The Paradox of Keynesianism, Paul Krugman and the Consumption Myth

By: MISES

Jonathan Finegold Catalán writes: In "China's Water Pistol," Paul Krugman turned commentary on China into a general attack on those who remain wary of the United States' large public debt. In it, he sums up the Keynesian views on saving, consumption, and government spending. Whatever his intentions, all Krugman does is underscore his own lack of understanding of economic theory.

Yet, it is his misguided view of economics that is most prevalent amongst those pseudo economists who shape national policy. For the sake of the hundreds of millions of individuals who have their livelihoods at stake, it must be made clear that it is capital accumulation — not consumption — that drives wealth-creation.

Krugman makes the following three assertions:

1. Given the "paradox of thrift," all types of savings are bad for the economy.

2. Government must make up for a loss in private investment.

3. The United States' economy would grow if China were to sell its US treasury bills.

Unsurprisingly, Krugman is wrong on all three points. What his argument boils down to, after wading through the myriad of contradictions that make up the majority of his writing, is the belief that our economic woes can be solved through inflation. His final assertion is the most telling, as it illustrates his faith in the principle that more money — a return of US dollars from China — would bring about more prosperity.

What Krugman offers us is a path, not to prosperity, but to poverty. Without savings there can be no investment, and as a result no job or wealth creation. The irony is that without savings government spending cannot be financed, and so the Keynesian bias against "thrift" is absolutely self-defeating. What Paul Krugman fails to wrap his head around is the fact that money is not synonymous with wealth or capital. When the Federal Reserve prints a million dollars it does not also produce steel, nails, or any other type of capital good. The conflation of money and capital is one of the crippling weaknesses of mainstream economic thought.

Thankfully, the world can still fall back on the sound economics espoused by the scholars of the Austrian School: Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, Friedrich Hayek, et cetera. Within the context of Paul Krugman's commentary, the most important part of Austrian theory that should be incorporated into the mainstream is capital theory. A basic understanding of the relationship between capital accumulation, investment, and wealth creation is of the utmost importance, given that this alone is sufficient to undermine the Keynesian fallacies of underconsumption and inflation.

Our purpose here is to offer an introduction to Austrian theory by refuting Paul Krugman's underlying mistake. Savings are absolutely necessary for economic growth.

Paradox of Thrift

One of John Maynard Keynes's biggest contributions to economic theory was his "paradox of thrift." Although the fallacy did not originate with Keynes, it was the publication of The General Theory of Employment, Interest and Money that popularized it in mainstream intellectual thought.

Keynes wrote,

The reconciliation of the identity between saving and investment with the apparent "free-will" of the individual to save what he chooses irrespective of what he or others may be investing, essentially depends on saving being, like spending, a two-sided affair. For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others make it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.[1]

Keynes's argument is that by saving part of an income, a saver necessarily takes away from the income of another. Keynes assumes that a person's income depends on the consumption of the product being sold, and by extension believes that by not consuming, one is denying a wage earner a wage. Accordingly, saving is self-defeating, as a loss in income will disallow individuals to save over the long-run.

But Keynes's mistakes are easy to spot. His principle limitation was his obvious lack of understanding of capital theory, which is interesting given that he made frequent references to Austrian theory and Friedrich Hayek. It goes to show that John Maynard Keynes really had no idea what he was reading. This allowed him to overlook Hayek's point entirely.

To this effect, Keynes finished the above-quoted paragraph with,

It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.[2]

This passage is a direct reference to the Austrian theory of the business cycle. Earlier in the chapter, Keynes asserted,

The notion that the creation of credit by the banking system allows investment to take place to which "no genuine saving" corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment.[3]

Here, John Keynes criticized Mises's and Hayek's theory that an extension of bank credit will lead to malinvestment. His reasoning was that the inflation brought about by the creation of money necessarily leads to a rise in wages, allowing the ratio between nominal investment and nominal savings to return to one. His downfall was his reliance on the mechanical quantity theory of money, which had already been refuted by the likes of Benjamin Anderson and Ludwig von Mises.[4] While the quantity theory of money suggests that inflation affects all sectors of the market simultaneously and proportionally, it ignores the microeconomic effects of inflation on the relative prices of capital goods versus consumer goods.[5] Paul Krugman keeps John Keynes's fallacious bias against savings, although Krugman perhaps does it out of blind faith, while Keynes simply misunderstood basic economic theory.

Savings, or capital accumulation, is the most important direct factor in wealth creation. The volume of capital directly influences the cost to borrow said capital, otherwise known as the rate of interest. Naturally, the greater the supply of capital, the lower the cost to borrow, providing an incentive for entrepreneurs to borrow and invest.

Investment in lines of production, whether it is the creation of a new factory or an investment in a new method of production, is what leads to rises in productivity. A rise in productivity leads to an increase in the quantity supplied of any given good, allowing for a reduction in price. It is this increase in the quantity supplied that leads to an increase in real wages, and an increase in the general wealth of society.

It is thus nonsensical to oppose savings on the grounds that an increase in savings will necessarily lead to a decrease in wages. Real wages rely directly on investment; without increases in productivity, wages are bound to stagnate at best. Furthermore, it has to be considered that the purchase of capital-goods for investment necessitates the payment of wages to workers in the relevant industries. For example, when a contractor purchases steel to use in the construction of a building, he necessarily pays the wages of the workers involved in the production of that steel, and so in that sense investment fulfils the same function as consumption.

The Keynesian fallacy of the paradox of thrift relies on their confusion between real wealth and nominal wealth. This fallacy builds from Keynesians' misunderstanding of the role and purpose of money in an economy. As opposed to being a source of capital, money is a common and widely-accepted good that represents the flow of capital in a common standard. Money is but a means to accommodate barter within a complex society with an extensive division of labor, in which the direct exchange of heterogeneous goods is nearly impossible. So, when Ben Bernanke orders the production of one million dollars he does not simultaneously make possible the production of one million dollars worth of steel. The production of steel can only be made possible through the exchange of goods, represented by dollars, and through the investment of capital goods.

Keynesians fail to understand this complex system of trade, and so do not realize that what is really paying for a worker's wages is one's capital, not one's money. By consuming capital, an individual necessarily reduces the total volume of capital available, and so over the long-run this is self-defeating in nature. Who will pay for wages when all the capital has been consumed? Keynes would have solved the problem by printing money, but he did not realize that what allowed for capital formation was investment made possible through capital accumulation. What use is a million dollars if there is no steel for you to purchase for the construction of your factory?

Finally, the Keynesian myth of hoarding must be dispelled. On the surface, Keynes's belief that an individual necessarily contributes to inefficiency by stashing money under his mattress makes sense. But this is just another product of the conflation of money and capital.

In an economy, what matters is the exchange and investment of goods, not money. Money is a standard by which economic agents decipher the exchange value of goods, and so it only becomes relevant at the moment of an exchange. Holding or using money will either increase or decrease the purchasing power of an individual unit of the money standard, but will not influence the flow of capital beyond that. In fact, the purchasing power of the money in circulation necessarily rises as a result of hoarding.[6]

Government Spending, China, and Money

Paul Krugman's thesis centers on the idea that if the private sector is unwilling to risk investment, then the government's role is to step in and invest. His prejudice against savings is ironic, given that without savings the government has no pool of capital from which to extract the resources necessary to make the investments Krugman wants it to make. He alludes to this himself:

As a nation, our dependence on foreign loans is way down; the surging deficit is, in effect, being domestically financed.

When an individual finances public debt through the purchase of treasury bills, the individual's time preference will change in favor of future goods. This is because the individual has allotted a certain percentage of his wage towards a long-term bond in an effort to collect on interest, or increase his wealth. The individual, in effect, is financing the provision of capital for the government to invest in whatever it fancies. So, Paul Krugman jumps from blasting savings as a bane to economic prosperity to then suggesting that savings is the only reason why our dependence on Chinese financiers is no longer as relevant.

Whether Krugman believes that government should consume or invest is for anybody to guess. It remains to be seen whether Krugman even differentiates between the two — both seem to fall under the more common term of "spending." The topic of government expenditure has been covered elsewhere,[7] nevertheless the belief that government can better predict the market than entrepreneurs is befuddling; it is what Hayek referred to as the "fatal conceit."[8]

Whilst discussing the topic of government spending and debt, Krugman makes the same mistake Keynes made when writing on the "paradox of thrift." Krugman writes,

The bottom line in all this is that we don't need the Chinese to keep interest rates down. If they decide to pull back, what they're basically doing is selling dollars and buying other currencies — and that's actually an expansionary policy for the United States, just as selling shekels and buying other currencies was an expansionary policy for Israel (it doesn't matter who does it!).

Krugman makes two mistakes. First, he assumes that by selling securities, China returns dollars to the United States. In fact, it is quite the opposite. When buying securities, the Chinese are using dollars earned in trade to buy US debt, and so the dollars used are now spent by the US government. What the Chinese buy is the promise of a greater amount of future dollars. When the Chinese sell securities, they receive a greater amount of dollars than they actually gave. All considered, that does not mean that the sale of securities will cause China to "hoard" dollars. The Chinese have absolutely no interest in hoarding dollars, because the dollar is only useful to exchange for American goods or to exchange with other individuals who find the dollar valuable.

Krugman's second mistake is the belief that a greater quantity of dollars leads to greater wealth. This is the same assumption Keynes erroneously made when expounding his beliefs on the paradox of thrift. To clarify, what matters is not the amount of dollars in circulation but the amount of capital.

As a final comment, it is important to recognize that it does not matter who holds American debt. Whether it is a Chinese saver or an American saver does not matter, as what the debt problem comes down to is the fact that the US government cannot permanently finance growing expenditure.[9] The US debt pyramid is bound to collapse when its financers are no longer willing to risk their capital on insecure government bonds. The trigger point will occur when the distortion caused by government spending is completely unveiled.

The Paradox of Keynesianism

The Keynesian argument against saving cannot stand on its own two feet. Keynes's "paradox of thrift" is nothing but the result of a bad economist making poor assumptions based on a weak understanding of economic theory. Ultimately, the Keynesian's deficiency comes down to their lack of capital theory, which eventually leads them to believe in a very disjointed monetary theory.

Given his education in the Keynesian framework, Paul Krugman's economics are nothing more than an extension of Keynes. His poor training has led Krugman to apply Keynesian theory to current events, and the unfortunate byproduct has been his influence — and the influence of those who think like him — on central macroeconomic policy; this includes the belief that there should be central planning at all.

Individuals should choose their time preferences based on their own subjective concerns. If this means that the individual prefers saving over present consumption, then that is all for the better, as saving is what leads to economic growth. Given the current global economic situation, the individual should not be blamed for a partiality in favor of "hoarding." The truth is that individuals should be keener on "hoarding" given that the alternative seems to consist of government-sponsored destruction of wealth.

Jonathan Finegold Catalán is an economics and political science major at San Diego State University. He blogs at economicthought.net. Send him mail. See Jonathan M. Finegold Catalan's article archives.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Notes
[1] Keynes, John Maynard, The General Theory of Employment, Interest and Money. BN Publishing, 2008: p. 84.

[2] Ibid.

[3] Ibid., p. 82.

[4] Anderson, Benjamin, "The Value of Money"; and Mises, Ludwig von, The Theory of Money and Credit..
[5] Huerta de Soto, Jesús, Money, Bank Credit and Economic Cycles. Ludwig von Mises Institute, Auburn, Alabama: 2009,; pp. 522–535.

[6] Rothbard, Murray N., What Has Government Done to Our Money?. Ludwig von Mises Institute, Auburn, Alabama: 2008,; pp. 30–34.

[7] See: Greaves Jr., Percy L., "Does Government Spending Bring Prosperity?" Mises Daily: August 27, 2009; and Finegold Catalán, Jonathan, "Passion Comes From Liberty" Mises Daily: February 9, 2010.

[8] Friedrich Hayek, In reference to Hayek's book, The Fatal Conceit: The Errors of Socialism.

[9] Finegold Catalán, Jonathan, "Garet Garrett's Invaluable Lesson", Mises Daily: 5 March 5, 2010.

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