How Keynesian Economics Has Distorted Economic Thinking (Somewhat wonkish)

For the better part of a century, most economists have believed that recessions are caused by overall demand failure—total purchasing power dropping below the number of total goods on the market.

Part of the reason for the predominance of this thinking is that the man who popularized it, John Maynard Keynes, mischaracterized “classical” arguments in order to better refute them. Unfortunately, few are aware of the success these distortions have had on economic theory.

Keynes began his criticisms of the classical school by insisting that it offered no explanation for “involuntary unemployment”—or forced unemployment—and hence recessions:

Classical theory…is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which in the above sense involuntary, cannot occur… [emphasis added]

He then added to his criticism by accusing his opponents of fallaciously arguing that “supply creates demand,” which Keynes would repudiate:

I believe that economist everywhere up to recent times … have not extricated themselves from his [Jean-Baptiste Say’s] basic assumptions and particularly from his fallacy that demand is created by supply. Say was implicitly assuming that the economic system was always operating up to its full capacity, so that a new activity was always in substitution for, and never in addition to, some other activity. Nearly all subsequent economic theory has depended on, in the sense that it has required, this same assumption. Yet a theory so based is clearly incompetent to tackle the problems of unemployment and of the trade cycle. [emphasis added]

Problem is, both of his arguments were disingenuous. Not only did classicalists like Jean-Baptiste Say, James Mill, Robert Torrens, John Stuart Mill, David Ricardo and others describe situations of involuntary unemployment, but they disavowed Keynes’s oversimplified notion that “supply creates demand.” Moreover, they categorically rejected what became the central tenet of Keynesian economics—overall demand deficiency—as an obvious fallacy.

Let’s first examine the classical business cycle theory, which began with the uncontroversial idea that, in order to obtain a good or service on the market, one must produce and offer something in exchange. For example, in order for a shoemaker to procure the watchmaker’s watch, the shoemaker must make and exchange a shoe for the watch. Of course, the classical school realized that we don’t operate in a barter economy, and that money acts as the medium of exchange (more on that below). But the point was that production was the key to economic booms and busts: When production increases, purchasing power—or “demand”—rises; when production diminishes, demand shrinks. “Men err in their production; there is no deficiency of demand,” asserted David Ricardo.

From here, however, Keynes took the argument and twisted it into the chimerical characterization, “supply creates its own demand”—that is, he accused the classical school of believing that simply producing a good guarantees its sale (“demand”). But had he read further, he would have known that none of his opponents believed such an absurd proposition. In fact, they went to great lengths to stress that production creates demand, only if consumers desire what’s produced. Here’s Ricardo:

Mr. Say, in the new addition of his book…supports, I think, very ably the doctrine that demand is regulated by production. Demand is always an exchange of one commodity for another. The shoemaker when he exchanges his shoes for bread has an effective demand for bread…. And if his shoes are not in demand it shews that he has not been governed by the just principles of trade, and that he has not used his capital and his labour in the manufacture of the commodity required by society, -- more caution will enable him to correct his error in his future production. Accumulation necessarily increases production and as necessarily increases consumption [demand]. [emphasis added]

In other words, if a producer fails to meet the demand preference of consumers, production goes to waste. Contemporaries of Ricardo, such as Robert Torrens, agreed: Production creates demand, as long as there are “proper proportions”—that is, assuming the structure of supply matches the structure of demand:

In every conceivable case, effectual demand is created by and is commensurate with production, rightly proportioned…. Vary our suppositions as we will, increased production, provided it be duly proportioned, is the one and only cause of extended demand, and diminished production the one and only cause of contracted demand. [emphasis added]

And, contrary to Keynes’s unfounded allegations, the lack of “proportions” is precisely how these economists explained recessions:

The want of due proportion in the quantities of the several commodities brought to market, which operates thus injuriously upon capitalists, inflicts equal injury upon the other classes of the community…. The ruin of the cultivator involves that of the proprietor of land; and when the motive and the power to employ productive capital are destroyed, the productive labourer is cut off by famine. [emphasis added]

In a word, failure in the structure of production—the disharmony of supply and demand—may reduce income and employment, ending in recession. But seeking a remedy via demand stimulation was viewed as a flagrant fallacy. The right prescription, according to Jean-Baptiste Say, was to stimulate production:

The encouragement of mere consumption [demand] is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption [demand]; and we have seen, that production alone, furnishes those means. Thus it is the aim of good government to stimulate production, of bad government to encourage consumption [demand].

Furthermore, while many Keynesians have denied this, classical economists accommodated the role of money. According to the Keynesian argument, classicalists ignored the fact that money isn’t simply a medium of exchange—or “neutral”—but is also a commodity that can be demanded, especially during recessions. When that happens, overall demand for goods and services falls (as people prefer holding money to purchasing goods), in which case the economy faces total demand failure, requiring a demand-side remedy.

But even while recognizing the recessionary impact of higher money demand, the classical school maintained its rejection of demand deficiency. Here’s John Stuart Mill:

It is a great error to suppose…that a commercial crisis is the effect of a general excess of production [insufficient demand]. … Its immediate cause is a contraction of credit, and the remedy is, not a diminution of supply, but the restoration of confidence.

Put differently, during recessions money demand may rise and production may slow, but it is caused not by too little demand but from fear in the marketplace. Once confidence is restored, production resumes along with demand.

Contrary to popular belief, Keynes and many of his followers have misrepresented classical economics.  This has led many to renounce classical theory without realizing that it not only offers logical explanations for the business cycle, but that the classicalists were well-versed in and rejected Keynesianism before it became known as Keynesianism.  And that’s a fact that merits more attention.

Cross-posted at Liberty Unyielding.