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Source link: http://archive.mises.org/13247/the-self-defeat-of-the-keynesian-cross/

The Self-Defeat of the Keynesian Cross

July 13, 2010 by

Given the inadequacies of the Keynesian paradigm, anyone interested in explaining the origins of the business cycle should seriously study other economic theories — especially the Austrian one. FULL ARTICLE by Predrag Rajsic

{ 20 comments }

Ben Ranson July 13, 2010 at 10:04 am

This particular attack on the Keynesian system is new to me. It is good, in the sense that someone who accepts the use of (supposedly measurable) aggregates could possibly be persuaded by it.

Clint July 13, 2010 at 11:23 am

Just what I’ve been looking for! Thank you!

Ron Finch July 13, 2010 at 11:56 am

Good picture but more accurately the keynesian gun should be pointed at his wallet.

Bob Roddis July 13, 2010 at 4:03 pm

Excellent article.

Regarding Krugman, how can he possibly know whether the Austrian School is “worthy of serious study” without having studied it? Sounds like proof positive to me that he, like all other “critics” of the Austrian School, not only haven’t seriously studied it, but are completely unfamiliar with its basic concepts. But I guess that’s modern science, eh?

AJ Nock July 13, 2010 at 5:43 pm

It is unsurprising that the establishment embraces Cambridge & London “English” School Economists. Though its practice limits the common overall wealth, it serves and preserves the elite dynasty. Austrian Schoolers will triumph in the long run, as long as they continue to be better predictors of the future. Keynesians, like Orwell’s big brother, always have to backtrack to give the impression of legitimacy by bending reality.
The story of Hayek soundly refuting Keynes on a matter, and his reply “Oh I no longer believe in all of that anyway” response lays bare the dissengenuousness to any scientist who is paying attention.

Daniel Hewitt July 13, 2010 at 8:20 pm

I had to print this one out, and work through it with a pen and paper. A few questions:

-pc and φ(N) should be interdependent, right? It doesn’t seem correct that pc is exogenous. As N fluctuates up and down, I think that pc would fluctuate also.

-Should D2 and pc be inversely releated? I think that when consumption decreases, investment would increase, and vice versa. Figure 2 suggests that D2 is constant, and that does not seem right to me either.

Predrag July 13, 2010 at 8:53 pm

Daniel, pc is exogenous. According to the model, it can range between 0 and 1. It is the share of income spent on consumption.

With respect to D2, Keynes spent some time arguing why he thinks there should be no particular reason for the current investment and current consumption to be related.

Ohhh Henry July 13, 2010 at 9:34 pm

the true logic of the Keynesian model implies that the equilibrium is restored by the cessation of the physical existence of the unemployed (i.e., death). Any other outcome contains unresolved internal contradictions.

That is exactly how Stalin, Hitler and Mao attempted to restore equilibrium during their respective heydays. Keynes famously wrote in the forward to the German-language edition of his General Theory:

The theory of aggregate production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire.

Keynesianism = Totalitarianism = Death

P.M.Lawrence July 14, 2010 at 4:10 am

Keynes based his 1936 treatise The General Theory of Employment, Interest and Money on one key assumption, that involuntary unemployment is a possible market-equilibrium outcome.

Wrong. That’s not an assumption, it’s an observation (using Keynes’s definition of involuntary unemployment). The supporting assumptions of his theory are other than that. However, those assumptions and that theory support the conclusion that that can happen, so the observation is a “confirming instance”. That doesn’t make it necessarily true, since other things could do that too.

Predrag July 14, 2010 at 8:17 am

I am aware that Keynes treats this as an observation. However, for this to be an observation, one needs to assume that the demand for labour is observable.

mundi July 14, 2010 at 6:56 am

It seems to me that this article is easily refuted. For example: unemployment could occur by people working less, with no individuals actually unemployed, therefore no extra ‘unemployment’ consumption is required to maintain them, just a reduction in living standards for everyone.

(Also, if the author is correct, there cannot be a reduction in production output without also having to produce some quantity to give away for free!)

I think the author is mistaken in the belief that an unemployed person suddenly no longer becomes part of the aggregate totals. Everyone is still in the aggregate totals reguardless of employment.

Seattle July 14, 2010 at 8:19 am

It seems to me that this article is easily refuted. For example: unemployment could occur by people working less, with no individuals actually unemployed, therefore no extra ‘unemployment’ consumption is required to maintain them, just a reduction in living standards for everyone.

Huh? How can there be unemployment if “no individuals actually unemployed?”

(Also, if the author is correct, there cannot be a reduction in production output without also having to produce some quantity to give away for free!)

The point of the article is to begin with the Keynesian assumptions and show that they’re self-contradictory.

Predrag July 14, 2010 at 8:27 am

For example: unemployment could occur by people working less, with no individuals actually unemployed, therefore no extra ‘unemployment’ consumption is required to maintain them, just a reduction in living standards for everyone.

If the Keynesian cross was intended to explain the situation you describe, I might have looked at that too, but this is not the case.

mundi July 14, 2010 at 10:48 pm

They are not different situations. If 10% of people are unemployed, or 100% of people take 10% cut in work, the aggregate is the same. This means the unemployed are already counted in the aggregate, indeed this is what causes the aggregate to change. If the unemployed were not counted, the aggregate demand per person would not fall when unemployment occurred, it would remain steady. When the employed give charity to the unemployed its coming out of what would have been their own consumption, it is already in the aggregate total.

Predrag July 14, 2010 at 11:35 pm

In the Keynesian cross model, aggregate demand changes due to the changes in exogenous propensity to consume. Aggregate demand is reduced because each consumer spends a smaller share of his/her income on consumption goods. Unemployment is a consequence, not the cause of the reduction in the aggregate demand. The cause is in the reduction in the propensity to consume – what Keynes calls the psychological characteristic of the population.

Kerem Tibuk July 15, 2010 at 3:33 am

The fundamental fallacy of Keynes was the belief that, consumption can come before production and not only that but consumption is a necessary prerequisite of production, and this article touches upon one aspect of this fallacy.

But in reality, the only possible consumption prior to production is “the consumption of capital”, if an economy has any.

Westland Cleaning October 3, 2010 at 12:15 pm

Reading the article of The Self-Defeat of the Keynesian Cross is pretty impressive ..
most of the information give since to me, so is the theories and the full article.

davidw October 28, 2010 at 6:02 pm

that is why the consumption function has a ‘a’ in it:

Y = a + bY

‘a’ is actually a store of wealth that people consume when they are unemployed. Your criticism is irrelevant.

However, there are a million things ‘wrong’ with the Keynesian cross – it’s a simplification, obviously. All it does is describe the market for savings and investment. The problem is that Income adjusts the market and not the interest rate because consumption and investment have little to do with the interest rate.

Predrag November 5, 2010 at 7:17 am

davidw, I am assuming you meant C = a + bY. Yes this is a variation on the theme used in more recent textbooks. However, it suffers from the same criticism since “a” is fixed (it is not a function of production) and, given a sufficiently long recession, becomes 0 (and the problem reduces to the one I criticize). The problem is different in degree but not in principle.

Davidw May 27, 2011 at 3:54 pm

It is not zero during long recessions, unless people die from poverty. For the ‘a’ is not just wealth, but could also be amounts spent on soup kitchens, homeless shelters, food stamps. In other words, the community’s investment in social insurance.

However, your main criticism of the Keynesian cross is that is a simplification – which is true.
If you want to add the complexity of unemployed people’s consumption, then you have to explicitly model that in a two consumer model and look at their incomes. But it makes no difference to the model – the idea is that people decide to spend less, and there is unemployment and income falls. Who really cares to what decimal this income is distributed?

The problem with the Keynesian cross is that the interest rate is not in the consumption function – and hence does not change savings. Thus people are blinding saving regardless of how much others are trying to invest. Thus, in order to equalize savings and investment, income adjusts.
It makes no difference if unemployed people are consuming a lot, a little or something or nothing.
The Modigliani IS-LM curve drops this assumption and equalizes savings and investment. Income is tied instead to the labor market, so you always have full employment if real wages are flexible.

To me, this is a ridiculous assumption, and instead the Keynesian Cross is actually a better model than the more complicated IS-LM. And it is likely it is accurate in the short run – people usually do not save depending on the interest rate much, nor do investors do real investment so much because of it. Therefore, there is likely a lot of income adjustment in the real world.

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