In Chapter 14 of Foundations of Economics, Shawn Ritenour discusses macroeconomic policy, focusing on the monetarist and Keynesian schools. He first outlines their tenets and then explains why he considers each a flawed approach to the questions of inflation and the business cycle.
Monetarism and Keynesianism both prescribe government intervention into the economy, particularly into the monetary system, to manage the business cycle. Monetarism is based on the Quantity Theory of Money, developed by David Hume, David Ricardo, John Stuart Mill, and Irving Fisher. In recent memory its most prominent proponent is Milton Friedman.
The central premise of monetarism is the equation MV=PT, where M is the stock of money, V is the velocity of money (rate at which it circulates), P is the price level, and T is the total quantity of goods bought with money. Monetarists believe that the business cycle is managed in part by maintaining a stable P, so as T increases through rising productivity, M should also increase by a proportional amount. Monetarists thus prescribe inflation.
While acknowledging that this equation contains some truth in connecting the stock of money to the overall price level, Ritenour argues that an “inferior mathematical approach” is unnecessary to reach the same conclusion already discussed in earlier chapters. In the equation MV=PT, T is a meaningless variable because there is no common unit of measurement that can be used to add up all the different goods in an economy. Since T is meaningless, P is meaningless as well because it can only be calculated in reference to T. Prices of goods measured in different units cannot be averaged. Attempts to solve this problem through the use of weighted price indices such as the CPI fail because ultimately the weighting assigned to each component of the index is arbitrary.
Ritenour states that market participants’ voluntary actions will lead to an appropriate adjustment in price for each good as productivity and the demand for money change. There is no need to manipulate the PPM through inflation, as this will lead to the harmful effects discussed in the previous chapter.
On to Keynesian theory! John Maynard Keynes’s General Theory of Employment, Interest, and Money was the most influential economics text of the 20th century not, as Ritenour states, because of its compelling arguments, but because it provided a justification for policies that governments already favored and in many cases were implementing. Keynes contended that recessions are caused not by inflationary booms, but by insufficient aggregate demand.
Keynes used the mathematical equation Y=C+I, where Y is national income, C is consumption spending, and I is business investment. Keynes is responsible for the current emphasis on GDP. He believed that saving was not linked to investment and was simply a residual left over after people had spent all they wanted on consumption. He called the fraction of income spent on consumer goods the “marginal propensity to consume” (MPC).
In Keynes’s thinking, the MPC was relatively stable, so the trick to ensuring economic growth is to increase business investment when it falters. He thought this could be done without increasing savings, positing a “multiplier effect” that brought about increased national income above and beyond the increase in business investment. (Ritenour uses a hypothetical example with some math I don’t want to reproduce. The bottom line is that Keynes severed the link between saving and investment, and then declared saving next to useless.)
Keynes viewed the interest rate, which he thought was purely monetary, and the return on investment as completely separate things, and that harmful economic effects resulted when the former rose above the latter. So he proposed a policy of inflation to force interest rates down and encourage greater investment. From this perspective, the one big danger of a policy of inflation is that rates could get so low that a “Liquidity Trap” would result, in which people would opt simply to hold cash rather than invest.
Having laid out the Keynesian view in twelve pages, Ritenour points out several problems with the paradigm. They largely have to do with Keynes’s ignoring of the time component in the economy. There can be no investment without prior savings. An increase in the demand for money does not necessarily lead to a change in the ratio of consumption spending to investment spending. In this scenario interest rates will not change because time preference is unaltered. Prices of consumer goods may fall, but prices of factors of production will fall, too, and a balance will be maintained. Because interest rates are a time phenomenon and not a money phenomenon, Keynes’s “liquidity preference” theory of interest is unsound.
Additionally, we’ve already seen that return on investment is a form of interest, so Keynes’s separation of interest from investment returns is flawed. Finally, the focus on aggregate demand without concern for supply puts the cart before the horse. Nothing can be consumed that has not first been produced. Attempts to raise consumption by itself will only lead to capital consumption and a fall in standards of living over time.
From the chain of deductions originating in the Christian insight that people made in God’s image act purposefully, Ritenour argues that the monetarist and Keynesian prescriptions for inflation will fail to solve the problem of the business cycle. The same holds true for “fiscal stimulus” of the kind we’ve seen over the last few years in this country. What is needed is the restoration of policies that favor capital accumulation and market-clearing prices. What is needed is a free market.