Summary of Keynes’ Theory, and the More Obvious Flaws in it.

Wisely Written by Smiling Dave, and Expertly Edited by Lady Saiga.

We have a Special Guest from Beyond the Grave with us for this article, the famed Henry Hazlitt. Using Clayton’s Universe-as-an-Acting-Being Ouija Board, we were able to establish contact with the late, great Mr Hazlitt. What follows is an exact transcript of our communication with the Next World:

SD: Mr Hazlitt, are you basing this article on your conversations with John Maynard Keynes in the afterlife?

HH: We are not in the same place, unfortunately, so I am unable to chat with him. All I say here is from my researches on Earth, as published in my book, The Critics of Keynesian Economics, Chapter 14.

SD: Could you begin by summarizing the essence of Keynes’s theory, in 25 words or less?

HH: Based on Chapter 3 of his famous work, I summarize Keynes’s position as follows, numbering each new assumption of his:

1. A free market makes people rich; so rich that they have so much money they do not know what to do with it.  When you are rich, you can finally snort more cocaine than you ever dreamed of, but you will still have left over money, says Keynes. So a lot of your money will just lie there in your wallet. One can only spend so much on the vanities of this world, claimed Keynes, and he thought this will lead to problems in the economy.

2. Because people don’t spend all their money, there will be unsold products left on the shelves. After all, you got wealthier because you were more productive. Your miserable factory job used to grind out ten pizzas a day in the old days. But now, due to improved productivity, you grind out a hundred a day. Which is why you got a raise in salary, but also why there will be 90 or so pizzas left to rot on the shelves.

3. Not only will you have more money than you can spend on yourself, says Keynes, you will be unwilling to take that leftover money and invest it in some business.

SD: Henry, may I call you Henry, Mr Hazlitt?

HH: Certainly, Dave. Up here we are very informal. Modesty and all that.

SD: Henry, I don’t see how Maynard could say rich people don’t want to invest.

JMK: Who said you could use my first name? Lord Keynes to you, Mr Smiling Dave, Esq.

SD: Our Ouija board seems to be picking up some static. The whole room smells of brimstone.

HH: I’m back. Let me explain Keynes’s position here. It’s a three step argument.

3a. If you have money, you love having it at your command, always ready to flash your billfold, says Keynes. You will want a nice fat rate of interest to persuade you to part with it.

3b. But rich countries, Keynes claims, got that way by exhausting all the truly profitable investment possibilities. The profits offered you will be less than you wish in return for unclenching your tight fist and handing over your beloved cash.

3c. Putting 3a and 3b together, Keynes concludes you want a greater return on investment than a rich capitalist country can provide, and the result is assumption 3, that you don’t wish to invest your money.

SD: So people can be too rich and have nothing more to buy or invest in.  What’s wrong with that?

HH: Keynes explained that…

4. …all of the above will reduce the profits of the manufacturers.  Money flows in a huge “circle of life”, according to Keynes.  First, the employer has, say $100.  He uses it to buy raw materials and to pay off his workers.  All his money is spent this way, and he winds up with a pile of goods.  The workers and the raw materials suppliers get $90, and when they buy up all the goods, the employer will charge them $110 in all, making a ten dollar profit.

But that only works if he actually sells everything.  We know he needs to get back at least $100 to start the next round of production.  And if he made so much that the workers and suppliers don’t buy it all [because they are so rich they don’t need everything he makes, according to Keynes, as assumption 1 above claims], but only, say, $75, then he can’t stay in business, for lack of cash to keep going. Of course, there is a plan B, one that is not as good. He can get the missing $25 by borrowing it from rich people. This means a bit of a loss for him, since he has to pay interest, but at least he can keep functioning.

But what if nobody wants to invest in his business, because they want more interest than he can afford to pay [As assumption 3 above claims]?  According to Keynes, this will happen all the time.  In that case, he has no choice but to close down, or at least make less stuff; only what $75 can create.

5. This means he will has to fire a few people, because he cannot pay their salaries, having only $75, not $90.  Plus, he has no use for those guys he laid off, because he is making too much stuff anyway.

6. These people will stay fired forever, says Keynes, because if he ever rehires them, he will have the exact same problem, making too much stuff.  That’s the problem that a free market has.  It makes too much stuff, and then people are fired permanently because the employer cannot afford to pay them.

7. The grand conclusion, that follows from all of the above: Depressions and recessions are intrinsic features of a free market, and could very well last forever. And so the free market must die [= Communism], or at least be thrown in a dungeon and chained [= govt intervention to “save” the economy].

That’s Keynes in a nutshell, as he himself writes in Chapter 3 of his work.

SD: Thank you, Henry. So where are the flaws?

HH: They are of two types, theoretical [= flawed logic] and practical [= don’t match reality]. Let’s jump right in.

Keynes’s assumption 1, that people will not buy anything for themselves with all their excess money, doesn’t match reality. It contradicts all experience; including yours, dear reader.

Look around you.  When, in your entire lifetime, have you heard anybody you know say, “Dang, I have too much money and nothing to spend it on”?  My guess is your answer will be, “Never”.

[At this point, the Ouija board started speaking with a heavy Russian accent].

Ouija: Comrades, you must be living in a rich capitalist country. Because in the impoverished Soviet Union, people had plenty of money they could not spend. The stores never carried any stock.

JMK: Comrade, I was referring to capitalist countries, predicting they will have an overstock of everything.

Ouija: Sorry Comrade, you may continue.

HH: Thank you, Comrade.

Next question:  How many times have you heard people say they are in debt [=the opposite of what Keynes said would happen; that is, they spend even more than their incomes]?  My guess is your answer would be “Every single day, from almost everyone I know.”

At this point, Dave snuck out of the room, because he does not rely on anecdotal evidence. He went out there and did his research.  And lo and behold, assumption 1, that rich people spend less on themselves than poor people, was the very first thing Keynesians had to sweep under the rug and pretend Keynes never said.

Keynes’s law of the propensity to consume is the important novel feature of his theory. It has been also the most controversial…These two assumptions—(1) that consumption is dependent on income and (2) that there is a “regular” or “stable” or “normal” relation between them, such that the consumption function can be derived as a given datum of the system and used as a basis of policy and prediction—constitute the essence of Keynesian economics[i].

And what’s so controversial about them? Because they are true of Bizzaro World, not our world:

Kuznets’ paper on “Capital Formation, 1879-1938,” at the University of Pennsylvania Bicentennial Conference constitutes an important landmark in the modification of Keynesian theory.  He demonstrated that, while national income rose greatly during that period, standards of living rose correspondingly, and the great bulk of the increase in income went into consumption.  Saving, as measured by real investment remained a constant fraction of income, with an apparent moderate tendency in the twenties (on which he does not insist) for consumption to increase relative to income. In England before the war, according to Colin Clark’s data, saving had been a diminishing fraction of a growing national income for at least a generation[ii].

Of course, the Keynesians came right out with their counter-research, to defend the mighty Keynes, right? Wrong:

Since Kuznets’ paper, the “secular upward drift” of the consumption function, to which no reference is made in Keynes,has become a standard part of the statement of the consumption function.  Its practical effect has been to bring the plane of discussion (the possible “gap between actual and potential production”) back pretty much to where it had been before Keynes wrote, by disposing of the more serious version of his law and the one which I think he himself believed—that consumption, as a society grew richer, became a diminishing fraction of income…[iii]

In other words, they pretended Keynes had never said it at all.  Instead they jumped to the other part of his thesis:

…limiting the stagnation thesis to a discussion of declining opportunities for investment[iv].

And that’s the situation Keynesians find themselves in to this day.

Dave went back to hear Mr Hazlitt speaking.

HH: Keynes’s assumption 2, that there will a general glut of products on the shelves, is theoretically flawed, because it contradicts Say’s Law. It’s clear why Keynes hated this law.  According to Say, an individual or a few individuals may make too much stuff, but there is no such thing as an economy as a whole making too much, which is the equivalent of Keynes’s assumption 2. People not buying everything is the equivalent of too much being made. Since Keynes’s whole theory rests on this, that there overproduction will occur on a scale grand enough to effect the economy as a whole, he had to deny Say’s Law.  I know Smiling Dave has written many excellent articles about the truth of Say’s Law, citing me among others, so I’m going to consider it a given.

SD: Henry, several people, perhaps realizing how absurd the “too rich to eat pizza” argument sounds, have responded by saying that assumption 3 is the important thing, that in a rich country there will be no new investment opportunities.  In other words, people might eat even more pizza, or buy big fancy cars when they get rich, spending even more than ever before on consumption, but there is another part of their money that people will just leave in their wallets, unspent.  That’s the money they used to put aside for investment, because a rich country has few opportunities left for investment. This sounds better to Keynesians, because it is supported by his reasoning outlined in points 3a and 3b above.

HH: Assumption 3, that rich people in rich countries don’t invest as much as poor people in poor countries is even more removed from reality than the previous one.  Which countries have more stock market websites, rich ones or poor ones?  When did you follow stocks more, during our booms [when we thought we were rich] or our busts [when we realized we were poor]?  Did the period before the Great Depression have more people investing in stocks than ever before, or less?

PS: Sorry for butting in, but I am the ghost of Paul Samuelson, the one man most responsible for spreading the Keynesian gospel. My research will prove beyond all doubt that those rich, fat cat consumers that a free market creates are just too lazy to take the money out of their wallets and invest, or at least that there is nowhere left for them invest.

HH: Sorry, Paul, your memory seems to have dimmed once you got here. I quoted your research in my book, and this is what I wrote about it:

His analysis yielded the striking conclusion that consumers in the aggregate spent virtually all their increases in money income…[v]

Yes, Paul Samuelson, the biggest Keynesian cheerleader that ever existed, the man responsible for spreading Keynesianism all over the world, the Nobel Prize winner, who wrote 19 editions of a book in forty one languages to praise Keynes to the skies, admits that Keynes blew this one big time. Assumptions 1 and 3 both, that there will be unspent moolah in peoples’ wallets when they get rich, just ain’t so.

Never one to be satisfied with half measures, Samuelson also shoots down assumption 4, that businesses will be left cash strapped. It doesn’t match reality. If anyone is saving their money, he writes, it is businesses:

…any additional saving accompanying rising income almost wholly took the form of business saving[vi].

SD: This of course, blows Keynes totally out of the water. He said the problem was that money will never work its way back to businesses.  And yet here is Samuelson admitting that actually the money does get back to businesses.

HH: On to Assumption 6, that a free market will create permanent unemployment. This of course is in direct contradiction to the most basic of economic laws, one universally recognized: the Law of Supply and Demand.  It applies to labor, just as it applies to everything else.  If there is unemployment, it is because the price of labor is too high.  In a free market, wages will fall because increased supply of labor, and thus end unemployment.

The truth is, Keynes himself knew this and admitted as much in his book.  His only concern was that the unions would be stubborn and uncaring and would not allow wage reductions. They would rather have high unemployment for everyone else, as long as the few remaining union workers get their bloated salaries. This was problematic for Keynes because he had a warm heart and wanted everyone to have a job, and also because he thought the union workers would be too rich, and wouldn’t spend all their money.

We see the flaw very clearly now. Keynes’s book should not a condemnation of a free market, but of a government that gives arbitrary power to unions.  His book should be called “The General Theory of How Unions are Ruining the Economy”.  He should have explained how we should weaken the unions, as indeed several states have done after they saw how the unions ruined the whole Rust Belt of the United States. But no. His proposal was that after the government allows the unions to rip everyone off, the government should step in and correct the problem by ripping everyone off some more.

SD: Makes one wonder how Keynesianism wasn’t laughed off right away. Thank you, Mr Hazlitt, for taking the long trip down here to enlighten us.

HH: Thank you. Gotta run, my good friend Maynard is about to walk on burning coals.

[i] Hazlitt, Henry, ed. The Critics of Keynesian Economics,

[ii] Ibid.

[iii] Ibid.

[iv] Ibid.

[v] Ibid.

[vi] Ibid.

3 thoughts on “Summary of Keynes’ Theory, and the More Obvious Flaws in it.

  1. Andris Birkmanis 01/29/2013 at 01:33 Reply

    Hey, my Russian accent is not that heavy 🙂

  2. Mauro Cella 01/29/2013 at 04:06 Reply

    Absolutely splendid.
    However you should fine tune that Ouija board. It picks up far too much unwanted chatter. .

  3. Andris Birkmanis 01/29/2013 at 08:46 Reply

    This is because of the government-mandated minimum level of noise in non-governmental Ouija boards – to prevent misuse by civilians, of course.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: