A Keynesian Fantasy Land

“Liberal” economists and pundits complain incessantly that the recovery from the Great Recession is weak, and in jeopardy, because the federal government hasn’t spent “enough” money. (See this for some examples of the “liberal” view.) How much is “enough” for Paul Krugman et al.? It is always more than the government spends, of course.

Why should that be? The blindingly obvious answer — but not obvious to Krugman and company — is that demand-side fiscal policy (i.e., government “stimulus” spending) is ineffective. If the economy depends on government spending, how does one explain the decades after the Civil War, when government spent less than 10 percent of GDP (vs. today’s 40 percent), while America’s economy grew faster than at any time in its history? It took World War II and regime change (the disruption of the New Deal by the war) to end the Great Depression. Mr. Roosevelt’s adoption of Mr. Keynes’s hole-digging prescription (the Civilian Conservation Corps and similar make-work projects) had nothing to do with it. Mr. Roosevelt may have been an excellent marketeer, but he was a dismal economic engineer.

This is not to reject supply-side fiscal policy: tax-rate reductions. When tax-rate reductions are prospectively permanent — as opposed to one-time tax rebates and “holidays” — they can and do spur economic growth. Christina Romer, former chair of Obama’s Council of Economic Advisers, once proved it — though she developed a convenient case of amnesia when she became a proponent of “stimulus.”

As any reputable economist will tell you, however, the best that one can expect of a temporary increase in government spending is a temporary increase in economic activity; it is a stop-gap until the economy recovers on its own. (And a reputable economist, unlike Krugman, will also tell you that a permanent increase in government spending diverts resources from productive uses — uses that yield economic growth and satisfy actual economic wants — toward less-productive and counter-productive ones, including the creation of paper-shuffling, regulatory bureaucracies.)

Despite the promises of Obama, Romer, and company, the “stimulus” has evidently failed to do much — if anything — to alleviate the Great Recession and its lingering aftermath. (See this, this, and this, for example.) Thus the wailing and gnashing of teeth by Krugman and company — who want to replicate the failure on a grander scale.

WHY THE “STIMULUS” FAILED TO STIMULATE: GENERAL OBSERVATIONS

What went wrong? Anthony de Jasay offers a piece of the explanation:

…In Keynesian parlance there is the multiplier effect and it is greater than 1. As long as there is spare capacity (unemployment) in the economy, the government ought to go on spending more, working through the multiplier, because the extra private saving takes care of the government dissaving and the extra consumption is, so to speak, a welcome windfall gain. Timidly refusing to generate it is criminal waste.

Despite truculent voices to the contrary, the Keynesian logic is faultless in that the conclusions do follow from the assumptions. Why it does not really work and why it singularly failed to work in 2009-2010 and maybe beyond, is that other things do not remain equal. Part of the extra spending stimulus fails to stimulate domestic income because as much as 0.3 of the multiplier might leak out through extra imports. Much of the rest may be offset by industry taking fright of the rising budget deficit and reducing investment, and consumers striving to reduce their indebtedness producing some saving to balance the government’s dissaving. The total effect of higher imports and lower investment might be a multiplier barely higher, or maybe even lower, than 1 and the stimulus stimulating nothing except the national debt. This is not the fault of Keynes but of those whose macro-economics exist in a fantasy land. (Library of Economics and Liberty, “Micro, Macro, and Fantasy Economics,” December 6, 2010)

Generally,

[t]he available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. (Robert J. Barro and Charles J. Redlick, “Stimulus Spending Doesn’t Work,” WSJ Online, October 1, 2009)

(For more on the subject see Barro’s “Government Spending Is No Free Lunch,” WSJ Online, January 22, 2009.)

WHY “STIMULUS” FAILS: SPECIFIC REASONS

Altogether, there are six reasons for the ineffectiveness of Keynsesian “stimulus.”

1. The “leakage” to imports, as indicated by de Jasay.

2. The disincentivizing effects of government borrowing and spending, to which de Jasay alludes.

As de Jasay suggests, industry (and the high-income earners who finance it) are being cautious about the implications of additional government debt. As I say here,

the sophisticat[ed] … institutions and persons who have the greatest interest in government’s actions [are] large corporations and persons in high-income brackets. They will react to government borrowing as if it would affect them and their heirs (corporate and individual).

That is to say, even if additional debt does not crowd out private-sector borrowing to finance business expansion, it will nevertheless inhibit investments in business expansion. This inhibiting effect is compounded by the reasonable expectation that many items in a “stimulus” package will become permanent fixtures in the government’s budget.

3. The timing-targeting problem.

The lag between the initial agitation for “stimulus” and its realization. In the extreme, the lag can be so great as to have no effect other than to divert employed resources from private to government uses. But even where there is a relatively brief lag, “stimulus” spending is essentially wasted if the result is simply to divert already employed resources from private to government uses.

The timing-targeting problem is one that strident Keynesians and their unsophisticated disciples in the media seem not to understand or care about. (They are happy as long as government “does something,” regardless of the cost.) The problem arises from the fundamental flaw in the Keynesian analysis: Economic output is portrayed as a homogeneous commodity, one that can be characterized  in terms of aggregate demand (AD) and aggregate supply (AS). Accordingly, in the Keynesian orthodoxy, all it takes to stimulate AD is to pump in some additional government spending (dG), and the rest takes care of itself.

Arnold Kling calls it “hydraulic” macroeconomics:

Once upon a time, Joe lived in Keynesiana, where he was a representative agent.

Joe worked in a GDP factory, making GDP. Every Monday morning, he went to work, and he worked five days a week. He was paid $1 for every 24-minute segment he worked, and he worked 100 segments (40 hours), so he earned $100 a week. Every Friday afternoon, Joe cashed his paycheck and went to the GDP factory outlet, where he spent it all on GDP.

One day, Joe decided that he needed to accumulate some savings. He made up a rule for himself. Knowing that he needed to consume at least $40 of GDP each week, he decided that his rule would be to save 20 percent of everything he earned over and above that $40. So the first week, that meant saving 20 percent of $60, or $12. So he cashed his $100 paycheck, but that Friday afternoon he only spent $88.

Next Monday, morning, Joe’s boss had some news. “A funny thing happened last week. We sold 12 percent less GDP than usual. So this week, we’re gonna put you on a short week. You work 88 segments, instead of 100.”

Joe was disappointed, because this meant he would only be paid $88 this week. Sticking to his new rule, he resolved to save 20 percent of $48, or $9.60. So that Friday afternoon, he cashed his $88 paycheck and spent $78.40.

Next Monday morning, Joe’s boss said. “Well, golly, it looks like we sold even less GDP last week. I’m afraid we’ll have to cut you back to 78.40 segments this week.” Still following his rule, Joe resolved to save 20 percent of $38.40, or $7.68. So he spent only $70.72 at the GDP factory outlet that Friday.

Seeing where this was going, the country asked Krug Paulman, the famous economist, what to do. He said, “The stupid people are saving too much. We need government to spend what the idiots are not spending.” So the government borrowed $29.28 from Joe and spent it at the GDP factory outlet.

Now, when Joe came to work on Monday morning, his boss said, “Good news, we sold 100 percent of what we used to sell, so you can work 100 segments this week.” Sticking to his rule, Joe saved $12 on Friday afternoon. But the government borrowed the $12 and spent it at the GDP factory outlet. They all lived happily ever after. (Library of Economics and Liberty, “Hydraulic Macro: A Fable,” August 30, 2009)

But in reality, economic activity is far more complex than that. One very important part of that reality the vast variety of goods and services changing hands, in response to constantly shifting tastes, preferences, technologies, and costs. The real economy bears no resemblance to the “hydraulic” one in which the homogeneous “fluid” is units of GDP. For “stimulus” — an increase in government spending (dG) — to generate an real increase GDP significantly greater than dG, several stringent conditions must be met:

a. dG must lead directly to the employment of resources that had been idled by a downturn in economic activity (or newly available resources that otherwise would lay idle), therefore eliciting the production of additional goods for delivery to consumers and businesses.

b. Accordingly, government functionaries must be able to distinguish between unemployment that occurs as a result of normal (and continuous) structural changes in the economy and unemployment that occurs because of a general slowdown in economic activity.

c. To the extent that the preceding conditions are satisfied, dG may be used to restore employment if government functionaries do the following things:

  • Ensure that dG is used to purchase goods and services that would have been produced in the absence of a general slowdown in economic activity.
  • Ensure that dG is used by those persons, businesses, and governmental units that have become unable to buy those goods and services because of a general slowdown in economic activity.
  • Allowing for shifts in tastes, preferences, technologies, etc., adjust the issuance, allocation, and use of dG so that goods and services are produced in accordance with those shifts in taste, etc.
  • Reduce dG as the demand for unemployed resources rises, in order to avoid the distorting and disincentivizing effects of inflation.

To the extent that dG is less than on-time and on-target, there is “leakage,” which causes the multiplier to recede toward a value of 1. It can easily slide below 1 — as Barro has found — because of the “leakage” to imports and the disincentivizing effects of government borrowing and spending.

4. Causality: Inadequate AD as symptom, not cause.

The fourth reason for the failure of the “stimulus” to stimulate is that it is does not address the cause of the drop in AD. A drop in AD usually is caused by an exogenous event, and that exogenous event usually is a credit crisis. Pumping money into the economy — especially when it results in the bidding up the prices of already employed resources — does not reinflate the punctured credit bubble that caused the slowdown.

If a credit crunch arises from a sharp rise in the rate of home-mortgage defaults — as in the case of the Great Recession — the obvious way to “solve” the problem is to prop up the defaulting borrowers and their lenders, and to do so quickly.

But, in practice, the propping up is hit-and-miss, and the misses have drastic consequences. Consider, for example, the decision not to bail out Lehman Brothers and the effects of that decision on financial markets.

Which leads into the fifth reason…

5. Inequity, moral hazard, and their consequences.

Any kind of “stimulus” that targets particular individuals and firms, in an effort to rectify their failures of judgment, has adverse political and economic effects.

Favorable treatment of defaulters and failing companies generates considerable popular resentment, which — in the present instance — has found a vocal and politically potent outlet in the Tea Party movement. Favorable treatment of defaulters and failing companies also creates moral hazard; that is, it encourage unwise risk-taking that can (and probably will) spark future crises, leading the government to assume more obligations and impose more regulations, in a futile effort to change human nature.

All of this adds up to a climate of political contention and financial pessimism — conditions that militate against consumer confidence and business expansion.

6. The human factor.

The preceding five reasons for the ineffectiveness of Keynesian “stimulus” point to a sixth, fundamental reason: the human factor.

Models are supposed to mirror reality, not the other way around. Those who cling to the Keynesian multiplier would like the world to comply with it. But the world does not because it is filled with people, whose behavior is not determined (or described) by a simplistic model but by their responses to incentives, their political predispositions, their informed and reasonable skepticism about the consequences of government intervention in economic matters, and — above all else — their fallibility. And, believe or not, government officials and bureaucrats are no less fallible than the “ordinary” citizens whose lives they would like to organize.

The human factor is an inconvenient truth. But “liberals,” in their usual arrogance and ignorance prefer magical thinking to reality. Belief in the Keynesian multiplier is a prime example of magical thinking.

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The Causes of Economic Growth
A Short Course in Economics
Addendum to a Short Course in Economics
The Indivisibility of Economic and Social Liberty
The Price of Government
The Fed and Business Cycles
The Price of Government Redux
The Mega-Depression
Ricardian Equivalence Reconsidered
The Real Burden of Government
Toward a Risk-Free Economy
The Rahn Curve at Work
How the Great Depression Ended
Microeconomics and Macroeconomics
The Illusion of Prosperity and Stability
Experts and the Economy
We’re from the Government and We’re Here to Help You
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
Our Enemy, the State
Competition Shouldn’t Be a Dirty Word
The Stagnation Thesis
The Evil That Is Done with Good Intentions
Money, Credit, and Economic Fluctuations