Keynes said failure to spend dampens ‘aggregate demand.’

By Donald J. Boudreaux

KENYESIAN ECONOMICS IS now resurgent. However, one of its fundamental flaws is its assumption that private citizens routinely spend too little – that they work and produce to earn incomes and then neither spend nor invest those incomes.

According to Keynesians, it’s this failure to spend and invest that keeps “aggregate demand” too low. And with total demand too low, businesses can’t sell all that they produce. So the economy contracts and unemployment rises. The solution recommended by Keynesians is for government to spend whatever private citizens don’t — for government to buy what private citizens won’t.

There’s much to unpack in this jumble of notions and suspicions. The first is the question: Why would people spend time and resources earning higher incomes when these same people have no desire to spend it all or to invest all that they don’t spend? Why would people strive and take risks only to accumulate pieces of paper that they stuff under their mattresses indefinitely?

It’s not sufficient to say that people might want to save as much as possible because they fear the economic future. Saving, after all, doesn’t necessarily mean stuffing currency into cupboards. Savings can be deposited in banks, loaned to governments, or invested in countless other ways to earn returns for those who save.

So for people to strive to earn more income while they neither want to spend it now nor to invest any portion of it, it must also be true that too few trustworthy banks or other potential users of these savings exist. These conditions are possible.

However, contrary to John Maynard Keynes’s assumption that they inevitably arise in advanced industrial economies out of the simple lack of new things to produce, these conditions arise only when government policies are excessively hostile to investment and enterprise.

In the extreme case, government can nationalize industries, but even less-extreme assaults on investment often drown investors’ enthusiasm. High capital-gains taxation, burdensome regulations, or the fear that these policies are in the offing might well scare investors away.

In his 2006 book “Depression, War, and Cold War,” economic historian Robert Higgs documents that the belligerent anti-capitalist rhetoric and the real likelihood of even more government intrusion into the economy during Franklin Roosevelt’s presidency were the chief reasons the Great Depression lasted as long as it did.

If government merely makes itself unobtrusive, entrepreneurs will constantly search for (and find!) new ways to satisfy consumer desires. Also, whatever portions of incomes are not spent today buying consumption goods will be invested in these projects. There will be no problem with total demand being chronically too low.

Keynesian economists also fail to understand what the great Austrian economist F.A. Hayek understood; namely, that markets allocate resources by relative prices. For example, suppose consumers’ taste for fish intensifies while their taste for beef weakens. Consumers will then spend more money buying fish and less buying beef. The resulting higher price of fish relative to the price of beef will signal to entrepreneurs, investors and resource owners to produce more fish and to produce less beef. This change in production patterns is precisely what should happen.

Specialized beef producers, though, aren’t so keen on this little piece of economic change. Some workers in the beef industry will lose their jobs.
Would it be a sound economic diagnosis to attribute these job losses to a reduction in total consumer demand? Of course not. Would it be sound economic policy for government to save those jobs by entering the beef market and buying more beef? Of course not, for to do so would divert scarce resources from other uses more valuable to consumers.

Now suppose that an unusual amount of such economic changes take place at one time. The result will be, and should be, that an unusual amount of economic displacement takes place in the short-run as an unusually large number of workers adjust to the new pattern of consumer demands.
Keynesians, however, misread such events as evidence that total demand is too low and prescribe higher government spending. Politicians, ever eager to justify meddling further into the economy, jump on this Keynesian bandwagon. The result is that the normal corrective adjustments in the market are thwarted and government’s power over the private economy grows dangerously.

Regrettably, this unhappy alliance between Keynesian economists and opportunistic politicians is fueling today’s enthusiasm for fiscal “stimulus.”
Mr. Boudreaux is professor of economics at George Mason University and senior fellow for economic policy and tax reform at the Virginia Institute for Public Policy.