Posted by Joseph Y. Calhoun, III

The very foundation of Keynesianism is based on a fallacy - the Paradox of Thrift. Paul Krugman explained this alleged paradox in one of his New York Times editorials:

Some background: one of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone’s income.

In fact, consumers’ income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.

At this point, however, the instructor hastens to explain that virtue isn’t really vice: in practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can’t offset the fall in consumer spending.

Krugman and other economists of the Keynesian bent, believe that we are at a point where Federal Reserve manipulation of interest rates will not yield the expected rise in “investment”. Their Keynesian prescription is for the government to borrow and spend to fill the gap left by the lack of consumer spending and private investment.

But this prescription rests on a fallacy which is introduced in the last paragraph of Krugman’s explanation. The fallacy is that the central bank can induce real, efficient investments by lowering interest rates below the natural rate that would prevail in a free economy or that other government intervention will produce the same result. What actually occurs is what von Mises called malinvestment. This malinvestment can take several forms:

1. The construction of the plant was economically justified at the time it was established. It is not so any longer because since then new methods of production have become known or because today other locations are more favorable.

2. Though originally a sound investment, the plant has become uneconomic because of changes that have occurred in the data of the market, such as, for example, a decrease in demand.

3. The plant was uneconomic from the very first. It was able to be constructed only by virtue of interventionist measures that have now been abandoned.

4. The plant was uneconomic from the very first. Its construction was an incorrect speculation.

5. The incorrect speculation (case 4) that led to the malinvestment has been brought about by the falsification of monetary calculation consequent upon changes in the value of money. The conditions of this case are described by the monetary theory of the trade cycle (the circulation-credit theory of cyclical fluctuations).

What we are experiencing today is the result of past government policy that was implemented in pursuit of “investment” to prevent a recession that was needed to correct past excesses that were themselves the result of monetary and fiscal policy mismanagement. The response to the collapse of the malinvestment of the internet bubble is the proximate cause of our present difficulties. The government response to that liquidiation of malinvestment did not produce investment but merely further malinvestment, this time in the housing sector. We have now reached the point where futher monetary manipulation will not even induce malinvestment. The Keynesians such as Krugman would have us believe that since further private malinvestment cannot be induced, the only answer is direct government malinvestment.

The Keynesian prescription has its own paradox which cannot be logically resolved. Mises said that the sum total of capital consisted of three parts: circulating capital, newly formed capital and that part of fixed capital which is set aside for reinvestment. The paradox for Keynesians is that the capital they intend to “invest” must come from somewhere. While central banks can create money, they cannot create capital. So the Keynesian prescription relies on the dubious assumption that capital moved from private hands to public will result in a greater return on that capital. The gain from public investment must exceed the damage done by a reduction in the capital available to private uses plus the cost of borrowing the capital. That reduction in capital could come from any of the three sources (or all), but it will have an effect. If it comes from circulating capital, it will effect current production. If it comes from newly formed capital, it will affect future production. If it comes from capital set aside for reinvestment, it will affect current and future production. But it will have an effect.

Another paradox for the Keynesians is that in a world wide slump, as we now face, all governments cannot borrow the necessary capital to accomplish their Keynesian goals. At any given time, there is a finite amount of capital in the world economy and every government will not be able to borrow the necessary amounts to fund their government directed investments. Furthermore, the individuals who control that capital may not be willing to provide it at the current artificially low interest rates. In fact, that may already be starting to happen; the German government recently held a bund auction that required the central bank to purchase one third of the amount up for sale. The Spanish government has seen interest rates rise at recent sales due to a cut in their credit rating.

If governments are not able to borrow the necessary capital, they will retreat to the last refuge of government scoundrels - the printing press. As I said earlier, central banks can create money but they can’t create capital. When governments debase their currencies, holders of private capital will seek to protect its purchasing power. One of the few asset classes to produce a positive return last year other than government bonds was gold:

This debasement was also predicted by Mises:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The question is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. There has never been any attempt to abandon the credit expansion. Indeed any crisis was simply an excuse to open the monetary spigots. This, then, is the beginning of the total catastrophe of the American dollar, indeed the entire world monetary and financial structure.”

The Keynesian Paradoxes:

The capital expended in a Keynesian stimulus plan must come from the current pool of available capital and therefore has negative effects in the private sector which offset, at least, the positive effects of the government directed spending. Furthermore, Keynesian stimulus plans cannot be enacted on a wide scale because the current pool of available capital is finite. Central banks cannot create capital so efforts to increase the quantity of money will result in a further reduction in the amount of capital available for productive investment whether by government or private actors. Finally, by creating more malinvestment, Keynesian stimulus plans will destroy capital that could have been invested in more productive activities. This destruction of capital will only further reduce living standards in the future.

Keyensianism is nothing more than an attempt to maintain the something for nothing mentality that led us into this economic valley. Real growth requires real savings and effort. There is no free lunch and there are no shortcuts. Nations cannot spend their way to prosperity and they cannot devalue their way to wealth. The only answer is to live with the consequences of our past actions and save today so that we have the capital to fund a higher standard of living in the future. Keynesian economics does not offer a solution but an impediment to true economic recovery.