Keynesian Errors on Time and Demand

The foundations for the prominent economic theory supporting leading policies worldwide for the last few decades was laid down by the mathematician John Maynard Keynes. The ideas he pushed and promoted during his lifetime are still common among academics and policymakers, and his theory is almost exclusively the one used for economic education.

However, as was pointed out many times before, the theory he presented, when logically scrutinized, appears to be flawed in many aspects¹.

In this article, I’d like to focus on a claim popularized by this theory, which is that spending is the driver for economic growth, and logically prove that this, in fact, is contrary to the truth, which is that savings are the underlying implicit requirement for economic growth, whilst spending, especially when artificially increased, will promote economic stagnation. All this, by applying the integral concept of time, which is fundamentally ignored by the Keynesian school of thought.

Production and Time

As a fundamental axiom, it is required to acknowledge that all processes of production (the transformation of goods of higher order into goods of the first order²) take time, as if it wouldn’t take time at all there would be no transformation happening, and it would mean that no production took place. A production process may, for example, be a lumberjack cutting wood and using it for heating during the winter, or a baker baking a cake.

We can notice here that those production processes are usually only a part of a much longer process. With the baker having to produce (or purchase from someone who produced) the ingredients for the cake, like flour, which had a relatively long production process (parts of which are planting wheat seeds, harvesting the wheat, and milling it into flour).

We can also observe the correlation between economic development and the increasing length and complexity of production processes. For example, while in the past a lumberjack might use a relatively simple tool like an axe, a more modern tool is an electrical chainsaw, which requires a much longer and more complicated production process than an axe, as it needs components like a motor, an energy source, and various other parts.

I will use the following citation to express the point of time and production more formally. Individuals act in order to remove uneasiness by allocating scarce resources throughout time. There are means available, and one can utilize them in order to achieve some desired end. Action is purposeful behavior believed to solve problems. This necessarily must take place in time. There is an a priori value judgment of the possible ends to seek out, and following the action to employ the means necessary to succeed in the plan. Time is the concept that something has changed, and since action is change it therefore implies the passing of time³. “Time is scarce for man only because whichever ends he chooses to satisfy, there are others that must remain unsatisfied.”⁴

The Incentive for Production

We shall now start investigating the Keynesian theory of spending, focusing on its reasoning. The reason Keynesian theory provides for the claim that spending promotes economic growth is that higher spending means an increase in demand and because production is dependent on and stems from demand, the higher demand will encourage more production. It argues that without enough spending, there will be low demand, which will discourage people from production and cause an economic slowdown.

I want now to focus on the claim that demand is the incentive for production, as though it is generally correct, we can nonetheless observe a slight inaccuracy in that statement, which we will explore now. The demand for any specific good is a continually changing variable, influenced by many factors such as available supply, consumer’s taste, and population size. The demand for a good is by no means guaranteed, or even likely to stay constant during any period, due to the vast amount of possible changes which can impact it.

If we now think of the process of production, we showed that there must be some time passing from its initiation until a final product is produced. If we were to consider that production is indeed a response to demand, we must take into account that during this time when the production process takes place the demand may (and probably will) fluctuate. Thus, during a production process, “demand” could mean a range of possible demands (anything on the timeline between current demand and the expected future demand at the end of production), and for this reason, we must specify the exact point on this “demand timeline” to which we refer. It should be pretty clear that there are only two options which we can regard as non-arbitrary, the current demand and the expected future demand at the end of the process (the beginning and end of the timeline). If we now turn to consider which one of the two possible demands serves the basis for an entrepreneur’s decision to initiate production, we must take into account that at the time of the decision, the product is not yet ready to be sold or used, thus cannot satisfy the current demand for the final product. Since we cannot claim that a product (in this case, the unready product) is subjected to demand it cannot satisfy, we must reject current demand as the answer.

It is due to the fluctuation of demand during the time of production, that we must conclude that the decision to initiate the production process is based not on current demand, but rather on the future demand expected to exist after a certain period passed, namely the period between the beginning of the production and its end. Put differently, we can logically conclude that the production of all goods must be in response not to the current demand, but the expected future demand which the producer expects to exist at the end of the production process. From that, we can go back to the initial statement at the beginning of this section and rephrase it more accurately by saying that the future demand expected by the producer to exist at the end of a production process is the incentive for production.

For example, the farmer is planting wheat seeds today not because of the present demand for bread, but because he expects a certain level of demand for it at the end of the production process when he offers it in the market. While this expectation might be implicit, especially in an economy with such a progressive division of labor as today’s, it nonetheless exists. This must be the case, as, other things being equal, if the actual demand for the product at the end of the production will be lower than a certain level, the producer will lose money (or make a smaller profit than expected). So, if he didn’t expect the demand (even implicitly) to be higher than a certain level (that which below he loses money) at the end of the production process, he would not initiate the production process in the first place. The fact that the farmer did start the process means that, like any other producer, he must have some expectation for the future demand for the product when he initiates the production process.

The Path to Economic Development

Now, let’s take a small pause for a moment to focus on what “economic development” means. In simple terms, economic development (progress) is the improvement of the ability of people to satisfy their needs.

A probably unique trait of humans, to which we may attribute the most significant effect on economic progress is the production of goods of higher order (goods which are meant not to be consumed but instead used to produce consumable goods, goods of first order). The larger and more advanced the stock of goods of higher order available for people, the more they can produce and the better they will be able to satisfy their future needs.

Moreover, as mentioned before, we should note that the increase in the length of a complete production process, the number of different goods used in it and its overall complexity tends to rise along with the progress of civilization.

We can, therefore, state that a path to economic progress may require increasing the stock and variety of high order goods available for production, thus improving the production processes. Improving production will provide for an increased output of consumption goods in the future, which will allow people to satisfy their needs better.

Spending and Economic Growth

Now we can start analyzing the theory that spending incentivizes production and thus leads to economic growth. The problem with this theory is that, while compelling, it fails to address the time dimension in economics (in this case, accounting for future demand as well as present demand), which, when addressed adequately, leads to entirely different conclusions.

To believe spending leads to economic growth is to think that enhancement of the production capacity (mainly by the production of goods of higher order), which is the primary form of economic growth, is the result of the current demand, rather than the expected future demand for consumption goods. However, since we showed that producers rely on the expected future demand, not current demand when deciding to start a production process, we can say with certainty that this is not the case.

We can now conclude that economic development stems from the improvement and enlargement of production, which is driven by an expectation for future demand, and not by present demand. This conclusion indicates that the hypothesis that more spending leads to economic growth can’t be accurate, as it ignores the fact that current demand, is different from, and has different economic implications than the future expected demand.

We shall now try to understand then, according to the corrected statement, which is that spending leads to higher present demand, what are the implications of spending on economic growth.

Spending implies people’s preference to direct resources into the current production and distribution of consumption goods, which they can purchase and consume in the present. This preference for current consumption arises instead, and at the expense of preference for the production of goods of higher order.

The difference between those preferences is that while the former does not contribute towards economic growth, as consumption goods cannot be used for the production of future goods which will satisfy future demands, the latter could facilitate the improved production of future goods, which is the essence of economic growth. In other words, we can say that the former is a preference for the consumption and therefore depletion of existing resources, while the latter is a preference for the improved production of future goods, and thus for the greater satisfaction of future needs.

From the above, we can conclude that increased spending will cause the rise of current demand, which does not promote economic progress, but stagnation and depletion of resources.

Savings and Economic Growth

It is only appropriate now to explore what will promote economic development, and it is not surprising that the answer is the opposite of spending, which are savings. As the opposite of spending, savings were demonized by the Keynesian theorists as holding back potential spending (which according to their theory could be used to drive economic growth), reducing present demand (and prices as a result) and by that reducing the incentive to produce. However, as pointed out above, it is not current demand but future expected demand which incentivizes production, Therefore, we should reject this argument against savings, and investigate into its actual economic effects.

Savings signal a higher demand for future goods than a need for present goods (people save their money for future use). Thus, savings increase the expectation for future demand and, in accordance, incentivize production and promote the allocation of resources into the improvement of the production processes, namely, developing the production of goods of higher order.

In other words, savings represent the phenomena of people delaying their consumption and saving their money to use later. Saving money for future use means that the expectations for future demand should increase, which in turn will incentivize long term production and economic growth.

According to the analysis above, we can describe the economic difference between spending and savings as follows. Spending is the preference for the satisfaction of current demand, rather than of future demand, and will drive more resources to satisfy the former over the latter. While, on the other hand, savings are the preference for satisfying future demand, which means an increased future demand will be expected and thus more resources will be available for and directed to the development of production goods, which will allow for the satisfaction of the increased expected future demand for consumption.

Time Preference and Economic Growth

This concept of preferences for the time of consumption (from the present to the very distant future), which we discussed above, is what we call time preference⁵. Other things being equal, an economizing individual will always prefer a more immediate satisfaction of needs compared to the same satisfaction in a later time. Therefore, whenever individuals delay the satisfaction of their needs, they will do so only if the future satisfaction is expected to be higher than the immediately available satisfaction by a certain magnitude which they find sufficient to compensate for the delay. In other words, they necessarily price the delay in the satisfaction of their needs. This subjective valuation of the delay is what determines the degree of time preference, the lower the relative value assigned to present satisfaction, the lower the degree of time preference is, and vice versa.

We can define the preference for current consumption expressed by spending as a relatively high time preference, while the delay of consumption and the preference for a better provision for the future expressed by saving, we should define as relatively low time preference.

Since we know that the path towards higher forms of civilization inevitably requires lengthening the production periods, we can conclude that lowering time preference (our valuation of the present) means more willingness to plan for increasingly more distant future. Thus lower time preference will allow to improve production and promote economic growth.

Economic Implications

Before finishing, I’d like now to briefly elaborate on what implications the corrected theory discussed above has on the economy. Thomas Sowell has defined the central concern of economics as “the allocation of scarce resources which have alternative uses.”⁶ Labor, capital and other resources will inevitably be allocated in one way or another (unless prohibited by regulations), the only question is how and to which parts will people direct the allocation of those resources.

Spending will cause more resources to be allocated to the current and short term production of goods of lower order and by that shift resources away from the long term production processes of goods of a higher order. Savings, on the other hand, will do just the opposite, by lowering spending on consumption, less cash flow will be available for the sectors of the short term production and distribution of goods of lower order⁷, and thus more resources (and further investments from savings) will be available for the long term production processes. The increase in available resources will, as mentioned, be accompanied by the expectations for higher future demand induced by saving, which will further promote undertaking long term production processes.

With the latter case, we can see a trend towards growth and improvement, which will eventually lead to a more abundant supply of goods than in the former case. The result of this further abundance will be gradually decreasing prices for goods, allowing the enhanced provision of each individual’s needs. This enhancement in individual provision reduces the need for present-oriented behavior, as the satisfaction of present needs can be met more thoroughly, thus making them marginally less important, and will allow focusing on the further improvement of production.

The continuous process of reducing spending, which leads to more abundance of goods, which reduces prices and thus allows for higher consumption and the even further reduction of spending, without lowering (and potentially increasing) living standards, is what we call the process of civilization.

The conclusion I would like to draw from the above is simple, high spending encourages economic stagnation, while savings encourage improving production processes and thus promote economic development. It seems that the main flaw hiding behind the opposite theory developed by Keynes could be attributed to an “ignorance of time”⁸, which caused the confusion of current demand with the expected future demand. Time is an inseparable dimension of reality and must be rigorously applied in the formulation of economic theory.

[1]: For a rigorous critique on Keynesian Economics, see “The Critics of Keynesian Economics” by Henry Hazlitt. https://mises-media.s3.amazonaws.com/The%20Critics%20of%20Keynesian%20Economics\_3.pdf

[2]: For a simple explanation on the idea of orders of goods see: https://wiki.mises.org/wiki/Orders_of_goods

[3]: Hillebrand. Shared Ownership of Scarce Bitcoin with Multi Signatures in the Lightning Network, Chapter 1 Human Action. 2019

[4]: Rothbard. Man Economy and State, 1. The Fundamentals of Human Action, 2. First Implications of the Concept. 1962

[5]: See the following page for a more elaborated explanation of the concept of time preference: https://wiki.mises.org/wiki/Time_preference

[6]: “Basic Economics: A Common Sense Guide to the Economy” by Thomas Sowell.

[7]: Despite fewer businesses in one sector of the economy (long term or short term production), it is important to mention that competition should not be hindered, as the prospect of profit by offering a better or cheaper service is not damaged by the economic shift of resources. Therefore, the contraction in resources is only likely to squeeze out superfluous businesses and business activities while leaving the superior and demanded ones uninterrupted.

[8]: Term borrowed from “The Trouble With Socialist Anarchism” by Per Bylund. https://mises.org/library/trouble-socialist-anarchism which used it in a similar fashion.