Keynes’ Error

Thoughts after reading Steven Kates’: “Why Your Grandfather’s Economics Was Better Than Yours: On The Catastrophic Disappearance of  Say’s Law”

Keynesianism has dominated economic thought and shaped public policy since the 1930s. John Maynard Keynes’ General Theory revolutionized economics and made the demand side of the equation paramount. Recessions, in his mind, were caused by insufficient demand. Fix the demand failure and you get the economy out of recession.

This theory refuted classical economics, specifically what had become known as Say’s Law. Professor Steven Kates tells us why : Keynes said insufficient demand led to recessions; classical economists, on the other hand, said there was no such thing as a demand deficiency. Keynes’ contribution, as Ludwig von Mises noted in 1950, was abandoning classical economics and offering a different way (the polar opposite way in fact) of fixing recessions.

Recessions could be fixed by government deficit spending according to Keynesians. This called for government to step in during recession and pump money (inject tax-pay dollars) into the economy. This will pick up the slack and will eventually put the business cycle back into equilibrium.

The General Theory relied upon the writings of Thomas Malthus, a late 18^th century/early 19^th century intellectual best known for his thoughts on overpopulation. In 1820, Malthus wrote a treatise on economics-Principles of Political Economy– that argued the recession in Britain following the Napoleonic Wars was a result of excessive savings/investment in the economy.

In other words, there was insufficient demand in the economy. This demand deficiency led to a breakdown in the business cycle and put the British economy into recession.

Malthus’ writings went against the classical consensus of his contemporaries, specifically the writings of David Ricardo and Jean-Baptiste Say. Classical economists said that demand played no role in understanding the business cycle.

Ricardo wrote to Malthus in 1821 shortly after the publication of Malthus’ Principles, saying: “men err in their productions…there is no deficiency in demand.” That point, along with several others, fused together and became known as Say’s Law. Say’s Law dominated economic thought throughout the 19th century, but was abandoned when it (and classical economics generally) looked impotent during the Great Depression.

There are several propositions in Say’s Law. Most importantly, there is no demand deficiency. Both Malthus and Keynes argued that excessive savings/investment would lead to an excess/glut of goods/services in the economy. Classical economists said this was nonsense. There is no such thing as excessive supply. Any unused supply was put into savings/investment which lead to capital formation. In other words, no hoarding of supply took place.

The second proposition is just as important as the first. Demand is constituted by supply. Read that again. Demand is made up of supply. It won’t grow unless there’s a growth in supply. Value added productivity must occur for demand to increase.

20^th century British economist Henry Clay put it this way:

An increase in the supply of cloth is an increase in the demand for other things; and vice versa, an increase in the supply of anything else may constitute a demand for cloth. What is divided among the members of society is the goods and services produced to satisfy its wants; and the same goods and services are both Supply and Demand.

Ludwig von Mises came to a similar conclusion. The Austrian said that commodities ultimately paid for other commodities. Money was just the means used during the transactions. In effect, our services rendered or our goods provided (our value added productivity) pay for new goods/services that we desire.

This is the third proposition of the classical economists: money is the conversion of one’s goods/services into currency which is used for new goods/services.

Here’s a thought experiment. Imagine you work eight hours a day on the assembly line of a profitable car factory. The company uses some of its profits to pay you X amount for the week. X is a reflection of services rendered. You take that X in the form of a paycheck and use that paycheck to buy other goods/services, e.g. groceries, mortgage payments, car notes, etc.

Those three propositions explain how an economy operates. But what explains why it slows down? What leads to recession?

Classical economists say that recessions occur because of high levels of involuntary unemployment. This is a result of structural problems in the economy. More often than not, this takes place when the structure of supply and the structure of demand are out of sync. When demand patterns no longer reflect the actual output of supply, the economy goes into recession.

19^th century British economist Robert Torrens said that market equilibrium was paramount. Keeping supply and demand properly proportioned was the goal of economics. If that market equilibrium was in place, Torrens asserted, increased value-added production would lead to an increase in demand.

Finally, Say’s Law highlights the importance of monetary policy. Many recessions occurred because of structural imbalances in the credit market-e.g. too many dollars chasing too few goods (excessive credit expansion) or too few dollars chasing too many goods (insufficient credit expansion). Monetary policy could also lengthen/prolong/exacerbate a recession if it was incorrectly implemented.

Nowhere do the classical economists say that recessions are a result of insufficient demand. This was/is a fallacy.

Keynesianism doesn’t work because it is based on an economic fallacy. Unfortunately, economists have embraced its policy prescription (deficit spending) as the solution for fighting recessions. But as David Ricardo could have told you, deficit spending will not fix an ailing economy. It will only hike the public debt and inflate the currency.

The key to economic expansion is market equilibrium and the growth of value added production. Let the invisible hand restore the natural order between supply and demand. That will, in turn, promote additional economic activity and lead to an increase in value added production. These two things-market equilibrium and increased value added production- will restore prosperity.

Tags: Austrian School of Economics, Classical Economics, David Ricardo, Jean Baptiste Say, John Maynard Keynes, Keynesian Economics, Ludwig Von Mises, Say's Law, Thomas Malthus