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Why Keynes Was Wrong, And Why It Matters

Author: Benn Steil, Senior Fellow and Director of International Economics
May 15, 2009
Forbes Online


The Congressional Budget Office estimates that the U.S. budget deficit will reach $1.85 trillion this year and $1.38 trillion in 2010, 13.1% and 9.6% of gross domestic product respectively. Much more worrying is that they project deficits averaging over $1 trillion a year for the next 10 years, which will raise the U.S. public debt-to-GDP ratio to over 80% by 2019.

The Obama administration and Congress have justified the vast new government borrowing and spending by asserting that it constitutes "fiscal stimulus." Not only would each dollar the government borrowed and spent produce a dollar of GDP that would never have been created had the dollar been left in private hands (a fiscal "multiplier" of 1.0), but it would stimulate a wave of new private sector spending, investment and employment that would generate 30, 40, 50 cents or more of additional new wealth per dollar (a multiplier above 1.0).

It is no wonder then that when President Obama told the public last month that stimulus projects were under budget, Nobel economist Paul Krugman cried "boo," pointing out that this meant "less stimulus." He backed his point with a quote from the 1936 General Theory of Employment, Interest and Money, in which John Maynard Keynes suggested that the government could raise employment, real income and capital wealth merely by burying money under rubbish heaps and inviting private enterprise to dig it up.

One of the many attractions of Keynes is that, like a good magician, he makes you think twice about what you think you see and know. And the General Theory is full of great tricks. Most people vaguely familiar with Keynes' economics associate his counter-laissez-faire views with the observation that nominal wages are "sticky" downward (that is, workers resist wage cuts), and that, in consequence, the free play of the price mechanism fails to steer the economy toward full employment.
But he goes well beyond this in the General Theory, arguing, contrary to classical economics, that even without assuming any fixing of prices there can be a stable, persistent equilibrium with chronic, large-scale unemployment.

How is this possible? Keynes said that the answer lies in the community's propensity to under-consume: "The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased, but not by so much as income. Hence employers would make a loss if the whole of increased employment were to be devoted to satisfying the increased demand for immediate consumption."

That is, employers will only hire if the increased demand (which would be brought about by the hiring) would be directed at either consumption or investment. What economists before Keynes had missed, explains Krugman, is the significance that "individuals have the option of accumulating money rather than purchasing real goods and services." Or, as Keynes biographer Robert Skidelsky observes, "Money is the root of all evil." This, he writes, is "almost a sub-text of the General Theory."

A demand for money, in Keynes' thinking, is the equivalent of a demand for nothingness--in the sense that, when people want to hold money, the extra production arising from hiring a new worker would fail to find any market. Keynesians call it "ineffective demand."

So unless the government steps in to stimulate investment spending equivalent to the income aspiring workers would hoard, their aspirations would go unfulfilled and they would remain unemployed. Keynes' theory is therefore preternaturally consistent with good, humanist sentiments, as it implies that labor is manifestly not a commodity: Lowering its price will not increase demand.

But is this true? Does holding money really mean that part of the income required for the absorption of the production associated with it is permanently lost, which is what is required to create a permanent state of under-employment?

No. This is most easily seen using the model of a commodity money system, such as one based on gold. When people demand more money, rather than consumer or investment goods, it increases the demand for labor to mine, move and monetize gold. Unemployment rises, of course, when demand shifts from any product to another, as it takes time for labor to shift from one sector to another. But the demand for money is not "ineffective demand": It is no different from the demand for anything else.

The argument for the case of money that isn't convertible into gold, such as our own, is analogous. The public sells securities, instead of gold, to the central bank in order to increase their cash holdings. Securities are the counterpart to valuable goods stored or sold on credit.

Again, there is no "ineffective demand": To demand money is to demand real wealth capable of being monetized within the framework of the existing monetary system. So just as an increased demand for gold does not itself diminish the purchasing power of the market, an increased demand for money does not itself do so.

The skeptical reader will rightly conclude that the Keynesians must have a riposte to this argument. Indeed, they have many. But all of them are founded on ad hoc "sticky wages" type assumptions. Nobel economist James Tobin, for example, in a spirited 1948 defense of the General Theory, offered observations such as "the supply of money is assumed constant." Explain that to Ben Bernanke.

What does all this matter? That is, what should we do or not do today to get ourselves onto a sustainable path out of recession?

Well, there are two brands of remedy. The first are government measures intended to eliminate obstacles to the adaptation of supply to changing demand. This is the now much-maligned classical brand of remedy. The second are fiscal and other government measures designed to force demand to adapt to supply. This is the Keynesian brand of remedy, now beloved in Washington, based on the belief that under-employment is a congenital defect of the economic system.

Each huge dose of this second remedy serves to further obliterate the functioning of the price mechanism, thus necessitating another huge dose. In the long run, this almost certainly means crippling debt, inflation or both. But Keynes, of course, advised against thinking too much about the long run.

Benn Steil is director of international economics at the Council on Foreign Relations, author of Lessons of the Financial Crisis (CFR) and co-author of Money, Markets, and Sovereignty (Yale University Press, 2009).

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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