Tuesday, August 23, 2011

Hutchinson's Blatant Ignorance of Anti-Keynesianism...

Only Alien Invasion Can Rescue Keynes

by Martin Hutchinson
August 22, 2011

New York Times columnist Paul Krugman, in a talk show August 14, remarked that the fiscal stimulus caused by a fake Alien invasion of the United States would best rescue the U.S. economy, providing the inflation and growth that according to him it needs (a real Alien invasion would be equally efficacious, but might cause unpleasant collateral damage.) In that one statement, we can at last nail the Keynesian fallacy, showing once and for all just WHY it is intellectually bankrupt. Krugman is after all not some mere scribbler who has misunderstood the exquisite and subtle nuances of Keynesian economics; he is the proud possessor, unshared with any collaborator, of the 2008 Nobel Memorial Prize in Economic Sciences.

The problem with Keynesian analysis comes down to a factor I discussed last week, the use of Gross Domestic Product as a measure of output or well-being. In the public sector, GDP does not discriminate between activities such as defense and policing that produce genuine benefits for society and the economy (even if those benefits are difficult to quantify precisely) and activities that produce no such benefit. Last week I wrote that by stripping government spending out of the Bureau of Economic Analysis’ measure of Gross Domestic Product, one could arrive at a metric, Gross Private Product (GPP), which measured only those activities traded between a willing buyer and a willing seller, and for which a value is thus determinable.

In general, GPP will underestimate the value of output, because government’s activities have some value to its citizens. In a democracy, if a government undertook activities far in excess of what citizens demanded, or activities that were positively detrimental to its citizens’ best interests, that government would be voted out of office.

However even in a democracy the mechanism that controls government’s activities is very imperfect, since there are generally only two major parties to choose from, and the electorate has only the binary choice of whether to keep a government in office or to replace it with a government of the opposing party. In political systems with proportional representation, such as Belgium, even that simple choice may be unavailable to citizens, since each election results only in the awarding of tickets for a gigantic negotiation between parties on who should form the next government. In such a system, the electorate may believe strongly that some particular item of policy is detrimental to its interests, and yet have no means of making that distaste effective, as all major parties are committed to the offending item. In the very long run, new parties may spring up on a platform of abolishing the offending item, but even then, they may be ostracized by existing parties and thus unable to form a coalition to remove it. In a multinational polity such as the EU, in which communication between different national electorates is limited, the difficulty of expressing an electoral will becomes even more extreme, and the cost to the electorate of unattractive policies may increase ad infinitum.

The greatest distortion of the GDP measure arises in societies where democracy does not exist, and so actions by government are arbitrary, with the populace on whom costs are imposed being helpless to remove them. In North Korea and in the former Soviet empire it is surely now clear that government imposed enormous costs on its people, reducing their living standards far below what would have been available to them under a free-market with a minimalist state. Yet under GDP accounting, every bureaucrat, every secret policeman is counted toward national output – one reason why GDP estimates for the former Soviet bloc were so inflated, with East Germany in 1989 being listed in my Economist 1991 Diary as having a higher GDP per capita than Britain.

Arithmetically, that calculation was correct, but in terms of living standards it was laughable. The inadequacy of GDP as a measure also accounts for the massive decline in reported GDP for the Soviet bloc when the Wall fell. There was a real decline in well-being, from the rupture of traditional trading arrangements between different countries of the former Soviet Union (as between different countries of the former Austria-Hungary after 1918). However the major decline in GDP was due to the removal of government functions that had artificially depressed national welfare while inflating reported GDP. Downsizing the KGB (alas, not far enough) put many unhappy secret policemen out of a job, and reduced GDP, but it greatly increased the life possibilities for everyone else.

Even in authoritarian states in which the price mechanism still existed, such as the Third Reich, the same effect took place. Keynesians will assert that Hitler caused an economic recovery in Germany -- under conventional GDP accounting, in 1960 purchasing-power-parity dollars, GDP increased from $45 billion in 1925 to $77.2 billion in 1938. Keynesians will also agree with the rest of us that little of that happened before 1933, as a modest economic recovery was succeeded by the Great Depression. But except for ardent Nazis and uniform fetishists, few if any Germans enjoyed higher living standards in 1938 than they had in 1925 – the increase had all gone into the state sector, and particularly into armaments, concentration camps and the like. GDP had increased, but the increase was almost entirely concentrated in the tools of oppression – Hitler’s Volkswagen was a prestige demonstration project that went into production of civilian automobiles only in 1946.

The same applies to the well-known Keynesian thesis that World War II cured the U.S. Great Depression. World War II increased GDP, but more than 100% of the increase was devoted to munitions, building the Pentagon, employing teams of bureaucrats to control prices and government activity generally, much of it misguided. Gross Private Product decreased from $921 billion in 2005 dollars in 1940 to $427 billion in 1944, well below 1932’s level, showing that the private economy was badly squeezed. Then in 1946, while GDP decreased by 11%, GPP more than doubled to $1,309 billion. Readjustment was inflationary and disruptive, but it saw an astonishing increase in output and living standards.

The Keynesian thesis can be further demolished by looking at 1946 compared to 1938-40. At the tail end of the Great Depression, in November 1938, there was a massive turnover in the U.S. Congress, similar to the Tea Party revolt of 2010, in which the Republicans gained six Senate seats and an astonishing 72 House seats (9 more than in 2010). Although this did not give them a majority, it stopped dead the New Deal policies of heavy state spending and economic experimentation. GDP increased by 8% per annum between 1938 and 1940 and GPP increased even more rapidly, by 9.2% per annum.

This pulled the U.S. out of the Great Depression, with 1940 GPP 10% above that of 1929, but left the economy far below capacity. If you apply the average 1929-2000 growth rate of 3.43% per annum to 1929’s GPP, you get a 1940 full employment GPP estimate of $1,203 billion in 2005 dollars, 31% above the actual figure. That suggests that without the war the 1938-40 boom would naturally have continued, perhaps slowing somewhat, until it ran up against resource constraints. Apply 1938-40’s actual growth rate to the next six years and you get a 1946 GPP of $1,558 billion, 19% above actual 1946 GPP. Applying the 1929-2000 growth rate to 1929 GPP gives you $1,473 billion in 1946, 13% above the actual level. 1947 and 1948 showed further GPP increases, but reduced actual GPP’s gap below full employment GPP only to 11%.

Bottom line: without the war, GPP would have continued recovering at a rapid rate after 1940, probably giving a higher GPP by 1946. Second bottom line: a combination of the Great Depression and the war, probably mostly the latter, depressed 1946’s GPP by around 10%-12% below the level it would naturally have reached in a free peaceful market.

Intuitively this makes sense. As policy was stabilized after 1938, the U.S. economy began recovering rapidly to its natural full-employment level. World War II depressed the private economy to a low level, but its effect was mostly temporary, with an astonishing bounce-back as peace returned. However, a combination of the Great Depression and the damage caused by the war caused the United States to lose about 10%-12% of its full-employment output by 1946-48 (catching up which long-term may have resulted in the exceptionally good economic performance of 1948-66.) The Keynesian story of World War II’s economic boost makes no sense; this one does.

Returning now to Krugman’s Alien invasion, any such enormous “War of the Worlds” rearmament effect, on the analogy with World War II, would increase GDP, by definition, as heavy government spending pushed up the numbers. Conversely it would depress GPP, as private output for private consumption was diverted to make Heat-Ray Defense Shields and Inter-Galactic Bug Spray, neither of which would have any value if there were no Aliens. Once the Alien War was declared to be a hoax, GPP would recover close to its previous level, as peacetime reconversion occurred, probably without much direct diminution from a war that did not exist.

If the U.S. deficits had been acceptably financed at moderate interest rates, that would be that. The only long-term effect of the non-existent war would be a greatly increased level of government debt and some redundant and useless anti-Alien equipment. However, if the U.S. started anti-Alien rearmament with today’s excessive level of deficits and debt the potential effect would be much more serious, resulting in either a debt default or hyperinflation or both. Germany’s GDP declined by 10% in real terms between 1913 and 1925, in a period when Western Europe’s GDP as a whole rose by 10%. Since almost all of Western Europe experienced World War I and Germany was not invaded (so suffered little direct industrial destruction) the 20% relative German underperformance must have been largely the result of the Weimer hyperinflation and effective default on pre-war debt. A U.S. hyperinflation and default, likely if we fought imaginary Aliens, would presumably have a similar effect on U.S. output and living standards, making us 20% poorer.

Krugman is an exceptionally intelligent man of great integrity. But Keynesianism, and the Gross Domestic Product metric that it uses, are weapons of intellectual charlatanism. Until a better metric is developed, taking account of government’s value rather than its cost, we should measure our economic well-being by Gross Private Product, direct our economic policies accordingly, and let the government take care of itself.