It has been more than 80 years since the beginning of the Keynesian revolution in economics with the publication of John Maynard Keynes’ The General Theory of Employment, Interest, and Money in 1936. During those eight decades many defenses and criticisms, restatements and refutations have appeared, some by many of the most prominent economists of the last century. Yet, untouched, it seems, is the continuing presumption that there is a macro-economy that can be easily inflated or deflated like a balloon through government monetary and fiscal policy.
J. Bradford DeLong, a professor of economics at the University of California, Berkeley, once more expressed this Keynesian view of the economy in a recent article titled “Debt Derangement Syndrome.” He argues that all the hue and cry over the growing U.S. national debt is misplaced. As long as interest rates are low so the cost of government borrowing is relatively cheap and as long as there are willing buyers of government bonds so debt is easily floated, there is really no need for policy makers, economists, or voters to be concerned with the national debt now going above $22 trillion.
Having low interest rates in the present means that interest payments on the debt in the future will not seriously absorb a large amount of tax revenues collected at that time. Having willing borrowers means that lending to the government seems more profitable and secure than loans to borrowers in the private sector, so it must represent worthwhile uses of loanable funds in no way harmful to the economic health of the economy. (See my articles “Why Government Deficits and Debt Do Matter” and “Debts and Deficits Are Out of Control.”)
But why would the government want to float that debt in the first place? Here we go back to the Keynesian “old-time religion.” The economy goes through periods of growth and periods of recession, and the recessions mean economic waste in the form of idle production capacity and unemployed workers. Plus, the market economy, the Keynesian refrain insists, is not always easily self-correcting, leaving the economy with levels of output below full-employment capacity, which could only be reached through government stimulating private sector spending or through money creation.
Professor DeLong finds it very hard to believe that anyone would take exception to government doing its job of keeping the economy on a full-employment even keel:
Whenever the private sector stops spending enough to keep unemployment low and jobs easy to find, the public sector needs to fill the gap in aggregate demand. The normal way to do this is for the central bank to buy bonds for cash, inducing those who then have the extra cash to boost their spending. But if and when interest rates approach rock bottom, the private sector’s desire to spend extra cash rather than hold it ebbs. In that situation, monetary stimulus should be aided by fiscal stimulus: in other words, the government directly buys stuff.
The Superficiality of Aggregate Demand and Supply
The fundamental flaw in Professor DeLong’s view, as in John Maynard Keynes’ 1936 book is the idea that there exists a macro-economy the two sides of which are composed of aggregate demand and aggregate supply. If employment is less than full and output less than its maximum potential, then people, in the aggregate, are spending too little on goods and services in the aggregate. Increase aggregate demand and you can bring about the desired increase in aggregate supply until full employment is restored.
Even at the time that Keynes’ book first appeared, there were critics who challenged the very premises of Keynes’ framework of aggregate demand and aggregate supply. For instance, in his review of The General Theory in late 1936, the Austrian-born economist Joseph A. Schumpeter said: “Mr. Keynes speaks of Aggregate Demand in the one case and Aggregate Supply in the other and makes them yield a unique ‘point of intersection,’” but there is “little justification for this extension of the ‘Marshallian cross’” to an analytical dimension to which it does not apply.
The University of Minnesota economist Arthur W. Marget who in the period between the two world wars was considered the most knowledgeable scholar on the history of monetary theories and policies over the centuries and in all the leading Western languages, insisted in his detailed book The Theory of Prices, vol. 2 (1942):
It is a fundamental methodological proposition of “modern” versions of the “general” Theory of Value that all categories with respect to “supply” and “demand” must be unequivocally related to categories which present themselves to the minds of those “economizing” individuals (or individual business firms) whose calculations make the “supplies” and “demands” realized in the market what they are.…
The type of problem raised by the necessity for establishing a relation between these “microeconomic” decisions and these “macroeconomic” processes is not solved by the arbitrary introduction of an “aggregate supply function” and an “aggregate demand function” for industry as a whole, in defiance of the fact that neither of these “functions” deals with elements which enter directly into the calculations of the individual entrepreneurs whose “microeconomic” decisions and actions make “macroeconomic” processes what they are. On the contrary, it must be said, of such an attempt at “solution,” that it misconceives entirely the true nature of the relation between microeconomic analysis and macroeconomic analysis.
The Misplaced Construction of Aggregate Demand and Supply
Indeed, it can be argued that the very notion of an aggregate demand or an aggregate supply is inconsistent with the very definitions of demand for and supply of a good.
“Supply” is usually understood to mean units of a good that are viewed as perfectly interchangeable for desired purposes by a decision-maker. It is this perfect interchangeability from the market actor’s point of view that distinguishes one good from another and on the basis of which the economic analyst then distinguishes between and elaborates on the relationships connecting complement and substitute goods, through which the various direct and indirect ramifications of changes in market conditions and prices may be theoretically analyzed and understood.
Now, for analytical purposes, of course, it seems equally relevant and conceptually legitimate to distinguish between categories of goods between which market actors may and must choose because of the inescapable scarcity of these goods or the factors of production with which these competing goods may be produced at the (marginal) cost of forgoing some quantity or use of the other.
Thus, it seems reasonable for various theoretical purposes to refer to the relative demands for and supplies of “consumer goods” versus “producer goods” (capital), or between the competing uses, applications, and trade-offs in production between “capital” and “labor.”
But it is also the case that there are many instances in which even these more generalized categorizations of goods are too aggregated, such as when it becomes useful or essential to distinguish between “skilled” and “unskilled” labor, or various different types of “skilled” labor among which market participants make distinctions for purposes of their production and employment decisions.
The same applies to different types of, qualities of, or uses for land or different types of and uses for more narrowly defined forms of capital, since in all these instances there may exist choice-relevant relationships of complementarity and substitutability between the uses of various capital goods that both market actors and economic analysts should recognize for greater logical and factual completeness.
At the microeconomic level, therefore, it is possible to distinguish between the demands for and supplies of, say, hats and shoes, horses and cows, bottling machines and cookie-making equipment. These demands and supplies appear to be and for choice purposes are independent from each other precisely because the chooser considers them different from each other for alternative goals or ends in mind; and the supplies appear to be and for choice purposes are independent from each other since they compete for some of the same scarce means through which one supply is increased or decreased relative to another.
But when the level of aggregation is taken to the demand for all goods as a whole in relation to the supply of all goods as a whole, one has aggregated away most if not virtually all of the choice-theoretic relationships in the context of which real decisions and actions are made in the market. In fact, aggregate demand and aggregate supply become conceptually meaningless and factually nonexistent.
The Statistical Illusion of an Objective Price Level
The same applies to the undue attention to the aggregate approach to the general “price level.” Here, too, there is a conceptual misdirection, an instance of what is sometimes called the fallacy of misplaced concreteness — the fallacy of treating a concept as if it represented something real or objective in the social or economic world.
The “price level” is merely a statistical creation resulting from a selection, summing, and averaging of a series of actual prices of specific goods in particular markets at a moment in time. The “price level” does not really exist; the structure of relative prices that has emerged from the interactions of individual demanders for and suppliers of specific goods bought and sold do exist. They are the basis upon and the context in which individuals in the marketplace make their consumption and production decisions.
As American economist Benjamin Anderson noted already back in the 1920s:
The general price level is, after all, merely a statistician’s tool of thought. Businessmen and bankers often look at index’s as indicating price trends, but no businessman makes use of index numbers in his bookkeeping. His bookkeeping runs in terms of the particular prices and cost that his business is concerned with.… Satisfactory business conditions are dependent upon proper relations among groups of prices, not upon an average of prices.
It should be fairly clear that all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macroeconomic aggregates. (See my article “Benjamin Anderson and the False Goal of Price Level Stabilization.”)
Balanced Markets Ensure Full Employment
Balanced production and sustainable employments in the economy, as a whole, require coordination and balance between the demands for and supplies of all the particular goods and services in each of the specific markets in which they are bought and sold. And parallel to this there must be comparable coordination and balance between the business demands for resources, capital equipment, and different types of labor in each production sector of the market and those supplying them.
Such coordination, balance, and sustainable employment require adaptation to the ever-changing circumstances of market conditions through adjustment of prices and wages, and to shifts in supplies and demands in and between the various parts of the economy.
In other words, it is these rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that ensure full employment and efficient and effective use of available resources and capital, meaning entrepreneurs and businesspersons are constantly tending to produce the goods we, the consumers, want and desire, and at prices that cover competitive costs of production.
All this is lost from view when reduced to that handful of macro aggregates of “total demand” and “total supply” and a statistical-average price level for all goods relative to a statistical-average wage level for all workers in the economy. (See my article “Macro Aggregates Hide the Real Market Processes at Work.”)
The Keynesian Aggregate Big Spender Unbalances Markets
In this simplified and, indeed, simplistic Keynesian-type view of things, all that needs to be done from the government’s policy perspective is to run budget deficits or create money through the banking system to push up aggregate demand to ensure a targeted rise in the general price level so profit margins in general are widened relative to the general wage level so employment in general will be expanded.
We can think of a Keynesian-inspired government as a big spender who comes into a town and proceeds to increase aggregate demand in this community by buying goods. Prices of final outputs rise; profit margins widen relative to the general wage level and the prices of other general costs. Private businesses, in general, employ more workers and purchase or hire other inputs, and aggregate supply expands to a point of desired full employment.
An additional core error and misconception in the macro-aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply and government spending that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary and spending “stimulus” was meant to cure.
Let’s return to our example of the big spender who comes into a town. The townspeople discover that our big spender introduces a greater demand into the community, but not for goods in general. Instead, he announces his intention of building a new factory on the outskirts of the town.
He leases a particular piece of land and pays for the first few months’ rent. He hires a particular construction company to build the factory, and the construction company in turn not only increases its demand for workers, but orders new equipment, which, in turn, results in the equipment manufacturers adding to their workforce to fulfill the new demand for construction machinery.
Our big spender, trumpeting the wonders for the community resulting from his new spending, starts hiring clerical staff and sales personnel in anticipation of fulfilling orders once the factory is completed and producing its new output.
The new and higher incomes earned by the construction and machinery workers, as well as the newly employed clerical and sales workers, raise the demand for various and specific consumer and other goods upon which these people want to spend their new and increased wages.
The businesses in the town catering to these particular increased consumer demands now attempt to expand their supplies and perhaps hire more retail-store employees. Over time, the prices of all of these goods and services will start to rise, but not at the same time or to the same degree. They will go up in a temporal sequence that more or less tends to match the sequence of the changed demands for those goods and services resulting from the new money injected by the big spender into this community.
Aggregate Spending Needs to Continue and Increase
Now, whether some of the individual workers drawn into this specific pattern of new employments were previously unemployed or whether they had to be attracted away from existing jobs they already held in other parts of the market, their continued employments in these particular jobs depend on the big spender continuing to spend his new money, time period after time period, in the same way and in sufficient amounts to ensure that the workers he has drawn into his factory project are not attracted to other employments because of the rise in all of these alternative demands.
If the interdependent patterns of demands and supplies and the structure of interconnected relative prices and wages generated by the big spender’s spending are to be maintained, his injection of new money into the community must continue, and at an increasing rate.
An alternative imagery might be the dropping of a pebble into a pond. From the epicenter where the stone has hit the surface a sequence of ripples will be sent out that will be reversed when the ripples finally hit the surrounding shore and will then finally cease when there are no longer any new disturbances affecting the surface.
But new pebbles must be continuously dropped into the pond and with increasing force if the resulting waves coming back from the shore are not to disrupt the ripple pattern.
The Austrian Analysis of Inflationary Processes
There is no doubt that this way of analyzing the dynamics of how monetary expansion affects market activities is more complex than the simplistic Keynesian-style of macro-aggregate analysis. But as Joseph A. Schumpeter highlighted in his posthumous History of Economic Analysis (1954):
The Austrian way of emphasizing the behavior or decisions of individuals and of defining the exchange value of money with respect to individual commodities rather than with respect to a price level of one kind or another has its merits, particularly in the analysis of an inflationary process; it tends to replace a simple but inadequate picture by one which is less clear-cut but more realistic and richer in results.
And, indeed, it is this Austrian analysis of monetary expansion with its resulting impact on prices, employment, and production, especially as developed in the 20th century by Ludwig von Mises and Friedrich A. Hayek, that explains why the Keynesian-originated macro-aggregate approach is fundamentally flawed.
Hayek once explained the logic of the process of monetary inflation:
The influx of the additional money into the [economic] system always takes place at some particular points. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about.…
It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances for borrowing for that purpose; it may be spent in the first instance on securities, or investment goods, on wages or on consumers’ goods.…
The process will take very different forms according to the initial source or sources of the additional money stream.… But one thing all these different forms of the process will have in common: that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of others and the whole structure of relative prices therefore will be very different from what the pure theorist describes as an equilibrium position.
An inflationary process, in other words, brings about distortions, mismatches, and imbalanced relationships between different supplies and demands, and the accompanying artificial relationships between the structure of relative prices and wages only last for as long as the inflationary process continues, and often only at an accelerating rate.
Or as Hayek expressed it:
Any attempt to create full employment by drawing labor into occupations where they will remain employed only so long as the [monetary and] credit expansion continues creates the dilemma that either credit expansion must continue indefinitely (which means inflation), or that, when it stops unemployment will be greater than it would be if the temporary increase in employment had never taken place.
The Stimulus “Cure” Creates More Market Problems
Once the inflationary monetary expansion ends or slows down, market participants discover that the artificially created supply and demand patterns and relative price-and-wage structure are inconsistent with noninflationary market conditions.
In our example of the big spender, one day the townsfolk discover that he was really a con artist who had only phony counterfeit money to spend and whose deceptive promises and temporary spending drew them into all of those particular activities and employments. They now find out that the construction projects begun cannot be completed, the employments created cannot be maintained, and the investments started in response to the phony money the big spender injected cannot be completed.
Many of the townspeople now have to stop what they had been doing and try to discover other demanders, other employers, and other possible investment opportunities in the face of the truth of the big spender’s false incentives for them to do things they should not have been doing from the start.
The unemployment and underutilization of resources that activist monetary policy by governments are supposed to reduce in fact set the stage for an inescapable readjustment period of more unemployment and temporary idle resources when many of the affected supplies and demands have to be rebalanced at newly established market-based prices if employments and productions are to be sustainable and consistent with actual consumer demands and the availability of scarce resources in the post-inflationary environment.
Thus, recessions are the inevitable result of prior and unsustainable inflationary booms. And even the claimed modest and controlled rate of 2 percent annual price inflation that has become the new panacea for economic stability and growth in the minds of central bankers can bring in its wake a wrong twist to many of the microeconomic and price-wage relationships that are the substance of the real economy beneath the superficial macro aggregates.
But as long as the Keynesian, and general macroeconomic, way of looking at the market in terms of economy-wide aggregates continues to prevail, it will be difficult to put economic policy back on the right track — a track that will lead to the understanding that it is government deficit spending and monetary creation that cause the unsustainable booms that result in the economic downturns bringing about the rising unemployment that economists like Bradford Delong are so concerned about.
Only by rejecting the type of policy prescriptions proposed by Professor DeLong and those who think like him can economy-wide fluctuations be reduced or maybe even eliminated in their occurrence.