vol. 43, no. 10 (October), 1993
The Trouble with Keynes
Roger W. Garrison
economics of John Maynard Keynes as taught to university sophomores for
the last several decades is now defunct in theory—but not in practice.
Keynes's 1936 book The General Theory of Employment, Interest, and Money
portrayed the market as fundamentally unstable and touted government as
the stabilizer. The stability that allegedly lay beyond the market's reach
was to be supplied by the federal government's macroeconomic policymakers—the
President (with guidance from his Council of Economic Advisors), the Congress,
and the Federal Reserve.
acceptance in the economics profession of fundamentalist Keynesianism peaked
in the 1960s. In recent decades, enthusiasm for Keynes has waxed and waned
as proponents have tried to get new ideas from the General Theory
or to read their own ideas into it. And although the federal government
has long since become a net supplier of macroeconomic instability,
the institutions and policy tools that were fashioned to conform with the
Keynesian vision have become an integral part of our economic and political
national income accounting system, devised with an eye to Keynesian theory,
allowed statisticians to chart the changes in the macroeconomy. Dealing
in terms of an economywide total, or aggregate, policy advisors tracked
the production of goods and services bought by consumers, investors, and
the government. Fiscal and monetary authorities were to spring into action
whenever the economy's actual, or measured, total output, which was taken
to reflect the demand side of markets, fell short of its potential output,
which was estimated on the basis of the supply side. Cutting taxes would
allow consumers and investors to spend more; government spending would
add directly to the total; printing money—or borrowing it—would facilitate
the opposing movements in the government's revenues and its expenditures.
chronic insufficiency of aggregate demand, which implies that prices and
wages are somehow stuck above their market-clearing levels, was believed
to be the normal state of affairs. Why might there be such pricing problems
on an economywide scale? What legislation and government institutions might
be standing in the way of needed market adjustments? These questions were
eclipsed by the more politically pressing question of how to augment demand
so as to clear markets at existing prices. The New Economics of Keynes
shifted the focus of attention from the market to the government, from
the economically justified changes in market pricing to the politically
justified changes in government spending.
still appeal to basic Keynesian notions to justify their interventionist
schemes. The continued use of demand-management policies aimed at stimulating
economic activity—spending newly printed or borrowed money during recessions
and before elections—requires that we understand what Keynesian economics
is all about and how it is flawed. Also, identifying the flaws at the sophomore
level helps students to evaluate in their upper-level and graduated courses
such modern modifications as Post, Neo and New Keynesianism as well as
some strands of monetarism.
extreme level of aggregation in Keynesian economics leaves the full range
of choices and actions of individual buyers and sellers hopelessly obscured.
Keynesian economics simply does not deal with supply and demand in the
conventional sense of those terms. Instead, the entire private sector is
analyzed in terms of only two categories of goods: consumption goods and
investment goods. The patterns of prices within these two mammoth categories
are simply dropped out of the picture. To make matters worse, the one relative
price that is retained in this formulation—the relative value of consumer
goods to investment goods as expressed by the interest rate—is assumed
either not to function at all or to function perversely.
The Centrality of Scarcity
Pre-Keynesian economics, such as that of John
Stuart Mill, as well as most contemporaneous theorizing, such as that by
Ludwig von Mises and F. A. Hayek, emphasized the notion of scarcity, which
implies a fundamental trade-off between producing consumption goods and
producing investment goods. We can have more of one but only at the expense
of the other. The construction of additional plant and equipment must be
facilitated by increased savings, that is, by a decrease in current
consumption. Such investment, of course, makes it possible for future
consumption to increase. Identifying the market mechanisms that allocate
resources over time is fundamental to our understanding of the market process
in its capacity to tailor production decisions to consumption preferences.
But as Hayek noted early on, the Keynesian aggregates serve to conceal
these very mechanisms so essential to the intertemporal allocation of resources
and hence to macroeconomic stability.
Keynesian theory the long established notion of a trade-off between consuming
and investing is simply swept aside. Consistent with the assumed perversity
of the price mechanism, the levels of consumption and investment activities
are believed always to move in the same direction. More investment generates
more income, which finances more consumption; more consumption stimulates
more investment. This feature of Keynesian theory implies an inherent instability
in market economies. Thus, the theory cannot possibly explain how a healthy
market economy functions—how the market process allows one kind of activity
to be traded off against the other.
The "Multiplier-Accelerator" Theory
The inherent instability makes its textbook appearance
as the interaction between the "multiplier," through which investment affects
consumption, and the "accelerator," through which consumption affects investment.
The multiplier effect is derived from the simple fact that one person's
spending becomes another person's earnings, which in turn, allows for further
spending. Any increase in spending, then, whether originating from the
private sector or the public sector, gets multiplied through successive
rounds of income earning and consumption spending.
accelerator mechanism is a consequence of the durability of capital goods,
such as plant and equipment. For instance, a stock of ten machines each
of which lasts ten years can be maintained by purchasing one new machine
each year. A slight but permanent increase in consumer demand for the output
of the machines of, say, ten percent, will justify maintaining a capital
stock of eleven machines. The immediate result, then, will be an acceleration
of current demand for new machines from one to two, an increase of one
multiplier-accelerator theory explains why consumption is increasing, given
that investment is increasing, and why investment is increasing, given
that consumption is increasing. But it is incapable of explaining what
determines the actual levels of consumption and investment (except in terms
of one another), why either should be increasing or decreasing, or how
both can increase at the same time. Students are left with the general
notion that the two magnitudes, investment and consumption, can feed on
one another, in which case the economy is experiencing an economic expansion,
or they can starve one another, in which case the economy is experiencing
an economic contraction. That is, Keynesian theory explains how the multiplier-accelerator
mechanism makes a good situation better or a bad situation worse, but it
never explains why the situation should be good or bad in the first place.
at the two extremities in the level of economic activity is a change in
direction of both consumption and investment sure to occur. After a long
contraction, unemployment is pervasive and capital depreciation reaches
critical levels. As production essential for capital replacement stimulates
further economic activity, the macroeconomy begins to spiral upward. After
a long expansion, the economy is bulging at the seams. Markets are glutted
with both consumers' and producers' goods. As unsold inventories trigger
production cutbacks and worker layoffs, the macroeconomy begins to spiral
downward. Keynes held that the economy normally fluctuates well within
these two extremes experiencing a general insufficiency—and an occasional
supersufficiency—of aggregate demand.
In the simplistic formulations of macroeconomic
textbooks, investment is simply "given"; in Keynes's own formulation, the
inclination of the business community to invest is governed by psychological
factors as summarized by the colorful term "animal spirits." Keynes recognized
that there are some "external factors" at work, such as foreign affairs,
population growth, and technological innovations. The market is envisioned,
in effect, to be some sort of economic amplifier which converts relatively
small changes in these external factors into wide swings of employment
and output. This is the basic Keynesian vision.
rates and prices are assumed either to be inflexible or to change in direct
proportion to one another. In either case the real wage rate (W/P) is forever
constant. The actual level of wages and prices is believed to be determined
(again) by external factors—this time, trade unions and large corporations.
If the real wage is too high, there will be unemployment on an economywide
scale. There will be idle labor and idle resources of every kind. The opportunity
cost of putting these resources back to work is nothing but forgone idleness,
which is no cost at all. The assumed normalcy of massive resource idleness
assures that the perennial problem of scarcity never comes into play. William
H. Hutt and F. A. Hayek were justified in referring to Keynesian economics
as a "theory of idle resources" and as the "economics of abundance."
Keynesianism has a certain internal consistency or mathematical integrity
about it. Given the assumptions that prices and wages do not properly adjust
to market conditions—that is, the assumption that the price system does
not work—then the Keynesian relationships among the macroeconomic aggregates
come into play. Even the policy prescriptions seem to follow: If wages
and prices do not adjust to the existing market conditions, then market
conditions must be adjusted (by the fiscal and monetary authorities) to
the externally determined prices and wages.
the final analysis, however, Keynesian theory is a set of mutually reinforcing
but jointly unsupportable propositions about how certain macroeconomic
aggregates are related to one another. Keynesian policy is a set of self-justifying
For instance, if the government is convinced that
wages will not fall and is prepared to hire the unemployed, then the unemployed
workers will not be willing to accept a lower market wage, ensuring that
wages, in fact , will not fall. Thus, while the intention of Keynesian
policy is to stabilize the economy, the actual effect is to "Keynesianize"
the economy: It causes the economy to behave in exactly the same perverse
manner that is implied by the Keynesian assumptions. This convoluted interrelationship
between theory and policy has long obscured the flaws in the theory itself.
often ask the obvious question: Why is government policy grounded in such
a flawed theory? From a political point of view, advocating and implementing
Keynesian policy is the surest way to election and re-election. The gains
from printing and spending money are immediate, highly visible, and can
be concentrated on individuals who make up powerful voting blocs. The costs
of this policy are incurred at a later date and can be spread thinly across
the entire population, making the link between policy and long-run consequences
difficult for the voting public to perceive.
fading in recent years of old-line Keynesianism in academic circles provides
little comfort. Even as the number of demand-managers continues to decline,
it is from this shrinking group of economists that government officials
seek advice and reconciliation. And opportunities to lecture to the seats
of power rather that in the halls of learning have a way of changing some
economists' minds about the advisability (political if not economic) of
managing aggregate demand. Printing and spending money in the pursuit of
short-run stimulation if not long-run stability remain the order of the
is good reason, then, to study Keynesian theory: it helps us understand
what the policymakers in government are likely to do in any given circumstance.
But to understand the actual effects of their demand-management policies
in the long run as well as the short, we need a more enlightening theory—one
that recognizes what market forces can do on their own to maintain macroeconomic
stability and how those forces are foiled by government-supplied stabilization.