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American Economy and Purchasing Power vs. Keynesianism

Larry Kudlow lavished praise on what he called "the great American consumer" Alive and Kicking Twenty-five years after the Reagan tax cuts, the economy is still cruising along, NRO 14 August 2006). Frequent readers know my opinion of the atrocious idea that consumption can drive an economy. Nevertheless it needs to be continually pointed out that putting stress on consumption can actually retard economic growth

Most commentators attempted to explain the Clinton recession (the one Democrats try to pin on Bush) in terms of falling consumer demand. But as I argued at the time the classical economists had refuted this fallacy by explaining that while consumption is never a problem production is. Now while I made use of classical economists, and still do, I try to make it clear that they were far from being in full agreement, particularly on value, prices, wages and costs.

Nevertheless, when it came to the truism that is called Say's law of markets the great majority of classical economist strictly adhered to the rule -- one that should be self-evident -- that production is the sole source of demand. Even the late Marxist Paul Sweezey, a well known American economist, realised that "...the Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say's Law is assumed."

The Keynesian response is to retort that Keynes refuted Says Law. But Keynes did nothing of the kind. All one needs to do is compare what Keynes wrote with what Say, Ricardo, Mill, etc., actually said and wrote. This needs to be done because Keynes deliberately misstated Say's Law so he could 'successfully' refute it. In other words he set up a straw man knowing how little acquainted modern economists are with classical thought.

Keynes quoted from John Stuart Mill's On the Influence of Consumption on Production in a way so as to distort its meaning. (It seems that Keynes really believe that "all's fair in love and war"). The substance of Say's Law is so simple that it should not need to be continually restated: there is no such thing as general overproduction. This has been taken by many as meaning that depressions are impossible. But classical economist, including Say, never made such an absurd claim, neither did they argue that gluts of particular goods cannot emerge -- quite the contrary.

Classical economists stressed, including Marx, the need for proportionality, what we now call equilibrium. This is why Mill could confidently write that if England were to suddenly double its productive power and hence the production of every good there would, for example, "be an appalling glut of salt" (On the Influence of Consumption on Production). They therefore clearly understood that to prevent the over-production of particular goods, which means avoiding shortages elsewhere, equilibrium must be maintained. In plain English, goods must be produced in the right proportions as determined by consumers' preferences.

The classical and correct view that demand springs from production which in turn must be in equilibrium to avoid gluts and depressions brings us right back to Mr Kudlow and the rest of the economic commentariat that puts such misplaced stress on consumption. If they understood their economic history they would surely know that during the dreadful 1930s it was the consumption heresy, as it ought to be called, that prevailed, even though economists like Joseph Stagg Lawrence were pointing out that consumption was being maintained and that it was the producer goods industries that were being hit. (The very same thing happened during the Clinton recession*).

Now If the consumption school of thought were right then consumption would have dropped first followed by a fall in production as "demand deficiency" worked its way up the production structure. But it is a little known fact that consumption actually accelerated during the last American recession, leaving Keynesians puzzled but completely unbowed.

Barrons published an article by John Oakwood in which he lashed out at the dangerous purchasing-power-of-wages doctrine, according to which maintaining money wage rates at pre-depression levels, regardless of a falling price level, was the real key to recovery. The heartbreaking consequences of this ill-conceived policy were the expansion of withheld capacity which aggravated unemployment, reducing output even further.

Oakwood tried to hammer home the fundamental difference between wages and purchasing power, laying as much stress as he could on the fact that purchasing power is the ability to produce goods for exchange against other goods and services. (Wage Cuts and Economic Realities, Barrons, 29 June 1931 and How High Wages Destroy Buying Power, Barrons, 29 February 1932). Benjamin M. Anderson was another economics writer who vainly warned about the dire consequences of trying to maintain purchasing power by raising real wage rates above their market clearing levels, arguing that

[p]urchasing power grows out of production. The producing countries are the great consuming countries...Supply of wheat gives rise to the demand for automobiles, silks, shoes, cotton goods, and other things that the wheat producer wants. Supply of shoes gives rise to the demand for wheat, for silks, for automobiles and for other things that the shoe producer wants. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. (Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, first published 1949)

In keeping with classical thinking Anderson followed with the caveat that "the doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium". [Emphasis added].

These economists understood that all exchange takes the form of values. Therefore, whenever the real wage rate exceeded the value of the worker's "added output", as Philip Wicksteed put it, unemployment emerges. Professor Hutt analysed the situation as one of withheld capacity. (The Keynesian Episode: A Reassessment, LibertyPress, 1979). William Röpke also put it well when he said: "The reestablishment of equilibrium creates purchasing power."

So the lesson of history is that yesterday's economic wisdom is indeed correct in warning us of the dangers of pumping up consumption to escape recession. No wonder William Röpke felt the need to remind his colleagues that "mondern theory itself remains heavily in debt to the spadework of the classical school.(Economics of the Free Society, Libertarian Press Inc., 1994, first published 1937).

Although the old medicine of letting market forces liquidate maladjustments and allow prices and costs, including wages, to adjust to the proper proportions between production and consumption may seem excessive the fact is that it worked.

Moreover, the real culprit is not the medicine but a fractional reserve banking system that is forever triggering booms and busts by flooding the economy with excess credit.

*Of course I'm not accusing Clinton of causing the recession, only of being in power when it started.


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