You Do Not Bake a Cake by Eating It

On the consumption-investment tradeoff and the Keynesian inversion of reality.

A cornerstone of Keynesian economics is the idea that consumption can “stimulate” the economy.

To clarify the multitude of errors in the assumptions and the logic behind this conclusion would require a full book. My goal in this post is to address just one element (and an important one): To explain why investment and consumption are mutually exclusive and what this means for the Keynesian idea.

To produce is to create something of value (utility) to human beings. You can produce for yourself directly (go fishing and eat the catch) or you can sell your products to a fellow man (go fishing and sell the catch), getting in return a token proving that you have produced but not yet consumed — money.

The final purpose of production, of course, is consumption. When you consume, you “cash in” on the value produced and you realize its utility — you eat the fish to nourish your body.

Properly defined, consumption, therefore, means the destruction of value. You do not consume a fish when you buy it. You consume a fish when you eat it. And by eating it you realize— hence destroy — its value (utility).

This provides us with precise definitions of two fundamental economics concepts:
Production = Creation of value (utility)
Consumption = Destruction of value (utility)

We have also seen that production necessarily precedes consumption. To consume is to consume something that has been produced. If not by you then by someone else.

A rational man consumes a value for one of two reasons:
1) To benefit (realize utility) today
2) To increase his ability to produce tomorrow

You can use wood to light a fire to keep you warm and cozy or you can use wood to build a boat which will improve your fishing output. Both choices consume the wood (although at different speeds). The first yields utility directly, the second yields utility indirectly through higher production in the future.

A precise way to label the two would be “unproductive consumption” and “productive consumption”, but in practice, they are simply called “consumption” and “investment”,

It is nonetheless important to keep in mind that both are, in the strictest sense, acts of consumption— of destroying previously produced value. What separates them is the purpose directing their destruction — immediate gratification or future production.

Clearly (and by definition), only investment can increase production hence “stimulate the economy”. And, clearly, the greater the share of our previously produced value we consume for utility today, the smaller is the share we can invest for higher production tomorrow.

This means that consumption is in fact the antithesis to stimulating the economy.

Keynes’ theory is not just wrong as in “slightly off”. It is the opposite of the truth. A complete inversion of reality. You do not bake a cake by eating it.

Rambling my way down the Bitcoin rabbit hole.