How to Mangle Keynesian Theory

Here is a classic Austrian misrepresentation and mangling of Keynesian theory by Robert Murphy, in his critique of the Keynesian explanation for America’s less than full recovery under Roosevelt:

“Yet to blame the slow American recovery on weak investment simply pushes back the problem one step: Why were investors so reluctant to risk their funds in the U.S. economy during the 1930s?

The Keynesian answer, of course, is that businesses won’t invest if demand has fallen off for their finished products. Why expand your plant when you’re already operating below capacity and piling up inventory? Indeed, this is precisely the answer Paul Krugman gave when George Will raised the issue of (non-)investment during the New Deal on ABC’s This Week.

The problem with the conventional Keynesian explanation is that it proves too much. In the simplest Keynesian story, every recession ought to lead to mass starvation. After all, their theory is that consumers for some inexplicable reason get spooked and reduce their spending. This causes sales to fall off, so businesses slash prices and lay off workers. The layoffs cause national income to fall, leading to a further decline in aggregate demand. And so on in a downward spiral until half the population die and the rest return to the fields. Krugman’s ‘explanation’ for the stagnant investment of the 1930s can’t explain why the U.S. economy managed to quickly recover from all of the earlier depressions in its history.” (Murphy 2009: 112–113).

Murphy claims that:

“In the simplest Keynesian story, every recession ought to lead to mass starvation.” (Murphy 2009: 112).

This, however, is a bizarre caricature, and had Murphy bothered to properly read Keynes, he would have discovered that Keynes did not think that deficiencies in aggregate demand always or often lead to some uncontrollable spiral which results in mass starvation.

Instead, Keynes thought that the main problem with market systems was that they have no necessary tendency to full employment equilibrium, and that they normally have considerable involuntary unemployment:

“For this reason, even those degrees of recovery and recession, which can occur within the limitations set by our other conditions of stability, will be likely, if they persist for a sufficient length of time and are not interfered with by changes in the other factors, to cause a reverse movement in the opposite direction, until the same forces as before again reverse the direction.

Thus our four conditions together are adequate to explain the outstanding features of our actual experience; — namely, that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.

But we must not conclude that the mean position thus determined by ‘natural’ tendencies, namely, by those tendencies which are likely to persist, failing measures expressly designed to correct them, is, therefore, established by laws of necessity. The unimpeded rule of the above conditions is a fact of observation concerning the world as it is or has been, and not a necessary principle which cannot be changed.” (Keynes 1936: 254).

Keynes’s view, then, was that there are stabilising tendencies in market economies, but that these will not necessarily cause a recovery to full employment, and that real-world capitalist systems have a tendency to fluctuate around a state well below full employment but above “the minimum employment a decline below which would endanger life.” And the solution to persistent states of involuntary unemployment is government fiscal policy.

So much for Murphy’s caricature.

Murphy also makes the following claim:

“Krugman’s ‘explanation’ for the stagnant investment of the 1930s can’t explain why the U.S. economy managed to quickly recover from all of the earlier depressions in its history.” (Murphy 2009: 112–113).

However, the belief that the US recovered quickly “from all of the earlier depressions in its history” is also untrue. The empirical evidence shows us, for example, that in the 1870s and 1890s the US fell into serious economic problems with stagnation or high unemployment persisting for years:

“US Unemployment in the 1890s,” January 24, 2012.

“Rothbard on the US Economy in the 1870s: A Critique,” September 24, 2012.

“US Industrial Production in the 1890s,” January 2, 2014.

“US Unemployment in the 1890s: Who is Right?,” December 30, 2013.

“US Unemployment in the 1890s Again,” February 20, 2014.

BIBLIOGRAPHY
Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Murphy, Robert. 2009. The Politically Incorrect Guide to the Great Depression and the New Deal. Regnery Publishing, Inc. Washington, DC.