I came across this interesting piece from Cullen Roche last week, in which he critiqued a critique of Keynesianism written by John Mauldin. In it Roche takes Mauldin to task for not only the usual crimes of not viewing the world through a MMT lens (even though that lens is just an obfuscation of reality enveloped in ‘accounting realities’), but for misrepresenting Keynesian economics. Perhaps one day I’ll take on MMT tenets in full, but the focus of the piece was on the obfuscation Mauldin was guilty of, namely the misrepresentation of Keynesianism.
Cart before Horse
At its most basic level, Keynesian economics is a view of the world that states the following:
- Investment (as in, spending, not consumed for future production and not stock market “investing”) is the primary driver of employment and involuntary unemployment occurs when investment is lacking (for whatever reason).
- One of the primary drivers of investment is aggregate demand. In other words, businesses make most of their investment decisions based on the demand they see from their customers.
- The government can be used at points during the business cycle as a countercyclical tool to stabilize swings in aggregate demand and investment by implementing fiscal and monetary policy. This means that Keynesians can favor both reduced government policies as well as expansive government policies depending on the state of the business cycle.
The first bullet point is basically correct once the portion within parentheses is removed. The quibbles start with the second bullet point. Before I unpack this point, it is necessary to establish some terminology so as to maintain consistency and to better highlight the issues with Roches’, and thus the Keynesian position.
When it comes to ones’ income, it can either be spent on consumption goods, or spent on production goods. Within the context of production goods spending, it can be direct (buying some capital good, or hiring labor) or indirect (saving in a bank). Both forms of ‘production goods spending’ as I’ve called it can be referred to simply as ‘investment.’ The allocation between consumption spending and investment spending is decided by the preferences of the income earner, which may change over time. It is also important to note that the same good can be a consumption good or a production good depending on its use.
The Keynesian concept of ‘aggregate demand’ attempts to quantify the total spending on – or ‘demand’ for – final goods and services. As I wrote in the prior paragraph, the same good can be either a consumption good or production good. For example the same computer can represent capital to a tech start up, or it could represent an entertainment vehicle to someone who just wants to surf the internet, watch movies and play video games. Yet from the perspective of ‘aggregate demand,’ there is no distinction. In each case the same money is spent on the same good, and that’s it. No further economic assessment is made. Returning to the second bullet point in the quote above, saying that ‘aggregate demand’ is the primary driver of investment is inaccurate because of that inherent vagueness. It is entirely possible to increase ‘aggregate demand’ and not increase investment if all of the demand went toward consumptive purposes. Further in the piece, Roche expands on Keynes’ view of production and investment:
Production is crucial to the economy. Keynes understood this. That’s why he focused on investment. But he also understood that production required consumption. Again, two sides of the same coin. Production matters. So does consumption. Firms need revenues to generate incomes so they can spend, invest, hire employees, etc. This is a cornerstone of Keynesian economics. Keynesian economics is not purely about boosting consumption all the time without the goal of boosting investment and production.
The intimation both here and in the second bullet point that ‘businesses base their investment decisions on the demand they see from customers’ is inaccurate. Fortunately, it only takes the change of one word to fix it. Namely, the sentence in question should read the following (word change highlighted):
Businesses make most of their investment decisions based on the demand they anticipate from their customers.
This is illustrated more clearly by the example of a business starting up from scratch. At this point, there are no customers, no products produced, just an idea. The business must determine how big the market is for the product in question, and estimate how much of the product can be sold at a profit. Once this determination is made, the business then acquires the resources and labor needed to produce that particular quantity of goods. This is the investment, and it has happened with the actual, observable demand from consumers unseen and unknown. Actual demand from consumers is only present at the end of the cycle, after the goods have been produced and brought to market.
The actual demand from consumers merely tells the producers how accurate their foresight was. When it comes to future rounds of investment, that decision is based on how many the producers think they can sell in the future, not how much they just sold. The consumer demand is just another piece of the puzzle a producer may use to determine how much to produce.
Said differently, investment precedes production, which always precedes consumption. Thus the act of consumption cannot ‘drive’ investment. Seeing that consumers are clamoring for a product or service might cause a producer to think ‘hmm maybe I should produce that product,’ but at the exact time of that revelation, no product had been produced. What spurs the producer into action is the desire (expressed or anticipated) consumers have for a product. Desire is not the same as economic demand, which can only be expressed after the producer has invested in and produced the product, which can then be exchanged for money. A misunderstanding of this concept tends to lead a lot of Keynesian analysis astray.
Countering Counter Cyclicality
The aggregate demand metric also does a fantastic job throwing analysis off the right path. The third bullet point from the Roche quote above pertaining to countercyclical policy illustrates this. The ‘swings in aggregate demand and investment’ are ultimately the result of changes in the allocation of incomes between consumption and production. This change in allocation is in turn the result of changes in individual preferences. In the Keynesian view, this is when a fall in aggregate demand happens. This fall is a merely a manifestation of a prior shift in preferences (for whatever reason) towards more investment spending with a view to an expanded production of goods and services in the future. However, since viewing the world in aggregates obscures a more nuanced understanding of this shift in spending, alarm bells go off.
For example, say that the demand for homes falls for whatever reason, in favor of building savings. As a result of lower spending on the final good of houses, ‘aggregate demand’ will drop, all else equal. In response to this, the Keynesian concept of countercyclical monetary and fiscal policy is employed to ‘stabilize’ the situation, with a view to restoring the level of spending on homes that existed before.
The main problem with this approach is that the underlying wishes of the economy, as expressed by its spending decisions, was to reduce its spending on housing. In building savings, or spending lower quantities of money on final goods, the economy was essentially saying ‘we have all the housing we can handle right now, so we’re going to put our money towards other lines of business.’ Economically speaking, the lower demand for housing products alerts home builders to a change in the possible future demand for their product, meaning future investments should be adjusted downward. This is exactly what the economy wants however, as the reduced usage of resources for housing enables other lines of business to increase investment, thus in the future bringing to market a larger quantity of goods it has selected for in the present.
This doesn’t happen overnight. Resources and labor once employed building homes and strip malls aren’t going to instantly transition into building infrastructure and pumping out goods from factories. There is going to be a period of adjustment. For Keynesian economics, nestled atop the crude vantage point of ‘aggregate demand,’ this represents a problem that needs fixing. So in comes easy monetary and fiscal policy designed to reignite spending in the same manner as before. It is important to note that, given the fundamental changes in spending preferences, the increase in income made possible by easing policies will not necessarily be spent in the same manner that produced the baseline ‘aggregate demand’ that was lost. Even if it goes according to plan, the restoration of housing spending may restore aggregate demand in the short term, but it also signals to home builders and producers of resources that there is still a high demand for homes that may justify another round of investment to satisfy an anticipated future demand. They continue to invest in a similar manner to before, consuming resources which the economy attempted to divert elsewhere. When producers bring their freshly produced goods to market, they will find that there is much less demand for them than was anticipated. In other words stabilization efforts result in spending that it is ultimately incongruous with the preferences of society, meaning investment funds and precious resources will ultimately be misspent. Aggregate demand slips again, and the Keynesians respond by recommending yet further easing measures.
It is because of this that counter cyclical policy is never really observed in practice, at least not fully. Governments and central banks never have problems when it comes to easing during recessions, but tightening during the good times is seemingly only an issue when your political party is not in power. Truly tightening, running consistent surpluses and allowing for tight money to reign supreme would result in lower spending and reduced ‘aggregate demand,’ given the impetus to spend during the prior easing period comes directly from that easier policy. The proof is in the current sentiment, as nearly every Keynesian commentator errs on the side of continued easier policy and has an aversion to any move to a less expansive government, despite being 5 years into a recovery, dubious as the recovery is.
Evil? Or Misguided
The overall point of Roches’ article is a fair one – Mauldin did present a cartoon version of Keynesianism, and he’s not alone in doing so. Most who write from opposing viewpoints certainly are guilty of taking various ideas and wrongly ascribing them to Keynes. The real legacy of Keynes was providing intellectual justification for government to assume a larger role in the economy, based on the premise that the market sometimes makes mistakes. It is true that the market makes mistakes, but this is because the market is made up of human beings. Last time I checked, human beings are prone to making mistakes. To hold that the government can credibly act as some sort of higher level corrective entity would be to assume that it was comprised of superior beings. Of course it isn’t, the government is full of the same mistake prone human beings that exist everywhere else. Yet Keynes opened the door for those who truly believe the government is composed of better stuff, and they walked right through. That they use Keynes’ misguided approach to justify their personal, more radical beliefs has led to bashing of Keynes himself which I can concede is over the top at times. For me, he was just a misguided economist whose ‘real’ views as put forth by Roche are heavily flawed on their own without need of additional strawmen. The bottom line is that Keynesianism is ultimately at odds with two related truths: all progress requires sacrifice; and there are scarce resources available with which to achieve progress.
Spending hours in the library instead of leisure activities, or doing countless monotonous physical exercises instead of lying sedentary represent the sacrifices one makes in order to achieve academic or athletic success respectively. On a larger, historical scale, the lower life expectancy and quality of life experienced by many during the Industrial Revolution was the sacrifice entire generations made for progression to the highly developed world we live in now. No matter where you look, if you find an example of progress, you will also find an accompanying sacrifice made. In putting forth the idea of economic stabilization through counter cyclical policy, the suggestion is that no sacrifices need to be made as we progress, and any of the bumps along the way can be smoothed out. This is flawed because those ‘bumps’ are exactly the vehicle through which progress occurs. Progress, while positive, is characterized by change. Change has been a hallmark of the human condition, and the shifting of individual preferences upon which those changes rest is generally unpredictable. When paradigms change, ventures and industries that cannot adapt to the new paradigm are rendered useless. Their liquidation and the resultant increase in ‘idle’ resources are the immediate sacrifice the economy has to endure for implementing a new, better paradigm.
Such language usually prompts Keynesians to accuse their counterparts of being pain fetishists who love to see misery and heartache spread. They continue on by declaring that economics is not a moral crusade, and it is inhumane to allow people to suffer or experience unemployment. In reality, the moralizing comes from the Keynesians in pushing for stability simply because it is a less painful existence, even though it may deny true progress. The fact that we have scarce resources available to us means that when we are on the cutting edge of progress, we can employ those resources in either furthering the progress or supporting the old framework, but not both. In recessionary times, Keynesian stabilizing through easy policy seemingly restores an abundance of income and capital with which to spend on consumption and investment. In reality, all easy policy enables is the ability for existing goods and services to clear the market at higher prices, so as to prevent the ‘aggregate demand’ metric from falling. The higher total of income going towards those goods prevents spending and investment from being focused elsewhere, ostensibly to better uses. This is a victory from the Keynesian point of view however, since conserving the old framework at the expense of a progressive one means the immediate ‘moral discomfort’ of idleness is avoided. Given the ‘progressive’ political tendencies of most Keynesians, the irony of that isn’t lost. With respect to the question posed in the title, Keynesianism is misrepresented – by its proponents. They purport that Keynesianism is a stabilizing force, and thus a force for good. Keynesianism is neither – ‘stabilizing’ efforts directly counter the spending preferences of the economy, ultimately creating a condition that cannot persist. It is resistant to true progress thanks to a distaste for the required adjustment period, and thus is not a force for good.