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
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.
Next Section: Milton Friedman and Monetarism
Return to Main Page