Keynes’s 1933 letter to Harlan McCracken


The letter you see I uncovered in 2008 in the Harlan Linneus McCracken Archive at Louisiana State University, which has now been published in the March 2019 issue of the Journal of the History of Economic Thought. It has already been published by me, but only in black and white. Here we see the letter as it actually is. If you would like to read more fully of the letter’s significance, you can go to:

Kates, Steven. 2008. “A Letter from Keynes to Harlan McCracken Dated 31st August 1933: Why the Standard Story on the Origins of the General Theory Needs to Be Rewritten.” History of Economics Review 47: 20–38.

The letter would be momentous were it not for the fact that it reveals that Keynes with certainty was reading other sources than those he had previously owned up to in writing The General Theory which he commenced writing in 1932 and which was finally published in 1936. The letter substantiates virtually beyond argument – there is always an argument – that Keynes took up the notion of demand deficiency because he had been reading Malthus at the time. Malthus had been the single most important economist to have argued for the importance of demand deficiency as a cause of recession and unemployment during the nineteenth century. Virtually every other economist at the time and through to 1936 thought Malthus was completely wrong. It was unanimously agreed among mainstream economists that the notion of demand deficiency was totally false.

Going further, it was from McCracken that Keynes took his definition of Say’s Law: “supply creates its own demand”. These words are found for the first time ever as a definition of Say’s Law in the very book Keynes is thanking McCracken for having sent to him and which he had “now read”.

The article the letter is attached to, and now published in the Journal of the History of Economic Thought, was written to demonstrates that “Say’s” Law not was invented by J.B. Say. No understanding of the classical meaning of Say’s Law can be found other than by going through the literature that followed the publication of Malthus’s Principles in 1820, not by reading Say’s Treatise, whose first edition was published in 1803. Moreover, “Say’s Law” was the name applied to this concept for the first time by Fred Taylor in the twentieth century. It was not a classical term. Keynes took the phrase “Say’s Law” from Taylor or from one of Taylor’s contemporaries. I am near enough the only person from whom this can be found out. Virtually no one else will even repeat it, and certainly no one is capable of refuting it since the term never shows up anywhere until it was coined by Taylor. Beyond that, no one ever said “supply creates its own demand” in relation to Say’s Law until it was said by McCracken.

You would not think there would be such a cover-up in something as esoteric as the History of Economic Thought, but the implications are explosive, the more so to the extent that others might begin to appreciate there is more in pre-Keynesian economic theory than anyone since 1936 has given it credit for.

The mystery of the Keynesian Revolution

Here is another book just published about the Keynes, this one, Reinterpreting The Keynesian Revolution by Robert Cord. This is what it’s about.

Various explanations have been put forward as to why the Keynesian Revolution in economics in the 1930s and 1940s took place. Some of these point to the temporal relevance of John Maynard Keynes’s The General Theory of Employment, Interest, and Money (1936), appearing, as it did, just a handful of years after the onset of the Great Depression, whilst others highlight the importance of more anecdotal evidence, such as Keynes’s close relations with the Cambridge ‘Circus’, a group of able, young Cambridge economists who dissected and assisted Keynes in developing crucial ideas in the years leading up to the General Theory.

However, no systematic effort has been made to bring together these and other factors to examine them from a sociology of science perspective. This book fills this gap by taking its cue from a well-established tradition of work from history of science studies devoted to identifying the intellectual, technical, institutional, psychological and financial factors which help to explain why certain research schools are successful and why others fail. This approach, it turns out, provides a coherent account of why the revolution in macroeconomics was ‘Keynesian’ and why, on a related note, Keynes was able to see off contemporary competitor theorists, notably Friedrich von Hayek and Michal Kalecki.

There are many reasons why it happened, but there is this for starters: if you say to kids that the best way to grow up strong and healthy is to eat lots of chocolate cake you will need to do very little convincing. You will actually ruin their health, but they won’t know that until they have tried it for themselves.

My own contribution to this issue of why Keynes with this theory at that time is to point out that Keynes was reading Malthus’s letters to Ricardo at the bottom of the Great Depression at the end of 1932 while preparing his “Essay on Malthus” for his Essays in Biography that was published at the start of 1933. And there, in the midst of Malthus’s letters, he discovered the general glut debate of the 1820s and Malthus’s arguments attributing recessions and unemployment to demand deficiency. So obvious is this sequence that it remains the most mysterious of all of the mysteries I have encountered in my dealing with Keynes and the Keynesians that not only do they not accept that reading Malthus had any effect on Keynes’s thinking, they will not even consider it as a possibility. But that’s how it happened, and the more evidence I have the more resolutely it is ignored. If you want to look at the sociology of science in relation to Keynes, that is where I would start.

Criticising Keynes – four years later nothing has changed

The following are four notes I wrote to the Societies for the History of Economics website back in November 2011. Brad Bateman and Roger Backhouse had written a book on Keynes and Keynesian economics – Capitalist Revolutionary-John Maynard Keynes – and had put up a note to let others know. I had also written a book just then, so thought I would mention it since there are alternative ways of looking at things. As it happens, even four years later, six years following the dead hand of the stimulus was first applied – no one else has written a book explaining what is wrong with Keynesian economics and laying out the alternative. These four posts could have been written yesterday, given how economic theory has dug in and refuses even to so much as notice how useless its advice has been. In reading these, please note that others had written comments as as well, only some of which I mention.

Professors Backhouse and Bateman invite us to indulge in a visionary perspective in dealing with the Global Financial Crisis and the subsequent recession that will not go away. They wish us to look at alternative ways of thinking about the economy and how it works.

As it happens, I have done just that. In August this year, Edward Elgar published my Free Market Economics: an Introduction for the General Reader which outlines the mechanics of an entrepreneurially-driven market economy embedded within a political structure where the rules and regulations that businesses work within are determined by others. And what is particularly notable about the book is that while it explains Keynesian economics as accurately as any other introductory text on the market, it is also at the same time the most relentlessly anti-Keynesian book written in the past forty years. Moreover, if you would like to have an economics text that explains the classical theory of the cycle – the best alternative I know to Keynesian theory – my book does that as well, and I think in this regard, it may be the first book to do so in over three-quarters of a century. To my knowledge, there is no other book like it, although I truly do wish the market was flooded by hundreds of alternative titles along the same lines.

Let me therefore highlight one of the sentences in the Backhouse-Bateman article:

“Even Keynes himself was driven by a powerful vision of capitalism. He believed it was the only system that could create prosperity, but it was also inherently unstable and so in need of constant reform.”

Well I can agree with half of this but the other half is plain wrong. Capitalism is without question the only system that can create prosperity. But as the existence in 1936 of the by then hundred year old classical theory of the cycle should tell you, there has never been much doubt that capitalist systems are subject to instability. Nor was Keynes intention to explain to his fellow economists that our economies were in need of constant reform, whatever that might mean. The point of The General Theory was to introduce into mainstream economic theory the notion of aggregate demand. (Read page 32 of the GT on Malthus and Ricardo if you are in any doubt). There is nothing else in the book that is novel or that has spread like a weed throughout the discipline the way this concept has. And its adoption has been the single most disastrous mistake economic theory has ever made. Because economists now think in terms of aggregate demand we are no longer capable of explaining even the basics of the cycle and cannot provide sound advice to governments when economies fall into recessions as they inevitably will.

Let me finally say that I endorse everything written by James Ahiakpor in his earlier post. But let me also add that while the tremendously faulty structure of the bailouts can only be explained by the need to do something straightaway, that there was a need for government action could have been found by reading Bagehot’s Lombard Street which was published in 1873. It was the stimulus that came after, pure Keynes in both structure and intent, that is the core problem we are dealing with right now. The stimulus packages themselves are the most important cause of the prolonged recession most economies are facing today. It is the problems of debt and deficit that are the major problems we must find answers to, not a failing financial system which was the problem in 2009. So where Backhouse and Bateman ask:

“How do we deal with the local costs of global downturns? … If economists want to help create a better world, they first have to ask, and try to answer, the hard questions that can shape a new vision of capitalism’s potential.”

OK, I’m in. Let’s find a solution to all of this and more. But if you think Keynesian theory is any part of the answer, then my friends, you are in my view part of the problem and in no way part of the solution.

Second tranche.

I appreciate Mason Gaffney’s query about the nature of my book. And if I could, I will reply using the text of a note I sent to Roger Sandilands after reading his brilliant compilation of some of the more difficult-to-find works of Allyn Young. Two of the longer parts within Roger’s compilation were Kaldor’s notes of Young’s LSE lectures which were delivered in 1927-29, and the various entries Young wrote in the 1920s for the Encyclopaedia Britannica. If you would like to see how economists thought about economic issues prior to the publication of The General Theory, this is the place to go. Hopefully, Roger will be able to let us know how to obtain copies of his compilation of Young’s work. But to explain what my book is about, I hope this note I wrote to Roger will explain how I think of this book myself:

“I have been meaning to write to you for some time. I took Allyn Young’s LSE lectures and Britannica entries with me as my morning train reading for many many mornings in a row and it was fantastic. The first thing that it confirmed for me was that the book I have written on Free Market Economics is actually what I wanted it to be. It is the book that an economist schooled in the classical tradition would have written in the absence of the arrival of the General Theory. I learned an immense amount from Young but all of it merely deepening my own understanding of things that I had absorbed from the classical literature generally. I attach the flyer for the book which you should ask your library to buy anyway, but if you look at it, you will see that it is classical theory right down to its downward sloping supply curves and its discussion of the theory of the cycle in an almost identical way to Young’s.

“The theory of the cycle as Young portrays it (discussed pp 76-84) is not just the classical stuff in general, but is explicitly soaked through with Say’s Law. He notes that J.-B. Say “pointed out” that “what is commonly called overproduction is merely ill-balance production” (p 77). And then on the next page, “people do not over-save, they miscalculate” (p 78). Where can you find that written in a textbook any more, other than in mine, of course.

“And if you look at my book, you will even find the history of economics discussed more or less in the same place, just half way past the middle (pp 85-88). He not only feels the need to say these things, but the logic of when to put the history into the text occurs to him in just the same way and at just the same point as it occurred to me.

“But it is not merely coincidence that our work is so in parallel, but it is that he and I both think about things in the same sort of way. I have the advantage of actually having seen Keynesian economics in action whereas one can only conjecture just how savage Young would have been about the GT had he seen it for himself. Given what he has written here, there is little doubt he would have found the GT nonsense from end to end. And now, today, instead of discussing Mises and Hayek alone, we would be also discussing Young.”

That is where my letter to Roger ends. But to supplement your reading of Young, for an explanation of the nature of the business cycle as understood by classical economists, the first edition of Haberler’s Prosperity and Depression is hard to beat. That is what I built my own chapters on. But if you go to Young, who unfortunately died at 53 in 1929, you will see these same theories described in more or less exactly the same way by someone writing before there was even a hint of the Great Depression to come.

Third tranche.

It is interesting to see just how relentlessly Roger Backhouse and Brad Bateman choose to ignore what I wrote. That was the reason I thought I would bring Allyn Young into the conversation since I understand perfectly well that some faraway economist living in the antipodes would have no standing in such discussions but I thought Allyn might. Nevertheless, I do wish to impress upon them once again that what I am writing about is a direct response to the issues raised. And since the only compass in which these issues can be properly discussed is the evolution of economic theory over the past hundred years, in every way this is a subject matter for this site.

Going back to the original NYT article, let me take the final sentence as the core point Backhouse and Bateman wished to make. What they wrote was: “If economists want to help create a better world, they first have to ask, and try to answer, the hard questions that can shape a new vision of capitalism’s potential.” To do this, they argued, economic theory should include a major recognition of government and its role. To emphasise how important this point is, they criticised Hayek and Friedman for ignoring the important contributions of government, writing:

“In the 20th century, the main challenge to Keynes’s vision came from economists like Friedrich Hayek and Milton Friedman, who envisioned an ideal economy involving isolated individuals bargaining with one another in free markets. Government, they contended, usually messes things up. Overtaking a Keynesianism that many found inadequate to the task of tackling the stagflation of the 1970s, this vision fueled neoliberal and free-market conservative agendas of governments around the world. That vision has in turn been undermined by the current crisis.”

Well, what I am trying to tell them is that I have attempted to do in my book on “Free Market Economics” exactly what they have argued needs to be done. It is not perfect but what is? And because of its hostility to Keynes and what he stands for, I fear that if they read it they would unlikely find much in it that would give them pleasure. But (a) it is obviously about capitalism (although the word does not appear anywhere in the book) and (b) it provides a vision of the world in which economic actions are of necessity buried inside a political structure. Don’t believe it? Here are the opening three paragraphs of the book:

“This is a book about the market economy.

“A market economy is one in which overwhelmingly the largest part of economic activity is organised by private individuals, entrepreneurs, for personal profit. Such entrepreneurs are private citizens not government employees. They make decisions for themselves on what to produce, who to hire, what inputs to buy, which machinery to install and what prices to charge.

“There are, of course, in every nation state legislative barriers put in place by governments which limit every one of these decisions. No market is or ever has been even remotely laissez-faire. Entrepreneurial decisions are circumscribed by the laws, rules and regulations that surround each and every such decision.”

My aim in writing the book was to explain to governments, and to their citizens, how an economy can be run so that prosperity for the largest number is the result. This is not a book about how governments should be kept away from economic interactions, a completely weird and self-defeating idea. This is a book that embeds within the text the very necessity for governments to intervene to make free markets work. The point that I try to make is that since governments not only are going to intervene but must, they should do so in a way that actually does some good.

But Backhouse and Bateman do not just say we need a new vision and leave it at that. In their article and subsequent post, they are promoting a book with the title, “Capitalist Revolutionary: John Maynard Keynes”. In their view, it is in Keynes that we are to find that vision. Well the point I wish to make is that it is precisely in Keynes that we will not find that vision, and that if we economists had any sense we would abandon Keynesian theory and policy root and branch. To draw some inference from Keynes that capitalism is in constant need of reform is about as vacuous a statement as I can imagine. The need for institutional adjustment to the changing nature of the world is hardly some great insight.

Fourth tranche.

Roger Backhouse and Brad Bateman have done us all an immense favour by opening up an issue that really ought to be at the top of the economics agenda today, and that is, given what we have discovered in the past two years, whether the Keynesian policy vision still makes much sense. They think it does, which is why they wrote their book, wrote their article for the NYT, and finally initiated this thread to alert the rest of us to what they have done.

Unless they were of the opinion that no one disagrees with them about Keynes and his vision, they must take it as a rightful expectation that there are some who are of a different persuasion and that they will actually say so in reply. And what seems to trouble some is this comment of mine and particularly the word “rancid”:

“The Keynesian policy vision has created a global nightmare both politically and economically, a nightmare whose end is nowhere in sight. There may be an old guard that wishes to cling to such rancid and outdated ideas but by now it ought to be obvious beyond argument that Keynesian policies do not work. There is not a single economy in the entire world that is safe from the ravages that the stimulus has caused.

“By all means, let us find a new vision, but for heaven sake, the last place we should be looking for that vision is in the works of John Maynard Keynes.”

There is nothing ad hom in this. It is, as Brad Bateman has himself noted, the ideas which I describe as rancid. It may not be a typical word used by economists but it gets my point across. Keynesian economic theory, assuming it was ever valid which I do not, should be seen by now as well past its use-by date and recognised as having become stale and moldy over the past three-quarters of a century. But in the use of this word, it is quite clear that it is the sin and not the sinner being attacked.

Thomas Humphrey has entered into this discussion thread in exactly the right way. A great scholar and one whose writings I admire, he has posted to say that the way Keynesian economic theory has developed since the 1930s has created a macroeconomic theory of immense power and penetration and that my approach would throw baby out with bathwater. And with this, the issues thatI think are important are engaged. And unless there were anything further for me to say on the issue of Keynesian theory and vision, I would have feel there is nothing else to add. I have said my piece. Keynes, yes or no. We report; you decide.

Rob Leeson has now, however, suggested that the moderator not only determine whether something ought to be published depending on its relevance, but also dependant on the choice of words used, on the number of words used and on some determination of the degree of ad hominem involved. I take it that Rob would not therefore have published my posts had he been the moderator which makes me grateful that he is not and Humberto is.

Of course we are all bad judges in our own case but I don’t think any of my posts, nor any of the others on this thread, have been too long. I have read each one through with great interest. And if they are too long, it is only the writer who loses out since eventually others stop reading what they have to say.

The moribund state of economic theory

I wrote about Hugh Goodacre’s post on the History of Economics discussion thread under the heading, How many economists can dance on the head of a pin?. This is what he said in his post:

Sir, The moribund orthodoxy that currently exercises such an inflexible grip on university economics departments will, as Wolfgang Münchau comments, inevitably face a challenge, and this “will come from outside the discipline and will be brutal” (“Macroeconomists need new tools to challenge consensus”, April 13). The orthodoxy has brought this dismal prospect on itself through the brutality with which it has purged those departments of any other school of thought than its own.

Indeed, in its extreme version, the orthodoxy’s doctrine holds quite simply that there are “no schools of thought in economics”, a totalitarian assertion all too true in most economics departments today, so ruthless has been the purge of alternatives. As a result, the different approaches to economic issues of Adam Smith, Bentham, Ricardo, Marshall, Keynes, Friedman and so on are all relegated to the fringe subject of the “history of economic thought”.

This is indeed a 1984 situation, in which the very idea that debate could exist on how to approach economic issues is regarded as a mere historical memory, and consequently of purely antiquarian interest.However, economics students are increasingly demanding a pluralistic curriculum, as discussed by Martin Wolf in “Aim for enlightenment, technicalities can wait” (April 11). Similarly, the “fossilised habits of thought” entrenched in much of the economics professions are facing increasing criticism from within the academic world (see, for example, “The world no longer listens to the deaf prophets of the west”, Mark Mazower, April 14). Let us hope that all this pressure from students, from the worlds of journalism and of interdisciplinary debate, will combine to bring university economics departments back into the world of liberal academic life from which they have for so long isolated themselves.

I left a very substantial space in time for others to say their piece, but after almost a week, I felt I had waited long enough. This is what I wrote:

I have let six days go by to see if anyone else was interested in Hugh Goodacre’s message on the moribund state of economic theory. The more time goes by, the more I am convinced there is this subject taught at universities called “economics”, and there is this aspect of the world that is called “the economy”, but the first has only a remote relationship to the second. And I could not agree more about the following in the letter Hugh quoted, with two minor qualifications which I will come to:

‘In its extreme version, the orthodoxy’s doctrine holds quite simply that there are “no schools of thought in economics”, a totalitarian assertion all too true in most economics departments today, so ruthless has been the purge of alternatives. As a result, the different approaches to economic issues of Adam Smith, Bentham, Ricardo, Marshall, Keynes, Friedman and so on are all relegated to the fringe subject of the “history of economic thought”.’

My first qualification is the exclusion of John Stuart Mill and second is the inclusion of John Maynard Keynes. Mill is excluded because he has become so far off the beaten track that virtually no one even thinks of his contribution to economic theory, which was massive and arguably a good deal greater than Ricardo or Bentham. Ricardo could no longer be read to gain insights into the operation of an economy, while with Mill you certainly can.

But the inclusion of Keynes is a mystery. Virtually all macro is Keynesian. Who nowadays writes contra-Keynes? Is there any economist in the world writing today – other than myself – who is associated with a strident anti-Keynesian perspective? I can think of hardly a one, and there are not many more than a dozen. Following the dismal failures of fiscal and monetary policies to restore growth – both of which I consider Keynesian to their roots – I cannot understand why there has been so little interest in a post mortem of some kind and the investigation of alternatives.

I can only wish Hugh and his associates the best of luck in their quest to broaden the spectrum of opinion that are considered worth consideration within schools of economics. It is long overdue.

If I knew how to write these things without antagonising the others, I would. But years in the midst of a political environment, and then all this blogging, has left me with a style of writing not necessarily perfectly equipped for the academic world. But following my post was this one from one of the great economists of the world, Professor Richard Lipsey, from whose world class introductory text I had previously learned and taught. And this is what he said:

I agree completely with the others who say that many modern economics departments (but not, I think, mine) admit of no conflicts among, or even the existences of, various modern approaches. It is a mystery how anyone can hold to this view in the light of institutionalists who emphasise the importance of institutions, ‘Newtonians’ of various sorts who use maximising equilibrium models and evolutionists who emphasis evolving systems without static equilibria. And this only mentions a few of the competing visions of how best to study the economy.

I do not suppose this is the place to dwell on the contentious additional point raised by Steve Kates but I would observe that there is a world of difference between traditional Keynesian, New-Keynesian, and post-Keynesians. The econometric models of my country’s Department of Finance and its Central Bank use updated and expanded Keynesian income-flow models. So, like it or not, updated traditional Keynesian concepts, insights and measurement categories are still useful in the work of applied economists.

Since as a text book writer, I am often accused of accepting the modern no-differences view, I mention below three of my recent publications that put forward alternative visions to the prevailing one. This is not only to set the record straight but in the belief that they might be of some interest to those who agree that creative criticisms of the prevailing view are needed.

I would also say that in going ahead, we should not throw the maximising baby out with the bath water of its overuse. Partial equilibrium, maximising models of some markets, such as foreign exchange and wheat, are useful.

Recent non-orthodox recent publications by Lipsey

“Does History Matter: Empirical Analysis of Evolutionary versus New Classical Economics” (with Kenneth I Carlaw), Journal of Evolutionary Economics, 2012.

“Some Contentious Issues in Theory and Policy in Memory of Mark Blaug,” in Mark Blaug: Rebel with Many Causes, M. Boumans and M. Klaes (eds.), (Cheltenham: Edward Elgar), 2013

“The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium” Simon Fraser University Discussion Paper, 2014

He may not agree with my anti-Keynesian views, but sees it properly as a legitimate perspective. More importantly, if Richard Lipsey sees the moribund nature of economic theory as a genuine issue to be considered, there are some very influential people who have seen the problem and are willing to add their names to the list of those who are dissatisfied with standard economic teaching and practice. I don’t know how much dynamite it will take to break up the logjam, but this is certainly a very much needed assist.

Debating Keynesian economics – the posts in order of publication

debate format jean-leon-gerome-a-collaboration-corneille-and-moliere

I began with this in the form of a letter to Louis-Philippe Rochon, the editor of The Review of Keynesian Economics amongst other accomplishments.

Dear Louis-Philippe

There are about as many versions of Keynesian theory as there are Keynesians but all versions have two things in common. The first is that economies are driven by aggregate demand. The second is that an economy’s rate of growth and level of employment can be increased by increasing aggregate demand, either through higher public spending or lowering rates of interest. Both are wrong and the destructive consequences of these beliefs are everywhere to be seen.

The following was written by two winners of the Nobel Prize in economics just as the fiscal stimulus was being introduced.

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. (Akerlof and Shiller, 2009: 2)

This is what I wrote at exactly the same time.

What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome. (Kates 2009)

You be the judge. Who was right? We had the stimulus and the unemployed have not been put back to work. We are instead in the sixth year of recessionary conditions which have indeed been deep, prolonged and which will still take years to overcome.

In the 1990s, Japan, at the time the most dynamic and amongst the fastest growing economies in the world, attempted the same kind of Keynesian stimulus. Its economy has remained comatose ever since.

And then, of course, there was the Great Stagflation of the 1970s brought on by the direct application of Keynesian theory to the problems of the time.

You would think after such consistent failure people would begin to understand that the problem is Keynesian theory, the common factor in each case. But so powerful has been the grip of the theory of aggregate demand that in spite of everything, the theory has virtually never been questioned.

If anyone knows anything about what Keynes wrote, it is that recessions are caused by too much saving. Public spending is therefore needed to soak up those savings, which businesses either cannot borrow because expected returns are too low or won’t borrow because interest rates have not fallen far enough. Here was Keynes’s advice on the kind of response that was therefore needed:

If the Treasury were to fill old bottles with banknotes, bury them . . . and leave it to private enterprise . . . to dig the notes up again . . . there need be no more unemployment. . . . It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing. (Keynes 1936: 128-129 and quoted with approval exactly as shown above in Temin and Vines 2014: 50)

This has been the essence of Keynesian theory from that day to this.

There is unemployment because the community is saving too much. Something must be done to put those savings to work. For various reasons, the private sector cannot be depended on to use those savings and interest rates cannot be lowered far enough. Therefore, public expenditure to soak up these savings must be increased and it is irrelevant whether such expenditure is in itself value adding. Even if a government increases expenditure on projects that are purely wasteful, this spending will increase the total level of aggregate demand. The increase in aggregate demand will then lead to an increase in national wealth and a fall in unemployment.

The specific point made by Keynesian economists is that spending on anything will restore an economy to full employment and raise living standards.

A century ago it was obvious to every economist alive why a stimulus of this kind could not work. Today the problems with such an approach are invisible and apparently incomprehensible.

Certainly a government can itself employ, or can buy from others causing those others to employ. And those additional employees can use their incomes to buy things from others still. And so, for a brief period of time, we can say there has been an increase in employment relative to how many might otherwise have been employed.

But unless whatever has been produced is value adding, as time goes by these additional employees merely drain away the productive capacity of the economy. Savings are indeed absorbed but the value left behind is lower than the value used up during production. The economy not only remains stagnant, it winds even further down as its resource base is diverted into wasteful forms of expenditure.

Moreover, the resource base of the economy is not just misdirected into the particular goods and services sought by governments, but the inputs, whose production has also been encouraged by the “stimulus”, become a further distortion of what was already a grossly misdirected structure of production.

The structure of the economy has thus become even more misshapen than it had been when the stimulus began and the problem cannot be cured until the non-value adding components of the stimulus are wound back. You can call the process “austerity” if you like. But the fact is that there can be no solution to the problems the stimulus has caused until the various non-value-adding projects the government has introduced are withdrawn.

The adjustment process is inescapably painful, far more drawn out than recovery from the original recession would have been, but there is no alternative if an economy is ever to regain its strength. But because they think in terms of aggregate demand, no Keynesian ever understands what needs to be done.

Let me approach this in a different way. This is the fundamental equation of Keynesian economics (leaving aside foreign trade):

Y = C + I + G

Aggregate demand (Y) is the amount spent by consumers on consumer goods (C) plus the amount spent by businesses on investment (I) plus total spending by governments (G). The underlying presumption is that the higher the level of Y, the higher the level of output and employment.

In a recession business investment goes down, and as Y goes down, employees lose their jobs. To lift Y back up and therefore raise employment, the policy recommended by Keynesians is to raise the level of government spending on absolutely anything at all.

What you then have is less investment by business and more spending directed by governments. The proportion of expenditure on productive forms of output has been reduced while spending on less productive and often totally unproductive forms of output has increased.

No one wants recessions and the unemployment recessions bring. But a Keynesian response that attempts to lift aggregate demand without first increasing value-adding supply can never succeed. There is no mechanism that can lead from higher levels of wasteful expenditure to higher living standards and more employment.

That so many seem unable to learn from experience, or any longer understand the reasons why wasteful spending can never be a solution to recessions and unemployment, is the most astonishing part about having watched events unfold since the GFC.

Obviously, none of this can be properly explained in a brief note of a thousand words. If you are interested in understanding not only why Keynesian economics provides no solutions to our economic problems, but also what should be done instead, read the second edition of my Free Market Economics: an Introduction for the General Reader</em>. There is literally nothing else like it anywhere.

Best wishes,


This was the reply:

Dear Steven,

Thank you for your letter, which I was happy to read. I must confess, however, that we seem to have very different memories of this crisis (a word, by the way, that never appears in your letter) and an extremely different interpretation of the history of macroeconomics. I also don’t quite understand your passion against anything Keynesian. My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction. For that, he is remembered as one of the greatest thinkers. By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates. As you say, ‘you be the judge’.

You also suggest that Keynesians were wrong in their predictions of the duration of the crisis and you are undoubtedly right about Akerlof. But many other Keynesians were also predicting a long and worrisome recovery. And may I add, virtually no one in the mainstream of the profession, including Austrians, Libertarians and neoclassical economists, predicted this crisis. They were too busy with their badly-designed models to pay any attention to the real world. So, yes, I point a finger to neoclassical economists who believe in the Efficient Market Hypothesis which even denies such a crisis can occur. For that reason, they could not even see the crisis until it was right under their noses. Funny enough, at conferences a few years after the crisis began, those same economists were back to business as usual as if the crisis never happened. Surely, you are not asking me to have faith in the same theories that directly contributed to the greatest crisis in over 75 years.

As a “post”-Keynesian (not to be confused with ’Keynesian’ new, neo or other), I too predicted at a talk I gave at UNAM in Mexico in 2009 that this was going to be a long, dragged-out crisis, and even stated at the time that it was going to take at least a decade to recover. Many of my colleagues on the left made the same arguments. And, here we are seven years later. But now, I think I may have been wrong: I think it will take much longer.

But the reasons I gave then are even truer today: while governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures. You say, “we had the stimulus” but forget to mention that the stimulus policies were completely reversed a mere year after they were introduced. And make no mistake: that stimulus was working. We were well on our way to recovery until governments got spooked by those who were warning against high deficits and debt levels, and who bought into the fear-mongering propagated by the right that governments were going to go bankrupt if they spent beyond their means. Well, we know what happened, don’t we?

First, the embarrassing gaffe (to put it mildly) by Carmen Reinhart and Kenneth Rogoff, whose paper, ”Growth in a time of Debt”, was widely cited as empirical proof that too much debt can harm growth. Well they were quickly defrocked and their research exposed for what it truly was by an honest doctoral student from University of Massachusetts, Amherst, Thomas Herndon, who took the time to properly dot the i’s and cross the t’s. So that myth was clearly debunked. In fact, UNCTAD just released a new report indicating that among the top 7 countries with the worse austerity measures are Italy, Spain, Portugal, Greece and Ireland – all countries facing a dire economic situation. You be the judge.

Second, we now know that any country with a sovereign currency can never go bankrupt since a sovereign central bank can always buy all the required government debt.. And financial markets and speculators know this. The proof is in the pudding: while the US, the UK and Japan’s debt levels were much higher than many other countries, their interest rates were much lower. Clearly, financial markets know exactly this to be the truth and did not turn away from the US when the debt levels were climbing.

The worst infliction we can impose on our economies is to leave them to the tyranny of the markets. We now know with conviction that markets are by their very nature unstable and prone to crises, and must be regulated. Unfettered markets only lead to recessions and crises at which time governments must swoop in and clean up the mess.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. When the private sector is not spending, governments have the moral responsibility to intervene and ensure the spending is sufficient to encourage investment. Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect! When you look at aggregate demand today, it is at best anemic. Consumers are saddled with debt, and private investment has flatlined; austerity measures are being imposed everywhere. There is no room for growth. That leaves only exports to ensure a recovery. But with Europe on the verge of deflation, the BRIC countries slowing down, the prospects for exports are dimming. So where will growth come from? I am afraid that without aggressive fiscal deficit spending, we are dooming future generations and ourselves to another decade or more of weak economic growth. This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

So what do we need to get the world economy back to prosperity? Here is my four-prong solution:

First, we must replace private debt with public debt. This can only occur with a well coordinated fiscal stimulus among the leading economies. Here in Canada, our infrastructure is crumbling and in desperate need of massive public investment. I can think of a number of places that need investment: our health care system, our education, our national parks, our roads and bridges, and why not create national day care to help struggling families. In the US and elsewhere around the world, there are plenty of examples of much needed infrastructure spending and public investment projects. If there is ever a good time to borrow, now is the time as interest rates are at historically-low levels. Governments engaging in austerity should be held criminally negligent for their actions.

Second, we must put job creation above all other goals. Work offers dignity, which every person deserves. This requires governments to adopt a policy of full employment. This would require as well a prolonged period of low interest rates, with an injection of fiscal cash. I am always in disbelief when I witness the cavalier-indifference policy makers have towards the unemployed. This must end.

Third, we must deal head on with the problem of income inequality, which is at the very core of the crisis in aggregate demand. Interestingly enough, income inequality was as pronounced right before the crash of 1929 as it was right before the crisis began in 2007. This leads me to suggest that income inequality is one of the causes of the financial and economic crisis. If governments do not address this problem, we are doomed to repeat the problems of 2007 before long. For starters, we need to have a higher marginal tax rate on the rich, a high wealth tax, an important increase in the minimum wage; we must also at all cost reign in corporate bonuses and inflated CEO paychecks, eliminate practices such as buy backs, and raise the corporate tax.

Fourth, with respect to Europe, well that’s a mess of a different colour. Yes, austerity has veered its ugly head there as well, but they also have to deal with the shackles of a common currency. They must either adopt the proper federal institutions to deal with the problems facing the Southern countries, or get rid of the Euro all together. This will undoubtedly create some short-term angst, but the consequences of the status quo are a few decades of deflation. The Euro was an ill-planned policy: you cannot have a monetary union without a political union.

So I end here by staying that had we had more Keynesian aggregate demand policies, we would probably not be in this mess today, which is entirely the result of anti-Keynesian, short-sighted policies designed to benefit the very few rather than the masses.

So my dear Steven, we disagree on many issues. I look forward to your reply.

This then was my reply:

Dear Louis-Philippe

Thank you very much for clarifying so much in your letter. But from its very subheading – “The worst infliction we can impose on our economies is to leave them to the tyranny of the markets” – I can see how far apart we are. To think of markets as a “tyranny” when they have been the single most liberating institution in possibly the entire history of the human race puts us very far apart indeed.

And to assume that we might even remotely disagree on the need for market regulation can only mean you have not understood what I wrote. There are an astonishing number of techniques and approaches available to manage an economy, with public spending to get an economy out of recession only one amongst this vast array. If you are going to start with the assumption that not trying to spend our way to recovery is the same as laissez-faire then there is no possibility of ever understanding what critics of Keynesian economics are saying.

Perhaps that is just the title. What more does your letter say? Let me look at a number of your assertions, starting with this.

The driving force behind economic growth both in the short run and the long run is aggregate demand, pure and simple. . . . Yes, that’s right: more government spending leads to more investment. It’s a crowding-in effect!

This is merely a statement without benefit of theory. Raising aggregate demand has a superficial appeal to those who don’t understand how an economy works. But if you said that people who counterfeit money and spend it are also promoting economic growth and employment, everyone would immediately see the flaw in your reasoning. The great error in Keynesian economics is to assume that expenditures without the backing of real value adding production can in any way raise living standards and increase employment.

The fact is there is no substantive theory to back your assertions. There is that piece of arithmetic – Y=C+I+G+(X-M) – and there are a handful of diagrams. But there is no actual way to explain why spending on wasteful projects will cause an economy to expand. There is famously no micro to go with Keynesian macro. There is no theory to explain at the level of human interaction how any of this would work in the real world.

You say instead we have historical experience as evidence. You wrote:

My recollection of Keynesian policies is quite different: they contributed to 3 wonderful decades of growth following WWII – what we fondly call the Golden Years of capitalism. Keynes is quite evidently the greatest economist of the 20th century who saved capitalism from self-destruction.

You may assert all you like that Keynes saved capitalism but what are the facts? First, The General Theory was published in 1936, three years after the Depression had come to an end in virtually every economy, which, moreover, was achieved through the application of classical economic policies which included cuts to public spending. In the United States, however, the Depression dragged on until the coming of the war in 1941, a delay due in large part to Roosevelt’s attempts at a prototype Keynesian stimulus.

But think of this. Those three wonderful post-war decades were preceded by the decision of the United States in 1945 to immediately balance its budget. The massive wartime deficits were brought to an end right then with no delay, and a balanced budget put in its place even with millions returning to the workforce after being mustered out of their wartime military service or from their jobs in wartime industries. The Keynesians of 1945 all wanted a continuing deficit. Truman turned them down flat.

How does a Keynesian explain any of that? Why should demand have been more “pent up” in 1945 than it was in 1935? We are instead reminded by you of the supposedly woeful economic outcomes of the 1980s, which I must confess not to remember in quite the same way as this:

By contrast, starting from the 1980s, with the monetarist debacle and the real business cycle shenanigans, we ended up with less average growth and higher average unemployment rates.

The real contrast, of course, is with the 1970s, the greatest period of Keynesian disaster until the one we are in the midst of now. How could you leave those years out – the catastrophic stagflation of the 1970s? What do you have to say about the 1970s?

Meanwhile, the only reason you can offer for the stimulus not working following the GFC is because it ended too soon.

While governments did put into place Keynesian aggregate demand policies in 2009, they quickly abandoned these policies in 2010 in favour of austerity measures.

One could only wish the stimulus had merely lasted a single year. The US is the paradigm example. Despite Congressional attempts to reduce deficit spending, the attempt to contain public expenditure in the US only seriously began with the “sequester” in 2013!

And indeed, the White House specifically dates the commencement of sequestration from the first of March that year. If ever a stimulus was given time to work itself out, it was then. The disastrous response of the American economy to the stimulus is perfectly in line with my own expectation. Your belief that conditions were improving until the sequestration began can only mean we are living in a parallel universe.

But how much we may differ on the timing when restraint finally began, we can certainly agree on the current disaster. You may think it’s because the stimulus was prematurely brought to an end. I think of it as the inevitable consequence of a Keynesian policy. You think it is deficient aggregate demand, that empty bit of Keynesian rhetoric. I think the problem is structural.

The theory you evade is recognition that our entire economic structures are now so distorted through public spending and “quantitative easing” that our economies are having great difficulty finding a productive base. To think this is deficient demand is to mistake the symptoms for the cause.

So on this much at least we can agree, that the world’s economies are in a mess: consumers deep in debt, savings eaten away by low productivity, government spending, and private investment going nowhere. And I didn’t just say the stimulus would not work; I said the stimulus would make things worse. You describe what I see, but I expected things to end like this from the start.

You only began to recognise a problem more than a year later, and only because by then it was obvious to all and sundry that in every place the stimulus had been introduced economic conditions had continued to deteriorate. You nevertheless still continue to believe, in spite of the evidence, that the problem is not enough government spending.

This secular stagnation is the direct result of a lack of fiscal spending advocated by austerity voodoo doctors and charlatans.

The plain fact is that there has never been a single instance in the entire period since The General Theory was published where a public sector stimulus has been able to bring a recession to an end. There’s not a single example, not one, with the coming of World War II the only supposed example when unemployment ended mostly because half the male population under 30 was put into the military.

It is not aggregate demand that matters, but value adding production. You must do more than build brick walls, you must build where what is built actually contributes to prosperity. To think more holes dug up and then refilled can generate recovery because it constitutes “fiscal spending” is the essence of economic illiteracy. And if we were looking to make matters worse, it’s hard to go past items 1-3 of your program for recovery:

First, we must replace private debt with public debt.

Second, we must put job creation above all other goals.

Third, we must deal head on with the problem of income inequality.

That is to say: we must socialise our economies.

Private debt is incurred by private sector firms. To replace this debt with public debt would so obviously drive us into deep recession that it is almost impossible to understand why this is not perfectly clear to you. And as for creating jobs – which everyone seeks to do, not just Keynesians – the fantastic proposition that governments will be able to choose productive value-adding forms of expenditure is an illusion. Your plan is to redirect the source of expenditure to the people least capable to choosing where the most productive investments would be found.

I’m afraid your program would be part of the problem and in no way part of any solution. I fear that three quarters of a century after the publication of The General Theory, economics is now at such a low ebb that what you have written will look like perfect sense to all too many, even as every attempt in the past to do what you have suggested has made things worse than they already were.

In times gone by, before Keynes, economists talked about “effective demand”, that is, what was required to turn the desire for products into an ability to buy those products. Now it is aggregate demand – the total level of demand – which has leached the original concept of any appreciation that for everyone to buy from each other – to raise aggregate demand as you might put it – they must first produce what others wish to buy. A freshly dug hole that is immediately refilled will not do even if money is paid for the work. If that is not obvious, then common sense has gone from the world.

But I say again. A short post cannot state everything that needs to be said. For a more complete explanation of these issues and what needs to be done, you must turn to the second edition of my Free Market Economics. It’s still not too late, but it is getting later all the time.

Kind regards

Steve Kates

And now Louis-Philippe’s reply to my second letter.

My dear Steven,

I read with much interest your most recent letter and I will confess I agree with you … we are indeed far apart! But surely this is not surprising as we both defend not only a very different vision of economic theory, but also a different vision of markets and society. At the core of our disagreement lies an understanding of markets, which you see as self-regulating, whereas I claim they are not. I view markets as chaotic and prone to instability and, quite honesty, capable of exploding (or rather deteriorating) into crises, with unimaginable consequences. Perhaps you are OK with that, but I am not. So when I said that the ‘worst infliction’ is to leave us exposed to the ‘tyranny of markets’, I meant precisely that: because of periodic crises, but also because of oft-occurring recessions, we cannot place our complete faith in free-markets. I see unregulated markets and unfettered capitalism as a scourge that must be tamed. To deny or ignore this would be a grave mistake, which would condemn us all to misery, and worse. How else would you characterize the massive inequality of income and wealth around the world and in particular in the United States, which is one of the most unequal developed economies? Is the fact that 40% of the wealth in the US rests within 1% of the population not a tyranny? Does this not shock you? It shocks me, and I will say it again: unless we address this calamity, we are bound to relive a crisis – and soon. Mark my words: another crisis is coming.

You seem to view markets as “the single most liberating institution in possibly the entire history of the human race.” Well, I can see where we disagree indeed. Markets are where goods are produced and sold, where incomes are determined. But they are not efficient, in the way that they do not always produce an optimum result; that is why we need some regulator and some other institution to intervene when markets fail. I would go further, I would argue that markets never allocate efficiently, and never perform optimally, so that there is a permanent and on-going need for the State to precisely regulate the cycles and minimize the pains that recessions and crises can inflict upon us, and to reduce the injustice of inequality. You say this is socialising our economies. I assume you say this in a derogatory way. I am by no means a socialist; like Keynes, I want to save capitalism from itself. But I will wear that label proudly if you meant it as somehow to denigrate. Rather, I see it as the only way of making capitalism work for mankind. In that sense, I stand proudly on the shoulders of Keynes and others who have defended that very notion. I will proudly stand and argue, supported by a vast literature of empirical research that the State is in a unique position, given its power to spend, to create wealth and prosperity for all.

You then suggest that my claim that economies grow from demand, both in the short and long term, is a mere statement devoid of a theory. Of course, you will pardon me if I did not, in less than 1,500 words, write a complete theoretical treatise on the economics of aggregate demand. But there is a vast literature on this topic, with which you are familiar I am sure, and well-developed theories, with considerable empirical support to buttress the argument.

But why are you so dismissive of Keynesian policies? The problem here, I believe, is your interpretation of what consists of Keynesian aggregate demand policies. Twice now you mention Keynes’s assertion that we should bury bottles full of banknotes as representative of Keynesian policy. My dear Steven, Keynesian economics is much more than that, and to isolate that sentence as representative of Keynes is both misleading and, well, dishonest. Keynes of course said much, much more, and Keynes was being more sarcastic than anything.

In fact, Keynes was clear, a bit later in the same often-quoted passage, that “It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing” (GT, p. 129). Did you not read that part of the General Theory?

Keynes’s message was that ideally, it would be better to build houses, or roads and bridges than to do nothing, the latter condemning us to misery and, yes, the tyranny of the markets. Keynes’s point about the bottles is that even something as silly as that would be better than doing nothing.

I suspect your insistence of that quote as an example of Keynesian economics is perhaps more sinister, knowing full well of course that the population would instantly be opposed to the silliness of that policy. So you must admit, there is some treachery afoot in your argument. If we are to have a dialogue, you cannot reduce the Keynesian edifice to ‘wasteful projects’. I know that you know that Keynesian economics is more than digging holes: there are large infrastructure projects and public investment. I suspect if we explained to the masses that Keynesian policy is about infrastructure, investing in the future, social justice and building civilizations, then I am convinced that they would see the wisdom residing within it.

Now regarding that ‘piece of arithmetic’, which you call the Y = C + I + G + (X – M), I am afraid that is simple national accounting, no more no less. But more than that, for me it is a point of pure logic: when consumers, private firms or governments spend, that increases the demand for goods, which firms must produce. Please, tell me where the flaw in that logic is? And when the private sector is incapable or unwilling to spend, governments must above all step in to sustain that level of demand, which will be hopefully met by the private sector producing.

I was struck at how different we interpret history, and recent history at that. I must admit I am at a loss for words. Keynes once famously said, “When the facts change, I change my mind. What do you do, sir?”, but I fear that no matter what I say, or in fact anything you read anywhere by anyone won’t change your mind. I think perhaps if you got away from digging holes as representative Keynesian policies would be a good start.

In closing, let me address what I consider the biggest lie in economics at the moment: the idea that reductions in government spending will lead to higher economics growth. This is pure theoretical poppycock. For instance, in Europe, it has proven to be disastrous. Austerity never works. After a few years of austerity, Europe is no closer to sustained economic growth as before. For instance, in France, after imposing several fiscal cutbacks, the government expected deficits of 2.2%. Austerity now translated into deficits running at double that, at 4.4%. This is because of that piece of arithmetic: austerity leads to depressed demand and economic activity that then deflates the entire system, more proof that demand is what matters. Policies based on supply do not work, never work, and never shall work. It is pure fantasy to believe that anything but demand is the driving force of economic activity. So we may not all be Keynesians now, but the real world is, and it operates along lines described by Keynes and Keynesians. And the General Theory, while written over 75 years ago, like you point out, remains to this day the best guide to successful macroeconomic policy we have. Granted, it needs updating, but the basic logic of the book is as relevant and as important today as it was back when it was published.

You say that what we need is value-adding production, and not just building brick walls as you put it. I completely agree. But, my dear Steven, that is what Keynesian spending does: by contributing to infrastructure building, by contributing to crowding-in, it value-adds to society.

In conclusion, the empirical evidence is squarely on the side of Keynesian economics and the importance and vital role of aggregate demand and the State. To advocate for free markets under the illusion of the efficiency dogma is pure nonsense and self-delusional. As Keynes said, that would be disastrous if we tried to apply it to the facts of experience. The real world is government by Keynesian laws, and any attempt to deny and interfere with those laws can only result in more hardship.

Finally, let me leave you with this wonderful quote by Keynes: “the man who regards all this [public expenditures] as a senseless extravagance which will impoverish the nation, as compared with doing nothing and leaving millions unemployed, should be recognized for a lunatic.” (Collected Writing, Volume XXI, p. 338).

Best wishes,



Krugman’s intro to The General Theory

This is Brad De Long’s edited version of Paul Krugman’s 2006 introduction to The General Theory:

In the spring of 2005 a panel of “conservative scholars and policy leaders” was asked to identify the most dangerous books of the 19th and 20th centuries…. Charles Darwin and Betty Friedan ranked high on the list. But The General Theory of Employment, Interest, and Money did very well, too. In fact, John Maynard Keynes beat out V.I. Lenin and Frantz Fanon. Keynes, who declared in the book’s oft-quoted conclusion that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil,” [384] would probably have been pleased.

Over the past 70 years The General Theory has shaped the views even of those who haven’t heard of it, or who believe they disagree with it. A businessman who warns that falling confidence poses risks for the economy is a Keynesian, whether he knows it or not. A politician who promises that his tax cuts will create jobs by putting spending money in peoples’ pockets is a Keynesian, even if he claims to abhor the doctrine. Even self-proclaimed supply-side economists, who claim to have refuted Keynes, fall back on unmistakably Keynesian stories to explain why the economy turned down in a given year….

It’s probably safe to assume that the “conservative scholars and policy leaders” who pronounced The General Theory one of the most dangerous books of the past two centuries haven’t read it. But they’re sure it’s a leftist tract, a call for big government and high taxes…. [T]he arrival of Keynesian economics in American classrooms was delayed by a nasty case of academic McCarthyism. The first introductory textbook to present Keynesian thinking, written by the Canadian economist Lorie Tarshis, was targeted by a right-wing pressure campaign aimed at university trustees. As a result of this campaign, many universities that had planned to adopt the book for their courses cancelled their orders, and sales of the book, which was initially very successful, collapsed. Professors at Yale University, to their credit, continued to assign the book; their reward was to be attacked by the young William F. Buckley for propounding “evil ideas.”

But Keynes was no socialist – he came to save capitalism, not to bury it. And there’s a sense in which The General Theory was… a conservative book…. Keynes wrote during a time of mass unemployment, of waste and suffering on an incredible scale. A reasonable man might well have concluded that capitalism had failed, and that only… the nationalization of the means of production – could restore economic sanity…. Keynes argued that these failures had surprisingly narrow, technical causes… because Keynes saw the causes of mass unemployment as narrow and technical, he argued that the problem’s solution could also be narrow and technical: the system needed a new alternator, but there was no need to replace the whole car. In particular, “no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.”… Keynes argued that much less intrusive government policies could ensure adequate effective demand, allowing the market economy to go on as before.

Still, there is a sense in which free-market fundamentalists are right to hate Keynes. If your doctrine says that free markets, left to their own devices, produce the best of all possible worlds, and that government intervention in the economy always makes things worse, Keynes is your enemy. And he is an especially dangerous enemy because his ideas have been vindicated so thoroughly by experience.

Stripped down, the conclusions of The General Theory might be expressed as four bullet points:

1. Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment

2. The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully

3. Government policies to increase demand, by contrast, can reduce unemployment quickly

4. Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach

To a modern practitioner of economic policy, none of this – except, possibly, the last point – sounds startling or even especially controversial. But these ideas weren’t just radical when Keynes proposed them; they were very nearly unthinkable. And the great achievement of The General Theory was precisely to make them thinkable….

So now let’s talk about the core of the book, and what it took for Keynes to write it…. In Book I, as Keynes gives us a first taste of what he’s going to do, he writes of Malthus, whose intuition told him that general failures of demand were possible, but had no model to back that intuition: “[S]ince Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to provide an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain.”… That need to “provide an alternative construction” explains many of the passages in The General Theory that, 70 years later, can seem plodding or even turgid…. When you’re challenging a long-established orthodoxy, the vision thing doesn’t work unless you’re very precise about the details….

Keynes’s struggle with classical economics was much more difficult than we can easily imagine today. Modern introductory economics textbooks – the new book by Krugman and Wells included – usually contain a discussion of something we call the “classical model” of the price level. But that model offers far too flattering a picture of the classical economics Keynes had to escape from. What we call the classical model today is really a post-Keynesian attempt to rationalize pre-Keynesian views…. The real classical model… was, essentially, a model of a barter economy, in which money and nominal prices don’t matter, with a monetary theory of the price level appended in a non-essential way, like a veneer on a tabletop. It was a model in which Say’s Law applied…. One measure of how hard it was for Keynes to divest himself of Say’s Law is that to this day some people deny what Keynes realized – that the “law” is, at best, a useless tautology when individuals have the option of accumulating money rather than purchasing real goods and services….

There’s a widespread impression among modern macroeconomists that we’ve left Keynes behind, for better or for worse. But that impression, I’d argue, is based either on a misreading or a nonreading…. If you don’t read Keynes himself, but only read his work as refracted through various interpreters, it’s easy to imagine that The General Theory is much cruder than it is…. Let me address one issue in particular: did Paul Samuelson, whose 1948 textbook introduced the famous 45-degree diagram to explain the multiplier, misrepresent what Keynes was all about? There are commentators who insist passionately that Samuelson defiled the master’s thought. Yet I can’t see any significant difference between Samuelson’s formulation and Keynes’s own equation for equilibrium employment, right there in Chapter 3: [29]. Represented graphically, Keynes’s version looks a lot like Samuelson’s diagram; quantities are measured in wage units rather than constant dollars, and the nifty 45-degree feature is absent, but the logic is exactly the same.

The bottom line, then, is that we really are all Keynesians now. A very large part of what modern macroeconomists do derives directly from The General Theory; the framework Keynes introduced holds up very well to this day.

Yet there were, of course, important things that Keynes missed or failed to anticipate. The strongest criticism one can make of The General Theory is that Keynes mistook an episode for a trend. He wrote in a decade when even a near-zero interest rate wasn’t low enough to restore full employment, and brilliantly explained the implications of that fact – in particular, the trap in which the Bank of England and the Federal Reserve found themselves, unable to create employment no matter how much they tried to increase the money supply. He knew that matters had not always been thus. But he believed, wrongly, that the monetary environment of the 1930s would be the norm from then on…. In the United States the era of ultra-low interest rates ended in the 1950s… Yet the United States has, in general, succeeded in achieving adequate levels of effective demand. The British experience has been similar. And although there is large-scale unemployment in continental Europe, that unemployment seems to have more to do with supply-side issues than with sheer lack of demand…. [Keynes] underestimated the ability of mature economies to stave off diminishing returns. Keynes’s “euthanasia of the rentier” was predicated on the presumption that as capital accumulates, profitable private investment projects become harder to find…. [T]he euthanasia of the rentier does not seem imminent. But there’s an even more important factor that has kept interest rates relatively high, and monetary policy effective: persistent inflation, which has become embedded in expectations…. [E]ven now, when inflation is considered low, most of the 20-year rate reflects expected inflation rather than expected real returns.

The irony is that persistent inflation, which makes The General Theory seem on the surface somewhat less directly relevant… can be attributed in part to Keynes’s influence, for better or worse. For worse: the inflationary takeoff of the 1970s was partly caused by expansionary monetary and fiscal policy, adopted by Keynes-influenced governments with unrealistic employment goals…. For better: both the Bank of England, explicitly, and the Federal Reserve, implicitly, have a deliberate strategy of encouraging persistent low but positive inflation, precisely to avoid finding themselves in the trap Keynes diagnosed….

What makes The General Theory truly unique… is that it combined towering intellectual achievement with immediate practical relevance to a global economic crisis…. There has been nothing like Keynes’s achievement in the annals of social science. Perhaps there can’t be. Keynes was right about the problem of his day: the world economy had magneto trouble, and all it took to get the economy going again was a surprisingly narrow, technical fix. But most economic problems probably do have complex causes and don’t have easy solutions….

A farrago of vacuous ideas and empty nonsense

I came across a book in one of the still remaining second hand book shops I frequent by two Nobel Prize winners, George Akerlof and Robert Shiller. It’s title was Animal Spirits with the basic premise stated on the cover, that “human psychology drives the economy and why it matters for global capitalism”. So far, so ordinary but since this is all part of the new direction in economics, I thought I would give it a go.

Well, what a farrago of vacuous ideas and empty nonsense. I had always thought it was ridiculous that Keynes had made such a fetish about “animal spirits” himself, seeing as how every classical economist was perfectly aware of how crucial business confidence is to economic outcomes. If nothing else, Frank Knight had published his Risk, Uncertainty and Profit in 1921, a book I am pretty certain Keynes raided in writing the General Theory published in 1936. That Akerlof and Shiller write as if they have introduced some new conceptions into economics was astonishing, but given the low level of historical knowledge within the profession, you can just about get away with anything.

But what really did get to me was this book, published in 2009 at the height of the GFC and as the stimulus programs were getting into full swing, were not just advocating such public spending but made it clear how much economists had learned from Keynes and how fortunate we lot were that economists such as themselves were now on the watch and in control of policy.

A repeat of the Great Depression is now a possibility because economists, the government and the general public have in recent years grown complacent. They have forgotten the lessons of the 1930s. In those hard times we learned how the economy really works. . . .

In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work. [My bolding]

I have an article on this book at Quadrant Online, Phlogiston with a Keynsian Twist. I think of it as a contender for the worst book on economics ever written. Lots of bad books on the subject, of course, but you don’t normally find two people at the highest level of the profession conspiring to write such stuff. Read the review, but spare yourself the trouble of reading the book, unless you would like to see just how empty economics can be in this day and age.

Is this the dumbest book on economics ever written?

There will have to be a wall of shame for economists who endorsed Keynesian solutions back in 2009 who will need to have their beliefs brought back to haunt them. Picked up in a secondhand bookshop a particularly pathetic version of what had been quite common back in those heady days of the stimulus, this being a book titled, Animal Spirits, written by two Nobel Prize winners, George Akerlof and Robert Shiller. If these types were ever capable of shame they would be buying up every copy in print and have them consigned to the flames. Instead and no doubt, they continue in the delusion that we have been saved from far worse by the timely actions taken to stimulate demand.

Mind you, I had been just as certain that the entire attempt to diminish the impact of the recession and return us to reasonable rates of growth would turn out the disaster it has been. But for myself, I can now run the told-you-so as much and as far as I like. There is not a shred of evidence, outside their own nonsense-Keynesian models, that the stimulus did anything but harm. But since they are incapable of even having a glimmer of a notion that the economic models they have devoted their lives to understanding are about as useful as the theory of phlogiston was in physics, they just carry on. It is only we critics who go back to those books and try to remind others that Keynesian economic policy has been an unmitigated disaster. So far are we now from a robust recovery, a ten year pause will turn out to be the best we can hope for. This is from the Preface, and recall that this is from 2009 just as the stimulus programs were getting under way:

“A repeat of the Great Depression is now a possibility because economists, the government and the general public have in recent years grown complacent. They have forgotten the lessons of the 1930s. In those hard times we learned how the economy really works. . . .

“In the middle of the Great Depression John Maynard Keynes published The General Theory of Employment, Interest and Money. In this 1936 masterwork, Keynes described how creditworthy governments like those of the United States and Great Britain could borrow and spend, and thus put the unemployed back to work.”

That was 2009. Is the world in 2014 the one they expected, the outcome they foresaw? I suspect not. Yet there is hardly another ripple of any other kind they could blame the deeply depressed nature of the American economy on other than the policies of the past five years. The one certainty is that no one is any longer telling us now about the great “masterwork” written by Keynes.

Almost as nonsensical is the potted history of economic thought they provide. Can they actually be as ignorant of pre-Keynesian economic thought as they suggest by these words:

“According to traditional economics, free market capitalism will be essentially perfect and stable. There is little, if any, need for government interference. On the contrary, the only risk of major depression today, or in the future, comes from government intervention.

“This line of reasoning goes back to Adam Smith.” (p. 2)

The notion that Adam Smith, or any other economist of the classical tradition, expected a ripple-free economy with no depressions and that no government interference was ever necessary is so lacking in historical accuracy that I would barely accept such ignorance from a first year student. That they could believe and commit to print such obviously untrue statements – obvious, that is, to anyone who has taken the trouble to learn even the rudiments of the classical theory of the cycle or what Adam Smith had actually written – is a disgrace.

But if I have to choose the least sensible statement they made in this startling superficial and inane book, it is their attribution of the cause of the Global Financial Crisis to an excess of saving, the precise issue raised by Keynes:

“In the short run, an exogenous increase in the demand for desired saving rate of just a couple of percentage points may be enough to tip the economy into recession, as indeed seems to be happening in the current financial crisis.” (p. 116)

The entire financial world held its breath as the banking system teetered on the edge of collapse, with every lender profoundly unsure of the safety of lending to others, and this is reduced to decisions to save. It is embarrassing to have to read such thoughts from two of the most respected economists in the world. This is more of the Keynes the master, but though no one any longer would write any such thing given how events have turned out, it makes one despair whether economic theory can ever again provide serious guidance to those who make economic policy. It is a frightening book lacking even the rudiments of depth or common sense.

Say’s Law goes to the movies

A while back I posted Say’s Law as Literature about a book of the name Waffle Street written by James Adams. The book is now being turned into a movie, and the story is now out in the open as they have now signed Danny Glover to play the lead role of Edward Collins. This is from the press release:

Legendary actor Danny Glover (Lethal Weapon 1-4, The Color Purple, Dreamgirls) has signed on to star in the upcoming feature film, Waffle Street. The drama-comedy tells the story of James Adams, a VP of a $30 billion hedge fund who lost his job in the recent market crash and wound up working as a waiter in a waffle shop. Amid the greasy madness of the 24-hour diner, Adams befriends ex-con grill master Edward Collins (played by Glover), who serves up hard lessons about finance, life, and grits.

Waffle Streets riches-to-rags tale is an adaptation of James Adams 2010 memoir of the same name (published by Sourced Media Books), which chronicles the financiers foray into the food industry. After being laid off at the hedge fund where he worked, and further jaded by his culpability in the crisis, Adams chose to work at a popular 24-hour diner where he claims most of his financial knowledge has been gleaned. Offering a fresh take on the fallout of corporate greed, Adams is a tale of the redemption and unlikely friendship found under the tutelage of Glover’s character Edward, the best short-order cook in town.

The story is a story of redemption for both the author, James Adams and for Edward Collins, who has found himself in productive work. How this relates to Say’s Law is through the “lessons about finance, life and grits” which includes experiencing the core understanding of economic life that the law of markets provides. This is from the review of the book by the President of the Mises Institute, Doug French:

But Adams does scrap with John Maynard Keynes in the pages of Waffle Street, lamenting, “How far we’ve fallen” in the area of economics education. Pointing out that Say’s Treatise was once the top economics textbook in America, he explains that now, “Instead of learning sound doctrine, today’s undergraduates are inundated with principles that will not bear the scrutiny of common sense and experience.”

I am still waiting to hear who will play Jimmy and then his wife. An amazing story. I’ve never been to a Hollywood premier before, but this is one I do not intend to miss. Meanwhile, you should read the book.

Getting Say’s Law exactly right

It is so rare for anyone to get Say’s Law exactly right that you must forgive me if I quote at length, specially since he quotes me. This is from an article by Steve H. Hanke, Professor of Applied Economics at the Johns Hopkins University in Baltimore, and titled, “GO: J.M. Keynes versus J.-B. Say”. It is found in the publication, Global Asia:

The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon – courtesy of John Maynard Keynes – this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.

Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.

All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand – namely, a fiscal stimulus (read: lower taxes and/or higher government spending).

The rest of the article deals with the new statistic that has just been released by the Bureau of Economic Analysis in the United States which has largely been undertaken because at the instigation of the great Austrian economist, Mark Skousen. The notion that consumption drives an economy is so nonsensical since consumer demand is the end of all forms of production, from mining coal to generating electricity and so to focus on consumer demand is focusing on nothing at all other than the end of the production process. But if we are looking at value added, as we ought to be, only about 5% of economic activity is directed at selling directly to consumers. The new supply side statistic that has been developed, which at long last gets this balance right, will make a great difference in how the economy is perceived, which should also make a difference in how it is managed, or at least it is to be hoped. Let me finish with one further quote from Professor Hanke:

Even though the always clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away. And, yes, the alleged importance of fiscal policy withers away, too.

Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.

If you really want to stimulate the economy, it is business at every stage of production you have to go through and not the consumer. How different that kind of economic policy would need to be, but at least it will have the merit of actually producing positive results.