The Circular Flow of Nonsense

The Circular Flow of Nonsense

Keir Martland

To all with an A-level in Economics, the Keynesian circular flow of income will be familiar. It is a representation of the macroeconomy, including the household, the firm, the global economy, the banks, and the government.

Injections are often represented on this diagram by a green arrow and they include consumption, investment, government spending, and exports while leakages are often represented by a red arrow and they include savings, taxes, and imports. While consumption is sometimes not included in the list of injections, injections are defined as expenditures on aggregate production, that is, money flowing into firms. On the other hand, leakages are defined as non-expenditures on aggregate production.

Keynes believed that the higher the levels of spending on aggregate production in the form of consumption, investment, government spending, and exports, and the lower the levels of non-expenditure on aggregate production in the form of savings, taxes, and imports, the better off the macroeconomy is.

Keynes, it can be seen from the above, then, was of the belief that saving, for instance, was a bad thing, to put it plainly. Since savings are just sat in the bank and are not doing anything productive, what really is the point of them? In a recession, especially, savings represent a leakage in that they are not being spent on consumer goods. Consumption, Keynesians might argue, drives the economy; when goods and services are consumed, firms are better off and can employ more workers and these workers now have wages which they can spend on goods and services, the producers of which can now afford to employ more workers, ad infinitum. Why on earth, then, would anyone save money when saving simply represents a restraint on the expansion of firms? Since saving is not investment or consumption or government spending or exports, it is a no-no.

One problem with this view of savings is that it is not up to John Maynard Keynes to tell savers that their savings are not also an investment. What is an investment, after all? A very general definition of investment is that it is the act of not consuming today in the expectation of a reward in the future. Applied to economics, investment is the acquisition of a good which will ‘pay for itself’, so to speak. A hairdresser invests in a pair of scissors only because she expects the income derived from the scissors to be more than the initial cost. What, then, of the saver? Does he not first acquire his money and then put it to some non-consumption use in the expectation of a reward in the future? The answer is: of course he does. If the saver did not expect such a reward, that is, if he did not expect to be better off as a result, then he would not save. Yet, this does not rule out the possibility that the saver could be wrong, that is, that he could actually make a loss (perhaps due to inflation). Nor does the reward have to be monetary. Indeed, even if the expected reward for not consuming was purely psychic, then the saver would still be making an investment. For saving is not simply keeping resources idle without reason. Every actor, and saving is an action carried out by an actor, has an end, and he would not act unless the end was perceived to be an improvement in some sense over his present situation. So, I repeat, it is not up to the Keynesians to tell savers that they are not also, by saving, making an investment.

Yet there is another, more fundamental problem with the Keynesian view of savings. Where does the money for investment come from in the first place? According to the Keynesian view, investment is a Good Thing, and Amen to that. Investment, though, as I have just said, is the act of not consuming – that is, saving, albeit temporarily – in the expectation of a reward. To invest, one must first save. That is, to accumulate the capital with which to buy a factory, one must first have not spent this capital on consumption. But, saving is bad. So, how, if saving is to be minimised and consumption maximised, is investment ever to take place? Perhaps one answer could be that the investor might borrow the funds with which to buy the factory. Even so, these funds, to the extent that they represent the freeing up of resources by actors in the economy and not the printing of additional loanable funds through credit expansion, would not have existed had not someone else saved. Also, what happens once the investor has borrowed these funds? Must he not refrain from consumption in order to pay them back? In a future article I shall deal with credit expansion and why this does not relieve us of the task of saving and why much of the present economic malaise is actually due to it.

Turning to government spending, in what sense is government spending ‘good’? That is, how can government spending create anything of value? The Keynesian view of government spending is that, as it generates activity, or boosts aggregate production, it reduces unemployment of factors of production. This is why the Alphabet Agencies of Franklin D. Roosevelt must be regarded as sound by Keynesian standards; they employed previously unemployed factors of production in some activity and thus boosted aggregate production.

The absurdity of this position may be more obvious. For the Keynesians, the aim is only to increase aggregate production (and aggregate demand). Production of what? That really does not matter. The production of waste is just as valuable as the production of goods. In this way, what is produced is likely to be of no value at all to consumers.

However, there is another flaw: just as investment must follow saving, government spending must follow taxation. Taxation, according to the Keynesian, is a leakage. Once again, the aim of the Keynesian economist is to maximise injections and minimise leakages. How would this work? Must we eliminate all taxes and yet simultaneously increase government spending to infinity? This is nothing but the logical conclusion of the Keynesian fiscal policy recommendations. We see that today most governments are actually making some progress towards this, with most of them running budget deficits, but none of them have actually gone so far as to run a deficit of infinity. Why is this? If governments are benevolent agencies which merely wish to increase the general welfare and which also have the power to minimise Keynesian leakages and maximise Keynesian injections, then why is there still poverty in the world? Why, in fact, do governments tend to run into problems when they run deficits? Surely, if Keynesian economics were true, a fiscal stimulus would boost aggregate production and thus increase real incomes. And so, what we ought to expect, if we accept Keynesian economics as true, is that the bigger the deficit the faster the rate of economic growth. I needn’t point out that this is not so.

Then we have to consider the opportunity cost of government spending. Everything has a cost and if something doesn’t have a monetary cost then at the very least it has opportunity cost, i.e. what was given up for it. Even if government spending does lead to the production of something identified as a good by a consumer, the money the government spent was forcibly taken from a citizen. How might he have spent the money? He would have put the money to its most highly valued end, at least in his own eyes. By taxing and then spending, the government is necessarily removing money, time, and other resources from more highly valued ends to lesser valued ends. The result of this can only be relative impoverishment. Government spending may well be an injection, but it is an injection of less value to consumers than the use which would have been made had not the government taxed.

Lastly, Keynesian economics strikes me as rather mercantilist in that it suggests that imports make us poorer. This is because Keynes’ circular flow of income shows imports to be a leakage, or a non-expenditure on aggregate production. This is true, in a sense. It is true that a firm or household which imports goods exchanges money for goods and does not contribute funds to the production of goods in the domestic economy. The mistake is the assumption that this will necessarily make the domestic economy shrink.

In fact, the opposite is true. Given that any actor will purchase the most highly valued good, at least in his eyes, and that goods are considered valuable because they are cheaper and of higher quality than less valuable ones, if actors in the domestic economy import goods then they are doing so because the equivalent goods in the domestic economy are either of an inferior quality or simply do not exist. Now suppose that a Keynesian, only wanting to minimise leakages, were to impose import tariffs or to ban all imports (Keynes argued for protection in the 1930s) . What would be the result? The result would be that more highly valued goods would now become either more expensive or simply unavailable and the actors would now turn to inferior substitute goods in the domestic market. Firms and households would now be worse off, since they can now get less for their money, so to speak. All else remaining constant, if a firm is worse off, it will have to either lower wages or lay off workers. Is this good for the domestic economy?

Rather than one being ‘good’ and another ‘bad’, one an injection and the other a leakage, exports and imports are simply two sides of the same coin. When a firm exports goods, it imports money, and vice versa. If an economy were to refrain from importing goods then the effect, all else remaining constant, would be a reduced demand for this economy’s goods in foreign markets. By importing goods from other countries, we give them the money with which they can import our goods. We cannot have the one without the other.

So, the circular flow of income is, I think, a very pretty diagram which does a good job of illustrating just how a domestic economy works. If the diagram were in black and white and if the terms leakage and injection were kept away from it, then that would be one way of improving it. Only by avoiding the Keynesian colouring of the circular flow of income can we avoid the palpable falsehoods that follow from it.



  • Yes – and it should be remembered that Keynes also praised the Progressive policies of the Herbert Hoover Administration (yes Krugman and co are lying when they pretend that Hoover was not an interventionist) – most of the Franklin Roosevelt agencies were just renamed Herbert Hoover created agencies.

    The general point of “consumption” or “effective demand” was refuted by J.B. Say and the other Classical Economists more than a century before. As, I believe, Henry Hazlitt (“The Failure of the New Economics”) pointed out – “Keyes misstates Say’s Law – then he “refutes” his misstatement”.

    However, there is an added twist these days…..

    If our Keynesian governments believe in “consumption” or “effective demand” – who do they not literally print money and hand it out (say “drop it from helicopters”)? Why is all government backed monetary expansion via the banks and the rest of the financial system?

    It is hard to escape the conclusion that at least PART of the motivation of the government monetary expansion is to prop the pre-existing bank credit bubble.

    One need not hold the “bankers control governments” view to have this

  • One need not hold the “bankers control governments” view to have this opinion.

    After all the bankers (and civil servants and so on) can, quite truthfully, say “if the financial system collapsed there would be terrible economic distress” – and “if you do not prop our credit bubble – our broad money (if you expand the money supply in some way that bypasses us – or, like that evil maniac Paul Marks would suggest, do not expand the money supply at all) then the financial system will collapse”.

    Of course this is dressed up in “scientific” technical language – but it is basically “the financial system is a massive credit bubble – unless you keep propping it up it will collapse”.

    But how long can governments (and their Central Banks) continue to prop a mad system – a system where bank lending is vastly greater than REAL SAVINGS.

    I just do not know – I am astonished that they have managed to prop things up so long.

  • Keir, you will cetainly fail your economics British-State-type-A-level, if you type stuff like that. The examiners – and (worse) your own teachers who will badmouth you to UCAS – won’t like it at all.

    Look, I just want you to “do well”. Just tell the bastards who mark your papers all the stuff that they want to hear, OK? This is “New Britain, A Young Country!” (Tony Blair said so in May 1997, so it must be true. That was _Year Zero_ .)

    • I got all my A*s at GCSE by purchasing all the relevant GCSE revision guides and cutting myself off from the world for about a month. I will get my As at AS Level only by practising my Maths, reading the court historians on the crusades and the Norman conquest, looking at the WJEC economics specification, and memorising the AQA Philosophy textbook. The Keir in exam halls is not the Keir you find on the LA Blog.

      • I am very, very glad to hear that, Keir. You MUST say in the exams what they tell you to. Specially if it is got from the “revision guides”. These are of course infallible. You and I know in our hearts that most of it is rather less than the truth.

        • Maths seems to be the only subject which has escaped political correctness.

          • That’s because mathematics is the only subject of academic study which requires the argument to proceed forwards (or, as I prefer to look at it, bottom up) from axioms to conclusions, in an entirely rational manner. And everyone in the field knows it, so the very few charlatans (unlike in science) tend to get called out

            BTW, an excellent article, Keir.

  • Pingback: Why You Should Fear The Boom and Bust Cycle! | DIEGONOMICS

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