The flawed logic of Keynesian economics: Part I

The economic policies being pursued in the majority of G8 countries are flawed. That’s because they are based on the flawed thinking of John Maynard Keynes. This article aims to give some insight into the flawed logic that lies that the heart of what is known as Keynesian economics.

British economist John Maynard Keynes was one of the most influential economists of the 20th century, and his ideas still profoundly affect modern macroeconomic thought. The problem however, is that much of the Keynesian philosophy is fatally flawed.

The Keynesian multiplier

At the heart of Keynesian economics lies the Keynesian multiplier, a formula that triggers a wave of spending in an economy.

An example of the Keynesian multiplier at work:

Let’s assume that the government spends $100 million on the construction of a new hydroelectric dam. The $100 million creates income for the workers who must dig the foundations and pour the concrete. The workers save 10% of the money but spend the rest on iPads. The money spent on iPads creates $90 million of income for workers at Apple which must ramp up production to replenish its inventory. The Apple workers then go out and spend 90% of their incomes on takeaway meals, which puts $81 million into the hands of restaurant workers. This process carries on propagating throughout the economy, such that each dollar of government spending generates an additional 10 dollars of income. In doing so it increases employment, income and wealth in the economy.

It is because of his belief in this spending multiplier that Keynes argued that the best way to reduce unemployment was for the government to engage in massive spending programmes, even if the money they spent was wasted.

In a radio address in 1931 Keynes proposed a plan that involved bulldozing half of London and then rebuilding it in order to lift Britain out of its economic slump.

“I should like to see schemes of greatness and magnificence designed and carried through. For example, why not pull down the whole of South London from Westminster to Greenwich, and make a good job of it – housing on that convenient area near to their work a much greater population than at present, in far better buildings with all the conveniences of modern life, yet at the same time providing hundreds of acres of squares and avenues, parks and public spaces, having, when it was finished, something magnificent to the eye, yet useful and convenient to human life as a monument to our age. Would that employ men? Why, of course it would.”

Clearly this proposal would create a spike in economic activity, but it would create little or no lasting employment.

In 1936 Keynes published his book The General Theory of Employment, Interest and Money, which remains the bible of macroeconomics even today. In the book Keynes argues that any kind of spending, wasteful or otherwise, increases employment, income and wealth in the economy. “The above reasoning shows how ‘wasteful’ loan expenditure may nevertheless enrich the community on balance. Pyramid-building, earthquakes, even wars may serve to increase wealth.”

He noted that, “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again, there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

What the Keynesian prescription ignores is that governments must finance their spending either by issuing bonds, or through taxation. When the government opts to go into debt, it simply brings forward spending from the future such that it can reap the benefit today, but it does so at the expense of tomorrow since the money must be paid back with interest.

In addition, as the debt burden grows, it becomes a powerful incentive for the government to raise taxes or increase the money supply in order to inflate the debt away, and as the purchasing power of money is eroded, it becomes harder for workers to pay taxes or save.

Raising taxes simply takes wealth from the private sector and gives it to the government to spend. The problem is governments will always spend money less efficiently than private businesses. That’s because private businesses have the advantage of the profit and loss feedback mechanism. They know if they have the right number of call centre staff, or the right number of delivery drivers because the marketplace tells them via their profit and loss statement. Governments however, don’t have the benefit of this feedback mechanism, which means they must guess how many courthouses to build, or how many fire fighters to employ.

The fact is, the value of the money sucked out of the economy by state schemes is always greater than the money that seeps back in.

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