The Keynesian- Neoclassical Ideological Conflict (2)
When we left this discussion, we had found that a Keynesian economist believes government stimulus spending must be used to kick-start (pump-prime?) the economy out of recession.
Neoclassical economists on the other hand believe care must be taken not to damage an already distressed economy further. At any particular time a country’s economy is a balance between the sources of available wealth and its consumption by individuals. Supply of a good must be balanced by its demand, or the supply will diminish. Demand or lack of demand tells a producer if he should make more or less. Up to this point a Keynesian will heartily agree. The neoclassical economist will go on however and state that the government can damage an economy even further by stimulating the consumption of goods for which the economy really has no need. At this point, the neoclassical economist will assert, we must examine more carefully what the sources of imbalance were that drove the economy into recession. If the government blindly throws new money into the system, it can easily create new imbalances or exacerbate old ones to worsen the situation even more. If the government should buy something with its stimulus for which the broader economy really has little need, it will misallocate valuable economic resources better used elsewhere. Also, the original cause of the imbalances that created the recession might well be something that the government has done itself. If government policies created the recession, it would be better to remove the policies than to engage in a Keynesian stimulus program.
A necessary question in this discussion would be: How well can the government choose where to put its stimulus dollars? If the government can choose goods and services that the economy (not the government) really needs, it could lessen the imbalances maintaining the recession instead of causing a misallocation of scarce resources. When I say we should stimulate the production of goods that the broader economy needs, I mean of coarse the needs of the vast multitude of people and companies that comprise the entire economy. Why is this requirement here? The stimulated production of goods must match the needs of the broader economy if it is to survive the removal of stimulus.
“Aha” exclaims the neoclassical economist, “this is exactly where the Keynesians get us into trouble! The government is a really lousy investor.” It is really hard to be a good investor at these national and international scales. It is hard enough to be a good investor at smaller scales, where you are only trying to find a few good companies for your IRA or 401K. To be a good investor, not just for yourself but for the entire economy, is practically impossible. To invest well for the entire economy means solving a nonlinear optimization problem for the optimal dollar inputs by the government. The quantity that we would want to optimize (i.e. maximize) would presumably be some aggregate like the GDP. If we could find some mathematical function to describe the GDP, it would be a function of hundreds of millions of variables for the U.S., billions of variables if we were to include the rest of the world to which our economy is connected. Why so many variables? Each individual in the world with dollars to spend would have several assigned to his behavior alone. Not all of these variables are independent but are connected to other variables by mostly unknown constraints. At the present time we cannot even pose the problem, let alone solve it. If we were to make our best educated guess about what the solution, i.e. the stimulus dollar inputs into the economy, would be, the odds of our getting the guess right would be vanishingly small.
One way that Keynesians try to surmount this problem is by developing economic models to describe economies. Effectively they are attempting to do the same thing for economics that statistical mechanics does for physics: describe a system of an arbitrary number of interacting particles, knowing the laws of interaction, using statistical methods. Economists have a rather large problem in attempting this. The “particles” in their system are individual human beings, and the “laws” of interaction between them are considerably more complex. Even with statistical mechanics in physics, success usually is limited to fairly simple systems. Simulation programs developed to describe the world’s climate, for example, have been spectacularly wrong. (See here and here and here and here) I have yet to see economic behavior that is accurately represented by a computer model. (See here and here and here and here)
If we cannot depend on Keynesians to devise an economic stimulus that actually works, what are we to do? Surely there is some way to come out of a recession or depression, as we have done so many times before. As you would expect from the previous statement, there certainly is an answer that works, and it comes from the neoclassical economist. One great advantage he has is his dependence on a free-market to accurately set prices and quantities of goods produced so that supply and demand are balanced. The economic world is still the complex place described in the previous two paragraphs, but each individual producer and buyer of a good deals only with a microscopic subset of the total economic universe: only that portion which involves them. This makes the economic problem of producing and buying their particular good much more tractable. They know the economic assets they have available, and the producer knows the economic cost of producing his good. The setting of the agreed price of the good is then a matter of bargaining, in the sense of finding the equilibrium price of the law of supply and demand. Sharp changes in costs and availability of raw materials would then be handled by the law of marginal utility. The operation of these two laws would be largely invisible to them (recall Adam Smith’s Invisible Hand), but knowing their own costs and needs, they can solve their own part of the economic problem of balancing supply with demand. With supply and demand balanced, the system is stable from collapse, but is also conditioned for growth. The imbalances that created the recession are washed away through bankruptcy of companies that produced things that the economy did not need or want. The scarce economic resources that they had swallowed up are then free to be invested in more needed products. People who saved their money in banks provide funds for investment through bank loans. The evidence of the past two centuries is that under these conditions, the economy will heal itself spontaneously over a few years and then resume vigorous growth.
Unfortunately, the neoclassical answer for a sick economy only works for a free-market economy. Not only that, but in the modern world, government intrusions into the economy are often the cause of the imbalances that create recessions. This will be discussed in future posts.
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