Keynesian paradoxes

Keynes gave little thought to generalities. He acknowledged that his prescriptions were limited to the special circumstances of the 1930s. With Bolshevism in mind, any fiscal deficit spending was justified to put men into work; but, for normal circumstances, Keynes offered only ad hoc musings: if ever real returns were exhausted, a ‘socialisation of investment’ might be necessary; and an unresolved task for ‘our statesmanship’ would be to prevent ‘money wages forever soaring upwards’.

After Keynes’s early death in 1946, Keynesians transformed Keynes’s ‘politicking’ into a universal manual for demand management. Thereafter students of macroeconomics were drilled with the paradox of thrift: increased saving drives the economy into recession, when - with lowered incomes - individuals save less.

Keynesians insist that the prescription still holds. Following upon the sub-prime housing investment crash (as with the busting of any asset bubble) individuals must save to rebuild assets for their future; but, for Keynesians, this drives an economy ever deeper into recession. So there must be fiscal interventions, chasing the needs of every periodic recession.

Keynes’s paradox of thrift sits among twin claims: that inflation is impossible where spare capacity exists; and that - ‘unimpeded by international preoccupations’ - a monetary authority is free to reduce domestic interest rates to any level it sees fit. With the 1970s wiped from memory, and the current non sustainability of eurozone debt levels ignored, Keynesians are fixated upon interventions by the state. Using his high media profile, Paul Krugman presents a new ‘twist’.

Krugman’s ‘paradox of toil’ is that, by giving a greater incentive to work, tax reductions cause output to fall. He argues as follows: as (labour) costs fall, competition ensures that prices drop. The fall in prices incites negative ‘inflation expectations’; that is, prices are expected to continue falling. The ‘paradox of toil’ quickly falls into place: 

1. the real rate of interest equals the nominal rate minus the inflation rate;
2. the nominal rate is at its lower bound (‘zero’);
3. so the real rate (‘zero’ minus the negative inflation rate) rises, which
4. raises the real burden of debts, which causes
5. consumers to cut spending, so that
6. output and employment shrink.

Reductions in taxation are, therefore, very bad for economic recovery.

By their shared logic, the paradox of thrift and the paradox of toil: (i) discount the force of market prices in bringing coherence to economic readjustments; (ii) view state controls as means to achieve balanced growth, income uniformity and the elimination of poverty; (iii) fail to understand that using interest rates to effect short-term demand management distorts long-term (inter-temporal) price adjustments.

Keynes’s General Theory was an endeavour to show that, in a deep recession, the laws of economics are held in abeyance. Fiscal deficit spending is then required to restore economic growth. Samuel Brittan has argued the same case: the ‘credit crunch’ recession placed the economy within ‘a kind of parallel universe ... when the normal rules are turned upside down’. Or, as Krugman writes, ‘we’re really through the looking glass, in a world in which lots of things have perverse effects - and basing your policy ideas on intuition from “normal” times can lead you very much astray’.

With the recent LSE Keynes/Hayek debate fresh in many minds, a summary conclusion draws from the original protagonists:

Keynes: ‘Many people are trying to solve unemployment with a theory that is based on the assumption that there is no unemployment ... these ideas, perfectly valid in their proper setting, are inapplicable to present circumstances’ (New Statesman, 1933);

Hayek: ‘An analysis on the assumption of full employment, even if the assumption is only partially valid, at least helps us to understand the functioning of the price mechanism, the significance of the relations between different prices and of the factors which lead to changes in these relations. But the assumption that all goods and factors are available in excess makes the whole price system redundant, undermined and unintelligible.’ (A Tiger by the Tail, 1972)

The nub: does economics operate by two sets of principles or just one?