The Central Fallacy of Keynesian Economics

0:00The central fallacy of Keynesian economics is that consumption is somehow superior and preferable to saving and investment. That the free decisions of individuals to divide their income into consumption and saving could somehow be bad for the collective of society. Keynesian economics views this antisocial decision to save too much as an invisible hand phenomenon, but an insidious one where optimal decisions by individuals become socially suboptimal. One thing Keynes fails to consider in the general theory is the implication of financial intermediation for his multiply. Keynesian economics is called on to justify bailout and stimulus spending and additional rounds of quantitative easing.

0:51As Christina Romer, former chair of the Council of Economic Advisors, has argued, theorists are getting in the way of the expansionary policy necessary for recovery because they want to fight inflation. But unlike empiricists, they are not looking at the real economy where CPI inflation is no higher than it was before the recession. So why worry? Empiricists who who are not necessarily tied to outmoded dogma, unless it's Keynesian dogma, can support continued expansionary policies. Anyone who's been buying groceries knows that the CPI has already lagged behind actual price increases. It's also biased downward because it uses a fixed pre-recession weighting for housing prices which have fallen.

1:39But that's not empirical proof. It's only an anecdote. Romer's own research shows that tax cuts have a multiplier of about three. Estimates of the multiplier for government purchases are much lower, often less than one. Every dollar of additional government stimulus makes the economy smaller, and empiricists apparently want us to make up the difference on volume. Theorists unhelpfully raise these irrelevant and objections grounded on that mysterious and arcane discipline of arithmetic. Oh wait, I'm sorry, I'm going too fast. Are Austrians theorists or empiricists?

2:24Are we saltwater economists or freshwater economists? Do we want to be grouped with anyone else? Probably not. These are not legitimate taxonomies but rhetorical devices intended to offer superficial explanatory Power, really the appearance of explanatory power to build the writer's credibility. It's akin to relating various disparate facts to a patently absurd conspiracy theory purporting to explain everything. Then the writer can sell the reader what they're going to sell them, at least for any reader who's still buying. The objective of economic policy is to restore the golden age of the great moderation.

3:09In the 30s, it was to bring back the roaring 20s, though without prohibition, or Republicans. To an Austrian, the Great Moderation was no justification for a multi-paradigm consensus because we were not one of those paradigms that was included, but it was an unsustainable period of inflationary expansion. Yes, the inflation rates were always lower than they had been during the 70s or during the 20s in Germany. Keep in mind that Bernie Madoff was able to keep his Ponzi scheme going for decades because his unrealistic returns were almost realistic enough to snow most observers, including all of his investors and the SEC.

3:57Charles Ponzi's scheme blew up in months because he promised a much higher return, and obviously unrealistic one. During the Great Moderation, the business cycle was obsolete. Nobel Prize winners like Lucas and Krugman were telling us so, just as Keynesian stabilization policy had made the business cycle obsolete in the 1960s.

4:24Here's the basic math of the Keynesian multiplier in somewhat more detail than Keynes provides in the general theory. The key point is that any permanent change in total aggregate income is the sum of successive changes in expenditure, which all result in income to somebody. Most of each increment in expenditure slash income is spent in the next round, and each successive round is always related to the preceding one by a fixed ratio, the marginal propensity to consume. And it's It's debatable whether this ratio is really fixed or if it varies significantly over the business cycle and with people's overall, Keynes would say animal spirits, but their overall optimism or pessimism.

5:10Assuming it's fixed, this enables us to derive a constant multiplier equal to one divided by the MPS. If we recognize, as Keynes failed to, that the portion of each round of expenditure that is saved is deposited and then most of that is loaned out to finance investment expenditure. We can see that each round of expenditure is actually related to the preceding one by the MPC plus the MPS times one minus the reserve requirement and that one minus the reserve requirement is not necessarily so much a regulatory feature but really just the bank intermediation Rate. This multiplier can be, or I'm sorry, this ratio can be rewritten as one minus the MPS times the reserve requirement and then the multiplier becomes one divided by the MPS times the reserve requirement. Because the reserve requirement is typically small, about 10% for the United States and as low as 3% in Europe and it appears in the denominator, this increases the multiplier far Contrast this with the conventional Keynesian view, which is that a high MPC means a high multiplier, and a high MPS is bad because then increasing government spending would be relatively ineffective. Horrors.

6:54This result should not be taken too literally because, like the money multiplier, it's an oversimplification and only gives an upper limit aggregate income and expenditure can approach. It does explain some empirical findings that the multiplier was fairly low even when, for the United States, the MPC was apparently very high. It had always been argued that the multiplier was, in reality, much higher than empirical examinations could confirm. Apparently, you know, it was okay to be a theorist in that context, but the multiplier operated with too much of a lag to be picked up in empirical studies. In particular, the permanent income hypothesis and the life cycle hypothesis were formulated to reconcile low observed values of the multiplier with high estimates of the MPC.

7:46These models of the consumption function turn out to be unnecessary, or at least less necessary, in light of financial intermediation. If we assume a full round of deposit expansion occurs between every round of additional aggregate expenditure, the ratio between each increment of spending and the succeeding one is then much greater, multiplying the second term in this ratio by the money multiplier. This makes the multiplier approach infinity. Income can be infinite, at least theoretically, even with a finite money supply, though to reach this upper limit, the velocity of money must also be infinite.

8:28Under 100% reserve banking, the multiplier reduces to its familiar form given by Keynes. This would probably not be too relevant in such a world, because conventional deposits would probably be partially superseded with innovative products, which were riskier but higher returning. Keynesian stimulus created the unsustainable boom which caused the recession in 2008 to 2010, and the one in 2001, and in 1992, and in 1982. Only private purchases are welfare maximizing because only free private decisions create Pareto improvements, that is, the only kind which Makes Somebody Better Off Without Making Anyone Else Worse Off.

9:20We can increase short-term output and employment through inflation and expansionary policy, but this leads to speculative bubbles, recession, higher unemployment, and longer-term unemployment. None of these are welfare-enhancing policy objectives. The Keynesian resurgence is in no way is merely a resurgence of Keynesian economics as an intellectual force. It is merely a resurgence of Keynesian economic policy. This policy is doubly, even triply discredited because it is precisely what has led to the financial crisis and the most recent recession. Thank you very much.