Keynes, Crackpots, and Deflation

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John Maynard Keynes changed his economic views every few years. His 1936 book, The General Theory of Employment, Interest, and Money, was his last book. He spent the war years in the British Treasury. He died in 1946. So, he did not change his mind again.

Keynes’ final book was a defense of government spending. This is why the book was hailed as a masterpiece. It backed up what all Western governments were already doing: spending money on welfare projects and running massive deficits.

Keynes believed that there could be permanent depression and price deflation. He said that prices do not always clear markets by balancing supply and demand. The General Theory is a convoluted, deliberately incomprehensible book devoted to disproving the fundamental premise of all economics, namely, that the search for profit motivates buyers and sellers to exchange scarce resources. If the price isn’t right, the seller of resources (buyer of money) suffers a loss. He cannot easily find buyers of his goods. In contrast, the buyer of resources (seller of money) has lots of people bidding against each other in order to get his money.

Money is the most marketable commodity, said Ludwig von Mises in 1912 in The Theory of Money and Credit. Because of this, sellers of goods and services will eventually deal at some price. They cannot use all of their output. They need money to survive in a division-of-labor economy. They buy money by selling products. The markets will clear. The depression will end.

Keynes argued that this is not true. He said that there can be an economy in which falling prices do not clear the market. The economy can be in an equilibrium with unemployed resources.

In attempting to prove this point, opposed to the logic of economics after Adam Smith (“supply and demand”), he resorted to arguments proposed by a pair of crackpots. One was an engineer, C. H. Douglas. Douglas founded the Social Credit movement in the 1920’s. The other was Silvio Gesell, an obscure merchant, journalist, and farmer who had briefly served as the People’s Representative for Finances for the one-week Bavarian Soviet Republic in 1919.

Both men had a theory of exchange that required the state to inject fiat money into the economy in order to balance supply and demand. For them, money was not an outgrowth of voluntary exchange. It was and is a ministry of the state.


Answering Major Douglas’s crackpottery is easy. I did it in 1993 in my book, Salvation Through Inflation. He was convinced that markets needed fiat money produced by the government in order to clear. He argued that when businesses repay loans after production, this destroys money. Then consumers cannot afford to buy the output. This was a distinction between finance credit and Real Credit. (Note: whenever you see the word Real capitalized, followed by a noun — also capitalized — be on the alert: a crackpot theory is close at hand.)

It did not occur to him that the banks immediately lend out the paid off loans. That is how they stay in business.

This error is found in most underconsumption theories. There is always a money bleed-off factor. Old money goes there to die, like the elephant burial grounds. The consumers cannot afford to buy.

Every variation of this theory is nuts, with one exception: when bank depositors withdraw currency and do not spend it, thereby not allowing sellers to deposit the spent currency in their banks. When there is a run on a bank in a fractional reserve system, there is money heaven. The inverted pyramid of fiat money shrinks, just as it expanded before. But this has nothing to do with paying off loans.

Douglas offered another theory — conceptually different — which he imagined was irrefutable. He called it the A + B theorem. I devoted an appendix to the A + B theorem in my book. He argued that there is a break in the flow of payments. A factory pays Group A wages and dividends. It pays Group B for raw materials, to cover bank fees, and other “external” expenses. His theorem assumed that payments to Group B do not constitute purchasing power for the output of the factory. The money ceases to provide consumer demand. So, the state must intervene and create money. This is another variation of his broken flow of funds argument.

Whenever you see any variation of the broken flow of funds argument, you are in the presence of crackpottery. It does not matter how many equations or graphs the author provides. He is an economic crackpot.

The supreme error in Social Credit is the error in all scenarios of price deflation, other than one that relies on the extinguishing of money due to a reversal of fractional reserves. They all fail to follow the money. They speak of saving as if it were a system for hiding paper currency under a mattress. They refuse to answer this crucial question: What does the bank do with the money that a consumer deposits instead of spending? Put another way: What analytical or conceptual difference does it make whether a saver deposits a dollar his bank, which the bank will lend, or whether he spends it, enabling the seller to deposit the dollar in his bank, which his bank will lend?

Keynes wrote this about Major Douglas.

Since the war there has been a spate of heretical theories of under-consumption, of which those of Major Douglas are the most famous. The strength of Major Douglas’s advocacy has, of course, largely depended on orthodoxy having no valid reply to much of his destructive criticism.

When he wrote of “orthodoxy,” he meant classical economics: price as the way to clear a market. Anyone with even a smattering of classical economics can refute the utterly nonsensical theories of C. H. Douglas. Nobody bothered. My book, published in 1993, was the first book-length refutation, as far as I can tell. The only reason why I wrote it was to answer a Social Credit promoter who said that I was intellectually incapable of refuting him or Douglas. It took me maybe three weeks to write that book in my spare time. Maybe it took a month.

Keynes continued. He grew incoherent, as you will see.

On the other hand, the detail of his diagnosis, in particular the so-called A + B theorem, includes much mere mystification. If Major Douglas had limited his B-items to the financial provisions made by entrepreneurs to which no current expenditure on replacements and renewals corresponds, he would be nearer the truth. But even in that case it is necessary to allow for the possibility of these provisions being offset by new investment in other directions as well as by increased expenditure on consumption. Major Douglas is entitled to claim, as against some of his orthodox adversaries, that he at least has not been wholly oblivious of the outstanding problem of our economic system. (General Theory, pp. 370—71)

Keynes was incoherent. This was deliberate. Why do I say Keynes was deliberately incoherent? Because when he chose to write clearly, he was a master of prose. Read The Economic Consequences of the Peace (1919) or Essays in Biography. When he could not sustain an argument, he adopted the strategy of incoherence. Most of The General Theory is incoherent.

There is not one argument in Douglas’ writings — and I have read all of his books — that is an accurate description of how the market works, banking works, or entrepreneurs work. To the degree that Keynes accepted any idea in Social Credit, he suffered from the same intellectually crippling handicap.


Keynes devoted a long section of Chapter 23 to Gesell. This might seem strange, except for the fact that Keynes’ theory depends on the same conceptual error as Gesell’s: the inability of the rate of interest to allocate the supply and demand of capital.

He began by admitting that he had long thought of Gesell as a monetary crank. Keynes’ initial instincts were correct.

It is convenient to mention at this point the strange, unduly neglected prophet Silvio Gesell (1862—1930), whose work contains flashes of deep insight and who only just failed to reach down to the essence of the matter. In the post-war years his devotees bombarded me with copies of his works; yet, owing to certain palpable defects in the argument, I entirely failed to discover their merit. As is often the case with imperfectly analysed intuitions, their significance only became apparent after I had reached my own conclusions in my own way. Meanwhile, like other academic economists, I treated his profoundly original strivings as being no better than those of a crank. Since few of the readers of this book are likely to be well acquainted with the significance of Gesell, I will give to him what would be otherwise a disproportionate space (p. 353).

He said that Gesell’s main book “as a whole may be described as the establishment of an anti-Marxian socialism, a reaction against laissez-faire built on theoretical foundations totally unlike those of Marx in being based on a repudiation instead of on an acceptance of the classical hypotheses, and on an unfettering of competition instead of its abolition. I believe that the future will learn more from the spirit of Gesell than from that of Marx” (page 355). This is an astounding statement. It is rarely quoted by Keynes’ disciples, whose name is legion. His disciples still think Gesell was a crank.

Keynes then praised Gesell’s theory at the place where it coincides with his own. I will not bore you with the details. They are found on pages 355—56. Gesell attacked the idea that a free market interest rate allocates capital rationally — in short, the heart of Keynes’ economics.

Then he praised Gesell at the point of Gesell’s crackpottery: stamped money. This was money that had to be spent by consumers fast. Why? Because the government would reduce to zero value dated pieces of paper money. Holders of money would have to stand in line at the Post Office each month to get their money stamped in order to restore it to face value. They would have to pay a fee for this service. Conclusion? Spend it fast!

This was the proposal of a failed Communist finance minister and his acolyte, John Maynard Keynes, the most important economist of the 20th century. The only rival to Keynes in academia today on the money question is Irving Fisher, and he held the same screwball view, as Keynes pointed out.

The incompleteness of his theory is doubtless the explanation of his work having suffered neglect at the hands of the academic world. Nevertheless he had carried his theory far enough to lead him to a practical recommendation, which may carry with it the essence of what is needed, though it is not feasible in the form in which he proposed it. He argues that the growth of real capital is held back by the money-rate of interest, and that if this brake were removed the growth of real capital would be, in the modern world, so rapid that a zero money-rate of interest would probably be justified, not indeed forthwith, but within a comparatively short period of time. Thus the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of “stamped” money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure (pp. 356—57).

The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale (p. 357).

Here is the fusion of three great monetary cranks: Keynes, Irving Fisher, and Gesell. All three of them attacked the idea of the gold standard. All three of them believed that the economy needs fiat money to operate efficiently. All three believed that experts should decide what rate of monetary inflation is appropriate.

Then there was the fourth great monetary crank: Milton Friedman, who was Fisher’s disciple. He proposed this solution: central bank expansion of the money supply by 3% to 5% per annum. At least it made better sense than stamped money. (To those who gasp in horror at my assertion that Friedman was a monetary crank, I recommend that they read Murray Rothbard’s analysis of Friedman’s monetary theory. The section on “Money and the Business Cycle” is the relevant section. It is short and to the point.)

I define a monetary crank as someone who proposes a system of causation for money different from causation for other market phenomena. Ludwig von Mises subsumed monetary theory under the same logic that governs all market processes: Theory of Money and Credit. In contrast, a monetary crank tells us that private property, entrepreneurship, and the forces of supply and demand explain causation in the overall economy, but then insists that money is different, that government-created and government-planned money is required to balance supply and demand for all other goods and services. He abandons his theory of economic causation when he gets to money. Fisher and Friedman were monetary cranks.


None of the four believed that a free market money system would allow prices, including the interest rate, to allocate capital, apart from government creation of money to assure the clearing of markets. They saw money as a government function. They did not trust the free market to provide a market-clearing monetary system under a legal system that prohibits fraud but does not allow government-created money.

None of them accepted the international gold standard. Keynes hated it. It kept government and central banks from inflating. This kept governments from creating policies that would match supply and demand.

I have pointed out in the preceding chapter that, under the system of domestic laissez-faire and an international gold standard such as was orthodox in the latter half of the nineteenth century, there was no means open to a government whereby to mitigate economic distress at home except through the competitive struggle for markets. For all measures helpful to a state of chronic or intermittent under-employment were ruled out, except measures to improve the balance of trade on income account (p. 382).

What was Keynes after? A fascist state: the fusion of private ownership and socialism.

It is not the ownership of the instruments of production which it is important for the State to assume. If the State is able to determine the aggregate amount of resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society (p. 378).

This is why, in his preface to the German edition (1936), he wrote that “the theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire.”

Keynes refused to accept the free market explanation of the Great Depression, that it had been created by central banks that had inflated, then ceased to inflate: the boom-bust cycle based on fractional reserve banking. He rejected the idea that governments had created price floors to protect special interests, and therefore that did not allow the clearing of markets. He blamed the free market for not balancing supply and demand through price competition. He rejected Mises, Hayek, and Robbins (p. 192), never bothering to mention Robbins’ The Great Depression (1934), which is as clear as The General Theory is muddled. It was published by his own publisher, Macmillan. He completely ignored Chester Phillips’ book, Bank Credit (1931), published by the American branch of Macmillan.

To defend his theory, he relied on two deflationists whose theory rested on the inability of the free market to create money as part of the market-clearing process. He argued that deflation was inescapable without government intervention: the managed economy.


Keynesians are deflationists, meaning “the free market will produce permanent depression and deflation apart from government spending and central bank inflation.” They believe that, without government spending, huge deficits, and central bank inflation, the economy will go into a deflationary spiral and not recover. They invoke the paradox of thrift and the liquidity trap as reasons. Both rely on the same idea: “money saved in a bank is not simultaneously money lent by the bank to increase production or consumption.” It is a fallacious idea. It is “currency under the mattress” economics. It is “break in the flow of funds” economics. It is crackpottery.

These Keynesian arguments rely ultimately on the monetary theories of C. H. Douglas and Silvio Gesell. These two crackpots provided the conceptual framework for Keynesian economics. Keynes’ disciples, deservedly embarrassed by this inconvenient fact, have done their best to conceal it for 70 years.

Whenever you hear about the need for a government stimulus-spending bill, think “crackpot economics.” Whenever you hear that deficits don’t matter, think “crackpot economics.” Whenever you hear about the need for quantitative easing, think “crackpot economics.”

If you want to be inoculated against Keynes and the crackpots, read Henry Hazlitt’s line-by-line refutation of The General Theory: The Failure of the ‘New Economics’ (1959). Then read Murray Rothbard’s What Has Government Done to Our Money? (1964).

July 14, 2009

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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