Monday, August 6, 2012

Lies, Damned Lies, and Definitions, XXVII: Keynes to the "Rescue" — Cut Consumption!

The Brookings Institution's four-volume study on America's potential to recover from the Great Depression of the 1930s, Distribution of Wealth and Income in Relation to Economic Progress, was, in essence, an application of Say's Law of Markets. Unfortunately, the study was published after the Roosevelt administration had implemented the Keynesian New Deal. While it could, of course, have been reversed at any time (and still can be), the fact was that America was now locked into a set of assumptions and economic prescriptions of doubtful validity that have not only not worked, the preponderance of evidence suggests — after eighty years — they can't work. Still, the powers-that-be keep insisting on them.

The basic assumptions of the Keynesian framework are:

1. New capital formation is impossible without first cutting consumption,

2. Labor is the sole factor of production, capital only enhances labor, and

3. Money consists solely of State-issued or sanctioned debt instruments backed only by the general creditworthiness ("faith and credit") of the government.

4. The State has the power to "re-edit the dictionary," i.e., change substantial reality, and abolish freedom of association/contract (liberty) and private property.

Everything in Keynesian economics appears either to be derived from these assumptions, or is an application of them. Nevertheless, all four are false, as we can readily demonstrate.  We'll take them one at a time:

New Capital Formation by Cutting Consumption

This is the easiest of the Keynesian assumptions to disprove. It was why, in fact, Keynes declared in 1919 in The Economic Consequences of the Peace that the world could not have reached its then-present state of development had not wealth been concentrated. The rationale is that poor people can't cut consumption to the degree required to finance the increasingly expensive capital instruments needed in a modern industrial economy. Only the rich can do so, and, in fact, the richer, the better.

First off, of course, if labor is the sole factor of production and capital only enhances labor, why are increasingly expensive capital instruments needed? It's all an illusion. Given that illusion, however, it is utter nonsense that the world requires concentrated ownership of capital in order to advance economically. This can only be justified if we accept that cutting consumption is the only way to finance new capital.

The facts of history tell us otherwise. In The Formation of Capital, the third volume in Distribution of Wealth and Income in Relation to Economic Progress, Harold Moulton proved that periods of rapid capital expansion were, in every case, preceded not by reductions in consumption, but increases. This justified the vastly increased amount of new capital formation that then resulted. As Moulton concluded, the demand for new capital goods is derived from the demand for new consumer goods. During periods of rapid expansion, consumption and capital expansion occur at the same time. It is not a case of one or the other.

That being so, where did the savings come from to finance the new capital? After all, if consumption increased before production, or increased at the same time as production, then savings were clearly being used to finance consumption, not investment. Savings were already being depleted by the increased consumption, and there would have been no existing savings to finance new capital.

The obvious conclusion is that the new capital was not financed by past cuts in consumption, but by future increases in production. Commercial banks were invented thousands of years ago to take advantage of this financing technique. Someone with a sound capital project prepares a contract — an offer — called a "bill of exchange." The drawer of the bill then either offers it directly to someone who promises to build or supply whatever capital is wanted, or takes it to a commercial bank that substitutes its own promise for that of the borrower.

If either a private individual or a bank accepts the offer, it is money, and can be used to purchase the capital. These acceptances can then be used as money between other people, as long as the original issuer makes good on the promise when it is presented for payment on maturity.

No capital — or even the materials with which to build the capital — has to exist before the decision is made to form the new capital. All that is necessary is for two people to exchange promises, and to make good on those promises by the due date. These promises can also be passed around the community in offers and acceptances between other people, creating a circulating medium or "currency" — "current money."

So, no, you don't need to cut consumption in the past in order to finance new capital formation. You only need to be able to increase production in the future, and to do so if that is what you promised to do.

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