Skousen The Big Three in Economics - Smith, Marx, Keynes (Sharpe, 2007)

178 THE BIG THREE IN ECONOMICS

[1936], 207). The man who first countered the liquidity-trap doctrine wasArthur C. Pigou, ironically the straw man Keynes vilified in The General Theory. In a series of articles in the 1940s, Pigou said that Keynes overlooked a beneficial side effect of a deflation in prices and wages: deflation increases the real value of cash, Treasury securities, cash-value insurance policies, and other liquid assets of individuals and business firms. The increased value of these liquid assets raises aggregate demand and provides the funds to generate new buying power and hire new workers when the economy bottoms out (Pigou 1943,1947).Thispositiverealwealtheffect,orwhatIsraelieconomist Don Patinkin later named the “real balance effect” in his influential Money,InterestandPrices(1956),didmuchtounderminetheKeynesian doctrine of a liquidity trap and unemployed equilibrium.

The Pigou “wealth” or “real balance” effect can also be extended to the issue of wage cuts during a downturn. Keynes rejected the classical argument that wage cuts are necessary to adjust the economy to new equilibrium conditions, from which a solid recovery could occur. Arguing against the conventional view that persistent unemployment is caused by excessive wage rates, Keynes claimed that wage cuts would simply depress demand further and do nothing to reduce unemployment. But Keynes and his followers confused wage rates with total payroll. Facing a recession and widespread unemployment, business leaders recognize that a reduction in wage rates can actually boost net employment and total payroll. Cutting wages allows firms to hire more workers at the bottom of a slump. When the economy bottoms out, well-managed companies begin hiring more workers at low wages, so that even though the wage rate remains low, the total payroll increases, and thus puts the economy back on the road to recovery (Hazlitt 1959, 267–69; Rothbard 1983 [1963], 46–48).

Growth Data Contradict Antithrift Doctrine

Economic historians had serious doubts almost immediately about the Keynesianantipathytowardsaving,whichhasalwaysbeenconsidered a key ingredient to long-term economic growth. They point especially toEuropeanandAsiancountries,suchasGermany,Switzerland,Japan, and Southeast Asia, whose growth rates have benefited tremendously from high rates of saving during the postwar period. Nobel laureate

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 179

Figure 6.4 Connection Between Growth and Savings Rates

25%

Japan

					O.E.C.D. Norm
				Italy			20
	W. Germany							RATE
			Canada
							15	SAVINGS
				France
	Britain		U.S.				10
							5
1	2	3	4	5	6	7	8%

GROWTH

(Compound annual growth in per capita disposable income)

(Personal savings % of disposable income)

Source: Franco Modigliani (1986: 303).

Reprinted by permission of The Nobel Foundation.

FrancoModigliani,aswellastoptextbookwriterCampbellMcConnell, bothKeynesians,haverecognizedthedirectrelationshipbetweensaving rates and economic growth. For example, the graph in Figure 6.4 was included in Franco Modigliani’s Nobel Prize paper in 1986.

Historically,theevidenceisoverwhelming:highersavingrateslead to higher growth rates–just the opposite of the standard Keynesian prediction.As one recent Keynesian textbook declared after teaching students about the paradox of thrift: “The fact that governments do not discourage saving suggests that the paradox of thrift generally is not a real-world problem” (Boyes and Melvin 1999, 265).

But then why teach the paradox of thrift at all? Not only is it historically unproved, but it is fundamentally flawed. The problem is that Keynesians treat savings as if it disappears from the economy, that it is simply hoarded or left languishing in bank vaults, uninvested. In reality, saving is simply another form of spending, not on current

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consumption, but on future consumption.The Keynesians stress only thenegativesideofsaving,thesacrificeofcurrentconsumption,while ignoring the positive side, the investment in productive enterprise. As noted in chapter 4, the Austrian economist Eugen Böhm-Bawerk stressed the positive side of saving: “For an economically advanced nation does not engage in hoarding, but invests its savings. It buys securities, it deposits its money at interest in savings banks or commercial banks, puts it out on loan, etc.” (1959 [1884], 113).

Saving Has a Multiplier, Too!

Saving is in fact a better form of spending because it offers a potentially infinite payoff in future productivity (thus Franklin’s refrain, “A penny saved is a penny earned”). If the public saves more generally, the pool of savings enlarges, interest rates decline, old equipment is replaced, and more research and development, new technology, and new production processes evolve.The future benefits are incalculable. Meanwhile, funds spent on pure consumer goods are used up within a certain period, or depreciated over time.

TheKeynesianmultiplier(k)ishigherasthepublicconsumesmore. But proponents assume that the savings remain uninvested—a false assumption under normal conditions. In truth, both components of income—consumption and savings—are spent. Thus, the multiplier

(k) is infinite! The saving component also has a multiplier effect in the economy as it is invested in the intermediate production stages. Moreover, the savings k is theoretically more productive than the consumption k because it is not used up as fast.

Going back to Samuelson’s hydraulic model (Figure 6.2), saving does not leak out of the system, but goes back into the system to improve the factors of production (land, labor, and capital) through new technology,education,andtraining.Figure 6.5 demonstrates how saving, consumption, and the economy really operate.

The Ekins diagram in Figure 6.5 is what Samuelson should have publishedovertheyearsinhistextbookinsteadofthehydraulicmodel. In this chart, the ultimate purpose of economic activity is to provide increasing utility. Note how in the diagram, consumption is used up. It is consumption—not saving—that “leaks” out and is consumed as utility. Saving, on the other hand, is invested back into the economic

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 181

Figure 6.5 The Growth Model Driven by Saving/Investment (Paul Ekins)

Utility/Welfare

Factors of Production

	Improvement	Land
				Consumption
	Educaton	Labour	Economic	Goods and
	Training		Process	Services
	Machines	Physically Produced
	etc.	Capital
				Investment

Source: Ekins and Max-Neef (1992: 148). Reprinted by permission of Routledge.

processoverandoveragain,facilitatingnewinvestmentandimproving our standard of living (utility/welfare). An amazing contrast.

A Critical Flaw in the Keynesian Model

The central problem with the Keynesian model is that it fails to comprehend the true nature of the production-consumption process. The Keynesian system assumes that the only thing that matters is current demand for final consumer goods—the higher the consumer demand, the better. Despite talk that Keynes is dead, this Keynesian preoccupation with consumer demand is almost universally accepted in the establishment media today. For example, Wall Street monitors retail sales figures to determine the direction of the economy and the markets. They seem to be disappointed if consumers don’t spend enough—as if they want the Christmas season to last all year!

Yet is consumer spending the cause or the effect of prosperity? If everyone went on a buying spree at the local department store or grocery store, would investment in new products and technology expand? Certainly investment in consumer goods would expand, but increased expendituresforconsumergoodswoulddolittleornothingtoconstruct

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a bridge, build a hospital, pay for a research program to cure cancer, or provide funds for a new invention or a new production process.

Accordingtobusiness-cycleanalysts,retailsalesandothermeasures ofcurrentconsumerspendingarelaggingindicatorsofeconomicactivity.Almost all of the components of the U.S. Commerce Department’s Index of Leading Economic Indicators are production and investment oriented,forexample,contractsandordersforplantequipment,changes inmanufacturingandtradeinventories,changesinrawmaterialprices, and the stock market, which represents long-term capital investment (Skousen 1990, 307–12). Typically in a business cycle, consumption starts declining after the recession has already started; similarly, consumer spending picks up after the economy begins its recovery stage.

This myth of a consumer-driven economy persists in part because of a misunderstanding of national income accounting.The media fre- quentlyreportthatconsumerspendingaccountsfortwo-thirdsofGDP. Recall that GDP = C + I + G, and typically in the United States:

C= 70 percent

I= 12 percent

G= 18 percent

Therefore, the media conclude that, since consumption accounts for approximately two-thirds of GDP, the economy must be consumer-driven.

Not so. GDP is defined as the value of all final goods and services produced in a year. It ignores all intermediate production in the economyatthewholesale,manufacturing,andnatural-resourcestages. If one measures spending at all levels of production, the results are surprisingly different.

I have created a national income statistic called gross domestic expenditures (GDE), which measures gross sales at all stages of production.3 Using this new, broader definition of total spending in the economy,itbecomesapparentthatconsumptionrepresentsonlyabout

3. See Skousen (1990, 185–92) for details of this new statistic. Recently, the U.S. Department of Commerce has developed a new statistic called “gross output” that approaches my GDE (although it leaves out gross wholesale and retail figures). SeeTable8inU.S.DepartmentofCommerce,“GrossOutput byIndustry,1987–98,”

Survey of Current Business (2000), p. 48.

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 183

one-third of economic activity, and that business spending (investment plus goods-in-process spending) accounts for more than half of the economy. Thus, business investment is far more important than consumer spending in the United States (and in most other nations).

The Keynesian macroeconomic model suffers from the defect of oversimplification—it assumes only two stages, consumption and investment, and it assumes that investment is a direct function of current consumptiononly.Ifcurrentconsumptionincreases,sowillinvestment, and vice versa.

How the Economy Really Works

William Foster and Waddill Catchings committed this same error. As Hayek pointed out in his critique of the Foster-Catchings debate, investment is actually multistaged and changes form and structure when interest rates rise or fall. Investment is not simply a function of current demand, but of future demand; both long-term and short-term interest rates influence investment and capital formation (Hayek 1939 [1929]). For example, suppose the public decides to save more of their income for a better future. Spending for cars, clothing, entertainment, andotherformsofcurrentconsumptionmightlevelofforevenfall.But thistemporaryslowdowninconsumptiondoesnotcauseabroad-based recession. Instead, the increased savings leads to lower interest rates, whichencouragebusinesses,especiallyincapital-goodsindustriesand research and development, to expand operations. Lower interest rates mean lower costs. Businesses can now afford to upgrade computers and office equipment, construct new plants and buildings, and expand inventories. Lower interest rates can even reverse the slowdown in car sales by offering cheaper financing to prospective car buyers. Contrary to the dire predictions of the Keynesians, an increase in the propensity to save pays for itself. It does not lead to a “recession and poverty for all” (Baumol and Blinder 1988, 192). Only the structure of production and consumption changes, not the total amount of economic activity.

An Example: Building a Bridge

A hypothetical example could be useful in reinforcing the benefits of increased savings. Suppose St. Paul and Minneapolis are separated

184 THE BIG THREE IN ECONOMICS

by a river and that the only transportation between the two cities is by barge. Travel between the twin cities is expensive and time-con- suming. Finally, the city fathers call a meeting and decide to build a bridge. Everyone agrees to cut back on current spending and put their savings to work to build the bridge. In the short run, retail sales, employment, and profits in local department stores decline.Yet new workers and new investment funds are assigned to the building of the bridge. In the aggregate, there is no reduction in output and employment. Moreover, once the bridge is completed, the twin cities benefit immenselyfromlowertravelcostsandincreasedcompetitionbetween St. Paul and Minneapolis. In the end, the twin cities’sacrifice has been transformed into a higher standard of living.

Say’s Law Redux: Production Is More Important

Than Consumption

In essence, the Keynesian demand-driven view of the economy fails to recognize another force that is even stronger than current demand—the demand for future consumption. Spending money on current consumer goods and services will do nothing to change the quality and variety of goods and services of the future. Such change requires new savings and investment.

Thus, we return to the truism of Say’s law: Supply (production) is more important than demand (consumption). Consumption is the effect, not the cause, of prosperity. Production, saving, and capital formation are the true cause.

KeynescreatedanotherstrawmaninTheGeneralTheory.Thestraw man was J.-B. Say and his famous law of markets. Steven Kates calls The GeneralTheory “a book-length attempt to refute Say’s Law.” But to do this, Keynes gravely distorted Say’s law and classical economics in general. As Kates disclosed in his remarkable Say’s Law and the Keynesian Revolution, “Keynes was wrong in his interpretation of Say’s Law and, more importantly, he was wrong about its economic implications” (Kates 1998, 212). In the introduction to the French edition of The General Theory, published in 1939, Keynes focused on Say’s law as the central issue of macroeconomics. “I believe that economics everywhere up to recent times has been dominated . . . by the doctrines associated with the name of J.-B. Say. It is true that his

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 185

‘law of markets’ has long been abandoned by most economists; but they have not extricated themselves from his basic assumptions and particularly from his fallacy that demand is created by supply. . . .

Yet a theory so based is clearly incompetent to tackle the problems of unemployment and of the trade cycle” (1973a [1936], xxxv).

Unfortunately, Keynes failed to understand Say’s law. He incorrectly paraphrased it as “supply creates its own demand” (1973a [1936], 25), a distortion of the original meaning. In effect, Keynes altered Say’s law to mean that everything produced is automatically bought. Hence, according to Keynes, Say’s law cannot explain the businesscycle.Keynesfalselyconcluded,“Say’sLaw...isequivalent to the proposition that there is no obstacle to full employment” (26). Interestingly, Keynes never quoted Say directly, and some historians have thus surmised that Keynes never read Say’s actual Treatise, relying instead on Ricardo’s and Marshall’s comments on Say’s law of markets. (For a detailed discussion of Say’s law, see chapter 2 of this book.) Keynes went on to say that the classical model under Say’s law “assumes full employment” (15, 191). Other Keynesians have continued to make this point, but nothing could be further from the truth. Conditions of unemployment do not prohibit production and sales from taking place that form the basis of new income and new demand.

Say actually used his own law to explain recessions.As such, Say’s law specifically formed the basis of a classical theory of the business cycle and unemployment.As Kates states, “The classical position was that involuntary unemployment was not only possible, but occurred often, and with serious consequences for the unemployed” (Kates 1998, 18).

Say’s law concludes that recessions are not caused by failure of the level of demand (Keynes’s thesis), but by failure in the structure of supply and demand. According to Say’s law, an economic slump occurswhenproducersmiscalculatewhatconsumerswishtobuy,thus causing unsold goods to pile up, production to be cut back, workers to be laid off, income to fall, and finally, consumer spending to drop.As Kates elucidates, “Classical theory explained recessions by showing how errors in production might arise during cyclical upturns which would cause some goods to remain unsold at cost-covering prices” (1998, 19). The classical model was a “highly-sophisticated theory

186 THE BIG THREE IN ECONOMICS

of recession and unemployment” that was “obliterated” with one fell swoop by the illustrious Keynes (Kates 1998, 20, 18).4

Keynes’s Nemesis

On one point Keynes was right: Say’s law is Keynes’s nemesis. It specifically refutes Keynes’s basic thesis that a deficit in aggregate demand causes a recession and that artificially stimulating consumer spending through government deficits is a cure for depression. To quote Kates, “Say clearly understood that economies can and do enter prolonged periods of economic depression. But what he was at pains to argue was that increased levels of unproductive consumption are not a remedy for a depressed level of economic activity, and contribute nothing to the wealth creation process. Consumption, whether productive or unproductive, uses up resources, while only productive consumption is capable of leaving something of an equivalent or even higher value in its place” (1998, 34).

Let us return to Samuelson’s model of income determination—the Keynesian cross he invented to represent unemployment equilibrium (see Figure 6.1). We see now that saving and investment do not involve two separate schedules at all. Except in extreme circumstances, savings are invested. As income increases, savings and investment both increase together. Thus, there is no intersection of S and I at a single point and therefore no determination of macro equilibrium. The Keynesian cross crumbles under its own weight.

The Inflationary Seventies: Keynesian Economics on the Defensive

Experience is often a far greater teacher than high theory. While the theoreticalbattleoverKeynesianeconomicsensuedduringthepostwar era, no event raised more doubts about the Keynes-Samuelson model than the inflationary crises of the 1970s, when oil and commodity

4. In his broad-based book, Kates highlights other classical economists, including David Ricardo, James Mill, Robert Torrens, Henry Clay, Frederick Lavington, andWilhelm Röpke, who extended this classical model of Say’s law. Many classical economists focused on how monetary inflation exacerbated the business cycle.

A TURNING POINT IN TWENTIETH-CENTURY ECONOMICS 187

Figure 6.6 The Phillips Curve Trade-Off Between Inflation and Full

Employment

Annual Price Rise (percent)

TRADE-OFF BETWEEN INFLATION

AND FULL EMPLOYMENT

∆ P/P

∆ W/W

+6

+9

+5

+8

+4

Phillips Curve

+7

+3

+6

+2

+5

+1

+4

0

+3

–1

1

2

3

4

5

6

7

8

+2

–2

Annual Wage Rise (percent)

Source: Samuelson (1970: 810). Reprinted by permission of McGraw-Hill.

prices skyrocketed while industrial nations roiled in recession. Under standard Keynesian analysis of aggregate demand, inflationary recession was not supposed to happen.

Keynesians relied heavily on the Phillips curve, a concept popularized in the 1960s and based upon empirical studies on wage rates and unemployment conducted in Great Britain by economistA.W. Phillips (1958). Many economists were convinced that there was a trade-off betweeninflationandunemployment.ReproducinganidealizedPhillips trade-offcurve(seeFigure6.6),Samuelsondescribedthe“dilemmafor macro policy”: if society desires lower unemployment, it must be willing to accept higher inflation; if society wishes to reduce the high cost of living, it must be willing to accept higher unemployment. Between thesetwotoughchoices,Keynesiansconsideredunemploymentamore serious evil than inflation (Samuelson 1970, 810–12).

But in the 1970s and 1980s, the idealized Phillips trade-off fell apart—Western nations found that higher inflation did not reduce unemployment, but made it worse. The emergence of an inflationary recession and the collapse of the Phillips curve caused economists to question for the first time their textbook models. In their search for alternative explanations, a sudden renaissance of new economic theories arose—from Marxism to Austrian economics.