Classical Theory Explained

1. Classical Theory Explained Steve Kates

2. Most likely because I am the only one “Steven Kates is probably the best-known present-day proponent of the old ‘classical’ macroeconomics of Jean-Baptiste Say, James Mill, David Ricardo, and John Stuart Mill.” (Grieve JHET 2017) School of Economics Finance and Marketing

3. My letter in The Economist – Sept 12, 2017 You don’t Say The term “Say’s Law”, (Economics brief, August 12th) was invented by the American economist, Fred Taylor, and popularised in his introductory text, published in 1921. Moreover, the phrase “supply creates its own demand” is not classical in origin, but was first used in print by another American economist, Harlan McCracken, in a text that John Maynard Keynes is known to have read while he was writing the General Theory. Jean-Baptiste Say neither invented the concept nor was he its most staunch [best] defender. STEVEN KATESAssociate ProfessorSchool of Economics, Finance and MarketingRMIT UniversityMelbourne, Australia School of Economics Finance and Marketing

4. Who are the classical economists? John Stuart Mill is the central figure in classical theory Mill’s Principles of Political Economy was the definitive statement Before Mill – Adam Smith and those who followed his lead After Mill – JE Cairnes, Simon Newcomb, Henry Clay Defining characteristics: supply-side theory, Say’s Law, no marginal analysis School of Economics Finance and Marketing

5. What you need to unlearn to understand the classics Every one of these is wrong according to classical economic theory A national economy is driven from the demand side * Classical economists did not accept the existence of involuntary unemployment * Classical economists had no theory to explain recessions * Recessions can be caused by demand deficiency * Thinking of national saving as a flow of money makes sense * Lowering interest rates will increase economic growth * Unproductive public spending can make an economy grow * Profits are maximised where Marginal Revenue equals Marginal Cost Supply and demand explains what businesses do and how markets work You can discuss economics without discussing the role of the entrepreneur in detail School of Economics Finance and Marketing

6. Winston Churchill’s UK budget speech 1929 “Churchill pointed to recent government expenditure on public works such as housing, roads, telephones, electricity supply, and agricultural development, and concluded that, although expenditure for these purposes had been justified: ‘for the purposes of curing unemployment the results have certainly been disappointing. They are, in fact, so meagre as to lend considerable colour to the orthodox Treasury doctrine which has been steadfastly held that, whatever might be the political or social advantages, very little additional employment and no permanent additional employment can in fact and as a general rule be created by State borrowing and State expenditure.’” (Peden 1996: 69-70) School of Economics Finance and Marketing

7. The largest cut in public spending along with the largest series of job losses in history Harry Truman resisted the pressure to provide a fiscal stimulus to the American economy even though millions of members of the armed forces, plus millions more working in armaments industries, had lost their jobs. In his State of the Union address in January 1946, he said and then actually acted on what he said: ‘It is good to move toward a balanced budget and a start on the retirement of the debt at a time when demand for goods is strong and the business outlook is good. These conditions prevail today.’ “The result was the commencement of the most sustained period of economic growth in American and world history.” School of Economics Finance and Marketing

8. “Demand for commodities is not demand for labour” Mill’s fourth proposition on capital ending the general glut debate in 1848 Keynes garbled version “supply creates its own demand” meaning that everything produced will find a buyer and therefore, according to Keynes, classical theory assumed involuntary unemployment was impossible No economist before Keynes ever believed anything so stupid (although 21st century “New Classical” economists come very close) It is an aggregate concept meaning that across an economy the ability to purchase is dependent on the ability to supply: we might better put it as aggregate demand is constituted by aggregate supply Most of what comprise aggregate demand and aggregate supply consist of goods and services already in existence and if not the goods and services themselves the means to produce them School of Economics Finance and Marketing

9. Involuntary unemployment in John Stuart Mill’s Principles of Political Economy [1848] Mill describing the effects of a recession: “Establishments are shut up, or kept working without any profit, hands are discharged, and numbers of persons in all ranks, being deprived of their income, and thrown for support on their savings, find themselves, after the crisis has passed away, in a condition of more or less impoverishment.” Why has no one in all the years since The General Theory was published brought this passage to light? Why has no one else used this passage to challenge Keynes and the Keynesians? How much more involuntarily unemployed do “discharged hands” have to be if they have been “deprived of their income”, “thrown for support on their savings” and “in a condition of more or less impoverishment”. It is either ignorance or deceit. School of Economics Finance and Marketing

10. Recessions are caused by structural dislocation A crisis and subsequent downturn are not caused by a fall in demand – the fall in demand has been caused by whatever brought on the recession There is no plausible instance when a downturn occurred out of the blue – there is always an explanation besides a sudden desire to save more and spend less Every recession can be explained by entirely visible external events Every recession has occurred because a larger than normal proportion of producers had been misled about the products that could be sold at prices higher than their production costs Often it is the financial system that breaks down – producers had been given finance to produce products that ended up being unprofitable Every product must either earn its own keep by being profitable or must be subsidised either by government or some charity Unprofitable products slow an economy and do not add anything to growth School of Economics Finance and Marketing

11. National saving consists only of productive inputs and not money Saving can only consist of bricks and mortar and NEVER consists of money Bread comes from wheat, flour mills, ovens, transport networks, electricity and bakers – each exchanges for money but none are themselves money If you think of national saving as sums of money you will never ever under any circumstances understand how an economy works – not ever Saving consists of the proportion of existing resources [which includes labour time] that are used to maintain the existing capital structure and then add to it These inputs exchange for money but should neverbe confused with money The minute you make this confusion you will be hopelessly lost Money only determines who gets to spend, but only a proper economic structure will put the ability to spend into the hands of its most productive citizens School of Economics Finance and Marketing

12. Lower interest rates do not increase saving levels only misdirect the real savings available A question I ask my classes. What did Simon Newcomb mean when he asked this question in his 1886 Principles of Political Economy text: “Trace the economic effect of the frugal New England population putting their money into savings banks. What do such savings really consist of?” These are the alternative answers I provide with the answers in bold the correct answers: a) the amount of money held by financial institutions constitutes a community’s savings b) national saving refers to the proportion of its resourcesmade available for investment c) artificially low interest rates misdirect resources into low productivity investments d) money facilitates exchange but resources are what matters e) lowering interest rates reduces the supply of real savings made available Information Technology Services

13. Negative Effect of Public Sector Stimulus All production uses up resources – C, G and I – Consumption, Government spending and Investment Only productive investment is value adding and adds to growth – moves the curve outwards over time Stimulus expenditures – increases in G – are virtually never value adding Keynesian aim is to go from R to B – Classical aim is to go from R back to A School of Economics Finance and Marketing

14. Marginal analysis properly done is a future-oriented Cost-Benefit Analysis X No one knows the future. No one knows the position of the demand curve, the actual future level of production costs, the timing and level of future revenue flows and much else besides Every business decision is an estimate made in the dark MC=MR presents a false narrative–no one ever knows how things will work out The most important point to understand: All decisions are made in the present before the outcome is known The only question any entrepreneur therefore ever asks is the following: If I do this what do I think will be the result? Future costs and revenues – the marginal costs and revenues – are projected estimates and on these and these only are business decisions based School of Economics Finance and Marketing

15. How marginal revenue and marginal cost look to an entrepreneur X School of Economics Finance and Marketing

16. John Stuart Mill on the theory of value X The second of 17 points on Mill’s supposedly out-dated theory of value All we teach most economic students today is the bit in bold that the price rises either because of increased demand or restricted supply, while price falls because demand falls or supply increases – with the added proviso that markets clear at the equilibrium price. “II. The temporary or Market Value of a thing, depends on the demand and supply; rising as the demand rises, and falling as the supply rises. The demand, however, varies with the value, being generally greater when the thing is cheap than when it is dear; and the value always adjusts itself in such a manner, that the demand is equal to the supply.” Mill’s Points 3-17 are essential to understand how markets work but are never mentioned To add that individuals spend the money they have so that they achieve the greatest expected utility from the array of goods and services they buy adds nothing of interest School of Economics Finance and Marketing

17. You cannot explain how a market economy works without discussing the entrepreneur X How do you explain this without mentioning the entrepreneur? In 1900 there were no cinemas in England. In 1914 there were more than 5000. What had to happen for those 5000 cinemas to come into existence? The entrepreneur is now almost never brought into the story and when it is, it is only to explain innovation. No modern introductory text has an extended discussion on the entrepreneur, and most have none at all. A person who runs a one-person lawn mowing service is an entrepreneur Any economic theory – macro and micro – that does not involve the entrepreneur as an important part of the explanation of why things happen as they do is junk science, root and branch. School of Economics Finance and Marketing

18. A water MILL on a bed of CLAY The two most important influences on my economics: John Stuart Mill’s Principles of Political Economy [1848] and Henry Clay’s Economics: an Introduction for the General Reader [1916] – and please note the title School of Economics Finance and Marketing