This article first appeared at TheFreemanOnline.org.
Sylvia Nasar, author of the New York Times bestseller, A Beautiful Mind, has a new book: Grand Pursuit: The Story of Economic Genius, which reviews the lives and ideas of a dozen economists from Marx to Keynes and Hayek to India’s Amartya Sen. It begins with a description of life in Jane Austen’s England (1775–1817). Briefly, it was a Malthusian world in which any improvement in living standards was quickly followed by an increase in population that drove living standards back down to the subsistence level—a level at which nine-tenths of the population was constantly at risk of death from disease and starvation. Nasar assures us that as grim as this world was, life was far worse on the Continent.
By 1870, however, some 50 years after Austen’s death, things had improved enormously. Real wages were significantly higher and rising. Most people could now afford more than a single set of clothes, life expectancy was increasing, and London was a far healthier place in which to live. What happened to so dramatically improve the average Englishman’s lot in just two generations? Nasar explains:
The economic historian Harold Perkin argues that “Consumer demand was the ultimate economic key to the Industrial Revolution,” providing a more powerful impetus than the invention of the steam engine or the loom. London’s needs, passion for novelty, and growing spending power supplied entrepreneurs with compelling incentives to adopt new technologies and create new industries.
There you have it. For millennia people were starving to death and the solution was right there in front of them: Consume more. Similarly, those who died of thirst in the world’s deserts could have been saved if they had only drunk more water.
This is not to deride Nasar, but to suggest that Keynes was on to something when he quipped that “even the most practical man of affairs [or the most intelligent historian] is usually in the thrall of the ideas of some long-dead economist.” Nasar’s passage, following as it does a recital of the terrible poverty that was the common lot for nearly all of human history, perfectly illustrates the emptiness and absurdity of popular Keynesianism. The work that Nasar quotes—The Origins of Modern English Society 1780–1880—was published in 1969 at the height of Keynes’s popularity: during the presidency of Richard “We are all Keynesians now” Nixon and before the stagflation of the 1970s.
Nasar’s last sentence, however, contains an important truth in the phrase “growing spending power.” The term spending power implies effective demand, which means not just need or desire but the wherewithal to fulfill that need or desire. Wherewithal, in turn, implies previous production and saving (deferred consumption).
What a man produces is what he can bid for the produce of others. The value of what he creates—that is, its value to others—represents his effective demand in the marketplace. If he produces nothing, if what he produces has no value (mud pies), if what he produces loses its value (stone knives in the Bronze Age), or if he produces more than can be consumed (houses after a housing bubble has burst), he has no effective demand though his needs be unchanged.
This restates Say’s Law, which Keynes in his General Theory popularly, though misleadingly, formulated as: Supply creates its own demand. This statement is misleading because a supply of goods with no value yields no effective demand and because supply that does have value to others does not create effective demand, it is effective demand.
What Keynesians do not understand is that if a man is hired to dig holes and then fill them back up, he is fully employed but he produces nothing of value; effective demand is not increased by his efforts. Nor does giving him money or goods in exchange for his useless labor create effective demand; it only shifts it from the people who produced what was given him.
Only production creates effective demand, and only after what was produced is sold can other goods be purchased and consumed. What changed England was not increased consumption but increased production, production that made increased consumption possible. And, yes, that increased production was due in large part to the entrepreneurial employment of the steam engine and the loom, inventions that Nasar cavalierly dismisses.