 Okay, people quieted down, it must be time to start. Today we're going to do a little exercise showing the difference between hiac and canes. And the nature of the exercise is we start with canes and we morph into hiac. And you pay attention to what we had to change to do the morphing. And that'll give you an idea of who's more nearly right, and it will also give you an idea about who's more nearly general. In other words, what's the real general theory? Canes called his theory the general theory. So keep in mind, how general is it? So we'll see about that. There they are. And I'll show you the days just to show you that hiac was younger than canes by about 16 years. But he held his own against canes. They didn't know each other and know each other fairly well. When LSE had to shut down and moved to Cambridge during World War II, canes actually helped hiac find an apartment. They were personal friends. But of course, they didn't see eye to eye on macroeconomics. They did debate one another. You'd have to put debates in quotes. What they did actually was review one another's books with a lot of hostility, especially Canes talking about hiac's prices in production. And so in my judgment, if you look at the original literature, they don't really come head to head. You don't really see what the difference is. And so my objective is to put them head to head. And it's really not as difficult as it might seem. There they are, little-known photograph. But eventually, hiac just dispaired and bailed out of technical economics and did political economics, starting with the road to serfdom. Came around laden life with a few more articles about macroeconomics, sometimes even lamenting that he had abandoned the debate with Canes. OK, let me give you just two sweeping summaries of what's going on here. I'll talk about visions, visions and frameworks. Visions is something that Schumpeter talks about. Economists typically have a pre-analytical vision of how the economy works that's before the analytical framework that shows how it works. So what's the Keynesian vision? You see the economy is in some kind of a circular flow which spending and earning are brought into balances by changes in the level of employment that should strike a chord with you who have taken principles-level courses in macroeconomics. High exhibition of the economy suggests the means-ends framework. Well, of course, I mean, that's mingar, that's mises and so on. So instead of circular flow, you get means-ends. You've got the time element in on the ground floor of that vision in which means of production are transformed over time into consumable output. So the transformed over time is key because you've got the time element right in there. Now, the graphical depiction of the circular flow appears as a Keynesian cross. I'll remind you if you have forgotten from your principal's class how a circle becomes a cross. The cross is intersection identifying the particular state of the economy in terms of full employment, unemployment or whatever in which the income and expenditures are in balance. Then graphically, the means-ends appear as a Hayekian triangle. We saw that yesterday the triangle's shape depicting the intertemporal pattern of investment in equilibrating the pattern of investment corresponds to the intertemporal preferences of consumers in the marketplace. That's the general visions and frameworks. I'll apologize just a little bit for a brief review of the Keynesian circular flow framework. I hope I don't give you bad feelings. But I think we can do an exposition that might bring a little more understanding to it than you got when you were in a principal's course. The circular flow envisions business organizations as just sort of a shell. It's a place where factors of protection are bought and output is sold. Downstairs here we have workers, consumers, investors. Those are the people all downstairs that deal with one another through business organizations. So you've got a flow of labor and other factors of production. You can't buy it that way without listing the other factors because those other factors kind of drop out of sight pretty quickly. That's just part of the background. The labor is the key factor here. So those people are providing their labor services and they get paid for it called income. It's only half the story, of course. If you look at the other side of the circle, you have goods and services being produced in the firms. And it has to be paid for, that's the expenditures. So there you have the circular flow. The interest rate is not in play directly but can be at least in a minor way with the policy action. So the interest rate is more or less a policy lever. There's Federal Reserve policy. You could have a high interest rate and the economy is kind of slow in circulating or a low interest rate and it will circulate factor. This is off now, let me turn it on. It circles, okay? Your textbook didn't do it that way. It is circulating kind of slowly. Well, of course, look, the interest rate is 6%. What do you expect? If you want to goose it up a little bit, turn it over to 2% and it goes faster. If that starts giving you inflation, hey, turn it back down. It goes back to its old level. So this is sort of a Keynesian mindset that we haven't exactly completely gotten rid of yet. All right, enough of that nonsense. Now, we've got a big job because there's Keynes and the circular flow. Here's Hayek and, of course, he has the means-ins framework, the structure of production. So we've got to morph from a circle to a triangle that changes shapes. You remember that you have a number of stages of production like that and the thing can even change shapes in response to that interest rate. Something gets ignored by Keynes. So we've got a lot of work to do. Now, I'll call your attention to the circle again because, look, you have income on one side and expenditures on the other. And when that thing circulates, those two have to be in balance and expenditures have to equal income. Y equals C plus I. C plus I are the expenditures for a wholly private economy. Probably write this down here. In Keynesian equilibrium, income equals expenditures. Y equals Z. For a wholly private economy, then Y equals C plus I. For a mixed economy, C plus I plus G. For my sophomores here at Auburn, I like to write out, wholly, W-H-O-L-Y, private economy because I had some students that thought I was saying H-O-L-Y wholly for the private economy that religious tinge to it. But no, just completely private. So there's that circular flow, but now expenditures on the vertical axis and income on the horizontal, of course, for them to be equal, that's given by the 45-degree line. That's your point of reference. Those are possible equilibrium rates of circulation there. What's standard, of course, in Keynesian theory, sort of bedrock is that consumption equation that shows that income rises, or consumption rises as income rises, but not as fast as income. And even at zero income, you spend a little something, call it A. As income rises, you increase your income with a slope of B, which is something less than one. That's the consumption equation, that's also bedrock is very stable, it doesn't shift around, it just sits there. And then on top of that, you put investment, C plus I. And of course, what you want to notice here is that unlike the Austrian view where C is traded off against I, here you just add them up, C plus I to get total expenditures, right? So we would add government if we wanted to deal with a mixed economy, but I don't need that for the lecture today. And those three components are distinguished, largely if not completely, in terms of their stability properties. Consumption is stable, investment is unstable, and government is stabilizing. That's the Keynesian view. And we can see exactly where C plus I equals Y. That's the intersection with the 45 degree line. And that's where you have equilibrium income. And to get there, the income level has to change, the employment level has to change, so the economy spirals up or spirals down until it finds that particular place. So there's income equals consumption plus investment. That's what you learned in your principal's course. Okay? Now, according to Keynes, he says it's by accident or design that the economy is actually performing at its full employment potential. What is he excluding here? Some students will say, well, gee, anything is either accident or design. No, no, what he's excluding is the impersonal forces of the marketplace getting us to full employment. He doesn't count on that. He doesn't count on the Smithian invisible hand getting us there. You just happen to be there, or it's by design, which means policy prescription. But we're going to assume, as Keynes does, that initially it leaves, we start out at full employment. Okay? Now, one way to show that is using that production possibilities frontier. If you're at full employment, it means you're on the frontier. And so you can see where consumption is on the left side, vertical distance up to the consumption equation. And we just look where that puts us on the right here, and we're on the production possibilities frontier with a level of investment. My investment scale is a little broader than the one on the left, but measuring that same investment magnitude. So that shows you the economy is fully employed or happens to be right now. Initially it is. Keynes doesn't show it that way. What he does is he looks at that income level and sees what the labor market looks like, supply and demand for labor and the market clearing wage rate. He doesn't think of it quite that way. He thinks of it as the supply of labor and the going wage rate, and then looks to see if demand is strong enough to clear the market at that going wage, because that going wage keeps going. It doesn't change its sticky as your textbooks explain. But those are two different ways of showing that the economy is at full employment at this point. Total income or at least labor income is just a wage rate times the number of worker hours bought and sold. So that labor income is shown in that bottom graph. And for Keynes, he treats that as if it were total income. He knows it's not, and he says he knows it's not, but he says, well, total income moves pretty much in proportion with labor income. In other words, he doesn't allow for changes in the distribution of income between the factors of production. You don't get more profits and less wages or more wages and less profits. You just get total income, which is proxied by labor income. And besides, he explains, labor is the lion's share of income anyway. So this is why I call it labor-based economics, because it just takes labor income to be total income, or at least to be a proxy for total income. Okay. So I've labeled that Y sub F E full employment income. That's where we happen to start. And I bring back my circular flow. E equals Y. Now, it looks to me like it's all working fine or at full employment. What's the problem? What's the problem? Well, the problem is, yeah, you're there now, but you probably won't stay there. And why not? And he explains. He says, a collapse in investment activity, the collapse of being attributable to a waning of animal spirits, animal spirits. That's the psychological thing. In other words, for no known reason, investors get cold feet, they lose their cool, lose their fire in the belly, become pessimistic, and pull back on investment. And that's what causes the collapse. It's the waning of animal spirits. Now, I don't have a graph. I don't have an axis for animal spirits, but there they are now. That would cool the heels out of any investor. And when there's a waning of animal spirits, that investment curve shifts downward. Well, you look now and see that expenditures are less than income. People aren't spending all their income, meaning they're producing stuff and getting paid for it, but they're not buying all of it. It's just piling up at the firm as excess inventories. There are the excess inventories on the left, and here they are on the right. Piling up of excess inventories. That's going to cause problems. Now, what happens then is the economy spirals down. Expenditure has fallen, and so people are laid off. Income falls, expenditure falls more, and the economy crashes and moves down until it's once again an equilibrium. So there's a new equilibrium. And you can see all the parameters here. Investment fell that much. You call it delta i, the change in investment. Income fell that much. That's delta y. And you know what the relationship is between those two, is the multiplier. Delta y equals 1 over 1 minus b. That's the slope of the consumption equation times delta i. That's the famous Keynesian multiplier, the 1 over 1 minus b. In the general theory, Keynes estimates it to be about 10. With our recent stimulus packages, it shows up to be somewhere between 1 and 0.9. It doesn't help us out. The stimulus doesn't help us out, but that's the multiplier. And importantly here, look what happens to consumption. The consumption equation doesn't change, but we move down along it, and so consumption gets reduced by delta c. So what you see, everything goes down. Investment goes down, income goes down, consumption goes down. And in terms of the PPF, you're inside the frontier. That's the whole story. And we want to take a look at that. You see what happens in the labor market. Demand for labor has fallen, but the wage rate hasn't changed. And I like to note that the going wage keeps going even after the market conditions that gave rise to it are gone. That's part of Keynes's general theory. Well, how general is it? Now, this little exercise goes on, but I think you've got the flavor, so I'm going to skip. Gee, can I skip? I guess I have to do something like this. Yeah, hey. Then let me skip to the morphing. And so what I want to do now is carry this PPF along with my demonstration of Keynesian theory. And so I start once again at full employment, like so, get the waning of animal spirits. And now, when I pull the trigger, it's going to spiral down. We're going to go down to that equilibrium point. But watch what happens in the PPF. It goes into the interior. We're in a depression, right? That's part of the Keynesian story. Keynes couldn't object to that. He just didn't show it graphically. He just showed it as a labor market that doesn't clear. You've got unemployment. And so you are inside the PPF. You're not at full employment any longer. Let's let a further waning decrease investment even more. And it turns out, you go down further, all right? Like so. Again, the wage rate doesn't change. You just get less employment. Now, what I want to show you is, let me back up here. If you look at the path that those points have traced out, you'll find out it's linear. And you could trace it back up to full employment and even beyond. For beyond, Keynes would just call that inflation. If you go beyond the PPF, you get more income and more expenditures in nominal terms, but not in real terms. So that's just inflation up there. And we can even draw a line like so. I call it the Keynesian demand constraint, because the Keynes economy is constrained to be in or moving towards its equilibrium position, which is somewhere along that upward sloping line. That's the story. And you might think that in principle's textbook, that line and even the equation of that line would have great significance. But I challenge you to find a principle's level textbook or intermediate level or advanced level that shows that line, okay? It's not there. And yet, it's a line that's easy to derive. Here I just say no, just so you see I got my construction right. If investment were to fall clear to zero, which means we'd be down there on the consumption function, then that would give you that vertical intercept of that demand constraint, all right? And what I need now is an equation for the line. I'm not going to derive it for you, but I'm going to tell you how to derive it and I'll show it to you. What you did in your principles classes, you took the two equations that are on the board, y equals c plus i and then c equals a plus by. So that's the equilibrium condition, y equals c plus i and the consumption equation, c equals a plus by. What did you do with that in your principles class? You solve it for equilibrium income, isn't that right? You solve it for equilibrium income. And that's all you do with it. But what I like to do with it is take those two equations and eliminate the y and solve it for c as it relates to i. How does consumption move when investment moves? And when you do that, what you find is that it's a, sure enough, it's linear and the vertical intercept is a over 1 minus b and the slope is b over 1 minus b. So that's the equation of the demand constraint. You can doodle and derive it if you want to. And what you notice about it is that the coefficient of i is positive because b is less than, or b is positive in less than 1. So 1 minus b is positive and b over 1 minus b is positive. So it, Keynes constrains consumption and investment to move up and down together, which precludes by construction any movement along the frontier. All right? I'll show you an example. I actually came from Keynes, that's what I'm going to do now. First I'll mention that when I first got my book published, Time and Money, I thought, gee, I might be the first macroeconomist actually to put that equation in print. Right? I've never seen it in print anywhere else. I'll be the first economist to put in print. And when I got my copy with the first printing, I opened it up to page 136. I wanted to make sure I wanted to see it, you know? And it turns out it wasn't there. There was a blank space where the equation was supposed to go, but they left it out, okay? So I failed. I tried, okay? But I failed. If you get my book at the library here at Auburn, it does have that equation. Because I went over there and put it in, okay? But you have to get the second and third printing or whatever to get that particular equation. Okay. Now, Keynes recognizes the essence of this line and what he says, and this is not in the general theory, but in the article he wrote a year later, called the General Theory of Employment, and he wrote it to tell people what he meant by the general theory, okay? And this is one of the things he meant for simplicity. This is my rendition right here, but I'm going to show you the Keynesian quote. Let A be zero. Well, it's not zero, it's some amount, some positive, but let it be zero. Let B be 0.9, which is what gives you that multiplier of 10. And then you get that equation C equals 0.9y. You see how you plug in and get that. So that's the example that Keynes is using. And here's what he says. If, for example, the public are in a habit of spending nine tenths of their income on consumption goods, that's the B is 0.9. It follows that if entrepreneurs were to produce consumption goods at a cost more than nine times the cost of investment goods, and that's the 0.9y over there, they're producing some part of their output that can't be sold at a price which covers the cost of production. So he's saying the economy is limited to producing consumption and investment along that line. And then here's what he says about it. This formula is not, of course, quite so simple as in this situation, right, because A is positive, but there's always a formula more or less of this kind relating the output of consumption goods which it pays to produce to the output of investment goods. The conclusion appears to me to be quite beyond dispute, yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance. So he's saying, look, people, the economy moves along that straight line, we've got to understand that and we've got to see how important it is. Well, it is important if it were true because it means you can't move along the PPF and that you're likely to either be in a depression or in some inflationary spiral, and of course that's what Keynes actually believed. Okay. Now, I want to keep track of the interest rate in a way that Keynes actually wouldn't object to. And I'll put it downstairs here where you've got the rate of interest in saving investors, just the loanable funds market that we used yesterday. And if that investment is the current level of investment, then there must be some market clearing there in that loanable funds market. Okay, so I'm just going to carry that along. Keynes wouldn't object to carrying it along, he just says it's not going to help you figure out anything. Carry it along if you want. And here Keynes was, he was willing to make several different arguments that weren't mutually consistent. At some points in the book he would say, neither saving nor investment depends on the interest rate, which means they're both straight up and down and only by coincidence would they be together. And in other instances he says, okay, they slope like Dennis Robertson thinks they do, but they move together. They move back and forth together. And so it doesn't help you out. I think it was Landhoof that pointed out that Keynes was arguing like a lawyer. Yeah, oh, we've got a lawyer. How many lawyers do we have in here? Okay, well cover your ears, cover your ears. Okay. The lawyer argues, my client didn't borrow your lawnmower. And it was already broken when you lent it to him. And it was still in perfect condition when he returned it. Okay. Now of course the theory is if you can get the jury to go for either any one of those arguments, you've got what you want. Okay, so Keynes just wanted to say, quit looking at the loanable funds market. That's not where the story is. And he would use several different arguments for that. He couldn't quite object to that. In fact, I'll show you he uses it for his own purposes. So he argued that both curves, as conventionally drawn, shift together leaving the interest rate unchanged. So he said you can't determine the interest rate by supplying the band of loanable funds because of one shifts the other shifts and it's the same interest rate. So you need a different theory for what the interest rate is. It would turn out to be liquidity preference theory, but we're not going to go in that direction. So now we've got loanable funds market in play. And we see here a decreased investment is accompanied by a leftward shift of the demand for loanable funds. People aren't going to invest as much. They don't need to borrow as much money. And so I'm going to show that same movement that I showed earlier of investment falling in that top diagram. But at the same time, the demand for loanable funds is going to shift to the left. That registers investment too. So let's watch it shift. There it goes. Now you might think that when that happens it puts downward pressure on interest rates and it causes the economy to adjust to these new market conditions. And Hayek says, no, no, no, no, don't worry about that because before that can happen something else happens. Can you guess what else happens? The economy crashes. And when the economy crashes that means income goes down, it means consumption goes down, and it means saving goes down. Which is to say saving shifts to the left. So when you show the economy crashing and watch it crash and watch the saving curve it shifts to the left validating that old interest rate. So the interest rate didn't change at all. We've moved down into the PPF along the Keynesian demand constraint and have struck an equilibrium in terms of income and expenditures. It pained me to do this but I showed that inside the frontier is a solid point which means equilibrium. The Keynesian equilibrium is called unemployment equilibrium and I showed the loanable funds in equilibrium too as Keynes would say. Okay, now a point that I made yesterday and I want to... Okay, so the particular supply and demand diagram for loanable funds in the general theory is in there to make this specific point. This is the curve that Herrod said he needs to put in if that's what he's going to throw out. So he has this diagram in there and he threw it out. And it's worthwhile I think to bring that up. That's the general theory on page 180. You find the one and only one diagram that's in the general theory. Can you see any mistake that you'd take points off of already if you were grading this graph, what's wrong with that graph? It didn't label the axes, okay? All right, it could have been the publisher after all they left out my equation. So we weren't blaming for that. But you can see it's called saving an investment that's on the vertical axis so we can put that on there for him. The horizontal axis is interest rate he calls it R as in rate of return. So that's the interest rate down there. But the interest rate is the price, right? And the other is the quantity so he's got it turned crankwise. And we can fix it though. We can flip it around and that's what I'm going to do here and bring it out like that so you can compare it to what I've got in my PowerPoint. And then you see a whole bunch of shifts of the supply of loanable funds. So he's got a cave instead of convex it. I don't know why he messed it up that way, but he did. And some of the shifts though are just to show that income is a parameter. In other words, at higher income you save more. At lower income you save less. So this curve shifts with income. It's income's a shift parameter. And he demonstrates that, well let's get rid of those that were just demonstrating that income is a shift parameter and this is what you've got, all right? And what's his point? Well, if you read the text closely, it don't have to be too closely, you see that if the economy is in a supply and demand equilibrium there and if investment demand falls like that then the economy will spiral down and income will fall too and because income falls, savings will fall and it falls by the same amount. And so the interest rate doesn't change. Now what you see is that diagram is in there to make the exact point that I've made with my auxiliary loanable funds market. So he's making the very same point and we can do it over on his own diagram and just be turned at right angles saying the same thing. Okay, I think that's significant and let me push it a little further. Keynes also denied that an increase in saving would have the effect, wouldn't have, or he denied that it would have the effect imagined by loanable funds theorists and because of his paradox of thrift, okay? And this is directly out of the general theory. He says every attempt to save more by reducing consumption, well that's how you save more will so effect incomes that the attempt necessarily defeats itself. That's a very strong statement, isn't it? Well, let's see how that works. If people actually do start saving more, now for the first time we're going to get that consumption equation falling. He said it doesn't fall. He says, good thing it didn't fall because if it did, we'd be in trouble. So the consumption falls, well if it falls, C plus I falls if only because I was sitting on top of C, all right? But also that demand constraint will fall because the intercept is A over 1 minus B, and if that vertical intercept changes then the demand constraint falls too. And of course in the third diagram the savings curve will shift to the left. That's what we mean by, or I'm sorry, the savings curve will shift to the right. That's what we mean by the increase in saving. So let's watch those shifts. So it goes like that. Now we're real close to a Hayekian diagram, aren't we? We've got an increase in saving and Hayek would say, well look, Maynard, savings increased, the interest rate is bent down. It gives you increased investment in the early stages and that's how the market translates saving into more future consumption. And Keynes actually didn't even follow the argument that far but he says, well never mind Hayek because before that happens something else happens. What do you think it is? You guys are quick learners, okay? The economy crashes. I tell my sophomores on my exams if I tell you in Keynesian theories something happens. It almost doesn't matter what. The economy crashes. So let's watch it crash. Now watch it crash. Okay. Now so importantly what you see look at the savings function it shifted back to where it was. In other words it shifted to the right because people want to save more it shifted back to the left because people had less income out of which to save. All right? Well that's exactly the paradox of thrift. That's what Keynes means by the paradox of thrift. Don't save more because if you do you'll throw the economy into a dump people will be earning less and they'll be lucky to save what they used to save. All right? That's the paradox of thrift. It's the paradox. Now to resolve the paradox of thrift and this is where we're going to do our morphing to resolve the paradox of thrift requires that we replace the Keynesian cross which reflects the economy's circular flow with the Hayekian triangle which depicts the means ends in their temporal sequence. Well let's do that. Let's see how this works. Now you can see where consumption is in the C plus I diagram but that consumption is represented in the Austrian view by that Hayekian triangle. There's consumption and we're just going to stick our Hayekian triangle in there and substitute that out for the Keynesian cross. And even now you can look and see how similar what I've got on the board is to the Austrian view but I'm going to let it behave like Keynes thought it'd behave. Keynes assumed a quote fixed structure of industry. This is in chapter four of the general theory called choice of units. This is in chapter where he says, okay here are my assumptions. One is a fixed structure of industry which translates into a fixed structure of production in the Hayekian view. And so the triangle can change in size but it doesn't change in shape because that is fixed. All right. We begin at full employment once again but we're going to assume that the labor market is representative of each of the stages of production that make up the economy's capital structure. He talks in terms of the labor market not stage specific labor markets. And so to show the labor market we would do it like this. That one labor market, supply and demand for labor pertains to all the stages of production which would actually be true if those stages of production were fixed. Okay. So the market mechanism in play here is still those envisioned by Keynes. So don't expect wonders to have you're not going to see poetry in motion here. And now we'll let the amount of savings increase to see how paradoxical it is. And you see the effect on the right two diagrams. We don't have savings represented specifically in the Hayekian triangle so it doesn't show up there. The economy crashes watch what happens to the structure. It crashes all down along the stages of production. There's nothing there but a derived demand effect. There's no interest rate effect. In fact there's no change in the interest rate. So even if the interest rate had an effect there would be no effect because the interest rate didn't change. And so the economy once again is in the dumper and labor is unemployed. Now let me remind you that this is what Keynes called the general theory. This is the general theory. How general is it? You might be interested to know if you didn't know already that he actually cribbed that title from you know who? Einstein. Einstein, the general theory of relativity. Keynes was an admirer so he said oh I've got the general theory of employment. They admired one another. Einstein admired Keynes and when Einstein started talking about the macroeconomy he sounded like Keynes. So it's not all that general. He's got it. So here it just says that the effect is the derived demand effect. Interest rates out of play left of shift of the saving pressure off of interest rates and in any case the capital structure is assumed to be fixed. Now we're going to do the bona fide morphing here. I'm going to make three modifications in changing some assumptions and I want to see if any of you object to those modifications and then note what it does to the theory. The first is divide the structure into stages of production. They don't all behave the same. And of course that's easy to do. Divided into stages of production. There it is. The second allow for stage specific labor markets not just one labor market that it pertains to everything in which wage rates are just to change market conditions. In other words get rid of this throat clearing assumption that the wage rates are sticky downwards. And so can we do that? Okay. Now we've just about got the Austrian view only one thing is in our way get rid of the Keynesian demand constraint and what you can see here is if you look at that triangle and you can see that it's flexible it can change in shape and it's changed in shape by movements of labor from one stage to another then that's what allows the economy to move along the PPF. All right. So the economy no longer needs to move up and down along that demand constraint it can move along the PPF so we have to get rid of the demand constraint. There. It gives you a feel good isn't there get rid of the demand constraint. All right. And now forgive my hyperbole here. The paradox of thrift becomes a gateway to growth. Okay. With wage rates and interest rates both adjusting to changing market conditions the economy can move along the PPF and the structure production can adjust to an increase in saving. And so what's the increase in saving that's the adjustment and there you get the poetry in motion. We've morphed from Keynes to Hayek. This is one of Hayek's overall criticisms of Keynes which you can see how it applies Mr. Keynes aggregates conceal the most fundamental mechanisms of change. If you allow for those mechanisms of change then you get entirely different results. Okay. That's it.