Keynes gave little thought to generalities. He acknowledged that his prescriptions were limited to the special circumstances of the 1930s. With Bolshevism in mind, any fiscal deficit spending was justified to put men into work; but, for normal circumstances, Keynes offered only ad hoc musings: if ever real returns were exhausted, a ‘socialisation of investment’ might be necessary; and an unresolved task for ‘our statesmanship’ would be to prevent ‘money wages forever soaring upwards’.

After Keynes’s early death in 1946, Keynesians transformed Keynes’s ‘politicking’ into a universal manual for demand management. Thereafter students of macroeconomics were drilled with the paradox of thrift: increased saving drives the economy into recession, when – with lowered incomes – individuals save less.

Keynesians insist that the prescription still holds. Following upon the sub-prime housing investment crash (as with the busting of any asset bubble) individuals must save to rebuild assets for their future; but, for Keynesians, this drives an economy ever deeper into recession. So there must be fiscal interventions, chasing the needs of every periodic recession.

Keynes’s paradox of thrift sits among twin claims: that inflation is impossible where spare capacity exists; and that – ‘unimpeded by international preoccupations’ – a monetary authority is free to reduce domestic interest rates to any level it sees fit. With the 1970s wiped from memory, and the current non sustainability of eurozone debt levels ignored, Keynesians are fixated upon interventions by the state. Using his high media profile, Paul Krugman presents a new ‘twist’.

Krugman’s ‘paradox of toil’ is that, by giving a greater incentive to work, tax reductions cause output to fall. He argues as follows: as (labour) costs fall, competition ensures that prices drop. The fall in prices incites negative ‘inflation expectations’; that is, prices are expected to continue falling. The ‘paradox of toil’ quickly falls into place:

  1. the real rate of interest equals the nominal rate minus the inflation rate;

  2. the nominal rate is at its lower bound (‘zero’);

  3. so the real rate (‘zero’ minus the negative inflation rate) rises, which

  4. raises the real burden of debts, which causes

  5. consumers to cut spending, so that

  6. output and employment shrink.

Reductions in taxation are, therefore, very bad for economic recovery.

By their shared logic, the paradox of thrift and the paradox of toil: (i) discount the force of market prices in bringing coherence to economic readjustments; (ii) view state controls as means to achieve balanced growth, income uniformity and the elimination of poverty; (iii) fail to understand that using interest rates to effect short-term demand management distorts long-term (inter-temporal) price adjustments.

Keynes’s General Theory was an endeavour to show that, in a deep recession, the laws of economics are held in abeyance. Fiscal deficit spending is then required to restore economic growth. Samuel Brittan has argued the same case: the ‘credit crunch’ recession placed the economy within ‘a kind of parallel universe … when the normal rules are turned upside down’. Or, as Krugman writes, ‘we’re really through the looking glass, in a world in which lots of things have perverse effects – and basing your policy ideas on intuition from “normal” times can lead you very much astray’.

With the recent LSE Keynes/Hayek debate fresh in many minds, a summary conclusion draws from the original protagonists:

Keynes: ‘Many people are trying to solve unemployment with a theory that is based on the assumption that there is no unemployment … these ideas, perfectly valid in their proper setting, are inapplicable to present circumstances’ (New Statesman, 1933);

Hayek: ‘An analysis on the assumption of full employment, even if the assumption is only partially valid, at least helps us to understand the functioning of the price mechanism, the significance of the relations between different prices and of the factors which lead to changes in these relations. But the assumption that all goods and factors are available in excess makes the whole price system redundant, undermined and unintelligible.’ (A Tiger by the Tail, 1972)

The nub: does economics operate by two sets of principles or just one?

6 thoughts on “Keynesian paradoxes”

  1. Posted 18/08/2011 at 15:11 | Permalink

    Someone here hasn’t read Skidelsky’s exposition “The Return of the Master”. What is meant by the paradox of thrift is that, though thrift is good for the individual, it might not be good for the community if everyone acts thriftily. Skidelsky states on page 91 that if everyone wants to save more, firms will sell less and therefore output will fall, unless the inducement to invest is increasing at the same time. Since recoveries increase the amount saved, simply as a consequence of incomes rising (the consumption function being a stable short-run variable) saving and investment may well be equalised before full employment is regained.

    The big word in the previous paragraph is “unless”. Hayek believed that prices would fall if demand fell,thereby increasing real incomes and stimulating demand. But then, there’s the big question of the effect on the present of expectations of the future, which blows the Keynes-Hayek debate wide open.

  2. Posted 19/08/2011 at 13:02 | Permalink

    @Michael Petek – what Keynesians, including Skidelsky, never seem to appreciate is the role of saving and capital formation. The Keynesian fixation with demand and demand management never deals with the supply side of the economy. If saving increases, the long run interest rate will fall and investment will become cheaper. This will promote longer-term economic growth, as Hayek et al have argued. The Keynesian idea that growth comes through high levels of demand is simply nonsense (see e.g Stephen Kates’ work on Say’s Law).
    These positions are further complicated by central bank control of interest rates, which Hayek realised. With a central bank currently creating inflation (via QE and by running low rates) or at the least preventing the necessary deflationary adjustments, it’s evident that prices will not fall – therefore we have stagflationary effects, albeit currently more moderate than those of the ’70s. Moreover, central bank control of interest rates also mean there is not a proper (i.e. market-determined) price of saving as interest rates are distorted by government manipulation. Government is currently forcing dissaving by running effectively negative interest rates; this has dire consequences for the long-term growth of the economy and the reallocation of resources from inefficient to efficient areas.
    I don’t see how ‘future expectations’ affect the Keynes-Hayek debate. The Keynes-Hayek debate is between those who believe an economy can be managed successfully and those who do not.

  3. Posted 19/08/2011 at 13:14 | Permalink

    Someone here hasn’t read Austrian capital theory – there would be too much to explain here – so just two short questions. Which spectification do you have in mind for your ‘short-run consumption function’? Where is the evidence that it is stable?

  4. Posted 20/08/2011 at 15:00 | Permalink

    Keynes’ position regarding increases in saving was that a decision to save is not the same as a decision to invest. Many people hold their savings in cash in view of the uncertainty of the future. Otherwise only a madman, wrote Keynes, would hold savings in cash which offers no returns, while long-term bonds and equity offer dividends and interest, as well as capital gain. In Keynes’s system the role of interest is to overcome the preference of savers (and banks) to hold cash (liquidity preference) and persuade them to commit to the long term. Now, it could be the case at times that the liquidity preference of the public is so strong that there is no interest rate capable of calling forth enough investable funds to service investment demand. Where liquidity preference is weak, then your comment about the effect of increased savings on the long-term interest rate is more likely to be valid than when LP is strong.

    Now, what is it that drives investment? The first element is the present value of an income stream expected from a capital investment. The second element is the interest obtaining at the time of the investment decision, which serves as a proxy for the rate of time preference. If the interest rate falls, the present value of the project rises, and it may or may not exceed the supply price of the outlay. If it does so for any particular project, then investment spending will take place. If not, then it won’t.

  5. Posted 22/08/2011 at 08:58 | Permalink

    @Michael Petek – as GR Steele suggests I think you should read some Hayek, or at least Roger Garrison’s work on this issue. The Keynesian position is entirely flawed as these works show.

  6. Posted 22/08/2011 at 11:03 | Permalink

    I have read David Gordon’s review of Professor Garrison’s work.

    Suppose that, in an economy, spending on consumer goods falls. Must depression inevitably ensue? Not at all, say the Austrians. Resources can shift into the production of capital goods. Keynes would not disagree as long as entrepreneurs’ expectations of future revenue were unaffected.

    It is said that, if the interest rate is driven below the “natural rate” – primarily determined by people’s preferences for present over future goods – investors might be misled. However, interest rates are not detemined only by people’s preferences for present over future goods, though this is properly called a “discount rate”. Liquidity preference is a way of coping with an uncertain future and explains why people hold cash which offers no return. The rate of interest then appears as a premium which must be offered to savers in order to persuade them to bear the inconvenience of holding illiquid securities, and that rate might be higher than it would be if a calculable probability distribution could be assigned to every possible future contingency.

    The liquidity trap – a situation where there is a large volume of cash savings coexisting with a low interest rate while, out of pessimism, few want to borrow and few want to lend, cuts down the proposition of a boom led by an expansion in bank credit. If pessimism seizes control of the financial markets, such a boom will neither commence nor continue, and if it has done so, then its reversal explains itself by the fact that old credit is being repaid (and money destroyed) while not being replaced by new credit.

    Austrians incorrectly assume out of hand that investors will meet changes in patterns of spending by shifts in the structure of production. They may or may not. Keynes held that investment is volatile, but he did not hold it to be irrational. What he did hold is that, where we have insufficient information to assign a cardinal or ordinal probability to an event, we will rationally make a capricious choice or create institutions and conventions to cope with irreducible uncertainty.

    Gordon says this. “Suppose investment were centralized under control of the government. No longer would we be at the mercy of evanescent animal spirits.” Not so! Keynes held that the market could cope with risk pricing, but governments had to deal with uncertainty and its consequences.

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