KEYNESIAN THEORY

From Keynes To Krugman

FUTURECASTS online magazine
www.futurecasts.com
Vol. 8, No. 1, 1/1/06.

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Keynes and Krugman:

 

 

 

 

 

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  As part of its Economic Basics Series, in the May, 2004 issue, FUTURECASTS  published two articles - about 70 pages - covering Keynes, "The General Theory of Employment, Interest, and Money." See, Keynes, "The General Theory" (I) (Keynesian theory) and Keynes, "The General Theory (II) (Keynesian theory, the business cycle, monetary policy, fiscal policy, international trade policy).
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  This is clearly too much material to be included here, but it is essential reading for understanding current economic events and prospects. FUTURECASTS  strongly encourages its readers to review this material.  See, also, Krugman, "Return of Depression Economics," for a critique of the concepts of a prominent modern Keynesian. Readers are strongly encouraged to review this material, also.
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  Segments from the two Keynes articles and the Krugman article - including the FUTURECASTS  comments explaining the blatant weaknesses in their concepts and gross inaccuracies in their supporting arguments - are provided herein as a supplement to its extensive coverage of Keynesian theory and related economic policies in the 2006 Futurecasts Annual Review.

Keynes, "The General Theory (I)" 
excerpts from Vol. 6, No. 5 (5/1/04)

Keynesian theory:


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Introduction to Parts I & II

  In the source of Keynesian theory, "The General Theory of Employment, Interest, and Money," John Maynard Keynes purports to provide a "general theory" for self-regulating capitalist market systems. He asserts that it is applicable generally in all economic circumstances. Classical concepts, on the other hand, operate only in those rare "special" circumstances where full employment is possible.
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With disconcerting frequency, Marxian stupidities were invoked with approval, although in only one instance explicitly crediting Marx.

  However, it is Keynesian theory that - if applicable at all - is applicable only in very narrow circumstances - like the "special" circumstances of the depths of the Great Depression where political leaders proved incapable of reforming the fundamental policy stupidities that prevented recovery.
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  Keynes nevertheless successfully convinced multitudes of supposedly knowledgeable economists to accept a series of black-is-white arguments. Savings became bad and deficits became good, and the prudent accumulation of reserves for foreseeable and unforeseeable contingencies was imprudently responsible for disastrous consequences. The accumulation of capital assets becomes an economic obstacle rather than an economic advantage. Investment and employment is stimulated by inflation and hindered by price declines. Market liquidity becomes more of a problem than an advantage.
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  Free trade has disadvantages and closed economic systems have advantages because of the greater ease of manipulating the latter. With disconcerting frequency, Marxian stupidities were invoked with approval, although in only one instance explicitly crediting Marx.
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  Although controversy over war debts and other international debts and trade war protectionism was raging around him, Keynes has not a word to offer about the obvious roles of such government policies in the business cycle in general and the Great Depression in particular. See Great Depression Chronology Series, beginning with "The Great Depression: The Crash of '29."
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Keynes provides a rationale for pursuing short term relief from economic problems by means of budgetary deficits and monetary inflation - palliatives that must  ultimately just make matters considerably worse.

  Over a century of capitalist economic history was thus ignored, as were all arguments to the contrary, until Keynesian theories were put to the test in the 1970s - and predictably failed miserably wherever pursued.
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  Nevertheless, Keynesian concepts are once again popular and in use today - especially in the United States under the Bush (II) administration. They remain very popular with political leaders, since they provide intellectual cover for doing what political leaders have always done when seeking to put off confronting the real problems that afflict an economy. Keynes provides a rationale for pursuing short term relief from those problems by means of budgetary deficits and monetary inflation - palliatives that must  ultimately just make matters considerably worse.
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The influence of Marx:

 

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  It is evident that Keynes rejected much of the worst of Marxian doctrine. - - -

  (He accepts competitive markets, exchange values, paper money, "profits" as traditionally defined, the stability of capitalism within its business cycle.)

  Moreover, Keynes avoids many of the weaknesses of logic that permeate Marx's work. See the series of articles beginning with Karl Marx, "Capital (Das Kapital)" vol. 1 (I), "Value Determined by an Abstract Labor Standard."
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Keynes, like Marx, ignores the particular reasons why particular periods of economic trouble have taken place.

 

Keynes appears totally ignorant of the inherent inefficiency of government management.

  Nevertheless, Marx's "mature capitalism" fallacy - for which Keynes cites Marx with approval - is the central feature of The General Theory, and Keynes relies upon some indeterminate concepts of his own to support his "mature capitalism" theme. In the process, Keynes, like Marx, ignores the particular reasons why particular periods of economic trouble have taken place.
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  Like Marx, Keynes believes the ownership interest is not an essential element in capitalist productivity. Stock market investors are "functionless." Ignoring Adam Smith's warnings about the weaknesses inherent in the separation of management from ownership, Keynes agrees with Marx that good management and supervision is always readily available and can be procured simply by offer of a suitable salary.
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  Like Marx and all socialists, Keynes appears totally ignorant of the inherent inefficiency of government management. See, "Government Futurecast," Part II, "Government Management." He has total faith in the capabilities of government and "community" administered economic systems. While Marx offers broad socialist solutions, Keynes offers narrower administered solutions directed at controlling interest rates, directing investment flows, redistributing wealth, and ultimately directing the activities of major business entities.
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  To entice the credulous, Keynes like Marx offers a vision of an impossible utopia. If a capitalist system is resolutely stimulated pursuant to Keynesian policies, it will generate abundant capital assets - "full capitalization" - so that capital assets are no longer scarce. Then, there would no longer be any need for financiers and rentiers. While residual entrepreneurs would continue to be tolerated, Keynes agrees with Marx that the entrepreneur will become unnecessary. - - -
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  Keynes - also like Marx - assumes that the study of economics is a "scientific" endeavor. He thus avails himself - or at least succumbs to - the "science" propaganda ploy that was a central feature in the propaganda myth created by Karl Marx. His followers would ardently continue this propaganda deception until forced to retreat somewhat by their gross failures in the 1970s.
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The savings gap:

 

 

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  Keynes provides us with psychological propensities to consume and save. He blames the business cycle and involuntary unemployment on the notion that wealthy nations - "mature" capitalist systems - will inevitably save more than can be profitably invested, leading to periods of economic decline - if not chronic economic decline.  Like Marx's concepts, none of this can be measured, and in fact all the evidence is exactly the opposite.
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Keynes asserts that as assets accumulate, people and businesses can - and observably do - rely more on their asset wealth than on monetary savings.

However, the decline in savings rates in the U.S. in recent prosperous times has been notorious for decades.

  Mature - wealthy -  capitalist systems require and have lower rates of savings - not higher. As assets accumulate, people and businesses can - and observably do - rely more on their asset wealth than on monetary savings. Their asset wealth supports vast increases in the purchasing power of credit, naturally stimulating both consumption and investment, with profit rates and interest rates sensitively adjusting these flows except when other factors undermine the pertinent markets.
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  Except during the depths of already developed severe depressions, financial intermediaries and the money markets have no trouble instantly putting all savings to work in commerce. As is repeatedly pointed out throughout the articles on Marx, "Das Kapital," and Keynes, "The General Theory," there is absolutely no evidence that excess savings play any role in initiating periods of economic distress.
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  In fact, savings declined substantially in the last full year before the Great Depression - the first decline since WW-I - accompanied by a substantial decline in the number of savings accounts. The decline in savings rates in the U.S. in recent prosperous times has been notorious for decades.
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Considering the extent and nature of man's weaknesses - and the stubbornness with which policy stupidities are frequently maintained, it is astounding that capitalism can function as well as it does.

  The roots of the business cycle are to be found in the multitude of pertinent weaknesses of man - NOT in weaknesses alleged in capitalism. Indeed, considering the extent and nature of man's weaknesses - both in the private sector and government sector - and the stubbornness with which policy stupidities are frequently maintained, it is astounding that capitalism can function as well as it does.
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  It is always the nitty-gritty of analyzing particular factors involved in particular periods of economic distress that is required for an understanding of the business cycle. Economists who are too lazy or inept for this task - or unwilling to offend political patrons or private employers - have nothing to tell us. No simplistic "General Theory" will suffice.

Effective demand:

 

 

 

 

It is when inappropriate private monopoly or cartel polices or government policies stubbornly resist such sorting out that labor markets fail.

 

It is thus more accurate to say that traditional labor market theory is indeed "general" - but only for economic systems and their labor markets that are reasonably flexible and competitive and subject to reasonably competent government policies.

The General Theory

 - - -
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  Keynes uses this term - "effective demand" - to distinguish it from previous theories of labor supply and demand that assumed that the market would always clear at a point that could be defined as full employment. "Says Law" - "supply creates its own demand" - is a prominent feature of such views.

  Labor market theories are based on competitive markets. When markets are disturbed because of ordinary excess - such as various "bubbles" in the private sector - the periods of increased unemployment can reasonably be attributed to temporarily increased levels of frictional unemployment while those excesses are sorted out under the pressures of economic decline. Such periods of economic decline are generally less than three years in duration.
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  It is when inappropriate private monopoly or cartel polices or government policies stubbornly resist such sorting out that labor markets fail. Conditions of involuntary unemployment can then last for a decade. Indeed, they can and do last indefinitely.
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  It is thus more accurate to say that traditional labor market theory is indeed "general" - but only for economic systems and their labor markets that are reasonably flexible and competitive and subject to reasonably competent government policies. During the Great Depression, and during the chronic inflation and stagflation of the 1970s, that was definitely not the case.
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  Says Law has its problems - but it was never presumed to operate outside reasonably competitive markets operating in economic systems subject to reasonable government policies.

  Keynes then explains his theory of employment.

  "When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income. Hence, employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption. Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment. It follows, therefore, that, given what we shall call the community's propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment. The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks."

Keynes asserts that when income increases, so does "the propensity to consume." However, the latter increases somewhat less than the former, according to Keynes, "since when our income increases our consumption increases also, but not by so much."

However, during times of prosperity, everybody keeps their savings in banks - for superior security and convenience as well as for some interest earnings - and the financing mechanism never has any trouble putting ALL savings to work in commerce.

  Then he asserts his key argument.

  "[There] is no reason in general for expecting that [the point of equilibrium will] be equal to full employment."
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  "The effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another. This particular relationship, which corresponds to the assumptions of the classical theory, is in a sense an optimum relationship. But it can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed."

  However, during prosperous times, investment levels generally run AHEAD of savings - pushing interest rates and prices higher in a familiar cyclical pattern as businesses compete for savings and productive resources that are at such times always in SHORT supply. Keynes amazingly attributes this last surge in interest rates to "fear." In fact, such surges occur when optimism reigns supreme - "irrational exuberance" - and a lack of caution is in fact the predominant characteristic.
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  During times of prosperity, everybody keeps their savings in banks - for superior security and convenience as well as for some interest earnings - and the financing mechanism never has any trouble putting ALL savings to work in commerce. When doubts arise, they strike equity values long before they begin to undermine a modern financial system. So Keynes fails to explain how periods of prosperity initially break down.

  When income increases, so does "the propensity to consume." However, the latter increases somewhat less than the former, according to Keynes, "since when our income increases our consumption increases also, but not by so much.
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Keynes asserts that the greater the volume of employment, "the greater will be the gap" between aggregate income and aggregate consumption that must be filled by investment to retain its stability. Whenever investment does not so rise, full employment cannot be maintained.

  This 'psychological law' is the key to the problem. The greater the volume of employment, "the greater will be the gap" between aggregate income and aggregate consumption that must be filled by investment to retain its stability. Whenever investment does not so rise, full employment cannot be maintained.

  "The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wage -- not the other way around. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage, and the equilibrium real wage will be greater than the marginal disutility of the equilibrium level of employment."

Keynes asserts that: "The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment."

 

Keynes asserts that: "The richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system."

However, this convenient theory relieves the Keynesians - again like the Marxists - of the chore of analyzing the particular causes of particular periods of economic decline.

  Thus, Keynes derives his overall reason for economic dislocations. It has definite Marxian overtones - that he acknowledges in a footnote.

  "'This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.
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  "'Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.
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  "But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate level, which [is covered later in the book]."

   Marx himself could not have written a more bleak picture of the fate of "mature" capitalist economic systems. However, why, then, is there observably more unemployment - and more intractable conditions of unemployment - in so many poor countries?
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  And how convenient this theory is. It relieves the Keynesians - again like the Marxists - of the chore of analyzing the particular causes of particular periods of economic decline. It is all, after all, just a function of mature capitalist systems - a weakness inherent in capitalism - just as Marx said.

  Keynes then acidly criticizes Ricardo and subsequent classical economic theorists for insisting on a theory that observably doesn't explain the facts of the business cycle - resulting at last in the hopelessness of the Great Depression. - - -

  In this Keynes is clearly correct. Classical theory indeed doesn't explain the business cycle. It doesn't deal with the factors of private and government excess and inappropriate policy that can temporarily or permanently undermine competitive markets. However, Adam Smith wrote of several such factors that were thus recognized a century and a half before Keynes was writing his General Theory. See, Adam Smith, 'The Wealth of Nations,' Part I, 'Market Mechanisms,' and Adam Smith, 'The Wealth of Nations,' Part II, "Economic Policy.'"

The savings gap:

  Consumption tendencies adjust to income fluctuations but to lesser degrees and with some delay.
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Keynes asserts that wealthy societies will save more than poor societies since immediate needs of the poor will require greater proportionate levels of spending. "These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases."

However, savings rates in the wealthiest nations - like the U.S. - have been in notorious decline for decades, while savings rates remain high in nations still only marginally beyond subsistence levels.

 

 

 

Keynes asserts that: "For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap."

  Thus, savings will fluctuate with income fluctuations, but more in the short term than in the long term. Cyclical fluctuations thus have a marked impact on savings rates.

  "Thus, a rising income will often be accompanied by increased saving, and a falling income by decreased saving, on a greater scale at first than subsequently."

  Wealthy societies will save more than poor societies since immediate needs of the poor will require greater proportionate levels of spending. "These reasons will lead, as a rule, to a greater proportion of income being saved as real income increases.

  Except for economic systems that cannot get above subsistence levels, this has not been the case. In fact, savings rates in the wealthiest nations - like the U.S. - have been in notorious decline for decades, while savings rates remain high in nations still only marginally beyond subsistence levels.

  A major factor in the business cycle, according to Keynes, is thus the tendency of consumption increases and decreases to be proportionately less than corresponding income increases and decreases. Thus, Keynes focuses on this mythological savings "gap."

  "For since consumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap."

  Somehow, the statistics generally fail to support this fundamental Keynesian conclusion. Not only have savings rates been in notorious decline in recent U.S. history, they even declined substantially in the last full year before the Great Depression - during the great surge of prosperity between mid 1928 and mid 1929. This savings decline was accompanied by a substantial decline in the number of savings accounts. These were the first declines since WW-I. Keynes is clearly writing in response to Great Depression phenomena - but fails to acknowledge, much less explain, this inconvenient fact.

However, savings even declined substantially in the last full year before the Great Depression - during the great surge of prosperity between mid 1928 and mid 1929.

 

 

 

(Keynes) By accumulating funds for future investments or emergencies, in 1928 and 1929, the dreaded savings "gap" was expanded and the investments that might fill the "gap" were delayed.

However, investment demand was expanding exuberantly - clearly outrunning available savings and pushing interest rates high enough to draw substantial funds from as far away as Europe. All types of debt - consumer as well as investment - expanded sharply well into October, 1929.

 

 

 

 

 

 

 

 

 

 

 

 

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  Like Marx, Keynes points an accusing finger at financial reserves. By accumulating funds for future investments or emergencies, the dreaded savings "gap" is expanded and the investments that might fill the 'gap' are delayed. Such reserves constitute "a drag on employment' during periods of accumulation - "suddenly made good in a lump" when the reserves are expended for the intended investment or emergency. (This stupidity could have been lifted straight out of Das Kapital.)

  "Thus sinking funds, etc., are apt to withdraw spending power from the consumer long before the demand for expenditure on replacements - which such provisions are anticipating - comes into play; i.e. they diminish the current effective demand and only increase it in the year in which the replacement is actually made. If the effect of this is aggravated by 'financial prudence,' i.e. by its being thought advisable to 'write off' the initial cost more rapidly than the equipment actually wears out, the cumulative result may be very serious indeed."

  Then, Keynes provides these remarkably inaccurate sentences:

  "In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump."

  If there was so much excess savings, why were interest rates so high in 1929? Investment demand was expanding exuberantly - clearly outrunning available savings and pushing interest rates high enough to draw substantial funds from as far away as Europe. All types of debt - consumer as well as investment - expanded sharply well into October, 1929.
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  While interest rates declined rapidly AFTER economic contraction began in August of 1929, the decline was from extraordinarily high levels and did not reach nearly normal levels until economic decline became obvious in October, 1929. Indeed, they did not reach levels indicating a lack of investment demand for all available funds until many months thereafter.

  On a more logically firm footing, Keynes points to the problems of excess savings in 1935 - in the midst of the Great Depression, when there was little profit inducement to borrow the accumulated savings. He belabors government "prudence" in accumulating sinking funds for future needs.
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  The data Keynes relies on for this point - admittedly less than precise - also shows that "net capital formation" remained high through 1929, and did not decline until thereafter - after the Great Depression had already begun. The decline thus was the result of the slump - not its cause.
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Keynes remarkably views the increase in capital in wealthy states as a problem rather than as a strength.

However, over-expansion is a short term problem that is routinely dealt with during the ordinary business cycle - involving periods of decline of about three years or less. It is not the long term problem that Keynes is talking about.

 

Keynes asserts that: "Each time we secure to-day's equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow."

 

Keynes asserts that only if interest rates are managed so as to maintain levels of full employment do the classical models hold and savings retain their status as virtues.

However, the propensity to save itself declines with the accumulation of capital and durable assets.

  Prudence and savings thus come under sharp attack by Keynes.

  "We cannot, as a community, provide for future consumption by financial expedients but only by current physical output."

  The terminology is different, but the fallacy is the same as that of Karl Marx.

  Keynes remarkably views the increase in capital in wealthy states as a problem rather than as a strength.

  True, the business cycle naturally involves tendencies to periodically over-expand capital assets and inventories during prosperous periods. Periods of irrational exuberance during prosperous times is a general factor in the business cycle properly recognized by all economists - including Marx and Keynes. Working these excesses off during periods of economic decline poses obvious difficulties. Nevertheless, this is a short term problem that is routinely dealt with during the ordinary business cycle - involving periods of decline of about three years or less. It is not the long term problem that Keynes is talking about.

  According to Keynes - and Marx - as savings increase for wealthy states, investment must also consistently increase to circulate those savings and avoid secular economic decline - a task that gets increasingly difficult in the face of a growing abundance of capital assets.

  "Thus the problem of providing that new capital-investment shall always outrun capital-disinvestment sufficiently to fill the gap between net income and consumption, presents a problem which is increasingly difficult as capital increases. New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase. Each time we secure to-day's equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow. A diminished propensity to consume to-day can only be accommodated to the public advantage if an increased propensity to consume is expected to exist some  day."

  Keynes - writing during the Great Depression - clearly views the nation's living standards as ultimately static. His mind - thus little better than that of Marx - is incapable of contemplating the constantly increasing standards of living of the 20th century, once the trade wars and financial obstacles of the Great Depression were removed.
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  Keynes fails to understand that widely accumulated assets - especially private homes - would DECREASE the need for private savings. Businesses, too, would be able to rely on the equity values of assets and businesses as going concerns as a substitute for savings. Thus, wealthy states with well developed and secure financial systems would have far less need for high savings rates than less developed nations.
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  The propensity to save itself declines with the accumulation of capital and durable assets. Anyone who has bought and furnished homes knows there are no natural limits to the propensity to consume. - - -

The multiplier:

 

Keynes asserts that inflation need be of no concern, since true inflation occurs only with full employment. (This is incredible ignorance.)

  - - - Inflation need be of no concern, since true inflation occurs only with full employment. (This is incredible ignorance.)

  This is a common Keynesian assertion refuted by centuries of economic history as well as subsequent experience with Keynesian policies during the stagflation period of the 1970s." (Because of the processes of stagnant capitalization and even decapitalization that accompany chronic inflation, inflation that is chronic at more than minimal levels ALWAYS CAUSES UNEMPLOYMENT.) - - -

Offsets:

 

 

 

 

 

 

 

 

Keynes admits that the artificial consumption and investment induced by Keynesian policies will increase imports - only a minor fraction of which will be recouped as foreign economic systems respond.

This obvious negative impact on the balance of trade and international payments would be determinedly ignored by Keynesians, who would express amazement at the collapse of the dollar in the 1970s after a decade of Keynesian policy implementation.

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  • Increased borrowing that pushes up interest rates, or increases in taxation, will reduce the multiplier impacts of an increase in public works. Any rise in the cost of capital goods due to the additional demand will reduce their marginal efficiency for private investors. Thus, interest rates must not only be kept steady, they must be pushed down, if increases in public works are to have their full multiplier impact.

  Deficit spending thus doesn't increase employment when the financial system is in tact. It is the monetization of debt to keep interest rates down that normally provides all the actual stimulus.

  • "Confused psychology" that causes loss of confidence in the private sector as a result of increases in government works financed by deficits and the expansion of the money supply may produce negative impacts. This may increase savings - "liquidity preference" - for contingency reserves, or diminish the marginal efficiency of capital and thus private investment.

  It may ultimately also cause capital flight and decapitalization as assets are milked rather than maintained.

  • Foreign trade reduces the multiplier for domestic employment. The artificial consumption and investment of Keynesian policies will increase imports - only a minor fraction of which will be recouped as foreign economic systems respond.

  This obvious negative impact on the balance of trade and international payments would be determinedly ignored by Keynesians, who would express amazement at the collapse of the dollar in the 1970s after a decade of Keynesian policy implementation. Today, again, Keynesian policies are accompanied by chronic (deficits in international trade and payments accounts and by) currency devaluation. - - -

  Closed economic systems are thus more amenable to Keynesian manipulation. - - -
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The inducement to invest:

 

Keynes asserts that expectations of inflation will stimulate investment and employment because of expectations of higher prices.

However, Keynes ignores noxious factors that are typical of inflation such as widespread loss of purchasing power due to price increases - the impact of capital flight - and the progressive collapse of credit. Omitted are the additional risks that accompany rising rates of inflation. Substantial levels of unemployment not only do not prevent inflation, they are ultimately invariably caused by inflation.

 

 

 

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  Persistent appreciation or depreciation of currency will create expectations that will impact investment rates, Keynes properly notes. However, then he ignores centuries of economic history. He asserts that expectations of inflation will stimulate investment and employment because of expectations of higher prices, while price deflation will depress investment and employment for fear of lower prices.

  Then, how does one explain stagflation and decapitalization during periods of chronic inflation like the 1970s? Keynes ignores noxious factors that are typical of inflation such as widespread loss of purchasing power due to price increases - the impact of capital flight - and the progressive collapse of credit. Writing in the midst of a world wide Great Depression, such concerns could be overlooked by Keynes.
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  Obviously, something is fundamentally wrong with Keynes' schedule of the marginal efficiency of capital. Omitted are the additional risks that accompany rising rates of inflation, as well as the adverse impacts not only of inevitable increases in real interest rates, but even of nominal interest rates. "The time cost of money" has real impacts even when only nominally high.
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  No nation has ever prospered with substantial levels of chronic inflation. Indeed, so destructive do the processes of inflation become, that nations invariably ultimately choose to suffer depression from austerity policies just to get out from under inflationary processes. Substantial levels of unemployment not only do not prevent inflation, they are ultimately invariably caused by inflation.
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 And, what happens to all that added purchasing power during periods of price deflation? This is a powerful stimulant that helps nations recover from recession unless offset by an economy that is deeply in debt - which is invariably the case for economic systems that have been managed with Keynesian policies.

  Keynes recognizes that rising rates of interest will offset this stimulation from inflation. Only if interest rate increases lag the increases in inflation (which is invariably the case during the pleasant early phases of inflation) will there be any stimulation.

  However, real interest rates at or near zero in the 1970s did not prevent the onset of stagflation in the U.S. - with double digit levels of inflation and nearly double digit levels of unemployment at the same time.

  Keynes explains the business cycle in terms of a broad theory, "the fluctuations of the marginal efficiency of capital relative to the rate of interest." Although the theories are somewhat different, this is quite similar to the approach of Karl Marx. It enables them both to ignore all the particular factors that contribute to particular periods of economic distress.

  These sorts of games are quite common in economics. There are always infinite chains of cause and effect in operation, and anything can be "proved" to be a substantive cause by merely choosing where along the chain to begin the examination. Keynes candidly admits that his choices of independent variables are not based just on their merits, but on the basis of whether he believes that they can be conveniently manipulated. - - -

  Prospective yield:

Keynes asserts that the crisis of confidence that afflicts the Great Depression world can only be cured by forcing people to either consume or invest their funds. (More incredible stupidity.)

 - - -
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  Keynes is thus driven to a remarkable radical conclusion.
The crisis of confidence that afflicts the Great Depression world can only be cured by forcing people to either consume or invest their funds. The "hoarding" of funds that Keynes believed to be the cause of the crisis might then be ended.

  Again, this Marxian stupidity afflicts Keynes.
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  Idle savings were a result of the Great Depression, not its cause.

Keynes, "The General Theory (II)"
excerpts from Vol. 6, No. 5 (5/1/04)


The impact of interest rates:

 

 

 

 

Keynes assumes that people part from their savings only if offered an interest return.

Interest Rates

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  Keynes uses the term "liquidity preference" for those who prefer to keep significant sums in the sterile form of cash. Keynes assumes that people part from their savings only if offered an interest return. Thus, the interest offered counters a "liquidity preference" to hold wealth in the form of immediately usable but sterile cash.

  "Thus, the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is not the 'price' which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption."

However, in developed nations with reliable banking systems, Keynes' "liquidity preference" disappears. It is then safer and more convenient to deposit cash in banks than in mattresses, even with little or no interest on offer. Except during the depths of already existing depressions, banks and other financial intermediaries have no trouble immediately circulating ALL savings through the money markets if not through direct lending.

 

Furthermore, only the elimination of the factors that undermined the reliability of the financial system and the functioning of the economy will reduce or eliminate "liquidity preference."

 

Still furthermore, only if banks are less secure than mattresses - and thus themselves constitute an investment risk - are yields essential to draw savings into the financial system.

  This is, in fact, a correct view of matters where financial intermediaries are unavailable or unreliable - as in undeveloped nations or -  during the Great Depression - even in the U.S. It is also true when - for any reason - profits are so scarce that there is no inducement to borrow at any interest rate - as during the Great Depression.
 &
  However, in developed nations with reliable banking systems, Keynes' "liquidity preference" disappears. It is then safer and more convenient to deposit cash in banks than in mattresses, even with little or no interest on offer. Except during the depths of already existing depressions, banks and other financial intermediaries have no trouble immediately circulating ALL savings through the money markets if not through direct lending.
 &
  In developed nations, idle hoards don't cause depressions. Depressions cause idle hoards.
 &
  However, interest rates WILL determine - along with various risk factors - whether funds available for loan will be drawn into domestic markets from abroad - or will flow abroad to take advantage of better opportunities in foreign markets. Artificially low interest rates will cause capital flight.
 
&
  Keynes provides some simplistic mathematical equations explaining "liquidity preference" - all of it inapplicable to capitalist economics except when - for other reasons - there has been a breakdown in the financial system. Even then, interest rates won't eliminate or reduce "liquidity preference." Only the elimination of the factors that undermined the reliability of the financial system and the functioning of the economy will reduce or eliminate "liquidity preference." This involves analysis and reform of fundamentals. Government deficits and manipulation of money and interest don't solve fundamental problems.
 &
    It is to the great credit of Keynes and his followers that - when given the authority and opportunity after WW-II - they took steps needed to end the trade war. With  commendable U.S. leadership, steps were taken to facilitate international trade, and war debts from both world wars were substantially written off. Wouldst that it had all been done two decades earlier. - - -
 &
  Only if banks are less secure than mattresses - and thus themselves constitute an investment risk - are yields essential to draw savings into the financial system. - - -

  [For] short period calculations, [a whole variety of other applicable factors] can all be treated as constants.

    This is the key to the Keynesian remedies of monetary expansion and budgetary deficits. By concentrating only on immediate results - and in a system substantially closed to international trade - the fact that these "policies" can be no more than temporary palliatives with inevitable unpleasant long term impacts can be ignored.

 Wages:

 

 

Keynes asserts: "There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment."

However, in an open system, cost reductions - any costs, not just wages - increase exports, reduce imports, boost currency values and purchasing power.

 

Furthermore, even for closed systems, rigid wage systems must put greater pressures for adjustment on other cost factors - each with their own complex of impacts.

 

 

Keynes notes that it is much easier to expand the money supply, which enables political leaders to avoid many of the immediate unpleasant consequences loosed by downward pressures on wages.

 - - -
 &
 
Keynes argues [that the same stimulus achieved by a reduction in wages] can be achieved by keeping wages fixed and increasing the supply of money. (He discusses only the impact on interest rates from an aggregate decline in costs. He ignores the increased purchasing power of existing money - disparaging such benefits because of the noxious impact on debt.) - - -

  "There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment; -- any more than for the belief that an open-market monetary policy is capable unaided, of achieving this result. The economic system cannot be made self-adjusting along these lines."

  This applies only in a closed system - a system that doesn't enjoy all the productivity advantages of international trade. Also, it applies only in a system that has relied to a great degree on debt.
 &
  In an open system, an increase in money supply increases imports and ultimately undermines currency values and purchasing power. Cost reductions - any costs, not just wages - increase exports, reduce imports, boost currency values and purchasing power.
 &
  Keynes thus draws a broad conclusion based on his very narrow special case. His conclusion applies only for a closed system - thus necessarily hobbled with grossly limited economic productivity and living standards - that determinedly ignores long term implications. Even for closed systems, rigid wage systems must put greater pressures for adjustment on other cost factors - each with their own complex of impacts - that Keynes doesn't consider.

  Keynes correctly notes that the benefits of declining prices can be offset by the increased difficulty of servicing debt. (He does not, however, deign to note that this is a powerful argument against over reliance on debt capital and government budget deficits.) He also correctly notes that it is much easier to expand the money supply, which enables political leaders to avoid many of the immediate unpleasant consequences loosed by downward pressures on wages. An expanding money supply is also favorable for existing debtors - as there are in abundance in a Keynesian system.
 &

However, inflation is always adopted for its palliative short term impacts - the reasons for the inflation of the money supply for millennia.

 

 

 

 

 

&

  The government - as the biggest debtor - benefits immediately from the monetization of vast quantities of its debt. The economy as a whole benefits in the short run by the palliative impacts on consumption and investment of an increase in the money supply.

  All of this is nothing new. Inflation is always adopted for its palliative short term impacts - the reasons for the inflation of the money supply for millennia. And the "long run" is not so long in arriving as Keynes assumed - especially for soft currency nations.

  Keynes thus advises rigid wage systems for closed economic systems.

  Both rigid labor markets and closed systems have since proven individually to be serious burdens on both productivity and employment. Something must obviously be wrong with Keynes' analysis. What could it be? - - -

Mercantilism:

 

 

 

 

 

 

 

 

 

 

 

 

&

Trade Policy:

 - - -

  Monetary devaluation - clipping the coins or running the printing presses - is a form of general taxation - appropriating the produce of the public for government purposes. That's the real reason all modern governments want as much inflation as they can get away with without causing observable economic harm. This generally includes about 2% price inflation in addition to the inflation which eats up productivity gains. Today, in the U.S., these two together generate additional revenue equivalents in excess of 5% of GDP.
 &
  International markets tend to be broadly self-correcting - in ways similar to those of domestic markets. Flexible exchange rates permit smoother adjustments, while fixed exchange rates generally require financial earthquakes to achieve any major adjustments that may be needed.
 &
  When not justified by productivity gains, lower domestic interest rates and higher domestic rates of investment and consumption will draw in additional imports and have similar equilibrating impacts on the balance of payments. Keynes recognizes such impacts - but discusses them only after they have proceeded sufficiently to increase domestic costs or to shift investment flows towards higher interest opportunities abroad. - - -

  The gold-based fixed exchange rate system prior to the Great Depression created dangerous conditions. The only means of correcting trade and payments imbalances while still maintaining the currency peg was to raise domestic interest rates sufficiently to slow down the entire economy. This reduced imports, drove costs down, and improved international competitiveness - but at the cost of domestic depression.

  "[Thus], the objective of maintaining a domestic rate of interest consistent with full employment was wholly ruled out. Since, in practice, it is impossible to neglect the balance of payments, a means of controlling it was evolved which, instead of protecting the domestic rate of interest, sacrificed it to the operation of blind forces."

  Heavens forbid that anyone suggest the productivity improvements always possible by the removal of government obstacles to and burdens on commerce. - - -

Keynes asserts that the gold standard was at the heart of the problem prior to the Great Depression. This sets every nation in competition over flows of precious metal that alone can dictate prosperity or decline.

However, competition is good for national economic policies as well as for so much else. It imposes discipline on political leaders that they hate. It forces them to strive to provide the most favorable commercial environment possible for the prosperity of their people,

  The gold standard - a fixed exchange rate standard - was at the heart of the problem prior to the Great Depression, Keynes asserts. This sets every nation in competition over flows of precious metal that alone can dictate prosperity or decline.

  Competition is good for national economic policies as well as for so much else. It imposes discipline on political leaders that they hate. It forces them to strive to provide the most favorable commercial environment possible for the prosperity of their people, and bluntly punishes political excess and irresponsibility - at cost to the citizenry as well as the politicians.
 &
  Where governments have sources of wealth that do not depend on the prosperity of the people - as where there are abundant oil or diamond resources in small nations - such wealth can prove a curse for the people. Then, political leaders need not give a damn for the commercial environment and the economic well being of the people.
 &
  Access to the monetary printing presses is conducive to similar disregard for the public well-being. The inability to print money is a major reason why individual states in the U.S. concentrate so hard on facilitating commerce within their borders. Small nations with soft currencies and little mineral wealth operate under similar imperatives.

Keynesians seek out scapegoats to divert blame from themselves. They blame capitalism and the disciplines of capitalist processes for the consequences of their own mismanagement.

  Keynes provides some interesting background on early mercantilist thought, but basically provides a simplistic - partial explanation of the problems of the gold standard and fixed exchange rates in the 1920s and before. He concludes that, if all nations abandoned fixed exchange rates and pursued Keynesian policies for achieving full employment, then all would benefit and international competition for precious metals would end.

  "It is the policy of the autonomous rate of interest, unimpeded by international preoccupations, and of a national investment programme directed to an optimum level of domestic employment which is twice blessed in the sense that it helps ourselves and our neighbors at the same time. And it is the simultaneous pursuit of these policies by all countries together which is capable of restoring economic health and strength internationally, whether we measure it by the level of domestic employment or by the volume of international trade."

  This is a typical assertion of many utopians - and all pyramid schemes. If only everybody would believe in the scheme and act on that belief, it would be sure of success and never break down. That Keynes would write such a paragraph is a strong indication that he knew and feared the impacts on international trade and payments balances that his policies would have for any particular nations that adopted them.
 &
  It is not fixed exchange rates and free trade that are the problems. Although financial excesses in the private economy can also play a role, always - and for any system - especially Keynesian systems - it is irresponsible government policies and government profligacy - and monetary expansion - that cause problems.
 &
  In fact, fixed exchange rates offer many benefits. See, "The determinants of purchasing power" in "Capital as Purchasing Power."
 &
  The politicians - and the Keynesian economists who provide them with intellectual support for irresponsible policies - rage against natural limitations - natural disciplines - that block their desire for unlimited expenditures and the easy solutions of the printing presses. They seek out scapegoats to divert blame from themselves, and blame capitalism and the disciplines of capitalist processes for the consequences of their own mismanagement.

The 1970s demonstrated that gold reserves and monetary pegs in fact offered some temporary shelter from the merciless judgments of international money markets.

  Thus, Keynes had to assume that floating exchange rates imposed no similar disciplines. He even looked with some sympathy on closed systems.

  The 1970s would prove Keynes' view to be disastrously in error. It was then demonstrated that gold reserves and monetary pegs in fact offered some temporary shelter from the merciless judgments of international money markets. For the U.S. after WW-II - with its then vast gold holdings - this temporary shelter extended for two decades.
 &
  Without gold or hard currencies to expend in support of a national currency, adverse currency movements quickly and ruthlessly punish government profligacy - especially in soft currency nations.

Krugman, "The Return of Depression Economics."
Vol. 6, No. 6 (6/1/04)

The dinosaur Keynesian:

 

 

 

 

 

 

&

  - - -
 &
  Krugman - - - still views Keynesian policies
as first line remedies - sufficient in their own right to cure most economic ailments that result in "unused economic resources" in free market systems. Rationalization of private practices and reforms of fundamental policies burdening an economic system are nice, but unessential. Political leaders should not be bothered with the need to change political policies that burden their economic systems. There is no need to wait until economic contraction forces rationalization of private entity practices.
 &
  At least in advanced, hard currency nations, any failure of Keynesian policies is simply the result of insufficient effort. If zero interest rates and massive deficit expenditures don't do the trick, then negative real interest rates become essential. By purposely generating inflation rates in the 2% to 4% range, real - after inflation - interest rates can be driven below zero - into negative territory - stimulating private sector spending sufficient to utilize all productive resources. - - -
 &

Insufficient demand:

  The return of the Great Depression is unlikely anytime soon, Krugman bluntly states. However, he still invokes the usual left wing scare tactics.
 &

Krugman insists that the problems of insufficient demand - private demand levels insufficient to employ all available productive capacity - have returned as essential features of capitalist systems.

 

However, insufficient demand never causes recessions in advanced market economies with properly functioning financial systems. Recessions cause insufficient demand.

  The type of economic problems that afflicted the world during the Great Depression have indeed made "a stunning comeback," he insists. Even without a Great Depression, they can cause enough economic problems to undermine public support for capitalist free market policies.

  The key difference - ignored by Krugman - is the absence of trade war levels of protectionism and the presence of continued globalization. As long as barriers to trade keep declining, nations and private entities will have a chance to service their international debts. This was not the case in the 1920s. See, James, "End of Globalization." Globalization means small free market nations can always devalue - stabilize their currencies at a suitably lower level - and then export their way out of any crisis - as the stricken Asian tigers ultimately did during the Asian Contagion crisis. This possibility, too, was constricted during the trade wars of the 1920s.
 &
  Recovery was far from immediate - and real suffering was imposed on the afflicted populations during the recent crisis periods. However, recovery has nevertheless been surprisingly swift and vigorous - surprising even to Krugman. Krugman was originally of the impression that the recent crises constituted the worst economic reversal since the 1930s.

    Only Keynesian policies can save capitalism from its inherent weaknesses. Only Keynesian remedies can avoid or mitigate the business cycle that inflicts hardships and threatens instability. Only Keynesian policies can make up for the inadequate demand that leaves workers unemployed and economic resources idled during periodic recessions. The public will not tolerate business cycle recessions, and only Keynesian policies offer a means to prevent or mitigate them.

  In fact, the public - even in shaky new democracies - has proven surprisingly resilient. Democracy - imperfect as it undoubtedly is - may not be as fragile a flower as Krugman believes. He expresses surprise at the fortitude of the peoples and governments of afflicted nations. Yet, this is hardly surprising, since they in fact have no better political and economic choices than democracy and capitalism - systems of political and economic freedom. - - -

  Krugman insists that the problems of insufficient demand - private demand levels insufficient to employ all available productive capacity - have returned as essential features of capitalist systems. Without saying so, he is asserting the old Marxian and Keynesian stupidity of "mature economy" problems.

  "For the first time in two generations, failures on the demand side of the economy -- insufficient private spending to make use of the available productive capacity -- have become the clear and present limitation on prosperity for a large part of the world."

  The Keynesian savings gap is an obvious stupidity - a stupidity Keynes picked up from Marx. There is no problem with savings during prosperous times in advanced capitalist systems with functioning financial systems. Banks with access to financial and money markets have no trouble circulating all savings during prosperous times. Moreover, people save less - not more - as they become wealthy, since they can and do depend more on their asset wealth for reserve purposes. Savings rates decline as capitalist nations become wealthier.
 &
  Whenever there is such "insufficient demand," there are always fundamental reasons for it - reasons which dinosaur Keynesians always ignore. Insufficient demand never causes recessions in advanced market economies with properly functioning financial systems. Recessions cause insufficient demand. - - -

A little inflation is a good thing:

 

 

&

  - - - [Krugman's remedy for Japan's economic ills in the 1990s involved the determined establishment of low levels of price inflation.]
 &
  Even when forced to recognize that Keynesian policies have limitations and risks, Krugman typically fails to analyze those limitations and risks. Keynes, himself, recognized that his standard low interest monetary expansion policies can fail to generate the promised growth. Keynesians even have a name for this failure: a "liquidity trap."
 &

  However, there is little desire to examine other problems and unintended consequences flowing from their policy recommendations. During the stagflation of the 1970s, inflation and unemployment both rose alarmingly at the same time, and economic volatility increased instead of succumbing to Keynesian policies. This evident failure is now breezily written off by Krugman as just an initial mistake in pushing too hard for levels of employment that proved to be inflationary. Once inflation gets entrenched, he acknowledges, it becomes a real problem.

  Krugman generally glosses over the many problems and dangers of inflation. The anemic productivity and economic growth of the two decades after the 1972 and 1973 devaluations of the dollar just happened to coincide with two decades of the highest inflation rates in peacetime U.S. history.
 &
  Krugman doesn't even deign to recognize the connection much less discuss it. What does inflation do to cause such malaise? In fact, inflation doesn't prevent unemployment, it always ultimately causes unemployment. In fact, no nation has ever prospered with chronic inflation rates as high as 4%. In fact, at 4% compounded for 10 years, the Japanese people would lose the equivalent of half their savings. How would the electorate respond to that?
 &
  One of the unique problems of inflation is that there is no straightforward way of ending it. Austerity is the only remedy, and austerity means a period of recession or depression must first be endured before healthy economic growth can resume. The efforts to achieve a "soft landing" from the inflation pressures that built up in the 1970s required (1) above average real interest rates, (2) a depression during 1980-1982 and (3) a mild recession in 1991, and (4) notoriously lackluster economic performance until the middle of the 1990s. That's why inflation is so dangerous. See, "Understanding Inflation." - - -
 &
  The unintended consequences of a long stretch of inflation at as much as 4% per year are not considered by Krugman. Krugman is like a doctor prescribing powerful drugs without seriously considering possible side effects.
 &
  By definition, the desired rate of inflation has to be high enough to change public expectations and alter public conduct. Will public response be only along desired lines? And if implementation of government policy is as usual considerably less than perfect, will Japan find itself in the stagflation morass experienced by the U.S. in the 1970s - with a 1980-1982 level of depression required to regain control - and Krugman wringing his hands over the human suffering caused by such austerity?
 &
  Will asset price bubbles again begin to inflate, as frequently occurs when interest rates are artificially low and credit policies are dangerously loose? After all - lacking positive interest rates - there is no time cost of money to guide investment decisions. Lacking positive interest rates, oil and other minerals in the ground become more valuable than if produced and sold. As interest rates inevitably rise in the U.S., the asset price bubble response to recent artificially low interest rates may indeed become a serious problem.

Good economies:

 

 

 

 

 

 

 

 

 

&

  - - -
 &
  Krugman ignores the cumulative nature of various economic problems.

  Indeed, there are a variety of fundamental problems that characteristically provide an initial illusion of healthy growth before inevitably suffering varying degrees of failure. Inflation gathers steam over time, debts grow until they reach unsustainable levels and are impacted by the inevitable onset of downward movements in the business cycle, regulatory costs and/or taxes grow to unbearable levels, etc. Also, as Krugman so eloquently explains, factors of growth unassociated with productivity gains eventually reach their limit.
 &
  Only during periods of economic stress are private business leaders and public policy makers forced to confront such problems. Krugman, himself, is one of the problems - offering a politically attractive easy way out - which can only make matters worse over time. - - -

  Krugman responds:

  "There is no good reason, however, why misguided investments in the past should leave perfectly good workers unemployed, perfectly useful factories idle. If the U.S. stock market should crash tomorrow, nobody would expect Alan Greenspan to shield stockholders from their losses; but we would and should accuse him of malfeasance if he did not do everything possible to keep those paper losses from causing mass unemployment."

  Greenspan, indeed, did do all he could do during this last stock market decline and economic recession that began after publication of this book. He undoubtedly mitigated the effects of the last recession. However, he could neither prevent substantial growth in unemployment nor hurry the pace of recovery.
 &
  And his efforts were not without cost - in terms of a substantially devalued dollar and a corresponding adverse shift in the terms of trade for the U.S. Now, price inflation and rising interest rates are being added to the noxious results of these efforts. Now, a weakened dollar and rising interest rates will limit the vigor and threaten the sustainability of economic recovery. - - -

Krugman's policy remedies:

 

 

&

  A little bit of inflation becomes an important part of Krugman's policy recommendations. By maintaining inflation at about 2%, real interest rates can always be driven as low as minus 2%.

  This was actually done in the 1970s - with nasty results. A "little" inflation is a tricky thing to keep in check - especially considering the inherent inaccuracy of official statistics.

  Some fundamental reforms are viewed as advisable - for the long term. Safeguards against hedge fund excesses and some limitations on reliance on foreign debt are eminently sensible recommendations.

  "[My] own suggestion is that governments actively try to discourage local companies from borrowing in foreign  currencies, and also perhaps from relying too much on borrowed funds in general - that is, reduce their 'leverage.' The best way to do this is probably by taxing companies that borrow in foreign currency. In so doing, countries might regain the ability to allow their currencies to slide without provoking a financial collapse and, in so doing, head off future crises at the pass."

  Heavens forbid a Keynesian should advise the importance of facilitating and attracting equity capital. How can reliance on borrowed funds be reduced except by the facilitation of the raising of equity capital.?

Krugman asserts that two to four percent inflation will cause no harm to advanced hard currency nations.

 

Governments love inflation. It is the easiest way to appropriate a percentage of a nation's produce for government purposes. It is a tax by use of the printing press. Krugman's Keynesian advice is thus music to political ears.

  For hard currency nations, whenever crisis approaches, interest rates should be cut "drastically without hesitation" to prevent the establishment of the dreaded "liquidity trap." Two to four percent inflation will cause no harm to advanced hard currency nations.

  It will also conveniently make it easier to handle heavy debt loads - until long term interest rates inevitably begin to rise.
 &
  Governments love inflation. It is the easiest way to appropriate a percentage of a nation's produce for government purposes. It is a tax by use of the printing press. Krugman's Keynesian advice is thus music to political ears.
 &
  Because of the massive reliance on debt capital in most modern nations, even modest levels of price deflation are feared. Price deflation increases real interest rates above nominal rates and makes it harder to bear the burdens of debt. In the absence of heavy debt loads, price deflation provides a very healthy increase in purchasing power without the noxious impacts of monetary expansion. Price deflation is actually one of the most powerful natural market mechanisms for bringing economic systems out of recession.
 &
  Any system that cannot benefit from the increased purchasing power of modest levels of price deflation is a system that is too heavily in debt. During the 19th century, the U.S. grew to become the wealthiest nation in the world while enjoying modest levels of price deflation at about 1 1/2% per year. Truly well run capitalist systems that encourage the investment of equity capital have nothing to fear - and indeed gain many benefits - from such levels of price deflation.

  For soft currency nations, Krugman admits having no easy answers. Defending an overvalued currency by raising interest rates can be catastrophic, he correctly points out. Devaluation has major costs in terms of loss of confidence, especially if further devaluations are expected. (The resulting adverse shift in the terms of trade is never mentioned by Krugman.) Capital controls may be the least bad choice. 

  Capital controls, by themselves, are also a totally ineffective remedy.
 &
  There are always reasons - almost always involving inept government policies - when pegged currencies become overvalued. Heavens forbid Krugman should analyze such policies and confront political leaders with the need to change some that are politically attractive but that are economic blunders. Heavens forbid that he should emphasize the need for governments to accommodate commerce in general and the investment of equity capital in particular.

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