All Commentary
Wednesday, September 22, 2010

John Maynard Keynes, R.I.P.

The late revered British economist John Maynard Keynes, whose 1936 treatise, The General Theory of Employment, Interest, and Money, changed the way many economists think about recessions, once wrote that “in the long run we’re all dead.” Well, maybe so . . . for everyone but Keynes.

Keynes’s ghost has haunted the halls of the Bush II and Obama administrations, where various “stimulus” packages were concocted. The Keynesian arguments undergirding the fiscal stimulus froth over the past two years went remarkably unrecognized in the media for their one-sidedness. The basic stimulus argument goes something like this: If the federal government engages in deficit spending during a recession, the added government expenditures (unaccompanied by tax increases) will boost “aggregate demand.” Greater federal spending on a road, for instance, will create jobs for construction workers, who can be expected to spend some if not all of their additional income on, say, bread. Bakers now will have more to spend on, say, cars and so on.

National income stimulated by the initial government road project can grow by some multiple of the expenditure, the theory says. It can even be wasted on pork-barrel construction projects like bridges to nowhere, according to Keynes. He even dared to advocate that the government bury dollars in bottles. Entrepreneurs could then be expected to spend money digging up the bottles, unleashing the multiplier magic and reducing unemployment (in the same illusory way).

A stimulus package (and budget deficit) of, say, $1 trillion would morph in short order, stimulus backers have assured us, into a minimum of $1.5 trillion in additional national income—maybe even into $4 trillion or $10 trillion. Pick your multiplier, because no one in Washington or academe really knows what it is. Even the best of econometricians can’t accurately assess the multiplier when the current crisis is “unprecedented,” as widely claimed.

Fantastic, wouldn’t you agree? Keynesianism offers the proverbial free lunch several times over.

But if it sounds too good to be true, it is. If such income growth were possible, the country and the world would now be awash in prosperity, given that the federal government increased the national debt by $1.88 trillion in fiscal 2009 and could run deficits of $1.6 trillion and $1.3 trillion in fiscal 2010 and 2011, respectively. Between 2012 and 2015 it will add at least another $3 trillion to the national debt. Why not go for even greater deficit spending, if Keynesian theory worked so magically? Of course, many Keynesian enthusiasts have recommended stimulus packages two and three times what the Bush and Obama administrations sought two and three years ago, with little to no recognition that an escalation in the size of the deficit can, at least beyond some point, curb any multiplier effect (if there were the prospects of a positive one) as the budget deficit rises and crowds out expenditures in private sectors of the economy.

In the 1960s Keynesianism was followed as fiscal religion, but by the 1970s economists found it to be a snare and delusion for a simple reason: The political version of Keynesianism is a one-sided theory, with almost total emphasis on what the federal government spends. It pays virtually no attention to the potential private-sector offsets to the greater deficit spending by government or to how current fiscal policies could have negative long-run real income effects that can feed the current generation’s expectations of impaired futures. Keynesianism, in the form practiced in political circles, has no appreciation for how people’s expectations can affect their current spending and investing plans.

The late great economist Milton Friedman frequently peppered Keynesian enthusiasts in the 1960s and 1970s with a remarkably simple question that needs to be remembered today: Where does the government get the money it spends on roads (or bridges to nowhere)? Friedman followed with an equally revealing observation: When the government engages in deficit spending, it must borrow the extra funds from someone who could have spent them on private-sector projects. An increase in government spending could be totally offset by a decrease in—or a “crowding out” of—private spending, as lendable funds are diverted from private to government uses. The net effect can be no net increase in aggregate demand—and no multiplier effect. Indeed, with the inevitable waste in government stimulus projects, the multiplier effect could as easily be negative as positive.

Okay, in a down economy some of the funds the government borrows to cover stimulus expenditures might have remained idle, which can mean that the increase in government spending is not totally offset. But Friedman still has a point: The multiplier effect of greater government spending will be muted at least somewhat and maybe in large measure. Commentators who tout the glories of stimulus packages and bemoan the difficulty that small and large businesses and consumers have been having in finding credit never seem to make the causal connection that government borrowing can dry up, and has dried up, credit for nongovernmental purposes. Why should banks loan their available funds to people for risky private projects when they can loan their funds at little risk to the government, with 300-million-plus Americans it can tax to cover the debt?

The Piper Don’t Take Visa

Keynesian policy advocates rightfully assume that if the government hikes taxes along with expenditures, the stimulus effects of the added government spending will be seriously muted, maybe negated. The problem is that American taxpayers aren’t the fools the Keynesian advocates would like to think they are. With the potential of a doubling of the national debt over the next ten years, many not-so-stupid Americans can anticipate that the fiscal piper will have to be paid in the future—with higher tax rates on future incomes. The anticipation today of those higher future tax rates can dampen private demand, as people set aside savings for future higher tax payments and as they refrain from making all the investments that can translate into higher future incomes—which will be taxed at higher future rates. And higher tax rates imposed currently on the rich can affect many now poor Americans’ saving and investment plans because they expect to be not-so-poor, and maybe rich, in the future. In short, the anticipated future tax rates will be another offset to today’s stimulus expenditures.

Then you have the threat of future inflation from today’s fiscal profligacy. The anticipated higher inflation is seen as a wealth tax. If the government has little debt, it gains little by hiking the inflation rate to lower the real value of its debt. However, when the debt grows to enormous levels, as already budgeted, the government’s temptation to inflate away its own debt—and the wealth of bond holders—grows concomitantly. And we must not forget the lessons learned in the inflationary 1970s: Inflation, and inflationary expectations, can have debilitating effects on the real economy—in people’s real income and real income expectations and, thus, on current demand.

Of course, if debt holders begin to worry that the real value of their debt will depreciate due to any future orchestrated government inflationary policy, all those foreign bondholders—most notably, the Chinese and British—might lose confidence in the international value of the dollar, which can cause them to dump their dollar-denominated bonds on international money markets, which in turn can lead to a deterioration in the international value of the dollar and to a reduction in the real incomes of Americans across the board—and to contraction in private demand, yet another offset to government stimulus spending.

Perverse Politics

Even if Keynesianism had validity, we would still have to worry that the politics of the day would pervert the goal of reviving the economy as politicians fall over themselves to pack “stimulus packages” with pork, designed mainly to stimulate the private economies of their supporters and not the national economy. (Indeed, that is what happened). As economists James Buchanan and Richard Wagner argued long ago, Keynesian economics provides a grand excuse for politicians to do what they love to do: spend other people’s money without having to incur the current political costs of asking them to cover the expenditures with higher taxes. Make no mistake about it, Keynesianism has the potential of transforming the United States in the not-too-distant future into a financial basket case much like Greece, Spain, and Ireland are today.

The Keynesian recovery prescription never gets sillier than when, as noted, advocates claim that the economic merit of the funded government projects is of little consequence. What counts for them is more spending. That couldn’t possibly be true, given Keynesian insistence that private aggregate demand is inextricably tied to aggregate real income. If a bridge to nowhere is built, the bridge is obviously of no economic value, which means it adds nothing to national income. Its construction must draw resources at least some (if not all) of which could have been used to produce something of real value to people. Bridges to nowhere can only undermine any potential Keynesian multiplier effect. If anything, bridges to nowhere must have a negative multiplier effect through the effect of the impairment of long-term income growth over time through the depression of aggregate demand.

But Keynes and his followers failed to appreciate the extent to which the long-run effects of short-run policies can affect people’s wealth and income expectations, which in turn can undermine their current buying decisions. If people’s expected future incomes and wealth holdings are reduced (from what they would otherwise be), then surely Keynesians would, for the sake of consistency in argument, have to conclude that current private consumption and investment demand would also be suppressed, which would partially negate the so-called stimulus packages.

Finally, when a national economy gets seriously out of whack as happened over the last decade—with housing prices rising to unsustainable levels because of an unsustainable credit binge, with the rising housing prices fueling the demand for big-ticket consumer goods as homeowners used their houses as ATMs—then the only route to recovery is a painful one, with falling housing prices, lost jobs, and foreclosed homes. Ownership of houses, office buildings, and plants must be shifted from those who can no longer afford them to those who can afford them and can use them productively and profitably at the lower prices.

So much of what the government has done under the guise of stimulating the economy has been directed at retarding the required adjustments—and therefore preventing the recovery. The government has worked hard to prevent housing prices from falling as far as they must by offering tax credits to first-time homebuyers and slowing the pace of home foreclosures. The Cash for Clunkers program has been a policy clunker in itself, given that it caused a minor boom and bust in automobile sales, just as the homebuyer tax credit distorted sales of houses over time. These are hardly the kinds of stabilizing forces the economy needs in times of instability.

Then, of course, the federal government has chosen to fight the devastating consequences of the private credit binge of the last decade with a credit binge of its own (with nearly one out of every two recent budget dollars financed with debt, or leverage). If the private credit binge gave rise to the moral hazard of excessive risk-taking in the private sector (by banks, nonbanks, homeowners, and credit card holders), should anyone not expect the same excessive risk taking in the political sphere when the government heavily leverages its current spending? Such risk-taking shows up in the government’s adopting the mantra of Keynesian stimulus economics even when it has little promise of yielding the results promised and carries the nontrivial risk of damaging the future growth path of the private economy.

Given all the Keynesian hype over the past two to three years, one fact stands out: The recovery has been weaker than what would have been expected from the promises of Keynes’s devotees.

Nevertheless, a recovery (at this writing) appears underway, albeit more delayed than past recoveries. But, as argued here, everyone should harbor deep skepticism that the current weak signs of recovery can be traced to the stimulus packages of the last couple of years, especially since the rate at which displaced workers have been finding new jobs has been the most sluggish of all recessions since World War II. This is partially because government policies have gradually increased the long-term costs of firms hiring workers, with the most recent imposed burden being the effective nationalization of health care and health insurance.

Think the analysis here is pie-in-the-sky theory? Well, Harvard macroeconomist Robert Barro has estimated that the five-year effects of $600 billion in fiscal stimulus over the past two years will come at a cost of $900 billion in reduced private demand. That’s hardly the free lunch the country has been promised.

The Obama administration has not been shy in its first year about floating a variety of tax-hike proposals, supposedly for higher-income groups. And the expected federal budget deficits harbor threats of major future tax increases, as a growing list of researchers are finding. For example, the Congressional Budget Office projects that under current law (with marginal income tax rates unchanged), the national debt will almost double, rising by more than $11 trillion, between 2009 and 2020. Researchers at the Tax Policy Center figure, optimistically, that if the annual deficits are reduced to 2 percent of GDP between now and 2020 and if all tax rates are raised proportionately for all income groups, the lowest federal income marginal tax rate would have to rise from 10 to 15 percent and the highest marginal rate would have to rise from 35 percent to 52 percent. If the deficit were lowered only by raising the top two marginal tax rates, now 33 and 35 percent, those top rates would have to go 86 and 91 percent—which of course might actually worsen the deficits, given that the current “rich” and the “rich-wannabes” would have little incentive to work, save, and invest.

The country will learn anew an old lesson: Don’t count on the federal government to wave away the country’s economic troubles with some refurbished fiscal wand. The wand didn’t work in the 1960s and 1970s (it only contributed to “stagflation”). The wand is an illusion that should have died with Keynes long ago. We will also relearn the oft-repeated wisdom of Keynes when he wrote, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

How true, how true! Regrettably.

  • Richard McKenzie, an economics professor and the Walter B. Gerken Professor of Enterprise and Society, has authored 30 books and is a nationally recognized authority on the Microsoft anti-trust case. His research focuses on economic policy issues. He is currently writing a book on In Search of a Defense of Rational Behavior in Economics.