The Passing of Keynesian Economics

JOHN MAYNARD KEYNES ranks with Adam Smith and Karl Marx among economists in the influence that his views have exerted on the general public. He had the vision to see that economics lacked a general theory of demand, and he proceeded with boldness and brilliance to construct one.

His theory produced the startling conclusion that highly developed industrial countries suffer from a chronic deficiency of demand, and that this deficiency is bound to grow worse as countries become richer. Hence, Keynes called upon government to assume a new responsibility and a new function — that of closing the growing gap between the power of progressive economies to produce and the size of effective private demand. Keynes suggested two general lines of action — that of controlling the size of the gap through changes in the distribution of income and that of offsetting the gap through greater government spending.

Keynes’s theory contributed invaluable tools of analysis to economics and started hundreds of able economists in many lands studying the important problems that the theory opened up. No one in the history of economics has done as much as Keynes to stimulate good work. But Keynes’s theory has turned out to have been wrong in all its essentials. Although intended to be a “general” theory, applicable to all conditions, it was unduly molded by the depressed thirties, the period when Keynes composed it. Advanced economies do not suffer from a chronic deficiency of demand — they suffer from a chronic excess of demand. It would be hard today to find an advanced economy that is not struggling to control demand, and most of them are having only partial success.

It is among the undeveloped economies, precisely where Keynes did not expect to find a chronic shortage of demand, that unemployment is endemic and most severe. Keynes’s theory that unemployment is caused by an excessive disposition to save obviously does not explain the high unemployment in countries which are too poor to have any savings at all. The high unemployment in undeveloped countries is best explained by Marx’s theory of unemployment — that men lack work because savings are insufficient to provide the growing labor force with the tools of production.

THE CONSUMER’S ROLE

Why has Keynes turned out to have been so completely wrong? He made two basic mistakes. In the first place, he assigned to consumers a relatively passive role in determining the demand for goods. In the second place, he overlooked the fact that the development of investment opportunities is itself an expanding industry carried on for profit and able to supply the community with a rapidly growing number of investment outlets.

Keynes thought that consumers play a rather passive role in determining the demand for goods because he believed that the amount spent on consumption depends pretty completely upon the size of the national income. Hence, the dynamic influences in the economy, the influences that make the national income and the total demand for goods change, must be found, according to Keynes, outside the spending habits of consumers. Keynes found a single dominant dynamic influence in the rate of investment, which by rising and falling determines whether the economy expands or contracts. As business increases or cuts its buying of investment goods, incomes will rise or fall, and as they rise or fall consumption too will rise or fall.

Had Keynes lived in the United States, he would perhaps have seen that consumers do not let their consumption be determined so completely by the size of their incomes. American consumers, with their strong desire to live better and with their freedom from customs and traditions that decree what ways of living are suitable for people in certain stations, have always been ready to cut their rate of saving, to draw on their capital, or to go into debt in order to buy new things.

Particularly in recent years, consumers have developed a growing willingness to incur shortterm debts in order to buy goods. Since the boom year of 1929 there has been an almost sevenfold increase in consumer credit, from a mere $6.4 billion at the end of 1929 to a whopping $41.9 billion at the end of 1956. During this period consumers were obviously not limiting their spending by their incomes. Their spending was being determined, as one would expect it to be, by their total resources, which include their credit, not merely by their incomes. Instead of playing the passive role ascribed to them by Keynes, consumers have been a powerful dynamic influence accelerating the expansion of the economy.

THE ETHICS OF BORROWING

Consumers have been encouraged to play a dynamic role in the economy by the rapidly growing consumer credit industry. This industry is based upon the discovery, only recently made, that consumers are far better credit risks than anyone had dreamed them to be. As a result, there has been a rush by finance companies, banks, mail order houses, automobile dealers, department stores, airplane and steamship lines, and many others to persuade consumers to buy goods on credit. At first consumer credit was limited to tangible goods with a rather definite resale value, such as automobiles or household appliances, but now one may finance trips and vacations on the installment plan. And the proportion of sales made on credit steadily rises. Sears Roebuck reports that in 1954, 39 per cent of its sales were made on credit. Last year the proportion was 44 per cent. With consumers behaving as American consumers are accustomed to behave, Keynes’s fear that people will insist on saving too much seems farfetched.

Incidentally, with the discovery that consumers are better risks than had been previously suspected, there has developed a marked change in attitudes toward personal loans — a real change in the ethics of borrowing. Time was when personal indebtedness, except for a few emergencies and to provide the necessary furnishings for a home, was regarded as imprudent or reckless. Today it is seen that debt is a stabilizing and stimulating influence, and that it is a good thing for most young men, particularly married men, to have at least a moderate volume of debts that they are paying off.

THE DEMAND FOR CAPITAL

Although Keynes thought that the dominant dynamic influence in the economy is investment, he conceived of businessmen as a surprisingly unenterprising and helpless lot — unable to do much about the scale of investment. Keynes was obsessed with the fear that, as the country’s stock of capital became larger and larger, outlets for savings would be harder to find, and he expressed his fears quite eloquently. He said that he felt sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital to the point where its ability to produce a return would fall to a very low figure.

Keynes’s belief that the return on capital would drop very drastically as the stock of capital increased must be ascribed to his failure to appreciate the significance of modern technology. Though a man of affairs, and a highly successful one at that, he failed to see what others saw, the large and growing capacity of industry to discover investment opportunities — a capacity that is far greater in highly developed countries than in undeveloped ones and that grows as the economy becomes richer and more industrial. Technological discoveries are the most important single influence on investment in advanced industrial economies, and yet Keynes’s brilliant work contains no discussion of technological research.

THE INDUSTRY OF DISCOVERY

It is ironic that at the very time that Keynes was proclaiming his pessimistic views on the shortage of investment opportunities, the rise of technological research was producing a revolutionary change in the economy. Technological research was becoming an industry. It is convenient to call it the industry of discovery. It consists of many captive laboratories which work only for the company which owns them and a rapidly growing number of firms which do research under contract. The industry of discovery is one of the most rapidly growing industries in the country. Industry spent $116 million of its own money on research and development in 1930, $234 million in 1940, and about $1.5 billion in 1953, and it has been making even larger outlays under government research contracts. Outlays on research and development would grow even faster were they not limited by the shortage of engineers and scientists.

The revolutionary nature of the rise of the industry of discovery is not appreciated even by economists. Until recently, discoveries have been made mainly in two ways: by the efforts of operating men (incidental to their regular work), who have seen opportunities to improve methods of production or products, and by the efforts of “inventors” who, using their own resources and often driven by much stronger motives than hope of gain, have made industrial applications of scientific knowledge. The revolutionary change is that it has become possible to find a large number of problems or areas of investigation on which money may be spent with a reasonable expectation that the outlay will produce enough useful information and understanding to justify the expense. This means that it has become possible to apply the economic calculus — the balancing of expected expenses against expected gains — to an important new area of human activity, and to have the organized pursuit of gain take over a field of activity where formerly there had only been haphazard individual activities.

Of course, there can be no guarantee that a particular inquiry will produce the required knowledge within the estimated time and cost. When economic calculations are applied to research, the application has to be made in a somewhat different way from the application of economic calculations to the use of known and tried methods of production. Economists as yet do not understand the process by which highly uncertain costs are balanced against highly uncertain returns. But the evidence that some sort of calculus is being applied is found in the enormous growth of research budgets. Industry is not throwing its money away; it is spending on research and development because it has good reason to think that the outlays will prove profitable.

One result of the rise of the industry of discovery is the revelation that the economy was devoting far too small a part of its labor and capital to efforts to develop new products and new methods. The large and rapid shift of resources into technological research is enormously increasing our capacity to develop investment opportunities. An even more important result of research becoming an industry is that we have created an enormous vested interest in expanding research.

Many thousands of able men now make their living by disturbing our lives and by forcing us to discard old equipment, old methods, and old ways of doing things. The more they disturb us, the better living they make. And the vested interests of the people who live by making discoveries cause them to strive to improve the methods and instruments of investigation, thus steadily raising the capacity of the economy to develop investment opportunities. The danger that Keynes feared — namely, that we shall run out of investment opportunities — grows more remote every day, and it becomes most remote in the highly developed economies, precisely where Keynes erroneously believed that it would be greatest.

THE OUTLOOK FOR PRODUCTION

How does the world look when Keynes’s theory of demand, constructed in the midst of the great depression, is replaced with one based on the developments of the last twenty years? On the whole, it appears to be a far better world than the one described by Keynes’s theory — though not a world from which tough economic problems are absent. The specter of chronic unemployment, slowly growing as wealth increases and as the rate of saving rises, has pretty completely disappeared, at least as far as the industrially developed countries are concerned. Only a series of major blunders in policy could produce the chronic unemployment that Keynes dreaded. Consumers are a far more dynamic influence than Keynes ever suspected, and industry has far greater power to create demand for goods, mainly through technological discoveries, than anyone a generation or so ago dreamed it might have — and this power is growing.

Of great importance is the fact that the real world also has a far greater capacity to increase productivity, and hence consumption standards, than does the world of the Keynesian theory. Keynes does not discuss the prospects of technological progress, but implicit in his view that investment opportunities will be scarce is the view that technological progress will not be very rapid.

A few followers of Keynes have attempted to reconcile Keynes’s pessimistic view of the shortage of investment opportunities with optimistic conclusions concerning the rate of technological progress. They argue that rapid technological progress may co-exist with a chronic shortage of investment outlets, provided inventions increasingly take the form of reducing the amount of capital required per worker. As a matter of fact, however, most inventions are of the opposite sort: they increase the amount of equipment that can be effectively controlled and operated by a worker. Keynes himself did not argue that the shortage of investment opportunities would be the result of a preponderance of a particular form of invention —he simply was not aware of our rapidly growing capacity to make discoveries. Hence, the real world of rapid technological change in which we live is one where the outlook for more production and higher standards of consumption is far brighter than in the world of scarce investment opportunities postulated by Keynes.

A CHRONIC EXCESS OF DEMAND

This is not to say that the real world is lacking in perplexing economic problems. In place of the problems of stagnation and chronic unemployment, the real world is confronted with the problem of a chronic excess of demand, the result of the growing capacity of industry to develop new products and processes. But if demand has a strong tendency to outrun productive capacity, the government will need to maintain rather steady control over the creation of bank credit.

The policy of credit restraint, that has received so much discussion this last year, will be in effect not for a few months but for most of the time in the foreseeable future. The policy of credit restraint is unpopular with a substantial number of shortsighted people who do not like to be prevented from spending all the money they could easily spend if credit were easier. Hence, one of the hazards of life in a period of chronic excess of demand is the danger that public opinion will force the government to abandon the policy of credit restraint. Such abandonment would produce a runaway boom that would end in collapse.

RISING WAGES AND RISING PRICES

Even tougher than the problem of curbing the tendency for demand to outrun productive capacity is the problem of the tendency for wages to rise faster than the productivity of labor, causing a slow rise in labor costs and thus a slow rise in prices. This is a problem that is produced by the combination of full employment and strong trade unions. No one as yet knows a satisfactory way of checking the tendency for rising labor costs to force up the level of prices. A policy of credit restraint can prevent prices from rising faster than labor costs. Indeed, a sufficiently drastic credit policy can prevent prices from rising as fast as labor costs, with the result that unemployment is created, the bargaining position of unions is weakened, and the rise in labor costs is eventually halted. A few extremists advocate such a drastic credit policy. It is safe to predict, however, that such a policy would not last long. Protests from the unemployed and their friends would soon force a relaxing of the policy.

Other persons suggest that rising labor costs can be prevented by persuading unions to practice self-restraint and to abstain from exercising all the power that a sellers’ market gives them. But unions are competitive and power-seeking organizations, and they live in a community in which the spirit of competition pervades all manner of activities. The rivalry among unions in winning gains for their members is no greater than the struggle for sales and prestige among soap companies, automobile manufacturers, or makers of tires, radios, or cigarettes. In a community where competition is a way of life, unions alone can scarcely be expected to abstain from trying to outdo one another.

Some people suggest that the way to stop wages from outrunning productivity is to spend more money on technological research. This procedure may partly answer the problem, but it cannot be counted on to do so. The difficulty, as experience shows, is that most technological discoveries increase the demand for capital goods by creating new investment opportunities. Thus they tend to make markets even more favorable to sellers.

There are, however, some types of technological changes that increase productivity without requiring the use of more capital. These are capitalsaving changes. Examples of such changes are better selection and training of employees, better scheduling of work, better setting of production standards, better control of raw materials, better maintenance of equipment. Greater emphasis upon these capital-saving changes will raise the productivity of labor while not increasing the demand for goods, and thus will help productivity to keep pace with the rise of wages.

Changes in the corporate income tax would stiffen the resistance of employers to the demands of unions and would thus retard somewhat the rise of money wages. One reason why employers do such an indifferent job of bargaining is that under existing corporate income tax laws, the government in effect pays 52 per cent of any wage increase. The backbones of employers might be stiffened by amendments to the corporate income tax law that would require employers to wait for a year or two before counting wage increases as deductible expenses in computing their liability for the corporate income tax.

Only experience will show to what extent industry and the public will support these several ways of checking the tendency for wages to outrun productivity, and only experience will show the effectiveness of these measures. In the meantime, we shall probably have to live with a slowly rising price, level, and the rise in prices may continue indefinitely. The upward creep of prices will itself create problems, but they will be far less serious problems than we experienced from the rollercoaster course of prices during the nineteenth century and most of the first half of the twentieth century. And the problems of a slowly rising price level may be regarded as the price we pay for two desirable conditions that are fundamentally responsible for the creeping price rise: full employment and strong trade unions.

All in all, the real world appears to be a much better place than the world of Keynesian theory — at least better for most people. It is true that the Keynesian problem of stagnation is more amenable to ti’eatment by policy than the real world’s problems of excessive demand and creeping inflation. But surely it is preferable to be struggling even with incomplete success with the problems of excessive demand and creeping inflation than to be confronted with a chronic shortage of investment opportunities. Fortunately, there is no incompatibility between creeping inflation and the capacity of the economy to raise productivity.

Undoubtedly, the greatest superiority of the real world over the world of Keynesian theory is in the attitude of people toward the basic economic institutions of capitalism and private enterprise. Keynes was not seeking to overthrow capitalism — on the contrary, when he proposed that the government take on new responsibilities and functions, he hoped to save capitalism. Nevertheless, widespread and continued acceptance of Keynes’s theory of demand would have been disastrous for capitalistic institutions. People could not keep up strong faith in institutions that were unable to provide the community with the needed number of jobs, and institutions in which people lacked confidence would be bound to wither and decay and to be replaced by others.

NEW CONFIDENCE IN FREE ENTERPRISE

The discovery that our economy has far greater capacity to increase the demand for goods than Keynes suspected has naturally produced a great resurgence of confidence in capitalism and private enterprise. Rising confidence in the effectiveness of capitalistic institutions has had the interesting result of causing radicals and conservatives alike to abandon extreme positions. As attacks on capitalism have moderated, the defense of capitalism has become less doctrinaire. In the United States there has been a marked growth of “middleof-the-road” opinion. The same thing has happened in Western Europe where the Labor and Socialist parties have shifted from advocating nationalization of industry to championing the welfare state — the operation of private enterprise within a comprehensive framework of public policies — and where the principal conservative parties have also accepted the welfare state.

We should be grateful that the world is what it is rather than what Keynes pictured it as being. It is a world in which the energies and aspirations of men are stimulated by expanding opportunities rather than depressed by the constant threat of chronic unemployment. Most important of all, it is a world in which the rapidly growing industry of discovery is creating the possibility of a great cultural revolution. For the first time in history, the high productivity of some countries is enabling their people to have sufficient income, sufficient education, and sufficient leisure so that the good life is ceasing to be the privilege of a favored few and is being brought within the reach of all members of the community.