Economic Theory

Keynes’s disastrous contribution to economic theory

In my view, Say’s Law may be the single most important principle in economics. But it is a principle that was deliberately eliminated from within mainstream economic theory by John Maynard Keynes in his General Theory and has disappeared from almost all economic discourse since that time. Yet it was this concept that made it virtually certain that the stimulus being applied across the world from the end of 2008 would lead to an economic stagnation that would last years on end. As I explained in 2009:

‘Just as the causes of this downturn cannot be charted through a Keynesian demand-deficiency model, neither can the solution. The world’s economies are not suffering from a lack of demand, and the right policy response is not a demand stimulus. Increased public sector spending will only add to the market confusions that already exist.

‘What is potentially catastrophic would be to try to spend our way to recovery. The recession that will follow will be deep, prolonged and potentially take years to overcome.’

While much of the economics profession seems to be flummoxed by what has happened since the stimulus, no one schooled in classical theory would have been in much doubt. It would have been as obvious as the noonday sun, even though invisible to anyone brought up on modern macroeconomics which has embedded within it the theory of aggregate demand, Keynes’s disastrous contribution to economic theory.

Say’s Law specifically stated that demand deficiency, that is, a deficiency of aggregate demand, could never be the cause of a recession (or in the archaic language of the classics, ‘there is no such thing as a general glut’). It then specifically told governments that while some additional public expenditure during recessions might become a minor part of a much more comprehensive approach to dealing with a downturn, it was understood that such a stimulus would never restore an economy to robust health. A ‘stimulus’ had, in fact, the potential to do serious damage, and the larger the stimulus the more damage it would do.

My book, Free Market Economics, not only explains in detail the nature of Keynesian economics but also why a stimulus could not possibly have returned our economies to rapid rates of growth and low unemployment. The experience of the past six years ought to have made all this supremely evident in practice. But without an understanding of Say’s Law, there is little chance anyone will understand why the stimulus has been the colossal failure it has been.

What is it that Say’s Law adds to our understanding? The traditional statement was that ‘demand is constituted by supply’ which everyone once perfectly well understood in just those words. In the modern era, I have had to amend this to read, ‘demand is created by value-adding supply’. Unless the value of what is produced is greater than the value of the inputs that have gone into its production, an economy will go backwards.

No introductory book teaches value-added any longer, other than occasionally as part of an explanation of the national accounts, but Free Market Economics has an entire chapter on exactly this.

Keynesian economics is based on the nonsensical notion that spending on anything will create jobs and growth. How such a fantastic belief ever captured the entire economics community would require an investigation into the role of authority and much else. But unless what is produced is value adding, you get the costs, you get the debt, but you don’t get the positive return. The wreckage you see at every turn in our economies is exactly what anyone who understood value-added would automatically expect.

Here is the difference that Say’s Law makes to theory and policy, put as succinctly as I can.

At the core of Keynesian theory is the belief that public spending – even if not directly value adding in and of itself – will lead to economic growth. Each dollar of public spending goes through the ‘multiplier effect’ leading the economy to grow by many times more than the initial amount invested. It is this theory that leads to stimulus package policy decisions.

At the core of classical economic theory is a directly opposing belief. It says that you can only grow an economy by investing in value-adding activities. Money spent in non-value adding ways will only distort the economy by creating a financial incentive for people to work in those areas. The spending goes through the same ‘multiplier effect’ as per Keynesian theory, but only acts to amplify the distortion.

Although named Say’s Law after the early nineteenth century French economist J-B. Say, the principle was part of the bedrock foundation of economic theory right up until 1936. But what will never be told to you by any Keynesian economist (in large part because they don’t even know themselves) is that the term ‘Say’s Law’ was introduced into economic discourse in the 1920s by Fred M. Taylor, an American economist who although identified with the left, thought the underlying principle was absolutely essential for clear thinking in economics.

2 thoughts on “Keynes’s disastrous contribution to economic theory”

  1. Posted 24/11/2014 at 02:53 | Permalink

    Reading Mr. Kates’ contribution reminded me of Prof. W. H. Hutt’s rebuttal of J. M. Keynes’ General Theory. Bill wrote an essay in 1974, republished by The Mises Institute in 2007, “A Rehabilitation of Say’s Law,” wherein he aims to prove that Say’s Law is in his word “inviolate.” That is, he holds the rule attributed to J-B Say, classically known as “the rule of markets,” is an inviolate principle. He further states that his rehabilitation denies the credibility of Keynes’ General Theory; only production that adds more value than it consumes that can lead to growth in an economy. A recent example of production that subtracts from economic output is the collapse of Solyndra, funded by more than $500B in taxes. I commend serious students of economics to read this short essay and to peruse the many sources that Prof. Hutt references. This essay ought to be included in any curriculum teaching theory of markets and ought to be required reading for all graduate students.

  2. Posted 24/11/2014 at 13:06 | Permalink

    An excellent article, clear and to the point, explaining why the disastrous QE experiment of the last 6 years has been a disaster. The excellent book by Henry Hazlitt “The Failure of the New Economics” and “Critics of Keynesian Economics” edited by Hazlitt contains 2 excellent essays, one by von Mises and the other by Joseph Lawrence which elaborate on the theme so clearly written by Mr Kates. If only our misguided politicians and central bankers could read (and understand) what has been written the disasters of the last 6 years could have been avoided. Robert Stewart.

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