Why Fear Keynes?

by: Bob McTeer

Time Magazine quoted its Man of the Year, Chairman Bernanke, regarding his boyhood interest in the Great Depression. He had heard his family discuss a town full of shoe factories that closed during the depression leaving the community so poor that its children went barefoot. He said he kept asking why they didn’t just open the factories and make the kids shoes. Good question.

A depression does seem paradoxical. People can’t spend because they don’t have the income. They don’t have the income because they aren’t spending. Around and around it goes with the gears not engaging. Looking ahead, there is no supply because there is no demand and no demand because there is no supply.

Which is it? Does supply create its own demand? Or, does demand create its own supply? Apparently, we must choose the one, and only one, correct answer. Who was right: Say (supply creates its own demand) or Keynes (demand creates its own supply)? Are you a Methodist, or a Baptist? We are discussing religion, you know.

On the first day of my Money and Banking class, circa 1961 or 1962, Professor Waller asked us if we knew the way to Kennedy’s New Frontier. We didn’t. He said, well you go to Harvard and turn left. Harvard was left; Chicago was right. Harvard, you see, was under the influence of the Great Satan, John Maynard Keynes. (Jean Baptiste Say was an early Classical economist who was influenced by Adam Smith and who, in turn, was a great influence on Frederick Bastiat, among others.)

Although I never quite learned why, I did learn early on that Keynesianism was a corrupting influence to be avoided, or, better yet, refuted. That wasn’t all that easy since the national income accounts had adopted Keynes’s spending categories and the elementary economics textbooks–by the late Paul Samuelson and his imitators–had laid out “the Keynesian System” with simple graphs and formulas that were easy to remember and easy to teach. Who can forget that the multiplier is the reciprocal of the marginal propensity to save?

Relevant to today, much attention was paid to showing that Classical economics had a logical answer to the Keynesian “Liquidity Trap,” a condition whereby the demand to hold cash balances becomes perfectly elastic (horizontal) so that increases in the money supply no longer reduce interest rates. Such a condition seemed highly unlikely at the time, and the search for a non-Keynesian way out struck me as the proverbial search for the number of angels that could dance on a pin. The root-canal solution at the time was that deflation would raise the value of cash balances to the point that spending would resume. A kinder-gentler reaction would be not to wait for deflation to prime the spending pump, but to increase the money supply anyway (called quantitative easing nowadays), until the marginal value or utility of additional money units held fell below the marginal utility of what could be bought with extra money and spending resumed.

If more money is only hoarded and does not lead to more spending, the solution is still more money until spending finally resumes. The metaphor in the modern era became dropping money from helicopters, which Chairman Bernanke caught so much flack for using mostly from people who had no idea he was using a well-known (among economists) metaphor. The root-canal version, which waits for deflation to become self-correcting after a while, was dubbed the Pigou effect or Pigou-Patinkin effect.

I wondered why there was such satisfaction at finding (or creating) this escape from the Keynesian liquidity trap when the Keynesian prescription of fiscal stimulus financed with newly created money was so much less painful and could actually be used in the real world. I suppose the answer was, and still is among some, that the Keynesian solution involved government action. Any solution that involves government action is to be avoided at all costs. I agree with the “avoiding part”; just not the “at all costs” part.

To me it seemed obvious that while Keynes’ General Theory may not be a guide for all times, it was a practical blueprint for fighting recessions caused by a lack of sufficient “aggregate demand.” In normal times, the supply side is the constraint and deserves our attention; in depressed times, insufficient demand must be remedied first. The gears have to be engaged for the supply side to work.

I don’t get why we can’t be supply-siders in normal times and yet accept that Keynes is relevant for depressions and deep recessions. Both supply and demand are important. Why must each side ridicule the other? Why must it be a religious issue?

I have much sympathy with the supply-siders who prefer private sector solutions to our problems. I am one, as they say. However, denying the relevance of demand–the relevance of Keynes during a deep recession–erodes our credibility unnecessarily. Why fear Keynes? He’s into his long run and can’t bite us. Why leave it to others to state the obvious?