Consumption and Keynesianism

Gene Callahan and Daniel Kuehn share their thoughts on the relationship between consumption and the Keynesian business cycle, with the essential take-away being that Keynesians emphasize the role of investment as much as any other school. I’m in broad agreement with both of them, and I echo Daniel’s concerns that an attack on Keynesianism which focuses on the “paradox of thrift” is bound to be misleading (Keynes wasn’t anti-savings). Yet, I don’t completely agree with them; consumption does play a bigger role in Keynesian theory that it does in some alternative theories, including Classical and Austrian business cycle theory.

Actually, Daniel mentions my point of contention, but I’m not sure he goes far enough when he writes,

The other thing is the multiplier — higher propensity to consume makes stimulus more effective. That’s of course a result of the slope of the consumption schedule, not because consumption is the primary issue.

I often harp on the differences between the Keynes–Kahn multiplier and the alternatives, such as Hayek’s Ricardo Effect and the more typical Classical relationship between investment and consumption. Keynes adopted the theory that the causality between consumption and investment suggests that higher levels of investment require higher levels of consumption, which is true in real terms (all final product must be consumed to make it worthwhile to produce) but not so much in nominal terms, at least according to those who disagree. The marginal propensity to consume (MPC) is largely a nominal figure (income minus savings), and not all macroeconomists agree that as the MPC falls the scope for investment also falls. (Edit: As I interpret it, the MPC determines the level of investment, because it determines the marginal efficiency of capital [MEC]. Others might also stress the role of input costs in determining the MEC.)

What does this have to do with Gene’s and Daniel’s points? While there are various explanations between Keynesians on the source of the business cycle — and I don’t think very many continue to adhere to a pure interpretation of The General Theory (even post Keynesians have seemed to adopt Minsky’s theory) —, at the most basic level most share the common characteristic that there is a disconnect between savings and investment. That is, idle savings leads to a reduction in the price level, causing the business cycle. There are two ways of restoring the price level: increase investment or increase consumption.

I agree that any characterization of Keynesians as economists who downplay the role of investment is wrong. Keynes stressed the importance of the “socialization of investment” under conditions where the market isn’t likely to intermediate savings to investors (e.g. when the MPC is relatively low); Keynes also advocated a reduction of interest to its lower bound, which clearly targets investment. Modern Keynesians stress the importance of public investment in infrastructure, oftentimes arguing that this, in turn, will increase private investment. Yet, none of this means that they interpret the roles of investment and consumption in exactly the same way as others.

Keynesians do emphasize the importance of consumption, and a major point they like to make during recessions is that consumption needs to rebound. An Austrian takes a very opposed position, where they favor savings over consumption for the sake of supporting the investment projects made during the boom (and a certain level of productivity). But, for the Keynesian it makes sense to support consumption-boosting programs, because a certain level of investment is directly related to a certain level of consumption. As such, even when it’s agreed that investment is low (which it is), a major cause of depressed investment, to the Keynesian, is depressed consumption.

Even though investment is still relevant in the Keynesian business cycle, I don’t think it’s totally unfair to call it a “consumption-based” theory. Consumption is a key determinant of private investment, and therefore is just as important in deciding the slope of the recovery. In this sense, I see Keynesian theory as unique (although, I’m a little wary of writing that since the “paradox of thrift” isn’t uniquely Keynesian).

There’s also room for considering “crude” Keynesianism, and, of course, “crude” economics, in general. As this post implies, approaching Keynesiansim as a consumption-only theory is wrong. But, Keynesians oftentimes don’t do much to dispel the error. Several Keynesian economists argue that “spending on anything” is good during periods of idle resources, which, in a sense, does away with the concept of opportunity cost (the only opportunity cost considered is that of leaving a resource idle, and it’s assumed that he value of that is zero and anything over zero is good — a strong assumption on idle resources to make). There’s also a lot of weight on the importance of maintaining “aggregate demand,” which I interpret as advocating the maintenance of a certain price level. This isn’t uniquely Keynesian, but whereas other schools might focus on ways of accomplishing this without disrupting the private allocation of resources, Keynesians come off as arguing that private allocation is second and aggregate demand is first — a corollary of this is that consumption over investment is fine, as long as aggregate demand is stable. It shouldn’t be surprising that a large swath of economists attack this in particular.

Mostly, I strongly agree with Daniel and Gene (or Callahan; I’m not sure on blogosphere first-name basis etiquette — I apologize in advance), but I have some reservations. There are a lot of aspects of Keynesianism that make it more focused on consumptions that alternative theories are. As such, it makes sense that many opponents of Keynesianism attack that feature of it.

21 thoughts on “Consumption and Keynesianism

  1. Bob Murphy

    Yep… Another good example: On the Sunday talk show George Will said investment was sluggish in the 1930s because of regime uncertainty (not his term) just like now under Obama, and Krugman scoffed saying businesses weren’t investing because demand for their products was so weak. That is quintessentially a Keynesian point; an Austrian or Chicago School guy wouldn’t talk like that.

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  3. Roman P.

    “There’s also a lot of weight on the importance of maintaining “aggregate demand,” which I interpret as advocating the maintenance of a certain price level.”
    Now that’s a strange interpretation. If anything, it’s better to interpret maintaining aggregate demand as maintaining the physical level of using goods/resources.

    1. JCatalan

      Total spending can decrease, but the same quantity of real resources can still be used. Price level maintenance is a result of wanting to avoid “price stickiness.”

      1. Roman P.

        By total spending decreasing do you mean price deflation without the fall in the physical consumption (in the broad sense) and the physical production?
        Whatever, use any definition you want, you’re just not on the same wave as most Keynesians who interpret ‘maintaining aggregate demand’ as maintaining AD=C+I+G+Xn in the real (vs nominal) sense.

        1. JCatalan

          I’m sorry, but I think it’s you who’s mistaken. All schools of thought, broadly speaking, want to maintain “aggregate demand” in the real sense. The difference is that some don’t think that prices adjust to changes in the quantity of money in circulation; those who don’t advocate price level maintenance, which is essentially what maintaining aggregate demand is in Keynesian theory. (Like I wrote in the post, Keynes’ definitions of consumption and investment were nominal.)

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  5. M.H.

    A question I was asking myself, if I may…

    If the US is borrowing from the rest of the world in order to finance public spending, when the other countries were actually experiencing a recession, it follows that borrowing is not an option. But the keynesian multiplier is supposed to hold for each country. Something is wrong here. Besides, the two other options are : monetary expansion or tax. The second is harmful, and keynesians don’t seem to agree on the effectiveness of such a policy. But if we finance the public spending through monetary expansion, this will distort the production structure, and the jobs located at the stages of production furthest from consumption will disappear, which leads to a flattening of the production structure. Overall, the economy will be poorer. And not to mention the rising prices.

    1. JCatalan

      Well, it’ll distort the structure of production depending on what’s being purchased. If the government is buying third stage capital goods to finance a second stage project, then it might sustain a lengthened structure of production. But, to an Austrian all government spending is distortionary, because it reallocates resources to where they wouldn’t have otherwise gone.

    2. M.H.

      If the production structure is lengthening, this would mean that the economy is becoming more capital intensive, right ? How could it be ? If the government wants to put people to work, it is likely that it will finance labour-intensive activities rather than the capital-intensive ones. Also, purchasing capital goods could not lead to an increase in private investment when industries expect that public funds are temporary. Government can purchase idle resources, putting them in use, but probably not stimulating investments in the wrong direction (although it can sustain an obsolete structure). So, the stages closest to consumption will probably expand relatively to the stages furthest from consumption.

      I have to develop this line of reasoning, but at first glance, it seems to me that the only possible way is a flattening of the production structure.

      Regarding the first sentence of my previous post, I was saying that, insofar as public borrowing crowds out private investment (I have previously pointed to a study by Garett Jones about the ARRA), borrowing from other countries could have been an option (from a keynesian point of view, at least) if they are not experiencing a recession.

      By the way, have you read this paper ?

      Fundamental Errors in Keynesian Multiplier Theory and Cross Diagrams
      (by Chapman)

      It is not bad at all.

      1. JCatalan

        That an economy is more capital intensive doesn’t mean that less labor can be employed. (Edit: And the ratio of producers’ goods to consumers’ goods shouldn’t necessarily comment on the techniques being used by individual firms.)

        1. Silvano

          Yes, former USSR had a lot of capital intensive factories but wasn’t able to provide even a decent car to his citizens. Central plannig suffer problem of calculation, coordination, bad targeting, squandering of resources, etc. But this doesn’t mean government is unable to set up a nuclear plant, a railroad or a factory.

        2. M.H.

          I was saying that capital-intensive sectors would invest more in capital goods if they are expecting higher demand. But this will not be the case if their activities are sustained by temporary, public funds. Since public spending crowds out private investment I don’t see how they can substantially increase the number of employees without investing in capital goods. If they don’t want to invest, demand for labor will not be so high.

          1. M.H.

            But this aspect of the theory is clearly wrong. Or, are you saying that public spending does not crowd out private investment ?

          2. JCatalan

            I’m not trying to argue that it’s right. But, it’s worth considering that all investment crowds out other investment. The government can invest, and take the place of a number of other investments, but there can still be a certain volume of private investment. If the government invests in second or third order goods, this will increase demand for third or fourth order goods. The effects aren’t exactly the same as those of credit expansion, but to some degree they’re similar. Whether private firms will invest in labor-saving capital or labor-intensive capital depends on the price of labor, per Hayek’s Ricardo Effect, but even the manufacturing of labor-saving capital requires labor. (As an aside, while I don’t remember Huerta de Soto’s argument exactly, this is one part of his book that I can’t agree with — the level of employment shouldn’t fluctuate as much as he thinks it does as the structure of production changes in shape.)

  6. Falcon

    Jonathan – I came across your blog while searching for an answer on the issue of savings vs. investments in emerging markets. I am a student. So please forgive my ignorance. Since you are so knowledgeable, any thoughts would be helpful. Following are my questions. Can high GDP, high investment level, and high savings level all occur at the same time? Will they be positively correlated in the short-term or just long-term? Secondly, does it require shift in spending patterns from consumables to capital goods and therefore industrial make up of a country? But that leads to a basic question, why would a business invest in capital goods unless they are also expecting increase in revenue through more consumption? Thirdly, how does this equation change if a lot of investment spending will leave the country because of high trade imbalances (specially for labor saving high tech inputs) ? Lastly, is high savings rate necessary to facilitate high investment spending if you can fall back on foreign direct investments and remittances?

    1. JCatalan

      By definition, S=I, so if we assume that greater quantities of wealth requires greater productivity (i.e. greater investment), then higher levels of GDP are associated with higher levels of investment and saving. I’m not sure how S and I fluctuate in accordance with textbook theory; from Keynes’ The General Theory I get the impression that S follows I (more investment = higher incomes, which are then distributed between consumption and savings). Similarly, I’m not that familiar with standard growth theory, so it’s hard for me to give you a good answer to your capital goods vs. consumer goods question. In the Classical theory, savings has to take place prior to investment, since the provision of more capital goods is necessary to fund investment projects.

      I alluded to it in the post, but the way a Classical economist would answer your question, about returns on investment and its relationship to consumption, is to point out that what also matters are the price of inputs. Price theory tells us that the prices of capital goods are imputed from those of consumer goods, so as consumer goods prices fall (as a result of higher savings) the prices of various inputs should also fall. Hayek also developed the “Ricardo Effect,” which posits that a reduction in consumer goods prices is tantamount to a real increase in the price of labor, causing an increase in the demand for labor-saving capital goods (by second order firms — those that manufacture the final consumer good).

      International trade shouldn’t change the basics. Remittances and foreign direct investment all reflect income, and need to be distributed between savings and consumption. But, there’s a “real” and “nominal” dichotomy at play, where those sending dollars back to home countries need to have that currency exchanged for the local currency; changing nominal conditions don’t necessarily reflect changes in the availability of real resources, or capital goods (which either need to be produced or imported). In a sense, returning dollars, for instance, represent claims on real U.S. goods (or, alternatively, financial assets).

      1. Falcon

        Jonathan – That makes sense (except the real vs. nominal dichotomy part at the end. I think I have to read up more on it to understand how the currency conversion will affect the situation, as you have cited). Thanks.

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