Tuesday, January 6, 2009

"The Paradox of Thrift": Keynes' Greatest Fallacy?

Today's rather eye-catching article title in the Wall Street Journal said it all: "Hard-Hit Families Finally Start Saving, Aggravating Nation's Economic Woes." In the Keynesian world of Looking Glass Economics, where everything is backwards and nothing makes sense, you can't invest unless you cut consumption and save ... and you can't invest if you cut consumption and decrease consumer demand which means no resulting investment. Logically, then, you can either save or invest. This is pretty scary when you realize that savings always equals investment, so (logically) Keynes' "paradox of thrift" means that both savings and investment necessarily equal zero if the economy is ever to be in equilibrium, which Keynes touted as the goal of his economic system. Maybe that's what Keynes meant when he declared that, in the long run, everybody is dead. Dead people neither invest nor save. They just exist in the perfect Keynesian equilibrium.

What follows is the text of today's letter to the Wall Street Journal, which you are free to copy and present to any Keynesian economist or government policymaker, along with the question as to how Keynesian economics is supposed to make sense.

Today's article by Kelly Evans, "Hard-Hit Families Finally Start Saving, Aggravating Nation's Economic Woes" (Wall Street Journal, 01/06/09, A1, A12) accurately reflects the inherently contradictory and unsound nature of Keynesian economics and the "paradox of thrift." That is, saving provides financing for capital formation, which raises living standards. In the Keynesian universe, however, saving is only possible by cutting consumption, and requires a class of people who cannot consume all they produce and are thereby forced to invest the excess. The catch is that cutting consumption means that the financial feasibility of newly-formed capital, as well as the viability of existing capital, is reduced, sometimes to the point where the economy implodes.

According to Lord Keynes, financing capital formation is impossible unless consumption is reduced to provide savings for investment. This is Keynes' iron law, and the basis of virtually all his economic theories, as well as his rejection of Say's Law of Markets and the "Real Bills" doctrine, the centuries-old foundation of commercial and central banking theory.

Contradicting Keynes' assumption, however, Dr. Harold G. Moulton, then-president of the Brookings Institution, in 1935 published a short monograph, The Formation of Capital. Dr. Moulton studied the rates of consumption, saving, and investment in the United States from 1830 to 1930. Contrary to popular myth, Dr. Moulton discovered that periods of intense capital formation were preceded not by decreases in consumption, as Keynes presumed, but by substantial increases, and a consequent reduction in savings. Saving was subsequent to investment, not prior, as Keynes assumed as an unalterable dogma.

Exploding another popular myth, Dr. Moulton discovered that the financing for capital formation during periods of greatly increased investment did not, as commonly believed, come from England and other industrialized nations, but by the extension of credit through the commercial banking system. The "new money" was backed by loans made for capital formation, and repaid out of profits once the capital became productive. This is a process known as "future" or "forced" savings, and is the essence of the "Real Bills" doctrine. Dr. Moulton further observed that cutting consumption in order to provide financing for capital formation instead of financing capital formation through the commercial banking system would ultimately reduce consumer demand to the point where both newly-formed and existing capital would become non-viable.

Dr. Moulton published his findings in 1935. Keynes was quick to respond in 1936 with his General Theory of Employment, Interest, and Money, in which he rejected Dr. Moulton's findings by the simple expedient of ignoring them. Keynes declared without offering any proof that "future" or "forced" savings are impossible, and that any evidence or argument supporting the concept is necessarily an illusion. (General Theory, II.7.iv.)

The dilemma facing economists and policymakers today is thus based on an unquestioned acceptance of a disproved theory. A reexamination of Dr. Moulton's work is clearly in order, and the powers-that-be in academia and government should cease being "the slaves of some defunct economist." (General Theory, VI.24.v)


Steve Roy said...

Thanks for clarifying this topic, Michael. Brilliant.

So the real problem right now is that economists are blindly following Keynes, and there's no mechanism to stop universities from churning out hundreds more just like them, right?

Admirers of Ayn Rand would find this a familiar story - they have been trying to introduce Objectivist philosophy into modern philosophical education for decades.

They seem to have chosen a "Promote what she wrote" strategy. Since most people have never heard of her or of Objectivist principles, they also seem to be having difficulty changing the direction of thinking at the academic level.

I think the work of CESJ, the Kelso Institute and many others (including you, Michael) is of critical importance in spreading the word. But more needs to be done to make this part of the public debate, especially among the young, who will carry the burden of this mess for decades to come.

Create a mass movement of college and university students (and their parents) who reject the old, disproven theories and demand investigation of new alternatives, and you'll find educators and their fund-raising departments running out in front of the crowd yelling "Follow me!"

Again, great letter, Michael. Thanks.

Steve Roy

Anonymous said...

I'm no Keynesian but what you attribute to Keynes is plain wrong. He did not say that you can only invest by cutting consumption - he agreed to this ONLY WHEN THERE ARE NO EXCESS RESOURCES. When resources lie idle, he claimed you could increase consumption and investment together through the multiplier. (I invest and the knock-on effects create current employment and demand. This demand then 'pays' for the investment.)

Michael D. Greaney said...

Keynes disagrees. In Chapter 7, Section I, Book I of "The General Theory of Employment, Interest, and Money" (1936), Keynes states, "In the previous chapter Saving and Investment have been so defined that they are necessarily equal in amount, being, for the community as a whole, merely different aspects of the same thing."

That is, savings equals investment.

Going to Section V of the same chapter, we read, "No one can save without acquiring an asset, whether it be cash or a debt or capital-goods; and no one can acquire an asset which he did not previously possess, unless either an asset of equal value is newly produced or someone else parts with an asset of that value which he previously had."

Since Keynes (Ch. 6, Sec. II) had previously defined "saving" as "that part of the income of the period which has not passed into consumption," we are forced to conclude that Keynes believed that it is impossible to invest unless we first cut consumption and save.

Bob said...

I thought Keynes called "saving" "HOLDING MONEY" and considered this an impediment to "spending yourself in to prosperity". I have always thought Keynes (both of them) were IDIOTS. So did Wniston Churchill, he said, "Spending yourself in to prosperity is like standing in a bucket and trying to lift yourself up by the bail(handle)." It's a bunch of crap. Everything I have ever seen tied to Keynes ends up making people SPEND instead of save, BB

Bob said...

Hell, everything I have ever seen on Keynes has condemned saving, he called it "holding money". His motto was, "You must SPEND yourself in to prosperity". He sold that crap to Roosevelt and RUINED our country!!!! BB in Texas

Bob said...

Well I have submitted two comments, this damned thing is too hard to use.

I am going to move on to one that is not so finicky and doesn't waste so much time, B