The Dangerous Persistence of Keynesian Economics

OUTSIDE the United States, no economy has fully recovered from the downturn that followed the Global Financial Crisis in 2008-09. The crisis came and went in half a year, but just about every economy continues to have problems generating growth, increasing employment and raising real incomes. As I was writing my article on “The Dangerous Return to Keynesian Economics” in 2009, I commenced working on an economic textbook, now in its third edition, to explain why modern macroeconomic theory is utterly useless, why no one using these economic models as a guide to policy would ever succeed. And here we are, ten years later, and everything discussed in that earlier article, explained in far more detail, has come to pass.

This essay appears in the March edition of Quadrant.
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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, Quadrant, March 2009
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?
—Question to Steven Kates from Senator Doug Cameron, Senate Economic References Committee, September 21, 2009


Why did I get it so right? Because nearly everyone else thinks economies are made to grow through increases in demand, while in reality, as was once universally understood, economies can only be made to grow through improvements in supply-side conditions. Demand has absolutely nothing to do with making an economy grow. Demand of course is crucial to how many units of any particular good or service will sell, but has nothing whatsoever to do with how fast an economy in total will grow, or how many workers will be employed. The underlying principle is known as “Say’s Law”, which since 1936 has been the grand villain of economic theory.

Say’s Law

The following were the opening paragraphs of my 2009 article, published exactly ten years ago.

* * *

The Great Depression, in most places, began with the share market crash in 1929 and by the end of 1933 was already receding into history. In 1936, well after the Great Depression had reached its lowest point and recovery had begun, a book was published that remains to this day the most influential economics treatise written during the whole of the twentieth century.

The book was The General Theory of Employment, Interest and Money. The author was John Maynard Keynes. And his book overturned a tradition in economic thought that had already by then stretched back for more than a hundred years.

The importance of these dates is important. The economics which Keynes’s writings had overturned is today called “classical theory”, yet it was the application of this self-same classical theory that had brought the Great Depression to its end everywhere but in the United States, where something else was tried instead. And at the centre of classical thought was a proposition that Keynes made it his ambition to see disappear absolutely from economics. It was an ambition in which he was wildly successful.

Following a lead set by Keynes, this proposition is now almost invariably referred to as Say’s Law. It is a proposition that since 1936 every economist has been explicitly taught to reject as the most certain obstacle to clear thinking and sound policy. Economists have thus been taught to ignore the one principle most necessary for understanding the causes of recessions and their cures. Worse still, they have been taught to apply the very measures to remedy downturns that are most likely, from the classical perspective, to push them into an even steeper downward spiral …

Keynes wrote that Say’s Law meant that “supply creates its own demand”. In his interpretation of this supposedly classical proposition, everything produced would automatically find a buyer. Aggregate demand would always equal aggregate supply. Recessions would therefore never occur and full employment was always a certainty. That economists have accepted as fact the proposition that the entire mainstream of the profession prior to 1936 had believed recessions could never occur when in fact they regularly did shows the power of authority in allowing people to believe three impossible things before breakfast.

But what was important were the policy implications of Keynes’s message. These may be reduced to two. First, the problem of recessions is due to a deficiency of aggregate demand. The symptoms of recession were its actual cause. And then, second, an economy in recession cannot be expected to recover on its own, and certainly not within a reasonable time, without the assistance of high levels of public spending and the liberal use of deficit finance.

The missing ingredient in classical economic theory, Keynes wrote, had been the absence of any discussion of aggregate demand. It was this missing ingredient that Keynes made it his mission to put in place.

* * *

No economy at any time in history has had a recovery occur as a result of an increase in aggregate demand. Not one, not ever. Yet the same Keynesian nonsense remains the staple across the entire economics profession, taught to this very day and in virtually every mainstream text as the basis for understanding what must be done to lift an economy out of recession.


Supply-side economics

What does work are measures that allow and encourage businesses to produce, employ and invest. Many changes can lead to these outcomes: lower taxes, less-onerous regulations, reduced public spending, increased competition. Anything that transfers resources into the hands of the most productive entrepreneurs and allows profits to be earned will do the trick. These are the policies that were at the heart of the economic policies adopted by Ronald Reagan in the 1980s and are the self-same policies adopted today by Donald Trump. Larry Kudlow, Trump’s principal economic advisor, said on January 4 this year, following the release of a series of economic indicators showing an unmistakeable return to rapid rates of growth in the American economy and a large increase in employment:

I just want to note that we are in a boom. We had this blockbuster jobs number today. There is no inflation. There is no inflation. More growth, more people working does not cause inflation.

These old Federal Reserve models are outdated and have proven to be incorrect. Right now the inflation rate is probably less than one and a half percent even while unemployment is low and jobs are soaring and we are growing at three per cent …

This is supply side revolution. We’re creating more goods and services. We’re increasing the capital stock and business investment and that’s what creates incomes and jobs.

I’m sure you remember Jean-Baptiste Say. He wrote in the early part of the nineteenth century. He was a French economic philosopher …

Say’s Law: supply creates its own demand. This is not government spending from the demand side, this is lower tax rates from the supply side, and it is businesses that ultimately drive the economy.

I would like Jay Powell [the Chairman of the US Federal Reserve] to hear that argument from President Trump, who knows the argument very well … 

The principles that underpin Say’s Law are explicitly recognised as having made the difference. And in spite of what is believed by just about every economist today, it is not possible to understand the nature of recession and the business cycle unless one has first understood the principles behind Say’s Law.


Classical theory of the cycle

Since the start of the Industrial Revolution, there have been periodic episodes when an economy in full flight has suddenly found itself in the midst of a downturn, with an abnormally large number of businesses closing and many more workers than usual losing their jobs. In even the best of times businesses close and workers lose jobs, but in a downturn the number of business closures and the number of workers becoming unemployed rapidly rise.

Eventually, four phases of the cycle were recognised. These phases could be listed in any order since each phase leads into the next; but begin with the most dramatic moment, the crisis, when, almost out of the blue, the economy suddenly falls apart. Things had been brewing for a while, but beneath the surface. And then, seemingly from nowhere, businesses are closing and employees are being let go. There is wholesale panic, during which uncertainty grows and the future looks black.

The crisis lasts a few months at most, after which disintegration comes to an end, those businesses doomed to close have closed, while most of those employees who will lose their jobs have lost those jobs. Conditions settle at a lower level of activity but at least things are no longer getting worse. The economy has entered into the next phase of the cycle, the period of recession.

Recessions are periods when those who have seen their businesses close, or their jobs disappear, begin finding other ways to earn their living. These losses represent a small proportion of firms and jobs across the economy, but they cause anxiety everywhere since no one can know who might be affected next.

The lost jobs represent lost incomes and can cause serious hardship. The lost businesses also leave their proprietors without an income, and they often find themselves facing a mountain of debt. Looked at from the perspective of the economy as a whole, the downturn represents a major loss in productive activity and a fall in the real level of output.

Eventually, as time goes by, after perhaps a year, a trough is reached where the economy is at the lowest point. From that point the recovery commences.

The recovery phase is what most people think of as “normal”, being the way most people would like to see an economy work. And this is the way an economy does work most of the time. New businesses open while others expand. Employment levels rise so that if a job is lost in one place another is soon found somewhere else. Real incomes pick up, with stability the apparent reality.

But eventually at some stage, the economy reaches another crisis, when again, apparently out of the blue, the entire cycle repeats itself: crisis-recession-trough-recovery. All with this added feature: the level of real incomes at the end of each recovery phase is higher than it had been at the peak of the previous recovery.


Why is there a cycle?

Why is there a business cycle at all? Why is it that in some years the economy is bursting at the seams, and in others business conditions are dead? It is obvious enough that in bad times there is less demand for the goods and services produced while in good times demand is growing and businesses can hardly keep up. But while increased demand may seem to be driving the economy forward, one should never confuse the symptoms for the cause.

What triggers the eventual downturn is that a larger proportion of businesses than usual find they are producing goods and services that cannot be sold at prices that cover production costs. Not all businesses; not even most businesses. But more businesses than usual find themselves unable to earn a profitable return on the goods and services they put up for sale.

If during a normal year, let us say 15 per cent of firms find themselves forced to close, then during a crisis the proportion may have risen to 20 per cent, so that suddenly an untypically large number of firms find themselves closing and many more individuals than usual find themselves out of work.The structure of supply—the actual composition of goods and services produced—is no longer synchronised with the structure of demand—the composition of goods and services buyers wish to buy with the incomes they have. It is not the level of demand that matters but its structure.

And then, beyond that, the initial downturn in activity creates so much additional uncertainty that fewer business are commenced, while existing businesses that might in normal times have expanded, not only slow their operations but halt further expansion. Their owners wait till things clear up, contracting even further the number of jobs created and the flow of output onto the market.

And beyond even that, the flow of credit not only seizes up, but the demand for funding intensifies among firms failing to sell as much as they had expected. Thus, just as the demand for funds increases, the supply of funding recedes. Eventually, there is a revival of entrepreneurial interest in production and growth, and in the willingness of those with funds to increase their lending. Recovery gathers momentum and continues until something once again brings this upturn to a halt.


The dynamics of the GFC

The Global Financial Crisis was an absolutely classical recession in every respect. In no sensible way could the GFC be described using a Keynesian macro model. What did not happen is that collectively across the world buyers decided they no longer needed to buy as much as they previously were buying and had chosen to save instead. A Keynesian explanation for the GFC is an absurdity.

What did happen was that a structural imbalance in the American economy led to a financial meltdown across the world. The American economy was being driven by its housing market, which was itself being driven by the supply of credit. Here is the Wikipedia explanation, as standard a depiction of the events as one could find:

The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally … The European debt crisis, a crisis in the banking system of the European countries using the euro, followed later …

The precipitating factor for the Financial Crisis of 2007–2008 was a high default rate in the United States subprime home mortgage sector—the bursting of the “subprime bubble”.

For a variety of reasons, the housing market in the United States had been force-fed with borrowed funds to such an extent that an almost inevitable failure was locked in. When the underlying credit conditions fell apart, there was a collapse in the house-construction sector, followed by a fall in those sectors that supplied material to the housing sector, and then a further fall in demand for the goods and services previously purchased by those who had been employed in the housing sector, and then the secondary and tertiary effects on all purchases and sales across the economy.

At the same time, the supply of credit to all industries evaporated. No one knew who would be affected next so that even as the desire for finance intensified, the willingness to lend came to an almost complete halt.

The absolute necessity to turn the economy around was, first, to recognise the housing sector had been over-extended and needed to contract, while measures had to be taken to restore confidence in credit markets. The one absolute not required was a public-sector stimulus to try to revive the economy in the midst of a period of profound structural change. Which brings us back to this from 2009, already quoted above:

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.

Of course, living in the Keynesian world as we do, the only thought in the minds of policy-makers everywhere was to pursue a fiscal stimulus. Public spending was the near-universal response, with the near-universal consequence that economies across the world have continued to struggle.

One might argue whether our economies have been in “recession” for the past decade,  but there is no denying that the contours of the post-crisis recovery phase have been generally dismal. Nowhere had there been the kind of rapid upturn that normally follows a downturn. The crisis came and went, economies around the world settled into a prolonged period of growth below their long-term average, real incomes never recovered, and aside from the United States, the unemployment rate has never returned to levels common before the onset of the GFC.


The business cycle described

To bring home how much has been lost through the advent of Keynesian theory, I will end with a discussion of the sixth chapter of Walter Bagehot’s 1873 book Lombard Street, whose subtitle was, A Description of the Money Market.  Chapter Six is a discussion of the business cycle in exactly the same terms described above.

Bagehot begins by asking why there is a cycle at all. He answers by providing two basic principles that underpin the performance of an economy. The second is particularly important, focusing on the need for the structure of supply to conform to the structure of demand. Businesses must find buyers for the specific goods and services they are trying to sell.

First. That as goods are produced to be exchanged, it is good that they should be exchanged as quickly as possible.

Secondly. That as every producer is mainly occupied in producing what others want, and not what he wants himself, it is desirable that he should always be able to find, without effort, without delay, and without uncertainty, others who want what he can produce.

How do these principles matter?

Taken together, they make the whole difference between times of brisk trade and great prosperity, and times of stagnant trade and great adversity … If they are satisfied, everyone knows whom to work for, and what to make, and he can get immediately in exchange what he wants himself. There is no idle labour and no sluggish capital in the whole community, and, in consequence, all which can be produced is produced, the effectiveness of human industry is augmented, and both kinds of producers—both capitalists and labourers—are much richer than usual, because the amount to be divided between them is also much greater than usual.

That is, if the structure of supply and demand conform, the economy just keeps ticking over. However, once a recession begins, where the structure of supply no longer conforms to the structure of demand, the effects cannot be contained.

There is a partnership in industries. No single large industry can be depressed without injury to other industries; still less can any great group of industries. Each industry when prosperous buys and consumes the produce probably of most (certainly of very many) other industries.

The downturn can begin in any industry with further repercussions across the economy:

A great calamity to any great industry will tend to produce [wide consequences], but the fortunes of the industries on which the wages of labour are expended are much more important than those of all others, because they act much more quickly upon a larger mass of purchasers … And far from its being at all natural that trade should develop constantly, steadily, and equably, it is plain, without going farther, from theory as well as from experience, that there are inevitably periods of rapid dilatation, and as inevitably periods of contraction and of stagnation.

There is one additional factor. In the passage below, let me note, I have changed the words from “a good state of credit” to a “bad state”, then adjusted the remainder of the passage to conform to the point being made:

Credit—the disposition of one man to trust another—is singularly varying. In England, after a great calamity, everybody is suspicious of everybody … In a bad state of credit, goods lie on hand a much longer time than when credit is good; sales are slower; intermediate dealers borrow with difficulty to augment their trade, and so fewer and fewer goods are more slowly and less easily transmitted from the producer to the consumer.

The same description and analysis of the business cycle are found throughout the nineteenth century and into the twentieth, but then, with the publication of The General Theory, they vanished. And with the disappearance of the theory, recognition that public spending cannot bring a recession to an end has also disappeared. This was the “Treasury View”, the universally accepted conclusion among the entire economics discipline during pre-Keynesian times: public spending would never lead to an upturn in employment. The quote below is a discussion of Winston Churchill’s budget speech in May 1929, delivered well before the Great Depression began that October:

Churchill pointed to recent government expenditure on public works such as housing, roads, telephones, electricity supply, and agricultural development, and concluded that, although expenditure for these purposes had been justified:

“For the purposes of curing unemployment the results have certainly been disappointing. They are, in fact, so meagre as to lend considerable colour to the orthodox Treasury doctrine which has been steadfastly held that, whatever might be the political or social advantages, very little additional employment and no permanent additional employment can in fact and as a general rule be created by State borrowing and State expenditure.”

Nothing has changed, other than the belief among economists that public sector spending will create jobs. It won’t, just as it never has, just as it will not create jobs in the future when the next economic crisis eventually occurs, as it inevitably must.

Steven Kates is Adjunct Associate Professor of Economics at RMIT University in Melbourne. In his book Free Market Economics (published by Edward Elgar), now in its third edition, all of the above is discussed in greater detail.


3 thoughts on “The Dangerous Persistence of Keynesian Economics

  • patternedrose says:

    Also, how about a brief exposition on the adjustment problems to changes in taste, technology, expectations, whatever. E. O. Heady wrote about asset fixity and labour immobility in agriculture around 1950/60’s in “Amer. J. Agric. Econ.” and it’s highly relevant to the general economy.

  • ianl says:

    Keynes’ doctrines persist because at least half the population are completely addicted to the notion of free money.

    Keynes understood the short-termism of this: “In the long run, we are all dead”.

    No rational argument or discourse can overcome this. Collapse may occur but this will not overcome the addiction.

  • Bwana Neusi says:

    Factor in the ‘Paradox of Thrift’ and its multiplier of “things look bad, we will put of unessential purchases”

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