Keynes’s First Claim: The Free Market’s Chronic State of Depression Is Caused by Too Much Saving and Not Enough Consumption and/or Investment

To Keynes, a state of high unemployment is a part of the normal conditions of a free market. He claims, “the evidence indicates that full, or even approximately full, employment is of rare and short-lived occurrence.” He also says, “it [the economic system] seems capable of remaining in a chronic condition of sub-normal activity for a considerable period.” To understand what Keynes means by a “condition of sub-normal activity,” one must keep in mind that he wrote The General Theory when economies were still recovering from the Great Depression and he was referring to an economy that was in a state of depression.

This chronic state of “sub-normal activity,” according to Keynes, is caused by too much saving and not enough consumption and/or investment. In Keynes’s words, “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.” . . . 

The problem of too much saving and the chronic state of depression is especially true for a wealthy society, according to Keynes. He states:

The richer the community, the wider will tend to be the gap between its actual and its potential production. . . . [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.

—Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 18-19.

Simpson (2014) on Methodological Objections to the Real Business Cycle Theory (Post 2 of 2)

I will make one last point on methodology before I start addressing specific RBC theories. RBC theorists, like Keynesians, use perfect competition in their analysis. The difference is that while Keynesians claim that the characteristics of perfect competition are not met (i.e., markets are “imperfect”), RBC theorists claim that they are and that fluctuations are a part of  competitive equilibrium and market clearing economic activity. RBC theorists accept the same false premise as Keynesian economists, they simply claim that the premise holds. RBC theorists, like Keynesians, need to reject the false premise and (among other things) embrace the sound theory of competition.

In a sense, RBC theory is worse than Keynesian “sticky price theory.” The Keynesians are right to claim that the characteristics of perfect competition do not hold in reality because these characteristics have nothing to do with the nature of competition. The RBC theorists are not deterred by this and claim that the business cycle consists of natural fluctuations within a perfectly competitive equilibrium. While it may seem plausible that expansions are consistent with market clearing economic activity, it is more difficult to believe this for contractions. This is the case in particular for severe contractions. Are we to believe that the recession of the early 1980s, the recession of 2008–9, and even the Great Depression were fluctuations in which markets cleared?

—Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 81-82.

Simpson (2014) on Methodological Objections to the Real Business Cycle Theory (Post 1 of 2)

Real business cycle (RBC) theories are nonmonetary explanations of the business cycle. Supporters of RBC theory claim that business cycles arise due to changes in real factors, instead of monetary factors, in the economy. The focus is on alleged causes of the business cycle that emanate from places other than changes in the supply of money and spending. Further, such cycle theory assumes markets are always in equilibrium (i.e., they always clear, even during recessions and depressions).

Probably the most popular version of RBC theory claims that changes in the level of technology affect the economy such that it causes fluctuations in output and employment (i.e., a business cycle). The claim is that a new invention will increase productivity and bring on an expansion in the economy as the use of this invention becomes widespread. Likewise, technological regression will cause a decrease in overall production in the economy, thus creating a contraction. . . .

__________

Let me start with a criticism pertaining not to the content of RBC theory but to the methodology of RBC theorists. RBC theorists often simply attempt to mimic the movement of variables during business cycles, such as unemployment and output, using mathematical equations.  They believe that this somehow makes their “theory” valid. However, simply being able to mimic a phenomenon does not provide an explanation for why that phenomenon occurs. To explain a phenomenon one must be able to show logically what factors are causing that phenomenon to occur.

One may be able to mimic changes in output, unemployment, interest rates, the money supply, and so on and one may even be able to obtain the correct relative changes in these variables; however, unless one can show why these variables are changing or why a change in one variable causes a change in another, one does not have an explanation for the movements. In fact, one does not have a theory at all for why the phenomenon occurs. One merely has an intellectually empty imitation of variables. . . . 

In addition, curve fitting data, or what contemporary, mainstream economists might call “calibrating” a “model,” does not provide an explanation of why the variables in the “model” change. It does not identify the causal factors involved. One needs a logical explanation grounded in the nature of the phenomenon and entities being studied to understand why variables move as they do.

—Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 79, 81.