Kaushik Das: The Keynesian debate re-visited

In a recent article, "Has Keynesianism failed?" (September 15), Sudhir Mulji has raised some debatable questions on the relevance of Keynesian economics.

Mulji's article, which was in response to an article I wrote ("The failure of Keynesian economics", September 3), is a sincere but failed attempt to defend Keynesian economics, the reasons for which I will expound here.

Deliberate wrong interpretation of Say's Law: The focal point of the Keynesian debate hinges on the interpretation of Say's Law of Markets. It states that the supply (sale) of one product creates the demand for (purchase of) another product. Or, in other words, supply is the cause of consumption and increased output results in higher consumer spending.

However, Keynes had deliberately distorted the interpretation of Say's Law to make way for his "demand management" theory. By incorrectly stating the law as "Supply creates its own demand", (and Mulji also agrees with this interpretation) Keynes arrived at the conclusion that Say meant that everything produced is automatically bought and, hence, Say's Law could not explain the business cycle.

The truth is that involuntary unemployment is perfectly consistent in the classical framework but that does not prohibit production and sales from taking place.

In fact, it forms the basis of new income and new demand. Or in other words, a correct interpretation of Say's Law leaves no space for Keynesian demand management theory to take shape in the first place.

Consumption or savings: Which is more important? Keynes, a self-proclaimed amoralist throughout his life, had absolutely no regard for virtues such as frugality. So he not only despised savings but also ardently believed it was consumption and not savings that can bring prosperity.

Keynesian statisticians such as Simon Kuznets (the father of National Income Accounting) seemed to vindicate this Keynesian proposition since GDP calculation showed that consumption expenditure comprises two-third of GDP whereas the investment is usually only 15 to 17 per cent of GDP.

But there is a basic flaw in this argument as with all Keynesian propositions. GDP measures a nation's output of final good and services. GDP excludes intermediate products and spending by entrepreneurs "" the goods-in-process sector of the economy, the natural resource, manufacturing and wholesale stages in the production process.

A much better indicator propounded by Austrian economist Mark Skousen is a statistic called the Gross Output (GO). GO is defined as GDP plus Intermediate Input, the latter including the sale of products in the natural resource, manufacturing and wholesale markets.

Calculating in the above-prescribed format, this simple equation reveals a startling fact. It clearly shows that savings and investment, not consumer spending, are the driving forces behind economic prosperity, just as Say's Law tells us.

Gross business investment is considerably larger than consumer expenditure, contrary to Keynesian belief. In 1998, for instance, business investment in the US was 52 per cent of GO, while consumer spending was only 38 per cent.

The half-truth of the Keynesian multiplier: The proponents of Keynesian economic theory argue that due to the strong "multiplier" effect (a concept introduced first by economist Richard Kahn), an initial consumption spending results in additional income and employment in the economy.

However, it should be noted that the Keynesians assume that saving is only hoarded and remains uninvested, which is an unrealistic assumption. In reality, both consumption and savings are spent in the economy thus making the multiplier infinite.

Or in other words, savings also has a multiplier effect in the economy because it is invested in the intermediate stages of production. Moreover, the savings multiplier is more productive than the consumption multiplier because savings and investment ultimately improve the factors of production through technology upgradation and innovation.

Wrong Fed policy: Mulji's argument that the severity of the 1930s recession was the result of the Fed's decision to withdraw credit at a time when actually it should have pumped in more money according to the Keynesian prescription has little substance.

In fact, such faulty theses arise out of the incorrect diagnosis of the causes of the Great Depression. The Great Depression would not have been so severe if the Fed had not tampered with the monetary policy at all.

Pumping in more money would have only deferred the recession to a later period, and the more the extent of artificial monetary stimulation, the more would have been the extent of severity of the depression.

The truth of the matter is that no central monetary authority can work as a substitute to the natural forces of the market because it is not possible to acquire all the knowledge required to steer the economy.

The impossibility of Keynesian policies to work: For a minute, assume we were to accept all the illogical assumptions that form the building blocks of the Keynesian framework.

It is still possible to show that the Keynesian policies of government intervention to move the economy back to its appropriate full-employment level in case of an adverse movement from the full employment level would simply not work because of time-lags.

The first time-lag is between the actual change in macroeconomy and the time required to collect statistical data, which will show if there is something wrong in the economy.

The second time-lag arises between the detection of the actual problem and the actual time required to put the monetary or fiscal policy in place given the political disagreements on such sensitive issues.

The final time-lag is between the implementation of the policy action and it's working through the economy and affecting the general level of employment and output.

Therefore, from the time the data has to be collected, interpreted and acted upon to the time a change in policy will begin to have its full effects, the economy being dynamic will not remain still. The economy will be following its own "natural" path.

As a result, by the time the policy change actually has its effect, the need for that particular policy may be redundant. To make matters worse, the new policy's effects may not only be too late to solve the problem but, in fact, can help create a new problem that would require another round of policy prescriptions thus entering into a never ending vicious circle of Keynesian trap.

In conclusion, I would beg to differ from Mulji's assertion that "for good or bad these (Keynesian) tools have become a feature of macroeconomics."

On the contrary, I would like to emphatically re-iterate the fact that the Keynesian economics has suffered a slow and painful death in the long run just as Keynes had aptly predicted in his oft-quoted dictum "In the long run we (the Keynesians) are all dead."

(The author is a research fellow at the Centre for Civil Society)