A Libertarian Take on Economic Faith, ‘Facts’ and Follies

BY John Papola  April 4, 2013 at 2:19 PM EDT

Still from a John Papola-produced rap on saving vs. spending, a la Friedrich Hayek and John Maynard Keynes. Thursday’s post is round three in the debate between Papola and his opponent, economic historian James Livingston. Image courtesy of John Papola and Russ Roberts at EconStories.tv.

A Note from Paul Solman: America must save and invest. No, that’s “the nonsense of austerity.” This debate rages in Washington today as it has since the 1930s, when economists John Maynard Keynes and Friedrich Hayek squared off in the economics fight of the century. We reprised it on the PBS NewsHour in late 2009 with Keynes biographer Robert Skidelsky in one corner and a tag team of libertarians – economist Russ Roberts and master video maker John Papola – in the other. (This was also the debut of the libertarians’ brilliant and notorious Keynes vs. Hayek video rap, ‘buked and scorned when word first got out that such a thing was about to appear. I’ve included some details at the bottom of today’s post.)

But savings vs. spending — Hayek vs. Keynes — remains as sharp a divide as ever and was vividly debated on PBS NewsHour, during the holiday season, when Papola released his latest economics video, “Deck the Halls with the Macro Follies” and economic historian James Livingston tried to refute it by taking me Christmas shopping at New York’s Grand Central Station.

The two men then continued to duke it out here on the Making Sense Business Desk in pugnacious posts in March: Papola’s “Consuming Our Way to Prosperity is Macro Folly” and Livingston’s counterpunch, “The Nonsense of Austerity.”

Here is round three of debate. John Papola takes on Livingston in particular and economics in general. Expect Livingston’s retort soon.

John Papola: As a filmmaker and entrepreneur with a passion for economics, I find inquiring into how nations become wealthy absolutely exhilarating. Along the way, I’ve discovered that some of the deepest insights into how civilization develops are not only found within the work of early writers like John Stuart Mill, David Hume and Adam Smith, but that these insights have largely been lost today. That early generation of classical liberal thinkers sought to combine their economics with a broader view of humanity and social interaction. They are important not because of some geeky canonical reverence or nostalgia, but for the richness of their understanding and its continued applicability to our world today.

Ironically, none of the foundational greats in the history of economic thought could get into Harvard University’s Ph.D. economics program today.

This is not because of radical advances in our understanding of economics. To paraphrase Milton Friedman, we have only advanced one step beyond David Hume in our understanding of economics. Rather than advance real understanding, the economics profession, bewitched by a century-long envy of the physical sciences, has collapsed into an esoteric and pointlessly hyper-mathematized maze of confusion. The result is an economic mainstream so disconnected from reality that we must resurrect 1800s debates over whether consumption, which by definition uses up our wealth, can somehow increase society’s supply of wealth as a result.

We are living in a dark age of economic understanding.

Professor James Livingston’s response to my holiday EconStories video and Newshour editorial, “Consuming Our Way to Prosperity is Macro Folly,” encapsulates how, starting with a mistaken methodology, the modern economist can end up in bedlam.

That Livingston holds to a different approach than I do about how an economy grows, and perhaps what “an economy” even is, is not the only reason. Yes, I believe he’s wrong. Increased consumption is never a path to prosperity, but a result of it. His insistence that using up valuable resources can mysteriously produce plenty as if by a perpetual motion machine is certainly part of the problem with today’s mainstream views.

He disagrees. No problem. There have always been pointed debates about these issues for centuries and always will be. But it is the means and methods of his disagreement which cause me such concern for the state of the profession.

Too Much Politics in Political Economy

Mr. Livingston kicks off his rebuttal with a politically-charged round of ridicule complete with a barrage of buzzwords like “austerity,” “trickle-down” and “Reaganomics” whose sole purpose is to rile partisan fervor in the reader. My argument was thus hand-waved away as mere “faith” in classical economics with the assertion that “no amount of evidence” can shake me of my baseless dogma.

This is a strange start considering the substantial evidence I put forward drawn directly from respected economic historians, and mainstream data sources, for both the Great Depression and Great Recession in support of savings and investment as the key drivers of growth and the business cycle. What’s especially ironic is that I provided more actual data about consumption, investment and employment for both major events via links than Mr. Livingston, whose “massive evidence” is dominated by an error-filled historical narrative about which theories came into vogue at the turn of the century.

More unfortunate, though commonplace in today’s economic discourse on both the “left” and “right,” is the attempt to undermine the opposing view through ad hominem and guilt by association. My argument has nothing to do with “Reaganomics.” In fact, understanding the central role of saving and investment in value-adding productivity by no means requires that one be a “libertarian,” or fan of free markets.

Consider a recent Huffington Post piece by progressive economist Jeffery Sachs in which he assails “crude Keynesianism” of the sort put forward by Mr. Livingston. Sachs writes “crude Keynesians believe that for all intents and purposes, ‘spending is spending.’ … Spending is not spending. The U.S. needs productive public investments, not wasteful spending.”

At the core of Mr. Sachs’ assault on crude Keynesianism and its fixation on aggregate demand is a view fully consistent with the Law of Markets: real growth comes from value-adding investment and production. That he believes the public sector should (or could) play a larger role in that investment is a separate issue.

Are we to believe that Jeffery Sachs has been indoctrinated by dogmatic “faith” in “Reaganomics” or even “libertarianism”? I think not. There’s no political or philosophical dogma necessary to understand and appreciate the Law of Markets. Growth is created by value-adding production and investment either from the private sector or the public sector, not consumption or consumer spending. The arguments for which institutions have the knowledge and incentives to excel at creating value, rather than wasting or destroying it, are another matter.

I see Mr. Livingston’s approach as symptomatic of our new dark age of economics. Today, even Nobel Prize-winning economists often seem to spend more time calling other people names and proudly exclaiming how they ignore opposing points of view than taking other arguments seriously and at face value.

What We Know That Isn’t So

The truth is that there’s a great deal of “faith” that goes into ALL macroeconomic analysis, particularly work like Mr. Livingston’s which purports to derive results purely from the “data.”

On second thought, perhaps “faith” isn’t the right word at all. Bias is the word. Without any strong way to test macroeconomic analysis against a real counterfactual and see what would have happened had there been different policies or behaviors, economists have turned to sophisticated mathematical modeling in their efforts to look more scientific. As economist Ed Leamer noted, there’s a lot of “con” going on in “econometrics.” The process of building these models is rife with biasing judgment calls about how to input and manipulate the “data.”

When studying any complex system, especially an entire economy, there is essentially an infinite amount of “data” from which to choose. Attempts to tease out correlations often fall victim to confirmation bias. With such “data,” seek and ye shall find.

A rapidly growing economy also exhibits rising levels of personal consumption. Is the growth enabling the consumption or is the consumption causing the growth? Good luck getting an answer from nothing but the “data.” And that assumes that the data has been accurately measured in the first place, a far-from-safe assumption.

Theoretical assumptions color even the choices and methodologies through which various “data” is collected, often leaving gaps which an alternative approach may require.

In fact, especially in modern macroeconomics, what is often talked about as “data” isn’t even really data at all. It’s just computer simulations. When the Congressional Budget Office attempted to determine the impact of the 2009 American Reinvestment and Recovery Act “stimulus” legislation, which was dominated by temporary transfer payments aimed at encouraging consumption spending, they concluded that the program “increased the number of people employed by between 0.4 million and 2.4 million.”

First off, that’s a six-fold range of potential impact. Not so precise. Second, it’s obviously far below the predicted outcome at the time the legislation was passed, as the now infamous stimulus employment projections graph reminds us.

But most importantly, it’s a fiction. It’s a computer-generated fabrication. The CBO didn’t actually gather the “data” showing who received stimulus money and how many people were hired as a result to come up with these numbers. Rather, they collected new total employment and output data, comparing it against the total money actually spent and re-ran the computer models with their so-called “multipliers” to guesstimate how reality may be different from an alternative world where the stimulus wasn’t passed. This “data” has been cited as the primary defense of the stimulus and “proof” that the policy “created jobs.” That’s not real science. It’s computer games.

Macroeconomists have a very special kind of “faith.” They hold to a belief in their models even when the predictions of those models fail.

All of this is happening now in our modern era of ubiquitous global real-time data. One can only imagine how error-prone the data from the early 1900s must be. Mr. Livingston claims that, based on the “data,” something changed in 1919 such that, simple economic logic be damned, consumption became the engine of growth. But our national income accounts were developed after this period, in the 1930s and 40s. And as I wrote previously, even these metrics feature problematic categorizations and assumptions that render them quite limited for our understanding of what actually generates economic growth. Older data is even more prone to error.

Consider Mr. Livingston’s reference to “the long slump of 1873 to 1896.” There is considerable debate over this period, particularly because it was marked by deflation which post-1930s economists had reflexively (and incorrectly) come to associate with depression. New estimates indicate that real GDP grew steadily throughout the period. Since increasing output in a world with stable money (such as under a gold standard) will lead to lower prices through competition, the period saw rising output AND falling prices. At least, that’s what many economists who study the period now believe.

Again, given the nature of this data, it’s hard to know for sure. And that’s the point. In economic analysis, the “data” alone isn’t enough. We must combine the best data we can find with logical and behaviorally sound theories about the way the world works and then seek to falsify them.

In considering these ideas it’s important to note that, when looking back at the pre-Fed era, economies did grow rapidly and recover from recession without a central bank or active government intervention on behalf of stimulating recovery. This indisputable fact is easy to forget in our modern dark age of macroeconomics.

When Ludwig von Mises and Friedrich Hayek were lonely voices in the wilderness, carefully laying out their economic and behavioral theories for why socialism and central planning would prove unsustainable, what was believed to be the “data” suggested they were wrong.

Paul Samuelson was including graphs in his famous economics textbook that showed gross national product in the Soviet Union eventually exceeding the United States. From 1948 until 1990 this bullish prediction for the U.S.S.R. continued, though the projected date for Soviet economic domination kept being pushed farther and farther into the future without any note about the prior error. And Samuelson wasn’t alone in the economics profession in his bullishness, though there’s strong indication that ideology played a role. These were the mainstream textbooks.

In the end, the faux-scientific economists and their mathematical models were wrong while Mises and Hayek were right. The Soviet Union was revealed to be a house of cards able to launch satellites into space only at the expense of poverty and slave labor for the mass of their people. Central Planning came at the expense of private planning and individual efforts, devastating the real living standards of the people while the planners built their rockets.

Did Samuelson or his colleagues publicly renounce their methodology in the aftermath of the Soviet collapse? Have the champions of fiscal stimulus admitted their model was wrong in the face of significantly higher unemployment than their forecasts?

As I said, we are living in the dark ages of macroeconomics.

Know The Other Side

Mr. Livingston fundamentally misrepresents the classical debate and the law of markets, demonstrating a lack of understanding about that which he criticizes. He claims that classical theory asserts that “the production of goods always generated enough income in the form of profits and wages to pay for all the goods produced — to clear the market at remunerative prices.” This is objectively false.

The law of markets is emphatically NOT “supply creates its own demand.” There was never any question among economists in the classical tradition about whether recessions or systematic business losses could or did occur. In fact, the law of markets was the classical foundation for understanding why recessions occurred in the first place.

David Ricardo noted that “men err in their productions. There is no deficiency of demand.” His point was simple: if goods are collecting on the shelves it’s not because of “overproduction,” but because the wrong goods were produced and thus could not be sold at remunerative prices. The solution was to restructure production. And as I noted, the classical economists, from Hume through Hayek, also understood how reactionary hoarding of money could make a bad situation worse. Today’s “market monetarists” like Bentley University economist Scott Sumner, who surely cannot be accused of ignoring monetary effects on the economy, are merely an extension of this classical tradition. No classical economist of any significance denied the possibilities of recession the way that Mr. Livingston posits. In fact, there is a massive body of business cycle literature devoted to classical explanations of recession fully rooted in the classical law of markets.

Moreover, Mr. Livingston’s intense focus on consumer spending even puts him at odds with Keynes himself. Keynes’ framework was developed in response to the volatility of investment and its impact on growth and employment. Yes, his proposed solutions were underconsumptionist, advocating even preposterously wasteful expenditure as stimulus, and his methodology was blindingly over-aggregated to the point where he failed to distinguish between value-creation and value-destruction.

Yet Keynes was within the broad classical tradition and the broad and ongoing historical record in building a theory around booms and busts in investment activity. Which brings me back to one of the key pieces of empirical evidence which falsifies Mr. Livingston’s thesis that consumption drives growth: the actual pattern of growth and employment over time.

As we’ve seen time and again, consumption is relatively stable throughout the business cycle yet growth and employment still fluctuate with changes in investment. The 2001 recession is of particular interest because growth declined and unemployment rose even through consumption never faltered. How can this be the case if consumer spending drives the economy? Why is investment spending so important to the business cycle?

Why does every significant business cycle theory in the past 100 years, including Keynesianism, focus on investment volatility as a core empirical issue to understand if consumption is the driver of our economy? Mr. Livingston has yet to engage this question.

And no, hand-waving these concerns away as “short run” considerations isn’t sufficient. What is the “long run” if but a series of “short runs”? Bad policies today will make us poorer tomorrow.

Mr. Livingston has also ignored the work of economic historian Robert Higgs regarding the impact of investment on the Great Depression. He points to fast growth rates in 1933-1937 as proof that investment doesn’t matter, failing to take into account that 1933 was the trough of Great Depression. What caused the turnaround in 1933? Many modern students of the Depression, including former Obama economic adviser Christina Romer and Bentley’s Scott Sumner, point to the devaluation of the dollar, which finally ended the Federal Reserve’s deflationary spiral, not some sudden increase in consumption.

If not for a change in monetary policy, then a sudden increase in consumption spending surely begs the question: where did these consumers get the money? And that is the most simple, yet most crucial question Mr. Livingston ignores. The core logic and insight of the law of markets is that our ability to demand goods and services from the market is enabled by our supply of valuable goods and services at remunerative prices.

In short, we have to earn an income before we can have an income to spend. Mr. Livingston denies this, claiming “Commodities are not ultimately bought with other commodities, regardless of what John Stuart Mill said. They’re bought with money, the universal commodity.”

How, sir, does one acquire this universal commodity? Is it not through providing goods or services to others or getting it from someone who does? How does the passage of time between earning an income and spending it change the fact that someone must first earn it?

Despite the enormous changes and global complexity of our modern monetary economy, production and exchange continues to underlie it all. Money is an important component of any macroeconomic story, but its role in economic growth is purely one of aiding exchange.

Our real incomes are best understood as the actual goods and services we ultimately consume, not the pieces of paper that help us do it. For if economic growth were as simple to generate as creating “demand” out of thin air, the path to universal prosperity would be as simple as matching our unlimited human desire with a hefty printing press. Global history of inflationary collapse from China to Interwar Germany to Zimbabwe has shown that this approach truly is the worst of all macro folly. We can’t consume our way to prosperity.

I fear that the economics profession, once a bulwark against popular economic fallacies, has now become a net drag on society and our collective understanding of the world. Not the economic way of thinking, which in its simplest form remains powerful and empowering. Not every economist. But the profession as a whole. As economist Arnold Kling recently put it: “It is a self-perpetuating, in-bred, smug, narrow guild.” These are harsh words from a member of the guild. But there’s truth in them too.

Early Reaction to the Keynes vs. Hayek Video Rap: Scorn

Paul Solman: Because libertarian John Papola is a master of economics video-making, we have featured his work early and often on PBS NewsHour and The Business Desk, though when his John Maynard Keynes vs. Friedrich Hayek video rap with economist Russ Roberts debuted here in late 2009, it was anticipated with derision.

As the estimable Bruce Bartlett wrote in a blog post, Roberts was booked for the story as the counter to Robert Skidelsky, noted Keynes biographer and enthusiast.

But why Roberts instead of Richard Rahn, the conservative economist we had initially asked?

“Because he was prepared to make his points in the form of rap,” wrote Bartlett. “I’m not making this up. For a segment on the economics of John Maynard Keynes, this news program found someone who apparently has produced a rap video on the subject …The absurdity of being rejected for an economist who brings bling, babes and limos to the table was bad enough. The idea of making a rap video about Keynesian economics made it even more absurd.”

Four million page views later, the Keynes-Hayek video rap — “Fear the Boom and the Bust” — may well have become one of the most popular lessons in the history of macroeconomics. The visual punchline tilts toward Hayek as Keynes gets progressively drunk in the video. But as Lord Skidelsky himself said at the time of the Keynes portion: “Absolutely fair and brilliantly rhymed. It’s not a complete account of Keynes but it seems to be completely right.”

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This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions