Don’t study economics at RMIT

RMIT's Dr Steven Kates wants to return economics to the classical foundations found so wanting in the Great Depression. Source: RMIT.

In Thursday’s opinion section of the Australian Financial Review, you can find one of the most comprehensively misguided articles on economics I’ve recently come across. Not only is it theoretically dubious, it’s also empirically wrong in a way that any ordinary citizen with access to the internet can quickly discover.

All the more curious therefore that is turns out to be authored by Dr Steven Kates, a lecturer in economics at the Royal Melbourne Institute of Technology, supposedly one of Australia’s better-respected universities.

The article, entitled “Blame the government, not the RBA”  (AFR, page 71, 4th November 2010) begins with a distortion, progresses through an argument of economic theory about 70 years out of date, and ends with a statement that is provably wrong.

Kates begins like this:

The trouble with all the free stuff governments like to give out is that is isn’t really free at all. The true cost of government spending comes out of our collective wealth in a process almost invisible to the naked eye, which governments aim to keep  as invisible as possible.

Kates is talking about monetary policy here, in other words interest rates. But it’s worth unpacking the ideology behind the rhetoric just a little. You can detect it in the barely-concealed disdain he uses in his opening phrase “the free things governments like to give out”, also known to many of us as public services like roads, schools, hospitals, police and the armed forces. Last time I checked, these services weren’t in fact “invisibly” provided, but were in fact paid for in the really quite visible process of taxation. But no matter, let’s continue with this remarkable article.

The rate of interest is the price paid for resources made available for investment. When people save, they may think what they are saving is money, but this is in many ways an illusion. They have provided goods and services, received an income for their efforts but chosen not to buy everything their income would allow them to buy. Unspent income is saving; to the individual these savings come as money.

From the economy’s perspective, savers leave for others for others the goods and services they had produced but did not consume. They have transferred to otheres, for a price, the right to use the output that has been made available by their decisions not to immediately buy as much as their incomes would entitle them to.

So far, so neo-classical. But as we progress through Dr Kates’ little lecture, we discover some surprising assertions.

But it is not just private firms who seek access to these savings. Governments, too, absorb huge amounts, taking these in as tax revenue and borrowing more to finance projects of their own.

Rising rates are a reflecction of the supply and demand conditions of private savings. What’s left after the government has taken what resources it has decided to use is what’s left for the private sector to divide among itself.

[…]

The Reserve Bank of Australia has been raising rates because the government is taking up domestic savings more rapidly than we are able to generate those savings through productive activity.

Spotted the underlying proposition yet? It’s Say’s Law, the idea that “products are paid for with products” and that therefore aggregate demand and supply across the economy are always roughly in equilibrium.

We know that Dr Kates thinks Say’s Law is a pretty useful doctrine because he’s told us so … in the text of a lecture to the Mises Institute, entitled (and I’m not making this up) “Why Your Grandfather’s Economics was Better than Yours: On the Catastrophic Disappearance of Say’s Law“.

One of the implications of Say’s Law is the crowding-out theory of investment, namely, that government investment necessarily diverts the investment in productive capacity of an economy away from private firms. This is why Kates argues that “it is the government that is absorbing our national savings and raising the cost of capital.”

There is a bit of a problem with this theory in the context of Australia. It’s called “the rest of the world.” Australia is an open economy with a floating currency and no foreign exchange restrictions. Australian firms can and do regularly access international finance through bond issues and overseas bank loans; indeed, the very low interest rates on offer in the US are being taken advantage of right now by firms like Fortescue and Paladin, who are cashing in by raising billions in bond issues.

Nor does the Australian government’s bond issues compete with the average business for investment capital. On the contrary, the average small business loan is issued by a bank, which source their funds from overseas credit markets as well the deposits of ordinary citizens in savings accounts.

And, when you think about it, the idea that the Australian government is somehow driving up interest rates by sucking up available domestic savings is simply not born out by economic history. This is because consumption and investment tend to expand in tandem during economic booms, and then contract in tandem during slumps. In 2007, interest rates were higher but capital was easy to raise – because bankers and non-bank lenders were all too willing to lend it. In early 2009, money was cheap but investment capital was scarce, because both banks and consumers were hoarding their cash.

Finally, Kates ignores the obvious political economy issues involved in setting interest rates. Ultimately, central banks are political institutions and can, in the extreme, be subject to the whim of elected governments or military dictators.

Ultimately, you don’t have to go to RMIT to learn the discredited economic theories advanced by Dr Kates. These are available to anyone prepared to ignore the last two centuries of economic history. But if you feel like understanding the knots that academic economics has tied itself in by its adherence to the outdated ideas of thinkers such as Mises, Hayek and Friedman and the ideas of the so-called “Real Business Cycle”, try John Quiggin’s Zombie Economics or Skidelsky’s Keynes: The Return of the Master.

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4 thoughts on “Don’t study economics at RMIT

  1. Pingback: 6th November 2010: Kates, Eltham & Keynes | Alex Burns

  2. I’m so glad you wrote this, Ben. I was reading Kates’ latest piece on the ABC’s Drum (it appeared as a link beside the national news) and was shocked that it could get published, let alone be written by a lecturer (hence the search that led me here.)

    RMIT seems to have a few like him; the IPA’s Sinclair Davidson also works there…

  3. Pingback: Why you should study economics at RMIT | Law of Markets

  4. Pingback: Responding to Steve Kates: more zombie shuffles | A Cultural Policy Blog

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