Nº 5: Keynesian versus Austrian Economics

The current global economic setup is essentially a by-product of Keynesian economic theory. But will it be able to hold its influence in the future?

Economics as a social science tackle the complex and dynamic relationships emanating from people and governments allocating, producing, distributing and consuming finite resources. Various schools of thought have evolved over centuries and decades each presenting their world view about the most efficient way to manage these relationships for achieving economic well-being at an overall societal level.

There is such a vast array of economic theories available that multiple books may be required to elaborate and discuss them fully with all their merits and demerits. This piece though only touches upon the salient points of the Keynesian school, which has become increasingly dominant in shaping all the major economies of the world at the moment, and Austrian school that has traditionally considered to be its main detractor. The purpose is to introduce readers to this key debate as it is lacks mainstream coverage, though it fundamentally affects all.

Keynesian Economics

Foundation of this school of thought was laid down by British economist, John Maynard Keynes, through his books after his research on the Great Depression of 1930's. His most important publication in this regard is "The General Theory of Employment, Interest and Money".

He started as a supporter of classical laissez-faire economics (free-market economy) at Cambridge University, but later radically changed his views and became the main proponent of government interventionist model.

Principles of Keynesian Economics

• According to Keynesian school, spending drives the economic growth. Savings impede it. In other words, if the government & consumer spending and investments are higher than the overall savings, it is considered to be a growing economy. Conversely, it is regarded to be in recession if overall savings are more than the aggregate demand in the economic system.

• Gross Domestic Product (GDP) is the main factor that determines the overall health of an economy.

• Government should influence the economy via countercyclical fiscal policy in which, during the boom periods, it should increase taxes or cut spending, but during the periods of economic downturn, it should borrow money and undertake deficit spending until the economy restores inflationary mode. This is because the natural business cycle is incapable of coming out of a recession on its own once it goes into a deflationary spiral.

The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom - Keynes

• Government should not only regulate the economy but also actively participate through injection of fiscal stimulus because it has a multiplier effect. The Keynes multiplier postulates that spending from one consumer becomes income for another worker. That worker's income can then be spent and the cycle continues. In this way, a dollar spent in fiscal stimulus eventually creates more than a dollar in growth.

• Steady growth at full employment level can be maintained only if the State steers spending and investment directly or indirectly depending upon the economic situation. A free market that is not managed by a government cannot sustain itself and creates a boom-bust cycle, which is not desirable.

These are few of the fundamental points based on which this doctrine has developed and received wide acceptance among academics, economists and policy makers for structuring the economies coming out of the Great Depression and World War-II. It faced setbacks during the stagflation of 1970's but has resumed its dominance in recent decades.

There are numerous other details related to Keynesian model, but they are beyond the scope of this article and are left out for another discussion. Though one point worth highlighting is that Keynesian model cannot work effectively under the confines of an asset-backed currency, which led US dollar to be de-pegged from gold in 1971, converting it into a fiat currency. All other world currencies these days are also fiat. A key feature of fiat currency is that there is no upper bound for the government to follow and it can print as much currency as it deems necessary.

Austrian Economics

Carl Menger is regarded as the founder of the Austrian Economics model through his book "Principles of Economics", which was published in 1871 in Vienna. His work is considered revolutionary as he demonstrated the shortcomings of labor theory of value in classical economics and presented the theory of marginalism. Thus, answering the paradox-of-value (also known as diamond-water paradox) arising from the apparent contradiction that although water is on the whole more useful, but diamonds command a higher price in the market. He used marginlism or subjective price theory to also refute Aristetolian view that business transactions involve exchange of equal value for equal value. He pointed out that value is subjective and people will give up what they perceive less valuable in return for what they value more at that time, which is why both sides can gain from an exchange.

All these ideas laid the foundation for Austrian school's fundamental belief that the broader economy is a resultant of smaller individual decisions and transactions. As a result it is a constantly evolving organism that takes its own natural course, which should be regulated as little as possible. This view is contrary to alternate theories, especially Keynesian, that believes in control and base itself in mathematical assertions, historical abstracts and broad statistical aggregates, termed as Positivism.

Menger also demonstrated that money, like language, developed naturally as a means to facilitate human interaction. Another prominent Austrian school economist, Ludwig von Mises, later expanded and showed that Menger's insight into the way in which money arose on the market was not simply a historical summary but a theoretical necessity. Mises in his book Theory of Money & Credit, published in 1912, used Menger's marginalism and views on money to develop the method of determining the price or value of money itself. This was considered groundbreaking because it allowed the general theory of individual action, supply, demand and price presented by Austrian school in earlier years to shake hands with the theory of money.

Friedrich A. Hayek, who was mentored by Mises, later made major contributions to the Austrian thought in the mid-twentieth century. In recent years, former US presidential candidate and congressman, Ron Paul, has remained the most prominent proponent of Austrian economics, but it lacks general support to be used as a blueprint to develop modern economy.

Principles of Austrian Economics

• Savings build real capital, which provides the sound basis for economic growth.

• Interest rate manipulation by government creates an environment for market participants to not only borrow excessively but also leads them to allocate funds in areas where they would not have allocated otherwise. This creates an artificial and misdirected economic boom. Government eventually raise interest rate to control money supply, which then leads to a bust because the previous demand in the economy was mainly due to cheap credit, not the actual saved up capital and real demand of market participants. To put it differently, inflation is caused due to artificial increase in currency and credit and it is always harmful in the long-run.

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production - Hayek

• Price decrease or deflation is natural because real demand shifts with time. Therefore deflationary cycles should be considered healthy as they bleed out excessive production and inefficiencies. It may cause short-term pain but greatly reduces systematic risk. Government policies should not interfere in this process.

• Praxeology is employed to study economy, which asserts that individual actors of a system adopt goals and believes and take certain actions to achieve them. There is also a time component attached to this process. This axiom ultimately leads to a conclusion that complex economy cannot be centrally planned because there is no way of knowing in advance what individual actors will put value in in the future and therefore prices will always be subjective. Stated differently, economy is social in nature and false conclusions may be drawn if relied heavily upon statistical data and mathematical equations in order to control and plan it.

• This model can work under the confines of an asset-backed currency. In fact, it demands it.

Discussion

Before moving to my personal deductions on this topic, I would like to present the table below that summarizes the text in priors two sections.

Keynesian school of thought came into existence and was adopted by western governments in the backdrop of the Great Depression and World War-II. It offered immediate solutions to the economic woes of that time. Later it seemed the governments liked the idea of more and more control over the economy. The academia and economists also preferred it as it was based in positivism. One can imagine the difficulty in taking serious interest in something based in the abstractness of Praxeology while the world was witnessing the golden era of scientific and mathematical progress.

It also gave the world an era of unprecedented economic growth due to readily available financial resources under a credit-based system and big government spending. At the same time, one can also see the problems with this model when compared with the Austrian doctrine. The analysis of major world economies at the moment that have evolved under the influence of Keynesian model for many decades now make them obvious.

The 2008 financial crisis was caused fundamentally due to irresponsible lending and excessive credit in the system generated due to loose monetary policies of governments in prior years, which is not only allowed but encouraged under the Keynesian regime. The situation at the time can be summarized by knowing the fact that one could have bought a house on a mortgage referred to as NINJA loan, where NINJA stands for No-Income, No-Job or Assets. Practically nothing was needed to get the loan approved. Ultimately it resulted in a situation where the then US Treasury Secretary, Hank Paulson, had to kneel in desperation in front of the House Speaker Nancy Pelosi to get a $700 billion emergency bill typed on two pages approved through congress within a day if they wanted to keep America and consequently the world in-business. They did approve it.

Since then the governments have deepen their involvement through ultra-loose monetary policies of zero or even negative interest rates and trillions of dollar in fiscal stimulus created through deficit spending. We are reaching "everything-bubble" phase as the world is awash in credit with global debt reaching a whopping $223.3 trillion. The infograph below provides some further insight about this issue.

I think the great Keynesian experiment is showing signs of reaching its last leg. The unraveling of this phase has the potential to become a major event of human history as governments may lose financial, and as a consequence political control. No one truly knows what will happen when the next financial crisis hits, with governments apparently out of bullets. It was once believed that the interest rate cannot be zero as it would be equivalent to free money and hence ridiculous. Modern Keynesian central bankers have shown that they can go below zero if pushed hard. This is unprecedented, which can result in unprecedented consequences.

If Keynesian model does reach its capacity in coming years, will the world turn Austrian? I would like to say yes, but I don't think they can or will. Austrian thought does offer a more humanistic and fairer system, but it's going to be a bitter pill to swallow after decades of easy credit, exponential expansion and government bailouts if in trouble. These are not easy habits to get rid of. Essentially governments would have to massively reduce their size and restructure their jurisdiction. The political actors would also be exposed to the idea to sitting through a deflationary cycle while population demands immediate action for short-term relief they are so used to of. Non-action may not be good for their reelection. Businesses too would have to learn their new role and fundamentally change their modus operandi. Moreover, Austrian school would need more research after being ignored for decades to offer solutions for some modern day issues. This would require academia to accept it as main alternate. It all seems improbable at the moment.

All I can say in the end is, we live in interesting times and despite some expected turbulence, future presents an opportunity to work out an alternate that will change the economic system for the better.