A penny saved is a penny lost?

It was during the Great Depression that John Maynard Keynes found what he believed to be an explanation for the crisis of capitalism. He boldly proclaimed that it was "impossible for all individuals simultaneously to save any given sums" and that attempting "to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself." Consider the following scenario: What will happen if I decide to save an extra dollar by not buying a loaf of bread from you? Unless you borrow my dollar from the bank, you will have one dollar less to buy eggs from me, decreasing my income by the same amount.

If everyone becomes thriftier, we all become less wealthy. To restate Ben Franklin: "A penny saved is a penny lost." In economist circles, this is known as the "paradox of thrift." I often use it to stump my undergraduate macroeconomics students. It is also known to be a fallacy, elegantly refuted by Friedrich Hayek years before Keynes developed his "general theory."

As a student, Keynes studied mathematics and showed great interest in philosophy. For some reason, his father and two prominent economists, Alfred Marshall and Arthur Pigou, pushed him later in his life and against his natural inclinations into economics. We can understand how a brilliant thinker with insufficient training in his field can be baffled by the so-called "paradox" in the 1930s. But it is inexcusable for professional economists in the 21st century to lack a basic understanding of capital theory and fall into the same old trap. Just as the actions of the Federal Reserve turned the recession of 1929 into a depression because its board of directors could not figure out the link between nominal and real interest rates, today's Keynesians, who can't tell the difference between real and nominal wealth, are trying to push us into a stagflationary cycle as the one engineered under the leadership of Presidents Johnson, Nixon, Ford, and Carter.

The truth is quite simple:

That briefly describes the only existing wealth generating mechanism in history. It is also supported by tons of empirical data linking high savings rates to economic growth-one can examine the experience of Germany and Japan after WWII or the more recent examples of China and India. The confusion occurs when one overlooks the nature of money. Money functions as a unit of account and thus serves in a complex market system as a means of exchange. It is not real capital but a convenient tool for measuring real capital.

If Obama convinces Federal Reserve Chairman Ben Bernanke to inject another trillion dollars in the economy, does he create a trillion dollars of additional wealth? No, the scheme simply increases the ratio of cash to goods, diluting the value of the currency. It may "stimulate" unsustainable short-term activity in a few preselected sectors of the economy, distorting prices and incentives as it moves. Since the temporary benefits are easily measured, the policy attracts public support.

But the limited knowledge and the pursuit of political benefits by the central planner limit the opportunities for long-term wealth creation, a fact that remains largely unseen by the people. Perhaps we can learn something from Japan where the government tried to "jump-start" the economy with a series of stimulus packages during the 1990s. They successfully doubled their debt but the period has gone into their history books as "the lost decade." We lost the decades of the 1930s and the 1970s-do we have to lose another one only to learn that Ben Franklin had a better economic advice than Keynes?