The uses and abuses of HET

Sometimes, we tend to focus so much on the decline of our discipline that finding names like Keynes and Hayek quoted by a newspaper’s columnist appears as a very exotic discovery. Historical arguments might not be used anymore by members of the economics profession but, obviously, some (Republican) media pundits think they’re still useful, especially when a financial crisis seems to unblock the road to socialism (or serfdom, depending on your opinion on current issues).

So here is reproduced, without further comment, Dick Armey‘s column published on Feburary, 4th by the Wall Street Journal:

“In the long run, we are all dead,” John Maynard Keynes once quipped. An influential British economist, Keynes used the line to dodge the problematic long-term implications of his policy proposals. His analysis of the Great Depression redefined economics in the 1930s and asserted that increased government spending during a downturn could revive the economy.

President Barack Obama and congressional Democrats (very few of whom likely have read Keynes’s 1936 book “The General Theory of Employment, Interest and Money”) have dug up the dead economist’s convenient justification for deficit spending in defense of their bloated stimulus legislation. But none ask the most important question: Was Keynes right?

According to Nobel economist Friedrich Hayek, a contemporary of Keynes and perhaps his greatest critic, Keynes “was guided by one central idea . . . that general employment was always positively correlated with the aggregate demand for consumer goods.” Keynes argued that government should intervene in the economy to maintain aggregate demand and full employment, with the goal of smoothing out business cycles. During recessions, he asserted, government should borrow money and spend it.

Keynes’s thinking was a decisive departure from classical economics, because arbitrary “macro” constructs like aggregate demand had no basis in the microeconomic science of human action. As Hayek observed, “some of the most orthodox disciples of Keynes appear consistently to have thrown overboard all the traditional theory of price determination and of distribution, all that used to be the backbone of economic theory, and in consequence, in my opinion, to have ceased to understand any economics.”

Classical economists up to that time had emphasized a balanced budget and government restraint as the primary goals of fiscal policy. The simplistic notion that “aggregate demand” drove investment and employment threw all of that out the window, but it had one particular convenience for policy makers. Government spending is, according to Keynes’s construct, a key component in determining aggregate demand, so more spending, even to resod the Capitol Mall or distribute free contraception, drives the economy in the short run.

A father of public choice economics, Nobel laureate James Buchanan, argues that the great flaw in Keynesianism is that it ignores the obvious, self-interested incentives of government actors implementing fiscal policy and creates intellectual cover for what would otherwise be viewed as self-serving and irresponsible behavior by politicians. It is also very difficult to turn off the spigot in better economic times, and Keynes blithely ignored the long-term effects of financing an expanded deficit.

It’s clear why Keynes’s popularity endures in Congress. Intellectual cover for a spending spree will always be appreciated there. But it’s harder to see any justification for the perverse form of fiscal child abuse that heaps massive debts on future generations.

Today, one problem with manipulating the economy through “discretionary” spending — that part of the budget not mandated by one entitlement or another — is that entitlements have grown large enough to influence the economy, a phenomenon unheard of when Keynes was alive. Medicaid, Medicare, Social Security and other entitlements are becoming larger factors in economic decision making than what Congress spends on, say, roads. Discretionary spending is becoming irrelevant as a fiscal tool.

Of course, despite Mr. Obama’s campaign promises to adhere to “Pay As You Go” budgeting, no one seems terribly worried about paying for what will likely be a trillion-dollar stimulus package. What everyone should agree on is that the money has to come from somewhere, either through higher taxes, borrowing or printing.

If the government borrows the money for the stimulus, then it will either have to print money later or raise taxes to pay it back. If the government raises taxes to pay for the stimulus, it will, in effect, be robbing Peter to pay Paul. If the government prints the money, it will increase inflation, which will decrease the value of the dollar. That would, in effect, rob Paul to pay Paul back with devalued currency.

Taking money out of the private economy — either through taxes or inflation — and spending it in a way that doesn’t offset the loss of money with real economic gains is worse than doing nothing.

Years ago I developed the “Armey Curve” to explain the negative burden government has on prosperity. The idea, borrowing liberally from Arthur Laffer’s curve (which demonstrates that tax revenues fall when the tax burden gets so high that it no longer pays to work), is that at some point the burden of government spending exceeds the private economy’s ability to carry it. “Stimulus” spending often does more harm than good, because it takes more money out of the system than it creates and thereby destroys jobs and leads to stagnation and diminished prosperity for all.

Hayek, who famously debated Keynes in a series of articles after the release of “General Theory,” gave what I believe to be the most devastating critique of government action to stimulate “aggregate demand.” Hayek viewed the boom and bust of the business cycle as primarily a monetary phenomenon created by governments’ artificial inflation of money and credit.

Sound money policy, conversely, allowed the disparate knowledge of millions of economic actors to be conveyed through the price system, rationally allocating capital and labor through relative prices. The problem with government attempts to manipulate the economy through fiscal policy — spending that takes resources away from those who are productive and redistributes it to politically favored interests — is that it is audacious. It assumes that government knows better how to spend and invest than individuals acting in their families’ best interest.

“The real question,” according to Hayek, “is not whether man is, or ought to be, guided by selfish motives but whether we can allow him to be guided in his actions by those immediate consequences which we can know and care for or whether he ought to be made to do what seems appropriate to somebody else who is supposed to possess a fuller comprehension of the significance of these actions to society as a whole.”

In reality, no one spends someone else’s money better than they spend their own. The charade of the current stimulus package, chockablock with earmarks to favored pet constituencies and virtually devoid of national policy considerations, is the logical consequence of Keynesianism in action. It is about politics and power, not sound economics, and I believe that the American people will reject it.

And because, it is even more unlikely to encounter the signature of a historian of economics in the popular press, here is Kevin Hoover‘s response, published as a letter in the February 10th issue of the WSJ:

Regarding Dick Armey’s “Washington Could Use Less Keynes and More Hayek,” (Feb. 4): A wholly justified admiration for Friedrich von Hayek should not encourage Mr. Armey to quote John Maynard Keynes out of context. His most famous quotation comes from his “Tract on Monetary Reform” (1923) — perhaps his most orthodox economic work and a favorite of Milton Friedman. It is offered not as a justification for ignoring the ultimate consequences of the policies thought to follow from his more famous “General Theory” (1936), but as an observation that monetary policy is not neutral but has real effects (for example, on output and employment) in the short run — a point fully supported by Friedman. Rendered more fully, it says: “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again.”

It’s a fact: We live in the short run. Keynes’s point, to which Mr. Armey surely assents, is that what matters about a hurricane is whether the house collapses on the family. Mr. Armey could be right that some future short runs will be worse if we follow Keynesian demand-management policies. Houses will collapse in future hurricanes, but the issue is still what happens in some short run.

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6 thoughts on “The uses and abuses of HET

  1. Armey is also incorrect in saying Hayek debated Keynes after the publication of the General Theory. It was actually after the earlier publication of Treatise on Money.

  2. believe this is going beyond the use of HET. Should instead be treated as an example of modern day propaganda. At every step of the way we have something like:

    “That would, in effect, rob Paul to pay Paul back with devalued currency.”

    Driving home a political point, charged morally (‘rob’), resorting to what sounds like to the reader a logic and academically validated economics discourse. The Laffer curve, Buchanan’s ‘big brother is out to get you’, a CATO caricature. (the guy that wrote it, is after all a ‘New Republican’)

    It’s, on the whole an abuse, of economics, history and HET, among others. And it happens all the time.

  3. This PJ O’Rourke is an odd fella. Isn’t he the one that shows up on “Wait Wait Don’t Tell Me…” the NPR show? Controversies about Keynes I can still follow, about A. Smith I have gone past the saturation point.

  4. A problem is that being a good public intellectual tends not to raise one’s reputation (and grants and all that) in economics departments… Nonetheless, historians do have a vast material to work on!
    As Keynes has created a straw man called “classic economists” for his own purposes, public intellectuals and politicians (not to mention economists) also create their straw men called “Keynes”, “Smith”, “Hayek”, “Friedman” for other uses.
    Nice references, Yann and Tiago. Thanks!

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