Keynesianism
 
The Critics of Keynesianism: A Survey "He who knows only
his own side of the case, knows little of that."
 
--John Stuart Mill
 
 Bryan Caplan Econ 199 Dickens Spring, 1991 An Overview
John Maynard Keynes' General Theory marks a turning point
in intellectual history. In less than a decade since its
publication, the numerous converts to Keynesianism attained
dominance in both the academic and political realms. Their
hold on these positions has, since the 1970's, weakened
under the combined force of theoretical criticisms and
practical failures. This theoretical criticism is not a
coherent edifice; rather, this criticism consists of
disparate strands of dissent from both the general
principles and the specific applications of Keynesianism.
This paper, then, will survey these criticisms of
Keynesianism, describing them, classifying them, and
tentatively evaluating them. One of the important barriers
to a thorough study of anti- Keynesian doctrines is that
Keynesianism is a broad tendency of thought rather than a
rigid set of theorems. Still, there are certainly basic
assumptions that all species of Keynesianism share. By
stating them explicitly, it will be possible to see what
portions of the Keynesian system the major schools of
critics reject. Two fundamental postulates underlie
Keynesian theories of all types: 1. Unemployment is caused
by insufficient aggregate demand. 2. The proper means to
eliminate unemployment is for the government to increase
aggregate demand through discretionary monetary and fiscal
policies. This definition is admittedly simple, but will
prove its worth by both distinguishing Keynesians from
non-Keynesians, and by allowing a clear way of classifying
the many schools of Keynesianism's critics. Roughly
speaking, there are those who criticise the first
postulate, and those who criticise the second. The first
group includes rational expectations, sectoral shifts, real
business cycles, the more extreme forms of monetarism,
Austrians, and, perhaps inadvertantly, Keynesians who
concentrate on microfoundations. The second group adds
moderate monetarists, public choicers, and advocates of
free banking. The critics of the first postulate can be
split into two main factions. The first approach, which
focuses on the microeconomic assumptions of Keynesianism,
spearheaded the modern wave of criticism but no longer part
of cutting-edge discussion; the second and more popular
approach emphasizes the influence of real variables such as
supply shocks, sectoral shifts, and search. The early
critics observed that Keynesians had not fully explained
the microfoundations of their models, and that this sin of
omission led to dangerous long-run consequences.
Unemployment, Friedman and others explained, is not caused
by insufficient aggregate demand per se; it is caused by
excessive wage rates. Increasing aggregate demand only
effects employment if, due to nominal wage rigidity, the
real wage falls relative to prices. A Phillips' curve,
then, does not describe a set of long-run equilibrium
positions. It works only so long as the market does not
anticipate what is going on. The widely varying pattern of
inflation and employment combinations both between
countries and within countries in different historical
periods testifies to the power of this insight. Other
modern critics of Keynesianism doubt that money illusion is
possible or relevant; at least, it matters much less than
Keynesians seem to think. Think of it this way: all
economists, Keynesians included, agree that some positive
amount of unemployment is the natural and inevitable result
of freedom of contract, due to quits, dismissals, search
and other frictions. Moreover, all economists agree that a
change in real factors can affect the rates at which
workers find and lose jobs; hence, there will always be
some fluctuations in employment. Given this, is it possible
that real factors have caused employment fluctations rather
than aggregate demand fluctations? There are many
variations on this theme. Robert Barro simply doubts that a
"strong" correlation exists between real and nominal
variables. David Lilien argues that sectoral shifts can
account for about half of recent cyclical unemployment
normally thought to be caused by fluctuations in aggregate
demand. The radical divergence between this approach and
Keynes' should be obvious. The second group of critics,
whether or not they agree with the first group, have a
decidedly different orientation. They argue that, even
granted the Keynesian view that unemployment is caused by
insufficient aggregate demand, that there are better means
to cure unemployment than active fiscal and monetary
policies. For example, they argue that active intervention
makes the economy unstable, since policy can change with
the winds of opinions of politicians and the central bank.
No one can know policy in advance, so they may make actions
which, though reasonable given their ignorance of future
policy, are foolish in light of the policy that actually
happens. Such critics advocate rules to strictly delimit
options the of monetary and fiscal authorities, such as a
balanced budget amendment, or a constititionally fixed rate
of money growth. This criticism is typical of both
monetarists and rational expectationists. Other critics,
especially with a public choice slant, doubt whether the
government actually would choose to pursue the "optimal"
policy even if it knew exactly how to achieve it. They
think government actors are self-interested, not angelic
servants of the public good. Put otherwise, they view
government actions as endogenously determined by the
motives of the officials and the incentives of the system,
rather than exogenously determined by the wise advice of
Keynesian economists. Some possible motives that would
deter the quest for "optimal" policies are: the desire to
win elections by subsidizing favored groups when
expansionary fiscal policy is not needed, or to obtain
seigniorage by economically unjustified expansionary
monetary policy. A final notable band of theorists of the
second group think that central banking is an ineffective
way to maintain monetary equilibrium. Instead, they endorse
"free banking," a system whose mildly unconventional
characteristics will be described later. Free bankers argue
that unregulated banks would expand or contract their
liabilities by varying their reserve ratios in response to
changes in the demand to hold money - and that they would
do so automatically in response to profit-and-loss
indicators. In their view, this compares favorably with a
central bank, which cannot easily discover how to adjust
the money supply in response to changes in demand to hold
or currency-deposit ratios. Since both the workings of free
banking (which has, incidentally, existed historically, and
is not merely idle hypothesizing) and the reasons why its
proponents think their system would improve upon central
banking are relatively unknown, this essay will devote
extra space to their critique.
 
Monetarism's and Rational Expectations' Microeconomic
Critique Monetarists and rational expectationists have, it
is fair to say, completely destroyed naive Keynesianism
with their attacks on its microfoundations. In modern
discussions Keynesians as well as anti- Keynesians agree
that if wages were perfectly flexible, involuntary
unemployment would be impossible. And, even if wages are
not perfectly flexible in the short-run, almost everyone
agrees that, first, wages are flexible in the long-run,
and, second, that this implies that a permanent trade-off
between inflation and unemployment is impossible. It is
true that all participants to the macroeconomic debate now
accept this microfoundational critique of Keynesianism.
Still, the power of this attack is clear from the fact that
Keynesian theories mitigate, and anti-Keynesian theories
emphasize, the practical importance of this fact. Let us,
therefore, investigate the classic statements of this
critique, then examine the work that builds on it. The
microfoundational criticism was forcefully expressed in
1962 by Murray Rothbard, just as the American government
for the first time invited leading academic Keynesians to
prescribe proper policy for the nation. Rothbard bluntly
stated, "Keynesian and neo- Keynesian 'compensatory fiscal
policy' advocates that government deflate during an
'inflationary' period and inflateÉto combat a depression.
It is clear that government inflation can relieve
unemployment and unsold stocks only if the process dupes
the owners into accepting lower real prices or wages. This
'money illusion' relies on the owners' being too ignorant
to realize when their real incomes have declined - a
slender basis on which to ground a cure."1 Rothbard's
thesis was ignored by the academic community at the time,
but other critics, notably Milton Friedman and Robert
Lucas, successfully advanced similar objections after
America experienced rising unemployment and rising
inflation simultaneously - a phenomenon inconsistent with
Keynesianism in its naive form. Writing in 1968, Friedman
criticized the Keynesian view that increased aggregate
demand increases employment: "But it describes only the
initial effects. Because selling prices of products
typically respond to an unanticipated rise in nominal
demand faster than prices of the factors of production,
real wages received have gone down - though real wages
anticipated by employees went up, since employees
implicitly evaluated the wages offered at the earlier price
level."2
 
Robert Barro is a leading advocate of replacing the
Keynesian model with an alternate, "market-clearing" model.
After defining the model, he summarizes its implications:
"The theory predicts that changes in the monetary base are
neutral. In particular, a one-time shift in the quantity of
base money leads to proportional changes in nominal
variables, but to no changes in the real variables."3 Barro
then makes a novel move. Economic theory, he says, must
explain the effect of nominal variables on real variables
only to the extent that the effect exists. Surely no one
would disagree with this. Barro then proceeds to examine
the historical evidence of relationships between nominal
and real variables. Barro's econometric methods have drawn
fire from critics. We shall focus only on his conclusions.
In the United Kingdom, he says, there is a negative
relationship between wage inflation and unemployment for
1862-1913; no relationship from 1923-39; and a positive
relationship for 1947-84. For the United States, there is a
negative relationship for 1890-1913, with no relationship
over 1923-39 or 1947-84. Extending the comparison to
seventy-eight nations, he concludes that there is no
significant relationship between real GNP growth rates and
inflation, currency growth, or M1 growth. Barro notes that
it is possible to explain even such relationships as do
exist by unique historical shocks to the real economy. He
concludes that, "At least in the long run, it is untrue
that more inflation leads to a lower unemployment rate, or
that to have low inflation a country must accept a high
unemployment rate."4 Barro then turns to the evidence for
short-run relationships between real and nominal variables.
He here limits his analysis to the United States; first he
discusses the period of 1890-1940, then the period from
1947-1984. In the earlier era, Barro finds no evidence that
changes in the monetary base have real effects, but thinks
that there is good evidence for a relationship between real
output and changes in the ratio of M1 to the monetary base
- specifically, banking panics and changes in reserve
requirements. For post-World War II, Barro says that
anticipated monetary expansion had no real effect, while a
1% increase in unanticipated money normally increases real
GNP by 1% over a one or two year period. Here is Barro's
calm conclusion to this chapter: "it is the nonneutral
effect of the monetary base - to the extent that it exists
- that conflicts with our theory. Although this result
deserves some weight in our thinking, it is probable that
the weight has usually been too large."5 Here we see the
important features of the rational expectations' critique
of Keynesianism. First, although the the market-clearing
theory fails to perfectly explain the data of history,
Keynesianism has severe empirical problems of its own.
Whatever their claims to be more interested in "facts,"
than their opponents, Keynesians have made strong
assertions without sufficient evidence. Second, Barro does
not claim that nominal variables never effect real
variables. He argues that the closeness of their causal
relationship has been over-rated. The Sectoral Shifts
Hypothesis Most macroeconomic models treat the economy as a
single market. Then, if unemployment rises, we can usually
assume that it is caused by insufficient aggregate demand.
But some economists, notably David Lilien, have noted that
the economy can also be treated as composed of several
markets or sectors, and that more unemployment could be
caused by shifts between sectors with total demand
unchanged. Lilien then shows that if the percentage of
persons who lose their jobs increases temporarily - as
might happen due to a large sectoral shift - then the
natural rate of unemployment rises. This change is not a
deviation from the natural rate that might be easily
corrected by demand adjustments. Instead a sectoral shift
represents a change in the natural rate itself. If wages
were perfectly flexible, Lilien's problem would not arise.
But even if wages are not flexible, traditional Keynesian
policies would not really solve the problem. As Lilien
states, "Such policies may have been successful in delaying
or smoothing the cyclical pattern of unemployment, but
since inadequate demand was not the source of unemployment,
aggregate demand policies were not an appropriate cure."6
Lilien's statistical support for his sectoral shifts
hypothesis has been challenged - for example, by Katz and
Abraham.7 Their dispute is too complicated for this paper.
What seems important about sectoral shifts, whether or not
it has in fact been important in modern times, is that if
it were true, a jump in unemployment would not necessarily
indicate aggregate disequilibrium. It might be a short-run
change in the natural rate in disguise. So a fall in
employment is not ipso facto grounds for expansionary
monetary or fiscal policy. One must also show that the job
losses are not mainly the result of sectoral shifts.
Explanations of Wage-Rigidity A. Implicit Contracts The
success of the microfoundational criticisms of Friedman,
Barro, and associates can be seen in the wealth of
attempted responses. No longer do the conversants debate
whether wage rigidity is necessary for Keynesian theories
and policies to work; now they discuss why wage rigidity
exists. Since everone agrees on the major premise, that
wage rigidity is necessary for Keynesianism to be true, the
debate focuses on the minor premise, of how wage rigidity
is possible. Probably the first major attempt to explain
wage rigidity was "implicit contracts" as advanced by
theorists such as Costas Azariadis.8 This theory begins
with plausible assumptions: workers are risk-averse, and
therefore prefer a certain and stable series of payments to
one that varies with their short-run, fluctuating
productivity; employers, in contrast, are risk-neutral.
Hence, we have a clear situation where both parties may
gain by shifting the burden of risk through a system of
insurance. The result: wages become rigid because market
participants desire it.
 
Some economists misinterpreted Azariadis' conclusions. They
observed that implicit contracts make wages rigid. Next,
they made the plausible jump that while this is reasonable
from the point of view of those making the contracts, it
allows the familiar Keynesian results of possible
involuntary unemployment and a wide role for discretionary
monetary and fiscal policies.
 
However, this view is wrong. Azariadis never made the above
conclusion, and in a later article, Akerlof and Miyazaki
showed explicitly that it is specious. Put simply, if
workers are risk-averse to drops in wages, they are surely
even more risk-averse to losing their job altogether. If
faced with a choice, risk-averse workers would clearly
prefer "implicit insurance" against job loss to a "policy"
that covered them against the lesser hazard of a pay cut.
Akerlof and Miyazaki state this thesis clearly: "Because
unemployment in many Keynesian macro-models is caused by
rigid wages, by a parallel argument it has been held that
the smoothing of wages caused by implicit contracts results
in non-Walrasian fluctuations in employment. The present
paper questions this last claim on unemployment; for it is
demonstrated here, if workers can (implicitly) make
contracts with the firm, they can also readily insure
against employment variations (i.e. layoffs) and, as a
result, implicit contracts even with sticky wages will lead
to full employment, in most instances, rather than to
unemployment,"9 (emphasis added). So we find a curious
conclusion. Implicit contracts, rather than being the
underlying defect that prevents the efficient operation of
the labor market, turns out to be another way for
individuals to quietly better their condition through
voluntary exchange. B. Efficiency Wages Even though
implicit contracts theory cannot explain involuntary
unemployment, Keynesians see that its basic approach is
persuasive to economists since it relies on traditional
assumptions. Implicit contracts theory assumes that firms
maximize profits and, more broadly, that economic
institutions are not brute facts but instead the rational
solution of market actors to problems.
 
Efficiency wage theory is another explanation for
involuntary unemployment that shares this basic approach.
Put simply, it argues that firms may prefer to pay above
market-clearing wages rather than face the consequences of
cutting them. And since firms' sole desire, by assumption,
is to maximize profits, efficiency wage theory tries to
explain why paying a lower price for labor may, on the net,
be an unwise move. The most plausible case of this is in
undeveloped countries where cutting laborers' incomes may
leave them unable to secure their bare sustenance - leading
to poor work performance.10 But what matters this for
industrialized nations where everyone earns well above a
subsistence income? Here, advocates of efficiency wage
theory point out other plausible cases where employers
might gain by paying above the market wage. First, they
might do this to reduce shirking. Workers paid more than
their opportunity cost would work more diligently lest they
find themselves replaced by another worker eager for a high
wage. Second, they might do so to solve an adverse
selection problem: namely, workers willing to work for
unusually low wages may be less able than those who insist
on holding out for normal wages.11 In its pure form,
efficiency wage theory can explain some involuntary
unemployment but cannot explain why nominal changes should
make any difference. Yellen agrees in principle, but argues
that if one weds efficiency wage theory with the assumption
that employers set wages according to "rules-of-thumb" -
that they only optimize perfectly in the long run -
Keynesian results follow. Be that as it may,
"rule-of-thumb" behavior could yield Keynesian results all
by itself. So efficiency wage theory seems somewhat skew to
the whole issue of why nominal changes have real effects -
although it can explain why involuntary unemployment might
exist even in the long run. Efficiency wage theory shares a
major defect with Keynesian theory generally: it does not
boldly state its basic assumptions upfront.12 The critical
underpinning of efficiency wage theory is imperfect
information of employers. If employers could perfectly
monitor workers, efficiency wage behavior reduces to
compensating wage differentials. Jobs that demand more
effort would pay more, those that require less effort, that
openly condone "shirking" as part of the benefit package,
would pay less. But when employees can potentially fool
their boss about how much effort they put into their job,
the bosses may rationally choose to give their employees
more money so that they will fear job loss and cheat less.
Here is a plausible analogy that shows why an employer
might pay efficiency wages: "It is instructive to contrast
the labor market and certain product markets. Firms that
rent bicycles, cars, or video cassettes wish to deter
misuse and damage but are not usually thought to create
rents with their pricing. Instead they rely on deposits. At
least in part this is because denying future access to
those who misuse products is likely to be difficult. On the
other hand, landlords often price apartments below the
market to insure loyalty on the part of their tenants
rather than relying on a huge security deposit."13
Efficiency wage theory is, therefore, reducible to two
aspects: compensating differentials and imperfect
monitoring. No economists think that there is anything
wrong with compensating differentials. As for imperfect
monitoring, critics of efficiency wage theory note that it
could be solved by auctioning off jobs to workers in
exchange for security bonds. Workers would place a suitable
bond with their employer. If caught shirking, they would be
fired and lose their bond; if not caught shirking (either
because they don't shirk or because no one notices) they
would get their bond back at the end of the period. (In a
multi-period setting, presumably, the employer would keep
the bond until the employee chooses to quit.) Advocates of
efficiency wages concede that this would work if employees
were willing, but suspect that legal restrictions and
damage to worker morale kill the labor market's cure in the
cradle. This is a complicated issue, but it is clear that
the market has many tools to whittle away at the power of
efficiency wages. A close cousin of efficiency wage theory
based on rational behavior is efficiency wage theory based
on "sociological" considerations. Here, it is fair to say,
"sociological" is a euphemism for behavior that economists
would call "irrational." Thus, they may posit "partial gift
exchange" behavior where employers pay workers more than
the minimum necessary to secure their services, and the
employees respond by applying more effort than their job
description demands. Or workers may retaliate against their
employer if they feel that their wages are unfair. The
standards for "fairness" would be set by prevailing
customs.14 This species of efficiency wage theory is more
open to criticism that its profit- maximizing relative,
since it is hard to imagine that the situations that it
describes could be stable. Since the individuals aren't
acting optimally, they create profit- opportunities for
anyone who is willing to act optimally. One could draw an
analogy between sociological theories of employment and
sociological theories of racial discrimination. Neither can
show why sub-optimal behavior does not beget the seeds of
its own destruction by creating blatant profit
opportunities for anyone willing to break with the
suboptimizing herd. C. The Insider-Outsider Approach The
last major explanation of wage rigidity that we will
examine is in many ways a throwback to an older theory of
unemployment that blamed current employees' use of violence
and sabotage to deter potential competition from the
unemployed. Mises, clearly sympathetic to this theory,
writes: "The labor unions are practically free to prevent
by force anybody defying their orders concerning wage rates
and other labor conditions. They are free to inflict with
impunity bodily evils upon strikebreakers and upon
entrepreneurs and mandataries of entrepreneurs who employ
strikebreakers."15 A updated version of this is known as
the "insider-outsider" approach.16 Here, the insiders are
current workers - possibly but not necessarily unionized.
The outsiders are unemployed workers who would be willing
to do the same job as those currently employed for the same
or slightly lower wages. There is thus a clear conflict of
interest between these two groups. Earlier theorists such
as Mises focused on the use of violence and sabotage to
deter "strikebreakers." But the insider-outsider theorists
implicitly note that this is a crude and needlessly bloody
method for the insiders to secure their ends. It is also
possible for them to refuse to share their firm-specific
training and knowledge with new workers - thereby reducing
the marginal product of the outsiders below what it
otherwise might be. Or, attacking the problem from the
other direction, the insiders might be unfriendly toward
outsiders or otherwise artificially worsen working
conditions, thereby raising outsiders' reservation wages to
such a point that they prefer to be idle. The success of
these tactics depends strongly upon the employers'
imperfect information of the insiders' conduct: else, the
employers would probably retaliate. This theory has some
virtues that other explanations lack. Some versions can
explain why short-run money illusion may imply significant
real effects. If insufficient aggregate demands leads the
pool of outsiders to swell, the insiders' exploitation of
their position can explain why wage rates do not quickly
adjust to solve the problem. Conversely, it explains why an
increase in aggregate demand could solve the problem by
"transforming" outsiders into insiders - at least in
Lindbeck and Snower's model where an outsider only needs
one period to graduate into an insider. Still, aggregate
demand management seems like a backwards way to solve or at
least substantially mitigate the insider-outsider problem.
The individual firms might themselves subdue the problem by
adopting a seniority-based pay scale, such as the one
described in Salop and Salop's "Self-Selection and Turnover
in the Labor Market."17 In the Salops' article, firms solve
the problem of variable employee tenure by setting a pay
scale dependent upon seniority to discourage turnover.
Employers with an insider-outsider problem might set such a
pay scale so that insiders feel less threatened by
outsiders who have newly joined the firms - since they
would no longer be in such direct competition with one
another. Second, rather than taking positive action to
mitigate the insider-outsider problem via demand-management
or industrial policies, the government could just take the
negative step of repealing laws that promote the market
power of the insiders. What is needed here is not a
draconian police-state crackdown on labor unions, but a
return to unabridged legal freedom of contract in the labor
market for both employers and employees. While this would
not solve the insider-outsider problem entirely, it would
probably get rid of its extreme manifestations. The
Argument Against Active Policy from Uncertainty and Lags
Let us assume that Keynesian theory is perfectly correct.
At first it would seem that Keynesian practice would follow
immediately. The government should use its monetary and
fiscal policies to insure the "full-employment" quantity of
aggregate demand, expanding if there is a short-fall,
contracting if there an excess. And of course, since the
private sector is free to alter its spending patterns at
any moment, the government needs the flexibility to
counterbalance any disturbance. Hence, the monetary and
fiscal authorities should have free reign so that nothing
prevents them from correcting the defects that they alone
have the ability and will to fix. But a second look here
reveals that Keynesian policies do not necessarily follow
even if Keynesian theory were conclusively proved. They
must also demonstrate a second series of propositions about
the ability and willingness of the government to act as the
theory prescribes. Critics of Keynesianism note this and
react appropriately. They have challenged the ability of
monetary (and fiscal) authorities to actually know when and
how much they should adjust aggregate demand. In fact, one
could doubt that the government will get the direction
correct. On top of this, other critics question the
willingness of the government to behave as the Keynesian
theory prescribes. Unless we assume that government
officials, unlike other human beings, joyfully serve their
fellow men and never take advantage of their position, we
face a clear agent-principal problem if authorities hold
wide powers unchecked by clear and binding rules. So even
if the "first-best" situation without agent-principal
difficulties set no prior restraints on the government, it
is futile to act as if such a state of affairs is really
possible. Let us begin with the argument that the
government discretion is harmful because they do not really
know when to do what. Milton Friedman is the most famous
and persuasive critic of Keynesianism on these grounds. He
has two main arguments: first, that there are "long and
variable lags" between the identification of a problem and
the effects of the designed remedy; second, that activist
policy often itself becomes a source of instability since
policy itself becomes a variable that the market must guess
at. In his classic A Program for Monetary Stability,
Friedman summarized his empirical findings on long and
variable lags: "on the average of 18 cycles, peaks in the
rate of change in the stock of money tend to precede peaks
in general business by about 16 months and troughs in the
rate of change in the stock of money to precede troughs in
general business by about 12 monthsÉ For individual cycles,
the recorded lead has varied between 6 and 29 months at
peaks and between 4 and 22 months at troughs."18 If this
were the case, it is difficult to see how any policy maker
could know which direction to adjust his policy, much less
the precise magnitude needed. Due to long lags that
preclude accurate forecasting, he cannot know what the
state of the economy will be when his policy takes effect.
And due to variable lags, even if he knew all future states
of the economy (in the absence of his adjustments, that is)
he could not know which future state of the economy he
should design his policies to correct.
 
Many Keynesians, Friedman notes, advocate "leaning against
the wind." By this they mean, in some sense, that the
monetary (and fiscal) authorities should try to balance out
the private sector's excesses rather than passively hope
that it adjusts on its own. Friedman tests the Fed's
success by checking whether the rate of money growth has
truly been lower during expansions and higher during
contractions. He admits that this method of grading the
Fed's performance is open to criticism, but decides to go
ahead and see what turns up. He finds that Fed has - for
the periods surveyed - been unsuccessful. "By this
criterion, " he explains, "for eight peacetime reference
cycles from March 1919 to April 1958Éactual policy was in
the 'right' direction in 155 months, in the 'wrong'
direction in 226 months; so actual policy was 'better' than
the [constant 4% rate of money growth] rule in 41% of the
months." Nor is the objection that the pre-Keynesian era
biased his study a good one, since, "For the period after
World War II alone, the results were only slightly more
favorable to actual policy according to this criterion:
policy was in the 'right' direction in 71 months, in the
'wrong' directio in 79 months, so actual policy was better
than the rule in 47% of the months."19 But that is not all,
Friedman quickly adds. Even if the Fed had a batting
average of 50-50, it would not show itself to be just as
good as a constant growth rule. There would be a tie in the
contest to preserve monetary equilibrium. But the variance
of the discretionary policies would inject instability and
uncertainty into the market, whereas the rule, being
changeless, would never be an independent worry to market
participants. Friedman concludes that any alternative to
his growth rule must succeed far more than 50% of the time
to warrant serious consideration. One of the best ways to
parry a metaphor is with another metaphor. Keynesians have
a host of metaphors in their rhetorical arsenal; one
frequently voiced is that a wise government should "lean
against the wind" when choosing policy. Friedman counters:
"We seldom know which way the economic wind is blowing
until several months after the event, yet to be effective,
we need to know which way the wind is going to be blowing
when the measures we take now will be effective, itself a
variable date that may be a half year or a year or two from
now. Leaning today against next year's wind is hardly an
easy task in the present state of meteorology."20
Friedman's remarks, as even his strong critics admit, are
mighty and strike at the heart of any activist
"stabilization" policy. By meeting Keynesians on their own
theoretical turf and scrutinizing their practice, Friedman
manages to produce objections that both Keynesians and
non-Keynesians must take seriously.
 
The Argument Against Activism from Conflict of Interest
Early Keynesians focused more on fiscal policy than
monetary policy. Specifically, they attacked the so-called
"responsible" annual balanced budget. "What's so important
about the year?" they asked. Why not balance the budget
over the cycle, with surpluses in boom years and deficits
in bad years? One could apply the same logic to Keynesian
monetary policy. Why not adjust the position of the money
supply, increasing it during hard times and decreasing it
during booms? There is nothing in the insufficient
aggregate demand interpretation of unemployment to suggest
money should have a positive rate of change. Strangely,
Keynesians leap from aggregate supply and demand curves
that relate output and the position of prices to output and
the rate of change of prices. Despite this, under Keynesian
management there has been some tendency toward systematic
budget deficits and a strong tendency toward continuous
increase in the money supply. This is true of many
countries, but I will limit these brief comments to
America. First, during the post-Keynesian era, the public
debt in America has stayed positive and at a high level
compared to pre- Keynesian peacetime years.21 Moreover,
there have been high deficits during boom years with
continuous deficits since 1970. Second, the money supply
has increased continuously since 1940 - though inflation
rates have, of course, varied, drifting upwards until the
early 80's, dropping sharply, and then slowly climbing
again. All this is old hat. Sophisticated Keynesianism can
easily explain these facts. Why bother to bring it up? Many
of the peacetime deficits occurred after fiscal policy was
no longer used for short-term stabilization. And of course,
when people expect positive inflation, it is movements in
the rate of change of prices, not the position of prices,
that matter. The reason to bring this up is: according to
Keynesian theory - even state-of-the-art Keynesianism -
there is no reason why the budget would not be balanced
over the cycle, and why there should be persistent
inflation. But Keynesian practice has never achieved these
goals, nor even loudly called for aiming at them. Some
critics of Keynesianism solve this paradox by pointing an
accusing finger at the free scope that Keynesian theory
grants to policymakers, unrestrained by strict and
objective rules. James Buchanan and Richard Wagner, in
their Democracy in Deficit, give a concise statement of
this public choice critique of Keynesianism. Active policy
gives wide powers to monetary and fiscal authorities,
limited only by their ability to show that, in some way,
their methods are consonant with their overall goal. But
authorities can act in a way which, though not blatantly
opposed to their announced purpose, really aims at some
other end - an end that the voting public would not endorse
if it understood the situation. In short, if we assume that
the government is properly a servant of the public's
wishes, active policy creates a principal-agent problem. As
Buchanan and Wagner put it, "The economy is not controlled
by the sagesÉ,but by politicians engaged in a controlling
competition for officeÉPolitical decisions in the United
States are made by elected politicians, who respond to the
desires of voters and the ensconced bureaucracy."21
Buchanan and Wagner think that an overlooked aspect of the
Keynesian revolution was its destruction of the implicit
"fiscal constitution" in America. Classical public finance
theory endorsed a balanced budget during peacetime. This
set firm and clear limits upon government spending. Why are
limits beyond simple voting necessary? The classical reason
pointed to the public good characteristics of fiscal
restraint. No one wants their programs cut, because the
costs come out of general tax revenues rather than the
pockets of the direct beneficiaries. And in the case of
deficit finance - which involves intertemporal substitution
of tax payments - the consumers of the government goods and
services may never be taxed for them, and the people who
will be taxed for them may never consume them. But why is
the principal-agent problem too severe to solve with
voting? Won't political competition work to deliver what
the voters desire? Buchanan and Wagner don't think so.
There are serious differences between competition in
markets and competition in politics. Market competition is
continuous, while political competition is intermittent.
Market competition allows the simultaneous survival of many
competitors, while political competition is typically an
all-or-nothing affair. On the market the consumer usually
knows the attributes of the good in advance, and may have
quality guarantees, while the "political consumer" votes
for a good with indeterminate attributes. He receives no
actionable assurances. (Imagine a "truth-in-advertising"
law for elections!) Last, market transactions require
unanimous consent, while political ones merely need a
majority.23 Each of these facts makes opportunistic
behavior less costly to authorities. Keynesians have on
occasion scoffed at the alleged "rationality" of market
participants. Buchanan and Wagner are analogously skeptical
of the rationality of political participants. Voters do not
merely make errors; they suffer from "illusion," that is,
they have systematic misconceptions. The government that
they live under can take advantage of this ignorance.
Buchanan and Wagner explain that this is hardly beyond our
common experience: "complex and indirect payment structures
create a fiscal illusion that will systematically produce
higher levels of public outlay than those that would be
observed under single-payments structures. Budgets will be
related directly to the complexity and indirectness of tax
systems. The costs of public services, as generally
perceived, will be lower under indirect than under direct
taxation, and will be lower under a multiplicity of tax
sources than under a system that relies heavily on a single
source."24 Buchanan and Wagner examine two major sources of
fiscal illusion. Rejecting Barro-Ricardo equivalence, they
argue that the freedom of the government to run budget
deficits artificially makes government goods seem less
costly vis-a-vis market goods. "The allocative bias stems
from the proposition that, if individuals are allowed to
finance publicly provided goods and services through
borrowing rather than taxation, they will tend to
'purchase' more publicly provided goods and services than
standard efficiency criterion would dictate."25 Another way
of thinking of this is that tax increases reduce
consumption of private goods, while budget cuts reduce
consumption of public goods. But deficits let individuals
have greater current consumption with only a vague
possibility that one day they will have to enjoy less as a
consequence. Different people may be paying the bills at
the later date. In a sense, then, unrestrained deficit
finance is a species of negative externality. Another point
implicit in Buchanan and Wagner's analysis is that each
instance of government spending gives highly concentrated
benefits to a minority, while the costs are thinly spread
out over the tax-payers as a whole. Thus, the lobbyists who
work to maintain and expand each program will have a lot at
stake, while each member of the public bears only a tiny
part of the burden. The norm of the balanced budget was one
method of checking this problem. Because Keynesianism gave
economic justifications for deficits, this norm is no more.
Buchanan and Wagner explain it this way: "The removal of
the balanced-budget principle or constitutional rule
generated an asymmetry in the conduct of budgetary policy
in competitive democracy. Deficits will be created, but to
a greater extent than justified by Keynesian principles;
surplus will sometimes result, but they will result less
frequently than required by the strict Keynesian
prescriptions."26 The other important hidden tax is the
so-called "inflation tax," which, more than budget
deficits, has increased because of the Keynesian
revolution. Keynes himself argued that inflation works in a
way that "not one man in a million is able to diagnose."
Buchanan and Wagner agree. To analyze inflation as a
species of tax requires a degree of economic literacy that
only a small minority of voters have. When governments use
inflationary finance, the government receives the benefits
of seigniorage, lower real interest rates, and real debt
erosion, but businesses and unions take the blame. "As it
appears to them [the voters], their real income declines
not because the government collects more real taxes but
because private firms charge higher prices for their
products."27 Unlike a true tax, the inflation "tax" is not
likely to deter the demand for public goods, since most
people do not perceive it as the price paid for government
services. On top of this, since stronger government is the
usual answer to perceived private sector failures,
inflation may have the additional bonus - from the
government's viewpoint - of making citizens more eager to
vote for its services, more willing to smile upon its
growth. If one is not yet convinced, Buchanan and Wagner
have a clinching argument: "If the effects of money issue,
in terms of behaviorial reactions, should be, in fact,
equivalent to those of a tax, there would seem to be no
point in all such activities of politicians."28 Hence, the
solution public choice theorists offer to the inconsistency
between Keynesian theory and practice is: Monetary and
fiscal authorities - the agents - take advantage of the
imperfect information of the voting public - the principals
- to have higher deficits and money creation than is
necessary for full employment. If authorities strove
unswervingly to fulfill the public good, then their free
reign might be best. But in the real world such persons are
few and difficult to identify. Given this, the only
realistic way to solve this problem is to whittle down the
sphere of independent decision-making the government holds
by binding it with strict and objective rules.
 
Buchanan and Wagner's derive two proposals from this
principle. The first is to constitutionally bind the
government to annually balance the budget. Deficits would
imply proportional across-the-board cuts; surpluses would
retire the national debt. The balanced-budget rule could be
suspended during time of emergency with a two-thirds vote
from both houses of Congress. Second, they would adopt
Friedman's constant growth rule for the money supply.29
Public choice theory, as we have noted, is like
Keynesianism in one respect: Both believe that individuals
are not perfectly rational Mr. Spock-type creatures. They
can make systematic errors. But they diverge in their
analysis of which sphere of economic life systematic errors
usually occur. Keynesians talk about the money illusion of
market participants and the animal spirits of investors.
Public choicers, in contrast, see most of the error in the
political sphere, and point to fiscal illusion and the
public good aspects of democracy. In a like vein, some
Keynesians believe that market imperfections explain
macroeconomic problems. Public choicers point to the much
more extreme cases of political imperfections:
 
the intermittent character of political competition, the
all-or- nothing victories that resolve political conflicts,
the lack of guarantees, the principal- agent problem, and
the substitution of majority rule for unanimous consent.
One flaw that I see in public choice theory is that it does
not go far enough. The analogy between voters and consumers
is very weak. Unlike consumption, which benefits the
individual directly, voting is a pure public good. The
intelligent citizen gets no benefit for his investment in
wise voting. The foolish voter pays nothing for his folly.
And the voting act itself involves positive costs of time
and effort.
 
Empirical studies of actual voter behavior by political
scientists show that voter behavior is virtually the
paradigm case of irrational action. Dye and Zeigler, in
their Irony of Democracy, define the following necessary
conditions for rational voting: "(1) competing candidates
would offer clear policy alternatives; (2) voters would be
concerned with policy questions; (3) election results would
clarify majority preferences on these questions; (4)
elected officials would be bound by the positions they
assume during their campaigns."30 From detailed research,
they find that none of these hold for the mass of voters;
indeed, "large numbers of the electorate are politically
uninformed and inarticulate."31 Another interesting area
for public choice theorists to investigate would be the
effect of government "advertising" on the voting public.
Liberals such as John Kenneth Galbraith inveigh against the
evils of private advertising. But surely this cannot
compare to the powers of persuasion that the government
possesses with its virtual monopoly on education and its
regulation of television and radio. James Buchanan, Richard
Wagner, and their fellow public choice theorists have made
an important contribution to the critique of the practical
aspects Keynesianism - to the analysis of what they call
"institutions." Interdisciplinary cooperation with
empirical political science would, I think, improve the
depth and realism of their research. Free Banking's Attack
on Central Banking Keynesian theory states that shifts in
aggregate demand cause real economic fluctuations.
Keynesians infer that the government should counterbalance
random variations with contracyclical policy. At first,
this inference seems obvious. But it is not. Another
premise must be added to this argument to draw this
conclusion: The market cannot provide this valuable service
for itself. Put in the economist's terms, it must be shown
that proper adjustment of aggregate demand is a public
good. If this premise were wrong, if the market could
supply this service, the case for government
macromanagement would be sharply hurt. Recently, some
economists pointed out these facts, and argued that the
market could indeed execute these functions. To be
specific, they envisage a system in which the banks become
the private suppliers of this so-called "public good." For
this system to work, they believe that many regulations
currently imposed upon banks must be eliminated. Hence, the
system they favor is called "free banking" and its
advocates may be called "free bankers." We shall, first,
describe exactly what "free banking" is, which regulations
- at a minimum - must be repealed for a system to count as
"free." Then, we will explain how free banking would
replace government management of the macroeconomy, and show
how free banking solves or at least substantially mitigates
many of the problems government demand management faces.
Last, we shall discuss some of the important objections to
free banking, especially the charge that it would
inadequately protect the public against bank failures. Here
are the crucial ways that free banking differs from current
banking. (1) There would be no central bank with a monopoly
of note issue or ability to increase the supply of base
money. (2) Banks would have no legal reserve requirements.
(3) Banks would be free to issue either deposits or
banknotes. Banknotes would take the place of currency as it
now exists. But, unlike under central banking, banknotes
would not be base money. Instead, they would be "inside
money" just as fully as deposits. For base money, there are
several possibilities - the only necessity is that the base
money be commonly accepted as valuable in itself. The most
plausible options are either gold or a frozen stock of fiat
dollars. The most novel feature of this, of course, is that
currency would be privately issued. This is not, however,
as strange as it sounds. It has existed historically in
most of the world. There is no reason to think that a
system of private issue of currency would be anarchic.
Economically speaking, notes would be no different than
travellers' checks. They would be a claim upon a bank that
is not contingent upon the reliability of the person using
it. In other words, banknotes are one step more marketable
than personal checks, since checks require that a seller
trust both the bearer and the bank, while the acceptability
of notes depends solely on the soundness of the bank
issuing them. Free bankers argue that freely fluctuating
reserve ratios would solve the problem of change in the
demand to hold money. To help our understanding, let us
examine how reserve ratios would be set when there are no
legal requirements. Once we understand this, we will see
how changes in demand to hold affect the optimal reserve
ratio. The necessary reserves for a bank - free or not -
can be conceptually divided into two parts. The first part
is its expected net reserves - the amount needed to cover
itself against expected net clearings with other banks. The
second is its precautionary reserves - the amount needed to
cover itself against random fluctuations in net clearings.
Banks will hold the precautionary reserves because they do
not know their actual net clearings with certainty. They
therefore create a protective buffer against illiquidity.
It is clear that, in the long run, every bank's expected
net clearings must be zero. As Selgin explains, "A bank
cannot continue to suffer a positive average net reserve
demand without eventually disappearing, and it cannot have
a continuously negative average net reserve demand unless
it fails to exploit fully the demand to hold its
liabilities and hence its lending power."32 Given this, it
seems at first that, without legal reserve requirements,
any ratio would be stable. This impression is incorrect,
because it neglects the fact that precautionary reserves
must always remain positive, even in the long run. The
variance of net clearings makes this a simple rule of
prudence. Given an expected gross level of clearings, banks
can estimate the expected deviation of clearings from zero
and hold precautionary reserves accordingly. In the long
run, then, since banks expect zero net clearings, they set
their total reserves equal to their desired precautionary
reserves - and it is this that determines their typical
reserve ratio. If we accept this, it is fairly easy to see
how the banking system would respond to either an increase
or decrease in the total demand to hold money. Selgin
explains that, "Since the precautionary reserves are held
against deviations of average net demand from its mean or
expected value, it follows that precautionary reserve
demand rises by the same factor as the variance of net
clearings. Since gross banking clearings increase whenever
their is an uncompensated, general decline in the demand
for for inside moneyÉand gross clearings fall when there is
an uncompensated, general increase in the demand for inside
money, it follows that bank reserve needs are affected by
changes in the demand for inside money even when these
changes affect all banks simultaneously and uniformly."33
To illustrate this, imagine a case where banks initially
have reserve ratios of 2%. Then, the total demand to hold
real balances doubles uniformly. All banks find that no
one's expected net clearings change. However, their gross
clearings halve, implying that they need only half the
precautionary reserves that they did before. It is
therefore safe for all banks to simultaneously expand their
notes and deposits until the previous ratio of gross
clearings to reserves returns. We reach equilibrium when
deposits and notes double, and the reserve ratio falls to
1%. Conversely, imagine that demand to hold halved
uniformly. Once again, no one's expected net clearings
changes. But their gross clearings double, implying that
banks need twice the precautionary reserves they did
earlier. Each bank, to protect itself, must contract its
notes and deposits until they return to the previous ratio
of gross clearings to reserves. This leaves the reserve
ratio at 4%.34 A second, less serious problem that any
monetary system must face is a change in the
currency-deposit ratio. Under a system of monopolized
note-issue, where currency is also base money, this can
involve serious problems - as economic historians such as
Friedman and Schwartz note in their Monetary History of the
United States. The reason is this: if the central bank
fully accomodates a temporary (for example, seasonal)
change in the currency-deposit ratio, they create a second
problem. Once the public re-asserts its normally preferred
mix of currency and deposits by depositing their excess
currency, the base money in the banking system will expand,
increasing the money supply by a multiplied amount. If the
central bank takes the opposite path and refuses to
accomodate, the banks may face a serious liquidity crisis.
This is not because of any aggregate change, but merely a
relative shift in the public's preferences. But the real
consequences may be severe - as numerous 19th and early
20th century panics during crop-moving season (when the
public required more currency and less deposits)
illustrate. Free bankings' solution to this problem is so
simple it is almost stunning. Under free banking, currency
is not base money. It is just as easy for a bank with full
freedom of note issue to respond to a change in its
clients' desired ratio of currency to deposits as it is to
respond to a change in customers' desired ratio of yellow
checks to white checks. The bank would be decreasing its
deposit liabilities by the same amount that it increases
its banknote liabilities. The limit on overexpansion of
either notes or deposits - as always under free banking -
does not come from legislative restrictions, but from loss
of base money to other banks if one overexpands.
 
Selgin notes that central banking is a species of central
planning; in consequence it suffers from a severe knowledge
problem. The problem of central planning is that, when
prices are not determined by market forces but are set by
the state, there is no automatic way to correct for
shortages and surpluses. Compare this to the market, where
prices can freely adjust as frequently as demand or supply
conditions change. Similarly, when the government is the
sole supplier of a good, there is no danger that
competitors will take advantage of its incompetance. Even
if we assume that the central planner is benevolent and
wise, it cannot know that no one could do the job better if
it is illegal even to try. (Why a benevolent dictator would
want to ban competition is a mystery to me.) Can we apply
this generalization to government versus market management
of money, to central banking and free banking? Selgin
argues that we can. The job of money management is to keep
the supply of money equal to the demand for it, so that
there is neither inflation nor deflation and demand
fluctuations do not affect real variables. If a free bank
is doing its job, it tries to avoid both over- or
under-expanding its liabilities. If it over-expands, it
suffers a loss of base money to other banks. If it
under-expands, it loses out on the interest that it could
have earned by loaning out more. A bank can see both the
direction and approximate magnitude of its errors by simply
checking its net clearings. This is very similar to any
other market; suppliers have an economic incentive to
charge neither too much nor too little, and can swiftly
discover their miscalculations by checking for shortages or
surpluses at a given price. Since a central bank manages
the money supply by adjusting the quantity of base money,
it cannot check its performance by examining the direction
and magnitude of its net clearings. This, Selgin explains,
is why central banks need monetary guidelines in the first
place. "When the currency supply is monopolized, as it is
under central banking, the clearing mechanism ceases to be
an effective guide to changing the money supply in
accordance with consumer preferences. Creation of excessive
currency and deposit credits by a central bank will not
cause a short-run increase in its liquidity costs. This
means that other knowledge surrogates (including both means
for informing money-supply decisions and means for their
timely ex post evaluation) must be found to replace
surrogate knowledge naturally present under free banking.
That is why there is need for 'monetary policy' and
money-supply 'guidelines' under centralized issue."35 Just
as the central planner must make Five Year Plans after it
short-circuits the market's spontaneous coordination
through the price system, the central banker must determine
Monetary Policies because it short-circuits the banking
system's spontaneous satisfaction of changes in money
demand through the clearing mechanism. Economists know that
bureaucratic decisions under central planning are both slow
and inaccurate. There are two reasons: imperfect
information and lack of incentives. Steven Horwitz, an
economist friendly to free banking, describes the
information problem aptly: "the goal of a central bank is
not just to know what that money supply is but what it
ought to beÉRather than having adverse clearings determine
optimal money supply decisions in accord with the wants of
the public, central bankers must rely on statistical
devices for estimating the course of money demand."36 These
statistical devices, like other statistics used by central
planners, are often inaccurate initially and take so much
time to gather that they are outmoded before they can be
used as a guide to action. Selgin notes four popular
monetary guidelines: price index stabilization, interest
rate stabilization, adjustment to achieve full employment,
and constant money growth.37 Each of these has been
persuasively criticized, one is "too inflationary," another
"ties our hands" and so on. None is perfect. But so long as
we must choose between them it is foolish to say, "A plague
on all their houses." We must weigh the pros and cons and
choose the least among evils. An important point made by
free bankers is that there is another, more radical option:
the abolition of any centralized monetary policy in favor
of market supply. "A plague on all their houses" may turn
out to be wiser than it seems. Earlier in this paper, we
discussed two criticisms levelled against Keynesian
practice as opposed to Keynesian theory. There was
Friedman's argument from long and variable lags, and
Buchanan and Wagner's argument from conflict of interest.
Does free banking do anything to help these problems? Free
banking does not completely solve Friedman's problem. But
it does help. The inside lag for free banking would almost
certainly be less than a central bank's, because free banks
would be managed by entrepreneurs who respond to current
market signals rather than bureaucrats who respond to
after-the-fact statistical aggregates. The outside lag
would also be shorter because free banks would only adjust
the supply of inside money, of notes and deposits. Compare
this to a central bank, which injects a given quantity of
base money and then waits for the money multiplier to do
its work. A central bank cannot safely compensate a change
in demand dollar- for-dollar with base money, because the
base money ultimately causes a multiplied expansion of the
total money supply. It is obvious that public choicers must
say that free banking lacks the vulnerabilities inherent in
government demand management. Free banks would not be run
by politicians, but businessmen. They would be checked,
like all businesses on the free market, by competitors.
Efficient execution of their duties would be a private
good, driven by profit-and-loss. Of course, doing a bad job
would not be illegal, but the costs would be borne
primarily by the capitalists. Political demand management,
as Buchanan and Wagner observed, is a public good. The
public bears the brunt of the burden if the authorities
mess up. On top of this, the authorities can benefit
themselves by deliberately "failing" (from the public's
point of view), due to the principal-agent problem. No such
problem exists under free banking, since the interests of
the principal are in harmony with those of the agent. Banks
can fail, and one of the buffers that prevents failure is a
bank's precautionary reserves. Some critics might
reasonably object that it is too dangerous to permit banks
to select their own margin of error when a mistake directly
harms its customers and indirectly injures everyone who
does business with these customers. Especially when the
government insures deposits it seems reckless to let each
bank select its own reserve ratio. Free bankers are quite
aware of this objection, and can, I think, marshall both
theory and history to their defense. From the outset, one
may point out that bank failures are a public bad only in
the loosest sense. If a bank fails, its customers may
suffer. They therefore have a direct incentive to protect
themselves by selecting only sound and prudent banks.
Similarly, those who trade with the customers of a bank
that fails may lose out. But once again, this gives them an
incentive to only accept the notes and checks of solid
banks - just as merchants do today when they guard against
bogus checks. Banks depend upon their reputation for
prudence just to stay afloat. A bank that helps its
customers simultaneously helps itself. Economic theory thus
predicts that banks would strive to bolster the security
that their customers enjoy. History corroborates this.
Countries without branch banking laws, such as Canada, have
stoutly resisted bank failures since it is easier to pool
risk. There were no bank failures in Canada during the
early years Great Depression - while thousands of American
banks collapsed.38 In the Scottish and Canadian banking
systems (once again unimpeded by branch banking laws),
insolvent banks often merged with rivals who would assume
the liabilities of the failed bank in full. In exchange, of
course, they got their former competitor's share of the
market. Some Scottish banks announced their unlimited
liability. Others wrote "option clauses" on their notes,
giving the bank the legal right to suspend payment for up
to six months. If the bank exercised this option, it paid
interest in compensation. The Scottish and Canadian systems
were systems of the past. If free banking were reborn in
modern times, there are other possible ways to supply
banking security. Private, competitively issued insurance
is not beyond the bounds of reason. Selgin suggests that
current deposit insurance, which charges a flat-rate,
subsidizes risk. He plausibly argues that private insurance
would set premiums according to portfolio riskiness.
Private insurers would have an incentive to monitor their
customers that government insurers lack, as the recent S&L
bailout brightly illustrates. Competing banks could pool
risk through a system of cross- guarantees.39 There is, in
sum, a long list of feasible ways for the market to provide
customers with the safety that they desire; this list would
surely lengthen if businessmen found that whoever tried
better ways earned handsome profits. There is no need to go
overboard and claim that free banking is a Utopia. Banks
could err in their estimates of money demand, or they might
be reckless. They might try new innovations only to find
that the old ways were best. Yet these criticisms hold true
of government money supply management too. If there is a
social problem that can be met by the market, if there is
no strong argument that the government would be better and
wiser, shouldn't the burden of proof rest upon those who
favor intervention and state control? The theory of free
banking argues that money supply management is not a public
good, and that free banks impose no obvious negative
externalities upon anyone. While it differs in form,
laissez-faire in the supply of money is in principle just
as worthy of consideration as laissez-faire in the supply
of comic books, bedspreads, and shaving cream. Conclusion,
or Finding the Forest Among the Trees The content and the
conclusions of economics are open to debate, but one fact
is clear: in itself, economics gives us no norms, no vision
of what we should do. "Policy implications," a phrase that
economists never seem to tire of repeating, are not,
strictly speaking, implications at all. They only become
implications when we wed correct economics to a body of
moral principles. Is economics then wholely detached from
the questions that really matter? Not at all. Economics
provides the political philosopher with vital tools. It
clarifies our thinking, taking a solid core of common sense
and refining it by purging our prejudices and organizing
our concepts consistently. From our everyday familiarity
with the practice of exchange, for example, we can deduce
that voluntary exchange as such benefits all participants.
Economics also tells us what types of societies are
possible, and which are merely daydreams or pure
contradiction. Thus, only after economic theory showed that
prices can peacefully coordinate the disparate actions of
any number of individuals could the idea of a
self-governing market order become a reasonable alternative
to absolute monarchy and mercantilism. Milton Friedman has
written, "I venture the judgment, however, that currently
in the Western world, and especially in the United States,
differences about economic policy among disinterested
citizens derive predominantly from different predictions
about the economic consequences of taking action -
differences that in principle can be eliminated by the
progress of positive economics - rather than from
fundamental differences in basic values."39 I must take
issue with this statement; I think that it is usually
wrong, especially about the debate between Keynesianism and
its critics on which this paper focuses. Keynesianism,
while the most influential economic system of the 20th
century, did not reverse the course of history. It was
rather a response to a prior change in the philosophical
climate, away from the vision of society as a voluntary
association of rational individuals, each pursuing his or
her self-interest, and toward the view of society as an
organic unit, with the mass of men as the obedient body,
and the government - guided by the intellectuals - as the
brain. Most texts argue that Keynesianism was the natural
response of economists to the Great Depression, which
seemed to flatly contradict classical economic theories.
But I cannot see why it should be any more "natural," in an
economy with both market and government, to attribute the
failure to the market and call for the government to
rectify it. It seems at least as natural for economists
during the Great Depression to attribute the problem to the
government and advocate market solutions, for example, free
banking and repeal of laws retarding wage adjustments.41
The proper explanation for economists' almost universal
turn against the market in favor of government management
is that they imbibed the philosophy of their time and
translated it into their field of speciality. This is not
to say that Keynesians had no convincing arguments or even
that most of them were intellectually dishonest. But I do
think that the Keynesian "revolutionaries" used a double
standard when comparing markets and government. I think
further that the driving force behind this double standard
was the dominant authoritarian political philosophy, not a
sober comparison of these contrary ways to organize
society. I see most of the rejoinders to Keynesianism
described in this paper as belated efforts to make a sober
comparison between markets and government. The quality of
these arguments, I admit, varies widely. But taken
together, I think that they should raise serious doubts
about the alleged necessity for the government to correct
the macro failures of the market. Determined moral
opponents of capitalism will likely aim to make government
management work more efficiently rather than abandon it.
This approach seems wrong to me. Do not many of the
criticisms show that the inadequacies of goverment
management are not mere coincidence, but something inherent
in the very existence of state control as such? Only if the
debaters recognize this can the crucial controversy, the
dispute over the nature of the just society, be resolved.

Notes 

1. Rothbard, Murray. Man, Economy, and State, (Nash
Publishing: 

Los Angeles, 1962), p.879. 

2: Friedman, Milton. "The Role of Monetary Policy,"
American 

Economic Review, March 1968, p.10. 

3: Barro, Robert. Macroeconomics, (John Wiley and Sons,
1987), 

p.453. 

4: ibid, pp.458-63. 

5: ibid, p.470. 

6: Lilien, David. "Sectoral Shifts and Cyclical
Unemployment," 

Journal of Political Economy, 1982, p.793. 

7: Abraham, Katharine and Katz, Lawrence. "Cyclical 

Unemployment: Sectoral Shifts or Aggregate Disturbances?,"
Journal 

of Political Economy, 1986, pp.507-522. 

8: Azariadis, Costas. "Implicit Contracts and
Underemployment 

Equilibria," Journal of Political Economy, 1975,
pp.1183-1202. 

9: Akerlof, George and Miyazaki, Hajime. "The Implicit
Contract 

Theory of Unemployment meets the Wage Bill Argument,"
Review of 

Economic Studies, 1980, pp.321-338. 

10: Dornbusch, Rudiger and Fischer, Stanley.
Macroeconomics, 

(Mc-Graw-Hill, 1990), p.699. 

11: Yellen, Janet. "Efficiency Wage Models of
Unemployment," 

American Economic Review, Vol. 74, No.2, pp.201-3. 

12: For an illuminating exception, see Dickens, William,
Katz, 

Lawrence, Lang, Kevin, and Summers, Lawrence. "Employer
Crime and 

the Monitoring Puzzle," Journal of Labor Economics, July
1989, 

pp.331-347. 

13: ibid, p.344. 

14: Akerlof, George. "Gift Exchange and Efficiency-Wage 

Theory: Four Views," American Economic Review, Vol. 74,
No.2, 

pp.79-83. 

15: Mises, Ludwig von. Human Action, (Yale University
Press, 

1966), pp.777-8. 

16: Lindbeck, Assar and Snower, Dennis. "Cooperation, 

Harassment, and Involuntary Unemployment: An
Insider-Outsider 

Approach," American Economic Review, March 1988, pp.167-88. 

17: Salop, J. and Salop, S., "Self-Selection and Turnover
in the 

Labor Market," Quarterly Journal of Economics, November
1976, 

pp.619-628. 

18: Friedman, Milton. A Program for Monetary Stability, 

(Fordham University Press, 1963), p.87. 

19: ibid, p.95. 

20: ibid, p.93. 

21: Barro, op. cit., p.380. 

22: Buchanan, James and Wagner, Richard. Democracy in 

Deficit: the Political Legacy of Lord Keynes, (Academic
Press, 1977), 

p.96. 

23: ibid, pp.96-97. 

24: ibid, p.129. 

25: ibid, p.99. 

26: ibid, p.103. 

27: ibid, p.63. 

28: ibid. p.111. 

29: ibid, pp.180-182. 

30: Dye, Thomas and Zeigler, Harmon. The Irony of
Democracy, 

(Brooks/Cole Publishing, 1987), p.205, and passim
pp.204-229. 

31: ibid, p.206. 

32: Selgin, George. The Theory of Free Banking, (Rowman & 

Littlefield, 1988), pp.72-73. 

33: ibid, p.76. 

34: ibid, pp.64-85. 

35: ibid, p.96. 

36: Horwitz, Steven. "Keynes's Special Theory," Critical 

Review, Vol. 3, Nos.3-4, p.424. 

37: Selgin, op. cit, pp.96-107. 

38: ibid, p.12. 

39: ibid, p.135-137. 

40: Friedman, Milton. Essays in Positive Economics,
(University 

of Chicago Press, 1953), p.5. 

41: On the "Keynesian" anti-depression policies of Herbert 

Hoover, see Rothbard, Murray. America's Great Depression,
(Sheed 

and Ward, Inc., 1975), especially pp.165-295; and Rothbard,
Murray. 

"Herbert Hoover and the Myth of Laissez-Faire," in A New
History of 

Leviathan, edited by Radosh, Ronald and Rothbard, Murray,
(E.P Dutton 

& Co., 1972), pp.111-145.