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Thursday, May 5, 2016

Keynesianism Is Not a “Big Government” Theory

The Model Is Wrong, but Not Because of Its Political Ideology

Before getting into this post, let me remind you of previous pointless debates, such as whether “Islam” is “really” a this or that sort of religion. I hope my readers can see the pointlessness of those debates. Similarly, I do understand that many Keynesians, and also many anti-Keynesians, think that Keynesianism is a sort of big government ideology, at least when compared to new classical economics, monetarism, Austrianism, etc.

So there is a sense in which the title of this post is wrong. If Keynesians act as if their model has big government implications, then in a sense it does.

So what do I mean? I mean that the technical aspects of the model have no big government implications, and that people who claim otherwise are simply using bad logic. To use the Islam analogy, I’m looking at the Koran. Here’s the Economist:

The fundamental reason for Europe’s low interest rates and bond yields is the fragility of its economy. Its unemployment rate is stuck at 10%. While the ECB has been doing what it can to press down the accelerator, however, the austerity preached by the likes of the German and Dutch governments has slammed on the brakes. For years, Mr Draghi has been saying that monetary policy alone cannot speed up the economy, and that creditworthy governments must use fiscal policy as well, ideally by raising public investment. If Mr Schäuble wants higher yields for German savers, he should be spending more money. Instead, his government is running a budget surplus.

I have lots of problems with this:

1. The Keynesian model is wrong, fiscal stimulus is not a good idea. The Economist is flat out wrong when they claim, “the ECB has been doing what it can,” that doesn’t even pass the laugh test. If they don’t know how to do more, then please call me in for an interview and I’ll show them.

But in this post I’m not interested in bashing the Keynesian model, and for the rest of the post I’ll assume I’m wrong, and the Keynesians are right. Fiscal stimulus is needed.

2. Fiscal stimulus does not mean “more spending” as the Economist claims, and as hundreds of other recent news articles claim, it means a bigger budget deficit. I don’t think fiscal policy ever makes much sense, but if I were wrong, I’d always favor tax rate changes, never spending changes. There are no big government implications from pro-cyclical tax rates.

3. Some claim that spending changes are more powerful, but that’s probably wrong, and irrelevant even if it’s right. Romer and Romer showed that tax changes had a surprisingly large multiplier effect, which you’d expect due to their supply-side effects. (There’s still no agreement as to the relative size of tax and spending multipliers.) Some people oppose tax cuts because they are regressive. But that’s also wrong; tax cuts can involve lump sum rebates, as with the 2008 Bush stimulus, or higher EITC, etc. The regressivity or progressivity is totally up to the government.

4. And even if I’m wrong and spending changes have a bigger multiplier effect, you should still never use spending increases. Just make the tax cuts bigger. Spending changes should always reflect classical cost/benefit considerations; they should never be used to boost AD.

5. Some Keynesians argue that government investment is more justified when interest rates are low. I hope by now that everyone sees that as a basic Econ 101 error, reasoning from a price change. Interest rates are often low precisely because the productivity of new investments is lower than usual.

6. Some Keynesians suggest that more infrastructure can be justified right now on cost/benefit (NPV) considerations. Fine, but don’t pretend that that has anything to do with Keynesian stimulus. Even anti-Keynesian economists agree that investments are justified if the benefit exceeds the costs, and that’s true even when there is no need to boost AD. If the term “stimulus” is to have any coherent meaning, in the sense that Keynes intended, then it must mean boosting the deficit in a way that would not be justified under classical cost/benefit considerations, but only becomes worthwhile when taking account of the expected impact on AD. Otherwise, you are just doing classical economics.

7. And even if everything I said above is totally 100% wrong, I’m still right, and the Keynesians and anti-Keynesians are still wrong: Keynesian economics is not inherently a big government model. It doesn’t call for bigger government, it calls for more countercyclical government. Thus if under classical assumptions you favored government spending 36% of GDP, with 4% of that infrastructure, a Keynesian who rejected all of my arguments above might favor spending of 34% during booms and 38% during recessions. The infrastructure spending would be 2% of GDP during booms and 6% during recessions. (In practice, other spending is also somewhat countercyclical; I’m just trying to simplify my example.)

So even if everything I said in points 1 through 6 is completely wrong (and they aren’t all wrong), the assumption that Keynesianism is a big government model is not based on anything in the model itself, but rather the (false) perception of both Keynesians and anti-Keynesians.

What can we infer from this widespread misconception? One possibility is that the model is being misused. Another is that people are confusing battles over the size of government with battles over stimulus. This might explain, for instance, why Paul Krugman favored higher taxes in 2013. He believed that a tax increase would lead, in the long run, to higher spending — which he prefers.

But I would caution readers that there are many more conservative Keynesians than most people assume. When people use the term “Keynesian,” they often instinctively think of progressives, but unless I’m mistaken, most conservative economists (Mankiw, Feldstein, etc.) also think of macro issues using a Keynesian framework. There is nothing necessarily “big government” about that theoretical framework.

I am a libertarian who dislikes Keynesian economics, but not for “anti-government” reasons. If you could convince me that it worked in a technical sense, I’d immediately favor tax cuts in recessions and tax increases in booms. I’m eager to be converted; I want to be a Keynesian. So show me the evidence.

This post first appeared at Econlog.

  • Scott B. Sumner is the director of the Program on Monetary Policy at the Mercatus Center and a professor at Bentley University. He blogs at the Money Illusion and Econlog.