Tuesday, January 6, 2009

In the Long Run, Keynes is Not Dead

To counter the argument that inflationary policies are destructive in the long run, John Maynard Keynes famously quipped that “in the long run, we will all be dead.” Unfortunately, the only person who will not die is Keynes and his disastrous economic theories. An article recently appeared on the front page of the Wall Street Journal entitled Hard-Hit Families Finally Start Saving, Aggravating Nation's Economic Woes immediately implying the utterly absurd notion that "savings" somehow hurts the economy. Quoting the article:

Usually, frugality is good for individuals and for the economy. Savings serve as a reservoir of capital that can be used to finance investment, which helps raise a nation's standard of living. But in a recession, increased saving -- or its flip side, decreased spending -- can exacerbate the economy's woes. It's what economists call the "paradox of thrift."

Of course, this is hardly a "paradox." When someone goes to the bank for a loan to buy a house, a car, etc. where does the money come from for this loan? So spending on anything other than inexpensive consumer items like soap and shampoo depends largely on the savings of others. Second, savings provides the capital necessary to fund productive expenditures which of course lead to greater productivity, increased real wages, and consequently higher living standards.

The catastrophic boom bust cycle which creates the phenomena discussed in the article is caused by government led credit expansion. In the "boom" phase, the government does everything in its power to decrease saving primarily by inducing illiquidity, i.e., as prices rise and credit is widely and easily available, firms and consumers tend to hold smaller cash balances. This induces individuals to consume as opposed to save (see the chart in the WSJ article of changes in personal consumption) and creates malinvestment throughout the economy as capital flows to businesses that momentarily appear to be profitable. When the supply of new money is subsequently reduced by the government (mostly to avoid hyperinflation) many businesses will fail as consumers stop spending money and retrench, i.e., are forced to rebuild their liquidity. In the short run, as the economy contracts in the wake of a bust it is true that many businesses will fail. But this effect is not caused by savings. It is caused by government credit expansion which led to over consumption and malinvestment in the first place. Ironically, it is savings that will come to the rescue. During a recession, as firms and individuals rebuild their liquidity (by saving more and spending less) prices and wages decline, profitability is restored and real wages can begin to increase.

We have been down the road of consumption vs. savings before (see my previous post Production and the Primacy of Existence.) Note that Dr. Reisman specifically addresses Keynes and the "paradox of thrift" in his treatise Capitalism in Chapter 18 Keynesianism: A Critique” specifically in Section 3 Critique of the “Paradox of Thrift” Doctrine p. 884. In this section, he discusses the more general argument but also refutes some more technical arguments that would appeal more to advanced students of economics.

Finally, for entertainment and educational value read the following research report published in November of 1934 by the American Institute for Economic Research. It could have been written yesterday. See especially the authors sarcastic reference to America's "unofficial English advisor, Dr. John Maynard Keynes." All of their reports are archived here. It's amazing how little has changed or been learned in the economics profession in 80 years.

5 comments:

Burgess Laughlin said...

Study Groups for Objectivists examined Yaron Brook and Onkar Ghate's lectures, "Cultural Movements: Creating Change." One point they covered was the failure of the conservative "free market" movement in the 1980s and 1990s to have a lasting effect. The reason, the lecturers suggested, was simple: the conservatives didn't provide an objective foundation for their support of a free market.

Keynes was not "killed," for the same reason one can't kill certain thorny vines by snipping their tips occasionally: One must uproot them. Conservatives support most of the principles underlying the left, so they can't destroy the foundation of leftist policies.

Doug Reich said...

Burgess,

I agree and have posted similar argument on many occasions.

This implies that we must focus on more core philosophical problems that can explain why the modern social sciences are essentially flawed, i.e., their theories often do not correspond to reality.

This is a complex task as it involves not only ethics (egoism vs. altruism) as I have discussed also more fundamental epistemological issues that relate to what constitutes knowledge and therefore what makes a theory valid. Most of the economics profession today appears to be of the empiricist camp meaning that they focus on relationships implied by quantitative data and do not accept principles on principle. Most economics papers and textbooks are essentially mathematical which is a total inversion. This results in most trained economists being unable to understand the present much less able to project the consequences of some policy.

The essential distinction between the physical sciences and social sciences of course is the issue of free will vs determinism. In other words, the physical world is deterministic and issues related to human interaction or behavior involve free will. Some social scientists appear to treat humans as if they were determined and others who accept free will take it to imply randomness. This is a false alternative.

Humans possess free will but they are not random either. This means we can make generalizations about human behavior but we also can not treat them as molecules or planets.

Anyway, this is major topic that I will post about in the future. My economics posts should not be taken to imply that I discount the role of more fundamental philosophy but I think it is still important to discuss economics since it is a difficult topic even for rational people and helps to understand the world.

Philosophical Mortician said...

Keynes once remarked that concrete bound, theory-averse people end up becoming, "slaves of some defunct economist." The irony.

Burgess Laughlin said...

Doug, I look forward to your future articles.

I want to make sure we are not having a miscommunication. My original comment was only a way of emphasizing a point. No essay can cover everything or give everything it covers strong emphasis. I was not in any way criticizing you or your writing.

I have been on the internet a long time. I hope I am not sounding abrasive as a standard operating procedure. That is an issue I am working on.

Best to you.

Doug Reich said...

Burgess,

I reread my comment and I can see how it sounded defensive, but I did not intend that at all and apologize for confusion. I greatly appreciate your comments and welcome them. Please comment as much as possible. It really helps to bring out more aspects to the various issues we discuss. Sorry again!