The Problem with Keynes

Previous:The Problem of Say's Law

Keynes begins his General Theory with a refutation of Say’s Law precisely on the grounds that had bothered Mill. Keynes treats Say’s Law, not as a tendency toward equilibrium, but as claiming an identity between the total supply and total demand for goods. Keynes put it this way: “Say’s Law, that the aggregate demand price of output as a whole is equal to the aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment.” Keynes pointed to the Great Depression, with its deflationary excess of supply over demand, and rested his case.

It is hazardous to simplify the argument over the General Theory. This is partly because Keynes, as somebody put it, had a habit of following a long and murky argument with a clear and triumphant conclusion. But basically, Keynes argued that the price mechanism cannot be trusted to bring about equilibrium at full employment, except perhaps in the very long run. And in the long run, went the famous phrase of that childless theorist, we are all dead. The use of money spent, to Keynes, that supply and demand did not have to tally. If people hoarded part of their income as cash (or, in Keynes’s view, short-term securities), instead of spending the money on goods or lending it to entrepreneurs to invest, total demand would fall short of total supply. The argument is a lot more complicated, but that’s the basic idea.

Mill had said: “Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells; and he does not therefore necessarily add to the immediate demand for one commodity when he adds to the supply of another.” Keynes puts it this way: “An individual decision to save does not, in actual fact, involve the placing of any specific forward order for consumption, but merely the cancellation of a present order.”

We note here that Keynes, like the Mercantilists, often confused demand with consumption. (As somebody put the distinction: If I have an apple, I can offer it for an orange – that’s demand; if I eat the apple, I’ve lost the ability to demand anything with it – that’s consumption.)

In any event, this is why Keynes asserted that the economy would settle into “unemployment equilibrium” before reaching full employment. Keynes proposed, like the Mercantilists, that the government fill this supposed gap in demand through deficit spending.

Rueff was among the first, though not the only critic of Keynes, to point out that this supposedly “general” theory rested on some very restricted assumptions. Above all, Keynes’s “unemployment equilibrium” depended, not upon some inherent characteristic of a market economy, but on a hidden assumption that prices and wages are immobile.

When people want to hold more money than they possess, they must sell more (or buy less of) other kinds of wealth to acquire it. If the money supply is fixed, as Keynes assumed, the prices of other wealth – goods and financial claims – will fall. This continues until the increased demand for money is released by a fall in the amount of money necessary to exchange any given volume of wealth. Rueff and others pointed out that if prices are free to adjust, total supply and total demand can be matched, with full employment, but at a lower price level.

Thus, Rueff noted, “the theory of employment which Keynes calls ‘general’ is valid only for very special cases, for economies which are entirely insensitive to movements of prices and interest rates.” (“The Fallacies of Lord Keynes’ General Theory,”The Quarterly Journal of Economics, May 1947, 343-367.)

Rueff also points out that Keynes is wrong in thinking that the money supply is fixed, or that to demand money is to demand nothing. But I would like to leave this to the discussion of Rueff’s monetary ideas.

A young fellow named James Tobin undertook to answer Rueff’s critique of Keynes in 1947 and tried to defend Keynes’s notion of “unemployment equilibrium.” But others, such Don Patinkin, quickly recognized that “this is an indefensible position.” Patinkin observed that price “flexibility means that the money wage falls with excess supply, and rises with excess demand; and equilibrium means that the system can continue through time without change. Hence, by definition, a system with price flexibility cannot be in equilibrium if there is any unemployment.” (“Price Flexibility and Full Employment,” American Economic Review, Sept. 1948, pp. 543-63).

Since the later 1940s, Keynes’s followers have been reduced to finding alternate theories to support his policy proposals, most of which emphasize the “stickiness” of wages and prices. But Rueff had demonstrated in 1947 that Keynes was wrong on the key point of his General Theory several decades before Keynes’s followers had their heyday in the United States.

Next Installment: Rueff's Macroeconomics: Minding Your P's and Q's


Kathleen M. Packard, Publisher
Ralph J. Benko, Editor

In Memoriam
Professor Jacques Rueff

Now Available on Amazon and from The Lehrman Institute

Gold Standard 3-Pack

Three Gold Standard Titles for One Low Price. Only from The Lehrman Institute Store.

Buy from
The Lehrman Institute