The View From 1776

Keynesian Predictions

A cornerstone of liberal-Progressive economic theory turns out to be fatally flawed, bringing the whole structure crashing to the ground.

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.

Confident that Henri de Saint-Simon’s 1820s socialistic theories had been validated, hordes of brash young Ivy Leaguers poured into Washington eager to join the New Deal and save America from the capitalists.

Unfortunately for the nation, they and Keynes were dead wrong.  The New Deal prolonged the Depression for eight years, with unemployment remaining in double-digit percentage levels.  In 1939, unemployment was still almost 17% of the workforce, nearly four times today’s level. 

Extorting tax revenues from investors and businesses, with marginal rates as high as 90%, and transferring the proceeds to individuals was not the same thing as saving and investing, without which no economy can grow.

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.

In A Guide to Keynes, Harvard economist Alvin Hansen wrote:

Keynes most notable contribution was his consumption function…the behavior patterns of the community are such that a gap exists (which gap widens absolutely as real income increases) between the amount the community wishes to consume and the output the community is capable of producing.

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.

Nonetheless, with gory entrails hanging out of its disemboweled gut, the decaying beast of Keynesianism remains an object of worship for liberal-Progressive-socialist, who are as eagerly grasping as ever for theories to justify their assuming complete management of the economy.

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