation was not demand-pull inflation caused by an overly active fiscal and monetary policy perverting the economy with a bloated money supply. The government was already issuing bonds to raise interest rates to stop the inflation, but it would not be stopped. That was because it was not demand-pull inflation but cost-push inflation caused by an exogenous shock from outside the system that had nothing to do with the Keynesian model at all, namely the two oil crises of 1973 and 1979.
I remember this latter crisis in particular. Gasoline was actually rationed and you had to line up at the gas station at something like 3 AM and sleep in your car if you wanted to buy gas the next day. As the chief raw material for heat, electricity and transportation, oil was a cost factor that affected the price of everything:
The direct relationship between oil and inflation was evident in the 1970s, when the cost of oil rose from a nominal price of $3 before the 1973 oil crisis to around $40 during the 1979 oil crisis. This helped cause the consumer price index (CPI), a key measure of inflation, to more than double to 86.30 by the end of 1980 from 41.20 in early 1972. To put this into greater perspective, while it had previously taken 24 years (1947-1971) for the CPI to double, it took about eight years during the 1970s.[17]
This was a phenomenon that was neither the fault of the Carter administration nor of John Maynard Keynes, but nonetheless it made Carter a one-term president, enabled a right-wing government far outside the previously acceptable political spectrum to take power, and it allowed for the fraudulent canonization of an economic theory that has dictated much of America’s economic policy ever since, with results that are quite catastrophic, in my view.
The period that one might refer to as “the Keynesian” era in America was from the 1950s through the 1970s, and is recognized on all sides as the time when the United States “had a middle class that was the envy of the world”, to paraphrase a typical phrase referring to this time. This prosperity was characterized by a good deal of public investment in infrastructure, defense, the space program and in education, both in the form of the “GI Bill” that gave scholarships to veterans to top universities, and to free public colleges for anyone in many states. Under the Republican president Dwight Eisenhower there was a marginal tax rate of 90%. Of course people could lower that bill by making charitable donations or by investing it into their companies, i.e. putting that money to good use that would also benefit the economy. It was a time of great optimism and prosperity in which every new generation knew that it would be doing better than the one before.
Since 1980 that trend has been dramatically reversed. Regardless of political stripe the one thing all Americans basically agree on is that something has gone wrong with the so-called “American Dream”. As you can see in the charts at the end of this article, real wages have stagnated and declined, homelessness and destitution have risen dramatically, as has the prison population and the number of people receiving food stamps, many of them working fulltime. The United States has the most expensive healthcare system in the world per capita but is practically the only industrialized nation in the world without a national healthcare system, and there are about 40 million people uninsured. The level of income inequality is staggering, with 45% of all new income going to the top 1% and the top 1/10th of 1% owning as much wealth as the bottom 90%. (See charts below). At the same time the phrase “America’s crumbling infrastructure” has become a political slogan and is a problem everywhere about which nothing at all is really being done.
Why, you may ask, is all this happening in the richest, most powerful country in the world, which has prided itself on being the world’s foremost democracy? Well one quite decisive part of the problem is the economic policy that I have been describing. Combined with the reactionary, mostly Confederate in origin, contempt for the central government, this policy has led to one tax cut after another ever since Reagan, again with a brief respite during the Clinton administration. Because of defense spending and successive tax cuts for the wealthy, that top marginal tax rate that was 90% under Eisenhower is now 39.6%. The result of this has been an enormous explosion in public debt. The party that calls itself “conservative” has built up a level of debt, adjusting for GDP, matching the US debt during World War II when the US was in a great war to save western civilization from the threat of fascism (See charts below).
The tax cuts that are passed are of great benefit to the donor class who rewards the efforts of the politicians who have voted for the tax cuts in the form of bribes, otherwise known as campaign contributions. The growth in the costs of political campaigns has exceeded even the exploding costs of healthcare (see figure) and the last presidential campaign was the most expensive, estimated at over $6 billion. The corruption of this nature has been greatly expanded and facilitated by a Supreme Court case in 2010 entitled “Citizens United vs. US Board of Elections”. Because of this decision it is now legal for foundations, private persons, corporations, mega Churches, think tanks, etc. to spend unlimited funds to produce and broadcast advertising in favor of or against any candidate they choose, wherever and whenever they choose, and they are allowed to do so anonymously. These organizations are so powerful they go so far as to actually write and hand off legislative drafts to the politician that comes groveling to their door so the group can buy him the election.
This kind of corruption is made possible by an economic policy based on a ruling class ideological concoction masquerading as a social science. The quantity theory of money asserts that leaving money in the economy, no matter who has it, will stimulate aggregate demand better than either fiscal or monetary policy, and as a result proposes tax cuts to the rich as the be all and end all of economic policy. The think tanks and lobbyists that construct the propaganda behind this myth spread this gospel to both politicians and public alike.
The quantity theory is also totally obsolete and dangerous for another reason. Because of the fact that it is based on the notion of metallic or gold backed currency, it is woefully incapable of dealing with what money has become. Since Nixon took America off the gold standard in 1973 the essential nature of money has changed. It is now almost a kind of fictitious money that can be generated by central banks in the trillions at will, with vast and profound implications for the structure and distribution of wealth, financial markets and the business cycle. The long term effects this has on accumulation, power relations and on economic life in general I will have to consider in another article.
For now I would say that it is essential to unmask the remnants of the classical theory for what they are: an immunized theoretical construct designed to benefit the privileged few over the increasingly desperate many.
I would like to close with two quotes, one from Ludwig von Mises and the other is from Milton Friedman:
“The free development of the market economy is to be recommended, not in the interest of the rich, but in the interest of the masses of the people.”
Ludwig Von Mises
“One of the great mistakes is to judge policies and programs by their intentions rather than their results.”
Milton Friedman
I would urge those who consider themselves the disciples of these two men to take these two quotes particularly to heart, to not judge by “intentions” but rather by “results”, and to renounce what can only be seen as a disastrous set of policies that have quite obviously failed to serve “the interest of the masses of the people”.
Charts
[1] Marx, Preface to the Contribution to the Critique of Political Economy, 1859.
[2] “Whenever the ‘classical’ system of the day is threatened by the results of new experiments which might be interpreted as falsifications according to my point of view, the system will appear unshaken to the conventionalist. He will explain away the inconsistencies which may have arisen; perhaps by blaming our inadequate mastery of the system. Or he will eliminate them by suggesting ad hoc the adoption of certain auxiliary hypotheses, or perhaps of certain corrections to our measuring equipment.” Karl Popper, The Logic of Scientific Discovery, Routledge Edition, 1992, pp. 59-60 (Originally Logik der Forschung, 1935).
[3] It was in fact the case during the time in which Say was writing his book that revolutionary France was still using paper money in the form of the so-called “assignat” which was not backed by precious metal but by confiscated Church land. Its overproduction had led to the hyperinflation that accompanied the downfall of the First Republic. It was not until the year of publication of Say’s Treatise, in 1803, that a new gold franc was issued.
[4] Ackley, Gardner Macro Economic Theory and Policy, Macmillan Publishing Co. Inc., New York, NY, 1978, pp. 88.
[5] Bulletin of the United States Bureau of Labor, No. 18, Volume III,” (September 1898) : pp. 5-33.
[6] History Today, 29 February, 2012.
[7] Karl Marx, CAPITAL VOLUME III, Chapter XV Exposition of the Internal Contradictions of the Law p. 256.
[8] Hansen, Alvin H. A Guide to Keynes, McGraw-Hill Book Company, Inc., New York, 1953, pp. 3-20.
[9] Popper, 1992, p. 60.
[10] From a well-known joke satirizing an economist on a desert island trying to open a can of food by assuming he has a can opener, i.e. an ad hoc hypothesis in the Popperian sense.
[11] Ackley, 1976 p. 126.
[12] Ibid p. 134.
[13] Ibid pp. 124-153.
[14]Hansen, 1953 pp. 178-182.
[15] John Maynard Keynes, The General Theory of Employment Interest and Money, 1936, pp. 114-131.
[16] Friedrich Von Hayek, The Road to Serfdom, Routledge, 1944, pp. 66-67.
[17] www.investopedia.com/ask/answers/06/oilpricesinflation.asp
