Squaring the Culture

"...and I will make justice the plumb line, and righteousness the level;
then hail will sweep away the refuge of lies,
and the waters will overflow the secret place."
Isaiah 28:17

01/27/2009 (1:39 pm)

Why Keynes Is Wrong

I came across the Center for Freedom and Prosperity on a tip from Hot Air, which has one of their videos featured today. It’s a good video, but they referenced an earlier video that I thought was more important — a brief and very simple discussion of why Keynesianism is off the mark. Listen:

Two minor complaints:

First, one of the features of Keynesian economics is that they assert a multiplier for government spending. They argue that when individuals have money to spend, they save some of it, but when the government has money to spend, they spend all of it. They argue that by taking the money as taxes and spending it as government spending, more money reaches the economy — the difference being what the taxpayers would have saved. That’s how they claim that taking money out of the economy through taxation then re-inserting it through government spending actually stimulates the economy.

This is nonsense, in my humble opinion, but it’s important to understand why Keynesians think their system works, and why they’re wrong. Dollars saved do not disappear from the economy, they get cycled into capital formation. Capital formation results in expansion, and expansion occurs by way of spending — Widget Manufacturing builds a new plant by buying materials from suppliers, paying construction workers, etc. So saved dollars circulate just as readily as spent dollars, only they cycle through the banking system first. I accepted the Keynesian multiplier when I first studied economics, because that’s what college freshmen do when their professors feed them an equation, but I’m not buying it now, especially with all the real-world examples of failed Keynesianism to work from.

And by the way, it probably was not WW II that got us out of the Great Depression. If you think it was, ask yourself why the economy would not therefore benefit if we simply bought goods from manufacturers and blew them up (which is what happens to many military goods produced for war.) WW II reduced unemployment by shipping so many workers off to fight the war, but it did not improve output of useful domestic goods. What ended the depression, in fact, was the exit of FDR from the scene, the repeal of several government programs, and a return to a predictable government.

Complaint #2 is that using the Nikkei Index as a proxy for the performance of the Japanese economy is not exactly right. It corresponds roughly to how things were going, but it’s not really a good economic indicator. That’s a minor technical dispute, though; the video is pretty much on the mark.

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January 28, 2009 @ 5:12 pm #

Hi Phil,

You said: ” So saved dollars circulate just as readily as spent dollars, only they cycle through the banking system first.”

Currently, the reason that I have been laid off from my job is that banks are NOT sending the money on – they are finding it best to hold on to it. Thus, the TARP funds that have been paid out so far remain in the Banks’ vaults.

If this were not so, my job would not have gone away.

So, while your statement has been generally true over the last several decades, it would be a mistake to think that giving money to those who would put it into savings would do anything to stimulate the economy. At least for a while, money saved will actually remain in the bank.

The key thing that needs to happen is that the money gets moving again…whether that happens via stimulus by the government or by some other mechanism is not all that important, no?

January 28, 2009 @ 5:57 pm #

If the banks are holding the money, flooding the economy with huge sums of cash will not solve the problem. This is one of the problems I have with the entire idea of “stimulus.”

In medical terms it would be like trying to cure a blood clot with a blood transfusion; more blood isn’t going to solve the circulation problem.

The original stimulus package was passed with the clear recognition that the funds would be used to purchase poisonous assets from struggling financial institutions. It’s not clear that these purchases ever took place. Instead, TARP funds have gone to auto manufacturers, credit card companies, and AIG, an insurance company, and now the politicians are talking of using remaining TARP funds for pet projects.

I’m curious to know more detail of what the banks are up to, and I have not found a good source. Please tell me anything you know. Thanks.

January 28, 2009 @ 6:13 pm #

darkhorse —

Let me add this: I just checked the statistics at the New York Federal Reserve Bank, and there’s no indication there that business loans have not been issued. The figures through the end of December show business loans at what appears to be an all-time high. Since the current crisis began in October, and the nature of the crisis was that banks were afraid to loan money, I’m curious — an understatement — to understand where I can find any statistical indication of the crisis.

Check here to see what I just saw; click on “Business Finance” and look at the business loans graph.

January 28, 2009 @ 8:39 pm #

Hi Phil,

I have deep reservations about the current “stimulus” package, mostly because I have no idea what is in it, and suspect that at least SOME Republicans voted against it because of principle.

But I can assure you: as of late November/early December, it became extremely hard for businesses to get loans, or my job would just be cruising right along.

Am I wrong that a chunk of the money went to buy stock in ailing banks? THAT was where the weak link happened – no strings tied to the stock purchases.

If I am wrong, no hurt feelings here. I’ll be poking around tonight for deeper answers.

January 29, 2009 @ 8:13 am #

Me too. In fact, I’ll be writing about this today. The articles I’ve found are ambiguous; some say banks are being too picky, others say there’s no demand (businesses are hunkering down instead of expanding), and still others say there’s plenty of loaning going on. This is very suspicious; if there really were a crisis, don’t you think everybody would be saying more or less the same thing?

As it relates to Keynes, though, even “money in the vault” gets back into the economy. They don’t leave it in the vault — most of it is not hard currency, anyhow — but if they’re not loaning it to you, they’re loaning it to the government, in the form of Treasury Notes, or to some other instrument they consider safe.

Banks’ currency on hand is set as a minimum 3% by law, as part of the FDIC system. I’ve never heard of a bank keeping much more than that, but if some do, I would imagine they do it as a matter of policy.

January 29, 2009 @ 3:05 pm #

[…] And by the way, it probably was not WW II that got us out of the Great Depression . If you think it was, ask yourself why the economy would not therefore benefit if we simply bought goods from manufacturers and blew them up (which is …$anchor_text[$anchor_choice] […]

January 30, 2009 @ 12:04 am #

The reason banks aren’t lending money, even after receiving the bail outs is simple. Real property values, the valuation of capital, are going Democrat, still declining.

All banks are still way, way under-capitalized. Look around and see what’s happening with the banks. They’re fewer and fewer of them. Many smaller ones being absorbed by bigger banks. This is like the movie, “Its a wonderful life” George Bailey’s smaller “Building and Loan Association” is a target for Potter’s takeover. Potter sends in the state bank auditor on Bailey’s business. Banks have always been in a position of trust, always under some type of state (now federal) government oversight. That movie was filmed long before fed FDIC, and its reserve requirements, existed. Why all these problems again?

Federal Government sabotage! There are only a handful of banks that have been designated “Tenessee Tuxedo”: Too big to fail. They are the chosen few banks that receive the bail out cash. Eg: Bank of America, US Bank, Northern Trust, Wells Fargo, Chase. All banks are required to carry FDIC insurance or lose their charters. To remain FDIC insured, banks are audited to prove a certain level of capitalization, or they lose their charters. Note that banks make money on lending money: To real-estate. Its safe, usually. It doesn’t normally depreciate. It can’t be moved. But..Can it go bad? Yep! We’ve seen 30%-40%, still progressing decreases in the value of properties as of late. This put the “safe” banks with sound realty investments, into the precarious positions of under-capitalizaton: at risk of losing their FDIC insurance and their charters. Hence, those “chosen” bigger, more “secure”, banks are to buy them up with federal (your’s and mine) money. Even when they receive the big bailouts, they can’t lend it. Or, be back in the same positions they were in. Screwed!

All of this happened because of the government interference, dictating what would constitute sound lending practices. This drained capital away from more worth causes, into realty. The unsound lending requirements caused the artificial inflation of real property values by an artificial demand. Specifically, the likes of “Kwiss Dodd” and “Bawney Fwanks”, whos function is to oversee the likes of Fannie Mae and Freddie Mac. That re-wrote the rules that forced the banks to loan money to those whom should never have been qualified for loans: “NINJA” Loans: No Income, No Job, No Assets. Bad credit risks that are overlooked because of rainbow goals. Their color, creed and national origin overide the ninja situations. Illegal aliens, included! All of this demand for “home ownership” for those that should have forever rented, resulted in demand exceeding supply, severely inflating the prices, even for those of us that are qualified. The ensuing lack of demand resulted in decreases in property values, reducing all banks’ reserves! The bad paper loans advocated by the government, are ultimately placed around the neck of the taxpayer. So, even though they receive the bailout money. It just sits at the bank, being the reserve necessary to keep the federal insurance requirements. They simply can’t lend it out! They have to keep it around to buy the next bank that fails.

Why aren’t Kwiss and Bawney brought up on malfeasance charges? They should be tarred and feathered! Instead ,they still set on their thrones: Continuing to bleed this economy dry.

February 10, 2009 @ 5:56 pm #

My question is simple, but i suspect the answer is not. How does the flow chart shown in the video change when the government gets money from outside of the country rather than from the citizens themselves? The US isn’t pulling much money from the domestic private economy to fund the stimulus. Most is coming from t-bills sold to China. I think that this opens the door for huge problems down the road, but it may seem to give keynesians a win in the short term as foreign money floods into the market. I would be very interested to see whether or not Japan tried to fund their 90s government works spending through taxation and the domestic sale of government bonds or through foreign debt purchases. I suspect it to be the former. Anyways, just my initial reaction… time to poke around for some answers.

February 11, 2009 @ 12:54 pm #

Actually, devin, I don’t think foreign money changes the flow chart at all. We all live in a global economy, so the money in the economy necessarily includes a great deal of foreign investment. Money that is borrowed by the federal government from China is money that might have been available for investment in private businesses in the US (or elsewhere) rather than in government securities, same as money taken in taxes.

As to the problems down the road, we’re likely to experience far, far worse problems when China decides to STOP buying T-bills than we’ll ever experience from their holding them. If war occurs between China and the US, for example, and we freeze their assets, China loses access to all the money invested in T-bills. If our currency collapses, likewise, China loses everything invested in T-bills.

The only way the US gets hurt is, unfortunately, a far more likely possibility: Obama and the Democrats borrow so much, and spend so much, and devalue the currency so much, that China starts to doubt our ability to repay, and stops buying. Reduced demand and reduced investor confidence will be met by raising the return on T-bills, which will pump interest rates ‘way up throughout the economy, and we’re back to 15% interest rate mortgages. (Mind you, GWB put us well on the road toward this already. The Dems just promise to accelerate it.)

Japan financed its 90s infrastructure projects by borrowing. The Japanese government bond market is more than $5 trillion USD, which means they’re getting a manure-load of their funds from overseas. See http://www.celent.com/PressReleases/20060530/eJGBs.htm on the Japanese Govt Bond market.

It also occurs to me that both Japan and China, the two largest foreign holders of US government debt, both finance their purchases using dollars obtained through an enormously positive trade balance with the US. In other words, they take the dollars out of the economy when they send us their goods, and then put the dollars back into the economy when they buy our bonds.

January 30, 2010 @ 11:17 am #

[…] Cato Institute explaining why Keynesian economics fails to stimulate economies. You might want to go back and read last year’s version, since I did have a few minor quibbles with the video. And then, you get to see a second video by […]

September 17, 2010 @ 6:49 pm #

The article above claims “Dollars saved do not disappear from the economy, they get cycled into capital formation.” Not necessarily – and that is the whole problem, as Keynes pointed out. That is, money saved is NOT NECESSARILY invested.

Indeed, there is a classic and very extreme example of this problem taking place at the time of writing: banks are sitting on record reserves, but businesses are not borrowing and investing!

September 18, 2010 @ 1:48 pm #


You’re correct about the current freeze-up, but that’s caused by government intrusion. Nobody’s borrowing and investing because they’re so uncertain what the government is going to do next, and whether the next government intervention is going to change the rules the way the last several have. If I were a bank, and were facing the prospect that the government would mandate that the terms of the loans I’m making would not be upheld, I would not loan money; or if I were a business and concerned that some ordinary business practice were about to be declared criminal or gobbled up by a government agency, or worse, taken from investors and handed to the union, I would not borrow.

The basic theories of economics assume that all activity takes place within a stable political and legal system. We’re not in those conditions today. So, the current freeze-up is not an instance of anything Keynes predicted.

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