THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

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)