The Long FAQ on Liberalism
A Critique of the Chicago School of Economics:

A BRIEF REVIEW OF KEYNESIAN THEORY


Because so much of the Chicago School is a reaction to Keynesianism, it's important to understand the latter before the former. The following is a brief introduction to Keynesian theory.

Although no one knows the ultimate cause of business cycles, most economists (even conservative ones) accept Keynes' explanation of what happens during them. In a normal economy, Keynes said, there is a circular flow of money. My spending becomes part of your earnings, and your spending becomes part of my earnings.

For various reasons, however, this circular flow can falter. Suppose that you are experiencing tough times, or see them on the horizon. Your natural response is to start hoarding money to make it through. There are many possible ways this process might start, all of which are open to argument. It could be a loss of consumer confidence in the economy, perhaps triggered by a visible event like a stock market crash. It could be a natural disaster, such as a drought, earthquake or hurricane. It could be a sudden loss of jobs, or a weak sector of the economy. It could be inequality of wealth, which results in the rich producing a surplus of goods, but leaving the poor too poor to buy them. It could be something intrinsic within the economy which causes it to go through a natural cycle of expansions and contractions. Or it could be the central bank tightening the money supply too much, depriving people of dollars in the first place.

Whatever the reason, let's suppose you decide to hoard money to make it through the hard times ahead. But if you're not spending, then I'm not earning, and in response to my own hard times, I'll start hoarding money as well. This breakdown of the circular flow results in a drop in economic activity, rising unemployment, and a recession. To get the circular flow started again, Keynes suggested that the central bank should expand the money supply. This would put more money in people's hands, inspire consumer confidence, and compel them to start spending again.

In the U.S., the central bank is the Federal Reserve System. It expands the money supply by buying U.S. securities on the open market. The money it pays to individual buyers therefore increases the amount of money in circulation. To contract the money supply, the Fed does the opposite: it sells securities. The money it receives from these transactions represents money taken out of circulation. Other methods that the Fed uses to control the money supply include credit restrictions among member banks, changing the prime lending rate, and moral suasion (using its considerable clout to get banks to voluntarily adopt a policy). So the Fed has many tools to expand the money supply -- which one gets used depends on the situation.

In extreme cases like depressions, Keynes suggested that the government should "prime the pump" of the economy, by doing what the people were unwilling to do: spend. (This spending would have to be with borrowed money, obviously, since taxing and spending would not increase the money supply.) Virtually all economists believe that deficit spending on national defense, in preparation for World War II, is what pulled the U.S. and other nations out of the Great Depression.

Controlling the money supply through the central bank is known as monetary policy. Controlling it through deficit government spending is called fiscal policy.

Now, if expanding the money supply results in increased economic activity, why can't the central bank create prosperity by just printing money as fast as it can? The problem is that this results in inflation. For example, let's suppose the central bank printed so much money that it made every American a millionaire. After everyone retired, they would notice that no more workers or servants are left to do their bidding… so they would attract them by raising their wages, sky-high if necessary. This, of course, is the essence of inflation. Eventually, prices would soar so high that it would no longer mean anything to be a millionaire. Soon, everyone would be back working at their same old jobs.

To fight inflation, the central bank does the opposite: it contracts the money supply. By removing money from the market, people no longer have cash to make the transactions they would normally make. The result is greater unemployment. In theory, this type of high unemployment should cause money to deflate. This should happen in two ways. The unemployed person who used to make $10 an hour might agree to take a job for $7 an hour, because something is better than nothing. And a merchant who used to sell widgets for $10 in a better economy might agree to sell them for $7 in a recession, because a sale is better than no sale. So, just like the millionaire example above, the amount of economic activity will readjust itself to the new level of money, and everything will be the same as it was before.

The problem with the second half of this story is that something quite different happens in real life. Money inflates easily and quickly, but it deflates slowly and at great cost. In a downward direction, prices are said to suffer from "price rigidities" or "price stickiness." There are several reasons for this. One is psychological -- people hate to cut their prices and wages. Another is that salaries and wages are often locked into contracts, the average of which is three years. And for many, cutting prices incurs certain costs (reprinting, recalculating, reprogramming, etc.) that may not make the price change seem worth it. Even if they do decide to change prices, it takes many companies quite some time to put them into effect. Sears, for example, has to reprint and remail all its catalogues. Another likely reason is that entrepreneurs don't want to sell things below cost, so they might wait for their suppliers to cut prices first -- but in a circular economy, everyone would be waiting for everyone else to cut their prices. The penalty for cutting prices first is a profit loss. Furthermore, with reduced sales volume, the unit cost of production is already going up, which only makes price reduction all the more difficult.

But perhaps the most important reason why prices are rigid is because people are nearly rational, not perfectly rational. This is the New Keynesian idea, and it's getting ahead of our story a bit, because this idea only surfaced after the Chicago School's had failed. Still, it's worth noting here for completeness' sake. New Keynesians argue that even though people know they are in a recession, they often don't know how much to deflate their prices and wages to get themselves out of it. They could if they were perfect calculating machines with perfect information, but they're not.

For example, suppose you run an Italian restaurant, and a recession hits. Where should your prices be? The answer would require you to know a wealth of information. One of the most important is how your restaurant competes against all the others in your area -- a true "apples and oranges" comparison, in that these other restaurants are French, Mexican, Chinese, etc., and they all have different profits, clienteles, trends, and advertising campaigns. You will also need to know what the inflation, unemployment and prime lending rates will be. A supercomputer might be able to solve this incredibly complex math problem, but humans cannot. They can only make best guesses. They may have a good idea of the range where their prices should be, but humans are self-interested, and usually err on the top end of this range. As a result, prices tend to resist deflating. This behavior might seem objectively irrational, but fixing it would require turning humans into supercomputers.

Price stickiness means that shrinking the money supply is translated into unemployment, not falling prices. In the days of the gold standard, when the amount of money possessed by a nation equaled its gold supply, an outflow of gold from a nation's treasury was always followed by high unemployment, sometimes even depression, rather than falling prices. The Great Depression was an extreme example of this. By 1933, the U.S. money supply had shrunk by nearly a third. But the Great Depression would drag on for another seven years, with the natural deflation of money proceeding at a glacial pace. It wasn't until World War II that the government was forced to conduct a massive monetary expansion. The result was such explosive economic growth that the U.S. economy doubled in size between 1940 and 1945, the fastest period of growth in U.S. history. Yet another example is Japan in the 1990s. The Japanese economy has been stagnating for five years now, and many economists have criticized the Japanese government for not doing more to expand the money supply. Japan's problems are controversial, but whatever the solution, the important point is that Japan's government has done very little, and its economy has not deflated or adjusted itself -- Japan's economic pain continues five years later.

But slow as it may be, deflation does occur. Many conservatives therefore argue that the economy is self-correcting, and government should leave the money supply alone. Keynes did not deny that slumps were self-correcting in the long run. But he said: "In the long run we are all dead." What he meant by this famous but frequently misunderstood remark is that it makes no sense to wait for catastrophes to correct themselves if social policy can do the job far more quickly.

How does all this relate to national economic policy? Keynesians believe their policies allow the government to take the rough edges off the business cycle. In other words, Keynesian policy is counter-cyclical: when unemployment starts rising, the government expands the money supply; when inflation starts rising, the government contracts the money supply. Another way of putting this is that the government is involved in a balancing act, creating just enough money to cover the natural amount of economic activity, without leaning either towards inflation or unemployment.

Rebutting this policy is where the Chicago School enters the story.

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