Gerry Jackson
30 February 2009

The global economic crisis that the reckless monetary policies of the world’s central banks visited upon us still leads the great majority of economists, economic commentators and know-all pundits mislabelling the situation as one of either market failure or another example of the innate increasing instability of the capitalist system¹. That vulgar Keynesian² thinking contributed mightily to the crisis never enters the heads of these economic commentators — but then very little ever does.

These crises are a very old story. David Ricardo and his contemporaries had a far greater understanding of the phenomenon than all the members of the economic commentariat put together, including those with Nobel Prizes. Paul Krugman, for instance, argues that recessions “happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves”³. This is pure baloney. No recession in economic history was ever caused by a sudden demand to increase cash balances. One only has to look at the profits and cash situation of firms in 1929 to see that Krugman’s assertion is completely baseless.

Recessions begin in the higher stages of production because the savings-consumption ratio has been distorted by the rate of interest being forced down below the market rate⁴. This led to excess investment in the capital goods industries and construction. (The exception would be a consumption boom⁵.)  Nineteenth century economists — including Marx — recognised this problem as one of disproportionality⁶. The recession does not begin because businessmen or the public at large has a sudden and irrational desire to accumulate cash balances: it begins when these businessmen either find themselves in a profits squeeze as costs rise faster than revenues or when interest rates are raised to slowdown the economy.

Now let us look at the situation that confronted the early nineteenth century British economists. Once the Napoleonic War was over the economic distortions that it had caused, mainly through inflation, were revealed as malinvestments, i.e., unemployed capital and labour. Evidently, this was not lost on Ricardo. To him this was an interval during which unsound investments were liquidated, some specific capital abandoned and labour was redirected so that proportionality was restored (the Austrians call it the readjustment period). As he put it during this interval:

The commencement of war after a long peace, or of peace after a long war, generally produces considerable distress in trade. It changes in a great degree the nature of the employments to which the respective capitals of countries were before devoted; and during the interval while they are settling in the situations which new circumstances have made the most beneficial, much fixed capital is unemployed, perhaps wholly lost, and labourers are without full employment. The duration of this distress will be longer or shorter according to the strength of that disinclination which most men feel to abandon that employment of their capital to which they have long been accustomed⁷.

The most striking thing about Ricardo’s analysis is its microeconomic aspect. The realisation that capital is not, in reality, homogeneous and thus malinvestments (disproportionalities) will occur. Further, inflations create malinvestments that will eventually have to be liquidated, perhaps with considerable loss of capital. Now wonder Hayek was moved to comment that since Ricardo the classical economists have been more “‘Austrian’ than their successors”⁸.  It’s important to bear Hayek’s observation in mind because the Austrian view of capital as a heterogeneous structure with a time dimension is a vitally important part of Austrian trade cycle theory.

Ricardo and his contemporaries clearly understood  that unless prices and costs are allowed to adjust to the new monetary conditions widespread persistent unemployment would emerge. Therefore, it is fair to state that the classical contention is that if wage rates (the total hourly cost of labour) are maintained above their previous market clearing rates then unemployment will persist.

This returns us to Keynes’ General Theory. His disciples tell us that he explained that the classical view of cutting wage rates to restore employment fails because it worsens the situation by reducing purchasing power thus keeping the economy depressed. Ergo, ” the government has to restore employment through fiscal policy.” (This means printing money). But there was nothing new in Keynes’ treatment of wages.

I think the best way of dealing with his views on wages is to first deal with his views on savings and investment. Keynes’ disciples assert that he revealed that savings can exceed investment and so cause aggregate demand to fall. But Keynes did nothing of the kind. The truth be told, he was hopelessly contradictory and confused on savings and investment, something that should be obvious to anyone who managed to conjure up the necessary fortitude to plough through the General Theory. Keynesians make much ado about savings exceeding investment which will send the economy into recession. Now this is how Keynes defined savings and investment:

 … saving is equal to the excess of income over consumption — all of which is conformable both to common sense and to the traditional usage of the great majority of economists — the equality of saving and investment necessarily follows. In short-

Income = value of output = consumption + investment.

Saving = income ? consumption.

Therefore saving = investment..

Thus any set of definitions which satisfy the above conditions leads to the same conclusion. It is only by denying the validity of one or other of them that the conclusion can be avoided. The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or the purchaser of capital equipment⁹.

At the very beginning of chapter 7 he freely admits that

PIn the previous chapter saving and investment [his italics] have been so defined they are necessarily equal in amount, being, for the community as a whole, merely different aspects of the same thing…. So far as I know, everyone agrees in meaning by saving the excess of income over what is spent on consumption. It would certainly be very inconvenient and misleading not to mean this¹⁰. P

Keynes then writes:

PThe prevalence of the idea that saving and investment, taken in their straightforward sense, can differ from one another, is to be explained, I think by an optical illusion…

Yet he also argued that

… it is unlikely that full employment can be maintained, whatever we may do about investment, with the existing propensity to consume. There is room, therefore, for both policies to operate together;— to promote investment and, at the same time, to promote consumption, not merely to the level which with the existing propensity to consume would correspond to the increased investment, but to a higher level still¹².

How can this be? He defines savings as equal to investment and admits that investment raises the demand for labour: yet he followed this with the argument that increased savings would lower aggregate demand and raise the level of unemployment. Hence the solution was more consumption and investment. But according to his own definition of saving and investment this is not possible. So he went from treating savings and investment as “merely different aspects of the same thing¹³” to being independent variables. He makes this shift very clear   where he writes:

An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand¹⁴.

Irrespective of any protestations to the country Keynes was merely ploughing old ground here. He had written in 1930:

PFor in certain cases a tendency for the rate of investment to lag behind the rate of savings might come about as the result of a reaction from over-investment. . . : inasmuch as, on my theory, it is a large volume of savings which does not lead to a correspondingly large volume of investment (not one which does) which is the root of the trouble¹⁵.

I think that what makes all of this so confusing is the absence of any consistent explanation of what savings really are. To define savings as income minus consumption is inaccurate and dangerously misleading. Savings are the process by which we transform present goods into future goods. That is, we use money to divert resources from current consumption into greater future consumption. It is this process that raises the marginal productivity of labour.

Footnotes

¹Each financial crisis has numerous pundits writing how Marx’s theory of the trade cycle got it right. Wrong! Marx had no theory. None of these pundits know that Marx used a theory that he filched from the banking school.

²Thus, a vulgar Keynesians applies Keynes thinking to everything from recessions to natural disasters. The destructive covid shutdowns is a prime example of vulgar Keynesianism.

³Paul Krugman, The Hangover Theory, Slate, 4 December 1998 .

⁴The boom is started when the rate of interest is forced down before its market clearing rate. This induces excessive borrowing and investment. This is a lot of confusion regarding this issue. Critics sometimes refer to Sraffa as having refuted this line of thought. In a later post I shall explain why Sraffa is wrong.

⁵If the additional borrowing was spent on consumer good alone the effect would be different. The same goes for a government that did the same thing.

⁶these disproportionalities are in reality malinvestments created by the newly created low rate of interest sending a false price signal to entrepreneurs.

⁷David Ricardo, On The Principles of Political Economy and Taxation, Penguin Books, 1971, p. 270-71.

⁸F. A. Hayek, The Pure Theory of Capital, The University of Chicago Press, 2007).

⁹John Maynard Keynes, The General Theory of Employment Interest and Money, Macmillan-St. Martin’s Press, p. 63.

¹⁰ Keynes, 74).

¹¹ Keynes, 81

¹² Keynes, 325

¹³ Keynes, 74

¹⁴ Keynes., 210

¹⁵John Maynard Keynes, A Treatise on Money, Vol. I, Macmillan and Co. Limited, 1953, pp. 178-79