Spending Our Way to Economic Collapse


Sean Gabb

Free Life Commentary,
A Personal View from
The Director of the Libertarian Alliance
Issue Number 177
24th November 2008

Comments| Trackback

The British Government’s Tax and Spending Proposals:
Testing Keynes to Destruction (Again!)
by Sean Gabb

Tomorrow afternoon, all the journalists have been primed to say, the British Government will cut taxes and increase spending. The alleged purpose of this is to prevent a deep recession. The real purpose, there can be no doubt, is to win the next general election for Labour – and, since the Conservatives remain as useless as ever, it may well work. I will, however, discuss the alleged purpose. Politics aside, it will be about as catastrophic a response to our current troubles as can be imagined.

The politicians of every party, and every journalist I have read, are agreed on the nature of these troubles. The crises of the past year in the banking sector have caused investment to fall. Consumption is now beginning to fall. To use the Keynesian jargon, aggregate demand has fallen, or is falling, below the level needed to keep national income at its full employment level. The answer is for the Government to cut taxes, thereby encouraging people to spend, and to increase its own spending.

It is also agreed by all that interest rates should be cut, thereby encouraging people to spend still more and encouraging firms at least to go back to investing as much as they were until the troubles began. It is admitted that doing all this might cause other problems. But this admission is followed by warnings about the horrors of the deflation we otherwise face.

This kind of economic reasoning is not as worthless as some of my friends believe. In countries as heavily regulated and corporatised as modern Britain and America, an increased preference to hold cash will not be balanced in the short or medium term by changes in the structure of relative prices. Firms will cut production rather than prices. Trade unions will prefer job losses to wage cuts. This can mean a very long and severe recession. There can be little doubt that, regardless of whatever would have followed, even without the Second World War,  the currency debasement of 1931 moderated the effect here of the Great Depression.

However, while not entirely worthless in certain conditions, what we are now being told is entirely worthless now. There is no doubt that people are spending and investing less than they were, and that they will continue to spend and invest less for some while to come. But, before agreeing that the politicians should be allowed to do what they most enjoy – namely, spending money that is not their own and that often does not yet even exist – we need to ask why we are in such trouble. The answer will explain why the proposed response will be catastrophic.

For many years, interest rates have been held below the sort of level needed to balance the supply of savings and the demand for loans. The result has been inflation. That many consumer prices have been falling is no argument against this proposition. Inflation is best seen not as price increases but as monetary expansion. There was a time when monetary expansion led fairly soon to price rises. Where at least Britain is concerned, though, most consumer goods are imported. So long as foreigners are willing to finance a growing current account deficit without devaluation, demand for imported consumer goods can expand rapidly and for years without any increase in prices.

The new money will therefore be used partly for investments in new production that may or may not be wise in the long term – and also to bid up the prices of property and of paper assets.

These bubbles never last. There comes a point where people lose faith in a currency, and where the upward spiral of asset prices is checked.  The fall in the currency will push up consumer prices. Overvalued assets will fall in at least real terms. Many other investments will be shown to have been unwise. The immediate reasons for their bursting are less important than that they always will burst. This has now happened. There is no definite rule in these matters. But it seems that the length and intensity of the boom is roughly in proportion to the scale of the recession that follows.

The financial collapse we are now witnessing, therefore, should not be seen as some autonomous fall in aggregate demand that can be offset by increasing other variables in the national income income equation. It is instead part of the unavoidable correction to past experiments in demand management. All the clever people disagree. They do believe that playing with aggregate demand can avert, or at least moderate, the coming recession. Now, these people are often very clever – most of them more so than I am. They are still wrong.

Cutting taxes is always a good idea. Not balancing them with spending cuts is not so good. If the British Government will do tomorrow what the journalists say it will, the inflation will be continued, though now without the confidence in sterling that allowed it before last year to create the illusion of prosperity. Taxes will fall. Government and other spending will rise. Interest rates will be cut. In the short term, this may be enough to win the next election for Labour. It not even before, though, the pound will collapse shortly after. Interest rates will then need to rise sharply, if the Government is to continue selling its bonds and if consumer prices are not to rise sharply and continuously.

There is no reasonable chance of deflation. For the next few months, while the collapse of sterling is only gathering momentum, firms will be able to reduce prices to keep up demand for their products. This will give the appearance of deflation. Eventually, though, their margins will not be further reducible, and the collapse of sterling will raise costs that must be handed on. This will happen even without further action. The bank rescues of last month were financed by money creation that will, sooner or later, find its way into circulation. Deflation is the last of our worries.

I have no professional expertise in finance, and so give no warranties of any kind. This being said, I think it a good idea for anyone who has a mortgage to get the best fixed rate he can between now and Easter, and otherwise to avoid saving money at any rate fixed longer than six months ahead. If he wants to buy imported consumer goods, he should do so now or, at latest, in the sales after Christmas.

Beyond this, I have no advice. Just because I do not believe in the solution that everyone else is urging on us does not mean that I have any alternative solution to offer. We should never have got ourselves into this mess. Failing that, the recession should have been allowed to hit last year. Since it was then deferred, it should be allowed to hit now. It will do nothing to moderate the inevitable recession. But there is a good case for cutting taxes and government spending now by at least a third, and then by five per cent a year every year for the next decade. And there is a case for returning to a fully convertible gold standard.

Of course, no politicians will take my advice. If any do read what I have just said, they will at best laugh with contempt. But I am right, and I feel some grim satisfaction in being able, come 2010, to send this article out again under the heading “See – I Told You So!”.

NB—Sean Gabb’s book, Cultural Revolution, Culture War: How Conservatives Lost England, and How to Get It Back, can be downloaded for free from http://tinyurl.com/34e2o3

About these ads

6 responses to “Spending Our Way to Economic Collapse

  1. Pingback: » Spending Our Way to Economic Collapse

  2. Steven Northwood

    Thanks Sean, I’ve got a little list of things I want to buy in, consumer products etc, and I think I’ll do so now before any price rises. Things are still looking relatively cheap in the shops.

    I came to the conclusion a while ago that although many of the beliefs held for example by the Austrian and Chicago School students may be hard for most people to accept, if the argument were to come down to who would win a test case, who is actually in the right, it is those people who would win.

    But as you say, the people in the chairs, particularly Gordon, wouldn’t hear of it. I’m sure he’s a nice old chap after everything though. Perhaps he should build a Colosseum, maybe something dome-shaped.

  3. Hello!

    If we were to learn that the highest economic policy decisions were being made on the basis of Astrology; or witchcraft; or divination of the reading of entrails; we would be rightly very concerned, because such pseudo-scientific theories and practices cannot have the three elements which are a necessary requirement of scientific methodology and decision-making.

    Yet, since around 1980, tht is exactly what has been happening.

    Thatcher, Reagan and the “conservative” movements in Britain and America were profoundly influenced by, structured by, and in practice led by the — supposed — “economic science” of the Chigago School of Milton Friedman, and the Austrian School of Friedrich Hayek, both of whom I’ve met on a number of occasions as part of “Free Market” activism. My Friedman books are inscribed by Friedman; my Hayek books by Hayek. I believed!

    By late 1980, it was increasingly obvious that something was seriously wrong with these ideas, and with attempts at their implementation, which led to “Crony-Capitalism” rather than free markets, and increased repression rather than individual freedom. The ideas were frequently used (as ideologies so often are) as “covers for unconfessable interests” (in Robert G. Wesson’s apt phrase).

    As a devotee of the works of Karl Popper, I set to work researching what was going wrong, even as stock prices and property prices boomed. It seemed very clear that these expansions were “bubbles” on an unprecedented scale, which would inexorably lead to catastrophic collapses. At that time, I did not fully grasp the reality of vast leveraged borrowing and its role in fuelling the “bubbles.” As I did, I realized that $4 could be leveraged into $100 and more, and that up to $100 trillion of “Toxic Debt” was accumulating. (It’s not possible to know the exact figure, or anything near it, because the undelying “assets” are structured into the accounts of businesses all over the world, and accounting standards have all but evaporated).

    My “best guesses” as to share prices and property prices were that the underlying stable values of shares were about 20% of peak prices, and property prices had underlying stable values of about 25% of peak prices.

    As fear-filled buyers’ wallets snap shut, even those figures are questionable now.

    It is very clear that the current economic “death spirals” are in large part fuelled by the failure of pseudo-scientific theories to analyse problems and offer predictive solutions. Increasingly, policy-makers are just flailing around on an ad hoc basis, creating even greater fears and uncertainties and disruptions.

    There has always been an intellectually deadly synergy between a whole range of Cognitive Biases (see Wiki, “List of Cognitive Biases) and these mistaken economic theories.

    http://en.wikipedia.org/wiki/List_of_Cognitive_Biases

    This is the day-to-day problem underlying the crises.

    ———— * * * * * ————

    http://en.wikipedia.org/wiki/Imre_Lakatos

    The underlying, profoundly relevant problem is described by (inter alia) Imre Lakatos (and Spiro Latsis). Lakatos was profoundly hostile to Marxism. After escaping both Nazism and Communism, he wanted an Open Society.

    “In 1960 he was appointed to a position in the London School of Economics, where he wrote on the philosophy of mathematics and the philosophy of science. The LSE philosophy of science department at that time included Karl Popper, Joseph Agassi and John Watkins. It was Agassi who first introduced Lakatos to Popper under the rubric of his applying a fallibilist methodology of conjectures and refutations to mathematics in his Cambridge PhD thesis.

    With co-editor Alan Musgrave, he edited the highly-cited Criticism and the Growth of Knowledge, the Proceedings of the International Colloquium in the Philosophy of Science, London, 1965. Published in 1970, the 1965 Colloquium included well-known speakers delivering papers in response to Thomas Kuhn’s “The Structure of Scientific Revolutions”.

    Lakatos remained at the London School of Economics until his sudden death in 1974 of a brain haemorrhage, aged just 51. The Lakatos Award was set up by the school in his memory.

    In January 1971 he became editor of the internationally prestigious British Journal for the Philosophy of Science until his death in 1974,[1] after which it was then edited jointly for many years by his LSE colleagues John Watkins and John Worrall, Lakatos’s ex-research assistant.

    His last LSE lectures in scientific method in Lent Term 1973 along with parts of his correspondence with his friend and critic Paul Feyerabend have been published in For and Against Method (ISBN 0-226-46774-0).

    Lakatos and his colleague Spiro Latsis organised an international conference devoted entirely to historical case studies in Lakatos’s methodology of research programmes in physical sciences and economics, to be held in Greece in 1974, and which still went ahead following Lakatos’s death in February 1974. These case studies in such as Einstein’s relativity programme, Fresnel’s wave theory of light and neoclassical economics, were published by Cambridge University Press in two separate volumes in 1976, one devoted to physical sciences and Lakatos’s general programme for rewriting the history of science, with a concluding critique by his great friend Paul Feyerabend, and the other devoted to economics.[2]

    [edit] Proofs and refutations

    Main article: Proofs and Refutations

    Lakatos’ philosophy of mathematics was inspired by both Hegel’s and Marx’ dialectic, Karl Popper’s theory of knowledge, and the work of mathematician George Polya.

    The book Proofs and Refutations is based on his doctoral thesis. It is largely taken up by a fictional dialogue set in a mathematics class. The students are attempting to prove the formula for the Euler characteristic in algebraic topology, which is a theorem about the properties of polyhedra. The dialogue is meant to represent the actual series of attempted proofs which mathematicians historically offered for the conjecture, only to be repeatedly refuted by counterexamples. Often the students ‘quote’ famous mathematicians such as Cauchy.

    What Lakatos tried to establish was that no theorem of informal mathematics is final or perfect. This means that we should not think that a theorem is ultimately true, only that no counterexample has yet been found. Once a counterexample, i.e. an entity contradicting/not explained by the theorem is found, we adjust the theorem, possibly extending the domain of its validity. This is a continuous way our knowledge accumulates, through the logic and process of proofs and refutations. (If axioms are given for a branch of mathematics, however, Lakatos claimed that proofs from those axioms were tautological, i.e. logically true.)

    Lakatos proposed an account of mathematical knowledge based on the idea of heuristics. In Proofs and Refutations the concept of ‘heuristic’ was not well developed, although Lakatos gave several basic rules for finding proofs and counterexamples to conjectures. He thought that mathematical ‘thought experiments’ are a valid way to discover mathematical conjectures and proofs, and sometimes called his philosophy ‘quasi-empiricism’.

    However, he also conceived of the mathematical community as carrying on a kind of dialectic to decide which mathematical proofs are valid and which are not. Therefore he fundamentally disagreed with the ‘formalist’ conception of proof which prevailed in Frege’s and Russell’s logicism, which defines proof simply in terms of formal validity. [ Alfred Tarski's work resolves this problem. ]

    On its publication in 1976, Proofs and Refutations became highly influential on new work in the philosophy of mathematics, although few agreed with Lakatos’ strong disapproval of formal proof. Before his death he had been planning to return to the philosophy of mathematics and apply his theory of research programmes to it. One of the major problems perceived by critics is that the pattern of mathematical research depicted in Proofs and Refutations does not faithfully represent most of the actual activity of contemporary mathematicians.[citation needed]

    [edit] Research programmes

    Lakatos’ contribution to the philosophy of science was an attempt to resolve the perceived conflict between Popper’s Falsificationism and the revolutionary structure of science described by Kuhn. Popper’s theory as often reported (inaccurately) implied that scientists should give up a theory as soon as they encounter any falsifying evidence, immediately replacing it with increasingly ‘bold and powerful’ new hypotheses. However, Kuhn described science as consisting of periods of normal science in which scientists continue to hold their theories in the face of anomalies, interspersed with periods of great conceptual change. Popper acknowledged that excellent new theories may be inconsistent with apparently empirically well supported older theories. For example, he pointed out in Objective Knowledge (p.200) that Newton’s theories were inconsistent with Kepler’s third law. However, whereas Kuhn implied that good scientists ignored or discounted evidence against their theories Popper regarded counter evidence as something to be dealt with, either by explaining it, or eventually modifying the theory. Popper was not describing actual behaviour of scientists, but what a scientist should do. Kuhn was mostly describing actual behaviour.

    Lakatos sought a methodology that would harmonize these apparently contradictory points of view, a methodology that could provide a rational account of scientific progress, consistent with the historical record.

    For Lakatos, what we think of as a ‘theory’ may actually be a succession of slightly different theories and experimental techniques developed over time, that share some common idea, or what Lakatos called their ‘hard core’. Lakatos called such changing collections ‘Research Programmes’. The scientists involved in a programme will attempt to shield the theoretical core from falsification attempts behind a protective belt of auxiliary hypotheses. Whereas Popper was generally regarded as disparaging such measures as ‘ad hoc’, Lakatos wanted to show that adjusting and developing a protective belt is not necessarily a bad thing for a research programme. Instead of asking whether a hypothesis is true or false, Lakatos wanted us to ask whether one research programme is better than another, so that there is a rational basis for preferring it. He showed that in some cases one research programme can be described as progressive while its rivals are degenerative. A progressive research programme is marked by its growth, along with the discovery of stunning novel facts, development of new experimental techniques, more precise predictions, etc. A degenerative research program is marked by lack of growth, or growth of the protective belt that does not lead to novel facts.

    Lakatos claimed that he was actually expounding Popper’s ideas, which had themselves developed over time. He contrasted Popper0, the crude falsificationist, who existed only in the minds of critics and followers who had not understood Popper’s writings, Popper1, the author of what Popper actually wrote, and Popper2, who was supposed to be Popper as reinterpreted by his pupil Lakatos, though many commentators believe that Popper2 just is Lakatos. The idea that it is often not possible to show decisively which of two theories or research programmes is better at a particular point in time whereas subsequent developments may show that one is ‘progressive’ while the other is ‘degenerative’, and therefore less acceptable was a major contribution both to philosophy of science and to history of science. Whether it was Popper’s idea or Lakatos’ idea, or, most likely, a combination, is of less importance.

    Lakatos was following Pierre Duhem’s idea that one can always protect a cherished belief from hostile evidence by redirecting the criticism toward other things that are believed. (See Confirmation holism and Duhem-Quine thesis). This difficulty with falsificationism had been acknowledged by Popper.

    Falsificationism, (Popper’s theory), proposed that scientists put forward theories and that nature ‘shouts NO’ in the form of an inconsistent observation. According to Popper, it is irrational for scientists to maintain their theories in the face of Natures rejection, yet this is what Kuhn had described them as doing. But for Lakatos, “It is not that we propose a theory and Nature may shout NO rather we propose a maze of theories and nature may shout INCONSISTENT”[3]. This inconsistency can be resolved without abandoning our Research Programme by leaving the hard core alone and altering the auxiliary hypotheses. One example given is Newton’s three laws of motion. Within the Newtonian system (research programme) these are not open to falsification as they form the programme’s hard core. This research programme provides a framework within which research can be undertaken with constant reference to presumed first principles which are shared by those involved in the research programme, and without continually defending these first principles. In this regard it is similar to Kuhn’s notion of a paradigm.

    Lakatos also believed that a research programme contained ‘methodological rules’, some that instruct on what paths of research to avoid (he called this the ‘negative heuristic’) and some that instruct on what paths to pursue (he called this the ‘positive heuristic’).

    Lakatos claimed that not all changes of the auxiliary hypotheses within research programmes (Lakatos calls them ‘problem shifts’) are equally as acceptable. He believed that these ‘problem shifts’ can be evaluated both by their ability to explain apparent refutations and by their ability to produce new facts. If it can do this then Lakatos claims they are progressive[4]. However if they do not, if they are just ‘ad-hoc’ changes that do not lead to the prediction of new facts, then he labels them as degenerate.

    Lakatos believed that if a research programme is progressive, then it is rational for scientists to keep changing the auxiliary hypotheses in order to hold on to it in the face of anomalies. However, if a research programme is degenerate, then it faces danger from its competitors, it can be ‘falsified’ by being superseded by a better (i.e. more progressive) research programme. This is what he believes is happening in the historical periods Kuhn describes as revolutions and what makes them rational as opposed to mere leaps of faith (as he believed Kuhn took them to be).

    [edit] The Milton Friedman neoclassical economics case study

    In August 1972 a case study of the methodology of neoclassical economics by Lakatos’s London School of Economics colleague Spiro Latsis published in The British Journal for the Philosophy of Science found Milton Friedman’s methodology to be ‘pseudo-scientific’ in terms of Lakatos’s evaluative philosophy of science, according to which the demarcation between scientific and pseudo-scientific theories consists of their at least predicting testable empirical novel facts or not.[5] Latsis claimed Friedman’s instrumentalist methodology of neoclassical economics had never predicted any novel facts.[6] In its defence in a three-page letter to Latsis in December 1972, Friedman counter-claimed that the neoclassical monopoly competition model had in fact shown empirical progress by predicting phenomena not previously observed that were also subsequently confirmed by empirical evidence.[7]But he notably never actually identified any specific economic phenomenon as an example of any such successfully predicted positive novel fact.[8]

    In early 1973, as Editor of the Journal, Lakatos invited Friedman to submit a discussion note based on his December 1972 letter to Latsis for publication in a symposium on the issue of the scientific status or not of neoclassical economics . Lakatos even assured Friedman he would have the last word.[9] But Friedman never took up Lakatos’s invitation. Three years later, in 1976 Friedman was awarded the Nobel Prize for Economics without this outstanding charge of ‘pseudo-science’ ever having been publicly conclusively rebutted. The citation for Friedman’s prize said it was awarded “for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilisation policy.” But four Nobel Prize laureates protested at Friedman’s award, and most notably the 1974 joint laureate of the Economics award, Gunnar Myrdal, complained that Friedman’s prize (and also Hayek’s) was undeserved because the economics did not qualify as a science, thus apparently concurring with Latsis’s judgment that Friedman’s economics was ‘pseudo-scientific’.

    ———— * * * * * ———

    This is what I wanted to convey to you.

    Best Wishes,

    Tony Hollick

    Rainbow Bridge Foundation

  4. Sean:

    Just a point on the Gold Standard.

    Already, Gold Bugs are being ripped off by purveyors of faked gold coins and ingots, consisting of gold jackets around tungsten cores. Tungsten has the same density as gold to three decimal places. Gold blocks x-rays. Without desreuctive testing, it is just not possible to distinguish fake coins and ingots from solid gold ones.

    Gold depositories are hardly in a much better position. Te “examiners” can be bribed or coerced.

    “Money” is whatever is used by people as a means of exchange and a store of value. Good definitions read from right to left! Annything that works for people is OK.

    It is interesting that in the present anarchy of Somalia, “official” banknotes have not been printed for years. Yet there is a thriving market in “new Somali banknotes.” And these circulate. This is interesting — it seems that any money is better than no currency.

    Best,

    Tony

  5. Buy gold from reputable suppliers. Otherwise, buy worn coins with no mintage and insist on cutting several chosen at random in half. Fraud is always a problem, but is not a big one.

  6. Sean:

    The problem is in everyday life, everyday transactions. While you can (I guess) sellotape GBP 20 notes back together after testing their “tear” authenticity, would you allow a shopkeeper to do that to your twenty? Or your gold coin? Gold-based currencies are only as good as the integrity of the depositories. After the recent debacle, would you trust those people??

    Best,

    Tony

    PS: The Black Market in Nazi Germany ran on gold, even though this was a capital offence. But what sirt of a “free market” was that?