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Monetary Central Planning and the State, Part 16: Keynes and Keynesian Economics

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John Maynard Keynes’s famous treatise, The General Theory of Employment, Interest and Money, was published on February 4, 1936. Its influence on the economics profession following its appearance was astonishing. And its impact on economic theory and policy over the last 60 years has been immense. Paul Samuelson of MIT, the 1970 recipient of the Nobel Prize in economics and one of the most influential expositors of Keynesian economics in the post-World War II period, contributed an essay to a volume entitled The New Economics, edited by Seymour Harris in 1948, two years after Keynes’s death. In an often-quoted passage, Samuelson explained:

“It is quite impossible for modern students to realize the full effect of what has been advisably called ‘The Keynesian Revolution’ upon those of us brought up in the [pre-Keynesian] orthodox tradition. To have been born as an economist before 1936 was a boon — yes. But not to have been born too long before! … The General Theory caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of south seas islanders. Economists beyond fifty turned out to be quite immune to the ailment. With time, most economists in-between began to run the fever, often without knowing or admitting the condition…. This impression was confirmed by the rapidity with which English economists, other than those at Cambridge took up the new Gospel … at Oxford; and still more surprisingly, the young blades at the London School [of Economics] … threw off their Hayekian garments and joined in the swim. In this country [the United States] it was pretty much the same story…. Finally, and perhaps most important from the long-run standpoint, the Keynesian analysis has begun to filter down into the elementary textbooks; and, as everybody knows, once an idea gets into these, however bad it may be, it becomes practically immortal.”

Even today, when the traditional Keynesian analysis has been challenged and set aside by many economists, the Keynesian framework still haunts most macroeconomic textbooks, demonstrating Samuelson’s point that “however bad it may be,” it has become “practically immortal.”

The essence of Keynes’s theory is to show that a market economy, when left to its own devices, possesses no inherent self-correcting mechanism to return to “full employment” once the economic system has fallen into a depression. At the heart of his approach was the belief that he had demonstrated an error in Say’s Law.

Named after the 19th-century French economist Jean-Baptiste Say, the fundamental idea is that individuals produce so they can consume. The classical economist David Ricardo expressed it this way:

“By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person…. Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected.”

Keynes argues that there is no certainty that those who have sold goods or their labor services in the market will necessarily turn around and spend the full amount of the income they have earned on the goods and services offered by others. Hence, total expenditures on goods can be less than total income previously earned in the manufacture of those goods.

This, in turn, means that the total receipts received by firms selling goods in the market can be less than the expenses incurred in bringing those goods to market. With total sales receipts being less than total business expenses, businessmen have no recourse other than to cut back on output and the number of workers they employ, so as to minimize their losses during this period of “bad business.”

But, Keynes argues, this merely intensifies the problem of unemployment and falling output. As workers are laid off, their incomes necessarily go down. With less income to spend, the unemployed cut back on their consumption expenditures. That results in an additional falling off of demand for goods and services offered on the market, widening the circle of businesses finding their sales receipts declining relative to their costs of production. And this sets off a new round of cuts in output and employment, setting in motion a cumulative contraction in production and jobs.

Why wouldn’t workers accept lower money wages to make themselves once more attractive to employers for rehire in the face of falling demand in the market? Because, Keynes says, workers suffer from “money illusion.” If prices for goods and services are decreasing because of a falling off of consumer demand in the market, then workers could accept a lower money wage and still be no worse off in real buying terms if the cut in their money wages was on average no greater than the decrease in the average level of prices.

But workers, Keynes argues, generally think only in terms of their money wages, not in terms of their real wages, i.e., what their money income represents in real purchasing power on the market. Thus, workers would often rather accept unemployment than a cut in their money wage. (See “Monetary Central Planning and the State — Part I: A Little Bit of Inflation Never Hurt Anyone, Right?” in Freedom Daily, January 1997.)

If consumers demand fewer final goods and services on the market, this necessarily means that they are saving more. Why wouldn’t their unconsumed income merely be spent hiring labor and purchasing resources in a different way in the form of greater investment, as savers have more to lend to potential borrowers at a lower rate of interest?

Keynes’s response is to insist that the motives of savers and investors are not the same. Income-earners might very well desire to consume a smaller fraction of their income, save more, and offer it out to borrowers at interest. But there is no certainty, he insists, that businessmen will be willing to borrow that greater savings and use it to hire labor to make goods for sale in the future.

Since the future is uncertain and tomorrow can be radically different from what it is today, Keynes states, businessmen easily fall under the spell of unpredictable waves of optimism and pessimism that raises and lowers their interest and willingness to borrow and invest. A decrease in the demand to consume today by income-earners may be motivated by a desire on their part to increase their consumption in the future out of their savings. But businessmen cannot know when those income-earners will want to increase their consumption out of their savings in the future or what particular goods will be in greater demand when that future day comes. As a result, the decrease in consumer demand for present production merely serves to decrease the businessman’s current incentives for investment activity today as well.

If for some reason there were to be a wave of business pessimism resulting in a decrease in the demand for investment borrowing, it should result in a decrease in the rate of interest. Such a decrease in the rate of interest because of a fall in investment demand should make savings less attractive, since less interest-income is now to be earned by lending out a part of one’s income. As a result, consumer spending should rise as savings goes down. Thus, while investment spending may be slackening off, greater consumer spending should make up the difference to ensure a “full employment” demand for the society’s labor and resources.

But Keynes doesn’t allow that to happen, because of what he calls the “fundamental psychological law” of the “propensity to consume.” As income rises, he says, consumption spending out of income also tends to rise, but less than the increase in income. Over time, therefore, as incomes rise in a society, a larger and larger percentage is saved rather than consumed.

In The General Theory, Keynes lists a variety of what he called the “objective” and “subjective” factors that he considers to be the influences on people’s decisions to consume out of income. On the “objective” side: a windfall profit; a change in the rate of interest; a change in expectations about future income. On the “subjective” side: “Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance.”

He merely asserts that the “objective” factors have little influence on decisions as to how much to consume out of a given amount of income — including a change in the rate of interest. And the “subjective” factors are basically invariant, being “habits formed by race, education, convention, religion and current morals … and the established standards of life.”

Indeed, Keynes reaches the peculiar conclusion that because men’s wants are basically determined and fixed by their social and cultural environment and only change very slowly, “the greater … the consumption for which we have provided for in advance, the more difficult it is to find something further to provide for in advance.” In other words, men run out of wants for which they would wish investment to be undertaken; the resources in the society — including labor — are threatening to become greater than the demand for their employment.

Keynes, in other words, turns the most fundamental concept in economics on its head. Instead of our wants and desires always tending to exceed the means at our disposal to satisfy them, man is confronting a “post scarcity” world in which the means at our disposal are becoming greater than the ends for which they can be applied. The crisis of society is a crisis of abundance! The richer we become, the less work we have for people to do because, in Keynes’s vision, man’s capacity and desire for imagining new and different ways to improve his life are finite. The economic problem is that we are too well off.

As a consequence, unspent income can pile up as unused and uninvested savings; and what investment is undertaken can erratically fluctuate up and down because of what Keynes called the “animal spirits” of businessmen’s irrational psychology concerning an uncertain future. The free-market economy, therefore, is plagued with the constant danger of waves of booms and busts, with prolonged periods of high unemployment and idle factories. Society’s problem stems from the fact that people consume too little and save too much to ensure jobs for all who desire to work at the money wages that have come to prevail in the market and which workers refuse to adjust downwards in the face of any decline in the demand for their services.

Only one institution can step in and serve as the stabilizing mechanism to maintain full employment and steady production: the government, through various activist monetary and fiscal policies.

This is the essence of Keynesian economics.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).