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Source link: http://archive.mises.org/8926/consumers-dont-cause-recessions/

Consumers Don’t Cause Recessions

November 11, 2008 by

The circular-flow diagram is a very misleading model of the economy. It leads us to think that output of finished consumer goods can immediately rise and fall with “spending.” This framework would hold if there were no capital goods, meaning that all consumer goods and services were produced immediately, as workers took gifts of nature and produced the finished item on the spot. FULL ARTICLE

{ 70 comments }

Enjoy Every Sandwich November 11, 2008 at 9:02 am

I may be reading too much into Krugman’s article, but I wonder sometimes if his hostility to consumer saving isn’t tinged with some collectivist feelings. After all, when you get right down to it what he is calling upon individual consumers like me to do is to rack up debt buying things I don’t need, for the sake of the collective.

I’m sorry, dude, but the car I have now isn’t paid for yet. I live alone so I only need one car. Hey, you’ve got that Nobel prize money, right? Why don’t you buy a car or two?

David Roemer November 11, 2008 at 9:10 am

To help you understand: Howard Gardner, famous for his work on the different kinds of intelligence, told the following story at a conference of educators I once attended. One day his daughter, frustrated to the point of tears, complained to him about the difficulty she was having understanding a college course she was taking in physics. Describing himself as the perfect father, he related how he listened patiently while she spoke, praised her industriousness, and tactfully suggested that she discuss the matter with her physics teacher. His daughter said, “You don’t get it, Dad. I get hundreds on all my tests.”

His point was that students succeed by repeating on tests exactly what the teacher said in the classroom, regardless of whether or not they understand what they were taught. The more successful students become professors themselves and pass on their so-called knowledge to succeeding generations.

Chris Sargent November 11, 2008 at 9:31 am

How has this country gotten so far into this “Nobody wins/Nobody loses” mentality? It seems like this is what’s driving he propping up, by the Fed, of the auto industry, AIG, Leihman’s, etc.

Why the fear of failure?

Bill Anderson November 11, 2008 at 10:11 am

Actually, Bob, I would be willing to have an all-day fast just to get another shot at Krugman. This was a fantastic, just fantastic piece. I’m glad to see someone debunking the circular logic, I mean circular flow, model.

I heard Israel Kirzner give his version of the “circular flow”:

Q: Why do you eat breakfast?
A: So I can go to work.

Q: Well, why do you go to work?
A: So I can have breakfast.

Curt Howland November 11, 2008 at 10:26 am

“If solving a recession really were as simple as getting people to spend, then we wouldn’t keep experiencing them.”

If central banks solved depressions, why have the worst depressions been under central banks?

Bill November 11, 2008 at 10:37 am

Also see the chapter entitled, “The Assault on Saving” in Henry Hazlitt’s ECONOMICS IN ONE LESSON.

Mike de Bary November 11, 2008 at 11:49 am

You can’t fully criticize the Krugman approach by your argument that “misalignments” must be”rooted-out” as opposed to his Keynesian recommendation that, in effect, “misalignments must be intensified.” What is the cause of the misalignments?–the central bank, fiat money system, we know. Letting time pass and misalignments get sorted is only a half-step. The money and banking system must be “rooted out.” Money and banking must be fully privatized. If not, you are just repositioning your “deck chair” on the central bank cycle.

Eric November 11, 2008 at 11:50 am

Why do people keep analyzing Krugman for economic flaws? The question is,

Why does Krugman go to work writing economic trash?

Because Krugman wants to eat Breakfast. And he has expensive tastes.

Krugman doesn’t need to believe anything he preaches, so long as he is paid, and paid handsomely for spouting the government line. He’s a court intellectual of the Rothbard type. Krugman is a sociopath who is able to lie and steal without feeling any guilt at all, and probably even gets a perverse thrill from getting away with it, like the kleptomaniac. He’s simply a clever flim flam man. He could sell junk used cars and never flinch. Just look at the smirk on his face all the time.

No, I say that Krugman has discovered his nitch in life. He sells economic garbage and people are falling all over themselves to pay for it. You can get a dog to bark anytime and anyway you want if you reward it over and over again.

Pat November 11, 2008 at 12:07 pm

Wow, Eric, that is quite harsh. I doubt Krugman is a sociopath. I think it is likely that he believes in what he says. If you believe the government must intervene in the economy and the free market is flawed (And believing that Bush and Co. stands for the free market and laissez-faire policies, despite the evidence to the contrary), then you might find that the New Keynesian economics are correct. No need to be a sociopath. Of course, that still does not prevent him from being wrong, and in this case, his conclusions are specious.

Michael November 11, 2008 at 12:11 pm

Chris, being fearful of failure is acceptable. It’s normal for humans to be fearful of fear because we are naturally risk adverse creatures, just like any other carbon based life form.

However, I think part of the whole bailout and entitlement nonsense is etched in the new American Culture of equalizing success; Every kindergartner gets a sticker on their homework assignment, regardless of their letter grade; Every contestant gets a pretty blue ribbon, no matter who won the race; All the teams that participated in the high school baseball tournament gets a little trophy, no regard to how they finished in the standings.

JGU November 11, 2008 at 12:24 pm

I’m not an economist, but you asserted that people can’t “demand” a TV unless there is a “TV” in the store, I think that’s plainly wrong. You have confused “purchase” with “demand”, no transaction doesn’t mean there is no demand. According to your logic, Walmart shouldn’t open a new store in any new place, because there is NO DEMAND in that area. I’m shocked you guys call yourselves economists, yet you don’t even understand basics. Shocking!

Inquisitor November 11, 2008 at 12:56 pm

In terms of effective demand there is none… and when economists speak of demand, they mean that. Shocking!

Nasikabatrachus November 11, 2008 at 12:57 pm

To my untrained eye, JGU brings up a good point, though I would not put it so rudely nor refrain from giving the author the benefit of the doubt unless they consistently betrayed a lack of understanding (rather than judge a whole volume by a single sentence, say). I’d like to know what Mr. Murphy meant by “demand” in that context.

Regarding Krugman, I think he believes what he says. It’s easy to say that he’s intelligent enough to know better, but that doesn’t take into account how easily people can fool themselves into believing things that accord with their predispositions, beliefs, etcetera. Krugman’s history says it all: he claims that he was inspired to become an economist by Isaac Asimov’s ‘Foundation’ series after he realized that the profession of “psychohistorian”–the people who use their knowledge to accurately predict and control human behavior–did not exist. So, a young man inspired by the idea that he can control large groups of people through his intellect grows up to become a collectivistic “progressive” economist. Go figure!

Stanley Pinchak November 11, 2008 at 1:19 pm

JGU,
you can demand until you are blue in the face, but you can not have instant gratification of your desires. Production takes time. Keynesian economics disregards time and as a result the importance of capital in the Economy. The TVs and Walmarts demanded can not be produced instantaneously as Keynesian Analysis contends. Thus i see no problem with Robert’s use of the word demand in debunking Keynesian Economics. As a student of Austrian Economics, and author of a study guide on “Human Action,” I am positive that Robert is quite familiar with the basics of supply/demand, and production and capital formation.

greg November 11, 2008 at 1:25 pm

Can we save our way out of a recession? What happens when you put money into a savings account? In simple terms it goes in an you are paid 2% interest on it. The bank turns around and loan that money to someone to buy something now for 10% interest and makes 8%. But it doesn’t stop there! The bank can leverage that cash up to 40X depending on the structure of the bank and regulations it must follow. So your investment in the savings account allows others to borrow and spend many times more than your investment.
Let’s take this to a larger level. China is buying a huge amount of our debt and financing our consumption of their products. The more they invest, the more we buy and the more they need to produce. And as our consumption of their goods have slowed, they continue to send money our way in hopes that will spark consumption with the low interest rates and cash.
The point I am trying to make is that saving is not enough. You need to direct you savings into capital goods that increase production in areas that have the greatest returns. Not for someone to buy the latest flat screen tv. China should not send money to buy T-bills, they should be investing into companies and products that will increase their production.

Matt November 11, 2008 at 1:53 pm

Very Good article.
However let’s assume that Krugman really believes what he says, the only logical conclusion then is that there is something wrong with Krugman’s brain, i.e. his inability to logically analyze.
Krugman is no new comer to the field of economics, he should know that what he is talking about makes no sense, but he doesn’t and can’t see his illogic.

The economic problems facing everyone starts with the creation of the FED.
Fractional Reserve Banking in place is outright theft, but it’s so convoluted only a few can see it.
One must remember why the FED was created, it was created to allow Congress to spend and spend beyond taxes collected and the banks to benefit by the use of fractional reserve banking, a very cozy position to have.
Unfortunately severe Recessions and even Depressions are the result.

Michael Smith November 11, 2008 at 2:00 pm

In addition to the excellent points made by Robert, we have one more: Government has no ability to create new, additional purchasing power.

To spend money, government must do one of three things. 1) Take it from the people directly in the form of taxes. 2) Take it from the people in the form of borrowing. 3) Print it up.

It should be manifestly obvious that none of these three results in additional consumer spending power. A dollar taken in taxes or borrowed simply becomes a dollar spent by government and not spent by the citizen. A new dollar printed up and spent simply reduces the value of all the other dollars proportionally. In no case has new purchasing power has been created.

And if Krugman is too dense to see that, let him simply look at the fact that the Bush administration has increased government spending by over 1 trillion dollars a year. Over 1 TRILLION DOLLARS per year — and yet, here we are facing a recession.

Tell us, Mr. Krugman, why this vast expansion of federal spending hasn’t stimulated us into full employment and fantastic economic growth……

Mr. Krugman?

DD November 11, 2008 at 2:24 pm

greg,

First, let’s get some confusing terminology out of the way. “bank can leverage that cash up to 40X..”. Describing the creation of money process by banks as leverage is quite misleading in my opinion. Banks don’t leverage anything, they simply take in the savings for their reserves and create money out of thin air many times more.
Second, I don’t see the multiplication factor for loaned credit over the savings as any positive element for the economy. This fact alone is part of the problem of inflation dure to excess credit, whcih causess the malinvestments that are caused during the boom.
Third, real savings are the only thing that can provide economic growth. It is assumed that savings are in the form of credit and not stacked under the mattress. Therefore, it will eventually be directed into capital goods.
Fourth, If the Governement let the market regulate itself, consumers and producers will gradually gain confidence and start spending. But the important thing is that the market will adjust by removing the bad and inefficient, clear up its resources, and allow the other business that are more sound to utilize these extra resouces to drive their costs down and increase their profits. This will eventually lead to increased production and/or new competition created by the new capital from savings. The economy will recover into a much sounder and more efficient economy. Of course, the Government is not allowing this to happen, so expect a longer depression, while we keep bailing out the sick at the expense of the healthy.

Liberty4All November 11, 2008 at 2:25 pm

When all you have in the toolbox is a hammer, everything else is a nail.

Excellent layman critique of the circular flow diagram!

markb November 11, 2008 at 2:30 pm

Hi All,

While I’m generally predisposed to Austrian concepts, I’m new to the field, and trying to figure it all out. (I’m an engineer by trade.)

I have a question about Prof. Murphy’s example with the pickup trucks. When most the factors of production are under-utilized, like they are now, isn’t the response to stimulus fast enough to be considered, for all practical purposes, instantaneous?

What am I missing?

Thanks,
markb

Inquisitor November 11, 2008 at 2:41 pm

Markb, the problem is that those capital goods are precisely the ones not in demand at the moment, hence for the present it is best that they remain unitilized, until demand for goods that require them rises again. Merely artificially generating demand for them will cause further misallocations, which Murphy did specify.

Bill November 11, 2008 at 2:48 pm

Markb:
The author is hinting that production is much more complex than the Keynes folks believe. He agrees that at full use of labor, a plant can not make more of something instantly. But the author notes that even at less than full labor use the plant may not be able to produce more as labor and materials may not be available in addition to other factors like power, spare parts etc.

This is only worse for a knowledge business. It is extremely difficult to deliver more product when it may take years to train people to perform their jobs.

Tim Kern November 11, 2008 at 3:24 pm

Murphy: “But still, the point remains that people cut back on present consumption in order to be able to ‘spend money’ in the future.”

Some of us cut back because we’ve already spent our lifetimes’ worth of money, and we don’t want to go over the cliff before we die. Those of us who don’t have reserves and have not built them (for one reason or another) look at this a bit differently.

It’s a lot like another classic myth (the view of which, but not the fact, largely depends on the position of the observer): thinking that “jobs” are goods, that companies have an inventory of “jobs” just waiting to be “given” to someone, and politicians can force companies to distribute those “jobs” to generic workers.

Without the demand for labor, there are no “jobs.” Without the option to save (or spend), there is no “spending.” That option to save comes when all one’s needs are met; and we are under such burdensome, frivolous, yet ever-increasing taxation that we can never be sure of our discretionary income.

It’s not a matter of deciding whether to spend or save (invest). It’s a matter of spending on our own needs or spending on government’s priorities, a process that’s done by proxy and outside our own decision-making ability.

When the government’s confiscation exceeds our discretionary income, we cannot “spend,” we cannot “save.” All we can do is get into debt or go to jail. THAT’s why we’re in debt, and that’s why we’re not saving, either.

Eric November 11, 2008 at 4:09 pm

Let me mention a favorite twilight zone episode, the one with a harmless looking man locked in room with the little staff of truth.

In the end, the conclusion was, man can see the devil but cannot recognize him. That is the devil’s power over man.

Let’s see, In the last few decades we have some whoppers told AND believed by most Americans. For example, Bill Clinton, George Bush, Cheney, Alan Greenspan, and Colin Powell. These men and most of congress have lied to us. Even with all the painful truths exposed here at Mises.org, human nature wants to think kindly of our fellow beings.

Human nature would also have us want to believe that Powell was fooled into lying on a world stage, but all his body language said was that he knew he was lying. He might have felt some pangs of guilt and so later resigned. How many were taken in by Clinton on his definition of sex?

It’s the big lie all over again. So, why would Krugman be any different.

Either he is an imbecile, or he knows just what he is doing. Why people who know just how wrong he is assume Krugman actually believes what he sells is beyond me. If this guy had to make a real living, what do you suppose he’d be doing? Used car Salesman I’m sure.

No, I don’t think I’ve been too harsh nor off target either. I think he has a cushy job and he knows it. All he has to do is go along with the story – and his story is the one that everyone desperately wants to hear – so why should he care if it’s all wrong, especially how it’s made him quite wealthy. I bet he has some gold or other real property hidden away somewhere.

Jacob Steelman November 11, 2008 at 4:30 pm

Krugman and other establishment economists are merely self promoters (trying to appeal to potential clients) or promoters hired by clients with an agenda. Don’t expect consistency from such promoters. Just as lawyers can argue opposite sides depending on their clients so can economists such as Krugman.

Mary Diane Dolan November 11, 2008 at 4:38 pm

DD: You say that (real) savings are assumed to be in the form of credit and not stacked under the mattress. Could you explain further? I guess that what you mean is that if I ask you to deliver to me, say, some bushels of wheat, you may do it if, and only if, you think I have got the money to pay you and will pay you. (If, and only if, I seem credit-worthy. If, and only if, my savings=credit). Doesn’t ALL savings equal credit? Here is my reason for asking: Right now, I haven’t heard any figure, rigged or otherwise, for “US rate of inflation” for many months. I cannot even find such figure. I suspect the figure for “US rate of inflation”–overall inflation–would have to be approaching zero. Interest on bank-deposits is also approaching zero. As both figures approach zero, it seems to me there is less and less reason to keep savings in a bank. When your money gains in buying-power all the time, and when deposit interest is zero, why would anyone fool with a bank? Banks are approaching the point of having nothing to offer any customer. I think that risk of bank-default MIGHT be one reason to avoid banks, but that that is probably not the major reason right now, what with all the gov’t guarantees. It is not unimaginable to me that soon we may all have our money “stacked under the mattress”. I try to imagine what that might be like.

Matt November 11, 2008 at 4:53 pm

“No, I don’t think I’ve been too harsh nor off target either. I think he has a cushy job and he knows it. All he has to do is go along with the story – and his story is the one that everyone desperately wants to hear – so why should he care if it’s all wrong, especially how it’s made him quite wealthy. I bet he has some gold or other real property hidden away somewhere.” ERIC

Good point Eric… This reminds me of Cardinal Spellman of New York (died 1967). The man was the most pious of creatures you would ever want to meet. I’ll bet his personal bank account had no more than $1000. However he left behind a Gold coin collection worth in the millions.. so much for outward appearances.

Al Sledge November 11, 2008 at 5:13 pm

There is a simple reason why Austrian economics is considered “kooky” by Krugman and other government economists while Keynesian economics is elevated to the status of irrevocable science. This reason is that the Austrian model does not require any government involvement, while under the Keynesian model government control is mandatory. (Actually under the Austrian model government is the problem, not the solution.)

As a government employee, consultant, or otherwise on the payroll, which scenario is the most likely: A) Argue that the system is fatally flawed due to government involvement, or B) Claim that the existing system will work. If you choose A, your career advancement potential is not likely to be enhanced.

Only options with government at the controls are viable. Government must be “needed”, thus the socialist ideas of free market regulation, legal tender laws for pieces of paper with pictures of dead white presidents, and all the other nonsense foisted on a gullible public. While it’s all about Human Action, Krugman’s actions are quite predictable. It shouldn’t take a PhD to figure that one out.

It should seem obvious today that we have a failed economic system. The results will be earth staggering I have no doubt. Exciting times we live in.

The other factor is hair. Murphy is like me, parting his hair widely. Krugman on the other hand looks the part of the aristocrat. So who you gonna believe?

greg November 11, 2008 at 5:40 pm

DD,
It is all about leverage. When Bear Stearns was going down it was all about leverage and the need to liquidate assets when the asset values started to fall. The same applies to Lehman, AIG, Washington Mutual, Wachovia and soon Goldman Sachs. It was the overleverage that pushed asset values up and the supply of those assets. When the values started to fall, it was deleveraging that cause the values to collaspe. Add a couple credit rating downgrades and overnight you had the perfect storm.
Now, what is the solution? I am with you, let the market correct itself. There is going to be a bunch of loosers, but the big ones are going to be the ones that poured money into the US from countries where we have a negative balance of trade. Which market conditions will help solve that problem too. It happen in the late 70′s when the Japanese came over here and bought up real estate and then sold them later at huge losses.
I just don’t see the consumer getting us into this mess and I don’t see the consumer getting us out.

DD November 11, 2008 at 5:43 pm

Mary Diane Dolan,
Usually people don’t keep their extra savings in cash under the mattress, but for the few who do, their money can’t be used for investment. Money under the mattress cannot be converted into capital. When i say credit I meant capital that is loaned out to investors, which has to come from savings.
The reason that interest rates are so low right now is because our moentary policy is backwards! The whole problem was due to excess of credit, which created the bubble. The remedy should have been to stop the excess credit that created this mess, and allow the market to correct itself. Since there really isn’t much savings, the credit or savings available to lend out should be very scarce right now, therefore interest rates should have hit the sky. This is just a consequence of the law of supply and demand. The high interest rates would initially discourage further reckless lending, while at the same time encourage us to put our savings in the bank to earn some nice interest during these times of uncertainty. The fact that our Government is doing just the opposite, means that you are right that there is less and less reason to keep money in the bank.
All I can tell you is to fasten your seat belt, because it is going to be quite a ride. With our governement in the controls, there is no telling when and if this will be over.

Stanley Pinchak November 11, 2008 at 6:03 pm

DD,
even money under the mattress has beneficial effects for this type of saver under a sound monetary system. The most important benefit that they get is the psychic satisfaction that physical possession of money provides in an uncertain world. A secondary effect is that by holding money, they increase the demand for money relative to supply. This means that when they go to spend their money in the future, the purchasing power is greater than when they started saving. This secondary effect helps out all savers, investors, and consumers. Third, by having savings to fund future consumption, they keep interest rates lower than had they entered the loan market as a purchaser of funds. This benefits themselves in the future if they intend to use their savings as part of a down payment on a large purchase. It also helps current borrowers by suppressing the interest rates.

Under a funny money standard, saving money under the mattress mostly only provides the primary effect above as intervention in the loan market and a policy of monetary debasement eliminate the secondary effects that savers have.

lwaaks November 11, 2008 at 6:14 pm

Robert Murphy has a wonderful knack for explaining difficult concepts (or confused concepts!) in a way that enlightens and entertains. He is a great asset to the libertarian movement. I’ll bet he is a great teacher in the classroom, too.

lwaaks November 11, 2008 at 6:15 pm

Robert Murphy has a wonderful knack for explaining difficult concepts (or confused concepts!) in a way that enlightens and entertains. He is a great asset to the libertarian movement. I’ll bet he is a great teacher in the classroom, too.

James R November 11, 2008 at 7:55 pm

Furthermore, the problem with storing your money in your mattress is that government will sneak into your house in the middle of the night and steal some of it from you.

Government won’t physically sneak into your house, of course, but by running the printing press, government inflates the monetary supply, and thus reduces the purchasing power of the money you saved in your mattress. So, effectively, you were robbed (taxed) for saving, even though government never physically touched your money.

The only way to prevent government from stealing the money you physically save in your mattress is to first convert it to a form that the government can’t debase, which is why bullion coins are in such incredible demand right now.

J Price November 11, 2008 at 10:45 pm

Loved the article, just wish you had explained the value of saving to prove the “paradox of Thrift” wrong, i.e. the value of capital creation etc.

J.

Pete November 11, 2008 at 11:48 pm

Can anyone help me with a question I have regarding the article?

I’m thinking Krugman and Keynesian followers assume that if we decrease consumption and shift towards investments, or just plain hoard cash, there will be an overstock of consumption goods. Maybe they were planning to sell them, but the drastic change all of a sudden leaves excess amounts of goods in inventory.

If I’m thinking about this right they argue that we just need an increase to begin the purchase of the goods that were already made. In this article Murphy argues that you need capital goods to produce those consumer goods in the first place and that increasing the money supply alone won’t increase capital, but what if the Keynesian arguement was the goods are already in place (from prior assumption before the recession) and once the spending begins again people will feel more confident in investing more in capital goods (to continue the process).

This would get people confident about investing again and we would stop hoarding cash. Once we stop hoarding cash and investment begins again they will try to pull most of the newly created money out of the economy to stop inflation. I’m not trying to play devils advacate here, but I do see a logical arguement if overstock of consumption goods comes into play.

I understand Murphy’s logic, but I think things change a bit if that comes into play. Anyone have any insight on the situation?

Any help would be appreciated.

Inquisitor November 12, 2008 at 12:14 am

This point was more or less raised by markb. The thing is, if capital goods are unutilized it is for a reason: there is a lack of complementary factors for them, demand for their end product &c. Hence, increasing funding in their direction is a misallocation, and besides this, cannot generate the complementary factors necessary to put them to use at the same (e.g. labour.) It’s not as simple as it seems in Keynesian theory. So money perhaps will flow in other areas it would not normally flow, or will not achieve the desired effect at any rate. The question should be why there would be unutilized capital goods assuming entrepreneurs are profit-seekers…

Paul November 12, 2008 at 3:53 am

I only wish these articles citing Paul Krugman’s inanities stop showing his damn picture. My eyes really try skipping past his annoying mug.

Other than that, cool article. Thanks again, Bob.

Michael Smith November 12, 2008 at 7:15 am

Pete said:

This would get people confident about investing again and we would stop hoarding cash.

There is a distinction between saving and hoarding.

Hoarding is the act of taking your money and putting it under your mattress or in a lockbox, thus isolating it totally from the economic system. And yes, wide-scale hoarding would mean a depressive, across-the-board drop in demand that would be economically harmful. Fortunately, very little actual hoarding goes on.

Saving is a different matter. If consumers simply lower their purchases and allow cash balances to accumulate in their accounts, this is not the same thing as hoarding. It is not the same because banks don’t just sit on that money — they give it to other people in the form of loans, some of which goes for consumptive spending for things like purchasing automobiles or appliances, some of which goes into investments for things like new businesses or new equipment for existing businesses.

So saving is just another form of spending; it is the choice not to spend the money yourself, but to let others spend it. This means that savings does not necessarily result in a reduction in aggregate demand.

It may well mean a redirection of some amount of demand away from consumer goods and toward capital goods — which, over time, would have the effect of causing a shift in employment away from some producers and toward other producers.

In a free market, without a central bank and without a fiat money supply, an economic contraction that caused consumers to stop spending as much and increase their savings would simply increase the pool of available capital and lower interest rates. Thus, the effect of the contraction would be an increased availability of funds for investment and an increased incentive (lower interest rates) for investment. In a free market, the seeds of economic recovery and a resumption of growth are present in the effects of the contraction itself. The free market is a self-correcting mechanism.

But government cannot act as a substitute for this mechanism, because government has no ability to create purchasing power. All government spending is ultimately done at the expense of private sector spending, for there is no other place for government to get money to spend. It must either tax the people — which takes money away from them — or borrow the money — which likewise takes the money away from them — or print the money up from scratch — which simply reduces the purchasing power of all the citizen’s dollars proportionally.

Dennis November 12, 2008 at 8:18 am

Absent from the simplistic and misleading Keynesian circular flow model is any mention of relative prices and the fundamental importance of price flexibility, including downward flexibility, in response to changed economic conditions. Without price flexibility, the economy is truly and significantly impaired and will not effectively function.

However, the absence of price flexibility is consistent with the overall Keynesian program, since other aspects of this system of political economy attempt prop up prices and prohibit them from reflecting economic reality and adjusting to changed economic conditions. This is all to the detriment of the establishment of a smoothly functioning economy that does not contain episodes of boom and crisis. Any attempt to label this hampered system a free market economy is erroneous if not a deliberate lie. I do not believe that it is much of a stretch to state that the only price that Keynesians desire to see decline is the rate of interest.

Tom November 12, 2008 at 8:40 am

I think we need to remember the joy of not judging the source of others utility (ipod comment).

David Roemer November 12, 2008 at 8:44 am

There is another way to understand Keynesian irrationality. It stems from the equilibrium theory of price. Just as prices go up and down if there is lack of equilibrium, so too the economy goes up and down when the supply side of the GNP is not equal to the demand side of GNP.

Stanley Pinchak November 12, 2008 at 10:19 am

Michael Smith,
hoarding is not the bogeyman you paint it to be. Mises clearly shows that hoarding and investing have similar effects on the economy. Both free up consumer goods for the use in lengthening production processes. Both allow for greater consumer spending in the future. Both reduce the demand for money in the present raising the purchasing power of money and driving up real wages, encouraging the Ricardo Effect. The biggest difference is that hoarders don’t enjoy the benefit of earning interest on their money. Other than that its a wash. Be careful in discouraging hoarding, for that is what 100% reserve banking boils down to. You seem to fall for the false dichotomy of spending versus saving (hoarding). It is a decision between spending now and spending later. All people who engage in the division of labor must engage in trade eventually, regardless of how low their time preferences are.

Larry N. Martin November 12, 2008 at 10:25 am

I think it’s Krugman’s beard that really bothers me–the intellectual elitism of a man who is intellectually bankrupt.

Deefburger November 12, 2008 at 10:53 am

The time factor is the killer. Look at what “demand” really means. For a good or service to be “in demand” it has to exist in the first place. The existence of the thing “in demand” had to be foreseen and then invested in, and then produced, marketed, and shipped to stores, FIRST. THEN the consumers can buy it, generating demand, or not, saving for something else. Just placing more funds in the hands of consumers, does not create demand for anything.

Krugman is a child of his world. He sees the Central Banks and their policies as a given, rather than a cause or effect. In the Foundation series, the empire simply existed. The psychohistorians manipulated this huge social being through subtle manipulations of forces already in existence. The difference between him and them is that they understood the details, and were not directly supported by the very thing they controlled. Krugman does not have the luxury of knowledge of the details and is wholly dependent on the “given” existence of Central Banking.

The reason the main-stream economists fail is that their theories don’t take into account value. Value is an intangible concept. But it is the basis for price. Value is created in the mind of the consumer, and is predicted by the mind of the producer. Value is independent of price. So, by focusing only on price, one sees a recession. The Keynesians, thinking that because Price is a numerical value, that it is calculable and predictible, and worse, fundamental. It is not. Price is the numeric result of the conflict between the value judgement of the consumers, versus the value judgement of the producers and suppliers. Change the value of the base currency, and the price will change accordingly, but not the actual value, only the numeric value, the price!

Hinging an entire theory of economics on the spectre of “Price” and the act of spending is a great way to make a career studying the intangible! In Krugman’s world, there are people who value such thinking, because it furthers their own interests, namely the banks, government, and first-in-line contractors to the government. The circular model looks fine from a price perspective. Funny, isn’t there a bank in that model somewhere? Did the money used in the cycle flowing one way just materialize out of the “demand”?

The model fails because it fails to account for the true fundamentals, namely value-judgement in both the supply and the demand directions, and the slipperyness of price as the central bank manipulates the value of the currency that the prices are based on.

Bob V November 12, 2008 at 11:09 am

Mr. Murphy writes: “…the point remains that people cut back on present consumption in order to be able to “spend money” in the future.”

But what if people cut back on present consumption, not to spend in the future, but rather to spend in the past (i.e., pay down debt)?
In that case, there is neither saving nor consumption. Now what?

Stanley Pinchak November 12, 2008 at 11:28 am

Bob V,
does the money for debt repayment magically disappear? Does it not add to someone’s current stock of money making it available for immediate consumption, or future consumption? Furthermore, should that money disappear (in the case of fractional reserve banking monetary contraction), does this not have the effect of increasing the purchasing power of the remaining money in the economy? Is this not a similar effect that saving and investment have on the purchasing power of money? Doesn’t this send all of the signals of increasing real wages and encourage the Ricardo Effect?

jgo November 12, 2008 at 11:54 am

RPM leaves out a tiny but important point. Before you can produce a TV, you also need to know how to do so. You need to have people who know specifically how to transform valueless or less-valued stuff into the parts, and how to assemble the parts, and at least the owner of the manufacturing firm has to be aware that there is value in doing so.

If you’ve got people with the wrong knowledge, they won’t be able to produce TVs.

I believe it was Sowell who pointed out that people had the same stuff at hand 10s of thousands of years ago that we have today, but lacked the knowledge and the capital goods (built up using more knowledge).

RPM’s counter to the circular flow thinking sounds like a variant of Skousen’s _Structure of Production_. Maybe, if we keep trying, we can get through to the public and the politicians.

So, we go back to the causes of recession being a combination of a crisis of confidence and mal-investment, i.e. misuse of resources of all kinds — from creative workers put to rote tasks, to scientists and engineers cat-sitting or serving coffee, to shopping carts left to rust. (OTOH, the shopping cart is left to rust because it would be more costly to send people out to find and fetch every one of them back.)

jgo November 12, 2008 at 12:12 pm

DR, sometimes, the ones who ace the tests and come out saying “I don’t understand any of this” are the ones who understand more of it than anyone else; their standards of are just higher. They want to not just “get the gist” or grasp the concepts, but to know them in depth and breadth and be able to thoroughly apply them and teach them to others and use them as a spring-board for figuring out more before they can bring themselves to say “I kind of understand most of this”.

I’ve known successful operating system architects (sometimes referred to informally in the corporation as “gods”) who declared lack of understanding, and newbies who claimed expertise after reading one tutorial.

Inquisitor November 12, 2008 at 12:21 pm

Um, if someone is being paid for debt owed, one would think they’d have money flowing in their direction… wow, what a calamity/conundrum!

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