Obviously the income tax is a tax on people’s income-generating activities. What this means is that it penalizes these activities relative to activities that do not generate income. In a market setting, income-generating activities are those that lead to the production of goods and services. So the income tax penalizes work relative to leisure, and saving and investment relative to consumption. It is the latter that tends to be least understood and therefore will be the focus of this essay.

Consume or Invest?

The broad choice facing an individual in choosing to allocate his or her income is to either spend it or save and invest it. This consumption/saving choice is distorted by the income tax in favor of consumption.

Using the traditional terminology, the income tax double-taxes saving relative to consumption. It should be noted that this terminology is somewhat misleading. As will be demonstrated, the tax does not explicitly double-tax saving but reduces the returns to saving twice, while reducing the returns to consumption just once.

This can be shown with a simple example. Start with an individual who has $100 of pretax income. In the absence of taxation this person has $100 for either consumption — the purchase of goods and services — or saving. If the interest rate is a simple 10 percent per year, then the person can decide whether he prefers to spend $100 or save the $100 and have $110 available for spending a year from now. The decision will be based on his preference for satisfaction now relative to satisfaction in the future. This is what economists call time preference.

Now assume that the individual faces a 10 percent income tax. His $100 is reduced to $90, cutting the amount available for consumption by that rate. Likewise, the tax implicitly reduces his returns to saving by 10 percent. In other words, by taxing the principal the government is simultaneously reducing the entire stream of returns from the investment. So if he saves the $90, because of the tax his interest income is reduced from $10 to $9.

The Returns to Waiting

In the absence of further taxation the individual’s choice is between spending $90 now or waiting a year and having the opportunity to spend $99. Returns to consumption spending and returns to saving have both been reduced equally by the tax. But under a standard income tax, the returns to saving are reduced yet again. The $9 in interest also is taxed 10 percent, leaving $8.10.

So the tax reduces the returns to savings twice: first from $10 to $9 when the initial $100 is taxed, and second from $9 to $8.10 when the interest is taxed.

Note that the return from consumption is only reduced once, from the level of satisfaction that could be obtained with $100 to the level that could be obtained with $90. The tax on interest or other returns to investment, including dividends and capital gains, biases decisions against saving, investment, entrepreneurship, and business expansion, and in favor of consumption spending.

In addition the government, at both the federal and state levels, further punishes investors with a separate corporate income tax. The corporate tax, which at the federal level is 35 percent, adds a third layer of tax on both dividends and capital gains.

Exempt Returns from Saving

The most straightforward way to remove the bias is to exempt from taxation all returns from saving. This is the approach that has been taken by those who advocate the flat tax, for example, Steve Forbes. From this perspective, saving and consumption are treated symmetrically.

An alternative way of remove this bias is by eliminating all saved income in the current time period from the tax base, taxing it only when it is withdrawn for consumption purposes. A tax that deals with the bias against saving in this way is called a “consumed income tax.” The idea would be to treat all savings and investment in the same way that IRA and 401k retirement investment plans are treated, except that there would be no penalties for withdrawing funds before any legally specified age.

In reference to our example, if the person decided to spend his $100 in pretax income, he would be subject to the 10 percent tax immediately and would have $90 available for consumption. If instead he decided to save or invest the $100 for a year, he would not be taxed on it until it was taken out of savings and used for consumption. At the end of a year, if he chose to withdraw the money from savings or to cash in his investment, the original $100 and the return of $10 would be taxed 10 percent. This would leave him with $99 for consumption, or the equivalent of a full 10 percent return on $90. The point here is that only income that is used for consumption is taxed, hence the name “consumed-income tax.” It should also be noted that this gives the same result as the flat tax, which would exempt the interest income from the tax base. The individual would save $90 ($100 minus the 10 percent tax) and earn $9 in interest.

Full Exemption of Expenses

The consumed-income tax suggests that all expenses incurred to generate future income, which is the definition of investment, should be eliminated from the tax base. This implies that all work-related expenses, including commuting expenses, educational expenses incurred to enhance future income, and day-care expenses, should be excluded from the tax base. These expenses are analytically equivalent to saved income. They represent forgone current consumption in an attempt to generate future income. This approach also implies that all business expenses (labor, plant, and equipment) should also be deducted in the year they are incurred rather than depreciated over time. This insures that the full cost of the investment, rather than a time-discounted cost, is realized in the tax deduction.

A word of warning is in order. It needs to be made clear that there is no such thing as a tax that does not damage productivity and economic growth. To invoke a term often used by economists, a “neutral tax” does not exist. At the very least, all taxation transfers the control of productive resources from the free market to government control, that is, from an institutional setting that will generate a more efficient use of resources to one that will generate a less efficient use of resources. What this means is that overall the economy, and therefore human welfare, always suffers as a result of taxation.

But is the sector too small? In an article titled “Yes, American Manufacturing Really Is in Trouble” (Huffington Post, February 11), free-trade critic Ian Fletcher says it is.

To judge whether a sector of the economy is too small, we need criteria. Fletcher writes: “Unfortunately, the only rational standard for how much America should produce is how much Americans wish to consume. Because the only way to consume is either to produce what you wish to consume, or produce something else you can exchange for it” (italics in original).

But if that were the only way, Fletcher should be content—yet he’s not. Why not? Because, as he well recognizes, it’s not the only way, and that’s why he wrote his article. He notes two ways that we consume what we get from foreigners besides selling them goods and services: 1) by selling them assets (these assets are produced, but that’s not what he means) or 2) by borrowing. He objects to both.

He writes: “And this is where American manufacturing is clearly falling short, because America is running a huge trade deficit in manufactured goods, and we don’t produce enough of anything else (raw materials, services) to cover the gap. So instead we borrow and sell off existing assets to pay for imports.”

Fletcher’s ideal is becoming clear: The “right” amount of manufacturing is achieved when the amount the United States spends on other countries’ manufactured goods (and I think he means to include raw materials and services) just equals the amount foreigners spend on our manufactured goods, services, and raw materials. In short, Fletcher’s ideal is a zero trade balance.

He’s almost right that if we have a trade deficit, which we do, we will have to borrow from foreigners or sell assets. Why almost? Because Fletcher leaves out two other possibilities. First is that foreigners will want to invest directly in the United States. Second is that they will want to hang on to some dollars: The U.S. dollar is still the closest thing there is to a world currency.

It’s true that the increases in foreign direct investment in the United States and in dollars held are substantially smaller now than the sale of assets and the increase in borrowing. So let’s grant that most of the trade deficit will be paid for with borrowing and asset sales. What’s wrong with that? In a later article, “The Biggest Bubble of All Has Yet to Pop” (Huffington Post, February 17), Fletcher explains: Americans will own fewer assets. That does seem like a problem, doesn’t it? Let’s dig further.

If the capital stock is growing quickly enough, even if foreigners own more of it, Americans might own more too. It’s true that private investment has declined, something likely due to President Obama and Congress making investors unsure about health care and other regulations in the future. Between 2008 and 2009 the value of the U.S. capital stock fell by about 2 percent. By the end of 2009 foreigners owned about $21.1 trillion of the $48.5 trillion U.S. capital stock–over 40 percent. Sounds scary, right? But it overlooks that Americans own $18.4 trillion of the rest of the world’s capital stock. So the U.S. “net international investment position” was negative $2.7 trillion, or less than 6 percent of the U.S. capital stock. Interestingly, even though “our” ownership of “their” capital is less than theirs of ours, in 2009 “we” made $121 billion more on them than they made on us. That suggests the U.S. government’s data underestimate the value of U.S. investments abroad or overestimate the value of foreign investments here, or both.

Bonds and the Trade Deficit

One of the main U.S. assets that foreigners invest in is Treasury bonds. If the federal government reduced its budget deficit, now running at more than $1 trillion annually, there would be fewer bonds for foreigners to buy. That wouldn’t necessarily cause our trade deficit to fall because if foreigners see private U.S. assets—corporate bonds, for example—as good substitutes for U.S. government bonds, they might simply shift to buying more. Still, private assets are unlikely to be a perfect substitute for government debt, and so reducing the budget deficit would probably reduce the trade deficit somewhat.

It’s also true that if we Americans increased the percentage of our income that we save, we would buy some of those bonds and buy fewer foreign goods and services, again reducing the trade deficit.

Fletcher recognizes these facts. In his February 17 article he writes: “It is indeed true that if we take our low savings rate as a given and ask whether we would be better off with foreign-financed investment or no investment at all, then foreign-financed investment is better.”

But Fletcher doesn’t want to take this low rate of saving as given. He wants a higher rate. Fine. There are two ways to accomplish this. The first is to reduce the budget deficits of the U.S. federal, state, and local governments. In 2009 they totaled a whopping $1.272 trillion, which exceeded net private saving (personal and corporate) of $945 billion. The result: a negative saving rate for the economy as a whole. Have the government spend less, and the net saving rate would probably increase. It’s still not clear, though, that we would manufacture more.

The second way to increase saving and thus reduce the role of foreign investment is for us individually to spend less and save more. Fletcher seems to like this idea, asserting that “domestically-financed investment is obviously better because then Americans, rather than foreigners, will own the investments and receive the returns they generate.” But how can he know whether it’s better for you to buy an iPhone or to put more money in your IRA? He doesn’t. Neither do I. I’m more humble than Fletcher: I want you to be able to choose. Do I trust your choice? Not necessarily. But I think you have the right to make even bad choices.

So what is my criterion for the “right” size of the manufacturing sector? Simple. The right amount of manufacturing is the amount that would be achieved if the government did nothing to distort people’s choices. Let’s focus on getting rid of government distortions and not attack the symptoms, if they are indeed symptoms, of those distortions.

How an Economy Grows and Why It Crashes is Peter Schiff’s most recent effort in that regard. Bypassing the academic crowd and avoiding an eye-glazing academic approach, Schiff and his brother Andrew have tried to grab readers’ attention with an amalgam of allegorical storytelling and current events. They aim to promote real economic comprehension.

The book’s introduction starts with a lucid explication of the key elements of Keynesian economics—showing how John Maynard Keynes, by making “something simple seem hopelessly complex,” paved the way for acceptance of “some very stupid ideas about what makes economies grow.” In chapter 1 the authors shift into allegorical mode, weaving a tale about a Crusoe-type economy based on fishing. Here they introduce the reader to the rudiments of capital theory. The story progresses logically from there. The use of capital leads to both greater wealth and income inequality. Then comes a cogent discussion of the counterproductive effects of forced income redistribution.

Next they turn to the role of saving—how it serves as the source of credit and a cushion permitting people to get through emergencies and how, contra Keynes, it is the true key to economic growth. In addition the authors correct the common misinterpretation of deflation—not as the disaster depicted by Ben Bernanke and his ilk, but as a key channel through which prosperity spreads. They proceed to describe the benefits of free trade, dissecting the canard that it is a job-killer and pointing out that “it is not the aim of an economy to simply provide jobs, but to create jobs that maximize labor productivity.”

Notable in their discussion of government is an endorsement of restricting voting to those who pay taxes, an idea going back at least to John Stuart Mill. They argue that retreat from this stipulation accelerates a nation’s downward trajectory into an inflationary welfare state. The Schiffs elucidate the unaccounted-for implications of the many popular policies dragging economies down this path. Included among those are the replacement of a commodity standard with fiat money, subsidization of loans to politically favored sectors of the economy, and so-called “stimulus” spending—all central elements of Keynesian monetary and fiscal policy.

They finish their allegory with the inevitable upshot of those policies (given the lack of political will to incur the short-term pain that would stave it off): the decision of our international creditors to cease enabling our profligate ways by redeeming our dollars, unleashing massive price increases, and pushing our standard of living off a cliff.

It’s well argued, but I wonder if the book is written at the right level for its intended audience. It is clearly not aimed at academics, which is too bad because many of them could use it the most. Rather it is aimed at noneconomists. Yet for the totally uninitiated I fear that it may throw too much at them too fast, without sufficient explanation. One can only hope they will be interested enough to seek the requisite explanations from other sources rather than throwing up their hands in frustration.

Also, I found the pervasive fish metaphor tiresome—not to mention that fish are too perishable to ever be used as a monetary commodity. (On p. 159 the Schiff brothers do mention the advantages of precious metals as money.) While I realize this is an allegory in which some literary license is permitted, the cost of this aspect of the story in reader confusion and lack of credibility may be high.

On the other hand I do like the way each allegorical chapter is followed by a takeaway that uses the principles presented to shed light on real-world events. Knowing that the authors of this book wrote it to share the economic insights that enabled them to predict the onset of our current recession, I hope my misgivings are unfounded because the lessons are ones all of us need to master.

This perception is misguided. In fact capitalism is fueled by creativity and makes possible a level of individuality never before seen in human history. The anthropologist Grant McCracken recently wrote that “capitalism is art, a transformational exercise that turns meaning into value and value back into meaning.” I think he’s onto something there, and viewing capitalism as creating meaning, like art, is a useful way to respond to the criticism noted above.

Creation of Value

That capitalist production is a “transformational exercise” should be fairly obvious: What entrepreneurs do is to take inputs and attempt to transform them into an output that is valued more highly than the sum of the values of the separate inputs (accounting for the time involved in production as well). A ladder is more valuable than a bunch of wood, some nails or screws, and some tools. Profit is the creation of value.

Note too the idea of “turning meaning into value.” The simplicity of the ladder example might hide it, but the hard part for the entrepreneur is figuring out what people value. One way of expressing this is that producers need to know what has meaning for potential buyers.

The goods and services we purchase are not really the ends we seek in the market — they are means for satisfying our various wants. The challenge for producers is to figure out what those wants are. This requires producers to try to understand the things that have meaning to consumers and then find ways to create them out of available resources. As McCracken says, producers try to transform meaning into value, which requires some elements of art in figuring out what carries meaning and how best to provide people with objects or services that embody it.

On the consumption side, the reverse is true. Capitalism makes it possible for us to better differentiate ourselves from others by providing an enormous variety of goods and services. This variety not only enables us to better fine-tune our purchases to our particular wants — which is itself a way of creating meaning in our lives — but it also lets us create and define who we are by the kinds of products we buy. As entrepreneurs create value by trying to anticipate what we want, we turn that value back into meaning by the patterns of consumption we undertake.

In the West most of us are wealthy enough that our day-to-day needs for food, clothing, and shelter are not pressing concerns. One consequence is that we can afford to make purchases that satisfy not just some particular want, but also the desire to create meaning in our lives. We spend money on our hobbies and interests, no matter how unusual they might be. We buy product lines that say something about who we think we are, or who we want to be, such as Apple products, hybrid cars, all kinds of clothing, and things like tattoos and hairstyles. We are artists creating ourselves through individualized consumption decisions.

Idiosyncratic Tastes

Market economies also produce goods that cater to the most idiosyncratic of tastes. Those with “minority” tastes, such as wearing Hawaiian shirts all the time or ties that look like fish, can find products that satisfy those tastes in the market. Imagine instead that we had to vote on what to produce according to majority rule. Much of what markets now produce to satisfy strange, unusual, or weird wants would never get produced. Markets make possible forms of creative individuality that alternative systems would not, and do not, tolerate.

Consumers take the values that entrepreneurs create and transform those products back into meaning for themselves. In some fundamental sense the creation of value and the creation of meaning are just two ways of looking at the very same process of production and consumption in a market economy. In other words, both entrepreneurship and consumption are acts of creativity, imagination, and art.

In that column I argued that the key to a healthy economy is production not consumption, and that the attention paid to increasing consumption during downturns is misguided.  I was accused of holding a naïve version of Say’s Law because I appeared to claim that “supply creates its own demand.”  However, I have written several pieces (examples here and here [pdf]) arguing that this is a misreading of Say’s Law.  His actual text shows the law is better rendered as “production is the source of demand”:  We cannot exercise consumption demands without having first produced value (or getting resources from those who have).

This argument hardly aligns me with the “interests of rich people and powerful business executives,” as Yglesias claims.  It applies to all producers of wealth, from minimum-wage workers to midlevel managers to the rich and powerful.  In a depoliticized, freed market, individuals cannot consume without having first produced (or having received voluntarily transferred resources from others). Yglesias is the one seeing sides where there are none.  Producers aren’t a distinct group — everyone in the market is both a producer and a consumer.

The ultimate source of wealth in society is producers who create value.  The hourly worker creates value by providing a marginal product whose value is greater than the real wage she is paid (though competition tends to compete this differential to a minimum).  The firm as a whole creates value by producing an output that consumers value more than the sum of cost of the inputs used by the producer, including the value of the time the production process takes.

Constant Innovation

All this value creation can be seen as forms of innovation.  As Deirdre McCloskey argues in her new book, Bourgeois Dignity, capitalism is best understood as a system of constant innovation.  Firms that figure out a better way to get consumers what they want, either by producing it with less-valuable inputs and/or changing making the final product more valuable to consumers, are innovators who create value and wealth.  Ongoing acts of successful innovation (as judged by genuine market profit) create wealth for both the innovator and the consumer.

The wealth for the innovator is the profit she earns.  The wealth created for the consumer comes as either lower prices through lower-cost production or improved and hence more-valuable goods.   In addition, workers who produce more-valuable goods and services see increases in their wages and hence their wealth. The value-creation that comes from the ongoing innovation of the market is what creates the wealth that makes consumption possible.

Notice that even though the producer clearly is thinking about the consumer when she innovates, wealth-creation does not require an already-existing increased power to consume.  An act of innovation alone produces wealth by cutting costs or adding value to a product.  Thus to suggest that my argument is undermined by the fact that the goal of production is consumer satisfaction is to miss the point.  Yes, producers produce because there are consumers who consume, but it is production not consumption that creates wealth.

Why Is Labor Idle?

This is no less true in a recession or during high unemployment.  The problem is not getting consumption power directly in the hands of idle labor.  The problem is whatever is making labor idle. Why is this wealth-creating potential lying around unused by owners of capital.  Again, consumers need not have additional wealth for firms to profit from innovation.  Why, then, do firms think they cannot do so?

There are several possible answers to this question, and just about all of them, in my view, are related to the misguided government policies of the last several years that have created an environment in which the private sector is pessimistic about the prospect of creating wealth.  Getting people back to work and returning the economy to wealth-creation will happen because production revives and not because we “stimulated” consumption.

Innovation by producers, not consumption, is what creates wealth in a market economy.  Producers know that simple truth, and I think most citizens know it deep down as well.  But sometimes the simplest truths are the hardest for the self-proclaimed elite to understand.

This belief is an inheritance of misguided Keynesian thinking.  Production, not consumption, is the source of wealth.  If we want a healthy economy, we need to create the conditions under which producers can get on with the process of creating wealth for others to consume, and under which households and firms can engage in the saving necessary to finance that production.

It’s tempting to say that this is really a “chicken and egg” problem; after all, what good is it to produce things if there’s no one there to consume them?  The way out of this circle is to recognize that we only have the power to consume if we have produced and sold something in order to acquire the means to engage in consumption.  Starting the analysis with consumption assumes one has already acquired means.  Contrary to that analysis, wealth is created through acts of production that rearrange resources in ways people value more than alternative arrangements. These acts are financed with savings that come from households refraining from consumption.

Putting more resources in the hands of consumers through a government stimulus package fails precisely because the wealth so transferred ultimately has to come from producers.  This is obvious when the spending is financed by taxation, but it’s equally true for deficit spending and inflation.  With deficit spending the wealth comes from producers’ purchases of government bonds.  With inflation it comes proportionately from holders of dollars (obtained through acts of production) whose purchasing power is weakened by the excess supply of money.  In neither case does government create wealth. Nor does consumption.  The new ability to consume still originates in prior acts of production.  If we want real stimulus, we need to free up producers by creating a more hospitable environment for production and not penalize the saving that finances them.

Blames It on Keynes

Historically it was Keynesianism that brought the emphasis on consumption into economics.  Before the Keynesian revolution the standard belief among economists was that production was the source of demand and that encouraging saving and production was the way to generate economic growth.  This was more or less the correct understanding of Say’s Law of Markets.  (See also James C. Ahiakpor’s article in the current Freeman). As J. B. Say himself wrote in the early nineteenth century:

[T]he encouragement of mere consumption is no benefit to commerce;  for the difficulty lies in supplying the means, not in stimulating the desire of consumption;  and we have seen that production alone furnishes those means.  Thus it is the aim of good government to stimulate production, of bad government to encourage consumption.

Of course “stimulating production” need mean nothing more than leaving producers free to seek out profits as they see fit within the standard classical-liberal framework of law.  It does not mean government should artificially benefit producers any more than it should encourage consumption.

The great irony is that leftists frequently argue that capitalism equals “consumerism.”  They think defenders of free markets believe that more consumption promotes economic growth; thus we are charged with providing the ideological cover that justifies the consumerism they see as deadening lives and wasting resources.  What the leftist critics miss is that economists never saw consumption as the driving force of economic growth and prosperity until the Keynesian criticisms of free markets became ascendant.

Thanks to Keynesianism, manipulating the elements of total income (consumption, investment, and government spending) became the focus of macroeconomic policy and economic development.  It was the Keynesians’ theoretical framework that led to the development of the relevant national income statistics and that implicitly informs the popular arguments for more consumption.

For over 150 years defenders of free markets saw consumption as destroying wealth, and saving and production as creating it.  They never argued that “stimulating consumption” was the path toward prosperity. Therefore they cannot be charged with justifying the “consumer culture.”  And the same is true of twentieth-century defenders of free markets such as Mises and Hayek.

If leftist critics want to decry the focus of modern economics on consumption, they should turn their sights on the Keynesian interventionists.

Why would increased saving reduce GDP? Saving, correctly understood or defined, is the acquisition of interest- or dividend-earning financial assets, such as bank deposits, certificates of deposit, mutual fund shares, bonds, and stocks. Thus saving is not cash hoarding but the transfer of funds from income earners to borrowers who spend the funds. Savings are the source of loanable capital sought by businesses, as Adam Smith in the Wealth of Nations well explains: “By what a frugal man saves, he not only affords maintenance to an additional number of productive hands, but like the founder of a public workhouse, he establishes as it were a perpetual fund for the maintenance of an equal number in times to come.” Also, “Capitals are increased by parsimony. . . . Whatever a person saves from his revenue he adds to his capital, and either employs it himself in maintaining an additional number of productive hands or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits.” Indeed, increased savings make increased borrowing at lower interest rates possible.

In his concluding paragraph, Gibson also quotes an explanation from Ludwig von Mises that is in accord with Smith’s argument and in contradiction to his earlier income-lowering claim: “There is but one means to improve the material well-being of men, viz., to accelerate the increase in capital accumulation as against population.” Gibson goes on to state: “Capital accumulation requires saving, saving requires confidence. . . .” I think he needs to acknowledge the error of attributing an income-lowering effect to savings or else explain the contradiction in the two paragraphs. We cannot get rid of the Keynesian nonsense that increased saving causes poverty—the so-called paradox-of-thrift proposition—by continuing to employ Keynes’s misconceived definition of saving to mean cash hoarding.

Warren Gibson replies:

Professor Ahiakpor quite reasonably questions my assertion that an increase in saving could temporarily suppress GDP. I lacked the space (and inclination) to explain this assertion in the article, but here it is: I agree with him that savings are invested in real assets, and I am willing to stipulate no growth in cash balances. And of course new investments do add to GDP. So it looks like a wash: some consumption is simply shifted to capital goods. But I suggest that if we consider the time structure of production we see a difference. Capital goods are priced at the estimated discounted value of the final products they are intended to produce, and because of this discounting the present value of new investments could well be lower than the consumption goods they replace. Only in the fullness of time will the productivity of the new capital work its way down to consumption, at which time we would expect increased GDP, other things being equal.

So why don’t they apply the same logic to the economy as a whole? The only tenable answer is that they are under the spell of the economic miseducation inflicted on the minds of economists and many among the general population by John Maynard Keynes. They believe that consumer spending drives the economy, without having stopped to consider from where consumers get the means to spend.

Consumption Doesn’t Need Stimulation

On their own—that is, in the absence of government handouts in the form of welfare payments or unemployment compensation (funded by taxpayer money)—people acquire the means to spend by earning income from producing and selling goods and services or directly selling their labor services. If they borrowed the money to spend, it must be from someone else who has earned income from production. And as Adam Smith long ago noted in The Wealth of Nations, “[C]onsumption is the sole end and purpose of all production. . . . The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it.”

Why else does anyone work other than to acquire the means to purchase goods and services? That is why consumption spending does not need stimulating. What we currently save out of our incomes is to enable us to smooth out our consumption spending over time or to acquire the means to increase consumption and/or our income-earning capacity in the future.

Such household investments may take the form of bank accounts or bonds to earn interest income, stocks to earn dividends, or educational skills to earn higher future wages and salaries. The only part of our unconsumed income that we do not devote to increasing our future capacity for increased consumption spending is cash hoarding; cash does not earn interest or dividends. But in normal times, when we are not too scared to keep our savings in bank accounts or to purchase stocks or bonds, cash hoarding constitutes a very minor part of our unconsumed income. Meanwhile, what we save is spent by borrowers of our savings, mostly producers of goods and services.

On the basis of these fundamental truths about how people manage their financial affairs and drawing on the wisdom of Adam Smith, Jean-Baptiste Say constructed the thesis now named after him, Say’s Law of Markets, in his 1803 Treatise on Political Economy. It is from production that people earn incomes to purchase those goods and services they themselves don’t produce:

Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have [acquired] this money itself by the sale of productions of our own. . . . It is then in strict reality with their productions that [people] make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands.

The law simply says that “productions can only be purchased by productions” (Say, Letters to Malthus, 1821).

Regarding the need for savings rather than consumption spending to promote economic growth, Say noted that:

The public interest is . . . not served by consumption, but it is served and served prodigiously by saving, and though it seems extraordinary to many persons, not being any the less true as a consequence, the labouring class is served by it more than anyone else. These persons think, perhaps, that the values which the wealthy save out of outlays on their personal pleasures in order to add to their capitals are not consumed [spent]. They are consumed; they furnish markets for many producers; but they are consumed reproductively and furnish markets for the useful goods that are capable of engendering still others, instead of being evaporated in frivolous consumption.

Failing to understand all this, Keynes made a fetish of consumption spending as the engine that drives an economy during the 1930s, especially in his famous book The General Theory of Employment, Interest, and Money (1936). He argued that Say’s Law applies only to an economy in which there is no unemployment or one in which money is not used as a means of exchange. Neither claim is true. However, many an economist has been hooked on Keynes’s miseducation ever since. In macro models legislated unemployment compensation is listed among “automatic stabilizers.” The thinking is that paying the unemployed so they would keep spending will sustain the economy’s so-called aggregate demand. Even if proponents of that view recognized that the government would have to pay the unemployed from its tax revenue (or borrowed funds), they still do not realize that total spending would not change. But unless the government borrowed the additional funds from outside the domestic economy, what it takes from purchasers of its bonds will not be available for private borrowers to spend on investment projects or for their own consumption. Put differently, variations in the level of government spending, besides the portion funded by external borrowing, do not change total spending in the domestic economy.

The Need for New Production

As for stimulating economic activity, it is not the level of consumer spending but new directions in production that make the difference. Entrepreneurs conceiving of new ways to meet economic necessities or desires in the marketplace create new incomes with their positive ripple effects in the economy. Meeting such needs requires that entrepreneurs find the savings, or loanable funds, to acquire the resources to engage in production. Of course, followers of Keynes’s mistaken 1937 view—“The investment market can become congested through the shortage of cash. It can never become congested through the shortage of saving. This is the most fundamental of my conclusions within this field”—do not recognize the necessity of savings to fund investment expenditures. But the fact is that the government’s taxing the employed or borrowing the community’s savings to pay people who are unemployed does not help entrepreneurs in their socially useful task of new wealth creation. This is also how we should recognize the failure of the $787 billion so-called stimulus of February 2009, the subsequent Cash for Clunkers program, and the first-time home purchasers’ subsidies of 2010 to stimulate economic recovery. The money to fund such programs has to be taken from the economy: There is no injection of new money by the government; it effects only a transfer.

Specialization and Trade

Adam Smith in The Wealth of Nations made the salient point: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.” The prudence is in the fact that households typically do not aim to be their own tailors, shoemakers, wine makers, homebuilders, or producers of all the numerous things they need, but rather specialize in those things they can produce at the cheapest cost and buy the others in the marketplace—the advantage of specialization and trade. That’s how Smith came to urge nations to adopt the wisdom of households in the management of their production and consumption activities and to reject mercantilist restrictions on trade and opt for free trade instead.

We can apply the same wisdom of households to the question of paying the unemployed. Just as no household would expect that giving money to any of its members to spend would stimulate wealth creation for the household, so it is for the economy as a whole. An economy is little more than the collective activities of households. It is ultimately the aggregation of household production and consumption expenditures that is called gross domestic product, GDP.

We also can learn from the experience of Europe. Its greater “generosity” in unemployment compensation does not produce less unemployment and greater economic growth but higher levels of unemployment and relatively poorer economic growth than in the United States. Extending the period of unemployment insurance compensation only assures that the unemployment rate stays permanently higher than the 4 to 7 percent range within which it fluctuated over the last 20 years or so until 2009. Arguing about the ballooning deficit may help stop the extensions, but that really is a side issue. The real point is that paying people who are unemployed simply discourages them from seeking and/or accepting alternative job offers quickly. And such payments do not change total spending in the economy.

It is truly a pity that followers of Keynes’s mistaken understanding of how a monetary economy works now claim the relevance of his ideas to our current economic situation and are implementing some of his misconceived policies.

(Yes, the poem came out two years before publication of Keynes’s General Theory, but one can see that Keynes’s way of thinking already was already in vogue.)

The lad tells the bishop:

“I want to be a Consumer,”
The bright-haired lad replied
As he gazed up into the Bishop’s face
In innocence open-eyed.
“I’ve never had aims of a selfish sort,
For that, as I know, is wrong.
I want to be a consumer, Sir,
And help the world along.

“I want to be a Consumer
And work both night and day,
For that is the thing that’s needed most,
I’ve heard economists say,
I won’t just be a Producer,
Like Bobby and James and John;

I want to be a Consumer, Sir,
And help this nation on.”

The poem is meant to be farce, but it also is a theme of Paul Krugman’s columns. If one can sum up all the present Keynesian claptrap into one sentence, it would be this: Americans need to consume more.

Should one doubt the close association of the poem with what the Keynesians are declaring, read on:

“I want to be a Consumer
And live in a useful way;
For that is the thing that’s needed most,
I’ve heard economists say.
There are too many people working
And too many things are made.
I want to be a Consumer, Sir,
And help to further trade.

“I want to be a Consumer,
And do my duty well;
For that is the thing that’s needed most,
I’ve heard Economists tell.
I’ve made up my mind,” the lad was heard
As he lit a cigar, to say;
“I want to be a Consumer, sir,
And I want to begin today.”

Last year, Hillary Clinton visited China and urged the Chinese central bank to continue to purchase U.S. government debt because “We are all in this together.” Clinton stated (in other words, of course): China is the producer, and the United States is the consumer, and this keeps the perpetual motion machine of a world economy going.

(Once upon a time, international trade involved the exchange of real goods, but today’s sophisticated economy has done away with that necessity. Paper for products will do.)

Clinton, in essence, was claiming that the responsibility of U.S. citizens is to consume Chinese products, and the Chinese should gratefully accept U.S. dollars. What do Americans receive? Why they receive computers and cell phones, clothing, and a million other items.

What do Chinese get for all of this? Why, they get jobs. (For lack of space, I won’t go into the current brouhaha about the value of China’s currency, which I will address in a future column.)

Never mind that Clinton advocated something akin to real exploitation, in which one group of people works for minimal compensation and another class of people receives goods without having to work for them.

If anyone really wants to understand the mentality behind the “stimulus” plans of former President Bush and President Obama, it is this: The United States must become first and foremost a nation of consumers, and the way to do it is for the government to provide dollars, Americans to quickly spend them, and people overseas to accept the dollars and keep working.

A fundamental tenet of economics is that the end of production is consumption. Unfortunately, Keynesian economists seizing the public microphone claim the purpose of consumption is to clear the shelves so producers will have something to do in the future.

So the lad apparently was right. The purpose of consumption is consumption, and the purpose of production is, well, production. Just ask the Keynesians.

Curious about what is so bad about gasoline that it was necessary to warn children, I bought it and found myself in an alternative universe of dreary ecological disasters. This was a far cry from the world of the classic picture books, such as what is undoubtedly today considered the criminally polluting tale of Mike Mulligan and His Steam Shovel by Virginia Lee Burton. Nor did it resemble the brightly colored and fantastic world in the books I read to my kids in the early 1990s. Even more depressing, when I dug further it turned out that What’s So Bad About Gasoline? is part of a series of “science” books aimed at elementary school kids that tell a tale of ecological catastrophe. These include Oil Spill! by Melvin Berger and Where Does the Garbage Go? by Paul Showers.

If these books are what kids grow up with today, we should hope they spend their time on video games instead of reading. The books are troubling because by ignoring economics and by focusing on eco-politics, they get the solutions to environmental problems wrong.

Worse, in the world these books present things don’t get better. We must always do more to repent for our environmental sins. As economist Robert Nelson observes, environmentalism in America has evolved into “environmental Calvinism.” Even worse, Nelson notes, it is “Calvinism without God,” as bleak a vision as one can imagine since we’re left only with an impersonal environment as the object of veneration. (Nelson’s The New Holy Wars: Economic vs. Environmental Religion is a great read.) Presenting consumption as ecological sin without showing the vast improvements in people’s lives produced by growing wealth ignores the great success of market economies and entrepreneurs.

Finally, the vision of the world these books present lacks human agency as anything other than motivating the mindless consumption that leads to ecological catastrophes. Not only is this a world missing entrepreneurs and inventors, there’s also no excitement to its vision of the future. Although I am still waiting for my personal jetpack, the world of the The Jetsons promised a future of excitement and fun rather than a grim time in which we merely replace our cars with hybrids. The optimism that prompted Julian Simon to term humanity “the ultimate resource” is missing from this literature.

Oil Spill! was first published after the Exxon Valdez event. It opens with a dramatic scene of the tanker hitting the reef in Prince William Sound. Missing from the story are the broken sonar system that should have alerted the crew to the impending collision, the overtired third mate in the wheelhouse because the union-protected captain was sleeping off a drinking binge, and the lack of sufficient crew. The spill just happens. Indeed, humans are a minor presence in the book—appearing on just eight of 29 pages of illustrations, only as a cleanup crew hosing down a beach, a family on a beach, people using energy, and a child writing her congressman. Oil Spill!’s solution to the devastation of nature is political action.

Kids reading Oil Spill! aren’t likely to be ready for a fact-heavy discussion of oil-transportation risks versus the benefits of energy consumption, the natural underwater oil seeps that could be reduced by offshore drilling, or whether using less electricity will really reduce oil spills, as the book suggests (oil-fueled sources account for under 2 percent of U.S. electrical generation).

Children do not learn that the profit motive is what drives inventors and manufacturers to improve products to reduce energy consumption. The U.S. economy has steadily become more energy-efficient: Per dollar of real GDP, energy use dropped by more than a third from the late 1970s to 2000. Compared to 1900 each unit of energy input in 2000 could provide four times as much useful heat, move a person 550 times farther, provide 50 times more illumination, and produce 12 times as much electricity. Moreover, oil spills like the Exxon Valdez or the BP disaster are exceptions rather than the rule and are more likely due to failures in regulatory schemes than to a lack of laws.

Where Does the Garbage Go? isn’t a new book, first appearing in 1974. Comparing the 1974 and 1994 editions reveals an interesting shift in environmental thinking. Originally, Where Does the Garbage Go? centered on a girl who went through her own trash to see what her family threw away. She found worn sneakers, potato peels, cans, bottles, and her old yoyo. She then visited her uncle on a farm, discovering that food scraps could be fed to pigs. The book generalized to the collection of garbage and its disposal in the ocean (showing children swimming in a polluted ocean), incinerators (children grimacing and rubbing their eyes from the smoke), and dumps (“a dirty place,” “a great big mess” with rats and “millions of flies”). After explaining recycling and showing crowds making more trash, the 1974 book concluded with the child narrator asking what the reader thought “we should do” about trash as she took her old yoyo from the trash and fixed it.

By 1994, however, the narrator was gone and the story was now presented as a school lesson. Dumps and ocean dumping were history. But, just as in 1974, “Waste never stops piling up.” Recycling and waste-to-energy plants could handle some of our trash, but “we must do more. We must stop throwing so many things away.” By the end children are depicted walking home from the grocery store holding string bags that “we never throw away” and use “over and over again.”

Set aside whether or not recycling makes economic sense, particularly in the forms advocated in Where Does the Garbage Go? No second-grader wants to read a cost-benefit analysis of curbside recycling programs. Let’s even forget whether there is a market for recycled products large enough to absorb our trash. The big problem in this book—and in the others as well—is the focus on making people feel bad about consuming goods because it creates “waste.”

Conspicuous Underconsumption

Consumption isn’t bad—it is how we are made better off by the goods and services we purchase. The great success of market societies is precisely that they make it possible for virtually everyone in them to consume at a rate greater than even kings and emperors did in even the recent past. It was Boris Yeltsin’s 1989 visit to a Houston supermarket, not a visit to a recycling center, that convinced him of the superiority of free markets.

Moreover, the bounty of a market economy is a relatively recent discovery. There was little change in consumption of calories anywhere in the world until about 1800 in western Europe. Only after the Industrial Revolution did the human condition experience a dramatic change for the better. The world’s most pressing problem is that there is too little consumption not too much. People living in poverty in societies that lack basic market institutions across the developing world need to increase their consumption not reduce it.

Simultaneously the worst and best thing about What’s So Bad About Gasoline? and its ilk is that they are excruciatingly boring. Boring is bad because energy isn’t a boring topic, and making it boring turns kids off to thinking about science and technology. To their credit the book’s author and illustrator try hard to make it interesting. The pictures are lively: glaciers melt and houses tumble into the ocean. But they aren’t enough because the eco-catastrophist version of energy is one in which people are passive and events inevitable.

That’s not how the world actually works, of course. Energy isn’t boring even for elementary school kids because it is crammed full of interesting discoveries, larger-than-life characters, and exciting events. The transformation of gasoline from a waste product into a valuable commodity is a series of exciting discoveries made by entrepreneurs and scientists who raised our standards of living and health. In transforming oil into gasoline, scientists repeatedly accomplished tasks no one believed they could—turning crude oil into hundreds of different products. Brilliant and interesting characters abound.

Unfortunately What’s So Bad About Gasoline? misses all this. There are no individuals in the story. A cast of anonymous people from the Middle East to China to the United States finds things to do with petroleum and gasoline, and then bad things happen because we’re using too much carbon-based fuel.

Presumably HarperCollins publishes books like Where Does the Garbage Go?, Oil Spill!, and What’s So Bad About Gasoline? because earnest parents want their kids to grow up with green values. They are just a small part of a large series from one publisher, and my search for these books soon had Amazon recommending dozens of other similar titles. Worse, it is not just in these books that a future of ecological gloom and doom is being taught. Michael Sanera and Jane Shaw’s Facts Not Fear: A Parent’s Guide to Teaching Children About the Environment documented the extent of the problem of teaching children to fear the future environmental catastrophe. For kids between kindergarten and 12th grade the dominant message in schools is: “The earth is badly polluted, the rain forest is about to disappear, and global warming will submerge New York City with floods—to name a few of the imminent catastrophes,” all problems caused by their parents, who “have brought the earth to the edge of doom.” Scientists and engineers are not problem solvers who make life better but evil exploiters of the environment. Congressmen solve problems.

How do people who believe humanity is indeed the ultimate resource rescue the future? We’ve got two key advantages over the prophets of doom. First, our stories are more interesting. Free societies have room for people to do things—to discover new ideas and invent new products. Children are engaged in a process of discovery about the world around them and the narrative of discovery is more exciting than one of catastrophes. Active beats passive for almost everyone, and free markets are active. Freedom and free enterprise are just much more interesting than the alternatives.

Second, “environmental Calvinism” is even less fun than the original Swiss version. Given a choice, kids’ dreams are not going to be about sorting trash into recycling bins but about personal jetpacks. Because we’ve got a more interesting story, we’ve got a chance to capture young people’s attention. If you spot a neighbor’s or relative’s young kids glumly reading Oil Spill!, slip them a life of Thomas Edison or a even Mike Mulligan and His Steam Shovel (still in print!) and most will opt for the excitement of markets, invention, and action over the gloom of environmental pessimism. If parents read stories of action, invention, and excitement, they might even think twice about their own gloomy outlooks.