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Why Keynes Was Wrong about Consumer Spending

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08/04/2020

As a result of the coronavirus pandemic, most experts are of the view that it is the role of the government and central bank to minimize the damage inflicted by the virus—and the policy response to it—on the economy.

The logic behind this reasoning is that increases in the demand for goods and services are the heart of economic growth. It is held that increases or decreases in demand are behind the rises and declines in the economy’s production of goods and services. It is also held that the overall economy’s output increases by a multiple of the increase in expenditure by government, consumers, or businesses.

An example will illustrate how an initial bout of spending raises the overall output by a multiple of this spending. Let us assume that of an additional dollar received individuals spend $0.9 and save $0.1. Let us also assume that consumers have increased their expenditure by $100 million. Because of this, retailers' revenue rises by $100 million. Retailers, in response to this increase in their income, also consume 90 percent of the $100 million, i.e., they raise their expenditure on goods and services by $90 million. The recipients of these $90 million in turn spend 90 percent of the $90 million, i.e., $81 million. Then the recipients of the $81 million spend 90 percent of this sum, which is $72.9 million, and so on (note that the key in this way of thinking is that expenditure by one person becomes the income of another person). At each stage in the spending chain, people spend 90 percent of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10 x $100 million) than it was before consumers increased their initial expenditure by $100 million (the multiplier here is 10).

Observe that the more is being spent from additional income, the greater the multiplier is and therefore the larger the impact of the initial spending on overall output is. For instance, if people change their habits and spend 95 percent of each dollar, the multiplier will become 20. Conversely, if they decide to spend only 80 percent and save 20 percent, then the multiplier will be 5. All this means that the less that is being saved, the larger will be the impact of an increase in overall demand on overall output.

The popularizer of the magical power of the multiplier, John Maynard Keynes, wrote,

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course by tendering for leases of the note-bearing territory), there need be no more unemployment and with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.1

Money and the Multiplier

Observe that in the example above the initial boost to consumption had to originate somewhere. As a rule, the source is normally the monetary pumping of the central bank. Money, however, cannot set in motion a real economic boost. If this were the case, all third world economies would have erased poverty a long time ago.

Money enables the exchange of something for money and then the exchange of money for something else. In this sense, it is a medium of exchange, not the medium of payments. Paraphrasing Jean Baptiste Say, Mises argued that,

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.2

When an individual increases his spending by $100 all it means is that he has lowered his demand for money by $100. The seller of goods has now acquired $100, which he can employ when he deems necessary. We can also say that the seller's demand for money has increased by $100. Likewise, if the seller then spent 90 percent of $100, all that we would have is a situation wherein his demand for money has fallen by $90 while somebody else's demand for money has risen by $90.

In addition, all other things being equal, if individuals have increased their expenditure on some goods, they will be forced to spend less on other goods. This means that the overall spending in an economy remains unchanged.

Only if the amount of money in the economy increases, all other things being equal, will spending in monetary terms follow suit. The increase in monetary expenditure as a result of an increase in money supply cannot, however, produce an expansion in real output, as the popular story has it.

All that it will generate is a reshuffling of the existent pool of real savings. It will enrich the early receivers of the new money at the expense of the last receivers, or those who do not receive it at all. Obviously, then, a loose monetary policy aimed at boosting consumers' demand cannot boost real output by a multiple of the initial increase in consumer demand. Not only will easy money policy not lift production, but, on the contrary, it will impoverish wealth generators.

Are More Savings Bad for the Economy?

Can more savings be bad for the economy as Keynesian economics suggests? Take, for instance, Bob the farmer, who has produced twenty tomatoes and consumes five. Fifteen saved tomatoes are left at his disposal—these are his real savings. With the help of the saved tomatoes, Bob can now secure various other goods. For instance, he secures one loaf of bread from John the baker by paying him five tomatoes. Bob also buys a pair of shoes from Paul the shoemaker for ten tomatoes. Note that it is the real savings at his disposal that limit the amount of consumer goods Bob can secure for himself. Bob’s purchasing power is constrained by the amount of real savings—the tomatoes at his disposal—all other things being equal. (Likewise, John the baker has produced ten loaves of bread and consumes two, making eight loaves his real savings. Equally, if out of the production of two pairs of shoes Paul keeps one pair for himself, then his real savings is one pair of shoes.)

When Bob the farmer exercises his demand for one loaf of bread and one pair of shoes, he is transferring five tomatoes to John the baker and ten tomatoes to Paul the shoemaker. Bob's saved tomatoes maintain and enhance the baker's and shoemaker's lives and well-being. Likewise, the saved loaf of bread and the saved pair of shoes maintain Bob the farmer's life and well-being. Note that it is saved final consumer goods that sustain the baker, the farmer, and the shoemaker. They are what makes it possible to keep the flow of production going.

The owners of final consumer goods, rather than exchanging them for other consumer goods, could decide to invest them to secure better tools and machinery. Better tools and machinery can improve their productivity, leading to a greater output and better quality of consumer goods that will be produced sometime in the future.

By exchanging a portion of their saved consumer goods for tools and machinery, the owners of consumer goods are in fact transferring their real savings to individuals who specialize in making them. These individuals' own real savings sustain them while they are busy manufacturing tools and machinery.

Once these tools and machinery are built, they permit an increase in the production of consumer goods. As the flow of production expands, it permits more savings, all other things being equal, which in turn permit a further increase in the production of tools and machinery. This, in tur,n makes it possible to further increase the production of consumer goods, i.e., raise the purchasing power in the economy. So, contrary to popular thinking, more savings actually expand, not contract, the production flow of consumer goods.

Can an increase in the demand for consumer goods lead to an increase in the overall output by the multiple of the increase in demand? To be able to accommodate his increased demand for goods, the baker must have a means of payment—bread to pay for goods and services that he desires. Once the supply of consumer goods has increased, this permits an increase in demand for goods. The baker’s increase in bread production permits him to increase his demand for other goods. In this sense, the increase in production gives rise to more demand for goods. People are engaged in production in order to be able to exercise demand for goods to maintain their well-being.

What enables the expansion in the supply of final consumer goods is an increase in capital goods, or tools and machinery, and it is real savings that permit the increase in tools and machinery. We can thus infer that an increase in consumption must be in line with the increase in the production of final consumer goods. From this we can also deduce that consumption does not cause the production to increase by the multiple of the increase in consumption. Increases in production are in accordance with what the pool of real savings permits and are not constrained by consumers' demand. Production cannot expand without support from the pool of real savings, i.e., something cannot emerge out of nothing.

Increased Government Demand and Economic Growth

Let us examine the effect of an increase in the government's demand on an economy's overall output. In an economy that is comprised of a baker, a shoemaker, and a tomato grower, another individual enters the scene. This individual is an enforcer who is exercising his demand for goods by means of force.

Can such demand give rise to more output, as popular thinking has it? On the contrary, it will impoverish the producers. The baker, the shoemaker, and the farmer will be forced to part with their products in for nothing and this in turn will weaken the production of final consumer goods. Again, as one can see, not only does the increase in government outlays not raise overall output by a positive multiple. On the contrary, it leads to the weakening of the process of wealth generation in general. 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.3

Summary and Conclusion

John Maynard Keynes's writings remain as influential today as they were ninety years ago. His ideas remain the driving force of economic policymakers at the Fed and government institutions. These ideas permeate the thinking and writings of the most influential economists on Wall Street and in academia.

The heart of the Keynesian philosophy is that what drives the economy is demand for goods. Economic recessions are predominantly the result of insufficient demand. In the Keynesian framework, an increase in demand not only lifts overall output, but increases it by the multiple of the initial increase in demand. Something can be created out of nothing.

In the real world, an artificial boost in demand that is not supported by production leads to the dilution of the pool of real savings and, contrary to the Keynesian view, to a shrinking in the flow of real wealth. It results in economic impoverishment.

  • 1. J.M. Keynes, The General Theory of Employment, Interest and Money (New York: Macmillan and Co., 1964), p. 129.
  • 2. Ludwig von Mises, “Lord Keynes and Say's Law,” in The Critics of Keynesian Economics, ed. Henry Hazlitt (Lanham, MD: University Press of America 1983), p. 316.
  • 3. Ludwig von Mises, Human Action, 3d rev. ed. (New York: Contemporary Books Inc.), p. 744.
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Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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