An Ordoliberalism Primer on Project Syndicate

On Project Syndicate, Lars Feld, Peter Jungen, and Ludger Schuknecht have a long article on Ordoliberalism and its enduring influence. The article is important, not least because two of the authors, Feld and Schuknecht, had important responsibilities in the recent past: Schuknecht was chief economist of the German Ministry of Finance, Feld was until the end of February chairman of the German Council of Economic Experts. I am not sure that either of them actually had much responsibility in shaping public policies, but their appointments certainly signaled, if not a real commitment, at least a degree of respect for the Ordoliberal tradition by Mrs Merkel’s Christian Democratic Party.

The article is rich in information and gives, for once, a sensible definition of what the label “social market economy” stands for:

The “social” element of the social market economy, then, is not about state ownership or state direction, as under socialism. Instead, it refers to a rules-based economy in which social interests are properly accounted for.

The authors argue that though Ordoliberalism originated in specific circumstances and the German “social market economy” was built “under unique conditions – namely, out of the ruins of the most devastating and destructive period in human history- “it is well suited for any country that is committed to pursuing patient, secure economic development.” To provide readers with a glimpse of the kind of choices that were made after WWII, the authors use an anecdote that Larry White also quotes in his The Clash of Economic Ideas:

The postwar German Wirtschaftswunder (economic miracle) was born. By unleashing the market to revitalize a moribund economy, German policymakers pursued a course that may seem obvious today but certainly didn’t at the time.
Ironically, those who were most skeptical of the ordoliberal reforms included representatives of the US, the world’s leading market economy. Though what is apocryphal and real are now impossible to reconstruct, there is an anecdote that General Lucius D. Clay, the military governor of the US-controlled zone, summoned Erhard and told him that he must not alter the rules of price administration:
“Mr. General, I have not altered the rules, I have lifted them,” Erhard replied.
“Professor Erhard, all my advisers tell me that a market economy in Germany will never work.”
“Don’t worry,” Erhard assured him, “all my advisers are telling me the same.”

The article ends with some examples of the lasting influence exerted by Ordoliberalism over public policy:

Ordoliberal thinking has also strongly influenced what one might call Europe’s “financial constitution.” It was the German Bundesbank that provided the model for the European Central Bank and other independent central banks across the Union. Likewise, the Maastricht deficit and debt rules that laid the foundation for the euro were a clear reflection of ordoliberal thinking. And the same can be said of the German deficit rule – the “debt brake” that allowed Germany to reduce its public debt after the global financial crisis and thus be well prepared to handle the fiscal challenges of the pandemic.
Ordoliberalism’s central tenets also underpin the European Stability Mechanism – which adheres to the IMF’s principle of conditional financial support to ensure solidarity within the EU – and the EU Treaty’s requirement of “subsidiarity,” or decentralized decision-making.

(…) policymaking in Germany is not a perfect incarnation of ordoliberalism. Political compromises have had to be made in the face of diverging interests. The state’s continued ownership stake in Volkswagen and a few other companies comes to mind. But these examples are exceptions to an otherwise private-sector-driven growth and innovation model.
Germany thus stands in stark contrast to countries that have engaged in “industrial policy,” aiming to identify the most promising industries to promote. This reflects the conviction that successful innovation policy does not pretend to know what the future will bring. Instead, it maintains institutional openness to ideas that no one today could even imagine. Indeed, no government could have foreseen that mRNA technology developed by a German startup (BioNTech) to fight cancer would be used to create a vaccine against the coronavirus in record-breaking time.
Finally, in fostering more green innovation, Europe has deployed rules- and market-based emissions trading schemes as the foundation of its decarbonization strategy. This, too, represents another win for ordoliberal thinking. It shows that the social market economy remains the framework for tackling our most pressing challenges today.
The social market economy model endures because it supports consumer interests before those of producers, just as it positions citizens, rather than the state, as the true sovereigns. At its heart is a commitment to constitutional and system-level thinking, not piecemeal, discretionary policymaking.

I wonder how much of this is holding in the Covid19 world. I suspect that Feld, Jungen and Schuknecht would agree that monetary policy in the Eurozone is no longer sticking with a “monetary constitution”-like approach. It seems to me that fostering green innovation requires precisely some kind of “industrial policy”, wherever it is happening, with some pretty strong convictions about what successful innovation policy should hold in store. The “debt brake” in Germany is gone because of the pandemic: will it ever be back?

Feld, Jungen, and Schuknecht’s piece is a good antidote against the prevailing rhetoric. We certainly need a better, more widespread understanding of the success of Ordoliberalism. But we also need some ideas to go back to rules, after all the discretionary measures taken because of the pandemic.

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Daniel Layman and the forgotten Lockeans

For the Independent Review, I’ve reviewed Locke Among the Radicals by Daniel Layman. It is a splendid book, which rediscovers “a coterie of nineteenth-century radical Lockeans with a penchant for anarchy and anti-capitalism”: Thomas Hodgskin (1797–1869), Lysander Spooner (1808–1887), John Bray (1809–1897) and Henry George (1839–1897). This is an unlikely lot, as these thinkers do not particularly resemble each other and are hardly considered in conjunction. But they are, in different ways, radicals who were strongly influenced by John Locke. Layman suggests that, in our usual understanding of the history of ideas, we tend to believe that Locke was unimportant in the 19th century and that he emerged again as an influence over political thinking in the second half of the 20th century.

It is quite interesting that Locke became central again for liberal thinkers after WWII. Those who fueled this Lockean renaissance were not necessarily friends or advocates of liberalism, but scholars who, like Peter Laslett or C.B. Macpherson, contributed substantially in placing Locke again at the center of the history of liberalism. Then Robert Nozick came and the influence of Anarchy, State and Utopia made the sort of natural rights classical liberalism that Locke embodied again a matter of discussion for political philosophers, and not exclusively for those more versed in the history of ideas.

I suppose it is relatively commonplace to say that Locke was not so important to understand 19th century liberalism; most such champions were Utilitarians. Layman looks for “Lockean influences” in the 19th century and finds them in radicals that foreshadowed developments that we can also acknowledge in the post-Nozick debate.

The book thus aims at correcting the view of the irrelevance of Locke in the 19th century, and it does so persuasively. Layman’s treatment of Spooner’s work is particularly noteworthy. The review is critical of the conclusions of the book when it comes to the actuality of Locke. But I cannot recommend it highly enough and I’ve learned a lot from it.

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The Economics of the Hispanic Scholastics

Economics, as a branch of knowledge concerned with human wellbeing, is somewhat like Jenga. The structure cannot hold if certain pieces, such as Adam Smith’s classical school, are removed. 

In Economics: An Introductory Analysis, Paul Samuelson presents a “family tree of economics” noting the contribution of Aristotle, Aquinas, and medieval Schoolmen to the history of economic thought. This may have been a nod to his dissertation advisor, Joseph Schumpeter, who believed that the 16th century development of natural law theory created a framework for economics as an independent discipline. This natural law tradition was subsequently passed on to Adam Smith at the University of Glasgow. 

An intense modern-day look at the economic contributions of late Hispanic Scholastic thought began with Marjorie Grice-Hutchinson (The School of Salamanca, 1952). It continued with Alejandro Chafuen (Faith and Liberty, 2003 and Raices de la Economia de Mercado en la Escolastica Catolica, 2nd Ed., 2017). 

The Hispanic Scholastics were the first to formulate a quantity theory of money and purchasing power parity, foundational in the canon of economics. However, it is worthwhile to consider how their methodology employed natural law, civil law, and revelation to explore a subjective theory of value, the moral neutrality of market transactions, and personal consent. 

The Hispanic Scholastics’ subjective (not to be confused with relativistic) theory of value applies to all goods, including money. Viewing consumption as the end of all economic activity implies that value is subjective, based on people’s needs and wants, even when those needs and wants are foolish. These ideas persisted on the European Continent with the ordinary person seen as a consumer rather than a producer.

In the 18th century, classical economists stressed production, inputs, and cost, even to the extent of holding to a labor theory of value. Measuring hours of labor and other inputs is relatively straightforward; whereas subjective satisfaction or utility is incapable of measurement. A theory of behavior describing how consumers reveal preferences was needed. The time had not yet come to advance theories of value into a coherent synthesis, combining subjective and objective elements. 

In the 1870s, Carl Menger in Austria defined the value of an economic good in essentially Hispanic Scholastic terms, i.e. its ability to satisfy a human need. Leon Walras, a French land reformer, modeled money into ratios of exchange between goods. William Stanley Jevons, a British economist departing somewhat from Smith, derived the value of goods from revealed intensities of satisfaction. Within four years of each other Menger, Walras, and Jevons independently set the precedent for marginal supply and demand analysis for understanding market prices.

Economics, within the tradition of classical liberalism, is perceived by some to be excessively individualistic and dismissive of national sovereignty. Multigenerational poverty and the hollowing out of employment in certain sectors are serious economic issues. However, sound economic principles formulated over time by those seeking truths about the human condition and the wealth of nations are essential building blocks. There is no need for future generations to bear the economic consequences of ignoring these relatively absolute absolutes. 

My recent essay at AdamSmithWorks provides a fuller summary of some of the most important ideas of the Hispanic Scholastics.

 


Maryann Keating O. is a research fellow at the Indiana Policy Review Foundation. She edited Paul Samuelson’s essays on Economics from the Heart (Thomas Horton and Daughters) and had co-authored several articles and books, including Microeconomics for Public Managers (Wiley-Blackwell).

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Golden Parachutes: The Alchian Thesis

Where do ideas come from, and how are they disseminated amongst economists? One of the great ironies in the history of economic thought has been the development of particular concepts, the theoretical importance of which is misattributed to another economist. For example, the concept of a Giffen Good, attributed to Robert Giffen, was first coined by Alfred Marshall in Principles of Economics (1890 [1920]). The Coase Theorem first appeared in the 3rd Edition of George Stigler’s The Theory of Price (1946 [1966]: 113). Moreover, what is known as the “Alchian Thesis” was first coined by Mark Blaug (1980: 117), which is “the notion that all motivational assumptions in economics,” such as assumption of profit-maximization among firms, “may be construed as as-if statements.”

At first blush, it makes sense for an economist to first develop a concept, to be named only later for its recognized importance. For example, the concept of rent-seeking, developed by Gordon Tullock (1967), was only later coined as “rent-seeking” by economist Anne Krueger (1974), who also was foundational in developing the concept.  However, it is oftentimes questionable whether or not each concept should be directly attributed to its namesake.

For my purposes here, I will focus on the Alchian Thesis, its interpretation, and its applicability, but before doing so, I will briefly illustrate how my argument runs parallel to the reception of another myth in economics, such as alleged existence of Giffen Goods. I realize that this is a strong claim to make, but let us consider how this concept has been applied, and if indeed its application has distorted our understanding of historical facts.

 

Dwyer and Lindsay (1984) challenged the notion that Giffen goods violate the law of demand by appealing to the very historical example used to exemplify their existence, namely the Irish Potato Famine. They raise two important points, which I’m paraphrasing. First, Giffen himself never wrote directly about this alleged exception to the law of demand (see also Stigler 1947). Second, and more importantly for my point here, if indeed there was an upward sloping demand curve for potatoes during the Irish Potato Famine, and if indeed (as we would expect during famine) the supply of potatoes contracted, then this would imply that the Irish ate less (not more!) potatoes as the price for potatoes fell. Could it really be the case that, as people are starving, they would eat less of a staple food as its price fell? In spite of the absurdity of this conclusion, this example is still utilized to demonstrate an alleged violation of the law of demand, to the expense of understanding how individuals are acting, given the particular circumstances of time and place. A more plausible explanation, given the expectation that potatoes would become more scarce in the future, is an outward shift, or increase, in the downward sloping demand curve for potatoes, not a change along an allegedly upward sloping demand curve.

Now let us turn to the alleged “Alchian Thesis,” the notion, presumably originated by Armen Alchian (1950) himself, that firms act as if they are profit maximizing. Not only is the claim absolutely false, but importantly, this interpretation of Alchian’s argument regarding firm behavior undermines its explanatory power. But before illustrating how misleading this interpretation is for understanding market processes, it’s important to ask how this interpretation first originated. As Neil Kay (1995) has argued, the influence of Milton Friedman’s “The Methodology of Positive Economics” (1953) on economic methodology had been instrumental in presenting this interpretation of Alchian’s argument. Though Friedman himself is careful to restate Alchian’s point that, as “a result of uncertainty,” profits “cannot be deliberately maximized in advance” by firms (Friedman 1953, p. 21, fn. 16) – not to mention the fact that it was Friedman who encouraged its publication at the Journal of Political Economy – Alchian’s argument has nonetheless been interpreted through Friedman’s broader methodological claim, namely that it’s not the realism of assumptions that matter for economic theory per se, “but whether they are sufficiently good approximations for the purpose in hand,” namely the accuracy of predictions (Friedman 1953, p. 15).

Alchian is very clear, however, that in “an economic system the realization of profits is the criterion according to which successful and surviving firms are selected” (1950, p. 213). “Realized positive profits, not maximum profits, are the mark of success and viability” (ibid., emphasis original). He goes further to argue that the “crucial element is one’s aggregate position relative to actual competitors, not some hypothetically perfect competitors…Even in a world of stupid men there would still be profits” (ibid., emphasis added). Therefore, contrary to the traditional interpretation of the Alchian Thesis, “[t]here are no implications of “profit maximization,” and this difference is important” (Alchian 1950, p. 217), because “[t]he pursuit of profits, and not some hypothetical undefinable perfect situation, is the relevant objective whose fulfilment is rewarded with survival” (Alchian 1950, p. 218). None of this implies that firm owners are unpurposive or irrational, but it does imply that the postulate of profit-maximization is neither a necessary nor a sufficient condition for understanding firm behavior.

One may object here and claim that I (or Alchian) am splitting hairs, and the point here is purely one of semantics. Perhaps so, but to conflate “profit-maximization” with “realized positive profits” across particular circumstances of time and place renders the term into a tautology, and therefore meaningless for explaining the particular manifestation of firm behavior adapting to at a particular time and place, specifically through adaptive variation and selection (see also Manne and Zywicki 2014).

If the Alchian Thesis is correct, then why do we observe “golden parachutes,” or severance packages paid to the CEOs of corporations, even when that CEO has been responsible for huge corporate losses? For example, in 2018, after a 14-month tenure as CEO of General Electric (GE), John Flannery was paid a severance package worth more than $10 million, even after GE’s stock plummeted under his watch, falling roughly 50 percent.

 

The objection that could be raised here is that, consistent with the Alchian Thesis, GE was approximating the conditions of profit maximization, given the constraints it was facing. This may be the case, but approximating compared to what? The conditions of perfect competition? Given this benchmark, GE would have known to pick another CEO, or for that matter anticipate the mistakes made by Flannery’s predecessors, Jack Welch and Jeff Immelt. The point here is not to argue who should be blamed for the GE’s tragic decline. Rather, it is precisely because firms cannot approximate the conditions of profit maximization ex-post by picking a profit-maximizing CEO that explains why they will adopt golden parachutes to insure against potential losses ex-ante. Under conditions of perfect competition, and hence perfect foresight, there would be no transaction costs associated with potential post-contractual litigation. Analogous to the purpose it serves for a marriage, the golden parachute serves like a prenuptial agreement for firms, which allows the firm to terminate its relationship with its CEO in a quick and cost-effective manner.  Without a golden parachute, Flannery may have found it worthwhile to sue GE for wrongful termination, attributing the failures to the firm to the situation he inherited from his predecessors or other economic circumstances outside of his control. The expectation of this fact, and the additional costs of legal fees and continued losses under a bad CEO, is what incentivizes firm to adopt golden parachutes, specifically as a contractual arrangement to reduce transaction costs. To simply assume that firms “profit maximize” independent of the subsidiary propositions of time and place does not explain why particular contractual and organizational arrangements emerge, namely the realization of positive profits through the reduction of transaction costs in an open-ended world of uncertainty.

To conclude, the purpose of theory is to abstract from reality, and therefore it is impossible to adopt assumptions that are perfectly realistic. However, this does not imply that attributing realism of assumptions to economic theory is a trivial point. The implication of ignoring the realism of assumptions is to render theoretical concepts, at best, irrelevant to understanding historical facts, or at worst, create a distortion of the interpretation of such facts. Nothing I am arguing here is new, but given the foothold of potentially misleading interpretations of particular concepts in economic theory, their applicability requires constant reassessment by economic educators.

 


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

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J.B. Say on Gains from Exchange

Say what you want; I think he’s great.

I’m the discussion leader next week of a colloquium on the writings of late 18th and early 19th-century French economist Jean-Baptiste Say. I hadn’t read much by or about him since 1992, when I researched and wrote his bio for the then Fortune Encyclopedia of Economics (and later Concise Encyclopedia of Economics.) Even then I read only little snippets of his work.

So it has been a real treat to work my way through over 200 pages of his writing.

Here’s a highlight where Say takes on the view that exchange is a zero-sum game:

The English writer, Stewart, who may be looked up as the leading advocate of the exclusive system, the system founded on the maxim, that the wealth of one set of men is derived from the impoverishment of another, is himself no less mistaken in asserting, that, “when one a stop is put to external commerce, the stock of internal wealth cannot be augmented.” Wealth, it seems, can come only from abroad; but abroad, where does it come from? from abroad also. So that in tracing it from abroad to abroad, we must necessarily, in the end, exhaust every source, till at last we are compelled to look for it beyond the limits of our own planet, which is absurd.

Forbonnais, too, builds his prohibitory system on this glaring fallacy; and to speak freely, on this fallacy are founded the exclusive systems of all the short-sighted merchants, and all the governments of Europe and of the world. They all take it for granted, that what one individual gains must needs be lost to another; that what is gained by one country is inevitably lost to another: as if the possessions of abundance of individuals and of communities could not be multiplied, without the robbery of somebody or other. If one man or set of men, could only be enriched at others’ expense, how could the whole number of individuals, of whom a state is composed, be richer at one period than at another, as they now confessedly are in France, England, Holland, and Germany, compared with what they were formerly? How is it, that nations are in our days more opulent, and their wants more supplied in every respect, than they were in the seventeenth century? Whence can they have derived that portion of their present wealth, which then had no existence? Is it from the mines of the new continent? They had already advanced in wealth before the discovery of America.

 

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All ideologies eventually (seem to) fail

All ideologies reach a point where they are perceived to have failed. What can we learn from that fact? I’d argue that there are almost no lessons to be learned.

Capitalism was widely seen to have failed in the early 1930s.

Authoritarian nationalism was widely seen to have failed in 1945.

Liberalism was widely seen to have failed in the 1970s.

Communism was widely seen to have failed in 1989.

Neoliberalism was seen to have failed in the 2010s.

Prediction: Islamic fundamentalism will be seen to have failed in the 2020s.

Just to be clear, I’m a neoliberal.  So I don’t believe either capitalism or neoliberalism actually failed, while I do believe that authoritarian nationalism, (1960s) liberalism, communism and Islamic fundamentalism actually did fail. But that’s not the point of this blog post. What I think doesn’t matter.

So what does it actually mean when a modern intellectual says something like, “neoliberalism has failed”. What exactly does that mean?

When people say an ideology like neoliberalism has failed, their thought process is as follows:

1. We have been in the neoliberalism era for a few decades.

2. Problems have cropped up.

3. Ergo, neoliberalism has failed.

That’s it? Surely there must be more to it than that? After all, problems always crop up over time. That’s inevitable. If that were the criterion for failure then every single ideology would eventually fail, except those that have never been tried. It must be more complicated than that!

Nope, it’s that simple. Every single ideology will be seen to have failed after some period of time. There are no exceptions.

One can imagine alternative universes where not all ideologies fail. Thus you could imagine a world where ideologies are judged on a cross sectional basis, not a time series basis. People might compare highly neoliberal places like Switzerland, Denmark and Singapore to less neoliberal places like Greece, Italy and the Philippines, and then those countries could be compared to highly illiberal places like North Korea, Venezuela and Cuba. In that universe, not all ideologies would seem to fail over time.

But that’s not the universe we live in. In our universe, intellectuals use time series evidence to judge ideologies. In this universe, all ideologies are eventually perceived to have failed, because it’s inevitable that problems will eventually crop up. So if you are young then don’t get too attached to your pet ideology. If it’s ever enacted, you will eventually see it get discredited.

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All ideologies eventually (seem to) fail

All ideologies reach a point where they are perceived to have failed. What can we learn from that fact? I’d argue that there are almost no lessons to be learned.

Capitalism was widely seen to have failed in the early 1930s.

Authoritarian nationalism was widely seen to have failed in 1945.

Liberalism was widely seen to have failed in the 1970s.

Communism was widely seen to have failed in 1989.

Neoliberalism was seen to have failed in the 2010s.

Prediction: Islamic fundamentalism will be seen to have failed in the 2020s.

Just to be clear, I’m a neoliberal.  So I don’t believe either capitalism or neoliberalism actually failed, while I do believe that authoritarian nationalism, (1960s) liberalism, communism and Islamic fundamentalism actually did fail. But that’s not the point of this blog post. What I think doesn’t matter.

So what does it actually mean when a modern intellectual says something like, “neoliberalism has failed”. What exactly does that mean?

When people say an ideology like neoliberalism has failed, their thought process is as follows:

1. We have been in the neoliberalism era for a few decades.

2. Problems have cropped up.

3. Ergo, neoliberalism has failed.

That’s it? Surely there must be more to it than that? After all, problems always crop up over time. That’s inevitable. If that were the criterion for failure then every single ideology would eventually fail, except those that have never been tried. It must be more complicated than that!

Nope, it’s that simple. Every single ideology will be seen to have failed after some period of time. There are no exceptions.

One can imagine alternative universes where not all ideologies fail. Thus you could imagine a world where ideologies are judged on a cross sectional basis, not a time series basis. People might compare highly neoliberal places like Switzerland, Denmark and Singapore to less neoliberal places like Greece, Italy and the Philippines, and then those countries could be compared to highly illiberal places like North Korea, Venezuela and Cuba. In that universe, not all ideologies would seem to fail over time.

But that’s not the universe we live in. In our universe, intellectuals use time series evidence to judge ideologies. In this universe, all ideologies are eventually perceived to have failed, because it’s inevitable that problems will eventually crop up. So if you are young then don’t get too attached to your pet ideology. If it’s ever enacted, you will eventually see it get discredited.

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Hummel on Posner and Garrison on Keynes

I followed a recent email discussion about Judge Richard Posner’s 2009 article in the New Republic in which he tried to revive John Maynard Keynes’s contributions to macroeconomic understanding.

Jeff Hummel, as per usual, had some cogent comments:

I read this and found it somewhat interesting. Posner does a fairly good job explicating Keynes’s General Theory (although I think I did a more persuasive job of making Keynes’s theories plausible when I taught intermediate and graduate macro). But except for Posner’s complaints about mathematics and his emphasizing the distinction between risk and uncertainly, I think he was quite unfair to mainstream economists. Posner is obviously grossly unfamiliar with the actual views of mainstream macroeconomists . For example, a fall in money’s velocity is precisely equivalent to what Keynes means by hoarding or passive saving, and nowadays nearly all macro and monetary economists, including even Austrians such as George Selgin, Lawrence H. White, and Steve Horwitz accept that negative velocity shocks can cause recessions. Almost the only major features of Keynes’s theory that aren’t incorporated in New Keynesian approaches are an interest-inelastic consumption function, full price rigidity, and a self-generating deflationary cycle.

I still consider the best exposition of Keynes’s views is in Roger Garrison’s Time and Money: The Macroeconomics of Capital Structure. It is the only exposition I’ve seen (I haven’t read Skidelsky) that shows how the more socialist parts of The General Theory smoothly integrate with the rest of Keynes’s views. Garrison also offers one of my favorite quotations about Keynes, not in his book, but in an article. He writes that Keynes argued:

Wage rates (1) will not fall because of unions or wage rigidities inherent in the market process, or (2) will fall but without making matters any better and possibly making matters worse because of the accompanying fall in the price level, or (3) should not be allowed to fall because of considerations mentioned in (2).

And then in a footnote, Garrison adds:

Keynes appears to be adopting a strategy usually confined to the legal profession: “My client didn’t borrow your urn; it was in perfect condition when he returned it: and it was already broken when you lent it to him.

See Keynes’s bio and Keynesian Alan Blinder’s entry on Keynesian Economics in The Concise Encyclopedia of Economics.

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