Our costly dalliance with Lord Keynes
In “The General Theory of Employment, Interest and Money”, Keynes virtually created macroeconomics. But Keynes was a mathematician, not an economist, and did not fully understand free markets, so he was hardly qualified to emerge as the most influential economist of the last century. His misconceptions still inform the establishment, comprising governments and their regulated financial sectors. Given that there is dawning acknowledgement that these policies are propelling leading nations into a common financial and economic crisis, a forensic dissection of Keynes’s errors and motivations is overdue. This essay is a brief attempt to rectify this omission.
Hayek’s assessment of Keynes
Perhaps we should have listened to Friedrich Hayek, when he said that his friend Lord Keynes was not an economist. This description of Keynes by Hayek is extracted from a video interview with Leo Rosten in 1975:
“He was a man with a great many ideas who knew very little about economics. He knew nothing but Marshallian economics. He was completely unaware of what was going on elsewhere. He even knew very little about nineteenth century economic history. His interests were very largely guided by aesthetic appeal, and he hated the nineteenth century and therefore knew very little about it, even about its scientific literature.”[i]
We must pick Hayek’s introductory statement apart, because despite Keynes’s alleged ignorance of economics, in modern times he became the most influential economist after his General Theory was published in 1936. He sanctified a new specialisation of macroeconomics which dominates economic literature today. He inspired a succession of influential economists, who were and still are devoted followers. He was also the ultimate establishment man (which Hayek never was). He won a scholarship to Eton and attended Cambridge University, where his father lectured on economics and moral sciences. It was at Cambridge where he fell under the influence of Alfred Marshall (1842-1924). Hence Hayek’s reference in the clip above to Marshallian economics.
Marshall took the view that past prices, or data, form the basis for estimating prices in the future, while accepting unforeseen factors would affect them such as variations in demand and the interplay with variations of demand for other goods. He downplayed consumer subjectivity in common with his predecessor, William Stanley Jevons, who firmly believed prices could be mathematically modelled. Marshall didn’t go the whole hog, taking a quasi-mathematical approach, which started being geometric-based analysis but evolved into differential calculus. This clashed fundamentally with Hayek’s Austrian tradition, which had been established by Carl Menger in his Principles of Economics published in 1871.
But Hayek’s inference that by ignoring Menger’s subjectivity, Marshallian economics was in error, is more than one school criticising another. Marshall’s approach got stuck without satisfactory outcomes, while Menger’s theory led to further discoveries by those who followed him: von Bawerk, von Wieser, von Mises and of course Hayek himself.
While Keynes’s views took on those of his mentor, he also laid increasing emphasis on mathematical analysis of economics. In this there can be no doubt that he was for ever influenced by Marshall’s teachings. The attraction of Marshall’s approach to a non-economist (such as Keynes) was that philosophical reasoning would be substituted by mathematical suppositions. Applied with inductive reasoning, data could then be used as the basis for generalised forecasts of economic outcomes and form the basis of the state’s management of the economy.
In the tradition of Adam Smith, Jevons Marshall and Pigou all assume a cost of production theory of prices. Yet our own experience tells us this cannot be true. Manufacturers will estimate a price-point for their product on the basis of evolving consumer intelligence. They will try to make a profit by adjusting their cost of production to meet that price point, not the other way around. When a manufacturer produces a range of products, one or more of them might be marketed for sale at a loss in order to complete a product range. In a free-market economy, any manufacturer who fails to respond to changing consumer commands will go out of business. Therefore, the cost of production takes a back seat. It is only government and government-sanctioned monopolies that manage to work on a cost-plus basis.
How consumer preferences change in the future cannot be known: the best guess for future prices for their niche products is made by skilled entrepreneurs immersed in their own niche markets. Marshall’s mathematically geometric approach of projecting prices on the basis of past supply and demand becomes no more than a what-if exercise, and not a viable basis for price theory. If, as Hayek intimated, Keynes had been aware of what was going on elsewhere in the field of economics, he might have understood the flaws in Marshallian economics.
That Keynes hated the nineteenth century is an interesting observation. If true (and Hayek would have been in a position to know, so we should not doubt it) it could explain an antipathy to the economic theories of free trade established by the likes of Cobden in England and Bastiat in France. But surely, he would have seen the progress free trade brought to a nation. Surely, he would have understood Ricardo’s theory of comparative advantage and the benefits it brought.
Equally, he could have been deterred by the writings and philosophies of Marx and Engels, which imparted a primal threat to the establishment. Marx inspired the early organisers of the Labour Party, which was founded in 1900 having evolved out of the trade union movement and the socialist parties of the nineteenth century. By the early 1920s it overtook the Liberal Party to be the main opposition to the Conservatives, forming its first government in 1924, twelve years before Keynes published his General Theory. The threat to the establishment had infiltrated parliament itself.
This was no gentle Methodist revolution. Originally drafted in 1918 by Sidney Webb, an apologist for Soviet communism and the founder of the Fabian Society, Clause 4 of the Labour Party constitution bound it to the Marxian ambition to take into public ownership the means of production. This threat to the establishment raised the possibility, that consciously or unconsciously, Keynes’s ambition might have been to find another way for the state to control the economy, since free markets appeared to be under mortal threat from Marxism.
Certainly, before the Great War, in Cambridge the academic environment would have been conducive to these thoughts, with many professors sympathetic to Marxism. An alternative socialism was required, and Keynes was willing to invent it. The sentiment was there. In the Concluding Notes to his General Theory Keynes observes that “Since the end of the nineteenth century significant progress towards the removal of very great disparities of wealth and income has been achieved through the instrument of direct taxation – income tax and surtax and death duties – especially in Great Britain”.
There is no mention of the obvious drawbacks to a policy that seeks to level wealth towards the lowest common denominator. Keynes’s laudatory discourse on wealth redistribution quoted above is socialism raw in tooth and claw. It guarantees the state a substantial income to spend on its own bureaucracy and other ambitions. And the productive benefits of wealth, if it had not been destroyed through government attempts to remove wealth disparities, is entirely forgone.
Keynes was and still is seen by many to have established a middle way between socialism and free markets. This is equivalent to claiming that to sin a little is not to sin at all. But one cannot be selective over the application of a general theory. The redistribution of some wealth is fatally destructive of that wealth, and the more that is transferred the greater the economic cost.
Of course, redistribution of wealth through taxation is not the only method of wealth destruction. Inflation, the dilution of the money stock, is the most certain and undetectable method. In the General Theory, Keynes ducks entirely the role of bank credit in inflating the money-quantity. It is as if he is unaware of the inflationary consequences of the Bank Charter Act of 1845, which set in stone the facility for banks to expand credit. Evidence, perhaps, to support Hayek’s assertion about his lack of knowledge of nineteenth century economics.
Keynes was wholly unfamiliar with the ground-breaking progress of the Austrian School in this respect, particularly the 1912 work of von Mises’s The Theory of Money and Credit. Until it was translated, Keynes would have had no adequate explanation for the cycle of credit expansion and contraction, which fed the booms and slumps in the second half of the nineteenth century. Despite the population enjoying a lift in living standards through the industrial revolution, it was the periodic slumps which fed Marxian support.
The value of von Mises’s analysis of the credit cycle cannot be overestimated. It is a great shame for us all that Keynes was unaware of Austrian economic literature until it was translated from the German – too late to undermine the beliefs of a man whose thinking was becoming firmly set and would not be radically altered. It fundamentally contradicts Keynes’s assumption that the trade cycle can be managed. But Keynes’s mind was made up: a benign state had to progress beyond the lender of last resort function of a central bank. A central bank’s beneficial role in saving systemically important banks from collapse had been proved to everyone’s satisfaction in the late-nineteenth century. The next task was to justify wider state interventions to stop a repeat of the late nineteenth century slumps, and particularly, a repeat of the 1930s depression.
In the 1930s Keynes was moving from Marshallian inductive reasoning to goal-seeking a favoured outcome. In order to get there, he had to ditch elements of classical economics that got in his way. His goal was to end the periodic slumps, and his prejudice led him to a utopian world without them. The Concluding Notes in his General Theory set this out. He decries unnecessarily high rates of interest as an inducement to save, making the mistake of not understanding that rates set in a free market are a reflection of the time preference on goods. He goes on to say it would not be difficult to
“…increase the stock of capital up to the point where its marginal efficiency had fallen to a very low figure… Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital.”
This, it turns out, is the ultimate objective of Keynes’s economics. With the redistribution of wealth and the state ensuring the provision of capital at a low interest cost, the system of savings providing the investment and working capital for entrepreneurs would become redundant. The state would gain control over the deployment of capital, thereby ensuring close to full employment. The General Theory is not a book explaining economics to his followers at all, but a propaganda tool to lead them to his vision of a non-Marxist socialist nirvana.
The discrediting of Say’s law
Of the many obstacles to Keynes’s new economics, the most significant was what is commonly termed Say’s law. He overcame it by playing a blinder, recasting it into a barely comprehensible aside which vaguely approximated to something that could have related to the principal elements of something described as a law. But it is properly understood only in expanded form as an explanation of how and why free markets work. Today, if you ask economists about Say’s law, they will most often revert to a variation of Keynes’s misdirection.
Keynes’s single reference to Say’s law in the General Theory is early on page 26, dismissing it so that his book can then proceed on the basis it doesn’t even exist. This is the relevant passage:
“Thus, Say’s law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.”
So, the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output. The best one can say is Keynes’s statement it is not untrue, but it is only one conclusion derived from the law, not the law itself. No matter: Keynes then proceeds to write that vitally important chapter of economic theory referred to in the clip above, which he now invents, before the reader, perhaps in thrall to the writer’s reputation, has time to reflect that the most fundamental truism of classical economics has been summarily dismissed.
To appreciate the depth of this travesty, we must dispense with potted versions of Say’s law, and examine what classic economics actually says to us on the matter. Ever since Man discovered the benefits of social cooperation, he has learned that each person has personal skills and characteristics which he can use to maximise his output. By exchanging his output for the output of others, he satisfies most effectively his own needs and wants as well as those with whom he interacts. Trade between individuals is facilitated by the use of a common commodity, suited and acceptable to all, in a system of indirect exchange. It is the basis of the division of labour and the glue that cements social cooperation and cohesion.
Stated so baldly, only an ignoramus can disagree with Say’s law. Keynes’s sleight of hand amounts to an acknowledgement of the obstacle its truth presents to his intentions. This truth must be smothered. From its concealment emerges the foundation of macroeconomics, that somehow, what happens at an individual level is different at a community level. But that cannot be true either, because Say’s law is a description of cooperation at a community level. The creation of macroeconomics must then assume nations are not comprised of cooperating communities, a proposition equally impossible to accept, but upon which Keynes then proceeds.
Following his dismissal of Say’s law, the remainder of the book develops the foundation for macroeconomics, a world somehow apart from human experience. If a community thrives through the division of labour, there is no room for a third party in any of the individual transactions between buyers and sellers. Keynes now tells us that at a macro level there can be a third party, the state. Now, the democratic state can justify an economic role, guiding the nation in a direction it determines for the benefit of those it represents.
The root of the logic behind his wish-list in his conclusions to the General Theory is that by redistributing wealth from those who disproportionally possess it to those who do not, the economic benefits to society as a whole outweigh the damage to the wealth of some individuals. And since, in accordance with the principals of the division of labour, some consumption is selfishly put aside for future use as savings to be recycled into capital investment, savers must be euthanised (rentiers as Keynes put it), along with exploitative capitalists. While admitting that both their starting points do not hold up to scrutiny, Keynes’s creation of macroeconomics is perhaps even less tenable in logic than Marx’s inventions in Das Kapital, because Marx did not sully his effort with unworkable compromises.
The fear with which the establishment held for communism a century ago was that it threatened to rob the bourgeoisie of everything. Keynes’s macroeconomics, appearing to be founded upon familiar free-market territory, was gladly embraced by the establishment. It is, nonetheless, alternative socialism. Importantly, by handing responsibility for the creation of money to governments and their central banks, it is also inflationism, just as much as John Law’s policies were, which in an earlier era led to the Mississippi bubble and the subsequent destruction of the French economy.
But it is the compromising nature of Keynes’s macroeconomics that has been key to its survival, while the uncompromising nature of Marxism, despite the suppression and widespread slaughter of its opponents, which demonstrably failed. In the Asian communist states, it is estimated that over a hundred million people died through executions and starvation. The political systems of the two largest slaughterers of their populations, the Soviet Union and China, collapsed, to be reinvented as mercantilist states. The Keynesian interventionists are yet to fail so dramatically, but nonetheless appear to be on a trajectory to do so.
The economic consequences of Lord Keynes
Keynesian socialism has survived so long because it never quite strangled free enterprise. So long as individuals have some freedom to divide their labour, they have a remarkable ability to adapt to the circumstances forced upon them by governments.
In the rare instances where governments strictly limit their economic burden on their productive sectors, it has been shown by its omission that Keynesian socialism is an economic cost, and not a benefit. Logic supports the evidence: if you destroy some people’s wealth an economy is worse off. You don’t need to be a classical or Austrian economist to understand that. What does require a grasp of economic theory is to explain why Keynes’s trade cycle is not rooted in private sector activity at all, but is the consequence of state intervention, particularly on the money side. The trade cycle is only the symptom; the credit cycle is the cause.
By advocating an increased monetary role for the state, Keynes has made the credit cycle considerably worse and more destabilising. The evidence pointing to the cause and therefore the guilty party is routinely obliterated by macroeconomic claptrap, bending of statistics and yet more monetary debasement, a process than cannot carry on indefinitely. The legacy of debt that has consequently arisen ensnares both governments and private sectors in debt traps, whose springing is only deferred by yet more monetary inflation. So freely is state currency made available that everyone now expects money will be provided without it being earned. Governments are so overburdened with existing debt and inescapable future liabilities that their only escape route appears to be from ever-deeper negative interest rates and accelerating debasement of the currency.
The invented science of Macroeconomics always bends to justify itself. Banks are now ceasing to create credit for the productive economy, except for the largest and most secure borrowers. Macroeconomists barely notice. In reality, inflationism now produces no benefits other than bare survival for governments and their licenced banks. Instead of the promised utopia, Keynes’s socialism has taken us all to the chasm’s edge that destroyed communism in the 1980s.
We are systemically blind to the consequences of overturning Say’s law and the other principles of economics established in the nineteenth century and subsequently developed by the Austrian masters.
If only we had listened to Hayek. Keynes’s utopian dream is turning into a nightmare for us all.
[i] See https://mises.org/wire/hayek-keyness-ignorance-economics
Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.