Our Current Keynesian Nightmare

By: Frank_Hollenbeck

It is not an understatement to say that the economic policy of the United States since 2008 has been purely Keynesian. Interest rates are near zero and the national debt stands at nearly $20 trillion. This is a direct result of applying the policy prescription recommended in Keynes’ General Theory. One day, his book will likely sit next to Karl Marx’s Communist Manifesto as works that generated dangerously false notions of reality with disastrous consequences.

Keynes obtains most of his conclusions against capitalism by gutting its essential characteristic, i.e. adjusting prices to allocate resources where society deems most urgent. His theory assumes price inflexibility (wages being a price).

Suppose someone claimed that gravity doesn’t hold us to the planet like Newton told us, and that people would float off into space unless we build large nets to save humanity. Such a person would normally be hauled off to the asylum–if it were not for Keynes. By assuming price inflexibility, Keynes concludes that unemployment can be a permanent fixture of a capitalist economy and that legal counterfeiting (monetary policy) and robbing Peter to pay Paul (fiscal policy) are sound economic policies. Instead of being discarded as a crackpot economist, monetary crank, or ignorant zealot, Keynes was given the status of economic genius.

Why was such an incredibly poorly written book as Keynes’ General Theory so widely acclaimed? It had innumerable errors in logic and ever shifting definitions (e.g. savings, marginal efficiency of capital, and interest rates). The answer is simple: Politicians put Keynes on a pedestal because he gave them the theoretical foundation to justify policies that had been previously ridiculed by classical economists. Even today, it serves as the foundation of economic policy.

Take the concept of the fiscal multiplier: it does not exist! Rather, it only exists in the illogical minds of Keynesian and other economic professors and writers of economic textbooks. Since this concept is incorporated in every undergraduate and graduate textbook, a simple recapitulation will do: The idea is that if the government spends $1, someone will receive $1, who will spend a portion, say 80 cents, which will be received by someone else who will also spend only a fraction, and so on. Keynesians give a nice little formula that says in this instance the multiplier is 5 and $1 spent by the government will create $5 in national income.

Now the natural question of the inquisitive student would be to ask: How did the initial $1 of spending get financed? Here, the Keynesian have a neat little answer: the balance budget multiplier. If the government spends $1 and taxes $1, spending still initially goes up by 20 cents since the person who was taxed would have only spent 80 cents of it. The multiplier in this case is $1. At this point, most professors go on to another topic, unnoticed by the unwary student is the insidious assumption underlying this theoretical conclusion.

The multiplier concept makes the heroic assumption that the entire 20 cents was hoarded, or held in cash–the equivalent of stuffing money in your mattress. If, instead, the amount taxed had reduced savings¹, in the place of hoarding, $1 of government spending will displace $1 of consumption and (savings) investment spending; the multiplier is zero, and government spending and, fiscal policy, have no direct aggregate demand influence on output. Of course, if we consider the supply side, the multiplier is negative. As Murray Rothbard eloquently said, this is a transfer of “resources from the productive [private sector] to the parasitic, counterproductive public sector.” The current $20 trillion debt reflects government spending or real resources that would have been put to better use had it been left in private hands.

Keynes also advocated the “euthanasia of the renter” by driving interest rates to zero. His faithful followers in the Eccles building in Washington have been busy following his advice. Yet, as Mises stated, this view of interest rates (here and here) is of unsurpassable naiveté².

A microeconomics professor will explain to his students how price controls create a divergence between what society wants and what it produces–the unintended consequence are wine lakes, butter mountains and unemployment. Yet, this schizophrenic economist will then cross the hall and teach a macroeconomic class and explain how fiddling with capitalism’s most important price, interest rates, will solve society’s economic problems.

The reality is that the economy is not like a car and interest rates are not like the gas pedal. Interest rates play a key role in aligning demand with output across time. The longer you interfere with interest rates, the greater will be the misalignment and the greater will be the unavoidable adjustment necessary to realign output with demand.

We are currently in a deep hole. Our currently ill-conceived policies will lead to the crackup boom that Mises predicted and will be much worse than 2008. Yet we do not have the intellectual consensus to dig our way out. What is worse is that the next crisis will undoubtedly call for more of the same.Our current crop of economists is brainwashed into believing that the only solution is more government spending and printing: the one trick pony! The end game will then be hyperinflation, ultimately leading to dictatorships. Yet, there is a better alternative, and it starts with 1. Reestablishing sound money (here) , 2. Ending fractional reserve banking (here and here) and 3. Putting an end to central banks.

Notes

1 The correct narrow definition of monetary savings is a transfer of claims from one group to another. This is the definition found in the classical loanable funds theory of interest rates. The saver is giving up his claims to be able to consume more goods and services in the future. He makes this transfer to investors who use these claims to purchase plants and equipment to produce goods and services in the future. Keynes created immense confusion when he used the single word “savings” to reflect two acts: the transfer of claims (classical definition of savings) and the holding of claims, or hoarding (here).

2 “It regards interest as a compensation of the temporary relinquishing of money in the broader sense –a view, indeed, of unsurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest holds an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.”

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

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