C Thomas compares the views of Adam Smith and John Maynard Keynes while touching upon today’s conjuncture
Good morning, I’m Austerity Jones. C Thomas and I will be discussing two heavyweights of our profession today. We usually end our discussions with the segment born on this date, but today we will focus on not one but two gentlemen that share this birthday.
C Thomas: Adam Smith was an 18th-century Scot that is the father of economics. His Magnum Opus, The Wealth of Nations, is one of the most important books ever written because it largely birthed the ideals for which our country was founded. Young America’s founding father and the resident wise old man was Benjamin Franklin and he was a large proponent of the teachings of Adam Smith. Adam believed that markets operated best by allowing little government interference and allowing the “invisible hand” of the market to set prices. Prices were set in the rational best interest of two men living in a society where there existed a division of labor.
Austerity: That’s pretty fancy economic speak C Thomas, do you mind if I simplify it a bit for our listeners? Let’s say we had two men, one a farmer and the other a blacksmith. Now, the farmer can’t form a horseshoe and the blacksmith can’t raise a pig or grow potatoes. We have the division of labor. The farmer comes to town and he needs to get a horseshoe fixed on his horse (there were no cars at this time). The blacksmith quotes him a price in dollars or gold, let’s say. The farmer takes that number and in his head decides well that price is worth a pig and bag of potatoes. For simplicity, let’s say there is no negotiation but a yes or no decision. The blacksmith has to weigh how long and how many times he has to bang his hammer and heat his fire versus the farmer trying to consider the cost of a porker and bag of spuds. Let’s say they agree, they did so because both men were willing to exchange (they could have bartered) or they can exchange money to buy other things more easily.
C Thomas: That’s right Austerity, well said. Nowhere was the government setting the price of one horseshoe at two pigs and a bag of potatoes. Independent markets and rational people set prices in the micro and lots of these exchanges every day formed the basis of our economy for the better part of the 19th century. People were so fiercely independent and mistrustful of the government after watching the behavior of Europe and their kings that they embraced this system and in 150 years, America carved out the greatest nation on earth out of the wilderness. Governments were limited and great productive men created great fortunes and cities. Bridges and buildings were built with private financing. Financing is indeed another exchange of two goods – upfront capital for expansion, etc. for a promise to pay with interest to compensate for time and risk.
These great men gave Americans cash-paying jobs to alter their lifestyle from agrarian to flight into the cities. Behind these jobs were great men and great ideas. This shift is similar to what we see happening as India and China are trying to use manufacturing and move their societies from the country to the city. We used Adam Smith and the “invisible hand” while they are a little more centrally planned. So Americans had moved to and populated the cities and America was accepting immigrants, providing them with opportunities, but storm clouds were on the horizon.
By the First World War, America, economically, was doing splendidly, but as so often happens it forgot how it got there in the first place. The previous century had been marked by several sharp contractions of panic and depression, some we have already mentioned in our previous episodes. However, these events largely clear out the poor and reckless producers, allowing a better allocation of capital from stronger producers. This caused bankruptcies and high unemployment until the market righted itself. Well, the government smelled an opportunity coining the phrase “We are from the government and we are here to help you.”
Austerity: What does that really mean C Thomas? Because it doesn’t sound quite right.
C Thomas: It was a tongue-in-cheek remark meant to warn the person to run. The government started the Federal Reserve Banking system and instituted an income tax and Congress was ready to begin establishing its power. Prohibition and alcohol were outlawed and then repealed as public outrage forced Congress to beg for a do-over. Government at the federal level was beginning to get involved and by the end of the 1920s, they allowed a bubble to be built by artificially low-interest rates (not the invisible hand of the market but a bunch of bureaucrats in government). It soon burst and, by not recognizing the error, the Fed kept tight policy up well after it needed to, driving America into a Great Depression less than 20 years after its founding.
Austerity: Do you think this was purposeful, C Thomas? The government created the situation where society needed them?
C Thomas: I would like to not be that cynical Austerity, but where there is power, there is corruption. But I would like to believe they were just inept. Regardless, this was the end of the invisible hand and where we met Mr. John Maynard Keynes.
Keynes was a brilliant scholar and he published his magnum opus The General Theory of Employment, Interest, and Money in 1936 which brings us to our word of the week. Austerity can you tell us what magnum opus means?
Magnum Opus- the greatest achievement of an artist or writer.
Keynes was very bright and he had a certain method of thought regarding macroeconomics and the role of government. He posited that government stimulus could be financed if necessary as a last resort to stimulate an economy in the doldrums, as the case in the 1930s. Now you are probably aware that by the late 1930s FDR had confiscated gold and devalued the currency by half and embarked on his new deal to spend government money to employ citizens and stimulate the economy. He started all kinds of government institutions and regulations that are still with us today like the SEC and Social Security. Projects like the Hoover Dam employed thousands and were an excellent political cover for spending that income tax that the government had taken from 1% in 1913 up to 76% by 1936. Adam Smith’s invisible hand had been replaced by the invisible hand of the government taking Americans’ money from their own pockets. Predictably, the economic output of the country tanked. Politicians loved Keynesian economics because it allowed them to usurp the power from private citizens and businesses and allowed them to garner favor with it. Keynes actually wrote about the ills of overdoing this and he mentioned that it should be used in crisis and then in prosperous times when the debt needed paying down. The government doesn’t focus on Keynesian economics so much on that part.
Keynesian economics was popular for the next couple of decades as the government taxed and inflated the money supply until the stagflation of the 1970s when economist Milton Friedman and monetarists became popular as Paul Volcker finally stamped out inflation in the early 1980s. But when times got tough again during the great financial crisis of 2007 guess who became popular once again Austerity?
Austerity: Keynes? Noo, did we not learn anything about tax and spending?
C Thomas: We did and we discarded those policies but those people were long gone Austerity and now instead of the New Deal we are getting quantitative easing and more recently The Cares Act. You see everything works in cycles Austerity, the moons, the tides, the seasons, and the economic stupidity of man. This is why it’s so important to learn from history because mankind doesn’t learn from history and will often repeat the follies of yesteryear. However, as individuals, we have the ability to plan ahead and avoid some of the painful lessons as those around us might still have to learn.
Keynes might have had a good idea for a temporary solution, but left to the government’s overreach, it has been a disaster. Keynes in his later years actually said:
I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago.I’d like to think that Keynes finally came full circle and figured out on his own that markets are better left alone or maybe he just realized that his ideas couldn’t be executed by governments. Even if it is invisible, when it comes to great economists I think even Keynes would agree with me that Adam Smith gets the upper hand. Both were very influential in American history and let’s continue to learn from each to better our way as we move forward on this day of their birth.
Sincerely Yours,
Austerity: Thank you, C Thomas. That is both informative and eerily prescient today. We will be back next week as we look at the start of quantitative tightening.
C Thomas
Also born on this date…besides our two famous economists… let me introduce the band: on guitar Mr. Pancho Villa, on bass the great back shooter Pat Garrett, on lead vocals Marky Mark from the Funky Bunch, the man on the horn Kenny G, and the man grabbed by the horn Robert Kraft.
Austerity: I knew it G Spot! I was already wondering, why you would want to do Also Born on This Date, as it is my thing…
Here you can find the link to the book The Wealth of Nations by Adam Smith.
Here you can find the link to the book The General Theory of Employment, Interest, and Money by John Maynard Keynes.