Austrians vs. Keynesians – the basics

 Frank & Ernest
 
Keynes suggests government expenditures to fight unemployment.  Many in the Austrian school question this prescription because they believe that recessions reflect underlying problems that the Keynesian fix will not solve.  Who is right?

Imagine a modern economy where Keynesian assumptions apply, and “animal spirits” or business confidence drives investment.  Such an economy can have unemployment because prices and wages are sticky downward.  If consumers save 25% of income, and in a recession, we have a multiplier of 4. (The multiplier is 1/(1-b) where b is the propensity to save.)

What happens if the economy starts at full employment but falls into a recession, induced by an exogenous fall in investment, and the government steps in to maintain employment?  What happens if later, business confidence returns and investment increases? We would then observe a boom-recession-boom business cycle, as can be seen in the following table, where C, I, G, and Y stand for consumption, investment, government expenditure, and income, respectively, and the initial condition is that Y=100.

 

 

C

I

G

Y

Remarks

Initial full employment

75

10

15

100

 

1st recession

69

 8

15

 92

Investment falls by 2

1st stimulus by government

75

 8

17

100

Government increases spending

Subsequent boom

73

10

17

100

Investment returns to 10, but C falls

2nd recession

67

 8

17

92

Investment falls

2nd stimulus by government

73

 8

19

100

Government increases spending

Subsequent boom

71

10

19

100

Investment returns to 10, but C falls

… and so on, and so forth

 

 

 

 

 

.. After 10 booms

55

10

35

100

Government is now more than twice what it was in the beginning

 

G is a flow, and the Austrians say you can’t do the Keynesian stimulus fix over and over.  Over time G will just get bigger and bigger.   And C will get smaller and smaller, as can be seen from the table. 

This result arises because investment responds to business confidence, but in the boom phase, at full employment, there is no “free lunch”:  investment will have to crowd out consumption through a rise in prices.  If C and G were perfect substitutes, there is nothing wrong with theoretical values of C=0, and G=90.   But we know they are not.  C is supposed to be private goods, and G public goods for the Keynesian model to even begin to make sense.  Since food is a private good, C=0 is starvation city.  Keynes was perfectly correct: in the long run we die!  Either that or we have an economy dominated by government, i.e. a centrally planned economy.  This is why socialists and communists think like Keynes, whereas libertarians and those who favor markets think like Austrians.

Conclusions:

1.       The Austrians have a point.  The way to stop the recession is to make the price mechanism work.  Either that, or government must be prepared to reduce expenditure during the boom phase.

2.       But the Austrians are wrong for railing against any Keynesian fix.  When times are bad, but prices and wages are sticky, a one-time or reversible Keynesian fix is OK.   

How do we test for all this?  We can look at countries where G has crowded out C, and ask if that country is in good shape.  The extreme case today is Zimbabwe, where inflation in annual percentage points is in the billions!  Why that high an inflation rate?  C is at subsistence, and no one else will lend to government, so money needs to be printed in ever-increasing amounts. Zimbabwe today tells us that the Keynesian model is flawed.   

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8 thoughts on “Austrians vs. Keynesians – the basics

  1. Dear Prof,

    I guess I said too much without really addressing your conclusions about Austrians… So going back to your original post:

    Austrians do not think a recession can be stopped, nor is it healthy to do so. Recessions, according to the Austrian Business Cycle Theory (ABCT), are part of the economic process. Recessions should be allowed to run their course in order to purge the excesses of malinvestment in the system.

    A freely functioning market will always have recessions. But “booms and busts” are characteristic only of markets where govt engages in credit expansion. The ABCT correctly predicted the current financial meltdown in the US because of the preceeding massive credit expansion that took place before the bubble exploded.

    On the other hand, Keynesianism believes in the idea that a recession must be controlled at all costs (ie, massive gov’t spending). In effect, they try to postpone the inevitable with the unintended consequence of inflating bigger and deadlier bubbles.

    That I think is the essential difference between Austrians and Keynesians. The difference of course is a matter of economic life and death.

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  2. I don’t know. It used to be that doctors prescribed blood-letting, and of course the patient died. So, doing nothing was better. But now we know a bit more about when to let out blood, or how to cure with other means. So, Keynes was hoping to fix Say’s Law, but his model became a politician’s dream and a citizen’s nightmare.

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  3. Dear Prof,

    The Soviets have tried their damn best to produce a superior economy through central planning and unlimited violence. After more than 70 years, all they can show is a total wreck. Seventy years is enough time to show what works and what doesn’t.

    Yet somehow, we still have people believing in the myth that gov’ts can actually succeed in running a centrally planned economy. And if they screw up, we are made to believe that govt can actually fix what they just broke.

    Mass media presents economists like Krugman who say that Obama should stimulate this or stimulate that. Or that he should stimulate more when the first stimulant fails to stimulate. It’s as if the tragic Soviet experiment on central planning never happened.

    So now that we’ve all been fooled by central planning, should we still remain as willing fools?

    Or should we light a candle… and enjoy a really big bonfire…:-)

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