In “Hydraulic Keynesianism,” the Models Resembled the Mathematical Description of a Plumbing System

The difficulty in understanding the General Theory may have contributed to its success as the founding text of macroeconomics. The book is open to alternative interpretations. In the post-war years, if you wanted to propose interventionist policies to ‘stabilise the economy’ or otherwise improve economic performance, you might well cite the General Theory as the source or context for your proposed policies. Thus, a variety of interventionist systems of thought were labelled ‘Keynesian’.

After the war, one version of economics, described as Keynesian, came to dominate macroeconomics. This breed of Keynesianism would estimate a consumption function, an investment function and other functions intended to represent stable relationships determining the overall levels of output, employment and prices. Changing policy variables such as the government deficit could, it was thought, shift these functions about and give us a better combination of output, employment and prices. Increasing money growth, for example, would inevitably cause some price inflation, but it would also reduce unemployment. This supposed inverse relationship between inflation and unemployment (Samuelson and Solow 1960) is known as the ‘Phillips curve’. Assuming a stable Phillips curve, any event that might increase unemployment could be met with a bit of inflation as a reliable offset.

This sort of macroeconomics is sometimes called ‘hydraulic Keynesianism’. Keynes was claimed as an important source and it was ‘hydraulic’ because the models resembled the mathematical description of a plumbing system. The flow of spending in an economy looked like the flow of water in a system of pipes. And just as we can regulate the flow of water with a few valves, we can regulate the economy with a few relatively simple policy instruments – or so it was thought.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 41-43.

For John Law, Money Is an “Instrument” That Is Deliberately Designed to Achieve the “Policy Goals” of Government Planners

In 1705, Law published his principal work on money, entitled Money and Trade Considered: With a Proposal for Supplying the Nation with Money. Law’s “proposal” was intended to provide his native Scotland with a plentiful supply of money endowed with a long-run stability of value. The institutional centerpiece envisioned in Law’s scheme resembles a modern central bank, empowered to supply paper fiat money via the purchases and sales of securities and other assets on the open market. Also strikingly modern are the theoretical propositions with which Law supports his policy goals and prescriptions.

Law initiates his monetary theorizing with two fundamental assumptions about the nature and function of money. The first is that if money is not exactly an original creation of political authority, it ideally functions as a tool to be molded and wielded by government. Law believes that the State, as incarnated in the King, is the de facto “owner” of the money supply and that it therefore possesses the right and the power to determine the composition and quantity of money in light of the “public interest.” Writes Law:

All the coin of the Kingdom belongs to the State, represented in France by the King: it belongs to him in precisely the same way as the high roads do, not that he may appropriate them as his own property, but in order to prevent others doing so; and as it is one of the rights of the King, and of the King alone, to make changes in the highways for the benefit of the public, of which he (or his officers) is the sole judge, so it is also one of his rights to change the gold or silver coin into other exchange tokens, of greater benefit to the public. . . .

Translating Law’s statement into modern terms, money is an “instrument” that is or should be deliberately designed to achieve the “policy goals” considered desirable by political money managers and other government planners.

—Joseph T. Salerno, “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot,” in Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), 3-4. 

Although the Demand for Money Can Be Defined as a FLOW or as a STOCK, We Will Use the Stock or Cash Balances Definition

The demand for money can be defined either as the demand for monetary payments (flow), or as the demand for cash balances (stock). As far as the determination of the price level is concerned, both definitions lead to the same result. We will work with the second definition (money demand concerns cash balances) because it highlights the crucial fact that money renders its services not only at the moment when it is used in spending, but also during the entire period when it is being held or “hoarded.” Money is the most marketable commodity. Thus cash balances, even while they are not being spent, provide liquidity services to their owners.

Cash balances are demanded for the liquidity services they provide. They are demanded for their purchasing power. The only exception is the merely nominal demand for money by collectors. The latter are not interested in the purchasing power of the bank notes and coins they collect. They are only interested in the notes and coins per se—that is why we call them collectors. But true money users do not demand mere nominal cash balances, but real cash balances. They demand a certain purchasing power.

—Jörg Guido Hülsmann, “The Demand for Money and the Time-Structure of Production,” in Property, Freedom, and Society: Essays in Honor of Hans-Herman Hoppe, ed. Jörg Guido Hülsmann and Stephan Kinsella (Auburn, AL: Ludwig von Mises Institute, 2009), 311.

The Static State Can Dispense with Economic Calculation But a Static State Is Impossible in Real Life

The static state can dispense with economic calculation. For here the same events in economic life are ever recurring; and if we assume that the first disposition of the static socialist economy follows on the basis of the final state of the competitive economy, we might at all events conceive of a socialist production system which is rationally controlled from an economic point of view. But this is only conceptually possible. For the moment, we leave aside the fact that a static state is impossible in real life, as our economic data are forever changing, so that the static nature of economic activity is only a theoretical assumption corresponding to no real state of affairs, however necessary it may be for our thinking and for the perfection of our knowledge of economics. Even so, we must assume that the transition to socialism must, as a consequence of the levelling out of the differences in income and the resultant readjustments in consumption, and therefore production, change all economic data in such a way that a connecting link with the final state of affairs in the previously existing competitive economy becomes impossible. But then we have the spectacle of a socialist economic order floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation.

—Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, trans. S. Adler (1990; repr., Auburn, AL: Ludwig von Mises Institute, 2012), 22-23.

Calculation “In Natura,” In an Economy Without Exchange, Can Embrace Consumption Goods Only and Completely Fails with Goods of a Higher Order

It is an illusion to imagine that in a socialist state calculation in natura can take the place of monetary calculation. Calculation in natura, in an economy without exchange, can embrace consumption goods only; it completely fails when it comes to dealing with goods of a higher order. And as soon as one gives up the conception of a freely established monetary price for goods of a higher order, rational production becomes completely impossible. Every step that takes us away from private ownership of the means of production and from the use of money also takes us away from rational economics.

It is easy to overlook this fact, considering that the extent to which socialism is in evidence among us constitutes only a socialistic oasis in a society with monetary exchange, which is still a free society to a certain degree. In one sense we may agree with the socialists’ assertion which is otherwise entirely untenable and advanced only as a demagogic point, to the effect that the nationalization and municipalization of enterprise is not really socialism, since these concerns in their business organizations are so much dependent upon the environing economic system with its free commerce that they cannot be said to partake today of the really essential nature of a socialist economy. In state and municipal undertakings technical improvements are introduced because their effect in similar private enterprises, domestic or foreign, can be noticed, and because those private industries which produce the materials for these improvements give the impulse for their introduction. In these concerns the advantages of reorganization can be established, because they operate within the sphere of a society based upon private ownership of the means of production and upon the system of monetary exchange, being thus capable of computation and account. This state of affairs, however, could not obtain in the case of socialist concerns operating in a purely socialistic environment.

—Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, trans. S. Adler (1990; repr., Auburn, AL: Ludwig von Mises Institute, 2012), 17-18.

A Consistent Macroeconomic Approach Would Have to Shun Any Reference to Prices and to Money

The macroeconomist deceives himself if in his reasoning he employs money prices determined on the market by individual buyers and sellers. A consistent macroeconomic approach would have to shun any reference to prices and to money. The market economy is a social system in which individuals are acting. The valuations of individuals as manifested in the market prices determine the course of all production activities. If one wants to oppose to the reality of the market economy the image of a holistic system, one must abstain from any use of prices.

—Ludwig von Mises, The Ultimate Foundation of Economic Science: An Essay on Method (Princeton, NJ: D. Van Nostrand Company, 1962), 84.

This Is Not Science — It Is Witchcraft! Seeing How Bad Econometric Forecasting Is

As for forecasting, a look at the literature on exchange rate economics gives us an idea of how bad econometric forecasting is. We can predict precisely when a falling object will hit the ground and where a projectile will land, but we cannot predict with a reasonable level of confidence whether a currency will appreciate or depreciate on the announcement of unemployment data — that is, we cannot even predict the direction of change, let alone the magnitude of change. I must admit, however, that economists (or applied econometricians) are good at finding explanations for currency appreciation or depreciation in response to the announcement of unemployment data — only after the fact, of course. It all depends on what the researcher wants to prove and if that turns out not to be the case, an explanation is found for why it did not turn out to be the case, sometimes blaming the unwanted results on econometrics itself (such as the low power of the test). This is not science — it is witchcraft.

—Imad A. Moosa, Econometrics as a Con Art: Exposing the Limitations and Abuses of Econometrics (Cheltenham, UK: Edward Elgar Publishing, 2017), 52.

Econometrics Has Been a Success Only in the Limited Sense That It Can Be Used to Prove Almost Anything

Econometrics has been a success only in the limited sense that it can be used to prove almost anything. I have always challenged seminar presenters, saying that if they let me have their data I could turn their results upside down and come up with a different conclusion. Econometrics is very useful for those wanting to prove a pre-conceived belief or find results that support an ideologically driven hypothesis. Take, for example, Brexit, which had proponents and opponents. The empirical results produced by the opponents on the effect of Brexit on the British economy of leaving the EU are all over the place but ideological bias is conspicuous. For example, the Confederation of British Industry (2013), which is against Brexit, estimated the net benefit to Britain of EU membership to be in the region of 4 per cent to 5 per cent of GDP — that is, between £62 billion and £78 billion per year. Conversely, Congdon (2014) puts the cost of Britain’s membership of the EU at 10 per cent, attributing this cost to regulation and resource misallocation. Congdon’s estimates were prepared for the United Kingdom Independence Party (UKIP), which has a strong anti-Europe stance.

—Imad A. Moosa, Econometrics as a Con Art: Exposing the Limitations and Abuses of Econometrics (Cheltenham, UK: Edward Elgar Publishing, 2017), 18.

Anglo-American Economists Are Living in Their Dream World and Are Ignorant of the History of Economic Thought

To one outside the magic circle of the Keynesians the reason seems to be what can be called the isolationism of Anglo-American economics. It is this isolationism that prevents economists from seeing the merits and weaknesses of their work in a detached and objective way and in the right perspective. It prevents them from being aware that most economists in Germany, France and Italy strongly oppose the Keynesian doctrines. For example, to Professor Adolf Weber, the well-known economist of the University of Munich, the idea that full employment is mainly threatened by a lag of investment behind saving, sounds merely like a bad joke. But the isolationism of Anglo-American economists is also historical. They believe earnestly that their ideas are fundamentally new, unique, and a definite answer to the problems of a competitive economy. Insufficiently educated in the history of economic thought, they do not realize that Keynesianism — down to the most technical details, like the concept of the foreign exchange multiplier — is mercantilism or, more precisely, John Lawism pure and simple. Thus they do not recognize that the objections of the classical economists to mercantilism are valid also in respect to their own teachings. Nor do they see that many concepts of the modern planners — fair prices, fair wages, fair profits, and so on — are nothing else than a new edition of the medieval scholastic concepts of justum pretium and justum salarium [just price and just salary], which proved so detrimental to economic progress.

Reading, quoting, praising and promoting each other, and only each other, will not liberate these economists from their voluntary isolationism. They will remain in their dream world. They will continue to predict the unpredictable.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 24.

Forecasting Mania Is an Integral Part of “Functional Finance,” the “Multiplier Effect” and the “Acceleration Principle”

The forecasting mania of our time is a natural concomitant of what is called Keynesian economics. It constitutes an integral part of the world of “functional' finance,” of the “multiplier effect” of the “acceleration principle” and similar concepts. If one really believes, as the “inventors” of functional finance do, that a depression can be prevented and a boom prolonged ad libitum [as much or as often as necessary or desired] by government deficit spending, if one fails to see that the elimination of the maladjustments in the price-cost relationship created during the previous boom are necessary conditions of revival, then indeed the economic future appears no longer too uncertain. And if one really believes in the working of the multiplier and the acceleration principle, then the more remote future also appears predictable. For according to the multiplier theory a given amount of spending on investment leads in time to an immediately ascertainable stable amount of spending on consumption; whereas a given amount of spending on consumption leads in time to an immediately ascertainable amount of spending on investment.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 23.

After Seeing Numerous Forecasting Failures in the 1940s and 1950s, Dr. Hahn Proposed a “Law of the Necessity of Errors in Forecasting”

All forecasts of postwar deflation turned out to be entirely wrong, as was to be expected. Almost immediately after the end of hostilities a postwar boom began. But the forecasters, in no way discouraged by their errors, stayed on the job. Now they predicted the continuation of inflation. Just when their forecasts became most articulate, in the spring of 1949, the recession of that year set in. Then deflation was considered here to stay; government intervention was advocated. The second postwar boom, not caused, I think, but accentuated by the outbreak of the Korean war in 1950, led again to predictions of continued and even of runaway inflation. But 1951 was basically a year of deflation, and of inflation only in the areas where it was governmentally fostered.

Clearly the regularity of these errors in forecasting can not be pure chance. Something like a Law of the Necessity of Errors in Forecasting must be at work.

It is seldom realized that belief in the possibility of “scientific” business forecasts, and the forecasting mania of our time, are comparatively new phenomena. Until about 1930 serious economists were not so bold — or so naive — as to pretend to be able to calculate the coming of booms and depressions in advance. It would not have fitted into their general view on the working of a free economy. They considered the economic future as basically dependent on unpredictable price-cost relationships and on the equally unpredictable psychological reactions of entrepreneurs. Predictions of future business conditions would have seemed to them mere charlatanry, just as predictions, say, regarding the resolutions of Congress two years from now.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 23.

To Apply to Economics Methods of Analysis Drawn from Physics Was Itself an Unscientific Procedure

Not all economists were carried away by the tide of equilibrium theory which swept through the profession in the second half of the twentieth century. A tiny handful of dissenters, known as Austrians because they followed the teachings of the late nineteenth-century Austrian economist Carl Menger, refused to accept equilibrium theory. One of their leading members, Friedrich von Hayek, wrote a series of articles during the Second World War which questioned the foundations of equilibrium theory. He pointed out that to apply unthinkingly to a social science like economics, which dealt with the behaviour of human beings, methods of analysis drawn from physics, which dealt with inanimate objects, was itself an unscientific procedure. He warned that it was particularly foolish to suppose that future economic events could be predicted as if the economic system behaved like a machine.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 23-24.

 

The Method of Reasoning Employed by the Neoclassical School Is Essentially the Same As That Followed by Ricardo

The method of reasoning employed by the neoclassical school is essentially the same as the procedure followed by Ricardo as described by Schumpeter:

This is the method of analysis which proceeds by excluding as many variables as possible. Then, for the rest, piling one simplifying assumption upon another until, having really settled everything by these assumptions, he [Ricardo] was left with only a few aggregative variables between which, given these assumptions, he set up simple one-way relations so that in the end, the desired results emerged almost as tautologies.⁴

Nevertheless, it was hailed by almost all professional economists as being a triumph for economic theory when in 1964 it was shown that, given specified endowments of resources, technology and consumer preferences, a system of competitive markets could in a logical sense be proved to exist. This triumph was only slightly marred by the fact that its proponents themselves were divided on its interpretation. Since it was recognised that the result had been achieved by making such drastic simplifications and such sweeping exclusions as were not remotely attainable in practice, did it mean that a real world market economy could work, or did it mean that it could not work?

__________

⁴Schumpeter continued: ‘The habit of applying results of this character to the solution of practical problems we shall call “The Ricardian Vice”’.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 16-17, 213n4.

It Is “In Principle” Impossible to Use Economic Theory and Statistics to Make Economic Forecasts

Morgenstern set out to show the impossibility of making any complete forecast of the state of the economy given the complexity of the mechanisms that shape economic events. He came against economic prediction from several angles, even contradicting himself in the process.

Thus was it “in principle” impossible to use economic theory and statistics to make economic forecasts. He based this claim on arguments concerning economic data, processes, and actors. The lack of homogeneity and the small size of samples made data wholly inadequate for statistical induction. Contrary to in the natural sciences, the data problems of economics were so significant as to render futile any attempt to apply probability methods. As for economic processes, Morgenstern held that attempts to understand the business cycle based on statistical considerations alone could never facilitate economic forecasting. For that, one needed to look to the underlying processes, of which prices were the surface phenomena. These mechanisms, however, lacked the regularity necessary to make them useful for any kind of prediction: only loose and inexact laws could be discovered. Finally, even when predictions were made, their effect was to create anticipations on the part of consumers, the reactions of whom would only serve to make the original forecast false. Unlike astronomy or medicine, the social sciences had the peculiarity of being able to affect their object of study. The prediction of the astronomer could have no effect on the movement of the stars, but that of the economist could change economic events. Morgenstern’s criticism of static theory is thoroughly Misesian: “In the static economy, nobody acts economically any more, and that means that they no longer ascribe value, and that no more acts of choice are made, and no decisions are made, because everything stands still.”

—Robert Leonard, Von Neumann, Morgenstern, and the Creation of Game Theory: From Chess to Social Science, 1900-1960, Historical Perspectives on Modern Economics (New York: Cambridge University Press, 2010), 101.

Equilibrium Theory Might Be Appropriate for a Planned or a Primitive Economy, But Is Not Appropriate for a Modern Market Economy

Equilibrium theory might well be appropriate for a planned economy, or perhaps for a very primitive subsistence economy, where little changes, and one year is much like the next. But it is quite unhelpful in understanding how a modern market economy works. Some of the most important elements of the contemporary economy, such as institutions, entrepreneurship and profits, are missing, while some extreme assumptions which contradict experience, such as perfect knowledge, optimising behaviour and constant returns to scale, have been introduced into the theory in order to achieve predictability. The justification of equilibrium theory therefore rests not on its explanatory power but on its predictive ability. On this point the evidence is overwhelming. All surveys of forecasting accuracy come to the same conclusion: economic forecasts based on equilibrium theory perform no better than naive forecasts which assume that next year’s values will be the same as this year’s.

—David Simpson, introduction to Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 3. 

The Austrian Aversion to Macroeconomic Aggregates Pertains to Laws Devoid of Reference to Individual Choice

The last 30 years saw the ascent of macroeconomics and a temporary eclipse of Austrian thought. What attitude should Austrian economists adopt today towards macroeconomic aggregates? We spoke above of skepticism engendered by a distrust of all formalizations of economic experience which do not have an identifiable source in the mind of an economic actor. But a more positive attitude is called for. Austrian economists must attempt, wherever possible, to impart a measure of subjectivism to the products of macroeconomic thought.

We may note that Austrian aversion does not pertain to these aggregates as such. Austrian economists, after all, did discuss the balance of payments of the Habsburg Empire. It pertains to the construction of an economic model in which these aggregates move, undergo change, and influence each other in accordance with laws which are devoid of any visible reference to individual choice. Like the bodies of a planetary system, each aggregate is affected by changes in other aggregates, but never, it appears, by changes taking place within itself. It is this conception of the mode of relationships among aggregates, rather than the existence of the aggregates themselves, which defies subjectivism.

—Ludwig M. Lachmann, “An Austrian Stocktaking: Unsettled Questions and Tentative Answers,” in New Directions in Austrian Economics, ed. Louis M. Spadaro (Kansas City: Sheed Andrews and McMeel, 1978), 8-9.

According to Marget, Keynes Misrepresents the History of Monetary Theory; Therefore, Progress Involves Escaping the Keynesian “Blind Alley”

Arthur William Marget (1899-1962) was a respected American monetary theorist and scholar who received his doctorate from Harvard in 1926 and taught for the next fifteen years at the University of Minnesota. His best known work, The Theory of Prices (2 vols: 1938, 1942), had three goals. Marget sought to demonstrate that Keynes misrepresented the history of monetary theory, to reveal the shortcomings of Keynes’s own approach, and to show that progress required an escape from the Keynesian “blind alley” and a return to the “high road” of earlier tradition.

The book was either behind its time, ahead of it, or (as I suspect) both. The doctrinal revolution that Marget opposed swept The Theory of Prices aside. Perhaps it was imprudent of him to pursue three ambitious goals at once, for even the book’s supporters found it long and arduous. Nicholas Kaldor, a non-supporter whose review managed to misstate the book’s subtitle, called Prices I “mid-Victorian,” with its “leisurely repetitiousness, elaborate style, pompous exactitude, and . . . exhaustive scholarship,” reminding him “of the bourgeois solidity and spaciousness of that bygone age” (1939, pp. 495-6).²

__________

²Marget’s response (1942, p. vii): “I, on the contrary, rest my case on the proposition that if the qualities of ‘exactitude,’ ‘solidity,’ and ‘exhaustive scholarship’ are indeed characteristic only of a ‘bygone age,’ that fact constitutes a condemnation of our own age and a commentary on our current needs.”

—John B. Egger, “Arthur Marget in the Austrian Tradition of the Theory of Money,” Review of Austrian Economics 8, no. 2 (1995): 3-4, 4n.

Doubting the Validity of Aggregates and Averages Is a Dagger Aimed Straight at the Heart of Statistical Analysis in Economics

In an interesting, though apparently neglected, aside, Professor Hayek has remarked that “. . . neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning. . . .”

Now, any serious doubt concerning the validity of aggregates and averages is a dagger aimed straight at the heart of much current empirical research and statistical analysis in economics. Therefore it deserves close and systematic attention, even if this involves, in the opinion of some dedicated empiricists, an annoying interruption of the “front-line” activity of measurement for the mere purpose of “armchair” discussion of methodological issues. Yet such is our contemporary spirited march on “objective data” that one who begins to suspect that a wrong turn may have been made sometime back almost naturally feels guilty for harboring this traitorous thought, and, if he expresses it at all, must expect to be regarded as a ruminant obstructionist in the company of men of action.

—Louis M. Spadaro, “Averages and Aggregates in Economics,” in On Freedom and Free Enterprise: Essays in Honor Ludwig von Mises, ed. Mary Sennholz (Auburn, AL: Ludwig von Mises Institute, 2008), 140.

For Frank Knight, John Maynard Keynes Succeeded in Carrying Economic Thinking Well Back to the Dark Age

The Keynesian avalanche soon swept away virtually all the competing approaches, ideas, or theories with which to explain the business cycle. Indeed, there was hardly a voice in the mainstream of the economics profession that was willing or able to directly question or challenge the near Keynesian monopolization of economic thinking on problems of economy-wide fluctuations in employment, output, and prices.

When Frank H. Knight declared in his 1951 presidential address before the American Economic Association that in his view “The latest ‘new economics’ and in my opinion rather the worst, for fallacious doctrine and pernicious consequences, is that launched by the late John Maynard (Lord) Keynes, who for a decade succeeded in carrying economic thinking well back to the dark age” (Knight, 1951, p. 2) it must have created shock and disbelief among many who heard these words spoken. Few besides Frank Knight could have been so blunt without permanently risking their reputation and standing in the economics profession of that time.

What was this “dark age” back to which Keynes took economic thinking? At its core, I would suggest, was its focus on macroeconomic aggregate building blocks: Aggregate Demand, Aggregate Supply, Total Output and Employment, and the average Price Level and Wage Level.

—Richard M. Ebeling, “The Misdirection of Keynesian Aggregates for Understanding Monetary and Cyclical Processes,” in What’s Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 79.

If We Want to Recover from a Depression, We Need to Restore Genuine Profits, NOT the Phony Profits of a Bubble

Keynesian analysis tells us that what is lacking during a depression is demand. Since private savings (in this view) will lie fallow, will not be invested, the only effective demand comes from consumer or government spending. But what really drives an economy is not demand; it is production. And what really drives production is profits. If we want to restore the economy, we need to restore profits, genuine profits, not the phony profits of a bubble.

A collapse of profits tells us that the price and profit system of the market has been damaged, usually by government interventions to reduce interest rates, increase wages, increase consumption, subsidize some sectors and enforce cartels in others. It is not the savers who have wrecked the economy, it is government interventions that have penalized savers and ultimately destroyed profits.

Even Keynes must have known how important profits are. In his Treatise on Money, he acknowledged that

the engine which drives enterprise is . . . profit.

By the time he wrote The General Theory, Keynes often used jargonish circumlocutions to sidestep the word profit, terms such as “the marginal efficiency of capital.” But the inescapable truth is that profit is the key to prosperity. And the way to rebuild genuine profit is to allow all prices, including interest rates and currencies, to tell the truth about the economy. In an environment of free prices, hard work, production, and saving will do all that is required, just as John Stuart Mill said they would almost two hundred years ago.

—Hunter Lewis, Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Bust (Edinburg, VA: Axios Press, 2011), Kindle e-book.

Keynes Tells Us to Praise the Mercantilist “Army of Heretics and Cranks” Who Argued for Lower Interest Rates

We should pay our respects to the “army of heretics and cranks” who in earlier periods argued for lower interest rates.

In The General Theory, Keynes acknowledged that he was refurbishing and updating

sixteenth and seventeenth century . . . [economic writers generally known as] Mercantilists.

This was ironic, because Keynes’s teachers in Britain, and Keynes himself early in his career, had regarded Mercantilist thought as a “fallacy” long since exploded.

Now Keynes saw an

element of scientific truth in Mercantilist doctrine, [especially in their view] that an unduly high rate of interest was the main obstacle to the growth of wealth [and in their] preoccupation . . . [to] increase . . . the quantity of money [in order to] . . . diminish the rate of interest.

In addition to the Mercantilists, Keynes acknowledged his debt to the economist Thomas Malthus (1766–1834), a few other economists, and even some 20th century figures, Sylvio Gesell and Major C. H. Douglas, whom he had previously dismissed as

no better than . . . crank[s].

In The General Theory, he described Gesell, best known for advocating stamped money whose value would expire if not spent by a certain date, as

an unduly neglected prophet . . . [with] flashes of deep insight.

Douglas, another proponent of what is sometimes called easy money, he somewhat backhandedly praised as

at least . . . not wholly oblivious of the outstanding problem of our economic system.

These people together Keynes called his

brave army of heretics

in which classification he happily included himself.

—Hunter Lewis, Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Bust (Edinburg, VA: Axios Press, 2011), Kindle e-book. 

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.

The Problem Is Not One of “Aggregate Demand” Or “Overproduction” But Rather One of Cost-Price Differentials

But, these theorists may object, “we do not claim that all desires have ceased. They still exist, but the people lack the money to exercise their demands.” But some money still exists, even in the steepest deflation. Why can’t this money be used to buy these “overproduced” goods? There is no reason why prices cannot fall low enough, in a free market, to clear the market and sell all the goods available. If businessmen choose to keep prices up, they are simply speculating on an imminent rise in market prices; they are, in short, voluntarily investing in inventory. If they wish to sell their “surplus” stock, they need only cut their prices low enough to sell all of their product. But won’t they then suffer losses? Of course, but now the discussion has shifted to a different plane. We find no overproduction, we find now that the selling prices of products are below their cost of production. But since costs are determined by expected future selling prices, this means that costs were previously bid too high by entrepreneurs. The problem, then, is not one of “aggregate demand” or “overproduction,” but one of cost–price differentials. Why did entrepreneurs make the mistake of bidding costs higher than the selling prices turned out to warrant? The Austrian theory explains this cluster of error and the excessive bidding up of costs; the “overproduction” theory does not. In fact, there was overproduction of specific, not general, goods. The malinvestment caused by credit expansion diverted production into lines that turned out to be unprofitable (i.e., where selling prices were lower than costs) and away from lines where it would have been profitable. So there was overproduction of specific goods relative to consumer desires, and underproduction of other specific goods.

—Murray N. Rothbard, America's Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000), 56-57.

Short of the Garden of Eden, There Is No Such Thing As General “Overproduction”

“Overproduction” is one of the favorite explanations of depressions. It is based on the common-sense observation that the crisis is marked by unsold stocks of goods, excess capacity of plant, and unemployment of labor. Doesn’t this mean that the “capitalist system” produces “too much” in the boom, until finally the giant productive plant outruns itself? Isn’t the depression the period of rest, which permits the swollen industrial apparatus to wait until reduced business activity clears away the excess production and works off its excess inventory?

This explanation, popular or no, is arrant nonsense. Short of the Garden of Eden, there is no such thing as general “overproduction.” As long as any “economic” desires remain unsatisfied, so long will production be needed and demanded. Certainly, this impossible point of universal satiation had not been reached in 1929.

—Murray N. Rothbard, America's Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000), 56.

To Most of the Classical Economists, the Theory of General Over-production Was a Heresy

It is one thing to deny the existence of demand deficiency and another to provide a theory of the cycle. Classical economists, because of their acceptance of the law of markets, had to do both. Those who accepted the validity of the law of markets had to explain the fact of recession without reference to demand deficiency or over-production. This was done by explaining recessions as resulting from misdirected production or other factors which drove demand and supply out of alignment.¹ This theory of recession must be seen as an integral part of the matrix of ideas associated with the law of markets since it was this which explained the existence of recession while denying the possibility of deficient demand or overproduction. The two concepts, in fact, evolved together and are part of a unified conception of the operation of an economy.

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¹ Cf. Wesley Mitchell (1927: 8) who wrote, ‘to most of the classical economists, the theory of general over-production was a heresy, which they sought to extirpate by demonstrating that the supply of goods of one sort necessarily constitutes demand for goods of other sorts. But maladjusted production they allowed to be possible, and their brief references to crises usually aimed to show how production becomes maladjusted through the sinking of capital in unremunerative investments.’

—Steven Kates, Say's Law and the Keynesian Revolution: How Macroeconomic Theory Lost its Way (Cheltenham, UK: Edward Elgar Publishing, 2009), 75, 75n.