The Trouble With Keynes; R. Garrison

The acceptance in the economics profes sion of fundamentalist Keynesianism peaked in the 1960s. In recent decades, enthusiasm for Keynes has waxed and waned as proponents have tried to get new ideas from the General Theory or to read their own ideas into it. And although the federal government has long since become a net supplier of macroeconomic instability, the institutions and policy tools that were fashioned to conform with the Keynesian vision have become an integral part of our economic and political environment. A national income accounting system, devised with an eye to Keynesian theory, allowed statisticians to chart the changes in the macroeconomy. Dealing in terms of an economy-wide total, or aggregate, policy Dr. Garrison teaches economics at Auburn Uni versity in Alabama and is a Contributing Editor of The Freeman. advisers tracked the production of goods and services bought by consumers, inves tors, and the government. Fiscal and mon etary authorities were to spring into action whenever the economy's actual, or mea sured, total output, which was taken to reflect the demand side of markets, fell short of its potential output, which was estimated on the basis of the supply side. Cutting taxes would allow consumers and investors to spend more; government spending would add directly to the total; printing money -or borrowing it-would facilitate the op posing movements in the government's rev enues and its expenditures.

A chronic insufficiency of aggregate de mand, which implies that prices and wages are somehow stuck above their market clearing levels, was believed to be the nor mal state of affairs. Why might there be such pricing problems on an economy-wide scale? What legislation and government in stitutions might be standing in the way of needed market adjustments? These ques tions were eclipsed by the more politically pressing question of how to augment de mand so as to clear markets at existing prices. The New Economics of Keynes shifted the focus of attention from the mar ket to the government, from the economi cally justified changes in market pricing to the politically justified changes in govern ment spending. Politicians still appeal to basic Keynesian notions to justify their interventionist 386 schemes. The continued use of demand management policies aimed at stimulating economic activity-spending newly printed or borrowed money during recessions and before elections-requires that we under stand what Keynesian economics is all about and how it is flawed. Also, identifying the flaws at the sophomore level helps students to evaluate in their upper-level and graduate courses such modern modifica tions as Post, Neo, and New Keynesianism as well as some strands of Monetarism.

The extreme level of aggregation in Keynesian economics leaves the full range of choices and actions of individual buyers and sellers hopelessly obscured. Keynesian economics simply does not deal with supply and demand in the conventional sense of those terms. Instead, the entire private sec tor is analyzed in terms of only two catego ries of goods: consumption goods and in vestment goods. The patterns of prices within these two mammoth categories are simply dropped out of the picture. To make matters worse, the one relative price that is retained in this formulation-the relative value of consumer goods to investment goods as expressed by the interest rate-is assumed either not to function at all or to function perversely. The Importance of Scarcity Pre-Keynesian economics, such as that of John Stuart Mill, as well as most contem poraneous theorizing, such as that by Lud wig von Mises and F. A. Hayek, empha sized the notion of scarcity, which implies a fundamental tradeoff between producing consumption goods and producing invest ment goods. We can have more of one but only at the expense of the other. The con struction of additional plant and equipment must be facilitated by increased savings, that is, by a decrease in current consump tion. Such investment, of course, makes it possible for future consumption to increase.

Identifying the market mechanisms that al locate resources over time is fundamental to our understanding of the market process in its capacity to tailor production decisions to 387 consumption preferences. But as Hayek noted early on, the Keynesian aggregates serve to conceal these very mechanisms so essential to the, intertemporal allocation of resources and hence to macroeconomic stability. In Keynesian theory the long established notion of a trade-offbetween consuming and investing is simply swept aside. Consistent with the assumed perversity of the price mechanism, the levels of consumption and investment activities are believed always to move in the same direction: More invest ment generates more income, which fi nances more consumption; more consump tion stimulates more investment. This feature of Keynesian theory implies an in herent instability in market economies. Thus, the theory cannot possibly explain how a healthy market economy functions how the market process allows one kind of activity to be traded off against the other.

The "Multiplier-Accelerator" Theory The inherent instability makes its text book appearance as the interaction between the' 'multiplier," through which investment affects consumption, and the "accelera tor, " through which consumption affects investment. The multiplier effect is derived from the simple fact that one person's spending becomes another person's earn ings, which, in turn, allows for further spending. Any increase in spending, then, whether originating from the private or pub lic sector, gets multiplied through succes sive rounds of income earning and consump tion spending. The accelerator mechanism is a conse quence of the durability of capital goods, such as plant and equipment. For instance, a stock of ten machines each of which lasts ten years can be maintained by purchasing one new· machine each year. A slight but permanent increase in consumer demand for the output of the machines of, say, ten percent, will justify maintaining a capital stock of eleven machines. The immediate result, then, will be an acceleration of cur388 THE FREEMAN • OCTOBER 1993 rent demand for new machines from one to two, an increase of one hundred percent.

The multiplier-accelerator theory ex plains why consumption is ipcreasing, given that investment is increasing, and why in vestment is increasing, given that consump tion is increasing. But it is incapable of explaining what determines the actual levels of consumption and investment (except in terms of one another), why either should be increasing or decreasing, or how both can increase at the same time. Students are left with the general notion that the two magni tudes, investment and consumption, can feed on one another, in which case the economy is experiencing an economic ex pansion, or they can starve one another, in which case the economy is experiencing an economic contraction. That is, Keynesian theory explains how the multiplier-acceler ator mechanism makes a good situation better or a bad situation worse, but it never explains why the situation should be good or bad in the first place.

Only at the two extremities in the level of economic activity is a change in direction of both consumption and investment sure to occur. After a long contraction, unemploy ment is pervasive and capital depreciation reaches critical levels. As production essen tial for capital replacement stimulates fur ther economic activity, the macroeconomy begins to spiral upward. After a long expan sion, the economy is bulging at the seams. Markets are glutted with both consumers' and producers' goods. As unsold invento ries trigger production cutbacks and worker layoffs, the macroeconomy begins to spiral downward. Keynes held that the economy normally fluctuates well within these two extremes experiencing a general insufficien cy-and an occasional supersufficiency-of aggregate demand. "TextbookKeynesianism In the simplistic formulations of macro economic textbooks, investment is simply "given"; in Keynes' own formulation, the inclination of the business community to invest is governed by psychological factors as summarized by the colorful term "animal spirits."Keynes recognized that there are some "external factors" at work, such as foreign affairs, population growth, and tech nological discoveries. The market is envi sioned, in effect, to be some sort of eco nomic amplifier which converts relatively small changes in these external factors into wide swings of employment and output.

This is the basic Keynesian vision. Wage rates and prices are assumed either to be inflexible or to change in direct pro portion to one another. In either case the real wage (WIP) is forever constant. The actual level of wages and prices is believed to be determined (again) by external fac tors-this time, trade unions and large cor porations. If the real wage is too high, there will be unemployment on an economy-wide basis. There will be idle labor and idle resources· of every kind. The opportunity cost of putting these resources back to work is nothing but forgone idleness, which is no cost at all. The assumed normalcy of mas sive resource idleness assures that the perennial problem of scarcity never comes into play. WilliamH. Hutt and F. A. Hayek were justified in referring to Keynesian economics as the' 'theory of idle resources" and the "economics of abundance." Textbook Keynesianism has a certain internal consistency or mathematical integ rity about it. Given the assumptions that prices and wages do not properly adjust to market conditions-that is, the assumption that the price system does not work-then the Keynesian relationships among the macroeconomic aggregates come into play.

Even the policy prescriptions seem to fol low: If wages and prices do not adjust to the existing market conditions, then market conditions must be adjusted (by the fiscal and monetary authorities) to the externally determined prices and wages. In the final analysis, however, Keynesian theory is a set of mutually reinforcing but jointly unsupportable propositions about how certain macroeconomic aggregates are related to one another. Keynesian policy is a set of self-justifying policy prescriptions. For instance, ifthe government is convinced WHY GOVERNMENT CAN'T CREATE JOBS 389 that wages will not fall and is prepared to hire the unemployed, then unemployed workers will not be willing to accept a lower market wage, ensuring that wages, in fact, will not fall. Thus, while the intention of Keynesian policy is to stabilize the econ omy, the actual effect is to "Keynesianize" the economy. It causes the economy to behave in exactly the same perverse manner that is implied by the Keynesian assump tions. This convoluted interrelationship be tween theory and policy has long obscured the fundamental flaws in the theory itself.