Monday, March 29, 2010

Where Keynes Went Wrong, by Hunter Lewis.

I just read “Where Keynes Went Wrong” by Hunter Lewis (or parts of it). The chapter entitled “Markets Do Self-Correct” looked interesting, because Keyes’s main point was that they don’t.

The crucial passage reads:

During a slump, people buy less. This reduces business revenues. Because revenues fall first, before expenses, profits fall. Business owners then lay off employees to reduce costs and restore profitability. If, instead, wages fall, profitability can be restored without layoffs.

This is especially necessary if prices start falling throughout the economy. If people buy so much less that almost all prices start to fall, businesses revenues will be especially hard hit. Not only will fewer widgets be sold, but each individual widget will sell for less. Under these circumstances, if wages do not fall with prices, businesses will certainly face bankruptcy. On the other hand, if both prices and wages fall together workers should be no worse off. Although wages are lower, the consumer products workers buy will also cost less. It will be a wash.

Poor old Hunter Lewis just doesn’t get it: if prices, wages (and profits come to that) all fall by X%, everyone is back where they started! The only change is that the value of the monetary base in real terms has risen which would encourage spending (the Pigou effect). Hunter Lewis has evidently not heard of Pigou or the Pigou effect; at least he doesn’t mention them.

The latter effect would certainly work, but we might have to wait rather a long time. It’s far easier to have the central bank continuously create monetary base. That more or less condemns us to inflation, but as long as we’re talking say 2% year, that’s not so bad.

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