China as a Test of Keynes vs. Hayek

Let's start by saying that I have an imperfect layman's view of Keynes and Hayek.  This is my understanding and over-simplification of how these camps deal with economic downturns.

  • Keynes:  Economic downturns result from some sort of failure of aggregate demand.  There are positive feedbacks in the system such that a small downturn can lead to a larger downturn if left unchecked (but on the flip side mean that a small stimulus can have a disproportionately large effect on demand).  The proper government response to a downturn is to create demand through government deficit spending.   Failure to emerge in a timely manner from a recession likely is the result of the government not being aggressive enough in its spending.
  • Hayek:  Economic downturns result from mis-allocation of savings and investment capital, often due to government policy by not necessarily so (one can argue the housing bubble was driven by government policy, but the first Internet bubble likely was not).  The proper government response to a recession is to stop any distorting government policy that drove it and let the economy sort itself out by restructuring.  Failure to emerge in a timely manner from a recession is likely due to interventions that slow this necessary restructuring (e.g. bailouts, government-directed investment programs).

I will say that if my Hayek description is not correct for the Austrians, it is correct for me -- this is what I believe happens.

That said, I have long thought the Japanese lost decade(s) were pretty much final proof of the Hayek vs. Keynes explanation, and I am sort of amazed people still argue about it.  I remember in the 80's people in the US admired the Japanese MITI system of industrial management that carefully directed investment into government-preferred industries and, by the way, stomped on the Japanese consumer (including laws that kept both the retail and agricultural sectors backwards) in favor of promoting the export market.

In the 20+ years since Japan slid into a downturn, they have been the poster child for Keynesian stimulation.  They have deficit spent like crazy and have driven up -- by a longshot -- the largest government debt as a percent of GDP of any of the industrialized nations.  Yet still they flounder -- I would argue precisely because they had an Austrian recession, based on years and years of government-enforced mal-investment, but have refused the Austrian solution.  Watching it evolve over the years, I have thought it impossible to miss the point, but it appears that Krugman-Keynesians can always argue, not matter how much government debt was run up, that the problem was that they just didn't spend enough.

Well, in my view we have another such test coming, perhaps even more stark -- in China.  China, perhaps more than Japan, has filled their economy with investment distortions -- the huge empty cities that get shown on the Internet seem to be one example.

China empty city

And over the past year or two, China has been deficit spending and stimulating like hell -- both at the central government level as well as with policies that have encouraged the accumulation of debt both locally and in industry.

This is why I think the crash is coming in China, and the longer they manage to delay it by artificial means, the worse and longer the crash will be.  There is probably a bet that could be had here, but I am not sure how it would be structured.


  1. Hoosierman:

    To be fair to Keynes his General Theory was published in 1936 when government intervention into the economy was not the norm.

  2. DirtyJobsGuy:

    In japan just watch the demise of formerly dominant international companies like Sony, Panasonic, Toshiba. Their restructuring/demise has been so much delayed that new firms cannot break the mold. The Chinese are operating on an additional problem with their quality control that is equivalent to Japan just after WWII.

  3. bigmaq1980:

    "I think the crash is coming in China, and the longer they manage to delay it by artificial means, the worse and longer the crash will be."

    They have no choice, if we mean by "they" the people who are currently in power. Their political power had, in part, been predicated on the assumption of their awesome management of the economy. Now, they must "do something" to turn it around and "Make China Great Again".

    Keynes is often used as cover for politicians to implement their favorite program, or subsidize their friends... err, strengthen industries and create jobs, and "level the playing field".

  4. Matthew Slyfield:

    To be fair to Keynes, his General Theory has never been properly implemented. Per his theory, government should spend on debt in an economic downturn and pay off the debt during the next boom. His theory doesn't work and in fact doesn't even claim to work when the government continues to operate on deficit spending during economic boom times.

  5. Daniel Suraci:

    ". . . but the first Internet bubble likely was not"

    Austrians tend to put very heavy emphasis on monetary policy. I believe they would look to the Fed as to the cause of the tech bubble (though I guess you can argue if Fed policy is private or government action on its own due to its strange nature). I think a proper analogy is that the Fed opens the floodgates with cheap credit, but there can be a variety of factors that determine where that money flows to - housing, tech, the stock market as a whole, bonds, etc.

  6. roystgnr:

    If you admit to the need for *some* government spending on long-term investment projects, then Keynesian countercyclical deficits are a pretty solid plan from the Austrian point of view too. To maximize return on investment, spending should be disproportionately done while prices and wages are relatively low, and taxes are likely to be less damaging if they're disproportionately levied while economic times are better.

    But of course that's not how we decide on deficits in the real world. With a politician's incentives, spending is always best done *now*, while you're in charge of where it goes, and taxes are always best levied *later*, when someone else is in office to take the heat.

  7. Dan Wendlick:

    I think a factor that both of these views overlook is the impact that assimilating new sources of resources or opening new markets due to technology shifts can have on the economy as a whole. Look at, for example the booms an busts that were created by such things as the opening of American colonization (arguably Spain has yet to recover from that bust); the introduction of the steam engine in the 19th century, and it's impact on mining, railroads, and shipping (heck even refrigeration if you follow the technology deeply enough); the petroleum boom of the late 19th and turn of the 20th century, leading to introduction of automobiles and consumer electrical goods in the 1920s; and to a lesser extent the uranium boom of the 1950s. I think the first Internet boom (1998-2002) was largely one of these, with the economy attempting to rapidly assimilate the new technologies of ubiquitous and asynchronous communication that the integrated circuit allowed.
    Just as there are many diseases that can cause a fever, there are many sets of circumstances that can cause a boom/bust cycle. And to continue the metaphor, applying the wrong cure without regard to the cause can cause more harm than good.

  8. ColoComment:

    It seems to me that part of what government considers stimulating demand a la Keynes consists of subsidizing the "busting" industries or occupations, e.g., those that are being made obsolete by new technologies, new processes, or new transportation innovations (container shipping, for example) for the purpose of "saving jobs." The unintended "unseen" effect is to delay adaptation to the "new" by the affected workforce, and to extend the shelf life of inefficient resources.

    I've never read Keynes -- does he address that? I've only seen the YouTube rap videos. :-)

    Also, as some several have said below, I too understand that Keynes advocated paying down the debt during the boom times. And it's not just that government spends on long-term projects to stimulate, but that it establishes programs THAT NEVER GO AWAY and that keep increasing the number of beneficiaries and expanding their budgets. The "stimulation" becomes the new baseline.

    Finally, don't miss Feldstein's op/ed in today's WSJ re: QE, as well as George Selgin's 3-part series on the effects of the Fed paying interest on banks' excess reserves. The link is to part 3.

  9. Hoosierman:

    I agree. Keynes had some notion of equilibrium. Government was supposed to spend at a deficit when times were bad and run budget surpluses when times were good to control inflation. Of course getting legislatures to act in a timely manner even if it means raising taxes a week before the elections is a tricky proposition. But are either Keynes or Hayek germane to China's mess? What I'm asking is are we looking to a simple business cycle or something beyond that. My notion is China's bureaucrats may have run out of brains. We see companies do this all the time. They always resort to the action that worked the last time until it stops working. Yes, a command economy has its advantages but it's only as good as the bureaucrats who run it. I doubt if they could or would call in some turn around expert. Implicit in the work of Keynes and Hayek was a free economy which is not the case here.

  10. Hoosierman:

    No Keynes would build roads bridges and dams rather than bail out a failing industry. Yes, he would budget surpluses during booms which begs the question would congress have the guts to take away the punch bowl.

  11. Dan Wendlick:

    But technology has made even roads and dams a failing proposition. These days you don't hire a hundred men and order a hundred shovels. You get one man and a bull dozer. And if the Bulldozer is imported from China, all your stimulus just crossed the Pacific. All of the labor-intense producers went out of business or relocated to low-wage countries. When you intentionally produce inefficiently, you are purposely destroying wealth.

  12. Andrew_M_Garland:

    From Hayek’s 1941 book The Pure Theory of Capital:
    === ===
    [heavily edited for readability -AMG]:

    The increasing concentration on short-run effects amounts to a concentration on purely monetary factors. This is a serious intellectual error, betrays the main duty of an economist, and is a menace to our civilization.

    It was the duty and the privilege of the economist to study and stress long-term effects which are hidden to the untrained eye. A businessman already understands as much as an economist about the forces which determine day-to-day changes in business.

    Two hundred years of developing economic thought have led us away from the more superficial monetary mechanism, to show the real forces which guide long-run development. But, new theories are taking us back to the pre-scientific stage of economics when the working of prices was not yet understood. Back then, economists were interested only in the impact of a varying money stream on a supply of goods at given prices.

    Mr. Keynes' views were first expressed by past mercantilist writers and gifted amateurs. Concern with surface phenomena was the first stage of the scientific approach to economics.

    We have already developed a systematic account of the forces which determine long-run prices and production. It is alarming that we are now called upon to scrap it. Instead, we are to adopt the short-sighted philosophy of the businessman raised to the dignity of a science.

    We are explicitly told that “in the long run we are all dead,” so policy should be guided entirely by short-run considerations. I fear that these believers in "apres nous le deluge" may get what they have bargained for, sooner than they wish
    === ===

  13. xtmar:

    Don't forget about demographics. Both China and Japan have rapidly aging populations with well below replacement birth rates. It's very hard for your economy to grow, no matter the government policy, when the population base is shrinking. I think this is especially true in China, as their greatest growth has corresponded with a population boom hitting their peak productive years, and growth going down as that population ages.

    Obviously, there are other factors at work, but I think we tend to focus too much on government action, because it's easily visible and supposedly easy to change, and not enough on less obvious factors, like demographics.

  14. ErikTheRed:

    The problem with Keynesianism from a scientific perspective is that it's "never wrong" - because if the carefully calculated stimulus that is guaranteed to make us all so rich we'll be farting through silk turns out later to not have its intended effect, then that just means you didn't spend enough (just listen to Krugbot, Obama, etc). It's a blatant tautology, but it has two very important practical effects: 1) It gives "scientific" cover for politicians to engage in endless cronyism (in my opinion, the only reason it wasn't laughed out in the first place), and 2) it vastly over-elevates the importance of Keynesian economists in academia, think tanks, governments, finance, etc. - again a blatant and obvious conflict of interest that is conveniently overlooked by many.

  15. poitsplace .:

    This song is probably going to be stuck in my head forever.

    I've come to realize that complex systems (as a whole) do not work well with someone trying to treat it as a whole system. Most of the correlations will fail if you try to force the system...because its the intent of the individuals within the system that was driving the correlations, not government spending. We have the same problem with racism and sexism...only with them we're now fighting against micro-biases and in most cases, reality its self (social justice warriors don't seem to understand that cultural and sexual differences are in fact...differences...and as such they have consequences that cannot be erased or adjusted for)

    And worse still, a lot of these negative results have an annoying delay in them, so it might even look briefly like it's accomplished the whole system slowly winds down and ends up worse off overall than it was initially. Then of course there's that final thing you need to come to terms with when dealing with complex systems...the fact that the optimal real-world not knowable. And when it's "optimal" it will still look like it needs something fixed. And since self-organizing systems they often flirt with the optimal conditions...and if you try to "fix" what looks run the risk of pushing it AWAY from optimal, since you've no idea what "optimal" was in the first place.

  16. Incunabulum:

    Something else about the Keynes bit - nobody will ever know if Keynes is correct (I don't think he is) because no government in the history of mankind is willing to do the other half of his prescription. Which is *build up a surplus during economic booms* to cover the 'stimulus' that is going to be done during the busts.

  17. Incunabulum:

    Don't forget that those *demographic* factors in China are *explicitly* the result of government policy.

  18. morganovich:

    his theory straight up does not work at all. you cannot "stimulate" out of recession.

    the great gaping hole in the keynes theory is this:

    GDP= C + I + g + (x-m)

    so, reason the keynsians, if we need demand, we up G. this seems like a mathematical tautology, but it's not.

    the great flaw is that C and I and G are not independent variables. the affect one another and G is a nasty one.

    a $1 jump in G crowds about about $1.20 in private investment.

    this is why keynsian solutions are a sucker bet. you stimulate, and GDP actually drops. worse, as I is the primary driver of future growth, GDP is hamstrung for some time. it never works. not ever.

    the depression was caused by stimulus and government interference in markets more than monetary policy.

    we made the mistake this last time which is why the recovery was so weak and really only got some steam after QE ended.

    the japanese have done the same thing.

    the history of keynsianism has been a serious of ludicrous failures and disasters. they predicted that the end of ww2 would cause a depression and though that building tanks and bombers was prosperity.

    they mistake the map for the terrain and still do not even understand the map.

    there is always the next generations of keynsians claiming we just need smarter guys to make the choices this time, but, when they get a chance, it's the same old failures. there is no "right" way to implement it.

    the idea is based on bad assumptions about variables and worse notions about being able to aggregate enough information for policy makers to effectively steer the economy.

    the reason it will not die is that it's the doctrine that politicians love because it lets them hand out goodies.

  19. morganovich:


    i think you are misreading keynes. regardless of what happens in the next boom, greater spending (according to keynes) should still help a recovery from recession. but the evidence on this is legion and clear: it doesn't. leaving aside the longer term issues around sustainability, we should still see the "animal spirits" enhanced bygovernment spending, but, instead, we see the opposite. there is no explanation under keynes for that. this is where the keynsians always go for "bigger hammer theory". we need MORE stimulus. or "imagine how bad it would have been without it!"

    yet we need no imagine this. we saw it in different parts of the EU. those that used a lot of stimulus stagnated. those that did not (like the swedes) recovered quickly.

    this last recovery in the US was weak BECAUSE of stimulus. it started to strengthen when the stimulus ended. now the EU is pushing more stimulus and (surprise surprise) it's hamstringing them.

    your point that no one pays off the debt in the good times is, to be sure, accurate, but that would not actually stop stimulus from working in a downturn.

  20. markm:

    The unwillingness of politicians to refrain from spending all the revenue isn't the only problem with the *build up a surplus during economic booms* part of the prescription: that assumes that there is a government investment agency that is neither incompetent nor politically-driven. If you wanted to *really* screw up the economy, it's hard to think of a more effective way than having the world's largest investment fund controlled by the likes of the EPA managers. Or a Secretary of the Treasury who "forgot" to pay his taxes.

    OTOH, *run a surplus during the booms to pay off the debt you ran up during the busts* only requires the fortitude to hold back spending a little when you're doing well - most of our ordinary citizens eventually become capable of that as individuals. But as a group, we're wastrels.

  21. Mr. Generic:

    I thought the a big part of the empty buildings problem in China is a local belief that investing in property is the best sort of investment while actually renting out the property lowers its value. I wish I could remember where I read that though.

  22. TruthisaPeskyThing:

    No doubt about it. Economic cycles are driven by Investment. By comparison, Consumption varies little, Government is a consistent upward trend, and Net Exports are too small to drive the cycle. Investment falls because of past BAD investment decisions. With bad investment decisions, the investment does not generate a cash flow sufficient to pay back the loan that financed the investment. Therefore both investor and lender are skittish to make another investment.
    There was a time that the biggest influence on investment was interest rates. Now, government policy is probably a bigger driver, and government policy DID drive the misallocation of resources into the housing market. Government caused the problem, but given its power, it can say that it was the fault of the banks. (On a related note, in the long run when panic subdued, the banks generally could handle their loan portfolio. The crisis happened because government policy caused a panic and made a couple of errors in addressing that panic in late 2008.)

  23. Hoosierman:

    Would you consider the interstate highway system wasteful? What about the lock and dam systems on the Ohio, Mississippi and Missouri Rivers? Productively gains in the heavy construction industry since the completion of the interstate system have been pretty marginal. Laser and GPS have been incorporated into some machinery and dozers and backhoes are larger and they can pump concrete now but nothing on the order as the invention of moveable type

  24. Dan Wendlick:

    Your kind of missing my point. If you look at the origins of the Interstate Highway system, it was intended to improve efficiencies of moving military equipment across the country. During WW II, the only way to move a large quantity of freight from a warehouse on the East Coast was to load it onto a truck, unload the truck at a railroad depot, reload the cargo onto a box car, wait for a train to deliver to a hub, wait for another train to take the boxcar to another hub, maybe several times, and then unload the box car, load to another truck, and deliver to the destination. That coupled with the fact that Eisenhower was heavily involved with an early demonstration project that took the Army several weeks to drive a truck from the east to west coasts, led to the authorization.
    The system became a disruptive technology that led to a boom in the Interstate trucking industry, allowed the creation of the containerized shipping industry, and destroyed the railroad-based express shipment carriers.
    The value in creating the Interstates was in what they allowed, not in the fact that the construction itself redistributed wealth within the economy, which is the Keynesian stimulus principle. The Keynesian extreme is portrayed as hiring 100 men to dig holes on Monday and fill them back in on Tuesday. these men will then use the money to buy stuff, giving work to others selling and producing, and the wheels turn and generate economic expansion.
    The problem is that when the thing being produced is not valuable in itself, you don't get the money multiplier above unity.

  25. Q46:

    Keynes: those who advocate Keynes observe only the second part of what he recommended, increased Government spending to get out of recession.

    Keynes's precursor to this was decreased Government spending during the boom. The object being that Government reserves would build up during boom, its borrowing requirement would be low when the boom ended, so less public debt in place to service when tax revenues fell in recession. Government spending could then be funded out of reserve, there would be less existing debt to service and less existing spending to support from new debt and deficit spending would (so the theory goes) build debt from a much lower level.

    Instead Western Governments simply spent and borrowed increasing amounts as the tax revenue rolled in during the boom, building Government spending levels and raising the debt platform - bribing voters of course. Then came recession and Governments were stranded with high debt mountains, high spending to support out of yet more debt, no reserves and increased spending just piled on more and more debt.

    Internet bubble not due to Government policy? Yes it most certainly was. Governments depressed interest rates - to encourage debt fuelled demand to keep the tax income rolling - and encouraged mis-allocation of capital. Cheap money encourages short-term risky, high reward investment... the bubble grows. If borrowed capital costs more, less is borrowed and people tend to be more careful where they place it, and its cost requires a longer terms strategy - rather than just taking a punt.

  26. mlhouse:

    The main problem of "Keynesian Economic" policy is that the critical execution of any of the policy is performed by the government. Governments run to maximize the political value of policy, not to maximize real economic growth/potential. With every policy, there are winners and losers (as there are in just about any economic state, for example debtors benefit from inflation, short sellers from stock market drops).

    While I agree with everything you say, the problem with the simple G argument is that there are many types of G. So, not EVERY dollar of G crowds out any private investment. Some G, I would argue, might even increase private investment (such as money spent by government to insure property rights).

    I would also argue that some G does have a multiplier > 1 and that there are some benefits to G spending that isn't measured in economic terms. One government program I would argue fits both those criteria would be rural electricfication, early transportation spending, and basic social spending.

    But like every economic process, there is a diminishing marginal returns. Electricfication is already satiated and continued over governmental regulation is a negative. Many transportation projects are wasteful. And social spending has become beyond wasteful, contributing to bad social behavior (crime, illegitimacy) and removing the incentive to become productive citizens.

  27. TruthisaPeskyThing:

    Democracy has a troublesome flaw. Once the majority views government as a means to get what they cannot get on their own work, they will devote resources to gain political power so that they can force others to do what the others would not do in their own freedom. These resources are wasted for society in the economic sense, and freedom is eroded. The Founders of the United States thought that they could curtail this tendency via a Constitutional Republic -- putting into the Constitution rights & freedom for individuals and restrictions on government power. After 200 years, we have seen that Constitutional guarantees have little power in today's political reality.
    Keynes facilitated the loss of individual freedom and individual responsibility by encouraging people to look to the government as the cure for their problems.