Felix Salmon: Why Bernanke’s Not Doing More
Modern Classical Economics Flunks Its Reality Tests

Hoisted from Comments: Austrian Insanity Department

dilbert dogbert said...:

Re: #4

This pin-headed amateur wonders if the argument that increased government spending is canceled out by decreased private spending can also apply within private spending? Increased Business spending is canceled out by a decrease in demand by individuals. The money has to come from somewhere.

Hayek appears to have made this argument, to hoots of derision, at a Cambridge seminar in the early 1930s:

Joan Robinson (1972 Richard T. Ely Lecture):

What was the state of orthodox opinion when the world was struck by the great slump? First of all, there was the famous Treasury View of 1929…. The Chancellor of the Exchequer was Churchill; he could not bring himself a second time to defend deflation and sound finance. It was left to the officials to produce the argument for the Treasury. Their case was very simple. It was based on the idea that investment is governed by saving. If the government borrowed £100 million to spend on public works, there would be £100 million less for foreign investment. The surplus of exports would fall by a corresponding amount. There would be a transfer of employment but no change in the total. It is not fair to put much weight on this. The Treasury, after all, was required to say something and this was what they thought of to say. The fact that it appeared to be a respectable argument, however, certainly was a symptom of the state of opinion at that time….

While the controversy about public works was developing, Professor Robbins sent to Vienna for a member of the Austrian school to provide a counter attraction to Keynes. I very well remember Hayek's visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles…. R. F. Kahn… asked in a puzzled tone:

Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?

"Yes," said Hayek, "but," pointing to his triangles on the board, "it would take a very long mathematical argument to explain why."

This pitiful state of confusion was the first crisis of economic theory that I referred to…

Hayek's argument, as best as we can reconstruct it, was:

  1. Richard Kahn takes money out of his bank account to buy an overcoat.
  2. His bank reduces its amount of construction lending.
  3. Unemployment is generated in construction.
  4. Overcoat manufacturers become optimistic and hire the unemployed to expand capacity.
  5. Overcoat manufacturers realize they were overoptimistic and fire their extra workers.
  6. As the pattern of demand returns to normal, the unemployed are rehired in construction.

Thus Hayek's argument is that Kahn's temporary boost to apparel demand and reduction in construction demand causes unemployment first as the economy adjusts to what it thinks is a permanent shift in the structure of production and then again causes unemployment as the economy returns to its initial configuration.

It is rather curious that Hayek is the only person who makes this Full Fama argument who has the guts to say that it applies to shifts in private-sector spending as well as to boosts to public-sector spending. For Hayek, the Confidence Fairy is not a factor...