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Chicago economics — a dangerous pseudo-scientific zombie

from Lars Syll

Savings-and-InvestmentsEvery dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn’t rest on any perceptions or behavioral assumptions.

John Cochrane

What Cochrane is reiterating here is nothing but Say’s law, basically saying that savings are equal to investments, and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity there is of course nothing to say about the law, but as such it is also totally uninteresting from an economic point of view. As some of my Swedish forerunners — Gunnar Myrdal and Erik Lindahl — stressed more than 80 years ago, it’s really a question of ex ante and ex post adjustments. And as further stressed by a famous English economist about the same time, what happens when ex ante savings and investments differ, is that we basically get output adjustments. GDP changes and so makes saving and investments equal ex ost. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

Government borrowing is supposed to “crowd out” private investment.

william-vickrey-1914-1996The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

A couple of years ago, in a lecture on the US recession, Robert Lucas gave an outline of what the new classical school of macroeconomics today thinks on the latest downturns in the US economy and its future prospects.

lucasLucas starts by showing that real US GDP has grown at an average yearly rate of 3 per cent since 1870, with one big dip during the Depression of the 1930s and a big – but smaller – dip in the recent recession.

After stating his view that the US recession that started in 2008 was basically caused by a run for liquidity, Lucas then goes on to discuss the prospect of recovery from where the US economy is today, maintaining that past experience would suggest an “automatic” recovery, if the free market system is left to repair itself to equilibrium unimpeded by social welfare activities of the government.

As could be expected there is no room for any Keynesian type considerations on eventual shortages of aggregate demand discouraging the recovery of the economy. No, as usual in the new classical macroeconomic school’s explanations and prescriptions, the blame game points to the government and its lack of supply side policies.

Lucas is convinced that what might arrest the recovery are higher taxes on the rich, greater government involvement in the medical sector and tougher regulations of the financial sector. But – if left to run its course unimpeded by European type welfare state activities -the free market will fix it all.

In a rather cavalier manner – without a hint of argument or presentation of empirical facts — Lucas dismisses even the possibility of a shortfall of demand. For someone who already 30 years ago proclaimed Keynesianism dead — “people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another” – this is of course only what could be expected. Demand considerations are simply ruled out on whimsical theoretical-ideological grounds, much like we have seen other neo-liberal economists do over and over again in their attempts to explain away the fact that the latest economic crises shows how the markets have failed to deliver. If there is a problem with the economy, the true cause has to be government.

Chicago economics is a dangerous pseudo-scientific zombie ideology that ultimately relies on the poor having to pay for the mistakes of the rich. Trying to explain business cycles in terms of rational expectations has failed blatantly. Maybe it would be asking too much of freshwater economists like Lucas and Cochrane to concede that, but it’s still a fact that ought to be embarrassing. My rational expectation is that 30 years from now, no one will know who Robert Lucas or John Cochrane was. John Maynard Keynes, on the other hand, will still be known as one of the masters of economics.

shackleIf at some time my skeleton should come to be used by a teacher of osteology to illustrate his lectures, will his students seek to infer my capacities for thinking, feeling, and deciding from a study of my bones? If they do, and any report of their proceedings should reach the Elysian Fields, I shall be much distressed, for they will be using a model which entirely ignores the greater number of relevant variables, and all of the important ones. Yet this is what ‘rational expectations’ does to economics.

G. L. S. Shackle


  1. May 31, 2017 at 2:46 am

    Generations to come will scarce believe that we spent 40 years learning and teaching the rubbish known as New Classical Economics.

  2. May 31, 2017 at 7:06 pm

    The underlying gist here appears to be impatience with returning to a sustained three percent growth rate even though us consumes at about the rate of five Earths (if the world economy were the same size).

    Econocracy does not recognize planetary limits. My impression pf the Chicago school of economics is that it is partially a propaganda source to supply ideology to School of the Americas cadets in their vigorous destruction of democracy to make a playground for corporatistas.

  3. June 2, 2017 at 4:37 pm

    Can we take on the Savings = Investment myth a bit more directly? How about we throw a couple of empirical facts into the discussion?

    Between 1988 & 1997, for example, an average of nearly 85% of the money that corporations spent on investment came from retained earnings or other internally generated funds. They financed most of their investments with money that was SPENT by their customers, not by money that was saved by their customers…or anybody else.

    Between 1998 & 2001 (years that included cyclically high levels of business investment) the combined borrowing of non-financial corporations and all non-corporate businesses varied between 20-34% of total borrowing nationwide. During the same period, the household sector of the economy accounted for 20-30% of total borrowing.

    In fact, only a tiny fraction of money spent on investment comes from savings. A large percentage of borrowed money is spent on consumption.

    Finally, savings are not the only source of loanable funds. Whenever The Fed buys securities in the open market, it pays for them with money that it creates out of thin air with a keystroke. It is “new money” that did not exist prior to the keystroke that created it. With any of its purchases of securities, The Fed provides loanable funds to banks that were not saved by any saver.

    The Classical conceptualization of the relationship between investment and savings has never been anything more than pure fiction. A much more accurate equation would be something like this:

    Investment = (some % of Savings not used for Consumption) + (the corporate earnings that finance 85% of Corporate Investment) + (any newly created money by the Fed deposited in banks that firms end up borrowing and spending on investments).

    I am so tired of this canard that has been infesting economics textbooks for ages.

    • Risk Analyst
      June 2, 2017 at 8:19 pm

      While those are all interesting numbers, I do not take that S equals I concept seriously enough to even need that much effort to refute. The S equals I to me is just an anachronistic leftover from NIPA creation based on accounting terms. There is no analytical content. Much more important to me is expectations and wealth, which NIPA does not address except in a couple of ‘me too’ tables buried in the Flow of Funds. Since the massive increase in housing prices and wealth and home equity loans before the last recession was barely addressed in NIPA and only indirectly via low reported personal savings rates, why emphasize this unhelpful approach? Along those lines, unless I misunderstand the concept and maybe I do, I think the “post-Keynesian” idea of stock-flow consistent models is a huge jump backwards into neanderthal times.

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