In this op-ed I am critical of Keynesian economics.
And another point:
One of the major ironies in economics is Keynesians' use of the fallacy of composition to explain why, allegedly, saving might be good for the individual but not for the group. But, in fact, the greatest commission of the fallacy of composition is committed by the Keynesians themselves. They build an entire corpus of economics on each business-person's understanding that if demand for his firm's output rises, his firm (and his workers and other suppliers) are made better off. Keynesians reach exactly the same conclusion that most business people reach, namely, if higher demand of my output is good for me, then higher demand for everyone's output will be good for everyone — for the entire economy.
That is a perfect example of the fallacy of composition.
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Yes, the aggregate demand fallacy is ubiquitous. Perhaps you've seen Brad DeLong's defense of Keynesianism in the debate with Luigi Zingales in the Economist. In his opening remarks, DeLong interprets the internet boom of the 90s and the effects of Chinese growth on the US economy purely in aggregate demand terms. He then concludes that these historic events show how . . . government spending can spur growth because "the government's money when spent is as good as anybody else's." I kid you not.
I've commented on DeLong's "defense" of Keynesianism in this post on my Streetwise Professor blog.
That aggregate demand, in a monetized economy, can be insufficient to employ idle resources is not a fallacy. Money is only a record of entitlement to consume or invest. It's easy to see how aggregate demand, in monetary terms, could be inadequate to employ idle resources.
Falling prices do not automatically solve this problem, because falling prices can bankrupt leveraged producers and because some productive resources cannot long exist with an arbitrarily low price relative to other goods.
If cattle stocks are too great and the price of beef thus falls so that growing beef is unprofitable, cattle ranchers liquidate stock by slaughtering cattle and selling at lower prices until the stock of cattle reaches a new equilibrium consistent with profitable production.
If human labor is too plentiful in a particular market, who slaughters the surplus laborers? Jonathon Swift pondered this question centuries ago, but modern economists somehow still grapple with it, largely oblivious to the implications of Swift's modest proposal.
Nominal "Keynesianism" is fallacious, but the fallacy is not in Keynes' notion of "inadequate aggregate demand". The fallacy is that only spending by central authorities selling entitlement to tax revenue can restore adequate demand. Alternatives to this central planning model are also easy to imagine.
But the central authorities, including the wealthy lords with a surplus of entitlement to consume or invest, like the alternatives less than they like central planners selling them entitlement to tax revenue. These Capitalists prefer fascism (the nominally "Keynesian" model) to either socialism or vigorously competitive capital markets with sufficient credit to employ idle resources. History is very clear on this point.
The first massively influential modern version of this fallacy was of course popularized by Foster & Catchings in the 1920s — influencing Hoover, FDR, Sen. Wagner & economists around the globe. Perhaps their biggest influence was arguably upon Keynes, who took Foster & Catchings and translated it into Cambridge economics.
It's telling, as Hayek point out in his essay, "The 'Paradox' of Savings" that not an economist in the world could identify the fallacy at the heart of the "lack of demand" argument.
Sadly — outside of a handful of Hayekians — that basically still true today.
What is the fallacy at the heart of the "lack of demand" argument?
"If human labor is too plentiful in a particular market, who slaughters the surplus laborers?"
Much like the cows, they can be put to other uses. The price mechanism serves to direct this. It is an odd question to come out of a modern economy where the answer to your question is observed daily.
You simply ignore the fact that human beings are neither durable nor disposable goods.
Suppose I can't feed and breed my current stock of cattle expecting to sell the beef profitably. I also can't put the cattle in storage for a few years until the price recovers, because cows are not durable goods.
Fortunately, I can dispose of the cattle now at the depressed price, so I needn't lose everything have in them. In this way, cattle stocks shrink to meet current demand. This self-correcting mechanism does not apply to human beings.
Humans certainly have more uses than cows, but the economic actors in an economy need not have sufficient entitlement to employ them at wages sustaining their productivity.
Monetized economies are all about credits and contractual obligations. Conceivably, every dollar of income can be pledged to some expenditure even before it is received. In this scenario, a market is effectively a closed system. Profits from existing organization cannot employ idle resources. Only new monetary credit from outside of the system can employ idle resources.
In principle, in such a closed market, even new credit can only employ idle resources to produce goods for one another, so we end up with two closed markets not trading with one another.
Real markets are never completely closed systems, but a "nearly closed" market can be insufficiently entitled to employ an arbitrary quantity of idle resources. It's easy to see how this scenario could occur, once you conceive its possibility.
But Keynes' analysis came out of a global depression with massive unemployment, and your "daily observation" has nothing to do with some theoretical economy without continual injections of new money by monetary authorities, because you've never observed such an economy. The U.S. economy has never operated this way throughout my entire life.
"What is the fallacy at the heart of the "lack of demand" argument?"
Ultimately it is failure to recognize the fact of wealth creation. Wealth creation (in a free economy) more than compensates for the income loss at fixed aggregate savings predicted by the money-pushing accounting of the paradox of thrift.
And though Hayek uses a complex argument describing capital structures, I think the reasoning would be made more accessible if economics would focus less on money-pushing in transactions (which has easier econometrics) and more on wealth creation in transactions, which may bear no resemblance to the money-pushing results.
That is, if economists would focus on the fact that while a $100 voluntary transaction likely corresponds to wealth creation, the wealth creation is not likely to be valued at $100, and in fact may vary wildly to much less than $100 to much more than $100 depending upon the transaction and the particular people involved.
Then they might also realize that a $100 involuntary transaction may very well result in significant wealth destruction. This is the part that leads governments to destroy economies while thinking they are benefiting them. This is why following GDP in an economy with significant involuntary transactions is particularly dangerous.
What is the fallacy at the heart of the "lack of demand" argument?
As I see it, there is a fallacy in presuming that the observer's conclusion about demand is what matters rather than the choices of actual consumers.
If people have reduced their current consumption, then it might follow that they have increased their demand for something else, such as future consumption.
Which is precisely why propping up failed businesses and propping up wages and salaries are a bad idea. When the demand for labor falls, the price of labor would fall with it. Useful resources like labor will not remain unemployed at the right prices. Cows have only a handful of uses, where as human labor is much more flexible and could be adapted to a wider variety of situations. Comparing cows and humans are not a useful comparison.
On a related note, more the number of laborers employed by the government, less flexible the wages would become.
Sam–
"If people have reduced their current consumption, then it might follow that they have increased their demand for something else, such as future consumption."
It is critical to note that this does not reflect an equal trade off, otherwise you wind up with the same false zero growth assumptions of the Keynesians.
I would say the most important thing to note is that the people making this decision are doing so because they are determining it to be in their self interest to do so, and so reflects a gain in their wealth.
And this is not, as Keynesians argue, at the expense of the aggregate economy, because the demand for future goods is creating a more efficient (wealthier) allocation of resources for the future economy.
"You simply ignore the fact that human beings are neither durable nor disposable goods."
You simply ignore the fact that human capital is efficiently reallocated every day, whether or not your theories can explain it.
I know you have had only one job in your life, and nothing is for certain, but I can virtually guarantee you that if you leave your job, you will not be slaughtered.
"Suppose I can't feed and breed my current stock of cattle expecting to sell the beef profitably. I also can't put the cattle in storage for a few years until the price recovers, because cows are not durable goods."
Fortunately the imagination of a REAL market player is greater than yours. It is also greater than mine, but even I might think of slaughtering fewer cows and producing more milk and manure. If it hit my wallet hard enough, I'd probably come up with a few more ideas.
And it is precisely these kinds of decisions that affect capital structures that Hayek is referring to which grows an economy disproves the foundations of Keynesianism.
Creating wealth creates money? I don't think so. Wealth is not money, and money is not wealthy. Money is an accounting device. It accounts for entitlement to spend, to consume or to invest. Ideally, production entitles us to consume or invest, but this relationship certainly is not necessary.
Martin,
"…the economic actors in an economy need not have sufficient entitlement to employ them at wages sustaining their productivity."
Much of the population is productive now. I can't see how a few percent more unproductive people matters much, as the society is easily capable of absorbing them.
…that should have been "unproductive now"
"Creating wealth creates money? I don't think so."
Neither do I. That has sort of been the theme of my posts.
But it is wealth creation that we SHOULD care about. Instead what Keynesians care about is money, the movement of which may (and with Keynesian policies probably does) correlate negatively with wealth creation.
"Which is precisely why propping up failed businesses and propping up wages and salaries are a bad idea. When the demand for labor falls, the price of labor would fall with it. Useful resources like labor will not remain unemployed at the right prices." – O. Shock
Well there you go M. Brock! In a free market recession the size of the unemployed drives down wages, low wages makes them more attractive for employers to hire the unemployed, unemployement is solved. Tada!
First I apologize for my horrible English.
You´re out of the track.
There´s a small conceptual change that could unify Keynes, Hayek, Friedman, Von Mises, Wicksell, Lucas, Walras, Smith, Solow and the others.
That change could solve this crisis in 24 hours without cost, regulatory changes, public expenditures or another odd managements.
As far as I´m out of the academic or professional string of contacts, I don´t know how to communicate it. But the idea is very very powerful and I believe I have some responsability to publish it.
I need some help to help the world, on the other hand I need 2 months to publish it wherever I imagine and the consecuences will be uncontrolated.
Again, you simply ignore the fact that wages may not fall to an arbitrarily low level. Again, if the price of beef falls below the cost of feeding cattle, cattle ranchers reduce their stocks of cattle, but this mechanism does not exist in the labor market.
If gasoline is sufficiently plentiful, it might trade for one cent per gallon, temporarily, until the supply of gasoline adjusts to a more profitable level, because a tank of gasoline doesn't starve to death if sold at this price for a few weeks or months. The supply of labor cannot operate this way.
Again, you ignore the fact that a given quantity of idle labor does not imply sufficient monetary entitlement to employ the labor at any price. A theoretical ability to employ idle labor at one cent per hour is irrelevant. If laborers may create new forms of money to reorganize themselves usefully, they might overcome a shortage of demand denominated in established forms of money, but their new money must be a legal tender for this purpose, because established debts are the root of inadequate aggregate demand.
You can conflate human labor with other goods, and you can nonsensically apply economic principles relevant only to the other goods, and you can ignore the supply of legal tender, but economists not sharing your ideological blinders will not take you seriously. You might was well ignore the horizon and tell me that the Earth is flat.
Clarification : … their new money must be a legal tender for them to trade with resources still employed …
If the productive population already owes everything it produces to one another other, then it can't produce anything for idle laborers to consume, and it therefore cannot consume anything idle laborers produce.
Bankruptcy doesn't necessarily solve this problem, because a million people owing everything they produce to one another does not imply that anyone is bankrupt; however, it does imply that this group of people may not trade with another group of a million people, because the first group has nothing to trade with the second group, as the first group is contractually bound to circulate its output exclusively within the first group.
I agree. That's why we want idle factors reorganized into new profitable organizations a.s.a.p. At least, we want them organized with a realistic expectation of profit, but this expectation cannot simply take established entitlements for granted.
We don't want many potentially productive factors, particularly human factors, which are most productive, simply entitled to sit idle, to consume without producing, rather than satisfying market demands.
But in modern lore, nominal "Capitalism" is all about these entitlements. The "American Dream" is no longer to carve out an independent living on some frontier by the sweat of one's brow. The "Dream" now is to "make enough money to live off of the interest". I've heard people describe their goal precisely this way.
We don't have a work ethic in this country anymore. We have a retirement ethic, an entitlement ethic. "Independence" doesn't mean producing what you consume or even producing what you can exchange for what you consume in a market. "Independence" means entitlement to a stream of monetary income sufficient to consume what you want regardless of your production.
The American Dream is now a job with the state promising a pension with a COLA after 20 or 30 years of service, if one can't win some state lottery instead. This retirement on monetary rents is the ultimate sign of success in our economy. That's "Capitalism" as a matter of fact, as a matter of common usage, but it's not classical liberalism, and it's not the market either.
I'm not a "Keynesian" in the conventional sense of this word. I'm not a "Keynesian" in any sense. I don't worship Keynes or consider his words holy writ; however, Keynes' notion of "aggregate demand" is not simply meaningless, although it is largely about money, if "money" means "legal tender".
My problem with "Keynesianism" is not the idea of aggregate demand or the idea that aggregate demand can be inadequate to employ idle labor. Keynes disputes the classical consensus that price variation alone can always employ idle resources, restore them to their productive potential and thus lift an economy out of recession. He was right to dispute it.
My problem is with the idea that only a central planning authority can provide the necessary demand. I don't know that attributing this idea to Keynes himself is accurate.
No. I don't ignore the fact, and my theories do explain it. We've had a monetary authority in the U.S. continually supplying new monetary credit since the day I was born and also since the day you were born. If you think you explain anything while ignoring this fact, you're out of touch with reality.
I've had half a dozen jobs in my life. I changed employers only last year.
I don't expect to be slaughtered. That's the whole point. We don't slaughter people for their meat, Ã la Jonathan Swift, when they're in excess supply; therefore, any economic theory simply conflating human labor with all other goods can't describe a real economy, because the theory is based on a false premise. Labor is not just like cattle or gasoline or gold.
"But it is wealth creation that we SHOULD care about. "
Thank you. I agree. It seems to me that most of modern economics has devolved into nothing but measuring cash flows. Doesn't anyone read Adam Smith anymore?