Prime Minister Rudd's Growth Gap Myth

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According to Prime Minister Rudd there is a global "growth gap" and massive government intervention is needed "if the demand-side gap is to be met and massive unemployment is to be avoided. Naturallly, Mr Rudd has the solution: "Classic Keynesianism, pure and simple." (Kevin Rudd, The Monthly, February 2009). That Keynesianism — "pure and simple" — is nothing less than letting the printing press rip is a fact of which Rudd is evidently ignorant. Moreover, what he calls "Classic Keynesianism" is better described as vulgar Keynesianism.

The idea that Keynes always proposed massive spending when unemployment emerged is nonsense. Mr Rudd's advisors are apparently unaware of Keynes' stern anti-inflationary opinions. Even though unemployment in the UK stood at 12.5 per cent in 1937 he publicly called on the British governmet to end new public works projects, warning it against the inflationary effects of any "general stimulus" (T. W. Hutchison, Keynes v. the 'Keynesians'...? The Institute for Economic Affairs, 1977, p. 11).

So what is an output gap? It is basically the difference between real GDP and potential GDP. In other words, a shortfall in aggregate spending at the full employment level. Keynesians argue that increased spending can close this gap and in doing so raise GDP and the level of employment. In addition, because of the existence of idle resources there should be no increase in general prices. Economics, like life, is not that simple. For instance, the Weimar inflation saw the elimination of an output gap even as real wage rates collapsed and prices rocketed and purchasing power disappeared.

Countries have experienced more benign situations where inflationary policies have generated tight labour markets and caused the emergence of bottlenecks invariably followed by tight money and rising unemployment. This became known in the UK as the stop-go cycle. The lesson here is that there is always slack in the economy and that this is perfectly normal. What is abnormal is for this slack to disappear. When it does it's a sure fire sign that inflationary pressures are stalking the economic landscape.

Two situations must be considered. The first, and in my opinion the most important, is when there is a great deal of unemployment. In such cases output is bound to below the level that would otherwise exist in the absence of unemployment. Professor Hutt dealt with this problem in The Theory of Idle Resources (1939), revisiting it a number of times, particularly in The Keynesian Episode (1979). Hutt's approach is basically a classical one, arguing that what we have here is a case of withheld capacity. In other words, factors, particularly labour, are overpriced in relation to the value of their products.

It was the refusal of factor owners, for whatever reason, to allow their prices to adjust to new monetary conditions, especially after a recession, that caused widespread persistent unemployment. This is a view in which I am in complete agreement. Thinking in terms of withheld capacity is really another way of thinking in terms of pricing. From this point of view the real output gap, the difference between the level of output that would exist under free factor prices and that which exists under a hampered market, can only be eliminated by allowing markets to clear. The Keynesian solution is to eliminate the gap by using inflation to lower real labour costs.

Now it's Keynesianism that brings us to counter-cyclical policies. The obvious assumption underpinning such policies is that the so-called business cycle is inherent in the market economy. It is not. As Ricardo, and later the currency school, observed so long ago, the problem lies not with the market but with the banking system. (Unfortunately the currency school ruined its case by adamantly refusing to accept checking accounts as money substitutes. This obstinacy saw the ideas of the banking school eventually prevail).

Professor von Mises refined the currency school insights into what is now known as the Austrian theory of the trade cycle. The key to the cycle is the lowering of interest rates below their free market level which then generates a boom that always ends in a bust. As irony would have it, Henry Thornton chided his fellow anti-bullionists by pointing out that their real bills doctrine would create unlimited credit expansion by keeping the discount rate below its market rate.

(The bullion debate of the 1800s was one of the most fascinating debates in the history of economics. Without a doubt, the most important work produced by the debate was Lord Peter King's Thoughts on the Effects of the Bank Restriction, 1804. This was an enlarged version of an earlier pamphlet. There is also Henry Thornton's An Enquiry into the Nature and Effects of the Paper Credit of Great Britain).

Following in the steps of von Mises — a man that Rudd managed to completely confuse with the neo-classical school — we therefore conclude that the cycle is a banking problem, not a free market flaw. Counter-cyclical policies are thus not only useless they are dangerous in that they perpetuate the boom-bust cycle by artificially forcing down the rate of interest, the very action that triggered the whole messy process in the first place.

Even if counter-cyclical activity was paid for out of a large government cash surplus it would have to reduce labour costs to their market clearing values and keep them there. This could only be done by bringing about an increase in general prices. (I'm assuming that the price-rising effects of spending the surplus would not be offset by increased productivity). I know of no case where the above has ever happened. Since WW II unemployment has always been tackled by expanding the money supply, only Keynesians call this raising aggregate demand — some of us call it inflation.

The Austrians predicted that Keynesianism would lead to continually depreciating currencies. This is exactly what happened. They also predicted that larger and larger amounts of money would have to be created by central banks to left economies out of their recurring crises. This is also true. During the last 40 years there has been an astronomical rise in money stocks.

To be fair, the present crisis cannot be blamed entirely on Keynes. Central bankers believe that money is basically neutral and that it is their duty to stabilise prices. These are two extremely dangerous fallacies that brought us the current mess. Manipulating interest rates in order to stabilise the price level requires a continual expansion of bank credit. This monetary growth distorts the structure of relative prices and hence the production structure, generating booms and busts. And this is where Keynesianism enters the picture.

These busts are now interpreted as falls in aggregate demand rather than adjustment periods during which relative prices are restructured in accordance with the new monetary conditions. It needs to be stressed that bank credit can only be continually expanded if the central bank forces interest rates down below their market clearing rates. This distorts the production structure which eventually results in falling production employment. The result is called by orthodox economists an "output gap". There solution? A dose of the same fallacious economic medicine that caused the crisis in the first place.

By the time WWII had begun young economists were so convinced that raising aggregate demand was the key to maintaining full employment that they predicted — Paul Samuelson among them — that the end of the war would see unemployment rise to 8 million because government spending cuts would cause aggregate demand to contract. In fact, the exact opposite happened.

Between 1945 and 1947 the US government slashed Federal spending from an annual $95 billion to $36 billion per year — a $59 billion cut in two years. This was a staggering 62 percent reduction. Instead of America spiralling into a depression it began the longest period of growing prosperity in its history

It's time the likes of Rudd did their homework. The same can be said of the Liberal Party.