The View From 1776

Robert P. Murphy’s article on the Mises.org blog, Consumers Don’t Cause Recessions, deals with Mr. Krugman’s recent socialist propaganda piece advocating a reprise of the Keynesian economic policies that so signally failed to end the Depression during Franklin Roosevelt’s New Deal. 

Mr. Krugman wants a large new Federal spending program (he doesn’t say spending on what), exactly what the New Deal tried repeatedly without success for eight dreary years of double-digit unemployment, from 1933 to 1941.  Exactly what president-elect Obama and the Democrat/Socialist Congress propose to repeat.

In his October 31, 2008, column, Mr. Krugman tells us that the current economic recession is a consequence of consumers cutting back on consumption spending.  We are, he declares, now ensnared in a Keynesian liquidity trap, from which only massive Federal spending can free us.

...consumers are cutting back just as the U.S. economy has fallen into a liquidity trap — a situation in which the Federal Reserve has lost its grip on the economy.

Some background: one of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.

In fact, consumers’ income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.

At this point, however, the instructor hastens to explain that virtue isn’t really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can’t offset the fall in consumer spending…

...what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn’t spend.

In the same vein, J.M. Keynes’s best known American acolyte, Harvard economist Alvin Hansen, wrote in the 1930s that the American private enterprise economy had matured.  That meant, he wrote, that the United States would remain permanently in economic Depression, that private business would never again be able to attain the production volumes of 1928.  The Keynesian prescription was that the Federal government would be required permanently to fill the gap by spending enough to maintain full employment.  Moreover, the government would have to become the initiator and funder of all investment in productive equipment.

In short, a socialist state-planner’s dream.

In the event, the depression was ended by the Japanese bombing of Pearl Harbor and our entry into World War II, not Keynesian inflationary, deficit spending.

Mr. Krugman’s Keynesian, socialistic nonsense, of course, is what ignorant and inexperienced young students are fed in our so-called educational system as part of their indoctrination in the secular religion of socialism.  The message is that only the collectivized political state can save us, and even then only when intellectuals like Paul Krugman call the shots.

Oddly, Mr. Krugman undercuts his own argument, writing that:

It’s true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent — sometimes it has even been negative — and consumer debt has risen to 98 percent of G.D.P., twice its level a quarter-century ago.

If consumers were behaving so admirably, in Keynesian economic terms, with almost no savings and very high consumption spending, how then did we get into a recession? 

If the Federal government gives consumers more money to spend why would that get us out of a recession, if consumers were already spending at the max when the recession started? 

Why didn’t the recent Federal $150 billion stimulus plan (tax rebates of $1,200 per person) forestall the recession?

If ending a recession is only a matter of more consumer spending regulated by the Federal Reserve’s “slashing interest rates,” why didn’t cutting the discount rate 75%, from 5% a year ago to 1.25%, not inject enough liquidity to maintain consumer spending at Mr. Krugman’s magic levels?

In Keynesian Predictions I wrote:

As noted in Krugman and Friedman - Part Four, Keynesian economic theory, now refurbished as neo-Keynesianism, dominates liberal-Progressive-socialist thinking in the United States.  Mr. Krugman is one of its fiercest proponents.

Like Keynes, he has been consistently wrong in his predictions, most notably in proclaiming that tax cuts in the first term of the present Bush administration would not revive the economy and, in any event, would not lead to creation of new jobs.  Only government spending can revive the economy, according to liberal-Progressive orthodoxy.

In “Krugman and Friedman - Part Four,” reference was made to Milton Friedman’s Theory of the Consumption Function, which flayed and butchered Keynes’s analysis.  From that opus came the prediction of conditions that became horrific reality in the 1970s stagflation.

Professor Friedman not only discredited Keynes’s predictions of consumer behavior, but also, in effect, eviscerated the entire Keynesian theory.

Keynes regarded savings as the villain that produced and sustained the Depression.  The economy, he theorized, had fallen into equilibrium at a low level with insufficient activity to produce full employment, because people weren’t spending enough money and businesses weren’t investing enough in new production.  The gap would have to be filled by Federal spending that, in the view of his chief American acolyte, Harvard’s Alvin Hansen, would be necessary forever.

It’s not hard to see why Keynes’s theories appealed so mightily to American liberal-Progressive-socialists.  It conformed so nicely to the socialist theory that only they were qualified to plan and to manage the whole economy.  Individual workers and individual businessmen couldn’t be depended upon to respond to market forces and create greater production and more jobs.  That was a job for the nanny-state that would provide security, not opportunity…

A crucial problem was that a cornerstone of Keynes’s theory - the villainous role of savings - was dead wrong. 

As Henry Hazlitt noted in his 1959 “The Failure of the ‘New Economics’: An Analysis of the Keynesian Fallacies,” Keynes theorized that the “propensity to consume” (Milton Friedman’s target) was quantifiable as a law of economics, so precisely so that Keynes reduced his law to a single calculus equation, which he called the consumption function…

The point was to support his contention that, as incomes increased, people consumed less of the increase and therefore saved more, with dire consequences for economic activity and employment.

Mr. Hazlitt points out that neither Keynes nor Hansen supplied any proof for the consumption function calculus equation.  They would not have found substantiation in statistics reflecting actual behavior, which proved to be the opposite of Keynes’s predictions.

As one of many possible examples, Mr. Hazlitt records that between 1944 and 1955, national income increased 83.5%.  According to Keynes’s economic “law” of consumption, savings were supposed to increase at an even faster rate.  In fact the actual amount of savings fell from $36.9 billion in 1944 to $17.1 billion in 1955.  In recent years, while our economy has grown at stupendous rates, consumers have actually had negative savings.

For additional background on this issue, see Democrats, the Fed, and Milton Friedman.