Ideas On Liberty

NOVEMBER 2004 and the Failure of Keynesian Economics

by Richard M. Ebeling

or four decades, from the mid-1930s to would establish his reputation as the leading the 1970s, Keynesian economics almost monetary theorist of his time.5 Instead, the monopolized economic policy in the book was savaged by reviewers, including FUnited States and around the world. The many of the most prominent economists in “new economics,” as it was called, was Great Britain and the . The going to assure mankind economic stability, most devastating criticisms were made by a full employment, and material prosperity— young Austrian economist named Friedrich all through wise government management of A. Hayek, who in a lengthy two-part review monetary and fiscal policy. So dominant was demonstrated the logical confusions and the- this view that only in 1959 did the first oretical misunderstandings that ran through book-length refutation of the ideas of John the entire work.6 Maynard Keynes appear: Henry Hazlitt’s For the next five years Keynes devoted his The Failure of the “New Economics”: An time to devising a new theory for his argu- Analysis of the Keynesian Fallacies.1 ment that a free-market economy was inher- Keynes (1883–1946)2 had a acquired an ently unstable and that only the guiding international reputation shortly after World hand of government could assure full War I, when he published The Economic employment in the face of the economic dis- Consequences of the Peace, a biting criticism aster being experienced during the Great of the Treaty of Versailles that formally Depression of the early 1930s. This work ended the war.3 In the 1920s he was a lead- finally appeared in February 1936 under the ing critic of the gold standard and a vocal title The General Theory of Employment, proponent of a government-managed cur- Interest, and Money.7 rency to maintain full employment. In his Except for some of Keynes’s young pro- 1924 book, A Tract on Monetary Reform, tégés at Cambridge University, most of the Keynes declared that gold was a “barbarous reviewers of the book were highly critical of relic” and that governments should use their many of its theoretical “innovations,” as well control over the money supply to maintain a as its inflationary prescriptions for unem- stable domestic price level even if this ployment.8 Even some economists who later required abandoning a stable foreign became proponents of Keynes’s “new eco- exchange rate between the British pound and nomics” were initially highly critical of his the other currencies of the world.4 work. For example, Alvin Hansen, who was In 1930 Keynes published A Treatise on one of the leading advocates of Keynesian Money, a two-volume work that he expected economics in the United States in the 1950s and 1960s, wrote in late 1936 that The Gen- Richard Ebeling is the president of FEE. eral Theory “is not a landmark in the sense 15 : Ideas on Liberty • November 2004 that it lays the foundation for a ‘new eco- for a prolonged period in what Keynes called nomics.’ . . . The book is more a symptom of an “unemployment equilibrium.” Couldn’t economic trends than a foundation stone workers improve their prospects by accept- upon which a science can be built.”9 ing lower money wages? No, Keynes Yet within a few years, and most certainly insisted, because workers suffer from a by the end of World War II, Keynes’s ideas “money illusion”—even if prices were falling had virtually pushed aside every other expla- and a cut in wages would make them no nation of the causes and cures of economic worse off in real buying-power terms, work- depressions.10 Keynes’s book became the ers would refuse to accept less money. foundation stone for the new “macroeco- Rather than demand that workers accept nomics.” His face even appeared on the lower pay, Keynes favored raising the gen- cover of the December 31, 1965, issue of eral level of prices so employers could make Time magazine. The feature article, titled profits without cutting wages. In other “We Are All Keynesians Now,” stated: words, Keynes’s solution to unemployment was price inflation. Today, some 20 years after his death, his theories are a prime influence on the Deficit Spending world’s free economies, especially Amer- ica’s. . . . Now Keynes and his ideas, Government deficit spending would pro- though they still make some people ner- vide additional market demand, pushing vous, have been so widely accepted that prices up and stimulating more hiring. they constitute both the new orthodoxy in Public-works projects would “prime the the universities and the touchstone of eco- pump.” This policy would continue until nomic management in Washington. . . . “full employment” was attained. But since, Now even businessmen, traditionally hos- in Keynes’s view, businessmen were usually tile to Government’s role in the economy, shortsighted and irrational in their fears have been won over. . . . They have begun about investment prospects, the private sec- to take for granted that the Government tor would always lag behind in creating jobs. will intervene to head off recession or The government would have to be con- choke off inflation, [and] no longer think stantly at the monetary and fiscal controls, that deficit spending is immoral.11 injecting spending into the economy to pre- vent it from sinking back into unacceptable Keynes argued in The General Theory that levels of unemployment. the free-market economy contained no built- In Keynes’s conception of the world, gov- in mechanism to assure full employment. ernments guided by his ideas would be wise The crucial weakness, he said, lies in the and farseeing, assuring that the mass unem- relationship between savings and invest- ployment of the 1930s never happened ment. People tend to consume more as their again. Government would manipulate inter- incomes go up, but the increase is not as est rates, the level of prices, and the amount great as the increase in income. In other and direction of investment to assure that words, they also save a portion of their society had high employment, socially bene- higher income. The problem, he insisted, is ficial investment, and general economic that saving is “non-spending” and if people stability. do not spend all the extra income they earn, There were critics of Keynesian economics businessmen may not have the incentive to in the 1940s and 1950s, but they were virtu- invest enough to employ all those who want ally ignored by academic economists and to work at prevailing wages. policymakers.12 Some mainstream macro- As a result, a large portion of the labor economists also took Keynes to task. But force may be left unemployed because the many of their criticisms were couched in private sector has failed to create enough terms clearly meant not to antagonize their jobs. The economy, therefore, may be stuck Keynesian colleagues. 16 Henry Hazlitt and the Failure of Keynesian Economics

Then in 1959 came Henry Hazlitt’s The money supply in the early 1930s increased Failure of the “New Economics.”13 What the degree to which prices and wages had to was unique about Hazlitt’s exposition was fall to re-establish full employment.) his chapter-by-chapter dissection of the Hazlitt considered Keynes’s inflationary arguments in Keynes’s General Theory.14 “fix” crude and dangerous. First, Hazlitt Central to Keynes’s theory was his insis- pointed out that Keynes’s focus on macro- tence that “Say’s Law” was wrong in claim- economic “aggregates” concealed the micro- ing that “supply creates its own demand.” economic relationships among a multitude Just because people supply goods on the of individual prices and wages. The price market does not mean they will demand level, wage level, total output, aggregate what others are selling. They may abstain demand, and aggregate supply were all sta- from spending by holding idle cash balances. tistical fictions that had no reality in the Thus there could be a general glut of goods actual market. Thus the wage level could not on the market. be too high relative to the general price level. But in the 1930s many wages for different Say’s Law types of labor were out of balance with the prices of individual goods sold on the mar- Hazlitt showed that Keynes had misunder- ket. What was needed to restore full employ- stood what the Jean-Baptiste Say and other ment was an adjustment of numerous indi- nineteenth-century economists meant. vidual wages and resource prices to the Goods can virtually always find buyers if lower prices of many consumer goods. The prices are sufficiently attractive. The pre- extent to which any individual money wage Keynesian “classical” economists never or resource price might have to adjust down- denied that goods can go unsold and labor wards depended on the distinct supply and unemployed if suppliers fail to adjust their demand conditions in each of the individual prices and wages to match existing market markets. demand. An inflationary policy attempts to bring Furthermore, Hazlitt explained, many of some individual price-wage relationships the classical economists, especially John Stu- back into balance by pushing prices up art Mill, understood that individuals could throughout the economy, Hazlitt explained. “hoard” money rather than immediately spend it. But this was most frequently due to Because Keynes, with his lump, aggregate the temporary uncertainties of an economic thinking, is opposed to restoring employ- crisis, usually caused by a prior, unstable ment or equilibrium by small, gradual, inflationary boom.15 piecemeal adjustments . . . we must The central flaw in Keynes’s thinking, achieve the same result by inflating the Hazlitt insisted, was his unwillingness to money supply and raising the price level, acknowledge that the high unemployment in so everybody’s real wages are slashed by Great Britain in the 1920s and the United the same percentage. . . . The Keynesian States in the 1930s was caused by govern- remedy, in short, is like changing the lock ment intervention, including the empower- to avoid changing to the right key, or like ing of labor unions, that made many prices adjusting the piano to the stool instead of and wages virtually “rigid.” Political and the stool to the piano.16 special-interest power prevented markets from competitively re-establishing a balance Second, Hazlitt pointed out that workers between supply and demand for various and labor unions are aware of how rising goods. Hence, the market was trapped in prices affect the real value of money wages. wage and price distortions that destroyed There is certainly no “money illusion” in an employment and production opportunities, upward direction. An increasing cost of liv- resulting in the Great Depression. (Hazlitt ing due to rising prices soon brings worker did not deny that the contraction of the and union demands for higher pay to make 17 The Freeman: Ideas on Liberty • November 2004 up for lost purchasing power. But if workers Keynesian Economics, which appeared a and unions demand the same real wages they year after his own book. He suggested that had before the inflation, then the Keynes Keynes’s theories rationalized the politics of solution to unemployment must fail. special-interest groups that desired to reap Finally, Keynes’s macroeconomic approach the benefits of an inflation. Also, while much also concealed the fact that beneath the of The General Theory is written in difficult aggregate rising price level, inflation distorts language, Keynes could dazzle the reader many of the relative price relationships, with literary imagery and wit that hid his including the rate of interest. This inevitably central logical flaws. Keynes used the “tech- brings about misdirection of resources, capi- nique of obscure arguments followed by tal, and labor across different sectors of the clear and triumphant conclusions,” Hazlitt market that will eventually require a reshuf- said. And finally, Hazlitt conjectured that fling of supply and demand once the infla- the success of the book may have had a lot tion ends. Thus the inflationary “cure” for to do with its appearing to overthrow the unemployment brings in its wake an even- existing orthodoxy in favor of radical and tual new bout of unemployment when work- fashionable ideas about social engineering. ers have to shift jobs and readjust their wage “But whatever the full explanation of the demands in the post-inflationary period. Keynesian cult,” Hazlitt concluded, “its Indeed, in a series of chapters, Hazlitt existence is one of the great intellectual scan- clearly showed that Keynes was confused dals of our age.”20 about the actual relationships among sav- The monolithic domination that Keynes- ings, investment, and the rate of interest. ian economics once had over all macroeco- The core of his theory was founded on a nomic policy has been broken for more than bundle of errors and mistakes. This resulted two decades. While too many of Keynes’s in Keynes’s failure to comprehend that sav- misconceptions still underlie how econo- ing, investment, and capital formation—not mists think about inflation, recession, and government-stimulated increases in aggre- unemployment, the original and primitive gate consumer demand—are the foundations Keynesian thinking has been more or less of sustainable employment and rising stan- overthrown. To a great extent this is because dards of living.17 of the thorough and brilliant demolition that Hazlitt also took Keynes to task for advo- Henry Hazlitt performed more than 40 years cating increasing government control and ago. direction of investment decision-making. 1. Henry Hazlitt, The Failure of the “New Economics”: An Keynes clearly believed, Hazlitt sarcastically Analysis of the Keynesian Fallacies (Princeton: D. Van Nos- observed, “that there exists a class of people trand, 1959), reprinted by the Foundation for Economic Edu- cation in 1995. (perhaps economists very much resembling 2. The most comprehensive biography of Keynes is Robert Lord Keynes) who are completely informed, Skidelsky, John Maynard Keynes: Hopes Betrayed, 1883–1920 (London: Macmillan, 1983), John Maynard Keynes: The Econ- rational, balanced, wise, who have means of omist as Saviour, 1920–1937 (London: Macmillan, 1992), and knowing at all times exactly how much John Maynard Keynes: Fighting for Britain, 1937–1946 (Lon- don: Macmillan, 2000); in addition, see, Roy H. Harrod, The investment is needed and in exactly what Life of John Maynard Keynes (London: Macmillan, 1951), and amounts it should be allocated to exactly D. E. Moggridge, Maynard Keynes: An Economist’s Biography (London: Routledge, 1992). All of them are highly sympathetic which industries and projects, and that these to Keynes as an economist and policy advocate. managers are above corruption and above 3. John Maynard Keynes, The Economic Consequences of the Peace (New York: Harcourt, Brace, 1920); see the critical any interest in the outcome of the next elec- analysis of Keynes’s arguments about the peace treaty by Eti- tion.”18 enne Mantoux, The Carthaginian Peace, or The Economic Con- sequences of Mr. Keynes (New York: Charles Scribner’s Sons, If The General Theory had so many fun- 1952). damental flaws, how did it become, in the 4. John Maynard Keynes, A Tract on Monetary Reform (New York: Harcourt, Brace, 1924); see the critical analysis of words of one of his most enthusiastic fol- Keynes’s arguments by Benjamin M. Anderson, “The Gold lowers, “the Keynesian bible”?19 Hazlitt Standard vs. ‘A Managed Currency,’” Chase Economic Bul- letin, March 23, 1925, p. 39. offered some possible reasons in his intro- 5. John Maynard Keynes, A Treatise on Money, 2 vols. duction to his edited volume, The Critics of (New York: Harcourt Brace, 1930). 18 Henry Hazlitt and the Failure of Keynesian Economics

6. Friedrich A. Hayek, “Reflections on the Pure Theory of Kelley, 1966 [1938 and 1942]); Benjamin M. Anderson, “The Money of Mr. J. M. Keynes,” Economica, August 1931, pp. Road Back to Full Employment” in Paul T. Homan and Fritz 270–95, and February 1932, pp. 22–44; reprinted in Bruce Machlup, eds., Financing American Prosperity: A Symposium Caldwell, ed., The Collected Works of F. A. Hayek, vol. 9: Con- of Economists (New York: Twentieth Century Fund, 1945), pp. tra Keynes and Cambridge: Essays, Correspondence (Chicago: 9–70; L. Albert Hahn, The Economics of Illusion: A Critical University of Chicago Press, 1995), pp. 121–97, which also Analysis of Contemporary Economic Theory and Policy (New includes Keynes’s reply after the appearance of part I of Hayek’s York: Squier Publishing, 1949), and Common Sense Economics review and Hayek’s rejoinder. (London/New York: Abeland-Schuman Ltd., 1956); Philip 7. John Maynard Keynes, The General Theory of Employ- Cortney, The Economic Munich (New York: Philosophical ment, Interest, and Money (New York Harcourt, Brace, 1936); Library, 1949); and Hans Mayer, “John Maynard Keynes’ he earlier presented an outline of his prescriptions for an ‘Neubegründung’ der Wirtschaftstheorie” [“John Maynard “activist” government policy in The Means to Prosperity (Lon- Keynes’s ‘New Foundation’ for Economic Theory”] in E. Lagler don: Macmillan, 1933). and J. Messner, eds., Wirtschaftsliche Entwicklung und soziale 8. Some of these reviews, especially those by Frank Knight Ordnung [Economic Development and Social Order] (Wien: and Jacob Viner, were published together many years later in 1952), pp. 39–55. Henry Hazlitt, ed., The Critics of Keynesian Economics (Prince- 13. Four years later another detailed critical study of Keynes- ton: D. Van Nostrand, 1960); there were many others not ian economics appeared: W. H. Hutt, Keynesianism: Retrospect included in this excellent anthology, especially the reviews and and Prospect: A Critical Restatement of Basic Economic Princi- essays by Henry Simons, Joseph Schumpeter, Dennis Robertson, ples (Chicago: Henry Regnery, 1963); it later appeared in a Arthur C. Pigou, Bertil Ohlin, Erik Lindahl, and Carl Landauer, revised edition under the title The Keynesian Episode: A which were highly critical and insightful about fundamental Reassessment (Indianapolis: Liberty Press, 1979); see also errors in Keynes’s ideas. W. H. Hutt, A Rehabilitation of Say’s Law (Athens: Ohio Uni- 9. Alvin H. Hansen, “Mr. Keynes on Underemployment versity Press, 1974). Equilibrium,” Journal of Political Economy (October 1936), p. 14. Hazlitt, The Failure of the “New Economics,” p. 4: “I 686. Hansen later wrote one of the most widely read popular know of no single work that devotes itself to a critical chapter- expositions of Keynes’s ideas; see his A Guide to Keynes (New by-chapter or theorem-by-theorem analysis of [The General York: McGraw-Hill, 1953). Theory]. It is this task that I am undertaking here.” 10. For a detailed exposition of the alternative “Austrian” 15. Ibid., pp. 361–71; see John Stuart Mill, “Of the Influence analysis of the causes and cures for the Great Depression com- of Consumption on Production” [1844] in Hazlitt, ed., The pared to the Keynesian perspective, see Richard M. Ebeling, Critics of Keynesian Economics, pp. 24–45. “The Austrian Economists and the Keynesian Revolution: The 16. The Failure of the “New Economics,” pp. 280–81; on Great Depression and the Economics of the Short-Run” in the degree to which inflexible money wages relative to the prices Richard M. Ebeling, ed., Human Action: A 50-Year Tribute for finished consumer goods raised the real cost of employing (Hillsdale, Mich.: Press, 2000), pp. 15–110. workers in the early 1930s, and therefore resulted in rising 11. “We Are All Keynesians Now,” Time, December 31, unemployment, see Richard K. Vedder and Lowell Gallaway, 1965, pp. 64–67B. The quotations are from pp. 64–65. Four Out of Work: Unemployment and Government in Twentieth- years later, Milton Friedman appeared on the cover of Time Century America (New York/London: Holmes & Meier, 1993), (December 19, 1969, pp. 66–72), with the magazine now say- pp. 79–95. ing that “Friedman, a 57-year-old economics professor at the 17. See also Henry Hazlitt, The Conquest of Poverty (New University of Chicago . . . has reached the scholar’s pinnacle: Rochelle, N.Y.: Arlington House, 1973), pp. 217–28. leadership of a whole school of economic thought. It is called 18. The Failure of the “New Economics,” p. 324; on the the ‘Chicago School,’ and its growing band of followers argues arrogance in Keynes’s thinking about an elite who are wise and that the money supply is by far the most important and fastest- good enough to macro-manage the economy, and the harmful acting of the economic regulators at the Government’s disposal. real world consequences, see also James M. Buchanan and . . . [M]ost economists now consider themselves . . . hybrid . . . Richard E. Wagner, Democracy in Deficit: The Political Legacy ‘Friedmanesque Keynesians’” (p. 66). of Lord Keynes (New York: Academic Press, 1977). 12. Among the strongly anti-Keynesian critics who took his 19. Seymour E. Harris, “About this Book,” in Seymour E. ideas to task in some detail were W. H. Hutt, The Theory of Harris, ed., The New Economics: Keynes’ Influence on Theory Idle Resources (London: Jonathan Cape, 1939); Arthur W. and Public Policy (New York: Alfred A. Knopf, 1948), p. 9. Marget, The Theory of Prices: A Re-Examination of the Central 20. Hazlitt, “Introduction” in The Critics of Keynesian Eco- Problems of Monetary Theory, 2 vols. (New York: Augustus M. nomics, pp. 9–10.

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