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Keynesians Can't Predict, Forecasts of Postwar Deflation Turned Out to be Entirely Wrong

Economics / Economic Theory Jul 28, 2009 - 07:17 PM GMT



Best Financial Markets Analysis ArticleL. Albert Hahn writes: If you take the trouble to interrogate a large number of economists about the economic future of the country you will find that an overwhelming majority argues in the following way: In about two years at the latest, rearmament will be completed and the amounts spent for this purpose will be negligible. At about the same time the pent-up demand for investments will be largely satisfied. The productive apparatus will be sufficiently enlarged, improved, and modernized to meet the needs of an increased population and all other reasonable requirements. A depression — or at least a serious recession from the present high level of production and employment — must follow.

These predictions will awaken unpleasant memories in those who do not believe in the possibility of objective, "scientific" forecasts. They will be reminded of the forecasts of a postwar depression so popular during the war. At that time it was the general opinion of the experts, based especially on a study by Morris Livingston, "Markets After the War," that the increase in population, the rising productivity and the inability of consumption to keep up with production would inevitably lead to unemployment of many millions of workers. And the well-known Swedish economist, Gunnar Myrdal, impressed by this line of argument, propagated it in many articles in the Swedish and Swiss press. I myself, in an article, "Do Not Predict Postwar Deflation — Prevent It,"[1] tried to show the fallacies of the underlying mechanical approach to economic problems and of a forecast so astounding to anybody who knows from the study of history that inflations and not deflations have always been the aftermaths of wars.

All forecasts of postwar deflation turned out to be entirely wrong, as was to be expected. Almost immediately after the end of hostilities a postwar boom began. But the forecasters, in no way discouraged by their errors, stayed on the job. Now they predicted the continuation of inflation. Just when their forecasts became most articulate, in the spring of 1949, the recession of that year set in. Then deflation was considered here to stay; government intervention was advocated. The second postwar boom, not caused, I think, but accentuated by the outbreak of the Korean war in 1950, led again to predictions of continued and even of runaway inflation. But 1951 was basically a year of deflation, and of inflation only in the areas where it was governmentally fostered.

Clearly the regularity of these errors in forecasting cannot be pure chance. Something like a Law of the Necessity of Errors in Forecasting must be at work.

It is seldom realized that belief in the possibility of "scientific" business forecasts, and the forecasting mania of our time, are comparatively new phenomena. Until about 1930 serious economists were not so bold — or so naive — as to pretend to be able to calculate the coming of booms and depressions in advance. It would not have fitted into their general view on the working of a free economy. They considered the economic future as basically dependent on unpredictable price-cost relationships and on the equally unpredictable psychological reactions of entrepreneurs. Predictions of future business conditions would have seemed to them mere charlatanry, just as predictions, say, regarding the resolutions of Congress two years from now.

The "Multiplier" and "Acceleration" Fallacies

The forecasting mania of our time is a natural concomitant of what is called Keynesian economics. It constitutes an integral part of the world of "functional finance," of the "multiplier effect" of the "acceleration principle" and similar concepts. If one really believes, as the "inventors" of functional finance do, that a depression can be prevented and a boom prolonged ad libitum by government deficit spending, if one fails to see that the elimination of the maladjustments in the price-cost relationship created during the previous boom are necessary conditions of revival, then indeed the economic future appears no longer too uncertain. And if one really believes in the working of the multiplier and the acceleration principle, then the more remote future also appears predictable. For according to the multiplier theory a given amount of spending on investment leads in time to an immediately ascertainable stable amount of spending on consumption; whereas a given amount of spending on consumption leads in time to an immediately ascertainable amount of spending on investment.

Pre-Keynesian economists would not, incidentally, have been seduced into forecasting and calculating such secondary and further effects of spending. They would have considered a development of multiplier and acceleration theory as unrealistic toying with ideas rather than the scientific achievement it is considered nowadays. For whether increased spending on consumption leads in time to increased investment is dependent on the unascertainable profit expectations of entrepreneurs. The fact that inventories have been used up through increased consumption may or may not improve these expectations. And whether spending on investment leads to a corresponding spending on consumption is dependent on the equally unascertainable presence or absence of buyers' resistance — as the early New Deal experiences clearly showed. Multiplier and acceleration theories thus do not answer but simply beg the question of what the long-run effects will be of single doses of spending.

The basic error of the whole approach lies in the fact that the causative link between objective data and the decision of the members of the community are treated as mechanical. But men are still men and not automatons. There does not even exist, as is sometimes maintained, a fixed correlation, for instance, between birth and marriage rates and the demand for housing; or between the increased need for electric current and the investments of public utilities. The investments can — and are — either speeded up or postponed according to whether entrepreneurs are optimistic or pessimistic regarding future demand, and prices — i.e., regarding the prospect that the investments will be profitable. If they are optimistic, a boom may develop; if they are pessimistic, a depression.

Forecasting the economic future means forecasting decisions on investment and consumption that are as uncertain as the whole future. The professional forecasters pretend that they have a sort of monopoly of clairvoyance in this respect. They forget, however, that it is precisely the main occupation of entrepreneurs to predict future demand in order to adjust their production to it. What leads to the maldistribution of demand — called the business cycle — is that the majority of entrepreneurs are at times too optimistic or too pessimistic; that they either invest too much and too soon, or too little and too late. Now there is not the slightest reason to assume that in the game of forecasting future demands correctly the theorists will be on the average more successful than the businessmen. On the contrary, it can be assumed that the businessmen will on the average do better. They are more responsible. For businessmen suffer losses when they err, whereas the theorists can forecast with no risk — not even to their prestige, it seems.

Thus the world does not consist, on the one hand, of theorists who can calculate future investment and consumption, including their "accelerating" and "multiplying" effect, and, on the other hand, of businessmen for whom the future is uncertain and who are forced to "speculate." The tragic — not to say tragi-comic — consequence in the real world is that the forecasts of the great majority of theorists can never hold good. If the businessmen in sensing future maldistribution of demand are at least as smart as the theorists, they will adjust to it by speeding up or postponing their investments — with the result that the predicted cycle will not materialize. It is, one can say by definition, impossible to calculate depressions in advance. Calculated depressions do not happen. Nor, by the way, do calculated inflations — though it was so popular, just before the latest recession in commodity prices, to calculate a new inflation in advance. A recession was clearly due the moment certain theorists began to speak of our age as the age of permanent inflation.

So don't forecast a post-armament deflation. It will not happen — whatever other depression, not yet recognized and recognizable either by you or the majority of businessmen, may materialize.

The Economic Isolationists

But why, it may be asked, are these simple and obvious ideas not widely accepted by American economists? To one outside the magic circle of the Keynesians the reason seems to be what can be called the isolationism of Anglo-American economics. It is this isolationism that prevents economists from seeing the merits and weaknesses of their work in a detached and objective way and in the right perspective. It prevents them from being aware that most economists in Germany, France, and Italy strongly oppose the Keynesian doctrines. For example, to Professor Adolf Weber, the well-known economist of the University of Munich, the idea that full employment is mainly threatened by a lag of investment behind saving, sounds merely like a bad joke.[2]

But the isolationism of Anglo-American economists is also historical. They believe earnestly that their ideas are fundamentally new, unique, and a definite answer to the problems of a competitive economy. Insufficiently educated in the history of economic thought, they do not realize that Keynesianism — down to the most technical details, like the concept of the foreign exchange multiplier — is mercantilism or, more precisely, John Lawism pure and simple. Thus they do not recognize that the objections of the classical economists to mercantilism are valid also in respect to their own teachings. Nor do they see that many concepts of the modern planners — fair prices, fair wages, fair profits, and so on — are nothing else than a new edition of the medieval scholastic concepts of justum pretium and justum salarium, which proved so detrimental to economic progress.

Reading, quoting, praising, and promoting each other, and only each other, will not liberate these economists from their voluntary isolationism. They will remain in their dream world. They will continue to predict the unpredictable.

L. Albert Hahn was one of the most highly regarded economists and bankers in Germany before the war but he was unknown in the United States until the 1949 translation of The Economics of Illusion, his frontal attack on the Keynesian system. See his article archives. Comment on the blog.

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