Keynes, the Future and Present Austerity

by Chidem Kurdas

In 1930, John Maynard Keynes dashed off an amazing prophecy. Extrapolating from the productivity gains of the past centuries, he came to the bold conclusion that the fundamental economic problem of scarcity would fade away in 100 years or so. Thanks to technological innovation and the accumulation of capital, the ancient condition of limited resources to satisfy competing wants would give way to a new age of plenty. Human beings would then face a very different quandary, namely what to do with themselves once they no longer have to work in order to survive.

Eighty-one years into the timeline Keynes suggested in his article, “Economic Possibilities for Our Grandchildren,” scarcity shows no sign of disappearing. Where did he go wrong?

He did hedge his bet by making it conditional on there being no important wars and no major increase in population. One reason we continue to experience a dearth of means to pursue the ends we desire is that wars absorb immense resources. Thus the $1 trillion spent on the Iraq war could have instead been used to satisfy myriad needs.

But aside from that, Keynes made a mistake in his reasoning. He argued that some high level of output be sufficient to meet needs because these will not grow as much as the ability to produce. He thought a point may soon be reached where what he called absolute needs – in contrast to relative needs or conspicuous consumption – will all be satisfied.

This notion of “absolute need” comes from a limited view of technological change as improving productivity while preferences for goods and services remain relatively stable. But in fact technology creates new products and tastes, working on the demand side as well as the supply side. It is not the case that there is a fixed basket of wants. We now want MRIs and smart phones; in the past there was no such need since we had no conception of these things.

That Keynes postulated less long-term growth in demand compared to supply fits in with his later theory that deficiency in aggregate demand causes recessions. Hence his argument that government spending can alleviate the down part of the business cycle by creating demand—the main rationale for large-scale stimulus programs, including the Obama administration’s questionable projects.

In a sense Keynesian policies reduce the possibility of the age of plenty that the man himself foresaw. Besides the question of the effectiveness of such programs – click for one of the posts on the subject by Mario Rizzo –  there is the matter of runaway government spending.  Keynes himself favored budget surpluses in good times to balance deficit spending in recessions.  Over the cycle surpluses would make up for deficits. But that is not the way it worked in reality.

A recent piece by Steven Horwitz in the Freeman reminds us of the seminal 1977 critique by James Buchanan and Richard Wagner, who pointed out that Keynes and the Keynesians removed institutional and moral impediments to deficit spending, thereby freeing politicians to spend without limit and rack up debt. No matter how huge the resources, the black hole of government spending can absorb it all.

Hence the current European debt crisis, brought on by various governments’ improvident spending.  Austerity is the word that dominates European policy discussions, the belt tightening necessary to counter past profligacy.  So Keynes provided governments with the excuse to run deficits with consequences that now threaten to create painful scarcity.

Almost certainly he would not have liked this unintended result. The end to the economic problem looks further off than ever.

43 thoughts on “Keynes, the Future and Present Austerity

  1. New England town governments have traditionally used a Stabilization Fund to smooth out the cycles of income and expense. As I understand it they set aside surpluses in good years to be drawn down to cover shortfalls in bad years. But the critical and prudent element is that the surpluses are set aside FIRST– and subsequent deficits are covered by those accumulated funds.

    The concept of Trust Funds, and the separation of income and principal, would be usefully employed to rein in government spending. It is based on practical wisdom and an understanding of human nature, tools conspicuously absent from the very unreliable theories of intellectuals and academic economists!

  2. Keynes was silly.
    There is no end to human wants.
    Each new want requires greater content.
    Each increase in content requires an increase in calories required for production..
    So, we are always in a malthusian game.
    Prosperity is what occurs while we seek equilibrium.
    And prosperity only lasts while we are seeking equilibrium.
    Once found we are once again equal in poverty.

  3. Chidem,

    Interesting post. A good test of your hypothesis would be to compare the increase of private debt in Europe with the increase in public debt.

  4. We have it on Krugman’s authority in the New York Times that no one understands debt and that we owe it to ourselves anyway!

  5. In “The General Theory,” Keynes explains the rationale for the “psychological law” underlying the “propensity to consume” on the basis of what he called the “objective factors” and the “subjective factors.”

    Objective factors were such elements as the rate of interest, windfall profits, and expectations about future levels of income. (All of which he discounts as significantly influencing the level of consumption out of current income.)

    Subjective factors were peoples propensities for generosity, greed, ostentation, etc. But also underlying peoples decisions to consume out of income were such things as social status and position (“class”), and race.

    These all implied that given one’s psychological make-up and one’s social position and status in society, there was a certain level of consumption consistent with one’s place in society.

    And beyond that, individuals would, in general, lose interest or motive to spend on things above their station in life. In other words, a world in which growing means confronted social and psychological limits on wants.

    In other words, the usual conception of unlimited wants always facing limited means was turned on its head by Keynes.

    Richard Ebeling

  6. Krugman, like Keynes, deals with intellectual concepts and abstractions that bear no necessary connection with the real world of interpersonal financial transactions. That is why they are called academics, economists, theorists, and more appropriately, useless.

  7. Greg Hill,

    Then Krugman has set up a strawman to knock down.
    No one thinks there are no differences between household debt and government debt.
    Two differences, of course overlooked by PK, are that a private individual makes a legal contract in incurring a debt, and enters into it and pays it off through economic means. His debt can only be paid off by him paying it back (and he might be given a gift by someone else to do so) or by his creditor forgiving it. The State uses political means in incurring debt and in paying it off. A second point missed by PK is that he can’t inflate his way out of his debt, unlike the State, which relies on its central bank to inflate away the value of its outstanding debt (another form of political means).

  8. Chidem Kurdas: Great post. Not surprising that Keynes, with his short-run thinking based on a fixed technological portfolio, would have been so myopic about the long term. One is reminded in that sense also of Marx, who credited the capitalists of his day with generating a great abundance, which only needed better (re-)distribution. In the long run, Marx and Keynes are dead, and the dynamic nature of markets that has yielded progress that they could not have imagined.

  9. Bill Greene–
    That’s an interesting historical application of balancing the budget across the cycle. Probably easier to do on the local level than the federal level. But it may be possible with the right legal framework.

  10. Bill Stepp–
    Re the Krugman notion that we warmly embrace our government’s debt and not feel bad about it.

    This argument does allow the government to grow even when tax revenues don’t. In other words, it does away with the tax limit on government growth.

  11. Allan Walstad–
    Good point. Keynes was of course the ultimate short-term thinker. In the long-run we’re all dead is probably his most widely quoted saying.

  12. chidemkurdas-
    Yes, the State can grow even when tax revenues don’t, which is another reason to cut its size to anarchy and a constable. Then it won’t need to issue debt. Governemt bond market RIP. Sniffle.
    I assume you understand why the “we owe it to ourselves” argument is wrong.

  13. Three things to consider:

    1) Keynes’s view of human wants was a bit like J.S. Mill’s, which is to say, he was willing to differentiate between pushpin and poetry. I know most commenters on this site aren’t comfortable judging our various wants, and therefore won’t be persuaded by arguments claiming that a lot of these wants are the product of advertising or are self-defeating in the sense of Robert Frank’s competition for positional goods. Evidently, Keynes overestimated our ability differentiate between real and “imaginary goods” (to borrow Carl Menger’s phrase).

    2) Keynes’s statement that “we’re all dead in the long run” has been ripped from its context. Here’s what he said, “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.” Keynes wasn’t saying that we should ignore the future, but that economists should have more to offer than to say that the economy will return to equilibrium if we’re patient enough (especially when millions of people had been unemployed for a long time).

    3) If anyone is wiling to look, you’ll see that *private* debt as a percentage of GDP went up in the U.S. and in many European countries in the years leading up to the crisis. I don’t think this was Keynes’s fault, but I’m open to being persuaded otherwise.

  14. Greg Hill–
    Re private debt. That has to be laid at the door of the Federal Reserve and certain other central banks. After the stock market bubble burst in 2001, the Fed pumped as much money as it could. Hence we ended up with serial bubbles.

  15. Re Keynes: Fact remains that he focused mainly on the business cycle, not on long-term growth. The result is that Keynesians like Krugman tend use the same cyclical model to reason about long-term growth. For some Keynesians the long run is just a string of short-term cycles, one after another.

  16. Greg Hill-
    Re: the consumer debt, can you spell F-E-D?
    Hayek refuted the advertising argument in “The Non- sequitur of the Dependence Effect,” which is reprinted in (I think) his _Studies…_.
    Re: l-t unemployment, in a genuinely free market (free banking and no Fed) there would be little unemployment, and nothing like 9% (official figure) and 15-17% (reality).

  17. My brother keeps joking that I must “separate my wants from my needs.” But that is folly– and funny. Most people cannot do that, do not want to do that, and often put their wants ahead of their needs!!

    The common man is actually quite smart–it is much more pleasurable to satisfy wants than needs. Keynes and his ilk simply fail to understand the ordinary person, and that is why their theories are useless.

  18. “I know most commenters on this site aren’t comfortable judging our various wants…”

    …while others appear quite comfortable imposing their own presumably superior judgment on their neighbors, preferably via the big gun of government.

    “Keynes wasn’t saying that we should ignore the future, but that economists should have more to offer than to say that the economy will return to equilibrium if we’re patient enough…”

    …and what other economists did and do point out is that policies rooted in Keynes’ short-run thinking can have negative effects, both short-run and long.

  19. The relationship between these numbers is a blunt instrument for underestanding what happened, but here’s one cut:
    Consumer debt was rising like a phoenix, which reflected rising time preferences. In a free market, this would have been reflected in higher market interest rates, probably at every point on the yield curve, but certainly at the lower end.
    The increase in market rates certainly would have outpaced both the artificially low Fed Funds rate and the 3-month T rates. This growing divergence would have given an additional filip to consumer spending, in effect a Fed-engineered subsidy for consumers to continue their party with more debt. And that’s exactly what happened.

    Also, in the wake of the 2001-2 recession, investment was a bit punk compared to its previous trajectory, and the spending gap was filled (and then some) by the consumer revelers. Guessing James Livingston loved it.

  20. I suppose that’s one way of reading the chart. But, leaving interpretations aside, there’s a continuous increase in debt regardless of the level of interest rates, except for the very recent reduction in debt during which time interest rates were falling to all-time lows. Sure, it’s just one graph (and I invite you to generate your own), but it just doesn’t look like there’s much of a relationship between T-bill interest rates and household credit debt outstanding.

  21. A lot of macro considerations go into setting T-bill rates, and to see a 1:1 correlation betwseen them and consumer debt is asking too much. The former are not the determinant of the latter.
    I note that you didn’t address the time preference-interest rate angle.
    Re: the invitation, thanks but no thanks. In my mind these set pieces obscure more than they reveal with the T-bill/consumer debt stuff being Exhibit A.

  22. Gregg Hill–
    Nice try. I believe there’s a technical problem with your graph: you’ve used the total amount of debt, which in general tends to grow if for no other reason because the population grows. In general, more people; more mortgages etc.; more total debt.

    So reset the variable to percent change in debt. Then what you see is that the short rate and the percentage change in debt move together in the post-war era except for some unusual periods. Now I was referring to one such period: namely the early 2000s, when the short rate was unusually low (the fed cut it repeatedly) and the percent increase in debt unusually and persistently high.

  23. I should add that the issues Bill raises also play a role, no doubt. One would have to correct for a number of factors, but my previous comment is the most basic correction.

  24. Chidemkurdas,

    You’re right; not a good measure of debt. Here’s the graph using HH financial obligations as a % of disposable income.

    I can’t really tell whether it supports your interpretation: “namely the early 2000s, when the short rate was unusually low (the fed cut it repeatedly) and the percent increase in debt unusually and persistently high,” but you can judge for yourself.

    I’d like to see your version of this graph with “the natural rate of interest” drawn on it, or maybe just estimates of the average “natural rate” for each 5-year period in the graph. I believe you’re interested in the difference between the “natural rate” and the market rate, particularly insofar as it’s influenced by the Fed, rather than in changes in interest rates.

  25. Greg Hill–
    Then again, we’re kind of reinventing the wheel here. John Taylor presents a persuasive empirical case that the Fed blew air into the twin credit and real estate bubbles. See Taylor’s book “Getting Off Track”

  26. It does not surprise me that Keynes did not take innovation into consideration. His proposals for getting us out of recessions is predicated on the economy only producing what it has already been producing, and does not consider the fact that the economy grows from new things being invented, meaning people are hired to make it. Established things don’t hire as many people, if any, because once you have been making something for a while, you just try to find more efficient ways of making it — meaning, fewer employees, if possible.

  27. Hi Troy.
    You’ve put it in a nutshell. Keynes’ cyclical reasoning — the basis of most 20th century macro economics — simply takes technology as given Only in the “Economic possibilities for our Grandchildren” paper I cited & a few other places does he even mention innovation. Not surprisingly, later growth models rooted in the Keynesian macro approach take technical change as given, as a rate of change of productivity.

  28. Good points on Keynes, innovation and technology.
    Chap. 15 of The General Theory is entitled “Sundry Observations on Capital,” as if capital (soon to be dubbed K by his followers) is merely an afterthought instead of the literal scaffolding and building blocks of the economy.
    A theory of capital, investment and entrepreneurship are at the heart of Austrian economics, in stark contrast to Keynesian economics, where they are at best lurking in the background, sometimes wheeled out as a truncated part of growth theory.
    Has anyone written a comparative history of thought book or article on the two approaches? I think Roger Garrison and Steve Horwitz have touched on it in their books.

  29. Perhaps slightly off topic, but I’m about halfway slogging through Keynes’ General Theory and I wonder, does anyone know where he was drawing the line between classical and neoclassical econ? Already on p 5 he was stating what he took to be postulates of classical theory, and the statements involve marginal quantities. Furthermore, he includes Marshall, Taussig and others, writing well after Menger et al, as classical. So I assumed he was just not distinguishing a separate “neoclassical” doctrine. Yet on p 177 he does explicitly disaggregate “classical” from “neo-classical,” but only in passing, with respect to whether saving and investment can be unequal.

    Though this is far from the only or most significant element in GT that leaves one scratching one’s head (!), I’m curious.

  30. @Bill Stepp,

    Amen. Steve Horwitz has a new paper on topic.

    @Allan Wallstad,

    Keynes knew little of the history of economics. By “classical” he meant the work of Pigou, which he caractured.

  31. Allan Wallstad–
    For the purpose of the General Theory the distinction probably mattered for him only to the extent that some classical writers focused on the role played by demand. I think toward the end of the book he has a chapter on under-consumption arguments that could be considered a precursor to his own demand-based theory.

  32. As a skeptic concerning the value of most economic theory, I wonder why anyone bothers to try and decipher Keynes’ Theories. Most everyone on this post concedes the vast errors and harm done by the application of his ideas which are opaque, counterintuitive, and in practice destructive.. Granted, there is a chance to display academic “learning” in such a debate, but does it really have any practical end use?

    Economic progress and affluence comes from the free market operating with just enough legal and financial institutional support to maintain a secure and level playing field. The important elements are the institutional supporting mechanisms that economists like Hernando deSoto set forth. But I have yet to hear any logical reason why we should give one hoot about anything Keynes ever said or wrote.

  33. Bill, I’ve generally found that reading old works stimulates a lot of thinking — in philosophy, in econ, even in physics. Keynes’ General Theory was very influential, and it’s just fascinating to come across again and again the origins of bad ideas that remain popular today.

    By the way, I may have found what Keynes meant by “neoclassical” econ. On p 183 near the end of Ch 14, he refers to “the attempt to build a bridge on the part of the neo-classical school which has led to the worst muddles of all.” Then he goes on to refer dismissively to what are clearly Austrian ideas and gives a footnote to Bohm-Bawerk and Wicksell. So it looks like “neo-classical” is being used as an epithet for “Austrian.”

  34. Trying to read Plato, Keynes, or Hegel and other “Enlightenment” philosophers may stimulate a lot of thinking but it provides little guidance for action. Hernando deSoto, on the other hand, lays out in clear understandable language, the detailed steps we could take to lessen poverty throughout the world. Which is more worthy of our attention?

  35. I agree that Hernando de Soto’s ideas are important for defending property rights, but here in the US the real battle is with the stimulus proponents ranging from Comrades Bernanke and Geithner et al. to left-wing think tankers and academics, Keynesians all. You know who they are.
    HdS’s ideas are relatively more important in the developing world, where basic property titles are either non-existent or less secure. His ideas are worth studying and advocating, but we shoudn’t neglect the Keynesian ideas that are leading us down the path of statism.

    One idea we should push is that big(ger) government domestically leads to both more foreign intervention and war mongering, as well as assaults on basic liberties in the US., which boil down to property rights, defining the latter as a person’s property rights in his own body and other property. The Keynesians never seem to reflect on this.

  36. There’s been arguments about the differences between Keynes vs. the Keynesians. To my mind the man himself is a lot more interesting as a thinker than his followers. That would be a reason to read him in the original.

  37. DeSoto is actually relevant to America’s predicament of today. Hernando de Soto’s work goes far beyond merely “defending property rights.” His extraordinary findings that clearly explain why the Third World peoples are poor represent a testament to “Western” originated financial and legal mechanisms that allowed our free and open economy to flourish.

    Americans borrowed from their English, Dutch, et al heritages the mechanics of a registry of deeds, banking corporations, mortgage financing, contract law, judicial systems, and related enabling institutions that allowed every citizen to participate in the market place. Having left virtually all intellectuals, aristocrats, and so-called experts behind in Europe, America’s common people flourished for 300 years after 1620 and built the USA into the supreme economy and power in the world, eclipsing Old Europe within a couple centuries.

    Third World people have few of those enabling institutions that allow an open economy to work well. Most are squatters and must persist in the most cumbersome licensing process to open even a hot dog stand. The people of those nations, and their latent economic activity, are stifled by aristocracies and bureaucrats.

    Keynsian arguments for managing and regulating the economy from “the top down” undermines the open enabling mechanisms that allowed America to prosper. We are becoming the Third World, mired in red tape, bled by incompetent and corrupt officials, more and more dependent on Big Government. Everything that comes from Keynes is a step backward to a managed economy, top down mandates, and burdensome laws and interference in the market place. It commenced in our 4th century as a nation and is undoing the successful first 300 years.

    Note that China is trying to emulate what we used to be like. Other nations like Hong Kong and Singapore have had some good results–All you have to do is read the latest “Annual Reports of Economic Freedom” published by the Heritage Societry or the one by the Fraser Fdn. The link between prosperity and minimal regulation, documented in over 100 nations, refutes Keynsian economics.

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