The Nonsense of Austerity


John Maynard Keynes, pictured above in 1942, overturned the ideas of neoclassical economics, advocating that fiscal and economic policy should be used to curb the adverse effects of economic recessions. Photo by Tim Gidal/Picture Post/Getty Images.

A note from Paul Solman: James Livingston first made a splash on PBS NewsHour when he provocatively argued that spending, or consumption, was both an economic and moral good. He believes that we should redirect our national obsession with saving and investing towards more consumption.

In an earlier Making Sense post, the libertarian-leaning John Papola took on Keynesian economists, like Livingston, who — as Papola would put it — have fallen for a consumptionist model of economic growth. Papola argued that Americans have to stop thinking of themselves as consumers only and start thinking as producers as well. Here is Livingston’s response.

James Livingston: Arguing with John Papola reminds me of arguing with old-line, hard-boiled Marxists, a habit I gave up in 1994. I would cite historical evidence that made the labor theory of value moot — it was useful in its time, I would say, but no longer. They would cite Marx, as if the invocation of his name settled the issue. It didn’t matter that Marx himself said that this very theory would have to stop making sense at a certain point in the development of capitalism.

It’s deja vu all over again in the case at hand. I cite historical evidence, and Mr. Papola invokes Jean-Baptiste Say or John Stuart Mill. I say let’s see how the Great Depression and the Great Recession compare as historical events, and Mr. Papola exclaims, on theoretical grounds, that saving and investment must drive growth, regardless of massive evidence to the contrary. How do you argue with that kind of faith?

I responded a month ago to the first iteration of Mr. Papola’s “libertarian” ideas about how economic growth happens. Since then he has revised several times, smoothing out the more jagged edges of the argument by covering his tracks. I am now responding to the fourth or fifth iteration. But nothing has changed in his argument except the subtraction of empirical detail.

Nothing can change, because Mr. Papola believes so fervently in Say’s “classical law of markets” that no amount of empirical evidence will convince him that, like the labor theory of value, it needs reconsideration in light of new historical circumstances: he cites it three times as a self-evident proposition in eight pages of urgent prose. It is a proposition similar to that found in George Gilder’s “Wealth and Poverty,” a treatise for supply-side, tax-cutting, trickle-down “Reaganomics.”

Say’s Law becomes an incantation, not a hypothesis to be tested by the available evidence, not something that might have stopped making sense. It becomes a purely ceremonial pronouncement, a categorical imperative with no actual purchase on the world as it exists — that is, as it can be measured and observed.

Say’s Law is No Law at All

Not counting supply-side economics — its current incarnation — Say’s Law has led two long lives since the early 19th century. It was supposed to explain the distribution of income between savings and consumption by reference to interest rates.

If there was temporary overproduction, profits would drop, the need for new capital would drop too, and thus the demand for money would fall, meaning lower interest rates. As interest rates fell, savings would decline, so why save money when you get paid nothing for it? And then, willy-nilly, consumer expenditures would increase. If interest rose, the opposite would happen.

According to Say’s Law, everything would automatically adjust.

By the late-19th century, however, the “Law” already lacked explanatory adequacy, and every kind of economist, from French free-market enthusiast Paul Leroy-Beaulieu to American banking expert Charles Conant said so: savings kept piling up, despite the fact that interest rates fell and profit rates declined. Why? Because the residual (and quite rational) urge to save for a rainy day had not yet been undermined by material abundance and government safety nets. It’s the same explanation given for the high savings rate in China today.

The result, back in the 19th century, was agreed to from left to right: too much savings or “surplus capital.” The surplus savings was then channeled, by banks and financial markets, into unproductive investments — speculations and bubbles which ended in economic crises like the long slump of 1873-1896 — or channeled to fuel neo-colonialism, the scramble to partition Africa and China into exclusive European “spheres of influence” where profits would be great; commodities, abundant; markets, captive.

The key word in the new lexicon of political economy became “overproduction”: production of goods beyond effective (remunerative) demand — beyond, that is, the ability of the population to absorb them. This is a phenomenon rendered invisible and impossible by Say’s “essential law of markets,” however: supply supposedly creates its own demand.

Say’s Law was also supposed to explain how and why equilibrium was the natural state of the market: the production of goods always generated enough income in the form of profits and wages to pay for all the goods produced — to clear the market at remunerative prices. It’s an intuitively persuasive explanation until you realize that savings themselves can be a deduction from aggregate demand — in other words, that income generated by the production of goods can be withheld from circulation when one or both of two conditions are met.

First, if a banking system exists. It collects deposits — the savings portion of wages or profits — and then lends out the money to businesses to make investments. But suppose demand for such loans from business is less than the supply of savings held by the banks. In that case, income is idled. It is not immediately circulated as per Say’s Law.

Second, what if profits become superfluous for further economic growth? That might happen because simply maintaining and replacing a company’s existing capital stock is enough to increase the productivity of labor and the output of goods. In that case, too, income — in the form of profits — is idled and not immediately circulated as per Say’s Law.

Equilibrium becomes impossible because consumer expenditures are stifled, and surplus capital — redundant profit — is free to roam speculative markets, looking for the best return in the most dangerous places.

Both of these hypothetical conditions are, of course, historical realities. The banking system has been able to pool savings from individuals and companies for well over a hundred years. But those savings do not necessarily wind up creating new wealth, as John Maynard Keynes painstakingly demonstrated when wearing his empirical hat in Volume 2 of “The Treatise on Money” [1930], and Chapter 16 of “The General Theory”[1936].

Meanwhile, the same 100 years, after accounting for the maintenance and/or replacement of buildings, machines and the like, private corporate investment kept declining. What that means is: “profits” (net of depreciation) became ever more superfluous. But Mr. Papola denies this very possibility, no matter how extensive my evidence.

In my book “Against Thrift,” I demonstrated that substantial growth has occurred as a function of declining rates of net investment since 1919; that the fastest growth rates of the 20th century were recorded during the recovery of 1933-1937, when the banks stopped loaning, net investment disappeared, and in fact the existing capital stock wasn’t even being replaced or maintained, but run down — depleted. Capital/output ratios have been declining for almost a hundred years. The atrophy of both personal saving and net investment in the late 20th century coincided with the growth of output and productivity under both Reagan and Clinton.

I could continue with more reasons. No matter. Say’s Law rules, according to Mr. Papola, damn the evidence. Again, how do you argue with that kind of faith?

Articles of Faith

Mr. Papola’s faith takes two imperative forms. On the one hand, in dismissing the Commerce Department’s method of measuring gross domestic product (GDP), he declares: “In order to invest more today, we have to save more and consume less.” On the other hand, in the imploring tone of the concluding paragraph, he says: “We must give before we can receive. We must produce before we can consume.”

Notice the formal symmetry of these commands, but notice, too, their different scope — one is presented as a macroeconomic truism, the other as a personal homily.

The question that never occurs to Mr. Papola is: what if we don’t have to invest more today in order to produce more tomorrow? He thinks it can’t occur, because the actual history of growth is not his concern. But in view of the fact that since 1919, increased output has not required increased inputs of either capital or labor, that is precisely the question we have to answer.

Ask it this way: what if more saving and less consumption are the ingredients of economic disaster — not because we want to loosen moral constraints and spend our way to ruin, but because the historical evidence tells us that more saving and less consumption have led directly to the worst economic crises of the last hundred years?

The personal homily has an ancient, almost biblical ring to it, perhaps because it summarizes the moral history of the human species under the economic regime of scarcity.

Mr. Papola clearly believes that your consumption of goods is justified only by your prior production of goods. In keeping with the old socialist nostrums that sustained belief in the labor theory of value long after it stopped making sense, he insists that if you haven’t produced anything of value, your income is a deduction from the sum of value produced by others, and is therefore illegitimate.

Effort and reward — work performed and income received — are transparently aligned in this austere moral sequence, but, alas, it has nothing to do with the world as it exists.

For no one can demonstrate an intelligible or morally justifiable relation between work performed and income received — not since outputs started increasing without any measurable increase of inputs, around 1910.

Down on Wall Street they make millions for pushing bad paper, and over on Main Street, they make the minimum wage for doing an honest day’s work. Twenty-five percent of the gainfully employed don’t make enough to push them over the poverty line, and half of them are eligible for food stamps. Twenty percent of all household income in the U.S. is a transfer payment from government. Since when is our problem the lack of goods produced, rather than the lack of income to purchase the goods?

As to the Rest of Mr. Papola’s Libertarian Argument

Mr. Papola’s forays into the real world come when he insists that the business cycles we know as the Great Depression and the Great Recession were determined by “failed investment,” when he contests the scale of consumer spending in GDP. He notes the percentage of retail workers in the composition of the total labor force, and when he complains that his efforts as an entrepreneur trying to manufacture an affordable diaper — a recyclable consumer good — went unpaid.

On the correlation of investment and the business cycle, Mr. Papola should revisit his sacred texts by the likes of Hayek and Friedman, because he’s putting himself at odds with them, particularly the monetarists.

And then, just for fun, he might want to consult the actual history in question. Investment failed, to be sure, but long before and after the Great Depression and the Great Recession. In both cases, the atrophy of net investment — a steady, long-term trend — and the transfer of income from wages to profits — a political event that began with supply side policy — combined to create a tidal wave of surplus capital that swamped all markets.

On the GDP calculations, he should consult with the liberal and left-wing economists, like Joseph Stiglitz, who have been challenging its classifications of expenditure and growth for many years now; his figures on retail employment are interesting but totally irrelevant to the argument I have made about consumer spending and growth.

On his own record as a small business owner who had to fold the enterprise before it was two years old, I am practically speechless. He didn’t borrow from the banking system, he got the start-up money from his brother-in-law. He worked for a year without salaried compensation, I think, designing and testing the product, building a website, but also hiring people to make the product.

Yet he can say that “Almost none of that activity was included in GDP for that year, except through the ‘consumer spending’ of people we paid.” His “sweat equity” was never counted, OK, unless he paid himself a salary, but all of the other activities of the company showed up in GDP as ‘consumer spending.’

I’m sorry Mr. Papola’s entrepreneurial dreams were dashed by the competition, which precluded a price hike on his diapers. But that’s how the real world of the market works. It always presupposes non-market regulatory mechanisms, like trade unions, social movements, families and governments. Without these outer limits — determined by civil society — markets typically destroy themselves. Do we really want a market for meat without the FDA? Has Mr. Papola never read Upton Sinclair’s “The Jungle”?

It’s Not a Barter Economy Any More

Commodities are not ultimately bought with other commodities, regardless of what John Stuart Mill said. They’re bought with money, the universal commodity, unless you’re off the books, maybe.

It’s not a barter economy anymore. Once you acknowledge that simple fact, Say’s Law becomes problematic, because the temporal difference between the collection and expenditure of earned income has been enlarged to the point where the immediate equivalence of supply and demand can’t be assumed.

In other words, once money becomes commonplace and banks exist to collect savings, there is no essential law of markets. Economic equilibrium becomes an accident, not a natural state — it becomes a social construct that requires planning. Not central planning, mind you. Just some kind of public, purposeful, collective action that acknowledges the social purpose of economic growth.

At that point, I would suggest that you try to figure out what drives growth. But you don’t base your decision on a theory from the 19th century, whether devised by Jean-Baptiste Say or Karl Marx. Instead, you might study more recent history. If it turns out that consumer spending rather than investment seems to be the key to growth, you should act accordingly. You should probably not resort to citing Say’s Law.

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This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions