As an Austrian economist, I’ve known for years that Keynesian economics rests on crude fallacies—indeed, Tom Woods and I have an entire podcast dedicated to the (usually wrong) columns of Paul Krugman. But in the arguments over the coronavirus, we see that the Keynesian commentary isn’t just wrong, but dangerous.
Specifically, Neil Irwin, the senior economics correspondent for the New York Times, recently tweeted a link to what he described as, “The most important thread you will read today, or ever, to understand macroeconomics.” Naturally, I was anxious to experience this life-changing event. But the link was to a series of tweets from a former New York Fed researcher who was arguing that it was literally impossible for state governments to have saved more in preparation for the current crisis. This “insight” was attributed to Keynes’s paradox of thrift, and the analyst further argued that only federal budget deficits—fueled by Federal Reserve monetary inflation—would make it even possible for state governments or private households to collectively save more.
This is obviously dangerous nonsense; of course individuals and lower governments can save, regardless of what Uncle Sam does. But since this fallacy is something that Nobel laureate Krugman kept repeating during the last recession, it’s worth taking another post to spell out exactly why it’s wrong.
The Keynesian Fallacy from a True Believer
Let me first allow Skanda Amarnath to make his case, in his own tweeted words. I’ll just reproduce his opening salvos here; interested readers can click the link for his full case.
In the above line of arguments, the most important—and dangerous—is Amarnath’s claim that “We can’t all save more. This is ALWAYS true. We couldn’t have prepared for this shock by ‘all of us saving more’.”
As I’ll show in the rest of this post, he is simply wrong—both in the big picture and even in a narrow technical sense. There is nothing in the principles of accounting or economics that would prevent everyone from saving more. To insist otherwise—and to claim that only if the feds run deficits can everybody else save—is dangerous nonsense.
Reality Check: Of Course State Governments Could Have Prepared for This Crisis
First things first. Before we dive into the bookkeeping, let’s state the obvious fact: of course state governments—and private companies and households, for that matter—could have been better prepared for the current crisis, if they had saved more over the years. (Note that I am a philosophical anarchist, so I don’t endorse coercive governments at any level. I’m just making an economic point here.)
For example, suppose that state governments had the same tax policies in place (so they collected the same revenue), but every year for the past decade they had spent less on consumption items—including things such as parades, personnel for state parks and beaches, and hefty sums on famous speakers for state university graduation ceremonies. Instead, the state governments used that money to begin buying and storing canned goods, bottles of hand sanitizer, and rolls of toilet paper, so that they eventually had enormous stockpiles of these items in warehouses across their jurisdictions.
Does anyone want to deny that the state governments would have been in a better position to help their constituents in mid-March if they had pursued this alternative strategy? Also notice that there’s nothing in accounting or economics that would have stopped them from doing so: their expenditures in the real world provided income to various people (such as state employees providing consumption services to citizens and university students), while in my alternate timeline their expenditures would have provided income to the merchants selling canned goods, hand sanitizer, and toilet paper. So “total income” would have been the same; it’s just that different people would have received it.
The Specific Mistake
It is in the following tweet that Amarnath makes a critical mistake:
It’s true that total income = total expenditure. But then Amarnath seems to think that if you save more it means that you must be reducing your total expenditures. Yet that is simply wrong.
For example, suppose you have an income of $100,000 and that initially you don’t save any of it. You spend (say) $40,000 a year on apartment rent payments to your landlord, you spend $25,000 a year on lease payments for your fancy car, you spend $20,000 on going out to fancy restaurants and bars, and you spend the remaining $15,000 on other living expenses and travel. An economist looking at your budget would conclude that you spend your entire income on consumption.
Then you decide to become more frugal. You cut your consumption spending down to $90,000 by cutting your food budget in half. Specifically, instead of going out to restaurants and bars, you save $10,000 by eating at home for a year.
Now here’s the important thing: with the extra $10,000 in your budget, you hire some contractors to install a separate entrance to the spare bedroom in your apartment so that you can take on another tenant to split the rent with you. (The landlord was happy with your proposal to do this.) This one-shot investment will effectively reduce your rent by (say) $5,000 a year, because that’s how much you charge the new tenant to use the spare bedroom.
How should we classify this new scenario? Clearly, you saved 10 percent of your income this time—you only spent $90,000 on consumption, and you spent $10,000 on an investment that will yield you a flow of future income.
It’s also true that the income of the rest of the community is unchanged. This is because your total expenditures are still $100,000. It’s just that you redirected some of those expenditures, away from restaurants and bars and toward the building contractors.
As this simple example shows, it’s possible for you to save more without “spending less,” because of course investment spending is still spending.
It’s Even Possible for Everyone to Acquire Financial Assets at the Same Time
In the previous section, I gave a simple counterexample to show why the truism “total income = total expenditures” does not imply that “we can’t all save more,” contrary to Amarnath, Krugman, and Neil Irwin of the New York Times.
But let’s take this further. I imagine these gentlemen or their defenders would tell me, Sure, if your saving consists of expenditures on hiring people to build you a physical asset, then maybe you get around the constraint. But c’mon, Nikki Haley and other right-wingers have in mind state governments and households saving by accumulating financial assets rather than hiring people, and that’s where the accounting rub kicks in.
Yet even this isn’t correct. Before showing why, let me illustrate where the fallacy comes from. Then, after we see what could have misled so many smart people, I’ll point out the flaw.
Imagine a community that originally starts out with no debt. Then Alice decides that she wants to cut her consumption spending by $10,000 this year in order to lend it out to Bob. This way, Alice ends the year with $10,000 less in consumption but an IOU from Bob with a face value of $10,000.
Now, if Bob simply increases his own consumption during the year by $10,000, then the total income of the community is unchanged: the people on whom Alice used to spend that money might see their incomes drop, but the people on whom Bob spends the money see their incomes go up by an offsetting amount.
However, notice that in this scenario Alice has only gained a net financial asset of $10,000 at the expense of Bob—he is now indebted to the tune of $10,000.
It seems that this kind of reasoning lies behind the (clearly wrong) claims that Amarnath made in his tweet thread, or that Krugman made back in 2011, for that matter.
A Business Can Issue Debt or Equity to Raise Funds
Yet even though it’s true that a debt claim held as an asset by one person in the community must necessarily be a liability to someone else, it doesn’t follow that it is impossible for everyone in the community to save and accumulate financial assets more generally. It just means that people in the community can’t on net accumulate debt claims against each other. This doesn’t prevent them from acquiring equity stakes in profitable enterprises.
For example, when Alice wants to acquire a $10,000 financial asset, suppose that instead of lending it to Bob in the form of an IOU, she buys $10,000 worth of newly issued stock in Bob’s corporation. Then, instead of Bob spending the $10,000 in incoming cash on restaurant meals and booze, he hires workers to install new equipment in his corporation’s factory so that it is more profitable in future years.
In this scenario, the community’s income is still the same as before; some of Alice’s consumption spending has ultimately been transferred to the workers whom Bob hired to revamp his factory.
Yet notice that Alice’s acquisition of $10,000 in financial assets—specifically the shares of stock in Bob’s corporation—do not correspond to a reduction in Bob’s financial wealth. In a world of perfect foresight (which we assume just to keep things simple and focus on the accounting), the enhanced profitability of Bob’s corporation would render the market value of Alice’s shares of stock exactly equal to $10,000, which is what she paid for them. The remaining stock shares held by Bob would have the same market value as before he issued the extra shares and made the new capital expenditure for the firm.
And there you have it: I just walked through a simple example showing how it is possible to reconcile accounting tautologies with the members of a community saving and accumulating financial assets, even on net. There is no need for an outside entity such as the federal government to run massive budget deficits. (See this article for my refutation of a similar claim made by the MMT (modern monetary theory) crowd.)
As the federal government embarks on racking up an estimated $3.7 trillion in extra debt this fiscal year alone, it’s critical for the public to understand just how destructive such action will be. It isn’t just wrong, but dangerous when Keynesian analysts come along and assure everyone that private saving is literally impossible without such federal profligacy.