The father of modern macroeconomics was Keynes. Before Keynes there were macro considerations, which were firmly grounded in human action, the personal preferences and choices exercised by individuals in the context of their own earnings and profits. In order to give a role to the state, Keynes had to get away from human action and devise a positive management role for central planners. This was the unstated purpose behind his General Theory of Employment, Interest and Money.
To this day, his followers argue that macroeconomics is different from individual actions, and the factors that determine the behavior of individuals are not the same as those that determine the wider economy.
This article explains why it cannot be true, why modern macroeconomic beliefs are fundamentally flawed, and why interventionism has not only failed to produce overall benefits for the wider public, but has been at an unnecessary economic cost.
The basic fallacy
Last week, Martin Wolf (the FT’s chief associate editor and chief economic commentator) presented a programme entitled Economics 101 on BBC Radio 4, in which he raised the question as to whether a democracy can function when voters have little idea of how the economy works and why there has been so little effort to teach economics in schools. The independent economists interviewed, Larry Summers and Joseph Stiglitz, and Wolf himself are strongly pro-Keynesian, and the programme made no mention of the fact that there are different schools of economic thought. The question as to what information should be given to the public and crammed into the minds of schoolchildren was never addressed, and it was clearly to be the Keynesian view.
Wolf is probably the most senior economic commentator in the British media, and one can therefore understand why the BBC, a state-owned broadcaster whose specific mandate is to be unbiased in matters of opinion, thought that by getting such a senior figure to present the programme, and for him to invite well-known economists to be interviewed, that there was no bias. The vast majority of listeners were similarly likely to be unaware of any bias. Furthermore, Wolf himself, being Keynesian, probably thinks that any other economic theory is simply wrong.
The supposed disconnection between individual economic experience and macroeconomics is addressed early in the programme. Wolf describes the problem as the fallacy of composition, which is the error of assuming that something that must be true for one part of the economy must also be true for the whole. Larry Summers agreed:
“There is a huge tendency on people’s part to conflate individual virtue with a better public outcome. So, if I tighten my belt, that might be a good thing for my family because I’ll have more money later, but if everyone tightens their belt, since my spending is your income, the result, as Keynes pointed out can be a substantial contraction in the economy. And it’s those kinds of cases where individual behaviour and what’s good at the individual level differ from what’s good at the national level, is most difficult for the public to understand.”
Nor should the public attempt to understand it. The mistake here is an assumption that to extrapolate what one person will do to the possible actions of the population as a whole is a valid argument. The best way to illustrate that it is not is to take a sound-money case and compare it with an unsound money example.
Why this version of the fallacy of composition is simply wrong
With sound money, that is money that is gold, or substitutes that are fully backed by physical gold, human behaviour is self-correcting through the price mechanism, the only possible exception being if a natural, as opposed to an economic disaster occurs. A community regulates the quantity of money it collectively holds through evolving preferences for it relative to goods. If, for example, social changes dictate that people at the margin increase their preference for money, then the prices of goods in general will adjust by falling. With sound money, people decide how much they need for their immediate purposes, and how much they put aside in savings.
Two correcting mechanisms come into play. The first is a domestic one, whereby an increase in saved money provides an increase in capital available for investment in production. The fall in interest rates that must reflect a switch from immediate consumption to an increase in saving (which is where the unspent money goes) allows businesses to invest in more efficient production at lower margins, and thus become profitable again at lower prices.
The second correcting mechanism is through arbitrage. Other trading communities which have not changed their money preferences will tend to buy the cheaper goods from those that have increased their preference for money. By the same mechanism, a community that at the margin instead increases its preferences for goods will drive up local prices, and due to the reduction of savings that results, local interest rates will tend to rise. At least some of the money reallocated to current spending is likely to be spent on imports whose prices have not yet risen, and that way some of the surplus money arising from the increased preference for goods ends up being exported to other communities, and their prices rebalance as well.
In any event, with sound money the shifts in overall preferences will always be a marginal effect and are corrective rather than disruptive. The changes in interest rates that result from changes in preferences between holding money and goods are also relatively small, compared with the fiat money experience. This is not hard to understand, but then Keynes revealed in his General Theorythat he didn’t understand prices, which are always the relationship between money and goods. The fallacy of composition to which Martin Wolf referred cannot occur in genuine free markets and can only occur as a result of a public reaction to earlier state intervention. Even then, the outcome predicted in the fallacy of composition is only partially possible. It cannot be stated loudly enough: the so-called fallacy of composition cannot occur with sound money, it takes Keynesian unsound money to create it. The fallacy of composition is itself a fallacy.
The motive for this cul-de-sac in Keynesian logic is simply to undermine the importance of savings in an economy, which was the theme behind The General Theory. Understand that and there is little need to argue the case further. But the Keynesians will probably persist by pointing out that sound money in the form of gold and fully-backed gold substitutes is simply irrelevant to the real world. But that misses the point. The problem is not pre-Keynesian economics, which basically took individual actions as the grounding for a wider economic theory, but the Keynesian tactic of creating fiat money to bury fundamental truths.
The fallacy of monetary stimulation
Let us take Keynes’s basic supposition, that free markets fail to optimise economic progress, and that from time to time the creation of a budget deficit can stimulate production to shorten a slump and return the economy to its potential. This is the essential theme behind Keynesian interventionism, which Martin Wolf suggests we should be taught to support.
First, we must overlook the origin of the slump, which can only be the result of a credit cycle based on unsound money, and just assume that for whatever reason the economy is in the doldrums. The government then decides to run a budget deficit; in other words, it spends more than it raises in taxes, and consequently the quantity of money in the economy is expanded. When that new money first enters the economy, it tends to drive up prices as it is absorbed.
The early receivers of this money benefit because the prices they pay reflect the old quantity of money in the economy, before it is diluted by the extra money created out of thin air. The losers are the last to receive it, or perhaps they don’t get any of it at all, and the rest of the population are somewhere in the middle. The losers end up paying higher prices, raised in the wake of the earlier introduction of the extra money. Therefore, far from stimulating the economy, all that has happened is some have benefited, and others have lost.
Our simplistic example, for the purpose of clarity, omits a further important consideration, which affects the purchasing power of money, and that is the value set on it by individuals adjusting their relative preferences as earlier described. In practice, the relationship between consumption and consumption deferred, which is what savings are, varies over the credit cycle.
After the previous credit crisis, consumers and businessmen will be naturally cautious and tend to increase their savings at the margin. Risk will be uppermost in their minds, based on recent experience. Consequently, any change in the general level of prices tends to be modest.
As they become more confident that the crisis is behind them, they gradually begin to both spend and invest in production, the investment being boosted by suppressed interest rates and by the expansion of bank credit. In an open economy, price rises initially remain modest, because much of the extra demand for goods is satisfied by cheaper imports. But prices will be beginning to increase noticeably as money and credit are increasingly taken up by both manufacturers and consumers. And finally, both businessmen and consumers see prices rising more strongly, and then they actively begin to decrease their preference for money, preferring ownership of goods.
At this point, there is a collective awakening to the consequences of earlier monetary expansion, and consumers’ time-preferences adjust, often quite suddenly. The future value of money, compared with cash values, decreases; and therefore, the equilibrium rate of interest begins to rise. Unless the central bank responds quickly to this market-led development, the shift in preference against holding money is bound to accelerate, given the continuing availability of bank credit. The purchasing power of money begins to decline sharply.
The dilemma for any central bank is the market is now reasserting control over interest rates, taking it away from policy makers. The central bank resists raising rates in the knowledge that the banks and businesses that it fooled with lower interest rates earlier in the credit cycle will risk sliding into insolvency. The next credit crisis, which unwinds these distortions is now inevitable.
More money simply leads to higher prices
If there is one passage in Keynes’s writing that exposes his lack of understanding over the relationship of money and prices, it is the following:
“…..if effective demand changes in the same proportion as the quantity of money, the quantity theory of money can be enunciated as follows: ‘So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money.’” [Keynes’s emphasis]
This is still the basis behind monetary policy today. The Fed operates a dual mandate and is meant to raise interest rates once “full employment” is reached. In other words, the expectation is that the general price level will not change as a result of monetary expansion until the labour market tightens beyond a certain point.
It is generally true that prices do not tend to rise as much when there is high unemployment compared with a full-employment economy. But crucially, Keynes’s reasoning as to why this is so is badly flawed. His underlying assumption, for it to be true, must be that all labour is homogenous, when in fact it is not. You cannot employ a dustman as a banker or a builder as an electronics engineer. The second error is to assume that the only cost variable is wages, when in a modern business other production costs are often far larger. Changes in commodity prices, energy, establishment costs, processing equipment, inventory and taxes have a far larger combined cost impact on a business than wages, particularly in the highly automated industries. Keynes ignores all consumer subjectivity in setting prices and appears to be subscribing to a Marxist cost-of-labour theory of prices in his redefinition of the quantity theory of money.
There is no escaping from the fact that if the quantity of money is expanded, prices will rise, even though it takes time for the effect to take place and the exact effect cannot be predicted. Any economic stimulation from monetary inflation relies on hoodwinking the public into believing there has been no change in money’s purchasing power. For that to be true, all the extra money injected into the economy would have to be hoarded as cash, not even saved as bank deposits to be made available for industrial investment. In other words, the people would have to withhold its circulation. This is not what the Keynesians intend.
Worse still, the extent to which new money does stimulate the economy then ends up deflating it, when any temporary beneficial effect wears off. This is because once the new money is absorbed and reflected in higher prices both for consumer goods and the factors of production, besides creating winners and losers, the overall economic situation can be expected to return more or less to where it was before. Therefore, there is no such thing as a one-off monetary injection to get the economy going. Even if you subscribe to a theory of state stimulation by monetary means, it must be admitted that a continuing and larger injection is required to both offset the negative effects of earlier monetary injections wearing off, and to keep the monetary scam going.
This is why monetary manipulation of the economy fails, because all it achieves is economic disruption. It is beloved by socialists, because they can use monetary policy to select winners and losers, and, indeed, the unpleasant aroma of moralising politics is barely concealed in the economic utterances of leading neo-Keynesian economists, such as Professors Stiglitz and Krugman. The desire to create a state-directed economy at the expense of consumers and for the benefit of the state must be what motivates state-educated economists to the exclusion of reasoned theory.
By calling it a business cycle, the state pins the blame for economic slumps and recession squarely on the private sector, when it is a problem entirely of its own making. It is a gentle but deceptive form of propaganda designed to ensure the state is seen as rescuing the private sector from its own follies, when in fact it is picking its pockets.
Central to the deception was Keynes’s denial of Say’s law, which he redefined into terms which suited his objective. It was never, as he redefined it, that supply creates its own demand.[vi] In fact, Keynes took what he described as the postulates of classical economics and blatantly misrepresented many of them, either deliberately or through ignorance. Supporting this inference, Hayek, the great Austrian economist, who besides his disagreements with Keynes got on well with him as a colleague and friend, said Keynes was not an economist but a mathematician. Yet, it is on Keynes’s say-so that his followers today want to extend education of his version of mathematical economics into the schools and to the general public.
Admittedly, a wider understanding and solution to the economic and monetary ills of today is less likely to come from aprioristic reasoning employed in this analysis, than from empirical evidence. The destruction that befell the Soviet regime after seventy years of implementing state-directed planning and pricing is there for everyone to see and is tangibly instructive. Undoubtedly, the Soviet suppression of individual freedom was far stricter than that imposed on the citizens of today’s welfare states, but the transgression of the laws of economics are the same.
It would be far better to remind the masses of the failures of communism and leave them to draw their own conclusions about interventionism, and whether the lessons apply to us today, instead of trying to get them to understand the false fallacy of composition.