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John Maynard Keynes is Dead. Viva Hayek!

Editor’s Note:  This piece is a re-post, retouched and updated.  It’s topical once again, inasmuch as the president’s “jobs” speech on September 8 established conclusively that demand-side, Keynesian economics is an immovable pillar of his intellectual and ideological faith.  At this point, few could reasonably dispute that no amount of abject failure of “stimulus” by pumping nonexistent dollars into the stalled economy will convince him to change course.  If ever there was a living example of what Einstein dubbed the definition of insanity—repeating the same thing yet expecting different results—playing out on the grandest of scales before an increasingly jaded nation, it is Obamanomics.  He’s reminiscent of the old Rocky & Bullwinkle cartoons, wherein Bullwinkle keeps telling us to watch him pull a rabbit out of his hat, but it always turns out to be a ferocious beast.  At least Bullwinkle always says, “I’d better get another hat.”  Obama keeps trying to produce a rabbit from the same hat.

I’m not an economist.  Oh, I’ve studied around the edges enough to have a passing, rather shallow familiarity with the Dismal Science, but start in on me with graphs and jargon and I’ll be lost in mere seconds.  What I am is someone involved in running a business, and the son and grandson of small business entrepreneurs.  Virtually every adult I grew up around who was influential in the development of my worldview ran some sort of business, creating jobs, employing people, and methodically building (or, albeit less often, losing) wealth through a process of decision-making and calculated risk-taking peculiar to the small businessman.  That gives me a solid foundation of what used to be called good business sense or, if you like, common sense–there being little practical difference between the two.

Academically credentialed economists love to confound those of us who are simply trying to make our way in the world while keeping the books reasonably balanced.  Attempting to understand where they’re all coming from, particularly when their Big Ideas are inherently counterintuitive, can be both intimidating and exasperating.  That’s why I typically don’t bother.  The word “counterintuitive” sometimes describes a theory which is valid despite being unobvious, such as General Relativity.  More often, ideas are counterintuitive because, once stripped bare, they are the utter nonsense they first appeared to be.  Thus if an academic economist, no matter how high he or she fallutes, makes claims that appear to run contrary to the commonest of sense, thinking people everywhere should scrutinize and, if necessary, challenge those claims without being deterred by the smokescreen of jargon that typically accompanies them.  This is particularly true if that economist is in a position to make or influence public policy.  Of late, the dusted off and once again ballyhooed model du jour is demand-side Keynesian economics and the myth of  its so-called “multiplier,” which together are plainly immovable articles of ideological faith within the current administration and among many in Congress (to say nothing of the Keynesians’ chief intellectual puppet, Paul Krugman of Princeton and The New York Times).  My aim is to take the common sense, everyman approach to exposing the Keynesian multiplier for the ethereal hooey it clearly is, and to do so in a jargon-free manner.  This shouldn’t be too difficult, since I’m not competent to use the jargon myself and so generally avoid it.

When Keynesian economics reared its long-dormant head toward the end of the last presidential administration with the passage of TARP, then went into hyperdrive in the form of a series of federal “stimulus” packages engineered by Treasury Secretaries Paulson and Geitner, something fundamental just wasn’t seeming to make sense.  We were told that if the federal government were to shore up a bunch of bad assets on the books of banks and add wildly to the national debt by dumping loads of nonexistent federal dollars into targeted sectors of the economy, this would have a “stimulative” effect.  It would break the lending logjam and “multiply” throughout the economy, since recipients of stimulus dollars would need to hire people, engage with suppliers and vendors, and so forth, which would lead to greater employment and more consumer spending. 

A moment’s pondering of this proposition should expose its fundamental illogic.  Under the Keynesian “multiplier” scenario, government is placing a dollar into the economy for the purpose of stimulating, in particular, demand–Keynes was very specific about this.  In order to exist in the first place, that dollar turned loose by the federal government must have been either (1) printed, so it’s not attached to anything tangible, or (2) appropriated (through taxation), such that it originally came about by being created in the conventional manner, but was taken by government and simply re-routed to some other use ordained by the sausage-making process that is politics.  Under the ordinary, capitalistic scenario, when the economy grows by $1, a dollar that didn’t previously exist is created by the following process: Capital is either borrowed (debt financing–when the entrepreneur goes to the bank for startup capital) or invested (equity financing–when the entrepreneur convinces investors–venture capitalists–to put money into an endeavor that will serve as its startup capital).  In either scenario, capital is put to work toward an enterprise which has been willed into being for the purpose of combining things of lesser value into things of greater value, ideally taking profits as part of that process.  Using as an example something I’m most familiar with, imagine a top-down integrated forest products firm.  Capital is invested in the hundreds upon hundreds of individual assets–chainsaws, yarder, rolling stock, sawmilling machinery, training and employment of various personnel, etc.–required to sever a log from its stump, transport it to a sawmill and transform it into lumber.  The lumber always “existed” within the tree, but it took human, financial and mechanical capital to bring it into being.  Wealth was added to the economy by employing those resources toward successfully increasing the value of the tree for human use.  Dollars exist after the lumber is sold that did not preexist the lumber, or the labor and capital that extracted that lumber from the tree, because adding labor and capital to the tree added value to it by turning it into lumber.

Under the Keynesian scenario, the government would have simply printed or appropriated money and handed it over to the sawmill.  This may have allowed the sawmill to produce more lumber for a time, or possibly to even hire more people, expand, increase purchases from suppliers, or do any number of other things it otherwise may not have done.  However, everything resulting from that handover of money would have been “stimulated” not by market demand, as is ordinarily the case, but by the influx of capital that either had to be created out of thin air or taken from someone else who might have put it to a different use.  Almost invariably, that would have been a higher and better use, since investors make carefully calculated decisions about where to put money that’s theirs to lose.  Money thrown about as a result of politics needn’t have any ties to good economic sense.  In any event, if there is no actual demand for the lumber thus produced, the entire transaction is a sham.  The sawmill got the money not because there was an underlying need for lumber in the stream of commerce that wasn’t being fulfilled, but because their member of Congress had more pull than someone else’s.  Economists actually have a term - market distortions - to describe these sorts of government policies which tend to cause players within an economy to act in ways that wouldn't make economic sense under ordinary circumstances.  

Demand is stimulated by people having money they wish to spend on certain goods, not by simply throwing money at something in hopes of–to use a metaphor that’s as inaccurate as it is overused–“priming the economic pump.”  The economy is not a pump, which simply moves water from one place to another.  If moving water is the metaphor of choice, it’s more like a hydroelectric dam, which converts the power of moving water to something of higher value by intensively focusing labor and capital in a very specific, calculated manner.  No wealth or value has been created under the hypothetical Keynesian scenario detailed above, or under any actual such experiment historically attempted.  Only a government mentality would torture sense into Keynesian doctrine, government being generally in the business of producing edicts, rules, and processes that are of little use to anyone other than government types interested primarily in broadening their power and justifying their existence.  In that light, it’s hardly surprising that bureaucrats should see the world through Keynesian goggles.  It gives them the ultimate, God-like power to take from some and give to others, choosing winners and losers based entirely on politics.

In a more fundamental sense, the chief flaw of the Keynesian view is that it mislabels division as multiplication.  Money multiplies only when value is added to something.  If I turn a profit in my sawmilling operation by the time my employees, all of my vendors and suppliers, the bank, the tax man and so forth have all been paid off, I’ve multiplied money by adding value to something (a tree) and increasing the overall wealth of the world around me by releasing this value-added product back into it in response to market demand for it.  If I’ve simply received money taken from somewhere else and spread it around (something else government types are generally disposed to do), I haven’t grown anything or produced any wealth.  I’ve divided money, not multiplied it, and would require another, similar infusion of cash from elsewhere in order to repeat the process.  The first example is self-sustaining, as some of the profit I turned can be put back into the enterprise to grow or maintain it.  The second example is a one-shot deal.  It should, of course, come as no surprise that lefties are innumerate.  There’s a reason they gravitate toward such professions as law, the humanities and political “science,” and shy away from business economics, medicine and the hard sciences.  Nor should it surprise us that people capable of so basic an error as mistaking division for multiplication should be the source of other numerically implausible mythologies, such as the notion that the “rich” who, depending on how these straw men are defined, pay anywhere from 80 to 95% of all taxes, are failing to pay their “fair share.”  We’re also persistently told by the left that failure to maintain confiscatory rates of estate taxation results in “concentrations of wealth,” even as anyone bothering to look or think for more than three seconds would inevitably observe that while there was only one Joe Kennedy, lamentable scores of his wretched heirs have been loosed on society to cause untold and continuing mischief.  Yet another failure to recognize division as it occurs in plain view. 

As another example, imagine if you were to take it upon yourself to “stimulate” your local economy by maxing out all of your credit cards at local retailers.  Once again, you’ve executed a one-shot deal.  The money ripples through the economy, temporarily enriching all who touch it.  In the end, however, what is left is a bankrupt consumer with no further purchasing power.  The local businesses have one less customer.  When that customer seeks bankruptcy protection, everyone who lent him money is forced to eat a loss.  That means there is less capital available in the economy for those who might borrow it for productive ventures, either because the bank has less to lend, or has made its lending standards more stringent in light of its losses resulting from the bankruptcy.

To illustrate the patent absurdity of Keynesian economic "stimulus" with a patently absurd example, imagine the government were to dissolve all agencies and fire all personnel responsible for implementing its various entitlement programs for the poor and aged, then print $300,000 to hand to every man, woman and child in the nation.  Would this be "stimulative"? Hardly.  Millions would simply cease all productive work.  The currency would be largely meaningless, because a fiat currency (which all world currencies have been ever since the gold standard was abandoned) must be tied, at least in some attenuated manner, to units of wealth produced in the manner previously described. This is what economists refer to as the "money supply."  What good is it to have $300,000 if there are no goods and services to buy because none are being produced?  As absurd as this example appears, there is a reason I picked $300,000 for my example:  It represents the amount, per man, woman and child currently living in America, of the combined, long-term unfunded liabilities of the three major entitlement programs: Social Security, Medicare and Medicaid.

The flaw of Keynesianism is also the flaw of demand-side economics more generally.  Demand-side economics assumes that demand is the key to simulating and growing the economy.  Supply-side economics recognizes that someone must put up the capital (machines, intellectual property, a trained workforce, office buildings, etc.) in order to provide consumers with the jobs and income that lead to demand in the first place.  Demand cannot be conjured from thin air.  People need to be making money in order to consume and invest.  When first setting about the writing of this piece, I was reluctant to call supply-side economics by name, reasoning that the very mention of those words would shut down readers who have been conditioned by nothing more than repetition and eye-rolling by intellectual elites to a reflexive belief that this way of viewing the economy has been somehow discredited.  The words “supply-side” are also inextricably associated with Reagan, and with another unfortunate idiom:  “trickle-down” economics.  But one needs to look past mere catchy words used to deride complex and substantive ideas—words Thomas Sowell refers to as “verbal virtuosity.”  The term “trickle-down” is a perfect example of a brief catch phrase calculated to dismiss an entire worldview.  But as Sowell points out in his masterpiece Basic Economics, in order for wealth to “trickle” up, down or sideways, it must first be created.  In capitalistic economies, this can only happen when entrepreneurs bring together labor and capital and organize them toward some end.  If social engineers want wealth to distribute in some manner they deem optimal, then, they cannot simply ignore the means by which it is produced.  That is the essence of supply-side economics.

Accordingly, nobody who subscribes to Keynesian or demand-side economics should be considered qualified to occupy an elected office higher than that of Dog Catcher.  This would disqualify the last two presidents of these United States. 

Addendum - Posted 2/24/2012:

By way of review, wealth and prosperity are created by applying human capital (labor/management) and other capital (machines, buildings, intellectual property, money, etc.) in order to either (1) add value to something (turning a tree to boards), or to combine things of lesser value into something of greater value than its component parts (what any kind of assembly plant does). It’s probably fair to say that there is a third manner in which wealth can be created, which is by developing processes or other tools (software, for instance) that increase efficiency, since all efficiency does is enable firms to produce more wealth with less capital. However, these are the ONLY three ways in which wealth can be produced or, more specifically, the only three ways in which the overall amount of wealth present within a society can be increased.

The reason it’s so important to harp repeatedly on the only possible ways to produce wealth on a society-wide scale is that all sorts of individual fortunes have been made in ways that, when analyzed using the correct criteria, were in fact only wealth transfers, not wealth creation. I’m not referring here to transfers from government through taxation and subsidies, although obviously these are hindrances to true wealth creation. I’m referring to the subtler, yet still pervasive form, which I’ll here dub "parasitic industries."

Take, as an example, a law firm. Most of us love to hate plaintiffs’ attorneys, so I’ll start with that example. A plaintiff’s attorney, if successful, obtains a judgment against a wealth-producing company. Some of the payoff from that judgment goes to the plaintiff and some goes to the attorney, but nothing has been created; it has merely been appropriated. Moreover, it’s money that, had it been retained by the defendant, would have gone into further wealth creation. And what of the defense attorney, whom most productive people would view as doing the Lord’s work? Still a parasite. Even if he successfully defends against a lawsuit, the defendant merely retains the wealth-creating capital it would have had it not been sued in the first place–less the defense attorney’s fee, of course. Incidentally, it was primarily for these reasons that I left the practice of law and got into manufacturing.

Another parasitic industry consists of the innumerable consultancy firms that exist merely to assist wealth-creating firms with regulatory compliance. They derive their income as a result of the existence of tangled, confusing, often paralyzing, grasping and arbitrary regulations, and would have no reason for their existence but for those regulations.

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Reader Comments (3)

If Keynesian economics really worked, then Obama was irresponsible – perhaps even "unpatriotic," to use his own phrasing – by spending a mere $450 billion. He should have spent hundreds of trillions and made us all rich beyond our wildest dreams.

The fact that he did not illustrates that even Obama understands that Keynesian economics don't work. $450 billion represents his best hope of being re-elected, not our best chances of getting out of this hole.

Another brilliant post, Sean.

September 11, 2011 | Unregistered CommenterShawn Smith

I don't see why you think something like building a road or a bridge doesn't add value just because the government pays someone to do it. A real-world, physical structure has been created that people can use (it may even make the market more efficient because products can be transfered across the bridge) and the employees who worked there are paid and spend money. Substitute "public need" for "profit motive" and not much is different... I understand why you don't want the government to get into the consumer market (and I don't know anyone who advocates it), but why is this type of spending so abhorrent? Or is this analysis limited only to when you cut a check to someone and say "spend"?

November 8, 2011 | Unregistered CommenterNick Caleb

Nick, there isn't anything inherently "abhorrent" about the sort of government spending you identified, particularly when it's for something like physical infrastructure which most people, regardless of ideology, recognize as a legitimate function of government. But something government does in the ordinary course of its existence, like building/maintaining/repairing bridges, should be done because there's an actual need for a bridge to be built/maintained/repaired. It's when the project is being contemplated purely for a "stimulative" purpose that the spending becomes abhorrent, because (1) the spending is, in this instance, driven by politics and not so much (if at all) by need, and (2) it requires either appropriation through taxation or deficit spending. In a free society, appropriation through taxation needs to be limited to compelling state needs. "Stimulating" the economy isn't a compelling state need, inasmuch as free people need to be allowed to voluntarily enter into transactions. Each dollar taken from them is a transaction they are disallowed from voluntarily entering into. And if the problems inherent to excessive deficit spending aren't readily, self-evidently apparent, I don't really know what to tell you.

December 19, 2011 | Unregistered CommenterSean M. Smith

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