Watching the failure of the “New Economics”

October 4, 2011

In his classic critique of John Maynard Keynes, “The Failure of the ‘New Economics’,” Henry Hazlitt notes in a passage entitled “Equilibrium of an Ice Cube”:

It is not too difficult to account for Keynes’s misuse of the term “equilibrium” and for the uncritical acceptance of this misuse by so many writers. The older economists thought of equilibrium as an actual state of affairs. They contrasted “stability” with “disturbance,” a “period of equilibrium” with a “period of transition.” But any living economy is always in “transition” – and fortunately so. An economy that had reached completely “stable equilibrium” would be an economy that had not only stopped growing but had stopped going.

The way Hazlitt derides the Keynesian concept of “equilibrium” reflects the view I have developed working with my colleague Dennis Santiago — namely that the human action we call “economics” is a lot closer to the physical concept of entropy than to metaphors such as bubbles.

Entropy is derived from the second law of thermodynamics and is a fancy way of describing the movement of energy in the physical world. We’re not talking the quantum world of atoms here, but rather things you can see and measure — the sensible, classical world as defined by Richard Feynman. A pendulum is an example of entropy, with roughly equal energy moving from one side to another.

Another example of entropy is an ice cube melting in a glass of water in a warm room. The disaggregation of the ice crystals into liquid or the energy spent in the change of state from ice to water and then ultimately into vapor, is entropy. The process is continuous and can repeat endlessly. When the room gets colder, the water vapor condenses and freezes. Think of the Fed trying to turn up the heat in the room when it comes to the US economy.

Entropy is applied to information theory as well as the physical world of people and markets, as when a piece of information is provided to a single agent. The progression of the data to other people mimics the way energy moves through the physical world – and data moves through financial markets. How that information moves from one person to another, driven by the relevance of that data, affects consumers and whole societies.

For classical liberals like Hazlitt, each person or company is free and independent regarding what it contributes to an economy. Call that contribution “energy” using the entropy metaphor. People were not the rational, consistent actors “assumed” by the Keynesian faith for the sake of selling their crackpot ideas, but independent agents.

But by the time Hazlitt stopped writing for The New York Times in 1946 and moved to Business Week, the evolution of US economic thinking toward a more “dynamic”, a.k.a. Keynesian model, was complete. Over the next half century, anything like a free market perspective in American economic thinking became more and more rare as generations of American economists adopted the Keynesian world view of government-managed economies and endless public debt.

Why did the Keynesian faith win out? Economist salesmen like Keynes focused on the future, a perfect formula for the political class to use to drive growth well into the 1990s. This Keynesian message of growth via inflation and debt was also perfectly aligned with the message produced on Wall Street of ever rising earnings growth and stock prices. With the Keynesian revolution, however, also came debt, inflation, and progressively larger and larger financial and economic busts.

In his new book, “Where Keynes Went Wrong and Why World Governments Keep Creating Inflation, Bubbles and Busts“, Hunter Lewis attacks Keynesian economic thinking when it comes to the role of the state in the economy and more. In an overt tribute to Hazlitt, Lewis wastes no time in calling out Keynes as an elitist who really had contempt for free individuals and markets.

Lewis divides his work into three opening sections, including a review of Keynes’ writings and statements, and then a discussion of how Keynes’ economic ideas went badly wrong. Lewis relates the abandonment of traditional American economic values to current events, and the shameful behavior of President George W. Bush following the 2007 financial crisis.

President Bush famously said to conservative critics: “I’ve abandoned free market principles to save the free market system.” He was talking about authorizing useless fiscal stimulus and bailouts for Wall Street banks. Lewis asks: “How exactly did Bush know that his actions were necessary or that they would prevent the worst? How could he be sure that his actions would not make matters worse, either immediately or over time?” How, indeed.

The answer, Lewis says, is because of Bush’s economic advisers — Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke. These men are adherents of the neo-Keynesian faith which, in bad times, says to increase spending and monetary policy, whether funded with tax dollars or debt. The predominance of the Keynesian world view is so complete, Lewis argues, that policy makers in Washington from Bush to Barack Obama see policy responses “through a Keynesian lens,” to quote economist Gregory Mankiw of Harvard.

For Americans and any other people who value personal freedom, the work of J.M. Keynes ought to be anathema, not a widely followed and respected economic rule for policy. Hunter Lewis provides an excellent overview and refutation of Keynes’s work that informs readers who are trying to understand the roots of the economic crisis affecting us and and provokes them to participate in the solution.

Comments

OK this tells me all I need to know: it’s a rant not a book. Move along nothing to see here.

Posted by SeanFernyhough | Report as abusive
 

An utterly wrong appraisal of the history of economic thought in the post WW2 period.

Posted by SeanFernyhough | Report as abusive
 

“People were not the rational, consistent actors “assumed” by the Keynesian faith for the sake of selling their crackpot ideas, but independent agents.”

That’s ironic considering Austrians and others are famous for a ridiculous conception of rationality while Keynes allowed that economic actors often display “animal spirits.”

“Over the next half century, anything like a free market perspective in American economic thinking became more and more rare as generations of American economists adopted the Keynesian world view of government-managed economies and endless public debt.”

So policies designed to maintain the stability of free markets, property rights, international trade, employment, etc. are not only wrong but are not “anything like a free market perspective”? That, sir, is ridiculous. It’s also ironic, considering that Milton Friedman, the champion of free markets, may have had the most technocratic view of Central Bank management of the money supply.

There are so many other outright errors in this article, I would say that for Americans and any other people who value truth, this article ought to be anathema, not a widely read and respected contribution to the world of ideas.

Posted by Jayhay | Report as abusive
 

So what’s the alternative? Bank failures on a massive scale? Should we have retried Hoover’s response to a major economic crisis of do nothing and hope for the best?

Posted by Aristocrat | Report as abusive
 

I believe the force of outropy is greater than the entropy. Outropy is stronger than entropy and holds entropy in check, creating order out of chaos and preventing systems from disordered dissolve. Keynes works great too: when the distribution of wealth inequality gets too great (we don’t need to go back to fiefdoms), take a lot of money away from the hoarding, freeloading banks and the rich people who aren’t spending enough of their money and give it to lower income people who are really good at spending money. How simple is that!

Posted by Woltmann | Report as abusive
 

OK Feynstein, please explain to me where all the energy (money) in the system went when the banks, GSE’s, federal programs like FHA, and other RE lending entities ended up owning all these foreclosed properties? Where did all this money evaporate off to? These “assets” all have to be on somebodies books somewhere. If it’s on somebodies books chances are 9 out of 10 the US government is subsidizing what its costing to carry it along. Note the Federal Government is subsidizing the Financial Institutions and not the investors. So why don’t we deregulate the banking industry more so they can buy, foreclose and then carry on some set of books somewhere yet more bad book property at ridiculously overinflated prices, and the financial industry can securitize the mortgages on yet even worse investments, the ace ratings agencies can blow AAA gold dust up everyones ass…ad nauseum… Anybody who wants to deregulate the banking and/or financial industry at this point in time is a babbling idiot ..

Posted by Woltmann | Report as abusive
 

Where Keynes went wrong????

This is like reading about an eight hour long film of economic GOP policy picking its nose and Libertarian critics acclaiming it as a profound examination upon the contemporary economical condition. Deeply moving.

I would say that Mr Hazlit needs to Occupy something else (why not Wall Street) rather than babble the same ad nauseaum right wing rhetoric.

Posted by elsueco | Report as abusive
 

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