Skousen The Big Three in Economics - Smith, Marx, Keynes (Sharpe, 2007)

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indefinitely.) In his presidential address before the AEA in 1937, Hansen boldly announced that the United States was stuck in a “mature economy” rut from which it could not escape, due to its lack of technological innovations, theAmerican frontier, and the population growth rate. His stagnation thesis was vigorously attacked by George Terborghinhisbook TheBogeyofEconomicMaturity (1945)andthen soundlydisprovedbyavibrantrecoveryafterWorldWarII.Thestigma of this unfulfilled prediction haunted Hansen throughout his life.

PaulSamuelson,undertheHansenstagnationspell,almostsuffered the same fate. In 1943, he wrote an article warning that unless the government acted vigorously after the end of the war, “there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.” In a two-part article in published in The New Republic in the autumn of 1944, Samuelson predicted a replay of the 1930s depression (Sobel 1980, 101–02).

Although he, along with most Keynesians, was proved inaccurate about the postwar period, Samuelson gradually began expressing strong optimism about the U.S. economy in successive editions of his textbook. “Our mixed economy—wars aside—has a great future before it” (1964, 809).

Samuelson found it an exciting time to be an economist: “To have been born as an economist before 1936 was a boon—yes. But not to have been born too long before!” (in Harris 1947, 145). He applied the following familiar lines from William Wordsworth’s The Prelude (Book 11, lines 108-9, previously quoted in chapter 2):

Bliss was it in that dawn to be alive,

But to be young was very Heaven!

Samuelson completed his dissertation in 1941, and it won the David A. Wells Award that year. (It was published in 1947 as Foundations of Economic Analysis.) In this work, Samuelson broke with Alfred Marshall by contending that mathematics, not literary expression, should be the primary exposition of economics.

But after graduation Samuelson discovered that heaven was not so sweet. He declared his preference to teach at Harvard, but his youthful exuberance, arrogant personality, and Jewish background all worked againsthim. Hiscockyattitudehadlongirritatedhis chairman,Harold

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 169

HitchingsBurbank,andthedepartmentofferedhimonlyaninstructorship. Determined to stay in Cambridge, he accepted a position at the relatively unheralded department of economics at the Massachusetts Institute of Technology.

Harvard soon came to regret its mistake. By 1947, Samuelson had been awarded the first John Bates Clark Medal for being the brightest young economist, his school had granted him a full professorship, and MIT had been ranked as one of the best economics departments in the country. And Samuelson was only thirty-two! A year later he would drop the bomb that would be the envy of every economics department: the first edition of Economics, Samuelson’s new testament of macroeconomics. Harvard professor Otto Eckstein remarked, “Harvard lost the most outstanding economist of the generation” (Sobel 1980, 101).

How Samuelson Came to Write His Famous Textbook: “A Singular Opportunity”

In the early postwar period, Harvard students studied economics from outdated textbooks that said nothing about the war and little about the new economics of Keynes. “Students at Harvard and MIT often had that glassy-eyed look,” commented Samuelson. His department head asked him to write a new text. Three years later, after toiling through nights and summers (“my tennis suffered”),

Economics was born.

Attacked from Both Sides

The first edition, published by McGraw-Hill, sold over 120,000 copies through 1950 and just kept selling. But it soon came under attack from the business community, on the one hand, which complained of its socialistic tendencies, and the Marxists, on the other hand, who complained of its capitalistic tendencies. William F. Buckley, Jr., protested in God and Man atYale (1951) that Samuelson’s textbook was antibusiness and progovernment. An organization called the Veritas Foundation published Keynes at Harvard and identified Keynesianism with Fabian socialism, Marxism, and fascism. On the other side, Marxists took umbrage at Samuelson’s assertion that

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Marx’s predictions about the capitalist system were “dead wrong.” A massive two-volume critique, Anti-Samuelson (1977), was published to counter Samuelson and introduce Marxism to students. Samuelson was pleased to hear that in Stalin’s day, Economics was kept on a special reserve shelf in the library, along with books on sex, forbidden to all but specially licensed readers. “Actually,” responded Samuelson, “when your cheek is smacked from the Right, the pain may be assuaged in part by a slap from the Left” (1998, xxvi). Meanwhile, Samuelson offered a seemingly balanced brand of economics that found mainstream support. While he favored heavy involvement in “stabilizing” the economy as a whole, he appeared relatively laissez-faire in the micro sphere, supporting free trade, competition, and free markets in agriculture.

The High Tide of Keynesian Economics

The success of Keynesian economics and Samuelson’s textbook reached its zenith in the early 1960s. The MIT professor became president of theAEA in 1961, the year John F. Kennedy was inaugurated president. Samuelson, along with Walter Heller and other top Keynesians, was a close advisor to Kennedy and helped steer through Congress the Kennedy tax cut of 1964, a Keynesian program designed to stimulate economic growth through deliberate deficit financing. It appeared to work, as the economy flourished through the mid-1960s. By that time, Samuelson’s textbook reigned atop the profession, selling more than a quarter of a million copies a year. And a year after the Nobel Prize in economics was established in 1969 by the Bank of Sweden, the prize went to Paul A. Samuelson.

Samuelson’s textbook has been on the decline since the turbulent and inflationary 1970s, and today—a half-century after the first edition—it no longer tops the list in popularity. However, the new front-runners (especially Campbell McConnell’s textbook, which has been among the top sellers for years) are mostly considered clones of Samuelson. Since 1985, new editions of Economics have been coauthored byYale professorWilliam D. Nordhaus, and Samuelson’s hair has turned from blond to brown to gray in his sunset years. Yet “his memory dazzles even when it fails,” writes an admirer (Elzinga 1992, 878).

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Figure 6.1 The Keynesian Cross of National Income Determination: How

Saving and Investment Determine Income

HOW SAVING AND INVESTMENT

DETERMINE INCOME

Investment

Saving and

S, I
+						S
		I		E		I
				B
O							NI
				M
			S			F
				National Income
–

Source: Samuelson (1948: 259). Reprinted by permission of McGraw-Hill.

Samuelson’s Goal: To Raise the Keynesian Cross Atop a New House of Economics

What was Paul Samuelson trying to achieve? There is no real Samuelson school of economics; he considers himself “the last generalist in economics.” (But what about Kenneth Boulding?) The MIT professor’s intention was, first and foremost, to introduce Keynesianism to the classroom: the multiplier, the propensity to consume, the paradox of thrift, countercyclical fiscal policy, national income accounting, and C + I + G were all new topics introduced in the first edition of Economics in 1948. Only John Maynard Keynes was honored with a biographical sketch in early editions, and only Keynes, not Adam Smith or Karl Marx, was labeled “a many-sided genius” (Samuelson 1948, 253).

The “Keynesian cross” income-expenditure diagram, invented by Samuelson and reproduced in Figure 6.1, was printed on the cover of the first three editions. The Keynesian cross incorporates all the elements of the new “general” theory. In the diagram in Figure 6.1, note that saving (S) increases with national income (NI). As people earn more, they save more. However, investment (I) is autonomous and independent of saving. It is set at a fixed amount because, according

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to Keynes’s theory, investment is fickle and varies with the “animal spirits” and expectations of investors and businessmen. So the investment schedule is set at any level, unrelated to income. Equilibrium

(M) is set at the point where S = I, which you will note falls short of full-employment income (F). Thus, the Keynesian cross reflects underemployment equilibrium.

This static equilibrium model represents Samuelson’s (and Keynes’s) view that capitalism is inherently unstable and can be stuck indefinitely at less than full employment (M). No “automatic mechanism” guarantees full employment in the capitalist economy (Samuelson and Nordhaus 1985, 139). Samuelson compared capitalism to a car without a steering wheel; it frequently runs off the road and crashes: “The private economy is not unlike a machine without an effective steering wheel or governor,” he wrote. “Compensatory fiscal policy tries to introduce such a governor or thermostatic control device” (Samuelson 1948, 412). Krugman compares the market economy to a system that needs a “new alternator” (Krugman 2006).

How the Multiplier Works Magic

How does compensatory fiscal policy work? There are two ways for the economy to grow and reach full employment under Keynesian theory: Shift investment schedule I upward, or shift saving schedule S to the right.

First, let’s look at investment. Schedule I can be shifted upward by restoringbusinessconfidence,primarilythroughincreasedgovernment spending or tax cuts. Both techniques have a multiplier effect—either a $100 billion spending program or a tax cut can create $400 billion in new income.

But Samuelson noted that under the Keynesian system, government spending has a higher multiplier than a tax cut. Why? Because 100 percent of a federal program is spent, while only a portion of a tax cut is spent—some of it is saved. Samuelson called his discovery the “balanced budget multiplier.” Thus, a new federal spending program is preferred over a tax cut by Keynesians because the expenditure side is considered a more potent weapon against recession than a tax cut.

Figure 6.2

+

	Investment	400
		300
	and	200
		100
	Saving
		–100
		0

_

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Samuelson’s “Paradox of Thrift”

Saving and Investment Diagram Shows How

Thriftiness Can Kill Off Income

						Q*
						S´
					100	S
I		E´	E				I
S´
							GNP
S	3,000	3,500		1,000

300
Gross National Product (billions of dollars)	Q*

Note: Q* = Full employment output or GNP.

Source: Samuelson and Nordhaus (1989: 184). Reprinted by permission of McGraw-Hill.

The Paradox of Thrift Denies Adam Smith

Thesecondwayoutofarecessionistoincreasethepublic’spropensity to consume, which would shift saving schedule S to the right.

Note that in the Keynesian model, if the public decides to save more during an economic downturn, it only makes matters worse. Consumersbuyless,producerslayoffworkers,andhouseholdsendup saving less.An increased supply of savings cannot lower interest rates and encourage investment under the crude Keynesian model because interest rates are assumed to be constant. In the Figure 6.1 diagram, more savings means that the saving schedule S shifts backward to the left, and has no effect on raising the I schedule.

Samuelson called this phenomenon the “paradox of thrift” (see Figure 6.2)—an increase in desired thrift results in less total savings! “Under conditions of unemployment, the attempt to save may result in less, not more, saving,” he declared (1948, 271). Keynes, of course, said practically the same thing, only more eloquently: “The more virtuous we are, the more determinedly thrifty, the more obstinately orthodox in our national and personal finance, the more our incomes will have to fall” (Keynes 1973a [1936], 111).

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Samuelson delighted in this attack on the orthodoxy of Adam Smith and Benjamin Franklin. Smith found thrift a universal virtue, writing that “What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom” (1965 [1776], 424). Franklin counseled every child, “A penny saved is a penny earned.” But Samuelson labeled this thinking a “fallacy of composition.” “What is good for each person separately need not be good for all,” he countered. Moreover, Franklin’s “old virtues [of thrift] may be modern sins” (1948, 270). As one modern-day textbook put it, “While savings may pave the road to riches for an individual, if the nation as a whole decides to save more, the result could be a recession and poverty for all” (Baumol and Blinder 1988, 192).

The Keynesians readily endorsed savings as a virtue during periods of full employment, but Samuelson was convinced it seldom happened. “[F]ull employment and inflationary conditions have occurred only occasionally in our recent history,” he wrote. “Much of the time there is some wastage of resources, some unemployment, some insufficiency of demand, investment, and purchasing power” (1948, 271). This paragraph remained virtually the same throughout the first eleven editions of his textbook.1

Savings as Leakage

Echoing Keynes, Samuelson declared war on uninvested savings, which could “leak” out of the system and “become a social vice” (1948, 253). He produced a diagram (see Figure 6.3) separating savings from investment. The diagram shows savings leaking out of the system, unconnected to the investment hydraulic handle above. (This diagram led observers to call the model “hydraulic Keynesianism,” with the emphasis on priming the pump through government spending.)

1.Amazingly,Samuelsonrecentlyprotestedbeinglabeledan“antisavingKeynesian” (Samuelson 1997).After noting that Martin Feldstein publicly complained that economists at Harvard also attacked savings in his college days, Samuelson said he regularly appeared before Congress to urge more saving and investment and less consumption. My response: Then why didn’t he say so in his textbook?

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Figure 6.3 Saving Leaks Out of the System While the Hydraulic

Investment Press Pumps Up the Economy

	Tech.	Investment	$
			Wages,
	Change,	A	Interest, etc.
	etc.
		BUSINESS	PUBLIC

Consumption	Z
$	Saving

Source: Samuelson (1948: 264). Reprinted by permission of McGraw-Hill.

Is Consumption More Important Than Saving?

The Keynesian model leads to the odd conclusion that consumption is more productive than saving. As noted above in the Keynesian cross model,anincreaseinthe“propensitytoconsume”(alowersavingrate) leads to full employment. Keynes applauded “all sorts of policies for increasing the propensity to consume,” including confiscatory inheritance taxes and the redistribution of wealth in favor of lower-income groups, who consume a higher percentage of their income than the wealthy (1973a [1936], 325). Canadian economist Lorie Tarshis, the first to write a Keynesian textbook, warned that a high rate of saving is “one of the main sources of our difficulty,” and one of the goals of the federal government should be “reducing incentives to thrift” (Tarshis 1947, 521–12).

Keynesian economist Hyman Minsky confirmed this unorthodox approach when he said, “The policy emphasis should shift from the encouragement of growth through investment to the achievement of full employment through consumption production” (Minsky 1982, 113). Of course, all of this Keynesian theory goes counter to traditional classical growth theory that a high level of saving is a key ingredient to economic growth.

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Is Keynesianism Politically Neutral?

Samuelson contended that the Keynesian “theory of income determination” is politically “neutral.” For example, “it can be used as well to defend private enterprise as to limit it, as well to attack as to defendgovernmentfiscalinterventions”(1948,253).Buttheevidence disputes this claim.

For instance, the balanced-budget multiplier (which Samuelson considers one of his proudest “scientific discoveries”) favors government spending programs over tax cuts as a countercyclical policy. According to Samuelson, progressive taxation (imposing higher tax rates on the wealthy) has a “favorable” redistributionist effect on the economy: “To the extent that dollars are taken from frugal wealthy people rather than from poor ready spenders, progressive taxes tend to keep purchasing power and jobs at a high level” (1948, 174).

Samuelson also endorsed Social Security taxes, farm aid, unemployment compensation, and the rest of the welfare state as “built-in stabilizers” in the economy. The index of Samuelson’s textbook consistently lists “market failures” (including imperfect competition, externalities, inequalities of wealth, monopoly power, and public goods) but not “government failures.” His bias is overwhelmingly evident.

Apologist for the National Debt

In early editions, Samuelson denied that the national debt was a burden. The first edition favors the “we owe it to ourselves” argument: “The interest on an internal debt is paid byAmericans toAmericans; there is no direct loss of goods and services” (1948, 427). In the seventh edition (1967a), after raising the specter of “crowding out” of private investment, Samuelson went on to say: “On the other hand, incurring debt when there is no other feasible way to move the C + I + G equilibrium intersection up toward full employment actually represents a negative burden on the intermediate future to the degree that it induces more current capital formation than would otherwise take place!” (1967a, 346). At the end of an appendix on the national debt, Samuelson compared federal debt financing to private debt financing, such as AT&T’s “never-ending” growth in debt (1967a,

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358). By implication, he suggested that government debt could also grow continually, rather than necessarily being balanced over the business cycle.2

In sum, Keynesian economics as presented by Samuelson became an apology for big-government capitalism in the postwar period. “A laissez-faire economy cannot guarantee that there will be exactly the required amount of investment to insure full employment” (1967a, 197–78). Only a powerful state can.

Critics Begin a Long BattleAgainst Keynesian Economics

Samuelson claimed in his first edition that the Keynesian system was “increasingly accepted by economists of all schools of thought” (1948, 253). Judging from the popularity of Samuelson’s textbook, he was right. In the 1950s and 1960s, scholars in the major economics departments spent their entire careers doing empirical studies on the consumption function, the multiplier, national income statistics, and other Keynesian aggregates. Keynesian macroeconomics also became popular among journalists, because it was easy to understand (increasing consumer spending is “good for the economy”), and among politicians, because deficit spending bought votes. Robert Solow, Samuelson’s colleague at MIT and a Nobel laureate, summarized the new orthodoxy when he proclaimed with considerable pride that “short-term macroeconomic theory is pretty well in hand. . . .All that is left is the trivial job of filling in the empty boxes” (1965, 146).

The Pigou Effect: The First Assault

But over time critics have chipped away at the Keynesian structure. The first objection was the “liquidity trap” doctrine, Keynes’s fear that the economy could be trapped indefinitely in a deep depression where interest rates are so low and “liquidity preference” so high that reducing interest rates further would have no effect (Keynes 1973a

2.A popular work coinciding with Samuelson’s support of deficit spending was A Primer on Government Spending,by Robert L. Heilbroner and Peter L. Bernstein. It stated, “Recent experience indicates that the economy grows faster when the government runs a deficit and slower when revenues exceed outlays” (1963, 119).