Keynes’ dangerous fallacies and errors

Gerard Jackson
Monday 11 October 2010

Now that Keynesianism is being promoted with renewed enthusiasm (clear evidence that economic fallacies never really die) we should take a look at Keynes’ dangerous fallacies and errors. Some years ago Alex Millmow, a Keynesian and senior lecturer in economics at Charles Sturt University at the time, wrote enthusiastically in the Australian Financial Review of Geoff Harcourt and Peter Riach’s commissioning of a two-volume set written by Keynesians that was intended as a ‘rewrite’ of Keynes’ General Theory of Employment Interest and Money. According to Millmow, this work would put an end to arguments about “what Keynes really meant”. Well the works were published and, as expected, they did not put an end to “what Keynes really meant”.

One thing latter day Keynesians are never short of, apart from academic bulldust, is arrogance. Millmow made this abundantly clear with his absurd and grossly misleading statement that “Those who argue that Keynes had his day have never read the General Theory.” I, for one, have read it three times and each time I became more convinced of Keynes’ economic shallowness. There is also a formidable body of respectable economists who have also read Keynes and concluded that he was wrong from beginning to end.

Like all Keynesians Millmow push’s the line that Keynes believed there existed an inverse relationship between real wages and employment but that this did not mean that cutting money wages would cut unemployment. This leads to the conclusion that the best way to raise employment in the presence of idle resources is to “lift aggregate demand” which would only cause “a fall in real wages”. In plain English, what the Keynesians are really saying is that cutting money wages directly would not necessarily raise employment but using inflation to cut real wages by raising prices would.

This seems to make sense once we remember that “lifting aggregate demand” is a code phrase for printing money. This was made clear by Keynesian Robert Kuttner (Business Week, 15 July 1996) when he wrote: “Workers resist cuts in the nominal dollars they are paid, though they do tolerate real wage cuts caused by inflation”. In short, if workers insist on pricing themselves out of jobs then we must use inflation to price them back into work.

But this Keynesian cure rests on the baseless belief that workers suffer from permanent “money illusion”, i.e., they are too stupid to realise that inflation is cutting their real incomes. (Does anyone imagine for a moment that is the situation in Australia, the US or Europe?) It would obviously be better for readers if we referred to the master rather than to his disciples. Keynes asserted, without foundation, that

Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labour whenever there is a rise in the price of wage-goods [consumption goods] (The General Theory, Macmillan-St. Martin’s Press, 1973, p. 9).

Clearly his disciples are not deviating from his teachings in this respect. More importantly, this is an admission by Keynes that the problem is not mythical demand deficiency but excessive wage rates. Keynes convoluted argument suggesting that direct cuts in wages could lead to a reduction in demand (Ibid. pp. 259-60) only demonstrated how much at sea he was on the subject.

Keynes seemed only to think in terms of wage incomes rather than wage rates or payrolls. That adjusting individual wage rates to the new monetary situation could expand payrolls and output and thus demand by releasing withheld capacity was simply not entertained. He thought in fictitious aggregate like wage levels. This lumpen-thinking led him to the absurd conclusion that laissez-faire economies could not overcome unemployment because it could not impose en bloc wage cuts. But no classical or any other free-market economist would ever suggest such a policy let alone support it. It is wage rates that matter, not so-called wage levels.

Further in his defence of Keynes Millmow tried, albeit indirectly, to persuade his readers that Keynes was not a supporter of deficit spending or cheap money policies. Yet it was Keynes who that “the remedy for the boom is not a higher rate of interest but a lower rate of interest!” (p. 329) (he had obviously not learnt the tragic lesson of Weimar Germany). In the Paper of the British Experts he made the absurd statement that credit expansion performs the “miracle… of turning stone into bread” (cited in Ludwig von Mises’ Planning for Freedom, Liberty Press, 1974, p. 51).

To Keynes, therefore, interest was a monetary phenomenon. This kind of thinking led him to assert that “there are no intrinsic reasons for the scarcity of capital” (ibid. pp. 375-76). This is an extraordinary statement for an economist to make. A world in which capital was not scarce, i.e., a free good, would be a world of superabundance. It is painfully obvious that Keynes’ mercantilist view that interest is the price of money has been totally discredited. As Mises explained:

It [the Keynesian view] regards interest as compensation for the temporary relinquishing of money in the broader sense — a view, indeed, of unsurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest hold an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy. (The Theory of Money and Credit, LibertyClassics, 1981, pp. 391-2, first published 1912)

Frank Knight was equally scathing, writing:

It is a depressing fact that at the present date in history there should be any occasion to point out to students that this position is mere man-in-the-street economics. (On the History and Methods of Economics, University of Chicago Press, 1956, p. 222).

To suggest, as Millmow did, that Keynes did not support cheap money policy leads one to wonder whether he has actually read Keynes. When it came to deficits he fared no better. Throughout his life, Keynes mocked thrift and encouraged profligacy. It was Keynes who claimed that earthquakes, pyramid-building or even wars could increase a nation’s wealth! (Ibid. p. 129). Having declared that national destruction was a cure for unemployment and economic stagnation, he then warmed to his theme by also claiming that wasteful expenditure, even in the form of labour digging up buried bottles filled with banknotes, could help “the real income, and its capital wealth also,…become a great deal greater than it actually is” (Ibid. p. 129).

Is it any wonder that politicians stormed the Keynesian dam to turn ‘pump priming’ into an inflationary deluge. What did he think they would do? Nevertheless, I am inclined to the opinion that Keynes took himself a lot less seriously than do his disciples. The truth is that he had no real understanding at all of capital theory and he never really understood the nature and vital coordinating function of interest — and neither do most of today’s economists.

These few examples of Keynes’ economic views should suffice to show how ridiculous was Millmow’s assertion that we “need Keynes back because of his eternal insight into the workings and failings of a monetary economy, the powers of uncertainty and expectation…” In fact, there was not really anything original in Keynes’ treatment of expectations, contrary to what his disciples claim. It is ridiculous to imagine that classical economists never took expectations into account. William Ellis (1794-1872) wrote about expectations in the Westminster Review, January 1826. The truth is that most of the classical economists took expectations for granted. It is true that Ricardo concentrated on the long run at the expense of expectations and the short run. As he himself expressed it in a letter to Thomas Malthus:

It appears to me that one great cause of our difference in opinion, on the subjects which we have so often discussed, is that you have always in your mind the immediate and temporary effects of particular changes — whereas I put these immediate and temporary effects quite aside, and fix my whole attention on the permanent state of things which will result from them. Perhaps you estimate these temporary effects too highly, whilst I am too much disposed to undervalue them. (The Works and Correspondence of David Ricardo Vol. II, liberty fund Indianapolis, 2004. P. 120).

Before any Keynesian gets excited about Ricardo’s failure to deal with expectations I should point out that despite assertions by Keynes and others that Ricardianism had “conquered England” the Ricardo school died shortly after Ricardo’s own death in September 1823. In 1831 Colonel Robert Torrens addressed the Political Economy Club, which Ricardo helped found, and declared that Ricardianism was dead. Nevertheless, Ricardo was not blind to the dangers of misplaced expectations.  In his Principles of Political Economy and Taxation, chapter XIX, Ricardo gave his opinion on why widespread unemployment can exist for very long periods:

The duration of this distress will be longer or shorter according to the strength of that disinclination to abandon that employment of their capital to which they long been accustomed.

In a letter to Malthus he made a pointed observation about the stubbornness and delusions of capitalists whose expectations have clashed with economic reality:

The difficulty of finding employment for Capital in the countries you mention proceeds from the prejudices and obstinacy with which men persevere in their old employments, — they expect daily a change for the better, and therefore continue to produce commodities for which there is no adequate demand. (The Works and Correspondence of David Ricardo Vol. III, liberty fund Indianapolis, 2004, p. 392)

Millmow’s hostile comments on what he — out of ignorance — called the “destabilising antics of financial markets” were answered in full by the late and much lamented Peter F. Drucker:

Keynes is in large measure responsible for the extreme short-term focus of modern politics, of modern economics, of modern business…Short-run, clever, brilliant economics — and short-run, clever, brilliant politics — have become bankrupt (Perter F. Drucker,  The Unseen Revolution, New York: Harper and Row, 1976).

It is Keynesianism policies that destabilised the markets and gave birth to monetary instability and reckless speculation. And all that Keynesians can offer us is more of the same along with a policy of controls. Perhaps we should not be too harsh on Mr Millmow. After all, no less a personage than John Stone, considered one of Australia’s arch economic rationalists (free marketeers), described Keynes’ EE General Theory of Employment, Interest and Money EE as a monumental work (Australian Financial Review, 7 November 1996).

The only thing monumental about the General Theory is the sheer magnitude of its fallacies, inconsistencies and embarrassing contradictions. Obviously, even some of our so-called rationalists still have a long and difficult intellectual road to travel. In the meantime, Keynesian thinking still dominates, making the world a lesser and more uncertain place.

Gerard Jackson is Brookesnews’ economics editor

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