Why I will never be a Keynesian.

• Author: Epstein, Richard A.

Necessity is both the mother of invention and the source of self-reflection. Nowhere is the latter more true than in social and economic affairs, where massive social and economic dislocations rightly prompt leading theorists to reexamine their fundamental beliefs in trying to figure out, as Paul Krugman framed the question: "Just what went wrong?" (1) Unfortunately, these bouts of self-doubt have led many prominent thinkers to turn their attention back to the leading economic thinker during a past depression, John Maynard Keynes, and his most famous tome--book does not quite do--The General Theory of Employment, Interest and Money. (2) The tome appeared in 1936, during the depths of the Great Depression that had been running for seven years and counting. Clearly the book did not cause the Depression, but it did not do anything to abate it either. That only happened with the onset of a far greater tragedy, the Second World War.

I confess that in my youth I purchased a copy of Keynes's masterpiece. Dutifully, I sought to read it several times, only to give up in frustration while trying to wade through its turgid prose. Fortunately, it is not necessary to plow through Keynes in order to get some sense of his basic position. Today's skillful expositors, including my colleague Judge Richard A. Posner, have provided lucid explanations of the Keynesian position. (3) Judge Posner's fascination with Keynes has led to a belated confession of past sins, chief of which is an excessive devotion to Chicago-type economics on both the macro and the micro levels. Thus, he tellingly writes: "Economists may have forgotten The General Theory and moved on, but economics has not outgrown it, or the informal mode of argument that it exemplifies, which can illuminate nooks and crannies that are closed to mathematics." (4) I yield to no one in the insistence that critical institutional detail often reveals far more than mathematical equations about the operation of the economic system. But that one point alone is consistent with the work of such theorists as Ronald Coase and such institutionalists as Douglass North, neither of whom is steeped in the occult mathematical arts.

Try as I may, however, I cannot yield to the same level of open-mindedness on this subject that Posner expresses. I come away from reading the new Keynesians more convinced than ever that they lack a coherent diagnosis of the origins and depths of the Depression. By implication, they lack a sensible program to shake the current economic malaise. President Barack Obama may be in the thrall of Keynesian economics, or perhaps just captured by the labor unions. But either way, any move to a larger governmental role in planning or stimulating the economy is likely to make the current recession deeper and the recovery slower than they ought to be.

To develop this thesis, I shall proceed in two parts. Part I deals with those issues that the Keynesians either forgot or swept under the table. In this context, I address not only the distinctive features in the current economic situation, but also those structural from the 1930s, many of which have still not run their course today. My point here is not that Keynes or modern Keynesians necessarily support these dangerous precedents. It is that they have nothing distinctive to contribute to their resolution that is not already understood within the standard neoclassical framework.

Part II takes a closer look at the inner workings of the theory to explain why any centralized effort to rejigger aggregate levels of consumption or savings will only make the task of economic recovery more perilous. There is no reason to try to establish some collective priority of one type of behavior over the other. The key move is to eliminate waste so as to allow both savings and consumption to expand, without trying at the center to find what Robert Nozick rightly called "patterned principles" (5)--an effort that always turns out to misfire. The only way to move forward on both dimensions at once is to avoid the major mistakes of industrial policy identified in the first portion of this paper.

1. THE MANY SOURCES OF ECONOMIC DECAY

   At first glance, we should all be impressed by the apparent breadth of Keynes's title, which seeks to link employment, interest, and money into a single theory. Success in unifying these three large classes of events has to count as a signal achievement in economic thought. But, by the same token, that synthesis should not be regarded as a comprehensive explanation of how the economy works in practice. Its scope is incomplete, and hence it gives only weak information about how to correct perceived economic imbalances, whether during the Great Depression or today. So it is useful to mention some of the issues that are missing from the Keynesian theory, each of which plays a real role in the operation of the economy.

   Free trade is the first topic not covered by Keynes's title, nor mentioned in Posner's recent salute to his new master. Keynes's writing on this point seems to indicate some sympathy with the laissez-faire position, for he surely understood the risks of mercantilist policies. (6) By the same token, however, Keynes also thinks that a bit of governmental oversight would not be all that bad. (7) Indeed, it would be hard for Keynes to maintain a strong free trade perspective given his own view that we cannot trust laissez-faire capitalism to determine "the current volume of investment." (8) The connection between the foreign and domestic markets is too intimate to let international trade run its course. Yet notwithstanding Keynes's doubts on the subject, vibrant international trade is clearly important to the overall health of the economy today, and it was also important (albeit at a smaller level) when transportation and communications costs were higher during the Depression. This observation is hardly new; the debate over free trade came to a head just before the passage of the Smoot-Hawley Tariff Act of 1930, (9) which put a serious kibosh on international exchange. The basic mechanics of comparative advantage as they apply to free trade have been well discussed in the work of Adam Smith (10) and David Ricardo, (11) in the late eighteenth and early nineteenth centuries. Their insights were widely disregarded by the Republican Party, whose 1928 platform revealed protectionist preferences that later became law. (12)

   The danger of this protectionist position was not completely lost in the pre-Keynes years. In 1930, a large group of economists, 1028 in all, led by Paul Douglas of the University of Chicago, drafted an impassioned plea to Congress not to pass the legislation. (13) That denunciation of Smoot-Hawley noted that any tariff increase would force distortions in domestic and foreign markets that would reduce overall levels of production to the detriment of consumers, encourage retaliation that would only make matters worse, hamper those in local service industries who had nothing to fear from foreign competition, and harm farmers by forcing them to pay more as consumers and shutting down their access to foreign markets. The letter even quoted President Herbert Hoover's cautionary words that "[i]t is obviously unwise protection which sacrifices a greater amount of employment in exports to gain a less amount of employment from imports." (14) There may be some doubt as to the exact extent of the damage caused by Smoot-Hawley given that total exports and imports were less than six percent of Gross Domestic Product at the time. (15) But there can be no doubt that it had a negative effect. President Hoover may have known all this, but the business pressure for protectionism was tough to resist. World trade shriveled, and, in part because of poor economic circumstances, a climate of unrest led to the rise of fascism and Nazism.

   It is not, of course, proper to charge Keynes with fostering these counterproductive maneuvers. It is sufficient to say that his general theory neglected to warn against such misguided government interventions, which are easily condemned within the standard neoclassical framework. So even if we were to classify Keynes and Posner as ardent champions of free trade, nothing about that position stems from the unique insights of a Keynesian theory.

   Nor should we regard these insights as unimportant today. We are blessed insofar as there is no powerful coalition in support of a return to Smoot-Hawley. The defenders of protectionism tend to rely instead on more modest claims, such as the inability to conduct "free and fair" trade--fear the "fair" in this formulation--with nations that do not maintain appropriate labor or environmental standards. Concern for fair trade has, for example, stalled various bilateral free trade agreements with Colombia. (16) But this effort to use trade policy to meddle in the internal business of foreign nations is a dead loser. We should trade with them whenever it works to our mutual advantage. The lure of foreign trade should help to discipline and rationalize internal productive capacities in both nations (thus bleeding out the monopoly power of unions), and with the increase in domestic wealth, we can confidently predict an expansion in efforts at environmental protection. No one wants to live in a mansion if he cannot breathe the outside air when he steps into his backyard. And so prosperity from free trade, and not protectionism, will increase pressure for sustainable environmental improvements.

   Tax policy also deserves more attention. It represented one of the key mistakes of the Hoover Administration, which in its own way was as misguided on tax matters as President Franklin Delano Roosevelt's New Deal was on social politics. In particular, President Hoover's Revenue Act of 1932 raised the top marginal tax rate from twenty-five to sixty-three percent in order to staunch the deficit at the federal level. (17) We hear similar calls for higher...