Why Keynesian Economics is a Disaster

Not only does the Keynesian system require arbitrary controls, but the particular form of inflation which Keynes recommended – the socialization of investment which he thought would facilitate the spending of income – means… the transfer of power to determine ends from the market to the government, from the people to the politicians, from society to a group, from the many to the few… The tragedy is that many of those whose ethical convictions cause them to abhor totalitarianism, fail to perceive that the transfer of power from society to the politician is a step from social to private control, a step toward the destruction of the ideally free society.                               W. H. Hutt  The Keynesian Episode

On October 24, 1929 the New York stock market had a very bad day. The prices of all stocks began to fall, and as they did so, panic selling began. That day, 12,895,000 shares changed hands. The volume swamped the mechanical ticker that reported trades to the outside world.  The boom in stock prices that had built up during the 1920′s collapsed. Stocks fell in value, rallied, and then fell again. When the market hit bottom, on November 13, 1929, the price of the average share had dropped by 53%.

Since many stocks had been purchased “on margin”  (meaning: the owner borrowed money from his broker to buy the stock) the fall in price brought the value of the stock below the amount of the loan. The brokers were forced to sell the stock for any price, and demand that the owners pay the rest in cash. In many cases, the owner didn’t have the money. He lost not only his investment, he lost everything. He owed more than he could pay, and went bankrupt.

So many people defaulted on their loans that many brokerage firms also went bankrupt. So many banks had loaned money to individuals and brokerage firms who went under, that banks too collapsed. Panic spread throughout the country. By 1933 more than 9,106 banks were suspended or ceased to exist. In many cases, the depositors lost everything.

In a spreading wave of depression and bankruptcy, orders for capital goods dropped, and industries began to lay off workers. The Gross National Product which stood at $103.9 Billion in 1929 dropped to $56 Billion in 1933. By that year, 12.8 million workers — 24.9% of the labor force — were unemployed.

The panic was not confined to the United States. One by one, great financial institutions and industries failed in Austria, France, and Germany.   England — long the symbol of world financial stability — abandoned the gold standard. Industries failed, unemployment grew.

The world had seen panics before. But they seldom lasted much more than a year or two. The great depression which began in 1929 dragged on year after year – 1930, 1931, 1932, 1933 with the direction always down, and no end in sight. People lost faith in the system, in the banks, in the government. Communism and Fascism — radical socialistic solutions — gained in every country.

Few economists knew what to do. Almost none had predicted the crash. In its aftermath, many of them were discredited. But then, in 1936, a British economist, John Maynard Keynes produced a book and a theory that changed the world. Within a dozen years, his ideas of what should be done to end the world depression were adopted not only by most economists, but by most government leaders in developed countries around the world. Keynesian theory was written into law in the United States in the Employment Act of 1946. Keynes is certainly the most influential economist of our time.

The Failure of Demand

Keynes began with the obvious. There were millions out of work who desperately wanted a job. There were idle factories filled with machinery and raw materials, but with no orders. There were starving millions at home that needed food, clothing, and other consumer goods.

The problem, as he saw it, was a failure of consumer demand. If people would only take some of their savings and buy something, the resulting sales would reopen the factories. Factories would call their employees back to work. The wages paid to the workers would be spent on more consumer goods; more reopened factories; more jobs; a return of prosperity.

The trick was to start the ball rolling: to get people to start spending again. People were scared. For years they had seen relatives, friends and neighbors wiped out. They were down to their bottom dollar and weren’t about to begin spending based on some economist’s hair brained scheme. So Keynes suggested the obvious answer: the government should “prime the pump” by putting people to work.

This had already happened in country after country. Many private relief agencies had been wiped out, so government began to distribute food, clothing, and to provide real — and make-work — jobs.  In the United States, under Franklin Roosevelt’s New Deal, millions were put to work in huge government relief agencies: the WPA, the PWA, the CCC. The same thing was happening throughout Europe. This was an obvious political answer to mass unemployment and hunger. But Keynes blessed these programs as economic solutions.

Not only that, his book, The General Theory of Employment, Interest and Money explained the cause of the depression, the methods for getting out of it — and for maintaining permanent growth and prosperity from then on.  Keynes theories were so persuasive that within a dozen years, most economists in most countries considered themselves Keynesians. His theories are today the conventional wisdom of our times.

The Propensity to Consume

Keynes began with an analysis of the activity of the consumer. A householder has two choices for what to do with his income: he can save it or he can spend it. If he saves it — puts it into the bank – Keynes said that he takes the money out of the spending stream. But if he spends it, he returns the money to the spending stream providing orders for factories, jobs for workers, and more income for himself.

Keynes used the “propensity to consume” to measure the percentage of a person’s income that he spends. He noted that the propensity to consume decreases as income increases:

Rich people save a higher percentage of their income than poor people. This certainly squares with common sense. The above figures are illustrative only. The actual amount saved and consumed varies from year to year and country to country.

He also noted that the “marginal propensity to consume” also varies with the income level of the consumer. The marginal propensity is a measure of the amount consumed out of a change in income. If, for instance, a person gets a pay raise of $1,000, how much of that extra $1,000 will be spent, and how much saved? The answer, said Keynes, depends on the income of the recipient. The higher your income, the lower is your marginal propensity to consume:

So rich people try to save more of their extra income than do poor people — but all people try to save more of their extra income than they do of their base income. Why is that? Well, clearly, for most people their first needs are to eat, to have a place to live, and to have heat and clothing. No one is going to save anything until these basic needs are met. But once you have your primary needs satisfied, saving for the future becomes a value for you which ranks with entertainment, luxuries, gifts, or travel. The higher your income, the more likely you are to want to get your future organized, and have a little money in the bank.

So, Keynes concluded, consumption is a regular, predictable economic fact of life. The amount of consumption by a household or a society depends on two things: the level of income and the propensity to consume.

Consumption = Y(income) times APC (average propensity to consume)

Marginal Consumption = dY (change in income) * MPC (marginal propensity to consume)

Investment — The Wild Card

Assume, for a moment, that government is very small economically (as it was in the early 1930′s) and that there is no foreign trade. The National Income would consist of only two factors:

National Income  =  Consumption + Investment

We can illustrate the flow of money in the economy by a simple diagram:

Gross Domestic Product

From this diagram, it is clear that national income can be maintained only if consumers keep spending, and businessmen keep hiring people and resources, and investing (buying plant and equipment). Consumers can be counted on, as we have seen. But, Keynes pointed out, employment and investment by business is not equally reliable.  Why is that?

Business investment is done with an eye for the future. A businessman will invest in a new plant or machine if he thinks that he can make a profit from it. If he is worried about the future, he may decide to wait until times are better. After all, business investment is not essential, like eating and drinking. It can always be postponed.

When thousands of businessmen all become worried and pessimistic at the same time (as happened during the great depression, and happens today in a recession), investment and employment will decrease. From 1950 to 2010 gross domestic private investment varied from a 52% increase from the previous year (in 1950) to a 13% decrease (in 1982). Clearly the figures support Keynes view that business investment is the most unstable component of the national income.

Income Determination

Keynes then went on to use these two components — consumption and investment — plus saving — to determine the equilibrium level of national income. He accomplished this by means of two simple formulas. The top of the diagram is:

Y = C + I

This formula tells us that national income (Y) is created by consumption spending and investment spending.

But, there is a second formula from the bottom of this chart:

Y = C + S

This tells us that national income, once created, and paid out to the public (in the form of wages, salaries, interest, rent and profits) can have only two possible dispositions: it can either be consumed (C) or saved (S).

From the above two formulas, you can easily see that, at equilibrium, Saving (S) must be equal to Investment. If Y = C + S and Y = C + I. then, at equilibrium, S = I

To put this into numbers, if consumers receive their $15 T (Trillion) national income, they save 10% of it, then the APS (Average Propensity to Save) is 0.10. Ten percent of their income of $15 T is $1.5 T. So saving is $1.5 T. This leaves $13.5 T left for consumption. Every time the circle is made, business contributes $1.5 T of investment, and the public subtracts $1.5 T in saving, so the economy is at equilibrium at a GDP of $15 T.

Investment increases

Let us suppose that for some reason, business leaders decide to increase their annual investment spending level from $1.5 T to $2 T.  National income is now greater: it equals $13.5 T consumption plus $2 T investment, or $15.5T.

The public now has $15.5 Trillion income, instead of $15. If they still want to save 10%, their saving will go up to $1.55. Subtracting this $1.55 saving from the income of $15.5, we come to a new national spending level of $13.95 Trillion.

Equilibrium requires several rounds

The economy is not yet at equilibrium. Investment is at $2 T, and saving is $1.55T. On the next round, the businessmen will again contribute $2 T, making national income go higher and higher in each round until S = I.

How long will it take to reach equilibrium where S = I? No one knows — in fact, the economy will never actually get there. The reason is that long before it reaches equilibrium, the businessmen will change their minds, will change their investment programs, and we will be off towards a new level of equilibrium — either higher or lower than the current level.

But the fact that we never reach equilibrium is unimportant. The important thing is to realize that the equilibrium calculation tells us the direction that the economy is likely to go (up or down) at any given time based on the level of investment and the APS.

The Multiplier

Looking at the above diagrams tells us something else. We saw that businessmen increased their level of investment from $1.5T to $2T per year. When the economy reaches equilibrium, the level of income will have increased from $15T to $20T per year. A $500 billion increase in investment gave us a $5 T increase in income. This is a ratio of 1 to 10. Keynesian economists call this resulting increase the “multiplier”. A change in investment alters the equilibrium level of national income by a “multiplied amount.”

What made the multiplier 10?  Clearly it was the Average Propensity to Save (which equaled 0.10 in our illustration). If the APS had been 0.20 the multiplier would have been 5. The Keynesian formula is:

Multiplier = 1 / APS      or        Multiplier = 1 /  MPS

(For total income)         (For a change in income)

In our case, the multiplier (M) = 1 / 0.10 = 10

The multiplier explains why slight changes in the level of business investment (up or down) after several rounds have such a profound impact on the whole economy — how the crash of the stock market could affect everyone in the United States — or the whole world, for that matter.

The Paradox of Thrift

It is impossible to accept Keynes’s theories without concluding, as he did, that saving is bad for the economy. Saving, to a Keynesian, can be viewed as a selfish act by an individual household thinking only of their own future well-being. Each attempt by a household to save deprives the economy of needed funds to keep up sales, wages, rents, profits and interest payments. If everybody decided to increase their level of saving, according to Keynesian theory, it could spell disaster for the economy. He called it the “paradox of thrift”.

If everyone tries to save an increasingly larger portion of his or her income, they would become poorer instead of richer. This is because the economy will slow down from reduction in demand and the very same people would lose their jobs.

So what is wrong with this idea?  The problem is that in the diagram shown above, savings is pictured as a bucket. Money goes in and just sits there. This would be true if everyone in the public converted their savings into cash and put the cash under their mattress or in a safe deposit box. In fact, that is not what happens today. Savings are put into a bank or stocks in some intermediary institution.  The owners of such intermediaries are entrepreneurs who are interested in increasing their own income. They could not make any increased money if their depositors just put their savings in a safe deposit box.  Some do, of course, but the vast majority of consumers put their savings into some account whereby the intermediary (an entrepreneur) can invest that money in some way to boost his own income. The only way that could happen is if the money were invested with some process that increased the amount invested.

Full Employment and Gross National Product

If you study the diagram, you can see that there is not necessarily any relationship between the equilibrium level of national income, and full employment. In fact, this lack of a relationship is central to Keynesian theory. Keynes insisted that the economy can, and often does come to an equilibrium that leaves millions unemployed. What is the solution?  There are several suggested by the Keynesians:

  • Get businessmen to increase their level of investment.
  • Get consumers to increase their level of consumption – reduce their saving.
  • Get the government to step in with additional spending.

All three have been tried extensively in the years since Keynes first published his theory in 1935. Let’s look at each one in detail:

Increase in Investment

Businessmen have always been a problem for Keynesians. In a free society, the government cannot order them to invest. All that can be done is to provide inducements.  Tax reductions for business have often been suggested, but they have two problems:

1.  Politically, legislators usually oppose giving businesses a tax reduction without also giving a break to workers. The attempt to reduce everyone’s taxes at once usually drops government revenue below acceptable levels.

2. Even when taxes are reduced, businessmen will invest only if they have confidence that the tax reductions are permanent and they will make a profit. In tough times, they may just sit on their hands.

As a result, Keynesians usually suggest stimulating investment by reductions in interest rates. In times of recession, the President encourages the Federal Reserve Board to bring interest rates down through open market operations.  This solution (central bank interest rate reductions) has two problems:

1. Even at low interest rates, if times are tough, businesses may still not invest unless they see a clear opportunity for profit.

2. The bigger problem: the interest rate reduction sends the wrong signal to businesses in the higher orders of production — those levels which are particularly responsive to interest rates. Low rates may spur higher order capital goods producers to expand, when there is usually at the time little real need for increased output down the line.  Workers are hired, office buildings built, and factories and major construction projects are started that are in excess of real requirements. Anyone who doubts this need only look at the glut of housing and empty office buildings in 2011. The end result: investors lose their capital, facilities sit idle, banks and savings and loans that financed the expansion fail by the hundreds.

The Accelerator

If a businessman sees that sales are going up, he is more likely to invest so that he will be able to profit by what looks to him like an expanding market. This tendency of investment to increase when national income rises is called by Keynesians “the accelerator”.  It has the effect of making booms more pronounced. At the same time, the accelerator works to reduce investment in a contracting market. When businessmen see sales going down, they postpone their investments. The accelerator is another reason why Keynesians feel that business investment is a weak reed on which to rest national economic policy. 

Built In Stabilizers

There are some factors in the economy which Keynesians see as working counter to the accelerator and other cyclical trends. These are things like unemployment compensation and welfare (which expand in hard times) and income taxes (which bite deeper in good times). These are called “built-in stabilizers” because, without any action by government managers, they help to dampen a boom, and reduce the effect of a dip in the economy.

Get Consumers to Consume More

As a result of the problems with business investment, many Keynesians have become disenchanted with businessmen. They feel that there is no way that they can get businessmen to do what is in the national interest: increase investment when there are millions unemployed. Many Keynesians, therefore, have turned their attention to encouragement of the consumer.

There is one good way to get consumers to spend more, and that is to give them a tax cut. In 1964 and in 1982 major tax reductions were pushed through a reluctant Congress. The result in both cases was a business boom that lasted for many years. Despite the success of these two experiments, few true Keynesians are happy with them for a number of reasons:

  • Most poor people pay no taxes. Tax cuts, therefore, go to the middle class and the wealthy. This disturbs many Keynesians who believe that assistance to the poor should be a key objective of government policy.
  • Most taxpayers have a high MPS — that is, they have a high propensity to save any extra income that they get. In effect, therefore, much of the tax cut results not in boosting consumption, as the Keynesian’s want, but in building up the savings accounts of the middle class.

The effect of this tendency to save can be seen in the following example:

To boost spending, a tax cut of $300 billion is voted. Let us assume that the average MPC of the taxpaying public is 0.67. What will be the increase in national income?

The taxpayers, with an MPC of 0.67, have a MPS of 0.33. This means that they will save 1/3 of any tax reduction, or $100 billion. Their increase in consumption, therefore, is only $200 billion ($300 – $100). The multiplier is 3 (1/0.33). So the increase in national income is only $600 billion (3 x $200). This may seem like a useful result, until you realize that the same $300 billion, if given directly to the poor (who have a very high propensity to spend — perhaps 0.90) could have resulted in an increased national income of $2,700 Billion! ($300 * .90 = $270 * 10 = $2,700). You can put a lot more people to work with $2,700 billion than you can with $600 billion.

Clearly, if your goal is to increase consumption, giving middle class taxpayers a break, according to Keynesian theory is a costly way to do it.

The third reason for rejecting tax cuts is that they are politically very difficult to accomplish, and almost impossible to reverse. Keynesian theory says that taxes should be low in bad times, and high in good times. But what legislator is going to raise taxes just because some economist says “times are good”?

Public Works

As a result of the failure of other techniques, the method of choice for restoring full employment and managing the economy for most Keynesians is the manipulation of government spending.

In the depression years, millions were put to work improving park land, building post offices, building dams, roads, and bridges.  The huge interstate highway system which has provided the United States with the best road system in the world was started during the Eisenhower administration, partially as a Keynesian response to the recession of mid 1950′s. But experience has shown that public works are not a good way to provide a Keynesian boost to an economy. There are three reasons:

  1. Large public works projects require years of planning, and usually take years to get started. The interstate highway system required years of public hearings, acquisition of land, engineering design, and letting of contracts before it had any real impact on the employment level. Such projects, therefore, take too long to get started to be able to be used to solve any immediate recessionary problems,
  2. Public works take a long time to complete — usually many years. By the time they get started, the recession which they were supposed to correct has often turned into a boom which the heavy spending only makes worse. But you cannot turn a public works program off in the middle.
  3. Public works projects today use very expensive and complicated capital equipment: bulldozers and cranes, and involve skilled crafts: plumbing, electricians, brick layers, dry wall finishers. There are virtually no pick and shovel jobs any more. The people most likely to be unemployed are low skilled workers who do not have the skills needed for a construction project.

Defense Spending

The defense budget today represents a significant amount of government spending. It certainly employs of millions of people both in uniform and in defense contractor industries. Keynesians have seldom been advocates of higher defense spending to solve unemployment for a couple of often cited reasons:

  1. Defense spending involves highly complex equipment — jet planes, electronics, missiles, etc. which provide employment only for the very highly skilled. These workers are often in short supply. Defense firms will boost their wages trying to hire them away from other firms. These workers, and the firms that employ them, have a high propensity to save. Much of the defense spending, therefore, winds up in personal savings accounts rather than multiplying the national income.
  2. If public funds are going to be spent for counter-cyclical reasons (countering recessions) the Keynesian’s argue, why not use the money to help our poorest citizens instead of providing fuel for the arms race?

Transfer Payments

As a result of the drawbacks of other methods, the only generally acceptable forms of “pump priming” agreed upon by most Keynesians are transfer payments: direct payments to the elderly, farmers, children, and the poor. Food stamps, school luncheons, rent supplements, Aid for Dependent Children, Medicaid, Medicare, and other forms of welfare and poverty assistance programs which are demanded by action groups representing the underprivileged have been approved and supported by Keynesian economists as solving two problems at once:

  1. They are easy to get through the Congress, since any objections to their cost and effect on the budget can be counter-balanced by economic arguments that they will “restore full employment”.
  2. The money is given, generally, to the poorest people who have a very high propensity to consume. As a result, the money is immediately put to work, and the multiplier tends to be large.

In the years from 1960 to 2010, transfer payments have grown faster than any other part of the government budget. They are generally called “entitlements” because they are usually written into legislation that makes them permanent.

Full Employment

Keynesian theory, therefore, suggests using government spending to maintain full employment by taking money from taxpayers with a high propensity to save, and giving it to tax-consumers with a high propensity to consume. The resulting spending is supposed to provide jobs, growth, and prosperity. At the same time, the re-distributed income will tend to reduce the gap between the rich and the poor making for greater fairness and equality.

What is full employment?

Full employment essentially means that everyone who wants one will have a job. It also means that industrial plants are operating at close to capacity.  Of course, in a large country like the U.S. with 150 million workers there are always going to be some people who have just been laid off, or fired, or who have quit, and have not yet found another job.  Unemployment can never be equal to zero. Even in good times, there is a certain percentage of unemployment:

From 1946 to 2011 the unemployment rate never dropped below 3.4%, and since 1974 it has never fallen below 5.2%. Obviously, in 2011, an unemployment rate of about 9.2% represents far less than full employment. It is a recession.

Using a number like 5% as the goal, Keynesians have tried for sixty years to determine what level of spending would put enough people to work to bring unemployment down to that level. This amount is called “The Deflationary Gap”. It is defined as “the amount of extra spending required to increase National Income to a full employment level.”

How do we get GNP to increase by enough to reach full employment? We could use a tax cut, or increased government spending. Changes in the tax laws in the past 50 years have resulted in a situation in which more than 50% of the American people pay no income taxes at all. A tax cut, therefore, would benefit upper income taxpayers who have a high propensity to save. For this reason, Keynesians prefer increasing government spending. They have consistently pushed for programs that benefit the poor or other special interest groups. The only requirement is that it be given to someone who will immediately spend it — put it into the spending stream — so that it will provide jobs.

Let us assume that the MPS of the recipients of our programs is 0.20. The multiplier is 5. So, if we increase government spending by $850 billion (as the Stimulus Legislation did in 2009) the result with a multiplier of 5 should boost national income by $4.25 Trillion. In fact, of course, it did no such thing. National Income from the first quarter in 2010 to the same period in 2011 went from $13.1T to $13.4T (in seasonally adjusted 2005 dollars) – an increase of $300 Billion with a stimulus of $850 Billion. The multiplier instead of 5 was 0.35.  Of course, in Keynesian theory it takes many rounds for the multiplier to produce its true effect, but after the first round it should at least equal 1 or slightly more.  What went wrong?

The expansion of government

GDP with Government

In the past 50 years, governments in the UK, the US and the EU have grown so large that they have greatly altered the way that GDP can be described.  Governments have gone way beyond maintenance of law and order and defense. Due, in large part to Keynesian theories, governments are heavily into the redistribution of income – from the rich to the poor, from the healthy to the sick, from the young to the old, from city dwellers to rural dwellers, from majorities to minorities.

Government now consumes 40% of the GDP. The Keynesian Theories that were based on a small government picture have to be replaced with a new picture. The $850 Billion stimulus legislation of 2009, for example, did not go into the spending stream to augment business investment (as the theory assumed) but in large part was spent on government projects and personnel.  In such a situation, the multiplier can be below 1, since money given to the government which is spent on government projects has a very low short term MPC. Government projects often take years to get going. There are all sorts of environmental studies, hearings, and delays with government programs (and with private industry programs) that greatly reduce the multiplier.

What has ruined the supposed benefits of Keynesian theory is the success of Keynesian programs. Government spending programs intended to boost full employment have produced constituency groups (farmers, advocates for the poor and minorities, defense contractors, labor unions, environmentalists, and entitlement advocates to name a few) who have had their benefits enacted into law. These laws are very difficult to change.

The problem of government debt

Another problem stemming from Keynesian economics is that governments have run up huge debts.  Arguments against government spending have been countered by economists saying that government spending is good for the economy: it puts people to work. There is a multiplier. Taxes are reduced (due to Keynesian theories).  So where does government get the money? From borrowing. No problem. State, municipal and US government bonds sell well. By 2011 the outstanding public debt was $14.4 Trillion dollars. The gross domestic product in 2011 was $13.4 Trillion dollars. The estimated population of the United States was 310,871,520 so each citizen’s share of this debt was $46,183. From 2007 to 2011 the debt grew by an average of $3.89 billion per day. A major problem of the growth of this debt is that without some heroic action, it cannot be stopped. Most of it is written into laws that are very hard to change. Looking at the future, seniors have been promised social security and Medicare in permanent legislation. In the Federal Government and in most states, public employees have been promised lifetime pensions and health benefits which are difficult to change. The poor have been promised medical and income support benefits through legislation.  Farmers receive price supports and ethanol benefits. These programs have been enacted because of the desire of government to benefit citizens, and through the activities of pressure groups. Since 1946 all such groups have been able to use as one argument that the government spending on their programs would have a multiplied positive Keynesian effect on the national economy.

The search for full employment

Since the Full Employment Act of 1946, the US Government has been committed to the idea that full employment should be achieved and maintained by government activities. As the years developed, it became clear that full employment represented about 5% unemployment since there are always people in transition from one job to another. To meet this objective, massive spending on government entitlement and employment boosting programs have grown the size of government and increased the national debt.  The basic problem is that Keynesian economics, the basis of the Full Employment Act, does not work.  Every year, the US (and world) economy becomes more productive. Due to new methods, machinery, and technology, workers produce more output per day each year than they did last year.  To maintain full employment, therefore, it is necessary to find jobs for workers displaced by higher productivity. Workers need new skills to deal with the internet, computers, software, marketing, etc.  Massive government programs do not help this situation.  Only individual initiative by entrepreneurs and workers can deal with it. Unemployed workers are similar to underutilized materials or machinery. They can represent a source of revenue for an entrepreneur who can find something for them to do.  We must leave it to human drive and ingenuity prompted by the desire for profit to solve the unemployment problem.

Conclusion on Keynesian Economics

Keynesian theories have been very powerful in the developed world. In the US and the UK, more than 90% of all economists are Keynesian. Most of the rest are advocates of monetary theory championed by Milton Friedman.  Very few are Free Market Economists (i.e.Austrians).  Keynesian economists take the MPS, the multiplier, and the accelerator seriously as if they really worked. They tend to ignore the national debt.  They ignore ridiculous parts of Keynes’s book including such quotes as:

“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…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…”[i]

Mistaken ideas in Keynes thinking should be discarded. For instance, saving is not bad. Saving is an essential first step to investment. The idea that saving results in ‘freezing money’ in idle bank accounts as Keynes maintains is completely contrary to what actually happens. The reason, of course, is that banks and other financial intermediaries are entrepreneurs who seek to make profits with the money invested in them. Economies that save generally grow much faster than economies that do not save as much.

Keynes theory calls for cut backs in government spending in good years. Government spending has never been cut back, even under Ronald Reagan who came to Washington pledging to do that.  The reason, say critics, is that Keynes did not anticipate the huge bureaucracies and constituent groups which would be created as a result of the government programs set up to administer the Keynesian spending programs. These bureaucracies (welfare, Social Security, Medicare, Medicaid, unemployment compensation, agriculture, environmental controls, food stamps, aid to education, etc.) have built up domestic constituencies and legal “entitlements” which not only maintain themselves, but every year successfully lobby for an expansion of benefits and spending — regardless of Keynesian economic prescriptions.

In summary, the Keynesian theory’s impact on society has been negative for the following reasons:

  • They led to a massive increase in government spending which is very difficult to stop.
  • They do not work out in practice: The multiplier is less than 1 in most cases, meaning that government spending makes things worse instead of better.
  • They have resulted in long term debts of federal and state governments.
  • They do not solve the problem that they were supposed to solve – unemployment.

What can be done?

The answers can be found on this website. In summary, they are:

  • Governments must live within their means. Government spending should be limited to the revenue that comes in.  Future borrowing should be restricted to wars, national emergencies and long term investment projects such as roads and bridges. This means that there must be serious spending cuts – particularly in entitlements.
  • The long term government debt should be paid off.
  • Taxes on corporations and individuals should be reduced.
  • Long term pensions and health benefits to government employees should be ended.  Employee’s salaries should be invested in private insurance programs that will continue to pay pensions and health benefits after they leave government service, leaving government with no responsibility for them once the workers are no longer employed.
  • Entitlement programs such as Social Security, Medicare, Medicaid and other programs should be put on a self-sustaining basis such that the annual payments are limited to the annual revenue.
  • The government should stop artificially maintaining interest rates below their natural level.
  • Unemployment insurance programs should be self-supporting. They should not extend beyond a few months, so that the workers will be obliged to find jobs.


  1. Keynes published his book The General Theory of Employment, Interest and Money in 1936 in the midst of the great depression. It offered a solution that made sense to millions: have the government spend money to put people back to work. His theory was that unemployment comes from a failure of demand: business and consumers are not spending enough. Since business cannot be controlled, and consumers do not respond to spending exhortations, the government must step in to do the job.
  2. There are only two things consumers can do with their income: save it or spend it. If they save it, said Keynes, it is taken out of the spending stream, and will reduce the national income. Their marginal propensity to consume (MPC) determines how much of an increase or decrease in income they will spend. Their MPS determines how much they will save. Low income people have a high MPC. High income people have a high MPS.
  3. Business cycles are made worse by businessmen who stop investing whenever they fear bad times. When many businessmen all worry at once, it produces a recession. Lower interest rates may induce them to begin investing again, but they are motivated by “animal spirits” and may not respond.
  4. Savings reduces national income, investment increases it. National income is at equilibrium when savings equals investment. The formula for determination of national income is:

Change in Y = Change in Investment times the multiplier

The multiplier = 1/MPS

The same formula holds true for changes in Consumption (C) or Government Spending (G)

  1. The paradox of thrift is that an attempt by many people to save their money during a recession will reduce national income so much that actual saving will go down (since saving is a percentage of income — MPS).
  2. One way to get consumers to consume more is to give them a tax cut. The problem with a tax cut is that only the middle class and wealthy pay taxes, so it goes only to them. The middle class and wealthy have a high propensity to save. So much of the tax cut may simply go into middle class bank accounts, rather than improving the national income. This is bad, according to Keynesian theory, but is actually good for the economy because savings do not sit idle. They get invested (financial intermediaries are entrepreneurs).
  3. Public works are not a useful way to manage the economy (increase spending in bad times, reduce it in good). This is because most public works take so long to get going that the recession is over before they make any contribution to spending. Then they keep on spending money during a subsequent boom when spending should be cut back.
  4. Keynesians maintain that the most effective form of government spending to maintain full employment is welfare and other programs aimed at transferring income to poor people. This is because poor people have a high propensity to consume (they will spend it right away), and spending on the poor tends to redistribute income so that there is less inequality. As a result of Keynesian theory, and a national concern for the poor, social welfare outlays from 1960 to 2010 increased from 27 percent of the federal budget to more than fifty percent.
  5. Full employment is defined as a certain level of unemployment. Most economists agree on about 5% unemployment as representing full employment.  Trying to maintain full employment year after year is difficult because increasing labor productivity means that less and less workers are needed to produce the same output. To maintain full employment, therefore, the federal government has gone deeply into debt every year for the past 40 years.
  6. Government guarantee of full employment encourages labor unions to seek higher wages without fear of the unemployment that normally follows such wage increases. American unions used this logic to increase their wages by significant amounts from 1950 to 1980.
  7. One effect of fifty years of Keynesian economics has been a massive increase in the federal debt. Government used to go into debt only in wartime. Since 1980 the peacetime debt has far exceeded the debt incurred in all former wars. Keynesian economists dismiss this concern with debt by saying that “we owe it to ourselves” and that the debt as a percentage of GNP is not significant.
  8. Critics of Keynesian economics say:
  • Saving, rather than being bad, is the only way real wealth in a society can grow.
  • The growth in federal debt is a danger today and a burden on future generations.
  • Investment creates wealth; food stamps and welfare do not. They are fundamentally different.
  • Full employment should not be a government goal — it encourages inflationary wage increases and government debt.
  • In theory, Keynesians want to pay off debt in good years, and increase it in bad. But in good years, it has proved politically impossible to pay off the debt.

[i] Keynes, The general theory of Employment, Interest and Money (London Macmillan, 1936, p 129


About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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