Why We Are Where We Are Today (Q4 2022)
Classical economic theory was an offspring of the industrial revolution as the world moved from monarchies and the mercantile system to a market system, as accurately and insightfully chronicled by Adam Smith in his seminal work, the Wealth of Nations. He formulated the basic classical economic theories that defined price, value, supply, demand and distribution in a free market environment. The concepts of free trade and laissez-faire (let things be) with little or no government interference in the market are basic to the efficacy of classical economic theory. Classical theory is well specified on the micro level (industry specific) stressing the importance of competitive markets while formulating demand and supply functions that define any industry’s level of concentration (from pure competition to monopoly). On the macro level markets classical theory assumes that supply creates its own demand (Say’s Law), wages and prices are flexible, markets will, therefore, clear over time, full employment will evolve over time, money is neutral (real income and real wealth are recognized), savings and investment are approximately equal (interest rates are functionally determined by the supply of and the demand for capital), and that the quantity theory of money holds over time. The quantity theory of money is best depicted by Fisher’s intuitive identity equation MV=PT, where M is the volume of money in circulation, V is the velocity of money in circulation, P is the general level of prices, and T is the total number of transactions (quantity of goods sold). In effect, the quantity theory of money rests on the truism that the amount of money spent on purchases (MV) equals the amount received for those sales (PT). Fisher postulated that price (P) is basically a dependent (passive) variable and that T and V are stable or exogenously driven (not effecting price). Consequently, there is a direct relationship between the volume of money (M) and price (P). For the purposes of this discussion, it is not essential to accept the rigidity of the assumptions relating to T and V. Even if the assumptions are loosened to recognize a small to moderate degree of correlation among all of the variables, it remains intuitive and persuasive that there is a strong relationship between the amount of money in circulation (M) and price (P). It is also important to keep in mind that Classical economic theory does not portend to address short run aberrations and that time is essential to their analysis of equilibrium.
Keynesian theory, in contrast to classical economic theory, is based on the logic that demand creates its’ own supply (demand driven economy), is focused on short tun economic changes and adheres to the belief that government intervention is critical for economic stability (balancing supply and demand). Keep in mind that Keynes was seeking to understand the deep depression of the 1930’s and was seeking to address what he viewed as the failure of the classical model to confront the issues in the short run. His theory prescribes short run intervention by the government and classical economic theory specifies that time is needed for the economy to return to full employment equilibrium after a downturn. Much of the Keynesian critique of classical theory is directly or indirectly connected to the relevant time period, the correlation between critical economic variables in the short run, and the roles of interest and money in investment and savings during downturns (money is not neutral). Money adjustments were originally intended to address liquidity and hoarding. His multiplier effect argument was directed primarily at fiscal stimulus (government spending) and to a lesser extent at money supply adjustments. The basic logic was that additional consumption regardless of origin expands total economic activity by more than the original stimulus (money spent on a project or product becomes income to a producer who then spends on inputs, taxes, wages, returns to investors, etc. and the cycle repeats).
Monetarism theory is an offshoot of Keynesian that prefers monetary policy (adjustment of the money supply) over fiscal policy to influence aggregate demand. In both cases central decision making is considered mandatory to “right the ship” during downturns. In both cases central decision making is deemed to be preferable to free market solutions. Hard core Keynesians believe that the government spending of other people’s money by politicians, generated by and drawn from the free-market consumers and producers, is a source of economic growth. Monetarists believe that the supply of money is the primary factor driving economic growth. The growth of money in the hands of consumers increases aggregate demand, which, in turn, spurs job hiring and lowers unemployment. Monetarism has been linked to the work of Milton Friedman, but it should be noted that his approach to monetarism is narrow in scope where the money supply should be expanded by a small amount each year to account for the natural growth of the economy, intended only to maintain stable prices and economic growth. Monetary policy as specified by Milton Friedman should be a fine adjustment tool whose sole purpose is to maintain stability.
From my viewpoint, the most significant difference between Keynesian fiscal spending and Monetarist adjustment of the money supply to drive economic growth is twofold. First, fiscal spending interferes with the free market by backing out efficient private sector consumption, saving and investment by individuals and producers and replacing it with less efficient government spending by bureaucrats. It is well recognized that the multiplier associated with government spending is typically less than one and the multiplier associated with private sector activity is typically greater than one. Second even though Monetarism and Keynesian theory have central decision making as a common trait, Friedman’s approach to monetarism is constrained to adjustments of the money supply through interest rate adjustments and is not intended to interfere with free market transactions. He was a fierce supporter of the free market and advocated for minimal government interference. In his seminal 1962 book Capitalism and Freedom, he equates the original definition of liberal with freedom which is most effectively achieved through the free market economic activity (see “Twisted Terminology” posted in georgeeconomics.com for a discussion of redefined terminology). His attitude toward supply-side economics is that there is no supply side and no demand side economics, only economics. He would, however, endorse their prescription of low tax rates and laissez-faire treatment (hands off) the free market. It is my position that tax cuts of any nature must be matched with government spending cuts, and the implementation of both would be wonderful for the economy. Tax cuts in isolation will lead to deficits in the short run which could be treacherous. Tax cuts alone are likely to create distortions in the overall economy that may be masked in part by the ensuing economic growth. It would be best to implement the spending cuts prior to or simultaneous with the tax cuts.
One important variable that has been recognized yet escaped emphasis is time. Capital formation requires long term scrutiny when investment decisions are made. Keynesian market intervention tools are short run devices that do not necessarily result in favorable long-term outcomes. Economic unbalances that do not resolve in the short run without government instigated fiscal or monetary policy actions are likely to be resolved by the free market without government interference if given enough time to resolve. Another important variable, that is basically a wild card, is the politician. Politicians favor the Keynesian model because it endorses government spending, and they have a history of spending, spending, spending. Out of control politicians can destabilize an economy in a short period of time, regardless of which economic theory they espouse, which may not have occurred or wouldn’t have been as severe if their policies in question were more in line with the economic theory they profess to follow. Left leaning politicians under the cover of Keynesian theory have more opportunity to create economic havoc than conservative politicians that follow the theories of Milton Friedman and the supply siders which mandate minimal government interference with the free market.
A text book example of the economic damage that out-of-control politicians can do in short order, that is not primarily attributable to the economic theory they profess to follow (in this case Keynesian), is the Biden Administration. Given that the Democrat party has had control of all branches of government between 2021 and 2022, they were able to pass trillions of dollars of agenda driven spending, far in excess that could be defended by any rational practitioner of Keynesian theory. Given the strong (sub 2% inflation) pre pandemic American economy in 2019 along with energy independence, resulting from the Trump Administration’s application of supply side pro-growth policies, and all of the stimulus injected into the economy during the pandemic coupled with the excess money floating around the economy due to quantitative easing started during the pandemic, the economy was set to take off in 2021. (Note that I did have misgivings about the lack of government spending reductions which should have accompanied the tax cuts in 2017 which was blocked by a split congress.) In 2021and 2022 the irresponsible spending by the Democrat party, coupled with a flood of money already in the economy and a debilitating energy policy, led to the worst inflation in over forty years and a totally unnecessary recession (according to the classical definition of recession) in less than eighteen months. None of the irresponsible agenda driven policies above can realistically be attributable to any of the economic theories discussed in this paper. The wounds sustained by the American economy have been politically inflicted.
At the time of this paper (November 2022) the economic pain caused by agenda driven politicians is not close to being over as the Federal Reserve Open Market Committee has its hands full implementing aggressive monetary policy to corral stubbornly high inflation while ongoing government spending counters their monetary tightening actions. In addition to countering the “very late to the party” efforts of the Federal Reserve to curb inflation by continuing to spend and pump money into the economy, the Biden Administration has continued its war on fossil fuels. From day one of his administration Biden has done the bidding of the far left by preventing the domestic oil producers from expanding production by blocking leases of public land, shutting down the permitting process, and along with his ESG (environmental social governance) allies making access to financing as difficult as possible. The prices of crude oil and oil byproducts such as gasoline, diesel fuel, heating oil, petrochemicals, etc., consequently, have radically increased and have, as a whole, been one of the major factors driving inflation. Given that energy is an input in every product and service, the headline inflation figure associated with crude oil alone does not factor in the energy portion of every good and service and, therefore, the critical impact of the Biden Administration’s myopic energy policy is significantly greater than appears at first glance. For a more detailed discussion of this issue see Oil Market And Inflation–Domestic And Global–2022 Q4 posted in Georgeeconomics.com.