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8 September 2017 Financial Analysts Journal Book Review

Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts (a review)

  1. Jerry H. Tempelman, CFA
Hunter Lewis offers a critique of Keynesian economics from the perspective of the Austrian school of economics, which used to be the principal intellectual counterweight to the Keynesian school but is now a relatively obscure branch of the science.

Hunter Lewis’s Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts is a basic critique of Keynesian economics offered from the perspective of the Austrian school of economics. Keynesian ideas spring from the work of John Maynard Keynes (1883–1946), the famous and influential British economist. Now a relatively obscure branch of the science, Austrian economics used to be the principal intellectual counterweight to the Keynesian school. Friedrich A. Hayek (1899–1992), the best-known proponent of the Austrian view, was awarded the 1974 Nobel Prize in Economics. The initial debate between the two schools took place during the first half of the 20th century, but it remains unresolved and has relevance for public policy to this day.

Keynesian economists believe that recessions are the result of a shortfall in consumer demand. When people save an increased portion of their income, doing so may be good for them individually; in the aggregate, however, it reduces the demand for consumer goods. In response to the decrease in demand, producers lower their production capacity, which entails employee layoffs and thus increases unemployment. Markets, including the market for labor, do not automatically clear, as the classical economists who preceded Keynes had maintained.

To make up for the shortfall in private-sector demand, Keynesians argue, governments should increase their spending and finance the extra expenditures with borrowing. The increased demand encourages businesses to hire again, which reduces unemployment. The resulting fiscal government deficits do not pose a problem because, in effect, we owe the money to ourselves, and in any event, the deficits will be less than the increase in government spending given fewer unemployment benefit payments. In addition to these fiscal policy measures, the central bank should lower interest rates. Doing so reduces the cost of funding investments, which encourages business activity and thus leads, in turn, to the hiring of new employees. Accommodative monetary policy also helps prevent deflation. Deflation is undesirable because lower prices encourage consumers to further reduce demand in anticipation of even lower prices.

Economists from the Austrian school counter that although a reduction in demand may be a symptom of recession, it is not adequately explained by Keynesian economics. They explain reduction in demand by introducing the element of time into their analysis. People may reduce their present demand for consumer goods and use the savings to increase their future consumption. The savings today enable the funding of investments that allow an increase in production to help meet the future demand for more goods. The lower demand today need not cause unemployment: Workers can shift from industries that produce consumption goods to industries that produce capital goods.

If left unfettered by government action, interest rates reflect the relative importance people assign to current consumption versus future consumption. If the central bank pushes interest rates below the level that reflects popular time preferences, doing so does not increase the economy’s capacity to produce more goods. In the long run, all it does is inflate either consumer prices or the prices of financial assets. Deflation is not inherently undesirable. Lower prices mean that more people can afford consumption goods. In fact, lower prices should come to be expected as, over time, the production processes for specific goods become more efficient because of experience.

Where Keynes Went Wrong is well researched, providing a plethora of citations from many works by Keynes and others, both in support of and in opposition to Keynesian tenets. Unfortunately, the author’s Austrian leanings get the better of him and the text comes across as biased. Many of the citations are brief and appear outside their original contexts, which may make readers cautious in their evaluation of Lewis’s arguments. Consider the following passage as an example of how Lewis interprets Keynes: “Another solution to the problem of too much savings is simply to work less. In this case, working less is the responsible thing to do.” This sort of paradox-laden phrasing is likely to leave readers questioning whether that is what Keynes truly thought. Similarly, not everyone is likely to come away persuaded that Keynes engaged in “sophistry” or that he “bamboozled” his fellow economists and policymakers into adopting his ideas. Lewis’s choice of language is unfortunate because there is plenty to critique about Keynesian economics, even in a more objective voice. (Readers interested in consulting primary sources for a fuller debate between Keynes and Hayek may wish to peruse the volume Contra Keynes and Cambridge: Essays, Correspondence in Hayek’s collected works.)1

Still, Lewis’s book serves a purpose. Keynes fell into some disrepute following the Great Inflation of the 1970s, which was widely attributed to Keynesian policy prescriptions. During the recent global financial crisis, however, Keynes made a reputational comeback of sorts among both ivory tower economists and policymakers. The latter implemented the most accommodative monetary policy in modern history, including a fiscal stimulus package in the United States that, if anything, was not large enough in the opinion of some Keynesian economists. Where Keynes Went Wrong provides a measure of balance in the current state of the ongoing debate.


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