The Essence of Keynesian Economics

The following is an excerpt from a speech/keynote address by Dr. Richard Ebeling (hat tip Bob Wenzel) [bold emphasis mine, italics original]

The General Theory of Employment, Interest and Money was published on February 4, 1936. The essence of Keynes’s theory was to show that a market economy, when left to its own devices, possessed no inherent self-correcting mechanism to return to “full employment” once the economic system has fallen into a depression.

At the heart of his approach was the belief that he had demonstrated an error in Say’s Law. Named after the nineteenth-century French economist Jean-Baptiste Say, the fundamental idea is that individuals produce so they can consume. An individual produces either to consume what he has manufactured himself or to sell it on the market to acquire the means to purchase what others have for sale.

Or as the classical economist David Ricardo expressed it, “By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person . . . Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected.”

Keynes argued that there was no certainty that those who had sold goods or their labor services on the market will necessarily turn around and spend the full amount that they had earned on the goods and services offered by others. Hence, total expenditures on goods could be less than total income previously earned in the manufacture of those goods. This, in turn, meant that the total receipts received by firms selling goods in the market could be less than the expenses incurred in bringing those goods to market. With total sales receipts being less than total business expenses, businessmen would have no recourse other than to cut back on both output and the number of workers employed to minimize losses during this period of “bad business.”

But, Keynes argued, this would merely intensify the problem of unemployment and falling output. As workers were laid off, their incomes would necessarily go down. With less income to spend, the unemployed would cut back on their consumption expenditures. This would result in an additional falling off of demand for goods and services offered on the market, widening the circle of businesses that find their sales receipts declining relative to their costs of production. And this would set off a new round of cuts in output and employment, setting in motion a cumulative contraction in production and jobs.

Why wouldn’t workers accept lower money wages to make themselves more attractive to rehire when market demand falls? Because, Keynes said, workers suffer from “money illusion.” If prices for goods and services decrease because consumer demand is falling off, then workers could accept a lower money wage and be no worse off in real buying terms (that is, if the cut in wages was on average no greater than the decrease in the average level of prices). But workers, Keynes argued, generally think only in terms of money wages, not real wages (that is, what their money income represents in real purchasing power on the market). Thus, workers often would rather accept unemployment than a cut in their money wage.

If consumers demand fewer final goods and services on the market, this necessarily means that they are saving more. Why wouldn’t this unconsumed income merely be spent hiring labor and purchasing resources in a different way, in the form of great¬er investment, as savers have more to lend to potential borrowers at a lower rate of interest? Keynes’s response was to insist that the motives of savers and investors were not the same. Income-earners might very well desire to consume a smaller fraction of their income, save more, and offer it out to borrowers at interest. But there was no certainty, he insisted, that businessmen would be willing to borrow that greater savings and use it to hire labor to make goods for sale in the future.

Since the future is uncertain and tomorrow can be radically different from today, Keynes stated, businessmen easily fall under the spell of unpredictable waves of optimism and pessimism that raise and lower their interest and willingness to borrow and invest. A decrease in the demand to consume today by income-earners may be motivated by a desire to increase their consumption in the future out of their savings. But businessmen cannot know when in the future those income-earners will want to increase their consumption, nor what particular goods will be in greater demand when that day comes. As a result, the decrease in consumer demand for present production merely serves to decrease the business¬man’s current incentives for investment activity today as well.

If for some reason there were to be a wave of business pessimism resulting in a decrease in the demand for investment borrowing, this should result in a decrease in the rate of interest. Such a decrease because of a fall in investment demand should make savings less attractive, since less interest income is now to be earned by lending a part of one’s income. As a result, consumer spending should rise as savings goes down. Thus, while investment spending may be slackening off, greater consumer spending should make up the difference to assure a “full employment” demand for society’s labor and resources.

But Keynes doesn’t allow this to happen because of what he calls the “fundamental psychological law” of the “propensity to consume.” As income rises, he says, consumption spending out of income also tends to rise, but less than the increase in income. Over time, therefore, as incomes rise a larger and larger percentage is saved.

In The General Theory, Keynes listed a variety of what he called the “objective” and “subjective” factors that he thought influenced people’s decisions to consume out of income. On the “objective” side: a windfall profit; a change in the rate of interest; a change in expectations about future income. On the “subjective” side, he listed “Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance.” He merely asserts that the “objective” factors have little influence on how much to consume out of a given amount of income—including a change in the rate of interest. And the “subjective” factors are basically invariant, being “habits formed by race, education, convention, religion and current morals . . . and the established standards of life.”

Indeed, Keynes reaches the peculiar conclusion that because men’s wants are basically determined and fixed by their social and cultural environment and only change very slowly, “The greater . . . the consumption for which we have provided in advance, the more difficult it is to find something further to provide for in advance.” That is, men run out of wants for which they would wish investment to be undertaken; the resources in the society—including labor—are threatening to become greater than the demand for their employment.

Keynes, in other words, turns the most fundamental concept in economics on its head. Instead of our wants and desires always tending to exceed the means at our disposal to satisfy them, man is confronting a “post-scarcity” world in which the means at our disposal are becoming greater than the ends for which they could be applied. The crisis of society is a crisis of abundance! The richer we become, the less work we have for people to do because, in Keynes’s vision, man’s capacity and desire for imagining new and different ways to improve his life is finite. The economic problem is that we are too well-off.

As a consequence, unspent income can pile up as unused and uninvested savings; and what investment is undertaken can erratically fluctuate due to what Keynes called the “animal spirits” of businessmen’s irrational psychology concerning an uncertain future. The free market economy, therefore, is plagued with the constant danger of waves of booms and busts, with prolonged periods of high unemployment and idle factories. The society’s problem stems from the fact that people consume too little and save too much to assure jobs for all who desire to work at the money wages that have come to prevail in the market, and which workers refuse to adjust downward in the face of any decline in the demand for their services.

Only one institution can step in and serve as the stabilizing mechanism to maintain full employment and steady production: the government, through various activist monetary and fiscal policies.

In Keynes’s mind the only remedy was for government to step in and put those unused savings to work through deficit spending to stimulate investment activity. How the government spent those borrowed funds did not matter. Even “public works of doubtful utility,” Keynes said, were useful: “Pyramid-building, earthquakes, even wars may serve to increase wealth,” as long as they create employment. “It would, indeed, be more sensible to build houses and the like,” said Keynes, “but if there are political or practical difficulties in the way of this, the above would be better than nothing.”

Nor could the private sector be trusted to maintain any reasonable level of investment activity to provide employment. The uncertainties of the future, as we saw, created “animal spirits” among businessmen that produced unpredictable waves of optimism and pessimism that generated fluctuations in the level of production and employment. Luckily, government could fill the gap. Furthermore, while businessmen were emotional and shortsighted, the State had the ability to calmly calculate the long run, true value and worth of investment opportunities “on the basis of the general social advantage.”

Indeed, Keynes expected the government would “take on ever greater responsibility for directly organizing investment.” In the future, said Keynes, “I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.” As the profitability of private investment dried up over time, society would see “the euthanasia of the rentier” and “the euthanasia of the cumulative oppressive power of the capitalist” to exploit for his own benefit the scarcity of capital. This “assisted suicide” of the interest-earning and capitalist groups would not require any revolutionary upheaval. No, “the necessary measures of socialization can be introduced gradually and without a break in the general traditions of the society.”

This is the essence of Keynes’ economics.

Read more about the policy influences from Keynesian economics by Dr. Ebeling here

I would add that the Keynesian economics has been fraught with many logical fallacies but had been gained wide acceptance due to its math models or aggregate driven analysis.

Nonetheless one standout among the many logical fallacies would be Begging the Question where (Nizkor Project)

Begging the Question is a fallacy in which the premises include the claim that the conclusion is true or (directly or indirectly) assume that the conclusion is true

The embedded conclusion is that government is the elixir while the market is the problem, thus, all premises have been adjusted to conform to these even if the logical sequence of their argument becomes self-contradictory (yes thus the crisis of abundance!)

In short, the cart before the horse reasoning.

Keynesianism is essentially heuristics but garbed with mathematical formalism.

So when practitioners of the faith are caught with their internal logical inconsistencies, they deliberately resort to verbal prestidigitation (usually by using moral high ground of social justice based on short term solutions) as an escape mechanism.