Keynesian Economics’ Dangerous Return

Just as the causes of this downturn cannot be charted through a Keynesian demand deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.

—Steven Kates, “The Dangerous Return of Keynesian Economics”, Quadrant, March 2009

The Global Financial Crisis enveloped the world’s economies at the end of 2008 and the start of 2009 but is now long gone. There is no financial crisis anywhere, although you would not be game to say that another might not be far ahead. But the GFC itself did not last half a year. It left in its wake a subdued world economy and higher unemployment, but the financial crisis was over. The efforts made by central banks to stabilise the financial system had done their job, and while not everything they did might have been done had they had a second chance, these kinds of unique economic events happen at great speed and policy mistakes are inevitable.

And then, from the start of 2009, stimulus packages were introduced one by one almost everywhere. The textbook approach to dealing with a deeply subdued economy is for governments to spend money, lots of money, as quickly as possible. According to the theory, economies are pulled along by demand. Since what was clearly missing, according to economists and policy-makers who had been brought up on this theory, was a sufficiently high level of demand, large increases in public spending were seen as the only answer that would get us out of recession and into recovery more rapidly than any other possible approach.

In the United States, the stimulus package was measured at around $787 billion but in actuality went much higher. In Australia the figure as a percentage of GDP was similar, and in dollar terms came in at around $43 billion. With only a handful of exceptions, a spending binge was put in place in every country of significance. And while even now, though there is talk of “austerity”—as in, “We are cutting spending”—so far the only thing that has been cut is the upwards trend in the rate of growth of expenditure. Public spending is higher by entire percentage points of GDP than it was when the GFC began.

Yet far from the world’s economies having returned to reasonable rates of growth, conditions have remained in the doldrums without much sign of an upwards momentum. Nowhere has there been a return to low rates of unemployment or, more to the point, to faster rates of employment growth. Real incomes are falling and confidence in the future is low and continuing to ebb. No one would say that our economic problems are over. The future looks more uncertain than ever. While the upheavals of the GFC are behind us, there is little confidence that better times are before us.

Keynesian economics

The problem is Keynesian economics, the bedrock element of modern macroeconomic theory. Hardly anyone else sees this as the problem, which from my perspective is of itself a large part of the problem. It is called “Keynesian” because our modern approach to macroeconomic analysis was introduced by the English economist John Maynard Keynes. During the GFC and the early days of the stimulus, it was Keynes: Return of the Master (an actual book title) and other comments of a similar kind one would hear all too often. Such talk has now disappeared and with good reason.

Keynesian economics is built on the notion that what causes economies to grow and businesses to employ are increases in aggregate demand. The more demand there is in total, the faster an economy will grow, and therefore the more people will be employed. Keynes’s theories were an outcrop of the Great Depression, whose dates are traditionally given as 1929 to 1933. Keynes’s response, his General Theory of Employment, Interest and Money, the centrepiece of macroeconomic theory ever since, was published in 1936. Whatever did or didn’t bring the Great Depression to an end, it was not the economics of Keynes.

The one and only place where you could say a “Keynesian” response was applied was in the United States under Roosevelt. There the depression did not end until the USA entered the war in 1941.

So far as understanding the theory goes, it takes about five minutes to turn anyone into a Keynesian. Keynesian economics is extremely easy to follow, combining a superficial understanding of how economies work with a truism that has been made to act as a theory. It is so simple and so beguiling that almost no one in politics can resist it and before they know it they find themselves in the quicksands of a sinking economy that will not behave in the way the theory says it should. Here, then, is the base Keynesian formula, leaving out international trade, which matters not at all in understanding the point:

Total output is the sum of everything spent by consumers on consumption goods, plus everything spent by businesses when investing in capital goods, plus everything spent by governments in buying whatever it is that governments buy.

The standard formula, using “Y” to represent total output, or GDP if you like, is this, taught to economists worldwide with virtually no exception:

Y = C + I + G

“C” represents spending on consumer goods, “I” represents spending on capital investment, and “G” represents government spending on goods and services. Add them up and, and since everything bought must have been produced, total spending must be equal to total output.

If you accept this truism as economics, the policy response to recession is immediately obvious. With the coming of recession, there is a fall in consumption spending and a much larger percentage fall in investment. Therefore, as a matter of arithmetic, the level of output must also fall.

Therefore, again as a matter of arithmetic, the answer to the fall in demand is an increase in demand, which in this case comes as a massive government stimulus. The fall in C and I is replaced with a compensating increase in G. Output is then restored, employment is maintained and the economy returns to the robust level of activity that had existed before the recession had set in.

With that theory in hand, you too could be Prime Minister, or Secretary of the Treasury. While there are more sophisticated and complex ways of explaining Keynesian economic theory, for all practical purposes that is all you need to understand about what has driven our economies into the ground.

The role of government

But if you are to understand the criticisms that follow in the rest of this article, it is also important to understand that none of it is based on a view that governments should do nothing when economies enter difficult times. During the GFC, I strongly supported the actions of central banks to stabilise, as best they could, the troubled economies they were managing. I also think these same central banks had brought on many of the problems we were facing. But when the world’s credit system collapsed as it did at the end of 2008, there was, to my mind, little else that governments and their central banks could do but take deliberate action to retstore stability.

I have, over the years since the GFC, pondered my judgment and still continue to believe that the actions by central banks in the USA, Europe, the UK and elsewhere were necessary and beneficial. This is still an open question, but after five years looking at the alternatives, I can only think things would have been much worse had central banks not intervened.

So in arguing, as I do here, against the stimulus, I am not arguing against the principle of government action to deal with economic problems. There is no principle I can think of that would lead one to the conclusion that economies are best left alone by governments to run themselves. What matters for me is whether some policy will actually provide a net benefit when all things, both short-term and long-term, are taken into account.

The actions by central banks to stabilise a financial crisis were appropriate. The subsequent actions to stimulate our economies after the crisis was past were a mistake we will be paying for over many years to come.

Two expectations

From the start of the stimulus I had two expectations. One has been more than confirmed over the past five years; the other has not.

The one that has been confirmed was that the economic consequences of the stimulus would be dismal. There was something very specific about my own criticisms, which you will find hardly anywhere else. The criticisms were not based on some blanket principle that governments should not intervene in economic affairs. They were not based on the fact that these expenditures would lead to an increase in the deficit and the level of debt. My criticisms were based on the argument that such public spending could not possibly work to bring a recovery about, and that, in fact, they would only cause economic conditions to deteriorate.

Here is an extract from a report in the Sydney Morning Herald following my testimony to the Senate Economic References Committee on September 21, 2009:

The Senate is hearing from a number of academics … to examine the impact of the government’s series of stimulus measures since October 2008 and whether economic circumstances warrant changes to the initiatives.

Professor Steven Kates from the Royal Melbourne Institute of Technology (RMIT) backed the government’s measures to support the banking system, but said interest rates should have been lowered further and taxation lowered.

“But one thing you shouldn’t do, you should not have this blanket expenditure as a stimulus—four per cent of GDP (gross domestic product) is an unbelievable amount of money,” Prof Kates told the Senate Economics References Committee.

“That will not create growth and, in fact, wastes resources so comprehensively. They are destroying our savings, they are going to push up interest rates, they are going to push taxation in the future, and may push up our inflation rate.”

He calculated that unemployment would have been 6.1 per cent now rather than 5.8 per cent, calculating that the government has spent $1.5 million saving each job.

There it is, on the record. I had “backed the government’s measures to support the banking system” but did not support the stimulus. As I noted then, and will return to momentarily, the stimulus had destroyed our savings and even in doing so, would not create growth and jobs.

But it was the response of Senator Cameron, also published by the SMH, which I will also come back to, since this gets to the very core of the questions at hand:

Labor senator Doug Cameron said Prof Kates’ comments had certainly embedded in his mind that you should never let an “academic economist run the economy”.

“Why have the IMF, the OECD, the ILO, the treasuries of every advanced economy, the Treasury in Australia, the business economists around the world, why have they got it so wrong and yet you in your ivory tower at RMIT have got it so right?”

The very question I ask myself.

The expectation not fulfilled

My second expectation, the one that has not been fulfilled, was that with the certain failure of Keynesian economics there would be a major reassessment across the profession over the theoretical accuracy of the macroeconomics that has been dominant since the 1930s. It is one thing to have a hypothesis that is never tested against reality. It is quite another to find when you use a theory and, based on that theory, forecast an outcome that does not occur, that you just get on with things and not have an in-depth review to see where, perhaps, that theory might have gone wrong.

No one can at this stage argue that the stimulus was a success. The increases in public expenditure have not brought recovery. Every economy in which the stimulus was applied with any kind of force is now in the midst of having to deal with subdued economic conditions that show no sign of ending. Economic growth has not returned to levels found before the GFC. There is not an economy anywhere whose long-term prospects can be said to have been improved as a result of the Keynesian policies that were applied.

What I had therefore expected was a reaction of some kind amongst the economics community. It had seemed obvious that economists would ask themselves what had gone wrong and why the policies that had been built on their theories didn’t work out.

Because whether or not economists have such thoughts, there is no doubt policy-makers do. From Greece on up, governments of countries mired in their post-GFC torpor have abandoned any thought of stimulus and, in spite of high unemployment and low rates of growth, have embarked in a new direction, which Keynesians have named “austerity”—austerity, as in wartime, where the resources of the nation are diverted away from domestic consumption goods. That’s the name given by Keynesians to policies designed to save their economies from the obvious dangers of deficits and the rising levels of debt.

Cutting spending levels and the deficit are the policies of choice today. Where, however, are the economic theories that explain, not just why these policies are sensible, but why they are even appearing to work? It’s a slow process to be sure, but governments are getting on top of their debts and are trying to pull down their deficits. And while you would hardly call such policies “popular”, there is general if sullen recognition of the grim necessity that these policies represent. It’s always fun to spend like drunken sailors. It’s not fun having to introduce cuts across a wide swathe of government outlays that have been put in place for some purpose, but there does seem to be at least some appreciation that all of this needs to be done.

The group which has said the least in support of this pulling back of public spending are economists. And the appalling fact is that they just don’t know any better. They have been taught Y = C + I + G with their mother’s milk and they are extremely reluctant to go back on the only macroeconomic organising principle they know. Take away aggregate demand and they are completely lost.

Say’s Law

It was not always thus. Economists and economic theory once knew perfectly well that aggregate demand was of no relevance in understanding the operation of an economy. Certainly for individual products there was supply and demand, but for the economy as a whole there was only supply. If the economy produced what people wished to buy, there was no difficulty in ensuring there would be sufficient demand.

This principle had no name amongst economists until the 1920s. Even then the name given to this principle became known to every economist only when it was included in Keynes’s General Theory as the designated villain within pre-Keynesian economics, which Keynes called “classical economics”, another Keynesian innovation that has stuck. The principle, at least in the garbled version used by Keynes, is referred to as “Say’s Law” and its meaning, also from Keynes, is that “supply creates its own demand”.

So first let me tell you what Say’s Law does not mean and then after that what it does mean. What Say’s Law does not mean is what Keynes said it meant. It does not mean that everything produced is guaranteed to be bought and therefore recessions are impossible.

In the minds of most economists, a return to Say’s Law would be similar to biologists deciding that, come to think of it, evolution by natural selection doesn’t really happen, or for physicists to say that perhaps, after all, e does not equal mc2.

Denying the validity of Say’s Law is as fundamental as you can get. If economists came to the conclusion that this proposition, in spite of generations of vilification, is actually a valid statement of how economies work, just about every macroeconomics textbook in the world would be worthless, since what they have been teaching is not just nonsense but dangerous nonsense.

To come back one last time to that article in the Sydney Morning Herald:

Prof Kates said the response to the crisis had been based on Keynesian economics that backs government intervention to stabilise growth during a downturn in a business cycle.

“The use of Keynesian economics has been one of the great catastrophes for economic theory in the west.”

And a catastrophe not just for economic theory, but for every one of those governments which have followed Keynesian prescriptions to bring their economies out of recession, not to mention those populations who have had to endure the results. Keynesian policies have never worked, not in a single instance. Nevertheless, the theory has remained the guide to policy since it was first introduced. While there was some weakening in acceptance during the great inflation of the 1970s and 1980s, Keynesian macroeconomics remains as entrenched within economic theory as supply and demand.

Say’s Law correctly understood

But here I am made to confront that old economics joke about why there can never be a twenty-dollar bill on the floor, because if there were, someone would already have picked it up.

Because the extraordinary part has been—and you can only imagine how extraordinary I find this—that there has been hardly another economist on the planet who thinks Say’s Law is true. There are probably no more than a handful, and I near enough know every one of them. If there are others, I have never come across anything they have written. This proposition, which seems simplicity itself, accepted by every economist for more than a hundred years up until 1936, is apparently an impassable obstacle in the modern world.

Nor is it as if I and these few others haven’t tried to make the profession see the point. For my own part, I have written books and papers, monographs and articles, but I don’t think I have personally convinced more than a few. So whatever gifts it may take to make this concept understood, I may just not have what’s required. Bear with me anyway, and we will see how we go.

Some history

The issue rose out of a controversy that emerged in England in the midst of the Napoleonic Wars. In 1807, an economist by name of William Spence wrote a book to argue that England, which had been shut out of trade with the continent, had nothing to worry about since to maintain employment, they just had to encourage landowners to stop saving and start spending. Their additional demand would drive the economy along and jobs would be preserved.

The following year, the economist James Mill took it upon himself to respond to Spence and in his reply gave the first unambiguous statement of Say’s Law:

No proposition however in political economy seems to be more certain than this which I am going to announce, how paradoxical soever it may at first sight appear; and if it be true, none undoubtedly can be deemed of more importance. The production of commodities creates, and is the one and universal cause which creates a market for the commodities produced.

The last sentence is strikingly similar to Keynes’s “supply creates its own demand”. But what Mill was arguing was that if there is to be demand at the aggregate level, what must come first is supply. It is production of goods and services, and production alone, which will create a market for other goods and services.

That’s where demand comes from. It comes from supplying what other people want to buy. And if sellers do not supply what others want to buy, that is, if what they produce is not bought, the result is recession. This too is from James Mill in what is more or less a throwaway line since in this discussion the causes of recession were not the issue: “All that here can ever be requisite is that the goods should be adapted to one another.”

Mill is making the point that if purchase and sale are going to increase, each person’s production must be adapted to the wishes of others. It is producing what others want that creates demand. But it was not for another decade before the causes of recession became the central issue.

The General Glut debate

The next staging post in understanding the actual meaning of Say’s Law takes you to what is known in economics as the “General Glut” debate. A glut is excess supply, too much production relative to demand. No one doubts you can have a glut of an individual good or service, too much milk or wheat perhaps, relative to the willingness of buyers to buy everything that had been produced. That is referred to as a “particular” glut, a glut of a particular commodity.

But could you have a “general” glut, that is, too much of everything relative to the willingness of the community to buy the lot at prices that covered their cost of production? A general glut represents demand deficiency across the economy, not enough aggregate demand, as it is described today. The possibility of a general glut was the issue of issues amongst economists for almost thirty years, commencing with the publication of T.R. Malthus’s Principles of Political Economy in 1820.

Malthus had argued that the recessions which followed the end of the Napoleonic Wars had been caused by an absence of demand for output. People had chosen to save rather than spend and, like Spence, he recommended having the landed aristocracy lead the way by supplying the missing demand needed to employ the entire working population. The General Glut debate continued for almost thirty years, at the end of which the entire mainstream of the economics community came to the universal conclusion that demand deficiency was never a valid explanation for recession.

The single most striking and informative statement during the whole of this debate was made by David Ricardo, the greatest economist of his day. In a private letter to Malthus, Ricardo wrote: “Men err in their productions, there is no deficiency of demand.” This is the full, comprehensive and to me anyway, irrefutable evidence that Keynes completely misunderstood what Say’s Law meant. Keynes may have been right about the economics—although by now that’s a very shaky claim—but that he was wrong on what classical economists had believed is undeniable based on what Ricardo wrote as far back as 1820.

What was Ricardo arguing? First, that of course you can have recessions. Second, that the cause of such recessions was errors made by those in business who had been wrong in their decisions on what to produce. Third, whatever else might have caused these recessions, it was not a deficiency of demand.

These are the constituent elements of Say’s Law from a theoretical perspective. It is a refutation of everything found in a modern macro text. For the reasoning you could do worse than to go to James Mill, but the language is more than 200 years old and no longer accessible to an economist today. But if you would like seriously inaccessible, I now turn to John Stuart Mill.

Mill’s Fourth Proposition on Capital

The General Glut debate came to an end with J.S. Mill’s Principles published in 1848. He was writing at the tail end of the debate, so no one at the time was in any doubt about what he was talking about. Right at the beginning of the book, he has what he calls his four “Fundamental Propositions Respecting Capital”, of which the fourth has possibly been the single most difficult statement made in the whole history of economic theory.

At least it’s been difficult since the time of Mill. But what has kept this proposition an evergreen conundrum is a statement made in 1876 by Leslie Stephen. In a two-volume discussion of eighteenth-century thought, out of nowhere Stephen wrote of Mill’s fourth proposition that it is a “doctrine so rarely understood, that its complete apprehension is, perhaps, the best test of a sound economist”. And what was this doctrine? It comes in eight words, although backed by pages of text in Mill: “Demand for commodities is not demand for labour.”

Some of the greatest minds economics has ever produced have had a crack at it but cannot solve what Mill meant. Yet in Mill’s own lifetime there was not a single dissenting voice. Since then, there has been almost total incomprehension. We are talking about discussions that include Alfred Marshall, A.C. Pigou, Friedrich Hayek, Sam Hollander and others. Not one could work out what Mill had meant in a way that didn’t make it seem that he had been prey to some obvious error. Surely, they said, buying shoes creates a demand for shoemakers. But Mill was not discussing an individual market and derived demand. He was discussing the entire economy looked at as a whole.

To others, it seemed Mill had expressed himself badly. Substitute explanations were suggested. You will have to go elsewhere to find Mill’s reasoning. Here we dwell only on his conclusion: the demand for labour cannot be increased by increasing the demand for goods and services. Why Mill thought so has remained a mystery since the 1870s.

But what is not a mystery is that however you might argue the toss, the reality of the world we live in conforms to Mill’s views and not Keynes’s. There have been massive increases in the aggregate demand for commodities that have not translated into an increase in the demand for labour.

Classical economics to a Keynesian has become like another old economics joke: “That’s all right in practice, but will it work in theory?” Well, whatever you want to say, classical theory works in practice, and if you understood the theory, it would work just as well.

Economic theory in practice

There was a time when it looked as if Keynesian economics was finally on its way out. During the 1970s, following the great inflation which ought to have exposed as pure nonsense the idea that spending of itself is good either for employment or economic growth, there was a small-scale retreat from Keynesian economics as a guide to policy. The most famous recantation was provided by Britain’s former Labour Prime Minister, James Callaghan, when he spoke to the Labour Party Conference in 1976:

We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.

This was wisdom hard won but eventually lost. The textbooks remained as they were, still teaching Y = C + I + G. In spite of the massive failures of demand to lift the level of production and employment in the 1970s and 1980s (and in Japan in the 1990s), there it lay in every text, waiting for the next recession when it would be called upon again.

And so an entire generation went by between the 1970s and the coming of recession in 2009. Thirty years later there was almost no memory of anyone in decision-making roles who had seen the problems created by the expenditure of that earlier time. So when the moment came, so too did the decisions, across almost the whole expanse of the world’s economies, to apply a stimulus to short-circuit recession.

Almost any economy could be chosen to hold up as an example of the failure of policy, but the moribund American economy had the best-known stimulus, which has been followed by its worst recovery since the Great Depression. Rather than the American economy having returned to any kind of robust condition, it has continued to sink. The recession may have officially ended in June 2009, but there has been no improvement in the labour market, while economic activity continues to stagnate.

Evidence is hardly needed, since no one pretends that the US economy has turned the corner. And even with the pumping of money into the economy hand over fist (a disastrous idea that will come back to haunt the American economy, as well as the rest of us, for years to come), the American economy continues to flounder.

Which economy today is not in a similar boat? No economy anywhere can be said to be performing at full throttle. Keynesian economic theory is therefore quietly being set aside.

L’offre crée même la demande

What ought to be, but won’t be the final epitaph for Keynesian economics has been spoken by the French President, François Hollande, in January this year. I will provide the words first in French, because they need to be seen to be believed, and then in translation:

Le temps est venu de régler le principal problème de la France: sa production. Oui, je dis bien sa production. Il nous faut produire plus, il nous faut produire mieux. C’est donc sur l’offre qu’il faut agir. Sur l’offre! Ce n’est pas contradictoire avec la demande. L’offre crée même la demande.

This is the socialist President of France quoting Say’s Law with approval. The words in bold italics are Hollande’s version of Keynes’s version of Say’s Law. This is the passage in my free translation:

The time has come to work through the number one problem in France: which is production. Yes, that’s what I said, production. We must produce more, we must produce better. Hence, it is upon supply that we must concentrate. On supply! This is not in opposition to demand. Supply really does create demand.

Perhaps it is easier for a President of France to speak well of Say’s Law, since Jean-Baptiste Say was the greatest French economist of the early nineteenth century, a contemporary of James Mill and Ricardo, who had opposed Malthus, possibly more strongly than any other economist of his time.

Will Hollande’s declaration, in company with the incredible failures of the stimulus, finally do the trick? I am no longer as optimistic as I once was, although you would think that the failures of the Keynesian stimulus are becoming too obvious to ignore.

Yet the attacks by the mainstream on Hollande for his entirely sensible statement have been astonishing. How it is possible not to understand that demand is created by supply is beyond me. But then I have been saying the same for years, even while this commonsense and logical proposition has been, with some honourable exceptions, denied across the board.

Say’s Law and policy

How, then, is policy different if Say’s Law is true? It starts from recognition that not only is it production alone that creates demand, but that this production must be value-adding. A Keynesian policy starts from the belief that it literally does not matter what the spending is on. Just spend and things will take care of themselves. Since the problem of under-employment and slow growth to a Keynesian is too much saving, the most urgent need, especially during recessions, is to put those savings to use. So if you look at the various stimulus programs found everywhere, you could hardly pretend they were a careful use of money. Money was spent with wild abandon.

The core understanding that comes with Say’s Law is that supply has to be value-adding if it is to create jobs and strong growth. Every dollar of spending draws down on existing resources. Even producing paperclips uses up resources. Paperclip production may create value, but the resources that were used up also had value. The labour, capital and whatever else required was used in this way and not some other way. Only if the value of what was produced was greater than the value of the resources used up could it be said production had been value-adding.

In sharp contrast to the private sector, where firms will go out of business if revenues do not cover costs, government spending is almost never value-adding. Perhaps the most productive 10 to 15 per cent, but not the rest. That is not of itself an argument against public spending. But it is an argument against thinking that when governments spend they are necessarily helping the economy grow. They almost never are.

The belief that public spending is good for growth is the largest fallacy associated with modern macroeconomic theory. Being unable to tell the difference between welfare and wealth creation is possibly Keynes’s most lasting legacy, a legacy which has been poisoning public policy since the 1930s.

Dr Steven Kates is Associate Professor of Economics at RMIT University in Melbourne. The book to read to get a better insight into these issues is his introductory text, Free Market Economics: An Introduction for the General Reader (Edward Elgar, 2011).


One thought on “Keynesian Economics’ Dangerous Return

  • Geoffrey Luck says:

    Keynesian economics has now been completely discredited – and Say’s Law validated. My wife found a $20 note on the floor in the Macquarie Shopping Centre the other day.

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