Friday, January 16, 2009

Mainstream Economics (or why we are in deep trouble)

My apologies for the lack of post recently. It is not through lack of work on the blog, but rather that I now have two posts (one of which is very long and detailed) sitting in draft form but which I am not inclined to publish. They will probably be deleted after I finish this post.

One of the posts I hesitated to publish, as I have been worried that I am obsessing about China's role in the world economy, and the post was quite heavily centred towards China. In the second of the posts, I was taking an overview of the world economy, and was falling into the trap of obsessing about the details of national current account balances, external debts, and a whole host of figures. I even started to try to develop a standard way of looking at the prospects for different countries.

This kind of standardisation is the economist's trap, stopping using thought and replacing it with dogmatic theory and equations. I have noticed that the dismal science (the nickname for economics) has been coming under some fire of late, and I believe it deserves to be under attack.

With a few notable exceptions, the economists have completely failed to spot this catastrophe, and failed to even notice that the world labour force had doubled in the space of ten years (for new readers - this is one of the key themes of this blog, explained in context here). Perhaps the most worrying part is that, even though the crisis is now upon us, now that there are massive upheavals in the world economy, this 'little detail' of the doubling of the global work force has still not registered as a possible cause in the minds of economists.

I can not emphasise this enough - the world has just gone through what is possibly the greatest supply shock in history, and the entire economics profession has missed it. It is quite simply astonishing.

However, for a short time, as I was writing the second post, I fell into the same way of thinking as economists. I thought that I could create a formulaic way of understanding the positions of countries in the world economy relative to each other. Such an idea is, of course, impossible. Each country has too many individual characteristics, quirks, features and circumstances to be neatly slotted into an easy formula.

I was recently speaking with a friend, who is very interested in economics, and who asks difficult and challenging questions (which is a very good thing). He asked me to explain how it is that Germany with its social democratic system, encompassing many structural features abhorrent to free market economists, has such a successful export machine. I will confess that I was stumped to come up with an easy answer, and was left to waffle about German culture.

Now I have said that I was waffling about German culture, but this is to be unfair to myself. I have worked for a German company and have seen their business culture close up. I have also worked for a French company (in two joint ventures in China), a US company, and a British company. In all of these cases I was also working with companies internationally (they were all multinational companies), and have therefore worked indirectly with a very wide range of people of different nationalities - from Japanese, Spanish, Italian, Swedish, Australian through to Vietnamese and so forth.

What I can tell you with absolute certainty is that each culture brings with it certain strengths and weaknesses in business, and these strengths and weaknesses must impact upon the economic strength of their countries. It is, of course, difficult to generalise and encode such cultural strengths and weaknesses, so economists pretend that they are not there. However, such strengths and weaknesses do play out in the real world, and do have an impact.

As a simple example, if something goes wrong because one of your suppliers has let you down, a UK company might explain to their customer that the problem was that of their supplier. The Japanese company by contrast would be more likely to say that it is their problem, as they chose the supplier. In this case I am generalising based upon personal experience, and whether such experience can create a generalisation can be a matter of argument. It is not a firm fact, but a personal interpretation of experience. However, if the generalisation is broadly correct, it has profound implications for the way in which business operates in the UK and Japan, and this in turn has impacts upon the economy overall. Whether in this case I am right or wrong, it is impossible to deny the impact of such cultural factors - but this is just what economists do. There is a reality disconnect in the way they think about the world.

The point I am trying to make here is that economics is not about clever formulas, and complex equations, but is about who is the most competitive at providing goods and services. It is for good reason that marketing is sometimes called applied economics, because all economics finally comes down to the choices of individuals who are the final decision makers in a county's economic success or failure. At its most basic it is the question of 'do I buy product x from the Japanese, German or US company?' If, across an economy, lots of people are making choices to buy goods from, for example, Japanese companies, then the Japanese economy will likely prosper from such decisions.

It is within such decisions that economics really resides. The factors that determine such decisions are very complex at the level of the purchaser. However, if we look at each country, we will see that they will offer various strengths and weaknesses which will determine part of that purchase choice. In one case a country may have a costly government overhead that is reflected in the cost of operating a business, but companies might offset such costs with high productivity and/or a culture of innovation. In another case, it might be that government overhead is low and productivity is relatively low, but the conjunction of the two still offers a competitive advantage. The permutations are endless and each individual business may be different, each will respond to their broader environment in different ways, but overall there will be general strengths and weaknesses in each economy.

Such individual differences in economies make a difference, and can not be reduced to simple formulas. How can you provide a formula for a culture of innovation?

To give an idea of the complexity, some examples of factors that will determine success of an individual national economy are culture, law, taxation, regulation, type of education, levels of education, social stability, social support systems, size of internal market, availability of natural resources. This is just a selection from the top of my head, and a little further thought would produce any number of additional factors, some of which you might think are more or less important than those that have been listed.

The point here is that there is no formula for success, no secret 'Goldilocks' formula that is 'just right'. It is for this reason that mainstream economists struggle so much. They try to imagine a formulaic answers to economics, and forget that what finally drives economic success is the decision of a person purchasing a product or service finally drives the process from the bottom up. What finally drives such choices is not based upon a formula, but how the many factors impacting upon an individual business come together, and how that business works with those factors to advantage or disadvantage withing their particular market.

All of this is not to say that the big picture of economics is without merit, in other words that macro economics is without merit. Just as any economist uses the big picture numbers, so do I. However, regular readers will have noted, for example, that I have talked about the hard working culture of the Chinese in my discussions. In other words, whilst looking at the numbers, it is necessary to incorporate subjective judgements on top of the numbers. No equation can account for the many factors for success or failure in circumstances of so much complexity.

Not only is it necessary to combine the numbers with subjective judgements, but it is also necessary to think about what the numbers actually mean. Again, economists have got into a rut, and seem to accept numbers at their face value. It is such complacency that has made a fetish out of GDP figures. As I have pointed out (endlessly), the GDP figures that have been watched so closely have incorporated debt fuelled consumption multiplied into huge activity in the economy. Steady GDP growth in Western economies became a fetish, and everyone forgot to ask what the source of the activity might be. It was a dogmatic formula that stopped people from thinking. The formula was constant GDP growth = economy performing well. Quite simply, it was wrong, and is proven to be wrong. Activity built in debt fuelled consumption has to be paid for by less consumption activity in the future.

The problems of economic thought run far deeper than this however. I have been reading a lot of philosophy of science of late and, by accident, came across an academic paper discussing an absurd economic theory (1). The absurd theory in question approximates to a theory that drug addicts were making rational choices, and the author points out how completely absurd the theory is. I will not discuss the details of the argument regarding why this economic theory was absurd, but rather his conclusions about the way in which economic theory operates. He points to the absurdity of the models that they created, and how clever these models appeared to be. However, the models were all founded upon assumptions with no solid grounding whatsoever, and a little thought on their assumptions simply revealed that the economists were talking nonsense.

Such absurdity is currently all around us. For example, we see it in the policy of quantitative easing. Such discussions are always surrounded by dense economic theory, jargon and buzzwords. Even the expression quantitative easing does not express what it really means, which is a massive creation of money from nothing.

This is a policy in which there is a 'fetishisation' of economic activity, rather than productive economic activity. If there is not enough credit flowing through the economy, then government will make the credit out of thin air. At the heart of this thinking, if we really think about it, is the belief that wealth can be created, not through labour and innovation, but through government command. It is also the belief that if businesses are borrowing, consumers are borrowing, then the economy will be fine. The fact that printing money is merely redistributing the value of money does not seem to cross their minds, and it appears that they actually think they are actually creating money, rather than destroying the value of money. The fact that within the economies there is simply not enough real wealth creation to support this new money is completely absent from their thinking.

The same argument goes for the revival of Keynesian spending. I wish I could find the article to reference it here, but I read the most clear and concise description of why the Keynesian theory of government borrowing and spending is simply absurd. Essentially, under the theory, building something with absolutely no value is a good thing, as it increases economic activity. It is related to the theory that smashing a shop window is a good thing, as this also creates activity. Another article points out how prevalent window smashing view is, and how utterly silly it is. An example in the article quotes several reputable sources who proposed that the bright side of Hurricane Katrina was that it would create a boost to economic growth - through creating a stimulus for activity in the economy. After all, the massive damage meant that there would be a need for lots of new construction and so forth.....

These are the ideas that are prevalent in mainstream economics. Such thinking would see an economy in which we would build a new skyscraper, knock it down the day after it was built, in order to build it again. The fact that nobody might want to live in, or hire office space in the skyscraper is irrelevant, as it will create economic activity. Economic activity is 'good' for the economy.

Of course, when it is presented to the public, it is never presented in these terms. It is investment in infrastructure, or couched in terms of economic stimulus and so forth. However, it was investment, then it would be done anyway. It would have a reasonable probability that it would produce a return on the capital, and therefore would attract the capital. As for the idea that it is a 'stimulus', yes it is a 'stimulus'. However, the idea that a stimulus can only be good is a fundamentally absurd idea. If a person gives me an ice cream this is a stimulus, but if a person gives me an electric shock this is also a stimulus. I think that the former is good and the latter is very bad indeed.

In the case of all government stimuli, the money for the stimuli does not come from the government, but in all cases comes from the tax payer. It is either taken from the tax payer in the form of inflation or through direct taxation. The taxpayer's money is then used to do the equivalent of building a skyscraper which no one wants. How can this be a good thing? Would it not be better that the tax payers use that money for something that they actually want? Would it not be better that the money was available for saving, which means that it is available for investment, and can then be used for investment in something that produces things that people actually want? Nobody wants the skyscraper. Why on earth build it? It is literally flushing all of that labour and material down the drain. It moves resources into quite literally pointless activity.

These are the answers governments to the economic crisis. Making money out of thin air, and redirecting the capital of nations into completely pointless activity.

To add insult to injury, they are also pouring money into bankrupt banks. They are literally pouring money into black holes resultant from bad / irresponsible lending and investment. Today comes news of a massive additional bailout of Bank of America of $US 138 billion. This is not money from the government but, one way or another, is money provided by every tax payer in the US. The difference here is that, instead of using that tax payer money to build a useless sky scraper that no one wants, they are simply destroying the value of money, as the funding for such activity will inevitably end up being achieved through money creation and inflation. Will this actually result in any new wealth creation, will that money ever lead to real productive activity?

The answer is that this is not even in the discussion. It is simply beyond mainstream economists to ask this question - as all they are seeking is activity in an economy. They want to stimulate lending and credit, and do not care how it is done because, as long as people are spending, then all is fine. Spending is activity, and activity in an economy means a good economy. After all, GDP growth is 'good' and GDP growth measures activity.....

Such a view can only be described as delusional, and it is the recognition of this delusion that started this blog (with my essay 'A funny View of Wealth').

As a blogger, I freely confess that I am not a trained economist. I have simply looked at the world around me, and have found that many of the ideas of mainstream economists are simply absurd (which is reflected in the 'I just don't buy you?' in the title of the blog). I have been a regular reader of the Economist, have read Adam Smith, and have an economics textbook as a reference. The only use I have for the textbook is in understanding the jargon of economics, so that I can understand the underlying principles of what is being discussed. Beyond that, the book is largely useless. As a technical explanation of the current economic structure it is fine, but as an explanation of the underlying economic world it is hopeless.

Since I started writing this blog, I have relied largely upon the observation of the real world and critical thought to get me through. None of what I have considered has been rooted in theory x or theory y. However, as I have written the blog, I have been increasingly exposed to different paradigms of economic thought, and ever greater depth of discussion of economic theory. What I have found is that there are voices in the world of economics that are also expressing their concern, that there are several others who also 'do not buy it' (e.g. the Austrian School of Economics). However, these voices are are ignored by governments and, as a result, Keynesian thinking has been alive and well in government (in various modified forms), for a very long time.

This mainstream thinking has been with us for a very long time, and has led to economies - such as the UK and US - being left in a terribly vulnerable state. I can not emphasise enough that it is a paradigm that can produce some of the most absurd thinking. It is a world in which Hurricane Katrina's after effects would recorded as an upwards blip in GDP growth, a world in which this 'growth' would be recorded as a positive thing. It is a world in which havoc and destruction can become a 'good thing'. If you want to understand the underlying principles of the economic mainstream, just keep this in mind. Hurricane Katrina = increased activity = GDP growth = good economy.

I have noted that many people who link to this blog, whilst positive about what is said, also give warning that it does not make pleasant reading, that it is a 'doom' blog. When we think that those who are deciding our economic destiny, people who think that the idea of building a sky scraper before knocking it down again might be a good idea, that creating money out of nothing is good, that Hurricane Katrina is good for the US economy, how can this blog be anything other than pessimistic?

Note Added Same Day: I have already had a couple of comments on this post and, at risk of messing up the RSS feed, will publish a reply. One comment goes to the heart of the problem with Keynesian spending.

The comment comes from Stever Tierney (see comment below), a regular and well informed commentator on the blog. Steve's comment was of great interest, as he has offered up the fairly standard answers for why a Keynesian boost is a good thing (this is not being rude, but an observation that you have understood the arguments). I recommend that you read Steve's comment before reading on.

The first point is this. Steve says the following:
'If the government uses the money to build a school, thats not something nobody wants. .'
If the school was something that really was of such value, why was the school not built before? It is a very peculiar idea that, at the very time you are most short of cash, that you start finding a mass of projects that, at the time that you did have cash, were not of great enough importance to spend money on. Is this coincidence? Last year, we did not need the school, this year we do need it. This year it is an investment, but last year it would have been a waste of money. It all seems very convenient that all of these 'good' projects have suddenly appeared as good projects, and are suddenly no longer a waste of money. A bad project yesterday, but a good one today.....

It really does not make any sense at all. A project is either worthwhile or not worthwhile, and unless there is a huge coincidence, nearly all of these projects were deemed a waste of money (or they would have been undertaken) - right up until someone opened the government floodgates of spending. I really don't buy it....

...and please, do not anyone suggest that the project would always have been done if the money had been available.....

If a project is an 'investment' it will create a return. A government can (normally) borrow extremely cheaply, such that even a very small return on the investment would be justification. As such the money is always there, it is just that the spending can not be justified in any way that looks reasonable or coherent.

As such I will continue on an assumption that this is spending that has no underlying need.

In the case of building the school, there is more that can be said. If the school is being built as a replacement for a school that is already there, the old school will cease to be a school. In this case, we are back to knocking down sky scrapers so we can build a new one (I know that it might be possible to sell the old building, but the principle is there, as the new building is almost certainly going to cost much more than the old, or the new school would have been build already if it was necessary/desirable).

On the other hand, if we are going to build an additional school, then we are back in the situation of building the sky scraper that nobody wants to live in. Even worse, in the case of a school, it is an additional cost, and provides no income. At least with a half full sky scraper there is some possibility of some income to offset the costs of maintaining the building. In this case, not only is the building surplus to needs, but it will probably be an ongoing drain on the finances. In other words it will add costs but with very little benefit - it will just make the education system that bit more inefficient.

There are several other examples given by Steve, and I will leave you to work them out yourselves. There is, however, another argument put forward by Steve, and it concurs with the general points made by defenders of the current proposals for the Keynesian spending spree. I will quote Steve again:
Bridges and schools and roads and the like do have to be built. If the government 'moves the building forward' that was going to be done sooner or later anyway so as to keep people in jobs and prevent normally-viable businesses closing down that is not necessarily the wrong thing to do.
This is the 'moving the building forward' argument. It might be summarised as, we were going to spend the money anyway, so why not just bring it forward. However, as these proposals are put forward, you will note there is a silence on the question of the future. Do we hear that there will be binding cuts on future expenditure on infrastructure? Do we actually believe that, in two years time, the money spent on the project today that was planned for two years time will actually be taken off the future infrastructure budgets? Do we really believe that, as these projects are moved forward, we will see a commensurate shrinking of future budgets. If a project is bought forwards 2 years, then in two years time will we see the same amount removed from the budget in 2 years, that a project bought forward three year will see the same amount removed from the budget in 3 years, and so on...

I think to believe that this will be the case is simply unrealistic. Furthermore, if the government were to do so, then the economy would simply contract by the amount of the expenditure now as a cut in the future. In this case, what has been gained? However, regarding the idea that they would cut the budget, I simply do not believe it. As such all of this so called 'bringing forward' is really just additional spending, and therefore falls under the 'building sky scrapers that nobody wants' argument.

Finally, steve gives the following argument:
After all, those still-employed people will otherwise be claiming benefits, defaulting on their mortgages etc.
Yes, people will otherwise claim benefits, but there is a significant difference in the cost of employing people to build infrastructure that is not needed, and the cost of benefits. The former solution is very, very much more expensive. Such an argument only makes sense if the projects on which these people are employed can be justified on their own merits. However, as I hope I have demonstrated, these projects are the equivalent of my original sky scraper argument. They are pointless projects.

As for saving individuals from defaulting on mortgages, this is the same as just paying their mortgages directly. Is this really a solution? Why not cut out all of the costs of concrete, earth movers, and the other costs associated with building infrastructure, and just have the government pay mortgages. When it is put this way, suddenly (I would imagine) it becomes less attractive as a solution.

As much as the government tries to bury it, spending is just spending, and it is not investment. Furthermore the spending is paid for out of taxes. The amount of wealth that the economy creates/has stored is fixed at any moment in time. What is happening when Keynesian spending takes place is that the government spends a greater proportion of that actual wealth at the expense of the taxpayers.

I must make this 100% clear. There is no new wealth, just a redistribution of wealth.

If people pay more tax, they have less money with which to consume and save. If they have less money with which to consume, there will be a commensurate decline in the situation of those companies that support such consumption. If they have less to save, their will be a commensurate decline in the accumulation of capital available for investments.

Added to this, if the government is borrowing to pay for the spending, then they are borrowing from a finite base of capital, thereby acting as a competitor for capital with private business. as such, the government borrows at the expense of private business borrowing. Furthermore, in the future, the government will have to increase taxation to pay for the borrowing, thereby creating a contraction in the economy in the future.

If governments pay for the spending through printing money, they are paying for the spending through the indirect taxation of money. As fast as they print the money, they are taxing every investments, every item of expenditure, through the transfer of wealth from the existing money supply onto the new money (you can not give money value through printing it, it must take the value from the existing money supply). In such a situation, the amount of money printed will match the value taken from the existing money supply so that, as fast as you are printing the money, you are removing exactly that amount from the existing money as a form of tax.

As I have said, there is no new wealth added in Keynesian spending, just a transfer of money from individuals to the government.

An then we think what the government is doing with that money.....

If we think of what that same money might do in the hands of individuals, or as savings available for investment in private enterprise....

A quick note: Lemming has mentioned that productive activity is an idea that is difficult to pin down. I can understand the point Lemming makes in his comments, and sympathise with the views. However, it is not up to us to decide what others value in their lives. For example, if they are foolish enough to buy an over-priced car, that is their own foolish choice. I am not sure how or why we should interfere with such choices.

Note Added Same Day:

I have had no less than three comments from a commentator, Lord Keynes. Perhaps as a result of his name he is offering a defence of Keynesian approaches. I think that he must have been writing his comment as I was writing my reply to Steve Tierney, so I will not address the 1st comment (unless he believes I have not addressed it). However, I will address the other two posts.

In the first of the two, he says the following:
(1) For example, we see it in the policy of quantitative easing … Even the expression quantitative easing does not express what it really means, which is a massive creation of money from nothing.

(2) In the case of all government stimuli, the money for the stimuli does not come from the government, but in all cases comes from the tax payer. It is either taken from the tax payer in the form of inflation or through direct taxation.

Does not statement (2) contradict statement (1)?
He is quite right, that this is a contradiction. On the one hand, governments treat it as if they are making money by magic, but the reality is that there is actually no real money created, just 'funny money'. I perhaps should have been more precise. When I mean I say creation of money from nothing, I should specify that that this is delusional perception. I am very clear that there is a transfer of value from the existing money supply, so I think I have made this clear elsewhere. I should make the distinction between what mainstream economists think, and what actually happens.

With regards to the second point, I am not sure I am clear on the point being made. Can you clarify your question? The ability of central banks to create money is not, I believe, a matter of great contention. The matter of contention is whether they should be able to do so, or how much money they should be able to create under what circumstances (for those that accept the principle). Of course, the terms in which money creation is discussed is never explicit, but that is another matter...

On the subject of Keynesian spending, Lord Keynes says the following regarding the school example, and presents a new argument:
Because schools are nearly always built with public money, and there has been a persistent trend since 1979 (the advent of neo-liberalism) in Western countries to cut public spending. Education was one of the many things to suffer.
This is an argument that is one in which it is now suggested that the spending now is being used to make up for past failures to spend. In this we start hitting one of the problems not with Keynesian theory, but with the way that is being applied. In simplistic terms, the idea is that governments should pay down deficits during the 'good times'. However, this has not been done, and the suggestion here is that not only has this not been done, but expenditure on infrastructure has also been neglected. As such there has been deficits and neglect of the infrastructure.

Does this not say something about the terrible underlying state of the economy?

As it is, the UK government share of UK GDP has risen, and the US GDP share has fluctuated somewhat, but not changed dramatically. In absolute terms in both cases the spending by governments have increased. As such, whilst it might be claimed that education budgets have been cut, this chart here actually shows the growth in educational spending in the US. What we have is actually greater spending, and yet we have claims that the infrastructure has the answer is to spend yet more to fix problems that occurred as a result of lack of enough spending in the good times, times in which spending increased.

The question this raises is: how much is enough, and if we can afford this spending in the 'good times' how can it be afforded now, or paid for in the future? Is it not the case that we just have to accept that there is not enough wealth creation to afford such spending?

Another point to make is that, if economic success is a result of good education, what level of spending should be directed at education. 5% of GDP, 2%, 10%? If it is such a basic good, then why not just pour in huge amounts of money? In reality we accept that there must be an optimum level of spending, before the money is wasted. Once again, if investment is increased in education today, when yesterday the money spent on education was considered to be at the right level, does this not say that the money is believed to be inefficiently allocated.

The answer in response will be; better that a person gets an education than sitting on benefits, but again there is the problem that yesterday it was not expected that the individual in question would benefit from further education, but today that person will increase their value in the workplace through education. If this is the case, why were they not encouraged into education before? They would have increased their value in the work place, gained a better salary and so forth. The economy would have benefited from better value from their input and so forth...As for building infrastructure, educating people is an expensive business. That means more tax, less consumption, and less money saved for investment (again).

With regards to the necessity for government funding of schooling, I would point to my post on education reform. My solution offers cost effective schooling in which individuals have freedom of choice, and a system focused on quality of outcomes. The system is one in which education becomes a real investment, in that the investment will be set at a level at which realistic expectations of returns on the investment are central. By contrast, government is pouring more money into the system with arguably ever poorer outcomes, and no way of measuring the so called 'investment'. It is quite simply, drop x amount of money in and hope for the best...

Lord Keynes also says of education:
'I would also add that there is more to educating children than just making them useful workers, but that’s an argument for another day.'
There are a large number of creative industries, people who make money writing history books and so forth. In addition, at least in the UK, for many jobs the exact subject of a degree is not considered a matter of concern. A system that allows for investment and returns still allows for breadth of education, rather than simply training for work. There is no reason to believe that such degrees will not continue to be funded if return on investment is a consideration.

The final argument is a continuation of the first comment as follows:
I would continue to ask why something like the Hoover dam, the construction of which has had many benefits, is a “bridge to nowhere” project? In none of your discussions, do you address the fact that governments do try and calculate the economic benefits of much public infrastructure spending (the US actually is inefficient because of Congressional control and pork barreling, something other government systems, for instance in Europe, do not have)
The question is, if it is going to make money, why would government finance be needed. A recent example of such a kind of project is the Channel Tunnel. This was privately funded and added a major piece of infrastructure. It has lost money, but nevertheless, it is still there, and still provides that infrastructure. A similar point can be made for the railway system in the UK, the massive boom in telecoms infrastructure.

On the other hand, it is also possible to look at Macquarie group, who have been making massive investments in infrastructure around the world (though I personally have some doubts about their business model), and making good profits. Some of these investments provide returns, some have been loss making, but the risk is not given to a public who have no choice through the tax system, but to investors willing to take the risks.

The trouble is, if the government is borrowing money, there is not so much capital available for such private investment. If you have the choice of what has appeared to be a low risk government bond, or a relatively high risk investment in an infrastructure project, you will go for the bond, unless the infrastructure project offers very big returns. In competition with this, you have governments raising money cheaply on the basis that if it goes wrong, which is a common occurance on infrastructure, then the taxpayers will foot the bill. How can private capital compete on such terms? It is a very difficult task, but they do still manage to compete.

It is the Fannie Mae/Freddie Mac story writ large. They came to dominate the mortgage market, as they were implicitly underwritten by the tax payer and could therefore raise finance cheaper. It made any true competition in prime mortgages virtually impossible.

So we can talk about the benefits of infrastructure, but the question is to ask why this has to be provided at risk to tax payer money, and at the cost of crowding private investment out of the market.
Furthermore, public works programs often simply maintain and repair crucial existing public infrastructure. The US, by all accounts, has crumbling public infrastructure simply because governments have not spent enough money to maintain them. Now is the perfect time to rebuild them.
So again, we have a situation in which these expenditures were not considered affordable during the 'good times' but are affordable now that there is no money? Does this make sense? You are broke, so you spend money on things that you did not think were worthwhile when you were rich? According to this argument (to paraphrase another person's argument), you should work on refitting your kitchen at home when you are made redundant, even if you have to borrow the money to pay for the materials. It needs to be done, as it is looking run down, you have nothing else to do with your labour, so why not?

The why not is because you are already in debt, can not pay down that debt, and are hovering on the edge of bankruptcy. Even without debt, would this be a good idea? Would you recommend such a course of action to your friend? Heh, you may as well do something useful with your time, even if it puts you into debt with no idea of when or how you might pay it back.

In the end, it is all just a continuation of the delusions. A continuations of the belief that, when a problem has been caused by debt, the solution is more debt....It is the fetish that activity means wealth, and if we can just stimulate enough activity, consume enough, it will all come right. The fact that the stimulus is built on debt and devaluation of money, is a small detail that passes many by.....

A long and a rushed response as I have spent a bit too much time on the blog, so I hope that it answers the questions.

(1) Rogeberg, O (2004), Taking absurd theories seriously: Economics and the case of rational addiction theories, Philosophy of Science, 71, pp. 263-285

Note 1: The post on China that I did not publish was an explanation of why I obsess with China, as well as why I personally would like to see China succeed. As such it was a little too personal for publication.

Note 2: I was asked some time ago to write an article for a finance magazine, and am hoping that it will be published in the near future. I will link to this as soon as it is out.


  1. Mark

    Glad to see your new post - I was getting withdrawal symptoms.

    I understand everything you say in your post, but I still can't get my head around why "productive economic activity" is defined, more-or-less, as the production of something that people "want". To me, the fact that people want, or think they want, polyphonic ringtones or Hummers or tongue piercings doesn't make it worthwhile economic activity. I have often pondered on the way quite ordinary people are prepared to spend, say, £40,000 on some brand of car that they think they like, never stopping to think that could retire years earlier if they didn't buy the awful thing. And they probably get bored with it in a couple of months. Surely this is not worthwhile economic activity, but a tragic waste of life?

  2. In principle what is the difference between an advertising agency persuading a million people to buy sandwich toasters that they use once and then put at the back of a cupboard, and a government department using tax payer's money to build a useless skyscraper? To my mind, in economic terms they are equivalent. I would bet that much of ordinary people's money in the West is spent on rubbish that they do not need and do not really want. If people were offered the choice not to work 9-to-5 until they were almost dead, I would bet that most would live their lives differently.

  3. Another great post, but I do have to take issue with one of the points.

    When governments build things to create an economic stimulus, which I agree is generally pretty stupid, I think its unfair and misleading to say they have "no worth".

    Your example of the "skyscraper nobody wants" for instance.

    While I am absolutely no fan of the UK government or its absurd mismanagement of the economy and the crisis, I do want to try and be fair.

    If the government uses the money to build a school, thats not something nobody wants. Nor, if it trains new wealth-creators, entrepreneurs and inventors does it have 'no value'.

    If the government uses the money to build a useful bridge that helps people move goods and increases the ease of trade, thats not something nobody wants and its not something without value.

    If the government makes a new hub airport in the North and links it to London via a high-speed train network, that could have a massive effect on the face of the country.

    As much as I detest our Prime Minister's ham-fisted and short-sighted Keynesianism, even I cannot honestly say I believe they would use the money they create or borrow to build things "nobody wants" or that have "no value".

    For instance, if the government built a new university which then trained a scientist who invented a miraculous new form of free energy that would result in an incredible amount of wealth creation and prosperity.

    I know that's a very wild flight of fancy, but no more so than the idea that things created during Keynesianism will be "of no value". They have value, they just do not represent wealth-creation in and of themselves.

    The error everybody makes is in assuming we wont have to pay through the nose for anything we spend the money on. One way or another, as you so rightly point out, we will.

    Bridges and schools and roads and the like do have to be built. If the government 'moves the building forward' that was going to be done sooner or later anyway so as to keep people in jobs and prevent normally-viable businesses closing down that is not necessarily the wrong thing to do. After all, those still-employed people will otherwise be claiming benefits, defaulting on their mortgages etc.

    Yes, I know that you feel that all this 'has to happen' anyway and that we're just staving off the inevitable and making it worse in the long run. But it may be possible to keep the country functional while working on ways of making ourselves wealth-creators again. If a 'little' Keynesianism were practised alongside some pretty dramatic changes to our culture, legislation and regulation, don't you think we could possible get through this intact?

    I'm just saying that I agree that the principle of Keynesianism does not create real wealth and is generally a pretty feeble tool. But it IS a tool, if used in conjunction with other more sensible measures by people with a grasp of what it really means.

  4. On Public Works and Keynesianism

    I think you dismiss Keynesian deficit spending in a way that is a reductio ad absurdum. Although reductio ad absurdum is not necessarily a logical fallacy, nevertheless the “broken window” argument degenerates into a strawman argument at the very least. Any Keynesian economist who proclaims that Hurricane Katrina is good for the economy without taking account of the human suffering involved is patently idiotic. The same goes for the broken window argument, in that the violence and vandalism involved has not been taken into account.

    There are no doubt quite a few “bridges to nowhere” projects (like your example of the skyscraper that nobody wants) that have been carried out by governments over the decades, in Keynesian public works programs. But there are plenty of projects which were not, and many potential projects that could be undertaken that would benefit the economy to a great extent.

    For instance, it is really the case that the Hoover dam, which was largely a New Deal government funded project, was useless and wasteful? The dam has long since paid for itself. Its massive supplies of water have allowed the growth of cities and the growth of farming. Its electricity is cheap and continuous. Its construction created many private sector jobs funded by government contracts.
    One commentator has correctly noted:

    “It is no wonder, frankly, that the average tourist to America still spends a lot of time looking at 1930s infrastructure, because Roosevelt’s New Deal created 122,000 public buildings, 77,000 bridges, 664,000 miles of road and 285 airports, as well as jobs for 8.5 million people. Like the German autobahns - built at roughly the same time - these investments were indispensable to the country’s future growth and economic might.”

    The author of this? The conservative Boris Johnson! Yes, he’s a convert to Keynesian evil, apparently.

    Providing badly needed public infrastructure is hardly “completely pointless activity.” In fact, public works enthusiasts in government are well aware that they have to calculate the economic benefit of a project first. America, for instance, badly needs better broadband internet infrastructure and a new electrical transmission grid.
    Furthermore, is there not a multiplier effect on economic activity here, even with public spending?

    You also fail to address the fact that much of public works spending often goes simply to maintaining and repairing existing infrastructure:
    … the American Society of Civil Engineers (AS CE) estimates the United States will need to raise $1.6 trillion just to repair and maintain … [its] existing infrastructure stock … The United States is currently investing less on infrastructure as a percentage of GDP than Europe, China, and many emerging economies … America spends only about 2 percent of GDP per year on infrastructure investment (this includes federal, state, local, and private-sector spending). By contrast, that number is about 5 percent in Europe and between 9 percent and 12 percent in China. In developed economies, the average is about 3 percent of GDP.

    This article also points out that, in the case of the US at least, what is needed is simply more efficient and better public planning and analysis to estimate which projects will have sound economic benefits which promote development. The answer to the problem of eliminating “bridges to nowhere” is simply more effective government or public planning (which could, in any case, be done by independent or semi-public organisations).

  5. Just a quick comment on these 2 statements:

    (1) For example, we see it in the policy of quantitative easing … Even the expression quantitative easing does not express what it really means, which is a massive creation of money from nothing.

    (2) In the case of all government stimuli, the money for the stimuli does not come from the government, but in all cases comes from the tax payer. It is either taken from the tax payer in the form of inflation or through direct taxation.

    Does not statement (2) contradict statement (1)?

    If the money for a government deficit comes from borrowed money (either domestically or from foreigners), the money was not just created from nothing (a monetary version of creation ex nihilo, if you like!).

    Is there a fundamental difference between the expansion of the money supply by a central bank and the money spent by a government during deficit spending?

    I may be grossly ignorant on this point, and I am happy to be corrected, but does the Federal Reserve have to borrow money to issue more dollars (inflate the money supply)?

    Does it really simply create the money from nothing?

  6. On Keynesian public spending, Part 2

    If the school was something that really was of such value, why was the school not built before?

    Because schools are nearly always built with public money, and there has been a persistent trend since 1979 (the advent of neo-liberalism) in Western countries to cut public spending. Education was one of the many things to suffer. Many countries have over-crowded public schools, which leads to poorer quality education. The private sector will not provide a solution, because schools are like public utilities: most people want free or low cost good public education. They don’t want expensive costs by transforming schools into high-profit private industries. Therefore there’s not a lot of incentive for private business in invest in new schools. This is a service that has to be publically provided.

    You used various scenarios to argue against the usefulness of the school, but none that would justify it. There are many such scenarios that you ignore. Here’s one: suppose there has been large population growth in a new outlying suburb of a city. Children have to commute a comparatively long way to other schools in different suburbs. The government of the country has cut money for education in recent years (a historical fact in most Western countries, incidentally), but public planning bodies say that having a school in the new location is badly needed to reduce numbers in other schools and make the travel to a school cheap and fast for local students. The recession is just the right moment to build the school, as it allows unemployed people to gain employment, get off the government welfare checks, and create new jobs for the private sector. The building of the school with money spent by the government will have a multiplier effect. It will help, with other monetary and fiscal policies, to revive an economy mired in recession.

    >i< Even worse, in the case of a school, it is an additional cost, and provides no income. >/i<

    Schools are a public service, with future benefits in the form of skilled, well educated students who can enter a productive work force. The “investment” is in training people for the long term, not making money in the short term. I would also add that there is more to educating children than just making them useful workers, but that’s an argument for another day.

    Added to this, if the government is borrowing to pay for the spending, then they are borrowing from a finite base of capital, thereby acting as a competitor for capital with private business.

    If the country is in a recession or depression, then by definition private investment has already collapsed. The money is sitting idle, because it is not being invested by businessmen who foresee no return on such an investment in the short term. It might as well be put to use in a socially useful thing like public infrastructure.

    I would continue to ask why something like the Hoover dam, the construction of which has had many benefits, is a “bridge to nowhere” project? In none of your discussions, do you address the fact that governments do try and calculate the economic benefits of much public infrastructure spending (the US actually is inefficient because of Congressional control and pork barreling, something other government systems, for instance in Europe, do not have).

    Furthermore, public works programs often simply maintain and repair crucial existing public infrastructure. The US, by all accounts, has crumbling public infrastructure simply because governments have not spent enough money to maintain them. Now is the perfect time to rebuild them.

  7. A Plan for the Recovery of Western Economies

    The Japanese had an asset bubble in the late 1980s and early 1990s. Japanese home prices peaked between 1990 and 1991. Then came a free fall. A banking crisis and recession ensued. The Japanese, however, made the disastrous mistake of failing to fix their financial system. It was not until 1998 before serious steps were taken to fix the banks. Some Japanese economists, who criticized their own government’s inaction, are writing some interesting advice for Western governments.

    I quote from Kobayashi, K. 2008“Subprime Loan Crisis – Lessons from Japan’s Decade of Deception.”

    I have also added my own suggestions.

    - Government spending can stop a recession from becoming a depression; it should be done.
    - If deflationary expectations take hold, then there is a serious problem for the economy
    - failure to fix the banking system would prevent a proper recovery
    - the shadow banking system is a major part of the banking crisis; it must be abolished by government regulation
    - there must be stringent asset evaluation and sufficient write-offs of bad loans and other credit instruments in the banking system by vigorous government intervention
    - To prevent debt deflation, the governments should establish asset management companies, public entities that purchase and hold the bad assets. The purchase and freezing of toxic assets is necessary to stop debt deflation.
    - The public entities should then restructure the bad assets and sell them off gradually after the market stabilises.
    - Direct debt relief for mortgage borrowers and distressed (but viable) firms, along with fiscal assistance for the liquidation of nonviable firms

    After this has been accomplished, then the traditional Keynesian solution can be applied: tax cuts and deficit spending. Unfortunately, the US must address its trade deficit with East Asia (mainly China) and start balance its budget after a recovery occurs. Ending the useless and expensive wars in the Middle East will be a start.

  8. It seems to me that Adam Smith's assertions amounted to just a neat idea, similar to evolution. There is no proof that individual people's self-interest collectively converts into some sort of wisdom that benefits all of society. People might think that it is Adam Smith style economics that has spurred progress, but without free energy literally bubbling out of the ground and an ever-increasing workforce of foreigners to exploit, where would be? Now that we have used up all the free energy, we will see where the markets get us. As someone pointed out: how is it that when war is declared, governments suddenly seem very reluctant to trust the miracle of the free markets to sort it out?

  9. Hi Cynicus,

    I think when I struggle with the acute and bleak outlook my mind at times experiences cognitive dissonance. Accepting what the future holds for Blighty is deeply upsetting. I too found the Austrian School as the people who had the common sense. Until this Crash I had little knowledge of economics. As I have dug further I have been amazed by the stupidity of politicians, economists and business people.

    Here is some of my latest critical thinking:

    A or L

    A = Argentina = Depflation.

    L = Japan = Deflation.

    As we enter a depression there seem to be one of two paths that we can travel. One path accepts that there has been a debt bubble, that this is the cause of the depression. The other path does not accept there was a debt bubble and that it will be policy responses that will stop a depression: Bernanke Panky is a master of the 30s and Japan’s slump, his wisdom will save us from a depression.

    If you accept the L then you accept that it is better to let the market find it is price and not bailout the badly run businesses. You go cold turkey. You do not run up massive debts on the State’s balance sheet, which only leads to higher taxes. You want people to save. You want the State to cut it’s cloth, to face the new reality that the high tax take from the debt bubble is not coming back. The delusion is dead. You want the State to cut business regulations and taxes. You want all your focus on nurturing wealth creating industries that can sell their goods and services globally. You give grants to such companies.

    If you accept the A then you accept that you can manipulate the price in the market and bailout badly run businesses. You put off the day of reckoning. You run massive debts on the State’s balance sheet. You want people to borrow and spend. You want the State to expand and you expect the pre-bubble days to reappear like magic. The delusion lives on. You continue to over regulate and tax business. You want all your focus on spending and piling up debt. You give money to the profligate who ran up too much debt, you start printing money.

    Life in the L is like hell. Many lose their jobs and GDP collapses.

    Life in the A is horrible. Many lose their jobs and GDP collapses.

    L lasts three to ten years as the economy is re-engineered to sustainable wealth creating industries. House prices fall 50%+ from peak to trough, with little chance of rising for many, many, years. People start saving. Money is sound and the Pound holds up relatively well, considering the situation. With sound money the populace is able to clothe and feed themselves, the lights stay on. The State supports those in trouble. It invests in retraining.

    A leads to a collapse in the Pound as the markets realise that the country can never repay interest and principal. This leads to unsound money and rising inflation as import prices explode. Interest rates need to rise but this will gut the debtors. Wage policies are enacted and a spiral of inflation takes hold. This leads to hardcore poverty for millions as the Middle Class sees it’s wealth vanish. With a collapsed currency few are able to holiday abroad. The IMF are called in and State spending is slashed.

    Both A and L lead to a drop in living standards for the populace. The key plus for L is that once the pain is out of the way a new base for growth and prosperity can be engineered. The balance sheet is strong enough.

    With A the balance sheet is wrecked and the Middle Class has been devastated. Argentina is a prime example of what happens when the wealth of the Middle Class is squandered.

    In the L one gets a sharp painful deflationary depression.

    In the A one gets a multi decade long depression that could lead to inflation = Depflation. The country becomes an Undeveloping Nation.

    Our ruling elite and most of the punditocracy are taking us to A.

    No Way Back:

    Thank you


  10. On Education

    Thanks for your comments. I need to do more reading to understand monetary polices and how money is created by central banks. I admit my understanding of the subject is not that good.

    I do have some other responses, which I make in the spirit of robust but reasoned debate.

    (1) Education spending in the US

    In absolute terms in both cases the spending by governments have increased. As such, whilst it might be claimed that education budgets have been cut, this chart here actually shows the growth in educational spending in the US. What we have is actually greater spending

    Correct. It is true that state spending has gone up in absolute terms, but the schools are still actually underfunded.

    The US population was about 254 million in 1992. Now its 303 million. That’s roughly 49 million new children entering your education system.

    Even in 1990, US education was underfunded by the standards of other Western countries:

    the United States spent less of its national income in 1985 on kindergarten through 12th grade than all but two of 16 industrial countries, Ireland and Australia. The institute maintains that two major economic competitors, Japan and West Germany, actually devoted more of their national income to precollegiate education, ranking sixth and ninth, respectively …. the United States spent 4.1 percent of national income on K[indergarten]-to-[grade] 12 education in 1985, compared with 4.8 percent in Japan and 4.6 percent in West Germany. Sweden spent the most at 7 percent.

    Kenneth J. Cooper, “Is U.S. Education Underfunded? Study Says Most Industrial Nations Spend More on Pre-College Students,” Washington Post, 17 January 1990, p 19.

    Another good measure is spending per pupil (per capita spent on each pupil). By that standard, the United States again ranked 14th out of 16 countries. This was in 1990. Your chart seems to bear this out: in the early 1990s education funding did not increase very much. Then it certainly increased in Clinton's last years and under Bush.

    But just looking at a chart like this does not tell us whether the funding is sufficient or insufficient.

    Although Bush passed his No Child Left Behind Act (2002), this in fact has been underfunded:

    In his 2005-2006 federal budget, President Bush cut education programs by $2 billion. And in his latest budget, which is for the fiscal year that starts on October 1, 2006, George Bush plans to cut education programs by a whopping $4.3 billion, and to entirely eliminate 42 more programs. Per the National Education Association, "President Bush released his budget proposal for FY07 on February 6, 2006. The President's proposal makes the largest cut to federal education funding in the 27-year history of the Education Department...." NEA is asking Congress to provide an increase of at least $14 billion for education in the Congressional Budget Resolution. This request would allow restoration of cuts made in FY06 and provide for essential and long-overdue increases in important education programs."

    Your chart on education actually shows the cuts to funding in the leveling off of spending around 2006.

    As for the UK, you only have to Google “UK education” and “underfunded” to get a flood of information on underfunded primary schools in the UK:

    “Although more money has been spent on education since 1997 than at any other period in history, primary schools receive only 80% of the funding given to secondaries. In comparison, some Scandinavian countries, which have far better literacy rates, allocate more than 100%.”

    The problem is failing to fund primary schools properly to get children literate and numerate by the time they are 10.

    (2) Another point to make is that, if economic success is a result of good education, what level of spending should be directed at education. 5% of GDP, 2%, 10%?

    Between about 5% (as in Japan) and 7% (as in Sweden).

  11. You began your post with some discussion of China and later included this: "He asked me to explain how it is that Germany with its social democratic system, encompassing many structural features abhorrent to free market economists, has such a successful export machine. I will confess that I was stumped to come up with an easy answer, and was left to waffle about German culture."

    I think I may be able to help. These concerns get to the heart of our our enormous trade deficit. It's rightly of growing concern to Americans, since it lies at the root of our economic melt-down. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9 trillion. What will happen when those assets are depleted? Today's recession may be just a preview of what's to come.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

    At this point, I should introduce myself. I am author of a book titled "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world's population.

    Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at or where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at

    Please forgive me for the somewhat spammish nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, "Five Short Blasts"

  12. Pete Murphy,

    Diminishing Marginal Consumption (nifty). This is not in my Economics course text book. Take care some economist twit does not try to d2y/dx2 DMC and then add it to an Econometrics course! I suppose if they could do a partial diff on Entropy it would, in the limit, be zero. Eureka!

    The population idea is an interesting concept. Have to give this some thought. Got any references?

    Brian P

  13. You start by stressing the importance of somewhat intangible aspects of nations, such as culture, to their economic potential.

    One aspect of Keynesian spending you neglect is to this culture. There is a psychological difference between 10% unemployment and 5%, between being on benefits and working for your living. Even if that work may be in some strict sense economically pointless.

    Thus it may be that such a public works campaign does create value, not in physical assets, but in the psychology of the populace.


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