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Friday, June 25, 2010

The Failure of Keynesian Economics

How Can Anyone Still Believe Keynes's General Theory?

That anyone can still believe Keynes’s General Theory holds any answers to the world’s economic problems is one of those sad facts that make one realize just how difficult it is to gain headway in the dismal science. An article on John Maynard Keynes in the Washington Post late last year, which argued that “Keynes’s work on the Great Depression was remarkably relevant to the dilemma Bush and Greenspan face now,” is a reminder of just why our economic difficulties seem to multiply rather than diminish.

That Alan Greenspan thinks of the General Theory as his font of economic knowledge only adds to the depressing quality of this article. There it said that “the Fed Chairman has been known to rise from his chair midconversation and read aloud relevant passages from that 65-year-old book for visitors.” It is anyway quite clear from the actions he takes that Greenspan does think this way, but it is only one more indication of just how deeply ingrained Keynesian theory has unfortunately become.

Even the simplest distinction between public spending and tax reductions seems too difficult. It is all stimulus, and in the structure of a Keynesian model it all comes to the same thing. Yet the two could not be more different. Tax cuts move expenditure out of the hands of the public sector and, so long as the budget remains in surplus, add to the momentum of the economy.

In contrast, unproductive public spending pulls an economy down with a relentlessness apparently impossible for any Keynesian economist to fathom. Such public spending, especially if it takes budgets into deficit, inevitably makes matters worse.

Keynes’s only interest in writing the General Theory was to encourage greater levels of public spending. He had been an advocate of higher spending for a period going back more than a decade by the time his magnum opus was finally published in 1936. There is nothing Keynesian about tax cuts. Tax cuts were never on Keynes’s agenda, and to infer that lowering taxation is in any way a “Keynesian” approach is an anachronism read backwards into what might have been said instead of what actually was said.

And we have an example of such Keynesian expenditure policy before us, if anyone would care to look. Japan has suffered under the effects of Keynesian demand stimulation for almost a decade now. The effect has been to take the relatively mild slowdown experienced internationally at the beginning of the 1990s and turn it into an ongoing, ever-deepening recession that shows not the slightest sign of retreat.

Japan is the paramount example of what happens through public-sector spending. There have been no end of pseudo-explanations for what has been an unexampled disaster. The rise in public-sector spending and the rise in the level of public debt have left the Japanese economy floundering. There will be no escape until the Japanese recognize the nature of the problem and bring their budget back into surplus and start to wind the level of public spending back.

Such a profound demonstration of the incapacity of Keynesian theory to provide useful policy guidance ought to have kindled somewhere a recognition that the theories now propagated in one textbook after another leave something to be desired. That this is not so only presents yet one more instance of how beliefs will persist even in the face of no evidence that they describe reality.

To find that the head of the Federal Reserve in the United States is a devotee of Keynes should be a further example of how poorly based monetary policy is. That we are now in serious risk of a global recession is largely related to the decisions of the Fed over the past two years. Other central banks throughout the developed world have followed the same processes, which have led to the same sorry outcome.

It is the modern Keynesian model that provides the theoretical advice that leads economies one after the other to adopt policies that do not work. We can keep applying these theories year in and year out if we like, but if we do, the hope must be that at some stage it will be recognized that these policies continuously lead us into outcomes entirely different from those that were supposed to occur and that alternatives to the current mismanagement of economies everywhere are possible and need to be put in place.