Home > Macro/Monetary Theory > Critique of the Existing Model

Critique of the Existing Model

So far I have only begun to lay out my model but I want to stop at this point and compare my approach to the Keynesians.  This critique focuses on the work of Keynes and his immediate followers.  The fundamental defects persist in the thinking of more modern economists, though often the really egregious parts have been cleaned up a little.  I will start with a broad philosophical view and then zoom in on the economics.

Keynes was a progressive and his theories have been the main academic justification for progressive policies for 75 years.  The fundamental flaw made by every progressive when evaluating the world is that they see it first for what they wish it were rather than what it is and think that they can transform it from the latter into the former via the power of the state.  Economics is the study of decision-making in the face of scarcity.  Scarcity is the fundamental law of nature that motivates the entire field of economics and it is this concept which Keynes tries to wish away.  Not surprisingly, this is also the concept which stands in the way of the socialist utopia envisioned by progressives.  Here is Keynes on the subject.

Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant.

The only problem with this theory is that the individual propensity to consume is of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant (what he means by sufficiently abundant is so abundant that the marginal rate of return is zero, which would mean the interest rate would have to also be zero).  We know this because we have always observed a positive interest rate whenever there has been something resembling a free market for investment.  This is because there is a real sacrifice involved with loaning money (the liquidity preference mentioned in the previous post).  Notice that I am not saying that capital should be scarce I am saying that based on all our observations of reality it is scarce.  Keynes is saying that capital should not be scarce and the fact that we observe things in reality that are only consistent with it being scarce indicates a defect in our economic system.   He is not using the power of observation to discover the laws of nature, he is assuming what the laws of nature should be and then using the fact that nature doesn’t conform to his assumptions to argue for government intervention.  But government can’t change the laws of nature to fit its whims, this merely puts man in constant conflict with nature. Incidentally, the reason he thinks it should not be scarce is that this would mean “the euthanasia of the rentier, of the functionless investor.” 

Scarcity means that there is less of a good available than what would be demanded if price were zero.  When this is the case, and there is a free market, the allocation of such a good is achieved by the price being bid up to some positive level where just as much is demanded as supplied at that price.  The positive price is endogenous and a manifestation of the scarce nature of the good.  The more scarce (to use the term loosely) the good, the higher the price.  The great task undertaken by progressives was to create an economic system in which the government controls the degree of scarcity.  Of course, this is impossible, so in reality they are just creating a system where they seem to control scarcity.  The way they did this was by seizing control of the effect of scarcity, namely the price.  The price of investment is the interest rate.  The way they seized control of it was by creating the federal reserve who has the power to set the interest rate.  Once they did this, they fundamentally changed the nature of the system.  They turned price into an exogenous variable.  Now price changes arbitrarily and the market adjusts to these changes in some way.  It is impossible to evaluate how it will do this in a traditional framework where price is an allocative tool. 

Keynesians and progressives would have you believe that lowering the price actually makes the good less scarce.  Here is Keynes again.

The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.

Essentially what he is saying here is that the demand for investment is downward sloping in price (the interest rate) while his predecessors believed that the supply is upward sloping.  Both of these views make perfect sense.  In a free market, the price and quantity would move together when demand changed and opposite when supply changed.  But when you make price exogenous, you have to deal with the question: when price arbitrarily changes, do you move along the supply curve or the demand curve.  Neither one of these is really more appropriate than the other and they lead to opposite conclusions.  In assuming that you move along the demand curve, Keynesians have implicitly claimed that by controlling price, the government controls the scarcity of the good.  That is to say that whenever they lower the price, more of it is magically created.  If they lower the price to zero, they have eliminated scarcity and we can all live in a paradise where we lounge around looking at art while robots tend to all of our needs and we won’t need those pesky capitalists any more. 

In the IS/LM model developed by Keynes’ followers, there is no inherent scarcity.  The only thing keeping output from approaching infinity is peoples’ annoying desire to save money.  Their solution to scarcity was to get people to invest as much of their savings as possible.  At the same time they were setting interest rates at levels lower than what would be determined in a free market.  This depresses the incentive to invest.  When people have the ability to hold real money instead of investing, it will soak up much of the demand for savings.  This meant they had to eliminate the ability to do this.  The way they accomplished this was by getting rid of real money and replacing it with imaginary paper money.  The important difference is that they can control the quantity of paper money (remember the relatively fixed quantity was wat allwoed money to function as a store of value).  This means they can print more of it to cause inflation.  The inflation is a cost to holding money.  This makes holding money less attractive and drives funds into other investments.  When they first did this, people put gold clauses into contracts to protect against this inflation so they had to make them illegal which they did in 1934.

The bubbles we observe in stocks, housing, precious metals, etc. are a manifestation of people’s “propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant.”  This is a reality of nature not a flaw in the capitalist system and all attempts to combat the natural effects of it simply cause other unintended distortions.  These distortions are what my model will attempt to explain.

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