Capitalism Faces Its Greatest Challenge

A thousand years hence 1920–1970 will, I expect, be the time for

historians. It drives me wild to think of it. I believe it will make my

poor Principles, with a lot of poor comrades, into waste paper.1

—Alfred Marshall (1915)

Keynes was no socialist—he came to save capitalism, not to

bury it. . . . There has been nothing like Keynes’s

achievement in the annals of social sciences.

—Paul Krugman (2006)

The capitalist system of natural liberty—founded by Adam Smith,

revised by the marginalist revolution, and refined by Marshall, Fisher,

and the Austrians—was under siege. The classical virtues of thrift,

balanced budgets, low taxes, the gold standard, and Say’s law were

under attack as never before. The house that Adam Smith built was

threatening to collapse.

The Great Depression of the 1930s was the most traumatic economic

event of the twentieth century. It was especially shocking given

the great advances achieved in Western living standards during the

New Era twenties. Those living standards would be strained during

1929–33, the brunt of the depression. In the United States, industrial

output fell by over 30 percent. Over one-third of the commercial

banks failed or consolidated. The unemployment rate soared to over

25 percent. Stock prices lost 88 percent of their value. Europe and

the rest of the world faced similar turmoil.

The Austrians Mises and Hayek, along with the sound-money

economists in the United States, had anticipated trouble, but felt

helpless in the face of a slump that just wouldn’t go away. A nascent

recovery under Roosevelt’s New Deal began in the mid-1930s, but

didn’t last. U.S. unemployment remained at double-digit levels for a

full decade and did not disappear until World War II. Europe didn’t

fare much better; only Hitler’s militant Germany was fully employed

as war approached. In the free world, fear of losing one’s job, fear of

hunger, and fear of war loomed ominously.

The length and severity of the Great Depression caused most of

the Anglo-American economics profession to question classical laissez-

faire economics and the ability of a free-market capitalist system

to correct itself. The assault was on two levels—the competitive

nature of capitalism (micro) and the stability of the general economy

(macro).

Was the Classical Model of Competition Imperfect?

On the micro level, two economists simultaneously wrote books

that independently challenged the classical model of competition. In

1933, Harvard University Press released The Theory of Monopolistic

Competition by Edward H. Chamberlin (1899–1967), and Cambridge

University Press published Economics of Imperfect Competition by

KEYNES RESPONDS TO CAPITALISM’S GREATEST CHALLENGE 135

Joan Robinson (1903–83). Both economists introduced the idea that

there are various levels of competition in the marketplace, from “pure

competition” to “pure monopoly,” and that most market conditions

were “imperfect” and involved degrees of monopoly power. The

Chamberlin-Robinson theory of imperfect competition captured

the imagination of the profession and has been an integral feature

of microeconomics ever since. It has strong policy implications:

Laissez-faire is defective and cannot ensure competitive conditions

in capitalism; the government must intervene through controls and

antitrust actions to curtail the natural monopolistic tendencies of

business.

The Radical Threat to Capitalism

But this threat was minor compared to the radical noncapitalist

alternatives being proposed in macroeconomics. Marxism was all

the rage on campuses and among intellectuals during the 1930s.

Paul Sweezy, a Harvard-trained economist, had gone to the London

School of Economics (LSE) in the early 1930s, only to return

a full-fledged Marxist, ready to teach radical ideas at his alma

mater. Sidney and Beatrice Webb returned from the Soviet Union

brimming with optimism, firm in their belief that Stalin had inaugurated

a “new civilization” of full employment and economic

superiority. Was full-scale socialism the only alternative to an

unstable capitalist system?

Who Would Save Capitalism?

More sober intellectuals sought an alternative to wholesale socialism,

nationalization, and central planning. Fortunately, there was a

powerful voice urging a middle ground, a way to preserve economic

liberty without the government taking over the whole economy and

destroying the foundations of Western civilization.

It was the voice of John Maynard Keynes, leader of the new

Cambridge school. In his revolutionary 1936 book, The General

Theory of Employment, Interest and Money, Keynes preached that

capitalism is inherently unstable and has no natural tendency toward

full employment. Yet, at the same time, he rejected the need to na136

tionalize the economy, impose price-wage controls, and interfere

with the microfoundations of supply and demand. All that was

needed was for government to take control of a wayward capitalist

steering wheel and get the car back on the road to prosperity. How?

Not by slashing prices and wages—the classical approach—but

by deliberately running federal deficits and spending money on

public works that would expand “aggregate demand” and restore

confidence. Once the economy got back on track and reached full

employment, the government would no longer need to run deficits,

and the classical model would function properly. As Keynes himself

wrote, “But beyond this no obvious case is made out for a system

of State Socialism which would embrace most of the economic life

of the community” (Keynes 1973a [1936], 378). His message was

really quite simple, yet revolutionary: “Mass unemployment had a

single cause, inadequate demand, and an easy solution, expansionary

fiscal policy” (Krugman 2006).

Keynes’s model of aggregate demand management changed the

dismal science to the optimists’ club: man could be the master of

his economic destiny after all. His claim that government could expand

or contract aggregate demand as conditions required seemed

to eliminate the cycle inherent in capitalism without eliminating

capitalism itself. Meanwhile, a laissez-faire policy of economic

freedom could be pursued on a microeconomic level. In short,

Keynes’s middle-of-the-road policies were viewed not as a threat

to free enterprise, but as its savior. In fact, Keynesianism brought

its chief rival theory, Marxism, to a total halt in advanced countries

(Galbraith 1975 [1965], 132).

“Like a Flash of Light on a Dark Night”

The Keynesian revolution took place almost overnight, especially

among the youngest and the brightest, who switched allegiance from

the Austrians to Keynes. John Kenneth Galbraith wrote of the times,

“Here was a remedy for the despair. . . . It did not overthrow the

system but saved it. To the non-revolutionary, it seemed too good to

be true. To the occasional revolutionary, it was. The old economics

was still taught by day. But in the evening, and almost every evening

from 1936 on, almost everyone discussed Keynes” (Galbraith 1975

 [1965], 136). Milton Friedman, who later became a vociferous opponent

of Keynesian theory, said, “By contrast with this dismal picture

[the Austrian laissez-faire prescription], the news seeping out of

Cambridge (England) about Keynes’s interpretation of the depression

and of the right policy to cure it must have come like a flash of light

on a dark night. It offered a far less hopeless diagnosis of the disease.

More importantly, it offered a more immediate, less painful, and more

effective cure in the form of budget deficits. It is easy to see how a

young, vigorous, and generous mind would have been attracted to

it” (1974, 163).

The Keynesian model of aggregate demand management swept the

profession even faster than the marginalist revolution, especially after

World War II seemed to vindicate the benefits of deficit spending and

massive government spending. It wasn’t long before college professors,

under the tutorage of Alvin Hansen, Paul Samuelson, Lawrence

Klein, and other Keynesian disciples, began teaching students about

the consumption function, the multiplier, the marginal propensity to

consume, the paradox of thrift, aggregate demand, and C + I + G. It

was a strange, new, exciting doctrine. And it was the beginning of a

whole new area of study called “macroeconomics.”2

The Dark Side of Keynes

Keynes may have offered a plausible cure for the depression, but

his theoretical heresies also created a postwar environment favorable

toward ubiquitous state interventionism, the welfare state, and

boundless faith in big government. His theories encouraged excess

consumption, debt financing, and progressive taxation over saving,

balanced budgets, and low taxes. Critics saw Keynesian economics

as a direct assault on traditional economic values and the most serious

threat to the principles of economic freedom since Marxism.

To them, Keynes’s General Theory “constitutes the most subtle and

mischievous assault on orthodox capitalism and free enterprise that

has appeared in the English language” (Hazlitt 1977 [1960], 345). As

Paul Krugman notes, “If your doctrine says that free markets, left to

their own devices, produce the best of all possible worlds, and that

government intervention in the economy always makes things worse,

Keynes is your enemy” (Krugman 2006).

Despite occasional pronouncements that Keynes is dead, Keynesian

thinking is still so pervasive in academia, the halls of parliament,

and Wall Street, that Time magazine aptly voted Keynes the most

influential economist of the twentieth century. Biographer Charles

Hession writes, “More books and articles have been written about

him than any other economist, with the possible exception of Karl

Marx” (1984, xiv). Appropriately, The New Palgrave gives Keynes its

longest biography—twenty pages, as compared to fifteen for Marx.

And Keynes’s latest biographer, Robert Skidelsky, places Keynes

on a pedestal: “Keynes was a magical figure, and it is fitting that he

should have left a magical work. There has never been an economist

like him” (1992, 537).

Keynes Born Amid Britain’s Ruling Elite

What kind of man was Keynes, who could engender such devotion

and such hostility?

John Maynard Keynes (1883–1946) was an intellectual elitist

from his earliest childhood. When asked once how to pronounce his

name, he replied, “Keynes, as in brains.” Born in 1883 (the year Marx

died) in the center of Britain’s most cerebral environment, he was the

son of John Neville Keynes, an economics professor at Cambridge

University and a friend of Alfred Marshall. Neville would actually

outlive his son, Maynard, by three years, dying in 1949 at age ninetyseven.

His mother, Florence Ada Keynes, also distinguished herself

as Cambridge’s first woman mayor. Keynes was always close to his

mother, while his father was distant. His father wrote in his diary in

1891, when Maynard was only eight years old, “The only person he

would like to be is his mother; at any rate, he would desire to resemble

her in everything” (in Hession 1984, 11).

Keynes went to Britain’s best private school, Eton, and then attended,

as expected, Cambridge University, where he obtained a

degree in mathematics in 1905. He would later write a controversial

book on probability theory.

His friends considered him precocious, clever, and sometimes

rude. His most distinguishing features were his “riotous eyes” and

“leaping mind” (Skidelsky 1992, xxxi). Keynes viewed himself

as “physically repulsive.” Nevertheless, he was selected as one of

only a dozen members of the Apostles, an exclusive secret society

at Cambridge (not unlike the Skull and Bones at Yale). Membership

is for life. Other noteworthy members have included the poet

Alfred Lord Tennyson, biographer Lytton Strachey, and philosophers

Bertrand Russell, G.E. Moore, and Alfred North Whitehead. The

Apostles were a close-knit group, meeting every Saturday night to

discuss papers.

The Truth About Keynes’s Homosexuality

At the turn of the twentieth century, the Apostles, under the influence

of G.E. Moore, developed a deep contempt for Victorian morality

and bourgeois values. They even propounded the subversive idea

that homosexuality was morally superior. Keynes was a practicing

homosexual during his early adult life, although he apparently

abandoned it upon marrying Lydia Lopokova in 1925. This fact was

covered up by his official biographer, Roy Harrod, for fear it would

destroy Keynes’s reputation. In his introduction, Harrod explained,

“In regard to his faults, I am not conscious of any suppression [of

facts]. Criticisms have been made by the malicious or ill-informed

which have no foundation in fact” (Harrod 1951, viii). Yet there

was suppression. More recent histories by Robert Skidelsky (2003),

D.E. Moggridge (1992), and Charles Hession (1984) spare few details

of Keynes’s sexual adventures. Moggridge even goes so far as

to print Keynes’s sexual engagement diary in an appendix (1992,

838–39).

Keynes’s sexual proclivities may have been influenced by his

family life (overprotective mother, weak father); the Eton school, an

all-male institution where Greek philosophy taught that platonic love

between men is spiritually higher than the carnal love between man

and woman; and the collegiate ideas of G.E. Moore, who preached

a disregard for morals and universal rules of conduct. Keynes firmly

believed in living the “good life,” without concern for right or wrong.

“[It] is too late to change. I remain, and will always remain, an immoralist,”

he wrote (Hession 1984, 46).

Was Keynes a misogynist? Keynes’s predilection for men may

have affected his attitudes toward women in his early years. Like

Marshall, he disliked the presence of female students in his classes.

In 1909, while teaching at Cambridge, he wrote, “I think I shall have

to give up teaching females after this year. The nervous irritation

caused by two hours’ contact with them is intense. I seem to hate

every movement of their minds. The minds of the men, even when

they are stupid and ugly, never appear to me so repellent” (Moggridge

1992, 183–34).

But Keynes shocked his homosexual friends in Bloomsbury

when he announced his engagement and subsequent marriage to

Lydia Lopokova, a Russian ballerina, in 1925. Based on private

letters between Maynard and Lydia, their marriage was far from

platonic. “Sexual relations certainly developed,” biographer Robert

Skidelsky writes (1992, 110–11; 2003, 300, 356–60). Keynes

also developed friendships with women in the 1930s, including

Joan Robinson.

But we are getting ahead of our story. After graduation, Keynes

entered the British Civil Service, spending two years in the India office

(although never visiting India). In 1909 he became a teaching fellow

at Cambridge, and from 1911 to 1944 he served as the general editor

of Cambridge’s Economic Journal. He was not trained in economics,

having taken only a single course from Alfred Marshall, but quickly

acquired the skills to teach it.

Keynes Writes a Best-Seller

In 1919, following World War I, Keynes served as a senior Treasury

official in the British delegation to the Versailles Peace Conference.

Distressed by the proceedings, he resigned and wrote The Economic

Consequences of the Peace (1920). It became a best-seller and propelled

Keynes into fame and fortune.

Many critics consider it Keynes’s best book. Writing in trenchant

prose, he revealed peculiar personal characteristics of the Allied

leaders.3 Keynes condemned the Allies for imposing impractical and

unrealistic reparations on the Germans. The defeated nations were

required to pay the complete Allied costs of the war, including pay,

pensions, and death benefits of troops—up to $5 billion “whether

in gold, commodities, ships, securities or otherwise,” before May 1,

1921. “The existence of the great war debts is a menace to financial

stability everywhere,” warned Keynes (1920, 279). A pessimistic

Keynes predicted negative consequences in Europe. He implied

that Germany would have no recourse but to inflate her way out. In

a famous passage, Keynes noted, “Lenin was certainly right. There

is no subtler, no surer means of overturning the existing basis of

society than to debauch the currency. The process engages all the

hidden forces of economic law on the side of destruction, and does

it in a manner which not one man in a million is able to diagnose”

(1920, 236).4

Keynes Makes Another Brilliant Prediction in 1925

Keynes followed this success with another insightful analysis in 1925

when Britain, under Chancellor of the Exchequer Winston Churchill,

returned to the gold standard at the overvalued prewar fixed exchange

rate of $4.86. Keynes campaigned against this deflationary measure.

In his booklet The Economic Consequences of Mr. Churchill, the Cambridge

professor warned that deflation would force Britain to reduce

real wages and retard economic growth (Keynes 1951 [1931], 244–70).

Once again, Keynes proved prescient; Britain suffered from an economic

malaise that only worsened as the Great Depression approached.

Unfortunately, Keynes’s gift of prophecy disappeared in the late

1920s. In his Tract on Monetary Reform (which Milton Friedman rates as

Keynes’s greatest work), he joined the monetarist Irving Fisher in rejecting

the gold standard, and later hailed the stabilizing influence of the U.S.

dollar between 1923 and 1928 as a “triumph” of the Federal Reserve.

“We Will Not Have Any More Crashes in Our Time”

Like Fisher, Keynes was a New Era advocate who was bullish on stocks

and commodities throughout the 1920s. In 1926, he met with Swiss

banker Felix Somary, anxious to buy stocks. When Somary expressed

pessimism about the future of the stock market, Keynes declared firmly,

“We will not have any more crashes in our time” (Somary 1986 [1960],

146–47). Somary had been trained in Austrian economics at the University

of Vienna and knew that the New Era boom was unsustainable.

But Keynes, like Irving Fisher, ignored the Austrians and pinned his

hopes on the Federal Reserve and price stabilization.

In late 1928, Keynes wrote two papers disputing that a “dangerous

inflation” was developing on Wall Street, concluding that there was

“nothing which can be called inflation yet in sight.” Referring to both real

estate and stock values in the United States, Keynes added, “I conclude

that it would be premature today to assert the existence of over-investment.

. . . I should be inclined, therefore, to predict that stocks would not slump

severely (i.e., below the recent low level) unless the market was discounting

a business depression.” Such would not be probable, he wrote, since

the Federal Reserve Board would “do all in its power to avoid a business

depression” (Keynes 1973b, 52–59; Hession 1984, 238–39).

KEYNES RESPONDS TO CAPITALISM’S GREATEST CHALLENGE 143

Making Money from His Bedroom

Keynes should not have been so confident. By the late 1920s, he

had developed a reputation for financial wizardry trading currencies,

commodities, and stocks. He was chairman of the National Mutual

Life Insurance Company and bursar of King’s College in Cambridge.

His personal account included a heavy commitment to commodities

and stocks. He held long positions in futures contracts in rubber,

corn, cotton, and tin, as well as several British automobile stocks.

Indeed, he was known for making trading decisions while still in

bed. Reports Hession, “Some of this financial decision-making was

carried out while he was still in bed in the morning; reports would

come to him by phone from his brokers, and he would read the newspapers

and make his decisions” (Hession 1984, 175).

Keynes Is Wiped Out by the Crash

Tragically, Keynes misread the times and failed to anticipate the crash.

His portfolio was almost wiped out: he lost three-quarters of his net

worth, primarily due to commodity losses (Moggridge 1983, 15–17;

Skidelsky 1992, 338–43). In his Treatise on Money, published in 1930,

he admitted that he had been misled by stable price indices in the

1920s, and that a “profit inflation” had developed (1930, 190–98).

However, Keynes, a stubborn investor, held onto his stocks and added

substantially to his portfolio starting in 1932. Although he was incapable

of getting out at the top, he had an uncanny ability to acquire stocks at

the bottom of the market (Skousen 1992, 161–69). He bought securities

that were clearly out of favor, such as utilities and gold stocks, and

was so sure of his strategy that he bought heavily on margin. In 1944,

he wrote a fellow money manager, “My central principle of investment

is to go contrary to general opinion, on the ground that, if everyone

is agreed about its merits, the investment is inevitably too dear and

therefore unattractive” (Moggridge 1983, 111).

Keynes Still Manages to Die Spectacularly Rich

Keynes was so spectacularly successful in choosing stocks that his

net worth reached £411,000 by the time he died in 1946. Given that

his portfolio was worth only £16,315 in 1920, that’s a 13 percent

compounded annual return, far superior to what most professional

money managers achieve and an amazing feat during an era when

there was little or no inflation and, in fact, much deflation. And

this extraordinary return was achieved despite fantastic setbacks in

1929–32 and 1937–38. Only David Ricardo had a superior record as

a financial economist.

A Revolutionary Book Appears

Keynes’s failure to predict the crash and the Great Depression deeply

influenced his thinking. He was bitterly resentful of the speculators

who drove prices down to ridiculously low levels and nearly put

him in the poorhouse. He had long before rejected laissez-faire as a

general organizing principle in society, but the 1929–33 crisis only

strengthened his rejection of conventional classical economics. In

BBC radio addresses, he lashed out at hoarders, speculators, and gold

bugs, while urging deficit spending, inflation, and abandonment of

the gold standard as solutions to the slump. He criticized Friedrich

Hayek and the London School of Economics for believing that the

economy was self-adjusting and for urging wage reductions and balanced

budgets as solutions to the depression.

All the while, at his home in Cambridge, Keynes was working on

a book creating a new model of economics, with the help of Richard

Kahn, Joan Robinson, and the Cambridge Circus that developed

around him. On New Year’s Day 1935, Keynes wrote playwright

George Bernard Shaw, “I believe myself to be writing a book on

economic theory, which will largely revolutionise—not, I suppose, at

once but in the course of the next ten years—the way the world thinks

about economic problems” (Skidelsky 2003, 518). It was an arrogant

prognostication, but one that proved to be right.

As already mentioned, The General Theory of Employment, Interest

and Money first appeared in 1936.5 Like other economists,

Keynes identified with the great scientists of the past. Adam Smith

and Roger Babson compared their analytical systems to those of

Sir Isaac Newton, and Keynes emulated Albert Einstein. Keynes’s

book title refers to Einstein’s general theory of relativity. His book,

he said, created a “general” theory of economic behavior while he

relegated the classical model to a “special” case and treated classical

economists as “Euclidean geometers in a non-Euclidean world”

(Skidelsky 1992, 487).

Like Marx, Keynes had high hopes that his magnum opus would be

read by students and the general public and convinced Macmillan to

price the 400-page treatise at only five shillings. But this was wishful

thinking. The General Theory turned out to be Keynes’s only unreadable

book, full of technical jargon and incomprehensible language.

Ricardo and Marx had their book of headaches and so did Keynes. The

following simple Q and A will demonstrate a few of the difficulties

found in The General Theory. (Thanks to Roger Garrison, economics

professor at Auburn University, for providing this bit of satire.)

Keynes’s Book of Headaches

Q: Please, Professor Keynes, what do you mean by “involuntary

unemployment”?

A: “My definition is . . . as follows: Men are involuntarily unemployed

if, in the event of a small rise in the price of wage-goods relative

to the money-wage, both the aggregate supply of labour willing to

work for the current money-wage and the aggregate demand for it at

that wage would be greater than the existing volume of employment”

(1973a [1936], 15).

Q: Humm . . . sounds very enlightening, Professor Keynes. Now tell

us, please, what governs private investment in a market economy?

A: “Our conclusions can be stated in the most general form . . . as

follows: No further increase in the rate of investment is possible when

the greatest amongst the own-rates of own-interest of all available

assets is equal to the greatest amongst the marginal efficiencies of all

assets, measured in terms of the asset whose own-rate of own-interest

is greatest” (236).

Q: Yes, I see. . . . One last question, Professor Keynes. Doesn’t

monetary expansion trigger an artificial boom?

A: “[A]t this point we are in deep water. The wild duck has dived

down to the bottom—as deep as she can get—and bitten fast hold

of the weed and tangle and all the rubbish that is down there, and it

would need an extraordinarily clever dog to dive down and fish her

up again” (183).

Even Paul Samuelson, a devote Keynesian, declared, “It is a badly

written book, poorly organized; any layman who, beguiled by the

author’s previous reputation, bought the book was cheated of his

five shillings. It is not well suited for classroom use. It is arrogant,

bad-tempered, polemical, and not overly generous in its acknowledgements.

It abounds in mares’ nests or confusions. . . . Flashes

of insight and intuition intersperse tedious algebra. An awkward

definition suddenly gives way to an unforgettable cadenza. When

finally mastered, its analysis is found to be obvious and at the same

time new. In short, it is a work of genius” (Samuelson 1947 [1946],

148–89).6

And Paul Krugman writes that “although The General Theory

is still worth reading and rereading,” he admits that he “labored

through” parts of it, and finds it helpful to describe the book as “a

meal that begins with a delectable appetizer and ends with a delightful

dessert, but whose main course consists of rather tough meat”

(Krugman 2006).

The General Theory is still in print, but only because of the elucidating

work of Keynes’s disciples, especially Alvin Hansen and Paul

Samuelson, who deciphered Keynes’s convoluted jargon, translated

it into plain English, and transformed the profession.

Keynes at War

Keynes was fifty-two when he completed The General Theory, his

final major work. He was at the height of his powers. Keynes was

never a bookish scholar and recluse like his Cambridge colleagues

Arthur Pigou or Dennis Robertson. He was a man of worldly affairs

who loved the limelight and the social life, enjoyed the company of

writers and artists, and was a devotee of cards, roulette, and speculations

on Lombard Street and Wall Street. His magnetic personality

attracted the highest leaders of government, who sought his counsel.

He was a master of the written word and an entertaining speaker who

regularly appeared on BBC radio.

After suffering a heart attack in 1937, Keynes had to slow down.

He and his wife became active in promoting the arts and establishing

the Arts Theatre in Cambridge. In 1940, when the war with Germany

broke out, Keynes returned to the Treasury as an advisor and wrote

an influential booklet, How to Pay for the War. He recommended

restrictions on consumption and investment, and a forced savings

program as a way to reduce demand and inflation.

In May 1942, Keynes’s name was submitted to the king, nominating

him to become Baron Keynes of Tilton, and in July he took his seat in

the House of Lords. On his sixtieth birthday, Keynes was made High

Steward of Cambridge, an honorary post. He thrived on the adulation

and elitist status.

Near the end of the war, Keynes and his wife traveled to the United

States to help negotiate a new international financial agreement. Keynes

was one of the architects of the Bretton Woods agreement, which established

a fixed exchange rate system based on gold and the dollar and

created the International Monetary Fund (IMF) and the World Bank.

Two years later, he died of a heart attack at the age of sixty-two.

Keynes’s Disdain for Karl Marx and Marxism

Let us now turn to Keynes’s approach to economics. It should be

noted at the outset that Keynes had serious reservations about the

economics of both Adam Smith and Karl Marx. The most influential

economist of the twentieth century, Keynes was an interventionist

and a supporter of Britain’s Labour Party. Like Marx, he was no

friend of laissez-faire. He argued that capitalism was inherently

unstable and required government intervention. But that was as far

as it went. Keynes couldn’t stand Karl Marx or the communist experiment,

which he regarded as “an insult to our intelligence” (Mog

gridge 1992, 470; Skidelsky 1992, 519; 2003, 514–18). Following

a trip to Russia in 1925, Keynes wrote three articles for the Nation,

debunking the Soviet “religion” as “unscrupulous,” “ruthless,” and

“contrary to human nature.” There was none of that naïve “I’ve seen

the future” optimism for Keynes. Individual freedom and a liberal

open society meant too much to him. “For me, brought up in a free

air undarkened by the horrors of religion, with nothing to be afraid

of, Red Russia holds too much which is detestable.” He added, “How

can I adopt a creed which, preferring the mud to the fish, exalts the

boorish proletariat above the bourgeois and the intelligentsia who,

with whatever faults, are the quality in life and surely carry the

seeds of all human achievement? . . . We have everything to lose by

the methods of violent change. In Western industrial conditions the

tactics of Red Revolution would throw the whole population into a

pit of poverty and death” (1951 [1931], 306). He lambasted Marx’s

magnum opus, Capital, as “an obsolete economic textbook” that

was “scientifically erroneous” and “without interest or application

for the modern world” (298–300).

In the middle of the Great Depression, the best and the brightest

intellectuals embraced Marxism, but not Keynes. At a dinner among

friends in 1934, Keynes said that, of all the “isms,” Marxism was “the

worst of all & founded on a silly mistake of old Mr Ricardo’s [labor

theory of value]” (Skidelsky 2003, 515). In a letter to playwright

George Bernard Shaw, Keynes labeled Das Kapital “dreary, outof-

date, academic controversialising.” He compared it to the Koran.

“How could either of these books carry fire and sword round half the

world? It beats me.” In a second letter to Shaw dated January 1, 1935,

Keynes complained of Marx’s “vile manner of writing” (Skidelsky

1992, 520; 2003, 517).7

Keynes’s Critique of Adam Smith and His Invisible

Hand Doctrine

Keynes has been lauded as the savior of capitalism, but his model

and policy recommendations were in many ways a direct repudiation

and assault on Adam Smith’s laissez-faire system. In the New

Era twenties he wrote, “It is not true that individuals possess a

prescriptive ‘natural liberty’ in their economic activities. . . . Nor

is it true that self-interest generally is enlightened. . . . Experience

does not show that individuals, when they make up a social unit, are

always less clear-sighted than when they act separately” (Keynes

1951 [1931], 312). This speech, appropriately titled, “The End of

Laissez-Faire,” was given in 1926, a full decade before The General

Theory was written. It was a clear attack on Adam Smith’s system

of natural liberty.

In the early 1930s, Keynes became increasingly disillusioned

with capitalism, both morally and aesthetically. The ideas of Sigmund

Freud were fashionable at the time, and Keynes adopted the

Freudian thesis that moneymaking was a neurosis, “a somewhat

disgusting morbidity, one of the semi-criminal, semi-pathological

propensities which one hands over with a shudder to specialists in

mental disease” (1951 [1931], 369). Later, in 1933, he indicted the

capitalist system: “The decadent international but individualistic

capitalism, in the hands of which we found ourselves after the war,

is not a success. It is not intelligent, it is not beautiful, it is not just,

it is not virtuous—and it doesn’t deliver the goods. In short, we dislike

it and are beginning to despise it. But when we wonder what

to put in its place, we are perplexed” (Hession 1984, 258). This is

a far cry from Adam Smith!

Keynes, the Heretic, Turns Classical Economics

Upside Down

The General Theory did not aim to rebuild the classical model; it

aimed to replace it with elaborate unconventional concepts and a

new Weltanschauung. Until the 1930s, the economics profession had

largely sanctioned the basic premises of the classical model of Adam

Smith—the virtues of thrift, balanced budgets, free trade, low taxes,

the gold standard, and Say’s law. But Keynes turned the classical

model upside down.

Instead of Smith’s classical system being considered the general

or universal model, Keynes relegated it to a “special case,” applicable

only in times of full employment. His own general theory of “aggregate

effective demand” would apply during times of underemployed labor

and resources, which, under Keynesianism, could exist indefinitely.

Under such circumstances, Keynes offered the following principles:

1. An increase in savings can contract income and reduce

economic growth. Consumption is more important than

production in encouraging investment, thus reversing Say’s

law: “Demand creates its own supply” (1973a [1936],

18–21, 111).

2. The federal government’s budget should be kept deliberately

in a state of imbalance during a recession. Fiscal and monetary

policy should be highly expansionary until prosperity

is restored, and interest rates should be kept permanently low

(128–31, 322).

3. Government should abandon its laissez-faire policy and intervene

in the marketplace whenever necessary. According

to Keynes, in desperate times it may be necessary to return

to mercantilist policies, including protectionist measures

(333–71).

4. The gold standard is defective because its inelasticity renders it

incapable of responding to the expanding needs of business. A

managed fiat money is preferable (235–56; 1971, 140). Keynes

held a deep-seated disdain for the gold standard and was largely

successful in dethroning gold as a worldwide monetary numeraire.

What Did Keynes Really Mean by “In the Long Run We

Are All Dead”?

Keynes’s cavalier statement, “In the long run we are all dead,” is in

many ways a symbol of his turning his back on classical economics.

Many economists consider his remark an affront to Frédéric Bastiat’s

classical view (“What Is Seen and What Is Not Seen”) that economists

must take into account the long-run and not just the short-run effects

of government policies. For example, deficit spending may stimulate

certain sectors of the economy in the short run, but what will be the

impact in the long run? Tariffs may save some manufacturing jobs, but

what impact will this have on consumers? As Henry Hazlitt declares,

“The art of economics consists in looking not merely at the immediate

but at the longer effects of any act or policy; it consists in tracing the

consequences of that policy not merely for one group but for all groups”

(1979 [1946], 17). And Ludwig von Mises, another critic of Keynes,

concludes, “we have outlived the short-run and are suffering from the

long-run consequences of [Keynesian] policies” (1980 [1952], 7).

Keynes may have indeed used his dictum to support short-term policies

like deficit spending, but he also used it in other contexts.

Keynes Attacks Monetarism

The first time Keynes made the famous remark quoted above, he used

it to deride Irving Fisher’s extreme monetarism, which claimed that

monetary inflation has no ill effects in the long run but only raises

prices (see chapter 4). Keynes retorted, “Now ‘in the long run’ this

is probably true . . . but this long run is a misleading guide to current

affairs. In the long run we are all dead. Economists set themselves

too easy, too useless a task if in tempestuous seasons they can only

tell us that when the storm is long past the ocean is flat again” (1971,

65). No doubt Hazlitt and Mises would find much to agree with in

this statement.

Britain First!

Keynes also used his famous phrase in the context of British foreign

policy in wartime. In 1937, when Churchill advocated rearmament

and warned against appeasing Hitler, Keynes seemed to support

short-term peace initiatives: “It is our duty to prolong peace, hour

by hour, day by day, for as long as we can. . . . I have said in another

context that it is a disadvantage of ‘the long run’ that in the long

run we are all dead. But I could have said equally well that it is a

great advantage of ‘the short run’ that in the short run we are still

alive. Life and history are made up of short runs. If we are at peace

in the short run, that is something. The best we can do is put off

disaster” (Moggridge 1992, 611). Was Keynes advocating peace at

any price?

After Pearl Harbor was attacked in December 1941, Keynes reacted

with dismay to the British Foreign Office argument that free

trade with America would be beneficial to Britain “in the long run.”

Keynes blustered, “The theory that ‘to get our way in the long run’ we

must always yield in the short reminds me of the bombshell I threw

into economic theory by the reminder that ‘in the long run we are all

dead.’ If there was no one left to appease, the F.O. [Foreign Office]

would feel out of a job altogether” (Moggridge 1992, 666). This was

Keynes the mercantilist.

Keynes’s Long Term

Keynes was truly a social millennialist who ultimately envisioned

a world evolving to the point of infinite accumulation of capital.

His utopian vision is best expressed in his essay, “Economic Possibilities

for Our Grandchildren” (1951 [1931], 358–73). Keynes

believed that by progressively expanding credit to promote full employment,

the universal economic problem of scarcity would finally

be overcome. Interest rates would fall to zero and mankind would

reenter the Garden of Eden. In Keynes’s mind, the gold standard

severely limited credit expansion and preserved the status quo of

scarcity. Thus, gold’s inelasticity—which the classical economists

considered its primary virtue—stood in the way of Keynes’s paradise

and needed to be abandoned in favor of fiat-money inflation (1951

[1931], 360–73). The Bretton Woods agreement was the first step

toward removing gold from the world’s monetary system. Keynes

would undoubtedly be pleased to see gold playing such a moribund

role in international monetary affairs in the twenty-first century.

In short, Keynes’s goal was not to save Adam Smith’s house, as his

adherents contended, but to build another house entirely—the house

that Keynes built. It was his belief that economists would live and

work most of the time in Keynes’s house, while using Smith’s house

occasionally, perhaps as a vacation home.

Is Capitalism Inherently Unstable?

Keynes rejected the classical notion that the capitalist system is

self-adjusting over the long run. The General Theory was written

specifically to create a model based on the view that the market

system is inherently and inescapably flawed. According to Keynes,

capitalism was unstable and therefore could become stuck indefinitely

at varying degrees of “unemployed equilibrium,” depending on

the level of uncertainty in a fragile financial system. Keynes wanted

to show that the economy could remain “in a chronic condition of

sub-normal activity for a considerable period without any marked

tendency either toward recovery or toward complete collapse” (1973a

[1936], 249, 30). Paul Samuelson correctly understood the meaning

of Keynes: “With respect to the level of total purchasing power and

employment, Keynes denies that there is an invisible hand channeling

the self-centered action of each individual to the social optimum”

(Samuelson 1947, 151).

Keynes explained what he meant by “unemployment equilibrium,”

but used no diagram to illustrate it. In a masterful article, “Mr. Keynes

and the Classics,” British economist John Hicks developed a graphic

framework (known as the IS-LM diagram) to demonstrate Keynes’s

version of full-employment equilibrium (the special classical theory)

versus unemployment equilibrium (the general theory) (Hicks 1937).

Today’s textbooks use a similar diagram to demonstrate aggregate supply

(AS) and aggregate demand (AD).

In Figure 5.1 we see how the economy is depressed at less than

full employment. According to Keynes’s model, the classical model

only applies when the economy reaches full employment (Qf), while

the Keynesian general theory applies at any point along the AS curve

where it intersects with the AD curve.

Who’s to Blame? Irrational Investors!

Keynes blamed the instability of capitalism on the bad behavior

of investors. The General Theory creates a macroeconomic model

based essentially on a financial instability hypothesis. As Keynesian

economist Hyman P. Minsky declares, “The essential aspect

of Keynes’s General Theory is a deep analysis of how financial

forces—which we can characterize as Wall Street—interact with

production and consumption to determine output, employment, and

prices” (1986, 100). Allan H. Meltzer at Carnegie Mellon University

offers a similar interpretation, that Keynes’s theory of employment

and output was not so much related to rigid wages and prices as to

expectations and uncertainty in the investment and capital markets

(Meltzer 1988 [1968]).8

Numerous passages in The General Theory support this view.

Keynes complained of the irrational short-term “animal spirits” of

speculators who dump stocks in favor of liquidity during such crises.

Such “waves of irrational psychology” could do much damage to

long-term expectations, he said. “Of the maxims of orthodox finance

none, surely, is more anti-social than the fetish of liquidity, the doctrine

that it is a positive virtue on the part of investment institutions to

concentrate resources upon the holding of ‘liquid’ securities” (1973a

[1936], 155). According to Keynes, the stock market is not simply

an efficient way to raise capital and advance living standards, but can

be likened to a casino or a game of chance. “For it is, so to speak, a

game of Snap, of Old Maid, of Musical Chairs—a pastime in which

he is victor who says Snap neither too soon nor too late, who passes

the Old Maid to his neighbor before the game is over, who secures a

chair for himself when the music stops” (1973a [1936], 155–56).

Keynes was speaking from experience. He reasoned that the

1929–33 crisis destroyed his portfolio without any rational economic

cause—the panic was due to Wall Street’s irrational demand for cash,

what he termed “liquidity preference” and a “fetish of liquidity”

(1973a [1936], 155).

The Culprit: Uninvested Savings

If Keynes were Sherlock Homes, the economist-investigator would

point an accusing finger at Miss Thrifty in his murder mystery,

“The Case of the Missing Savings.” In Keynes’s model, the key

factor causing an indefinite slump is the de-linking of savings and

investment. If savings failed to be invested, total spending in the

economy would fall to a point below full employment. If savings

were hoarded or left in excessive reserves in the banks, as was the

case in the 1930s, the fetish for liquidity would make national investment

and output fall. Thus, thrift no longer served as a dependable

social function.

In The General Theory, Keynes argued that as income and wealth

accumulate under capitalism, the threat grows that savings will not

be invested. He introduced a “psychological law” that the “marginal

propensity to save” increases with income (1973a [1936], 31, 97).

That is, as individuals earn more income and become wealthier, they

tend to save a greater percentage of their income. Thus, there is a

strong tendency for savings to rise disproportionately as national

income increases. But wouldn’t a growing capitalist economy always

be under pressure to invest those increased savings? Keynes

responded, “Maybe, maybe not.” If savings are not invested, the

boom will turn into a bust.

Actually, this criticism of uninvested saving is an old saw with

Keynes. He acknowledged the necessity of thrift and self-denial during

the nineteenth century in a delightful passage of The Economic

Consequences of the Peace (1920, 18–22), stating that thrift “made

possible those vast accumulations of fixed wealth and of capital improvement

which distinguished that age from all others” (19). But

in A Treatise on Money (1930), the Cambridge economist raised the

likely possibility that saving and investment could grow apart, creating

a business cycle. In a modern society, saving and investing are done

by two separate groups. Saving is a “negative act of refraining from

spending,” while investment is a “positive act of starting or maintaining

some process of production” (1930, 155). The interest rate is not

an “automatic mechanism” that brings the two together—they can

“get out of gear” (1951 [1931], 393) and savings can be “abortive.”

If investment exceeds savings, a boom occurs; if savings exceeds

investment, a slump happens.9

During the depression of the 1930s, Keynes lashed out at frugal

savers and hoarders who kept down “effective demand.” The conventional

wisdom in bad times has always been to cut costs, get out

of debt, build a strong cash position, and wait for a recovery. Keynes

was opposed to this “old-fashioned” approach, and he was joined by

other economists, including British Treasury official Ralph Hawtrey

and Harvard’s Frank Taussig, in encouraging consumers to spend. In a

radio broadcast in January 1931, Keynes asserted that thriftiness could

cause a “vicious circle” of poverty, that if “you save five shillings, you

put a man out of work for a day.” He encouraged British housewives

to go on a buying spree and government to go on a building binge.

He urged, “Why not pull down the whole of South London from

Westminster to Greenwich, and make a good job of it. . . . Would that

employ men? Why, of course it would!” (1951 [1931], 151–54).

Keynes’s bias against thrift reached its zenith in The General Theory,

where he referred to traditional views on savings as “absurd.” He boldly

wrote, “The more virtuous we are, the more determined by thrift, the

more obstinately orthodox in our national and personal finance, the

more our incomes will fall” (1973a [1936], 111, 211). Keynes praised

the heterodox notions of underworld figures and monetary cranks, such

as Bernard de Mandeville, J.A. Hobson, and Silvio Gessell, who held

underconsumptionist views (333–71). He was undoubtedly influenced

by the popularity of Major Douglas of the social credit movement and

underconsumptionists Foster and Catchings during the 1920s.

An Antisaving Tradition

Keynes was not the first to question the virtue of thrift. Over the years,

a small group of radical thinkers, known generally as underconsumptionists,

have dissented from the traditional endorsement of thrift.

They include Simonde de Sismondi, Karl Rodbertus, J.A. Hobson,

and Karl Marx. Keynes expressed sympathy toward the “heretical”

views of Major C.H. Douglas, an engineer who began the social credit

movement in Canada in the 1920s and wrote several books championing

“economic democracy” (1973a [1936], 370–71). Believing that

saving created a permanent deficiency in a nation’s purchasing power,

Major Douglas advocated strict below-market price controls so that

consumers could afford to buy the products they produced.

William T. Foster, past president of Reed College, and Waddill

Catchings, an iron manufacturer and partner in the investment firm of

Goldman Sachs, proposed a different scheme. Foster and Catchings

wrote a series of books on a similar antisaving theme. “[E]very dollar

which is saved and invested, instead of spent, causes one dollar of

deficiency in consumer buying unless that deficiency is made up in

some way” (Foster and Catchings 1927, 48). What way? Foster and

Catchings advocated that the government issue new money credits to

consumers to make up for consumer buying deficiency.

158 THE BIG THREE IN ECONOMICS

To generate interest in their theory and proposal, in 1927 they offered

a prize of $5,000 to anyone who could refute them. They published the

best essays a few months later, but the best critique was written by the

Austrian economist Friedrich A. Hayek in 1929. His essay, “The ‘Paradox’

of Saving,” was translated and published in Economica in May 1931.

According to Hayek, the Foster-and-Catchings dilemma depended on

a single erroneous assumption. They assumed a “single-stage” model,

so that investment depends entirely and immediately on consumer

demand. Under such a restrictive assumption, “there would be no inducement

[for consumers] . . . to save money . . . [or] . . . to invest their

savings,” noted Hayek (1939 [1929], 224, 247). With a capital-using,

time-oriented period of production, Hayek demonstrated that increased

savings lengthens the capitalistic process, increases productivity, and

thereby enlarges profits, wages, and income sufficiently for consumers

to buy the final product.10

Keynes Focuses on Spending as the Key Ingredient

In Keynes’s mind, saving is an unreliable form of spending. It is only

“effective” if savings are invested by business. Thus, savings that are

hoarded under a mattress or piled up in a bank vault are a drain on

the economy and aggregate demand.

Only “effective demand”—a powerful new term introduced in

chapter 3 of The General Theory—counts. What consumers and businesses

spend determines national output. Keynes defined effective

demand as aggregate output (Y), which is the sum of consumption

(C) and investment (I). Hence,

Y = C + I

Today we refer to Y, or “aggregate effective demand,” as gross domestic

product (GDP). GDP is defined as the value of final output of goods and

services during the year. Simon Kuznets, a Keynesian statistician, developed

national income accounting in the early 1940s as a way to measure

Keynes’s aggregate effective demand. Keynes effectively demonstrated

that if savings are not invested by business, GDP does not reach its potential;

recession or depression indicates a lack of effective demand.

Demand Creates Its Own Supply

What was Keynes’s solution to recession? Increase effective demand!

If demand is stimulated through additional spending, more goods have

to be produced and the economy should recover. In this sense, Keynes

turned Say’s law upside down. Demand creates supply, not the other

way around.

To increase Y (national output), the choices are limited in a recession.

During a downturn, the business community might be afraid

to risk its capital on I (investment). Equally, consumers might be

unwilling to increase consumption (C) due to the uncertainty of their

incomes. Both investors and consumers are more likely to pull in their

horns when left to their own devices.

Adding G to the Equation

There is only one way out, wrote Keynes. Get government to start

spending. Keynes added G (government) to the national income

equation, so that

Y = C + I + G

Keynes saw government (G) as an independent agent capable of

stimulating the economy through the printing presses and public

works. An expansionary government policy could raise “effective

demand” if resources were underutilized, and it could do so without

hurting consumption or investment. In fact, during a recession, a rise

in G would encourage both C and I and thereby boost Y.

Digging Holes in the Ground: Keynes Endorses an

Activist Fiscal Policy

Keynes overturned the classical solution to a slump, which had

been to “tighten one’s belt” by cutting prices, wages, and wasteful

spending while waiting out the slump. Instead, during a recession,

he recommended deliberate deficit spending by the federal government

to jump-start the economy. He endorsed an even more radical

approach during a deep depression like that of the 1930s: government

spending could be totally wasteful and it would still help.

“Pyramid-building, earthquakes, even wars may serve to increase

wealth,” he proclaimed (1973a [1936], 129). Of course, “It would,

indeed, be more sensible to build houses and the like,” but productive

building was not essential. According to Keynes, spending is

spending, no matter what the objective, and it has the same beneficial

effect—increasing aggregate demand.

Keynes Favors Public Works over Monetary Inflation

Keynes felt that tinkering with fiscal policy (changes in spending and

taxes) was more effective than monetary policy (changes in the money

supply and interest rates). He had lost faith in monetary policy and

the Federal Reserve in the 1930s, when interest rates were so low that

reducing them wouldn’t have made much difference (see Figure 5.2).

Inducing the Federal Reserve to expand the money supply would not

be very effective either, because banks refused to lend excess reserves

anyway. Keynes called this a “liquidity trap.” The new money would just

pile up unspent and uninvested because of “liquidity preference,” the

desire to hold cash during a severe depression (1973a [1936], 207).

How the Multiplier Generates Full Employment

Public works would serve several benefits. First, public works are

positive spending, putting people to work and money into business’s

pockets. Moreover, they have a multiplier effect, based on the nation’s

marginal propensity to consume.

The multiplier, a concept introduced by Richard Kahn, was a powerful

new tool in the Keynesian tool box, demonstrating that a “small increment

of investment will lead to full employment” (Keynes 1973a [1936], 118).

Suppose in a recession that the government hires construction workers

and suppliers to construct a new federal building costing $100 million.

These previously unemployed workers are now getting paid. In the first

round of spending, $100 million is added to the economy.

Now suppose that the public’s marginal propensity to consume is 90

percent, that is, these workers spend 90 cents of every new dollar earned.

(Another way of saying it: their marginal propensity to save is 10 percent.)

In the second round of spending, $90 million is added to the economy.

Then there is a third round. After the workers spend their new

money, that $90 million becomes the revenues of other businesses—

shopping malls, gas stations, supermarkets, car dealerships, and movie

theaters. These business may in turn hire new workers to handle the

new demand, paying them more wages, too, and these workers also

spend 90 percent of that income. They receive an additional $81 million

(90 percent of $90 million) of spending power. Ultimately, the

public investment has a multiplier effect that generates round after

round of gradually declining spending. By the time the new spending

has run its course, the aggregate spending has increased tenfold.

Keynes’s formula for the multiplier (k) is,

1

k = __________

1 – MPC

where MPC = marginal propensity to consume.

Figure 5.2 The General Theory Was Written When Interest Rates Were at

Their All-Time Lows

Since MPC = .90 in the example above, k = 10. As Keynes stated,

“the multiplier k is 10; and the total employment caused by . . .

increased public works will be ten times the primary employment

provided by the public works themselves, assuming no reduction of

investment in other directions” (1973a [1936], 116–17).

Keynes Makes a Mischievous Assumption

Note that in the Keynesian model, only consumption spending generates

additional income and employment in the economy. Keynes assumes

that saving is sterile, that it aborts into cash hoarding or excess

bank reserves. Thus, the Keynesian model as originally proposed is

considered a “depression” model. As we shall see in the next chapter,

this was a crucial mistake that led to much mischief and misunderstanding

in economics in the postwar era.

Keynes Offers a Drastic Measure to Stabilize Capitalism

The Cambridge leader was not satisfied with temporary measures such

as public works and deficit spending to reestablish full employment.

Once maximum output was reached, he reasoned, there is no reason to

believe it will stay there. Investment is unpredictable and ephemeral,

Keynes said. Long-term expectations, a stable business climate, and

savings equal to investment could never be guaranteed as long as irrational

“animal spirits” operated in a laissez-faire financial marketplace.

What was Keynes’s solution? He favored a gradual but comprehensive

“socialisation of investment” as the “only means of securing an approximation

to full employment” (1973a, 378). This was by no means

“state socialism,” but it could mean government ownership of the entire

capital market. Keynes also sanctioned a small “transfer tax” on all

securities sales as a way to dampen speculative fever.11

6

A Turning Point in

Twentieth-Century Economics

Keynsesian economics is . . . the most serious blow that the

authority of orthodox economics has yet suffered.

—W.H. Hutt (1979, 12)

Two factors created the right atmosphere for the Keynesian revolution

to sweep the economics profession after World War II. First, the depth

and length of the Great Depression seemed to justify the Keynesian-

Marxian view that market capitalism was inherently unstable and that

the market could be stuck at unemployed equilibrium indefinitely.

Economic historians noted that the only governments that appeared to

make headway in eliminating unemployment in the 1930s were totalitarian

regimes in Germany, Italy, and the Soviet Union. Curiously, Keynes

himself acknowledged in the introduction to the German edition of The

General Theory, that his theory “is much more easily adapted to the

conditions of a totalitarian state, than is the theory of the production and

distribution of a given output produced under conditions of free competition

and a large measure of laissez-faire” (1973a [1936], xxvi).

Second, World War II came along right after the publication of The

General Theory, giving strong empirical evidence of Keynes’s policy

prescription. Government spending and deficit financing increased

dramatically during World War II, unemployment disappeared, and

economic output soared. War was “good” for the economy, just as

Keynes suggested (1973a [1936], 129). As historian Robert M. Collins

wrote, “World War II set the stage for the triumph of Keynesianism

by providing striking evidence of the effectiveness of government

expenditures on a huge scale” (1981, 12). The following quote from

a popular textbook repeated what other textbooks were saying in the

postwar period: “Once the massive, war-geared expenditure of the

1940s began, income responded sharply and unemployment evapo164

rated. Government expenditures on goods and services, which had

been running at under 15 percent of GNP during the 1930s, jumped

to 46 percent by 1944, while unemployment reached the incredible

low of 1.2 percent of the civilian labor force” (Lipsey, Steiner, and

Purvis 1987, 573).

Paul Samuelson Raises the Keynesian Cross

As noted earlier, Keynes died in 1946, right after the war. It would

be left to his disciples to lead the charge and create a “new economics.”

Fortunately for Keynes, a young wunderkind was ready to fill

his shoes. His name was Paul Samuelson, and he would write a

textbook that would dominate the profession for more than an entire

generation.

The year was 1948, one of those watershed years that occasionally

crops up in economics. Remember 1776, 1848, and 1871? In early

1948, the Austrian émigré Ludwig von Mises, secluded in his New

York apartment, was typing a short article, “Stones into Bread, the

Keynesian Miracle,” for a conservative publication, Plain Talk. “What

is going on today in the United States,” he declared solemnly, “is the

final failure of Keynesianism. There is no doubt that the American

public is moving away from the Keynesian notions and slogans. Their

prestige is dwindling” (Mises 1980 [1952], 62).

Perhaps it was wishful thinking, but Mises could not have misread

the times more egregiously in 1948. It was in that very year that the

new economics of John Maynard Keynes was being hailed by Keynes’s

rapidly growing number of disciples as the wave of the future and

the savior of capitalism. Literally hundreds of articles and dozens

of books had been published about Keynes and the new Keynesian

model since Keynes wrote The General Theory of Employment, Interest

and Money.

The Other Cambridge

The year 1948 was also when Seymour E. Harris, chairman of the

economics department at Harvard, produced an edited volume entitled

Saving American Capitalism. This was a sequel to his 1947 edited

work, The New Economics. Both best-sellers were filled with laudaA

tory articles by prominent economists preaching the new economics

of Keynes.

Darwin had one bulldog to propagate his revolutionary theory,

but Keynes had three in the United States—Seymour Harris, Alvin

Hansen, and Paul A. Samuelson. They all came from the “other Cambridge”—

Cambridge, Massachusetts. Both Harris and Hansen were

conservative Harvard teachers who had converted to Keynesianism

and devoted their energies to convincing students and colleagues of

the efficacy of this strange new doctrine.

The American advancement of Keynesian economics represented a

subtle but clear shift from Europe to the New World. Before the war,

London and Cambridge in the United Kingdom shaped the economic

world. After the war, the magnets for the best and the brightest graduate

students were Boston, Chicago, and Berkeley. Students came from

all over the world to do their work in the United States, and not just

in economics.

The Year of the Textbook

Finally, 1948 was the year in which an exciting new breakthrough

textbook came forth from Harvard’s neighboring university, the Massachusetts

Institute of Technology (MIT). Written by the “brash whippersnapper

go-getter” Paul Samuelson (his own words!), Economics

was destined to become the most successful textbook ever published

in any field. Sixteen editions have sold more than 4 million copies

and have been translated into over forty languages. No other textbook,

including those of Jean-Baptiste Say, John Stuart Mill, and Alfred Marshall,

can compare. Samuelson’s Economics survived a half-century of

dramatic changes in the world economy and the economics profession:

peace and war, boom and bust, inflation and deflation, Republicans

and Democrats, and an array of new economic theories.

Samuelson’s textbook was popular not so much because it was

well written, but because it elucidated and simplified the basics of

Keynesian macroeconomics through the deft use of simple algebra

and clear graphs. It took the profession by storm, selling hundreds

of thousands of copies every year. Samuelson updated the textbook

every three years or so, a practice that every textbook publisher now

imitates. Economics sold over 440,000 copies at the height of its

popularity in 1964. Even a conservative institution such as Brigham

Young University, my alma mater, used the Samuelson textbook.

The Acme of Professional Success

Samuelson is known for more than just popularizing Keynesian economics.

He is considered the father of modern macroeconomic theorizing.

He has made innumerable contributions to pure mathematical

economics, for which he has been both honored and blamed—honored

for making economics a pure logical science, and blamed for carrying

the Ricardian vice and Walrasian equilibrium analysis to an extreme,

devoid of any empirical work. (See chapters 2 and 4.)

For his popular and scientific works, the academic community

has awarded Samuelson virtually every honor it confers. He was the

first American to win the Nobel Prize in economics, in 1970. He was

awarded the first John Bates Clark Medal for the brightest economist

under forty, and beyond economics, he received the Albert Einstein

Medal in 1971. There’s even an annual award named after him, the

Paul A. Samuelson Award, given for published works in finance. His

articles have appeared in all the major (and many minor) journals. He

was elected president of the American Economic Association (AEA),

has received innumerable honorary degrees from various universities,

and has been the subject of many Festschrifts, gatherings at which

scholars honor a fellow colleague with essays about his work.

“The Young, Brash Wunderkind”

Paul A. Samuelson was born in Gary, Indiana, in 1915 to Jewish parents,

and moved to Chicago, where he received his B.A. in 1935—at

the tender age of twenty—from the University of Chicago. Chicago

in the 1930s, as it is today, was the citadel of laissez-faire economic

thought. In those days, it was run by Frank Knight, Jacob Viner, and

Henry Simons, among others. Paul’s first class in economics was

taught by Aaron Director, who was perhaps the most libertarian among

the faculty and who later became Milton Friedman’s brother-in-law.

Both Friedman and George Stigler were graduate students at the

time. Director’s laissez-faire philosophy failed to take in the youthful

reformist Samuelson, who enjoyed being an intellectual heretic in a

conservative institution and who was influenced by a father known as

a “moderate socialist.” Moreover, during the depression, most of the

leaders of the Chicago school advocated deficit spending and other

government activist policies as temporary measures. Samuelson did

inherit one concept from Chicago that he carried with him until he

encountered Keynes—monetarism. He called himself a “jackass” for

having been taken in (Samuelson 1968, 1).

Alvin Hansen Switches Sides to Become the

“American Keynes”

After Chicago, Samuelson immediately went to Harvard, where he

witnessed an amazing transition. His teacher, Alvin Hansen (1887–

1975), a long-standing classical economist, converted to Keynesianism.

Most older economists at first rejected Keynes’s heretical ideas,

including Hansen, who was at the University of Minnesota. Only

Marriner Eccles, the exceptional Utah banker who became head of the

Federal Reserve, and Lauchlin Currie, an economic aide to Roosevelt,

were prominent Keynesian advocates.

Then, in the fall of 1937, Hansen transferred to Harvard and suddenly—

at the age of fifty—recognized the revolutionary nature of

Keynes. He would become an outspoken exponent—the “American

Keynes.” His fiscal policy seminar attracted many enthusiastic students,

including Samuelson, and convinced many colleagues, including

Seymour Harris. Keynes had to be translated into plain English and

easy-to-understand graphs and math, and Hansen was the principal

interpreter, from Fiscal Policy and Business Cycles (1941) to A Guide

to Keynes (1953). Hansen also campaigned for the Employment Act

of 1946. According to Mark Blaug, “Alvin Hansen did more than

any other economist to bring the Keynesian Revolution to America”

(Blaug 1985, 79).

“Stagnation Thesis” Discredits Hansen and Almost

Destroys Samuelson’s Reputation

However, Hansen fell into a trap. He logically extended Keynes’s

unemployment equilibrium theory into a “secular stagnation thesis.”

(Keynes himself believed that conditions of the 1930s could persist

indefinitely.) In his presidential address before the AEA in 1937,

Hansen boldly announced that the United States was stuck in a “mature

economy” rut from which it could not escape, due to its lack of

technological innovations, the American frontier, and the population

growth rate. His stagnation thesis was vigorously attacked by George

Terborgh in his book The Bogey of Economic Maturity (1945) and then

soundly disproved by a vibrant recovery after World War II. The stigma

of this unfulfilled prediction haunted Hansen throughout his life.

Paul Samuelson, under the Hansen stagnation spell, almost suffered

the same fate. In 1943, he wrote an article warning that unless the

government acted vigorously after the end of the war, “there would

be ushered in the greatest period of unemployment and industrial

dislocation which any economy has ever faced.” In a two-part article

in published in The New Republic in the autumn of 1944, Samuelson

predicted a replay of the 1930s depression (Sobel 1980, 101–02).

Although he, along with most Keynesians, was proved inaccurate

about the postwar period, Samuelson gradually began expressing

strong optimism about the U.S. economy in successive editions of

his textbook. “Our mixed economy—wars aside—has a great future

before it” (1964, 809).

Samuelson found it an exciting time to be an economist: “To have

been born as an economist before 1936 was a boon—yes. But not to

have been born too long before!” (in Harris 1947, 145). He applied

the following familiar lines from William Wordsworth’s The Prelude

(Book 11, lines 108-9, previously quoted in chapter 2):

Bliss was it in that dawn to be alive,

But to be young was very Heaven!

Samuelson completed his dissertation in 1941, and it won the David

A. Wells Award that year. (It was published in 1947 as Foundations

of Economic Analysis.) In this work, Samuelson broke with Alfred

Marshall by contending that mathematics, not literary expression,

should be the primary exposition of economics.

But after graduation Samuelson discovered that heaven was not so

sweet. He declared his preference to teach at Harvard, but his youthful

exuberance, arrogant personality, and Jewish background all worked

against him. His cocky attitude had long irritated his chairman, Harold

Hitchings Burbank, and the department offered him only an instructorship.

Determined to stay in Cambridge, he accepted a position at the

relatively unheralded department of economics at the Massachusetts

Institute of Technology.

Harvard soon came to regret its mistake. By 1947, Samuelson had

been awarded the first John Bates Clark Medal for being the brightest

young economist, his school had granted him a full professorship,

and MIT had been ranked as one of the best economics departments

in the country. And Samuelson was only thirty-two! A year later he

would drop the bomb that would be the envy of every economics

department: the first edition of Economics, Samuelson’s new testament

of macroeconomics. Harvard professor Otto Eckstein remarked,

“Harvard lost the most outstanding economist of the generation”

(Sobel 1980, 101).

How Samuelson Came to Write His Famous Textbook:

“A Singular Opportunity”

In the early postwar period, Harvard students studied economics

from outdated textbooks that said nothing about the war and little

about the new economics of Keynes. “Students at Harvard and

MIT often had that glassy-eyed look,” commented Samuelson. His

department head asked him to write a new text. Three years later,

after toiling through nights and summers (“my tennis suffered”),

Economics was born.

Attacked from Both Sides

The first edition, published by McGraw-Hill, sold over 120,000 copies

through 1950 and just kept selling. But it soon came under attack

from the business community, on the one hand, which complained

of its socialistic tendencies, and the Marxists, on the other hand,

who complained of its capitalistic tendencies. William F. Buckley,

Jr., protested in God and Man at Yale (1951) that Samuelson’s textbook

was antibusiness and progovernment. An organization called

the Veritas Foundation published Keynes at Harvard and identified

Keynesianism with Fabian socialism, Marxism, and fascism. On

the other side, Marxists took umbrage at Samuelson’s assertion that

Marx’s predictions about the capitalist system were “dead wrong.”

A massive two-volume critique, Anti-Samuelson (1977), was published

to counter Samuelson and introduce Marxism to students.

Samuelson was pleased to hear that in Stalin’s day, Economics was

kept on a special reserve shelf in the library, along with books on

sex, forbidden to all but specially licensed readers. “Actually,” responded

Samuelson, “when your cheek is smacked from the Right,

the pain may be assuaged in part by a slap from the Left” (1998,

xxvi). Meanwhile, Samuelson offered a seemingly balanced brand of

economics that found mainstream support. While he favored heavy

involvement in “stabilizing” the economy as a whole, he appeared

relatively laissez-faire in the micro sphere, supporting free trade,

competition, and free markets in agriculture.

The High Tide of Keynesian Economics

The success of Keynesian economics and Samuelson’s textbook

reached its zenith in the early 1960s. The MIT professor became

president of the AEA in 1961, the year John F. Kennedy was inaugurated

president. Samuelson, along with Walter Heller and other top

Keynesians, was a close advisor to Kennedy and helped steer through

Congress the Kennedy tax cut of 1964, a Keynesian program designed

to stimulate economic growth through deliberate deficit financing. It

appeared to work, as the economy flourished through the mid-1960s.

By that time, Samuelson’s textbook reigned atop the profession, selling

more than a quarter of a million copies a year. And a year after

the Nobel Prize in economics was established in 1969 by the Bank

of Sweden, the prize went to Paul A. Samuelson.

Samuelson’s textbook has been on the decline since the turbulent

and inflationary 1970s, and today—a half-century after the first

edition—it no longer tops the list in popularity. However, the new

front-runners (especially Campbell McConnell’s textbook, which has

been among the top sellers for years) are mostly considered clones

of Samuelson. Since 1985, new editions of Economics have been

coauthored by Yale professor William D. Nordhaus, and Samuelson’s

hair has turned from blond to brown to gray in his sunset years. Yet

“his memory dazzles even when it fails,” writes an admirer (Elzinga

1992, 878).

Samuelson’s Goal: To Raise the Keynesian Cross Atop a

New House of Economics

What was Paul Samuelson trying to achieve? There is no real

Samuelson school of economics; he considers himself “the last

generalist in economics.” (But what about Kenneth Boulding?)

The MIT professor’s intention was, first and foremost, to introduce

Keynesianism to the classroom: the multiplier, the propensity to

consume, the paradox of thrift, countercyclical fiscal policy, national

income accounting, and C + I + G were all new topics introduced in

the first edition of Economics in 1948. Only John Maynard Keynes

was honored with a biographical sketch in early editions, and only

Keynes, not Adam Smith or Karl Marx, was labeled “a many-sided

genius” (Samuelson 1948, 253).

The “Keynesian cross” income-expenditure diagram, invented by

Samuelson and reproduced in Figure 6.1, was printed on the cover of

the first three editions. The Keynesian cross incorporates all the elements

of the new “general” theory. In the diagram in Figure 6.1, note

that saving (S) increases with national income (NI). As people earn

more, they save more. However, investment (I) is autonomous and

independent of saving. It is set at a fixed amount because, according

to Keynes’s theory, investment is fickle and varies with the “animal

spirits” and expectations of investors and businessmen. So the investment

schedule is set at any level, unrelated to income. Equilibrium

(M) is set at the point where S = I, which you will note falls short

of full-employment income (F). Thus, the Keynesian cross reflects

underemployment equilibrium.

This static equilibrium model represents Samuelson’s (and

Keynes’s) view that capitalism is inherently unstable and can be

stuck indefinitely at less than full employment (M). No “automatic

mechanism” guarantees full employment in the capitalist economy

(Samuelson and Nordhaus 1985, 139). Samuelson compared capitalism

to a car without a steering wheel; it frequently runs off the road

and crashes: “The private economy is not unlike a machine without

an effective steering wheel or governor,” he wrote. “Compensatory

fiscal policy tries to introduce such a governor or thermostatic

control device” (Samuelson 1948, 412). Krugman compares the

market economy to a system that needs a “new alternator” (Krugman

2006).

How the Multiplier Works Magic

How does compensatory fiscal policy work? There are two ways for

the economy to grow and reach full employment under Keynesian

theory: Shift investment schedule I upward, or shift saving schedule

S to the right.

First, let’s look at investment. Schedule I can be shifted upward by

restoring business confidence, primarily through increased government

spending or tax cuts. Both techniques have a multiplier effect—either

a $100 billion spending program or a tax cut can create $400 billion

in new income.

But Samuelson noted that under the Keynesian system, government

spending has a higher multiplier than a tax cut. Why? Because

100 percent of a federal program is spent, while only a portion of a

tax cut is spent—some of it is saved. Samuelson called his discovery

the “balanced budget multiplier.” Thus, a new federal spending

program is preferred over a tax cut by Keynesians because the expenditure

side is considered a more potent weapon against recession

than a tax cut.

The Paradox of Thrift Denies Adam Smith

The second way out of a recession is to increase the public’s propensity

to consume, which would shift saving schedule S to the right.

Note that in the Keynesian model, if the public decides to save

more during an economic downturn, it only makes matters worse.

Consumers buy less, producers lay off workers, and households end up

saving less. An increased supply of savings cannot lower interest rates

and encourage investment under the crude Keynesian model because

interest rates are assumed to be constant. In the Figure 6.1 diagram,

more savings means that the saving schedule S shifts backward to the

left, and has no effect on raising the I schedule.

Samuelson called this phenomenon the “paradox of thrift” (see

Figure 6.2)—an increase in desired thrift results in less total savings!

“Under conditions of unemployment, the attempt to save may result

in less, not more, saving,” he declared (1948, 271). Keynes, of course,

said practically the same thing, only more eloquently: “The more

virtuous we are, the more determinedly thrifty, the more obstinately

orthodox in our national and personal finance, the more our incomes

will have to fall” (Keynes 1973a [1936], 111).

+

_

400

300

200

100

–100

0

I

E´ E

100

I

GNP

Q*

Q*

3,500 1,000

300

3,000

S´

S´

S

S

Saving and Investment Diagram Shows How

Thriftiness Can Kill Off Income

Gross National Product (billions of dollars)

Note: Q* = Full employment output or GNP.

Saving and Investment

Figure 6.2 Samuelson’s “Paradox of Thrift”

Source: Samuelson and Nordhaus (1989: 184). Reprinted by permission of

McGraw-Hill.

Samuelson delighted in this attack on the orthodoxy of Adam

Smith and Benjamin Franklin. Smith found thrift a universal virtue,

writing that “What is prudence in the conduct of every private

family, can scarce be folly in that of a great kingdom” (1965

[1776], 424). Franklin counseled every child, “A penny saved is a

penny earned.” But Samuelson labeled this thinking a “fallacy of

composition.” “What is good for each person separately need not

be good for all,” he countered. Moreover, Franklin’s “old virtues

[of thrift] may be modern sins” (1948, 270). As one modern-day

textbook put it, “While savings may pave the road to riches for an

individual, if the nation as a whole decides to save more, the result

could be a recession and poverty for all” (Baumol and Blinder

1988, 192).

The Keynesians readily endorsed savings as a virtue during periods

of full employment, but Samuelson was convinced it seldom

happened. “[F]ull employment and inflationary conditions have occurred

only occasionally in our recent history,” he wrote. “Much of

the time there is some wastage of resources, some unemployment,

some insufficiency of demand, investment, and purchasing power”

(1948, 271). This paragraph remained virtually the same throughout

the first eleven editions of his textbook.1

Savings as Leakage

Echoing Keynes, Samuelson declared war on uninvested savings,

which could “leak” out of the system and “become a social vice”

(1948, 253). He produced a diagram (see Figure 6.3) separating

savings from investment. The diagram shows savings leaking out of

the system, unconnected to the investment hydraulic handle above.

(This diagram led observers to call the model “hydraulic Keynesianism,”

with the emphasis on priming the pump through government

spending.)

Is Consumption More Important Than Saving?

The Keynesian model leads to the odd conclusion that consumption is

more productive than saving. As noted above in the Keynesian cross

model, an increase in the “propensity to consume” (a lower saving rate)

leads to full employment. Keynes applauded “all sorts of policies for

increasing the propensity to consume,” including confiscatory inheritance

taxes and the redistribution of wealth in favor of lower-income

groups, who consume a higher percentage of their income than the

wealthy (1973a [1936], 325). Canadian economist Lorie Tarshis, the

first to write a Keynesian textbook, warned that a high rate of saving

is “one of the main sources of our difficulty,” and one of the goals

of the federal government should be “reducing incentives to thrift”

(Tarshis 1947, 521–12).

Keynesian economist Hyman Minsky confirmed this unorthodox

approach when he said, “The policy emphasis should shift from the

encouragement of growth through investment to the achievement of full

employment through consumption production” (Minsky 1982, 113). Of

course, all of this Keynesian theory goes counter to traditional classical

growth theory that a high level of saving is a key ingredient to economic

growth.

BUSINESS PUBLIC

Consumption

$ Saving

$

Wages,

Interest, etc.

Investment

Tech.

Change,

etc.

A

Z

Figure 6.3 Saving Leaks Out of the System While the Hydraulic

Investment Press Pumps Up the Economy

Source: Samuelson (1948: 264). Reprinted by permission of McGraw-Hill.

Is Keynesianism Politically Neutral?

Samuelson contended that the Keynesian “theory of income determination”

is politically “neutral.” For example, “it can be used as

well to defend private enterprise as to limit it, as well to attack as to

defend government fiscal interventions” (1948, 253). But the evidence

disputes this claim.

For instance, the balanced-budget multiplier (which Samuelson

considers one of his proudest “scientific discoveries”) favors government

spending programs over tax cuts as a countercyclical policy.

According to Samuelson, progressive taxation (imposing higher tax

rates on the wealthy) has a “favorable” redistributionist effect on the

economy: “To the extent that dollars are taken from frugal wealthy

people rather than from poor ready spenders, progressive taxes tend

to keep purchasing power and jobs at a high level” (1948, 174).

Samuelson also endorsed Social Security taxes, farm aid, unemployment

compensation, and the rest of the welfare state as “built-in

stabilizers” in the economy. The index of Samuelson’s textbook

consistently lists “market failures” (including imperfect competition,

externalities, inequalities of wealth, monopoly power, and public

goods) but not “government failures.” His bias is overwhelmingly

evident.

Apologist for the National Debt

In early editions, Samuelson denied that the national debt was a burden.

The first edition favors the “we owe it to ourselves” argument:

“The interest on an internal debt is paid by Americans to Americans;

there is no direct loss of goods and services” (1948, 427). In the seventh

edition (1967a), after raising the specter of “crowding out” of

private investment, Samuelson went on to say: “On the other hand,

incurring debt when there is no other feasible way to move the C +

I + G equilibrium intersection up toward full employment actually

represents a negative burden on the intermediate future to the degree

that it induces more current capital formation than would otherwise

take place!” (1967a, 346). At the end of an appendix on the national

debt, Samuelson compared federal debt financing to private debt

financing, such as AT&T’s “never-ending” growth in debt (1967a,

358). By implication, he suggested that government debt could also

grow continually, rather than necessarily being balanced over the

business cycle.2

In sum, Keynesian economics as presented by Samuelson became

an apology for big-government capitalism in the postwar period. “A

laissez-faire economy cannot guarantee that there will be exactly the

required amount of investment to insure full employment” (1967a,

197–78). Only a powerful state can.

Critics Begin a Long Battle Against Keynesian Economics

Samuelson claimed in his first edition that the Keynesian system

was “increasingly accepted by economists of all schools of thought”

(1948, 253). Judging from the popularity of Samuelson’s textbook, he

was right. In the 1950s and 1960s, scholars in the major economics

departments spent their entire careers doing empirical studies on the

consumption function, the multiplier, national income statistics, and

other Keynesian aggregates. Keynesian macroeconomics also became

popular among journalists, because it was easy to understand (increasing

consumer spending is “good for the economy”), and among

politicians, because deficit spending bought votes. Robert Solow,

Samuelson’s colleague at MIT and a Nobel laureate, summarized

the new orthodoxy when he proclaimed with considerable pride that

“short-term macroeconomic theory is pretty well in hand. . . . All that

is left is the trivial job of filling in the empty boxes” (1965, 146).

The Pigou Effect: The First Assault

But over time critics have chipped away at the Keynesian structure.

The first objection was the “liquidity trap” doctrine, Keynes’s fear

that the economy could be trapped indefinitely in a deep depression

where interest rates are so low and “liquidity preference” so high that

reducing interest rates further would have no effect (Keynes 1973a

 [1936], 207). The man who first countered the liquidity-trap doctrine

was Arthur C. Pigou, ironically the straw man Keynes vilified in The

General Theory. In a series of articles in the 1940s, Pigou said that

Keynes overlooked a beneficial side effect of a deflation in prices and

wages: deflation increases the real value of cash, Treasury securities,

cash-value insurance policies, and other liquid assets of individuals

and business firms. The increased value of these liquid assets raises

aggregate demand and provides the funds to generate new buying

power and hire new workers when the economy bottoms out (Pigou

1943, 1947). This positive real wealth effect, or what Israeli economist

Don Patinkin later named the “real balance effect” in his influential

Money, Interest and Prices (1956), did much to undermine the Keynesian

doctrine of a liquidity trap and unemployed equilibrium.

The Pigou “wealth” or “real balance” effect can also be extended

to the issue of wage cuts during a downturn. Keynes rejected the classical

argument that wage cuts are necessary to adjust the economy to

new equilibrium conditions, from which a solid recovery could occur.

Arguing against the conventional view that persistent unemployment

is caused by excessive wage rates, Keynes claimed that wage

cuts would simply depress demand further and do nothing to reduce

unemployment. But Keynes and his followers confused wage rates

with total payroll. Facing a recession and widespread unemployment,

business leaders recognize that a reduction in wage rates can actually

boost net employment and total payroll. Cutting wages allows firms

to hire more workers at the bottom of a slump. When the economy

bottoms out, well-managed companies begin hiring more workers at

low wages, so that even though the wage rate remains low, the total

payroll increases, and thus puts the economy back on the road to

recovery (Hazlitt 1959, 267–69; Rothbard 1983 [1963], 46–48).

Growth Data Contradict Antithrift Doctrine

Economic historians had serious doubts almost immediately about the

Keynesian antipathy toward saving, which has always been considered

a key ingredient to long-term economic growth. They point especially

to European and Asian countries, such as Germany, Switzerland, Japan,

and Southeast Asia, whose growth rates have benefited tremendously

from high rates of saving during the postwar period. Nobel laureate

Franco Modigliani, as well as top textbook writer Campbell McConnell,

both Keynesians, have recognized the direct relationship between saving

rates and economic growth. For example, the graph in Figure 6.4 was

included in Franco Modigliani’s Nobel Prize paper in 1986.

Historically, the evidence is overwhelming: higher saving rates lead

to higher growth rates–just the opposite of the standard Keynesian

prediction. As one recent Keynesian textbook declared after teaching

students about the paradox of thrift: “The fact that governments do

not discourage saving suggests that the paradox of thrift generally is

not a real-world problem” (Boyes and Melvin 1999, 265).

But then why teach the paradox of thrift at all? Not only is it historically

unproved, but it is fundamentally flawed. The problem is that

Keynesians treat savings as if it disappears from the economy, that

it is simply hoarded or left languishing in bank vaults, uninvested.

In reality, saving is simply another form of spending, not on current

consumption, but on future consumption. The Keynesians stress only

the negative side of saving, the sacrifice of current consumption, while

ignoring the positive side, the investment in productive enterprise.

As noted in chapter 4, the Austrian economist Eugen Böhm-Bawerk

stressed the positive side of saving: “For an economically advanced

nation does not engage in hoarding, but invests its savings. It buys

securities, it deposits its money at interest in savings banks or commercial

banks, puts it out on loan, etc.” (1959 [1884], 113).

Saving Has a Multiplier, Too!

Saving is in fact a better form of spending because it offers a potentially

infinite payoff in future productivity (thus Franklin’s refrain, “A

penny saved is a penny earned”). If the public saves more generally,

the pool of savings enlarges, interest rates decline, old equipment is

replaced, and more research and development, new technology, and

new production processes evolve. The future benefits are incalculable.

Meanwhile, funds spent on pure consumer goods are used up within

a certain period, or depreciated over time.

The Keynesian multiplier (k) is higher as the public consumes more.

But proponents assume that the savings remain uninvested—a false

assumption under normal conditions. In truth, both components of

income—consumption and savings—are spent. Thus, the multiplier

(k) is infinite! The saving component also has a multiplier effect in

the economy as it is invested in the intermediate production stages.

Moreover, the savings k is theoretically more productive than the

consumption k because it is not used up as fast.

Going back to Samuelson’s hydraulic model (Figure 6.2), saving

does not leak out of the system, but goes back into the system to

improve the factors of production (land, labor, and capital) through

new technology, education, and training. Figure 6.5 demonstrates how

saving, consumption, and the economy really operate.

The Ekins diagram in Figure 6.5 is what Samuelson should have

published over the years in his textbook instead of the hydraulic model.

In this chart, the ultimate purpose of economic activity is to provide

increasing utility. Note how in the diagram, consumption is used up.

It is consumption—not saving—that “leaks” out and is consumed as

utility. Saving, on the other hand, is invested back into the economic

process over and over again, facilitating new investment and improving

our standard of living (utility/welfare). An amazing contrast.

A Critical Flaw in the Keynesian Model

The central problem with the Keynesian model is that it fails to

comprehend the true nature of the production-consumption process.

The Keynesian system assumes that the only thing that matters is

current demand for final consumer goods—the higher the consumer

demand, the better. Despite talk that Keynes is dead, this Keynesian

preoccupation with consumer demand is almost universally accepted

in the establishment media today. For example, Wall Street monitors

retail sales figures to determine the direction of the economy and

the markets. They seem to be disappointed if consumers don’t spend

enough—as if they want the Christmas season to last all year!

Yet is consumer spending the cause or the effect of prosperity? If

everyone went on a buying spree at the local department store or grocery

store, would investment in new products and technology expand?

Certainly investment in consumer goods would expand, but increased

expenditures for consumer goods would do little or nothing to construct

a bridge, build a hospital, pay for a research program to cure cancer, or

provide funds for a new invention or a new production process.

According to business-cycle analysts, retail sales and other measures

of current consumer spending are lagging indicators of economic activity.

Almost all of the components of the U.S. Commerce Department’s

Index of Leading Economic Indicators are production and investment

oriented, for example, contracts and orders for plant equipment, changes

in manufacturing and trade inventories, changes in raw material prices,

and the stock market, which represents long-term capital investment

(Skousen 1990, 307–12). Typically in a business cycle, consumption

starts declining after the recession has already started; similarly, consumer

spending picks up after the economy begins its recovery stage.

This myth of a consumer-driven economy persists in part because

of a misunderstanding of national income accounting. The media frequently

report that consumer spending accounts for two-thirds of GDP.

Recall that GDP = C + I + G, and typically in the United States:

C = 70 percent

I = 12 percent

G = 18 percent

Therefore, the media conclude that, since consumption accounts for approximately

two-thirds of GDP, the economy must be consumer-driven.

Not so. GDP is defined as the value of all final goods and services

produced in a year. It ignores all intermediate production in the

economy at the wholesale, manufacturing, and natural-resource stages.

If one measures spending at all levels of production, the results are

surprisingly different.

I have created a national income statistic called gross domestic

expenditures (GDE), which measures gross sales at all stages of production.

3 Using this new, broader definition of total spending in the

economy, it becomes apparent that consumption represents only about

one-third of economic activity, and that business spending (investment

plus goods-in-process spending) accounts for more than half of

the economy. Thus, business investment is far more important than

consumer spending in the United States (and in most other nations).

The Keynesian macroeconomic model suffers from the defect of

oversimplification—it assumes only two stages, consumption and investment,

and it assumes that investment is a direct function of current

consumption only. If current consumption increases, so will investment,

and vice versa.

How the Economy Really Works

William Foster and Waddill Catchings committed this same error.

As Hayek pointed out in his critique of the Foster-Catchings debate,

investment is actually multistaged and changes form and structure

when interest rates rise or fall. Investment is not simply a function of

current demand, but of future demand; both long-term and short-term

interest rates influence investment and capital formation (Hayek 1939

[1929]). For example, suppose the public decides to save more of their

income for a better future. Spending for cars, clothing, entertainment,

and other forms of current consumption might level off or even fall. But

this temporary slowdown in consumption does not cause a broad-based

recession. Instead, the increased savings leads to lower interest rates,

which encourage businesses, especially in capital-goods industries and

research and development, to expand operations. Lower interest rates

mean lower costs. Businesses can now afford to upgrade computers

and office equipment, construct new plants and buildings, and expand

inventories. Lower interest rates can even reverse the slowdown in car

sales by offering cheaper financing to prospective car buyers. Contrary

to the dire predictions of the Keynesians, an increase in the propensity

to save pays for itself. It does not lead to a “recession and poverty for

all” (Baumol and Blinder 1988, 192). Only the structure of production

and consumption changes, not the total amount of economic activity.

An Example: Building a Bridge

A hypothetical example could be useful in reinforcing the benefits of

increased savings. Suppose St. Paul and Minneapolis are separated

by a river and that the only transportation between the two cities is

by barge. Travel between the twin cities is expensive and time-consuming.

Finally, the city fathers call a meeting and decide to build

a bridge. Everyone agrees to cut back on current spending and put

their savings to work to build the bridge. In the short run, retail sales,

employment, and profits in local department stores decline. Yet new

workers and new investment funds are assigned to the building of the

bridge. In the aggregate, there is no reduction in output and employment.

Moreover, once the bridge is completed, the twin cities benefit

immensely from lower travel costs and increased competition between

St. Paul and Minneapolis. In the end, the twin cities’ sacrifice has been

transformed into a higher standard of living.

Say’s Law Redux: Production Is More Important

Than Consumption

In essence, the Keynesian demand-driven view of the economy

fails to recognize another force that is even stronger than current

demand—the demand for future consumption. Spending money on

current consumer goods and services will do nothing to change the

quality and variety of goods and services of the future. Such change

requires new savings and investment.

Thus, we return to the truism of Say’s law: Supply (production)

is more important than demand (consumption). Consumption is the

effect, not the cause, of prosperity. Production, saving, and capital

formation are the true cause.