It has become a highly entrenched orthodoxy in public opinion, public policy, and academia that consumption is fundamentally good for the economy. If the economy is not doing well, then it is because consumers are not doing their job well enough, and the solution is that consumption needs to be increased. If individuals are not willing to increase their consumption, then it falls to the government to increase its consumption by increasing expenditures; and typically deficits as well, because if the government were to pay for its increased consumption at the time through increased taxes, then that would further discourage individuals’ consumption. You can find this belief in people from Paul Krugman to George W. Bush. This orthodoxy is rooted in the General Theory of Employment, Interest and Money (which can be read online here), written by John Maynard Keynes, who is today considered the father of “modern economics.”
However, modern mainstream economics —more correctly known as the neoclassical synthesis, because it incorporates most of the formal structure of classical economics along with supposed Keynesian “insights” into how economies work on the macro level— has failed. It failed to predict this recession, and it has failed in trying to correct the flaws in the economy that have led to this recession. A major reason why it has failed is because of this view of consumption.
The crux of the debate over the nature of consumption is Say’s Law, often called the law of markets. In essence, Say’s Law states that the goods and services an individual supplies to the market also constitute that individual’s demand for other goods and services, or simply that people buy real goods and services and sell real goods and services in exchange for the ones that they buy. Your production determines how much you can consume, because the total amount of goods and services in the economy is simply the sum of the production of each individual. Money simply acts as a method of indirect exchange, but at the end of the day, it is real goods and services that are being produced, consumed, and exchanged. Money, and particularly changes in the quantity of money, can have interesting effects on the real economy, but we can never lose sight, as Keynes does, of the fundamentally “real” nature of the economy: the actual production and consumption of goods and services.
The major implication of Say’s Law is that there can never be a general “glut” or overproduction of all goods and services, or conversely, there can never be a lack of aggregate demand, or under-consumption: the reason being that the price mechanism of the market —where the actions of every individual in the market, through the goal of maximizing profit by buying in the cheapest market while selling in the dearest, result in prices that ensure an economic equilibrium— creates an equilibrium in which supply and demand are equal. The whole body of thought that is Keynesianism, however, rests on the belief that Say’s Law is false. Keynes’ reasoning for this belief was that he observed that, in the real world, prices could be “sticky,” or resistant to change. If some shock occurred in the economy that would encourage people to save more, such as a recession, and if prices for consumer goods did not fall in response to this change, then one could expect to see a general surplus of goods and services in the economy. Say’s Law assumes that prices can change.
However, there is one more important assumption that Say’s Law is based on, and that assumption is that the market in consideration is a free market, with the absence of government regulations, interventions, and special privileges for certain individuals or groups. The world in which Keynes was writing did not have a free market. For example, during the Great Depression, President Hoover quickly embarked after the stock market crash to ensure that wages would not fall, even though prices in the economy were falling all around. He met with business leaders and encouraged work sharing, all in the name of preventing wages from falling, because he believed, in a proto-Keynesian manner, that if wages were to fall because of the falling demand for businesses’ products, which was in turn a result of the falling demand for those products, then the fall in wages would cause a further decrease in demand and would result. This hypothetical scenario, where a small fall in demand could completely destroy the economy, is called a deflationary spiral. A deeply held belief in this possibility is a major way that Keynesians try to justify massive government spending and inflation in periods of economic turbulence. And so it came to be that through Hoover’s policies of propping up wages, and through the efforts of the unions through their special governmental privileges which enabled them to prop up, increase, and prevent their wages from falling, the economy ended up in a situation in which the price of labor was no longer easily changeable in a downward direction. The result in the deflationary economy of the depression was, as expect, a large surplus of labor, generally known as unemployment, which reached unprecedented levels during the Great Depression.
Therefore, because the labor market is so important to the economy as a whole, given that most people rely on selling their labor to make an income and the fact that all goods and services require labor to be produced, the sabotage of the price mechanism in the labor market had drastic economic results. So what is the solution to such a problem? The answer is quite simple, and should have been to Keynes as well: it is that the government should stop restricting the movement of prices in the market and should stop enabling other organizations, such as labor unions, from doing the same. Keynes, however, a liberal of his day, did not want to attack the unions or prevent them from doing as they pleased, and so his proposed “solution” was to print money and use government spending to raise prices in the economy, which would then cause any wages that stayed constant to drop in real terms. Inflation would lower any prices that did not move up proportionately with the rate of inflation. The excess of labor caused by prices being too high would be reduced and employment restored.
Keynes’ “solution,” however, fails not only to address the underlying problem in the economy, but it also entails a course of action with a host of its own problems. While writing and arguing against what he considered the fallacies of the laissez-faire economists, he argued against the current economic policies present in the world, rather than actual free market economies, of which there were none. He fails to realize that a free market would in fact be stable and equalizing, where there could be no lack of aggregate demand because it would be in the interest of the individuals in the markets to lower their prices until they could sell all of their products. He inspired fear of deflation, and a love of inflation and government spending, all of which continue to damage our economies and our study of economics to this day. Consumption may be the final purpose of all economic activity, but saving and capital accumulation is a vital process to the production of consumer goods. Keynes not only thought that saving was unimportant, but destructive in itself; contradictory he could be on the subject, however. Many of today’s economists continue in this tradition: “consume more, save less, and the economy shall prosper” goes their mantra. We are, however, all the poorer in more sense than one because of this grand mistake.
