FOO Law and Economics

Sunday, February 8, 2009

Why Zimbabwe is a nice empirical test of the Austrian-Keynesian debate

Keynes is right in the short run, but the Austrians think “what next”?

Start at full employment, and “animal spirits” cut investment. If prices-wages are sticky downward, then you have a multiplier of 4 if consumers save 25% of income. Example: I falls by 2, so Y falls by 8.

Let the INITIAL full-employment data be: C=70, I=10, and G=20. If I falls by 2, the RECESSION data must be: C=64, I=8, and G=20.

The Keynesian fix is to increase G by 2, and we are back at full employment. But now C=70, I=8, and G=22.

Note that G is a flow, and the Austrians say you can’t do this over and over. Over time G will just get bigger and bigger.

This must be so because if I were to increase by 2 at full employment, prices-wages rise (they are not sticky upward), so I must crowd out C and not G during a BOOM phase. Thus, when I rises after the first Keynesian fix, we have C=68, I=10, G=22.

Another recession comes along, and the Keynesians fix it by moving G to 24. I stays at 10, so C=66. There is a boom, and I moves to 12, C to 64, and G stays at 24.

Repeat the business cycle, and … C=64, I=10, G=26. And so on, and so forth. C keeps going down, I stays where it is, and G keeps going up.

If C and G were perfect substitutes, there is nothing wrong with C=0, and G=90. But we know they are not. C is supposed to be private goods, and G public goods for the Keynesian model to even begin to make sense. Since food is a private good, C=0 is starvation city. Keynes was perfectly correct: in the long run we die! Either that or we’re under a centrally planned economy.

1. The Austrians have a point. The only way to stop the “nonsense” is to make the price mechanism work.
2. The Austrians are wrong for railing against a particular Keynesian fix. When times are bad, a one-time Keynesian fix is OK.

What’s an empirical test for all this? Look at countries where G has crowded out C, and ask if that country is in good shape. The extreme case today is Zimbabwe, where inflation in annual percentage points is in the billions! Why that high an inflation rate? C is at subsistence, and no one else will lend to government, so money needs to be printed in ever-increasing amounts.

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