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Do We Need More of Keynes Now?

Mises Daily: Friday, October 31, 2008 by

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Now that governments and central banks are subjecting their economies to aggressive  monetary and fiscal-stimulus policies, many people say that the ideas of Keynes are back in fashion. We heard that Keynesian remedies can save world economies from plunging into a severe economic slump. In the United States, for instance, Republicans and Democrats are competing against each other to subject the American economy to various stimulus packages. On this the Financial Times recently wrote,

The lapses into Keynesianism take different forms. For Republicans, it is a time to propose new tax cuts for small businesses, including a waiver of the capital gains tax, which many believe would help stimulate economic activity. For Democrats, the preferences are for an extension of unemployment insurance, food stamps and assistance to struggling homeowners.

Despite trillions of dollars that central banks worldwide have pumped, some prominent commentators still maintain that it is not enough. For example, Martin Wolf writes,

Yet, in current conditions, monetary policy will be insufficient. This is a Keynesian situation that requires Keynesian remedies. Budget deficits will end up at levels previously considered unimaginable. So be it.

It is extraordinary to suggest that Keynes's ideas are now coming back to save the world. Keynesian ideas have never left the rooms of government and central-bank decision makers. The essence of the thinking of the most influential economists was and still is Keynesian. So various stimulus packages that are now introduced are a continuation of the same Keynesian policies we have been subjected to for many decades. The present economic crisis is the outcome of the large dose of Keynesianism we have been given over many decades.

In a nutshell, John Maynard Keynes held that one cannot have complete trust in a market economy, which is inherently unstable. If left free, the market economy could lead to self-destruction. Hence there is the need for governments and central banks to manage the economy.

Successful management in the Keynesian framework is done by influencing the overall spending in an economy. It is spending that generates income. Spending by one individual becomes income for another individual, according to Keynes. The more that is spent, the better it is going to be. What drives the economy then is spending.

Consumption and Production

In the Keynesian framework, the largest chunk of spending is on account of consumer outlays. Therefore consumer outlays are regarded as the motor of the economy — consumption sets in motion real economic growth.

But is consumption the motor of the economy? We suggest that one must make a distinction between productive and nonproductive consumption. While productive consumption is an agent of economic growth, nonproductive consumption leads to economic impoverishment.

Productive Consumption

A baker exchanges his ten saved loaves of bread for ten potatoes. The potatoes are now sustaining or funding the baker while he is engaged in the baking of bread. Likewise the bread sustains the potato farmer while he is engaged in the production of potatoes. The respective production of the baker and of the potato farmer enables them to secure goods for consumption.

What makes the consumption productive in this example is the fact that both the baker and the potato farmer consume in order to be able to produce. The consumption of both the baker and the potato farmer maintains their lives and well-being. This is the only reason for production.

The introduction of money doesn't change what was said so far. For instance the baker can exchange his ten loaves of bread for $10 — he then uses money to secure ten potatoes. Likewise the potato farmer can now exchange his ten dollars for ten loaves of bread. Observe that, apart from fulfilling the role of the medium of exchange, money has contributed absolutely nothing to the production of bread and potatoes.

Nonproductive Consumption

So far we have seen that to secure potatoes, the baker had to exchange bread for money and then employed money to secure potatoes. Something was exchanged for money, which in turn was exchanged for something else — or something for something is exchanged with the help of money.

Trouble erupts when money is created "out of thin air." Such money gives rise to consumption, which is not backed by any production. It leads to an exchange of nothing for something.

For instance, a counterfeiter has printed a perfect $20 note. Since he secured this money by means other than the production of some useful goods or services, the counterfeiter has therefore obtained the $20 by exchanging nothing for it.

The counterfeiter uses the $20 to buy ten loaves of bread. What we have here is the diversion of real funding — ten loaves of bread — from a potato farmer towards the counterfeiter. Note that the diversion takes place by the counterfeiter paying a higher price for bread — he pays two dollars per loaf. Previously the price stood at one dollar per loaf. Also note that since the counterfeiter doesn't produce anything useful he is engaged in nonproductive consumption.

The potato farmer is now denied the bread that he must have to sustain himself while he is producing potatoes. Obviously this will impair the production of potatoes. As a result, fewer potatoes will become available, which in turn will undermine the consumption of the baker, thereby impairing his ability to produce.

We can see that, while productive consumption sustains wealth generators and promotes the expansion of real wealth, nonproductive consumption only leads to economic impoverishment.

Printing money by the central bank produces exactly the same damaging effect as the counterfeit money does. Likewise the creation of money through fractional-reserve banking produces the same damaging effect. The expansion of money sets the platform for nonproductive consumption — an agent of economic destruction.

In the Keynesian framework, during a recession when consumers tend to lower their outlays, it is the duty of the government to step in and boost its expenditure. For instance, the government could employ various unemployed individuals to dig holes in the ground.

The money that the government pays these workers will boost their consumption, and this in turn will lift the overall income in the economy. According to this framework, it doesn't really matter whether holes in the ground contribute to individuals' well-being; what matters is that people are getting paid and then using the money to boost consumption.

Government doesn't earn money as such. It is not a wealth generator. So how then does it pay various individuals who are employed in non-wealth-generating projects? It secures the money through taxation, by asking the central bank to print money, or by borrowing. If we ignore overseas borrowings, it basically amounts to the diversion of wealth from wealth generators to government activities. This is the same outcome achieved by printing money: it sets in motion nonproductive consumption.

According to Mises,

there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens' spending and investment to the full extent of its quantity.

From this we can conclude that since government is not a wealth generator it therefore cannot grow the economy. Contrary to popular belief, the more government spends, the worse it is for the health of the economy and thus for economic growth.

Rescue packages aimed at saving the economies of the world are just laying the foundation for more misery in the months ahead. Many commentators and economic experts who advocate strong government stimulus measures never bother to ask how those measures are going to be funded — and by funding we mean real stuff: where are all the bread and the potatoes going to come from?

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It doesn't occur to the Keynesian sympathizers that it is the fiscal and monetary policies of the past several decades that have given rise to nonproductive consumption. The outcome of all this is the vast amount of bubble activities. How can more of the same Keynesian policies — policies that have inflicted massive damage on wealth producers — revive the economy?

What is now required is not more Keynesian policies but rather allowing wealth producers to move fast and start generating real wealth. What is required is plenty of productive consumption. More government spending and the massive pushing of money by central banks only strengthens nonproductive consumption, thereby delaying prospects for a meaningful economic recovery.