Tuesday, August 31, 2010

CATO’s Cheap Shot at Keynes

The CATO institute is the foremost libertarian political organization.  I like their blog because even though it's ideological, it's non-partisan.  Meaning they will criticize both political parties and criticize both depending on what their advocating.  That being said, in a recent post they took some cheap shots to try and disprove Keynesian economic theory.
Wikipedia gives a good summation of Keynesian economic theory:

Keynesian economics (pronounced /ˈkeɪnziən/, also called Keynesianism and Keynesian theory) is a macroeconomic theory based on the ideas of 20th century British economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize output over the business cycle

Economists who accept this theory usually advocate that when the economy is doing good - as indicated by rising inflation- the government should reduce spending and pay off past deficits, but when the economy is bad - as indicated by high unemployment - our government should increase spending in spite of any deficits that may occur.  The key part of the theory is that in a typical business cycle unemployment and inflation are indirectly related.  As one rises, the other should fall.

It is with this part of the theory that CATO tries to "disprove" in a post called Does High Unemployment Make Inflation Impossible?
If this “slack theory” of inflation makes you too sanguine about future inflation, recall that it is the same theory that predicted stagflation would be impossible in 1973–75 and 1979–81. Figures from The Economist, August 21, raise some doubts.  The latest unemployment rate in Argentina is 8.3%, but CPI inflation over the past year was 12.2%. Unemployment in Venezuela is 8.2%, but inflation is 13.3%. Unemployment in Egypt is 9.1%, but inflation is 10.7%.  Unemployment in India is 10.7%, but inflation is 13.7%.  Unemployment in Turkey is 11%, but inflation is 7.6%.   Wasn’t high unemployment supposed to make high inflation impossible

My first problem with this is that Keynes never said High Unemployment makes inflation impossible, so I think CATO setup a straw man argument.

My second problem is the 2 examples used to point out when the united states had both high inflation and high unemployment.    Both of them were caused by a giant oil shock(1973 and 1979).  No macroeconomic theory can fix or prevent a sudden scarcity of a natural resource that is integral to an economy.  Of course it's going to wreck it.  Those 2 cases weren't caused by a typical business cycle and had a clear cause.

Third, and finally, CATO tries to disprove their straw man argument by listing off countries that have fairly high unemployment and inflation.  The problem with this is that typical inflation and unemployment is different for every country.  It varies based on natural wealth of the country, their various policies and laws, and levels of corruption.  Therefore comparing one country to another isn't useful.  You have to compare trends within the country.

Let's take a look at Egypt.  According to the CIA, unemployment in Egypt was 9.4%, but inflation was 11.8% in 2009, but in 2008 unemployment was 8.7% and inflation was 18.3%.  So when CATO says that inflation in Egypt is 10.7% you can see that 10.7% is a low inflation rate... for Egypt.  Turkey's numbers play out similarly to Egypt's.   Inflation was 10.4% in 2008, and went down to 6.3% in 2009.  At the same time, unemployment, as Keynesian economists predict, went up from 11.2% to 14.1%.  I went through all of the countries listed, and India was the only country whose inflation and unemployment didn't act in perfect accordance of Keynesian economics.  However, in India's case, it's GDP grew at the same rate both years suggesting that something else was going on because GDP growth and employment rate almost always rise and fall together.

In the end, India and the two oil shocks of the 1970s does disprove the straw man argument that CATO setup.  It is possible to have high unemployment and high inflation, however I think that's a long ways from disproving what Keynes actually theorized.
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