Keynesian Revivalism

pagan powerCalling the Keynesians’ Blufftax the rich

By Nathan Smith

It’s time to enter the   inner sanctum of Keynesian theory and see what (little) it’s worth.

As a rule, the latest economic figures are not that important in themselves, but they shed fresh light on long-run trends. It may or may not be true, as Dean Baker suggests, the 0.1 percent decline in GDP in the fourth quarter of 2012 (according to preliminary Bureau of Economic Analysis estimates) was caused by a decline in government, especially military, spending. But the real question is why the economy is so feeble that it couldn’t take a few defense cuts in stride. The big picture, which the latest data make a little clearer, is the ongoing poor performance of the Obama economy and the Keynesian paradigm that has informed the Obama administration’s economic strategy.tough times

An influential group of Keynesian economists remains undaunted in its advocacy of fiscal stimulus. Paul Krugman, in particular — far from thinking he has anything to apologize for in his full-throated support for stimulus back in 2009 — regularly crows vindication and blames his opponents for not surrendering. Krugman and other Keynesians would say that they continue to be confident because the data support them, but they can only say that because their theoretical prejudices enable them to look at the data in some very odd ways. They wax triumphant over low inflation and low interest rates, which, for theoretical reasons inscrutable to non-economists and debatable by economists, they regard as proof that “aggregate demand” is the problem and stimulus would work, while dismissing as irrelevant the fact that deficit spending at a rate of well over $1 trillion per year since 2009 has left us with anemic growth and 12 million people unemployed, and many more abandoning the labor market in discouragement, while median incomes fell by upwards of 7 percent during Obama’s first term in office.

The political effect of Keynesianism has been to provide a warrant for fiscal irresponsibility. This isn’t necessarily a left/right issue: Keynesianism encourages conservatives to prioritize tax cuts over spending cuts, and liberals to focus on increasing spending more than raising taxes. Doubtless politicians have always been tempted to run deficits, but Richard Wagner and James Buchanan, in Democracy in Deficit, show that prior to the Keynesian Revolution, politicians largely restrained themselves, borrowing during wars and balancing budgets or better in peacetime.

Keynes once said that “practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” In this case, it’s true. Today, we’re living in a Keynesian brave new world. Savings, which Keynes disliked, have been way down for a generation in the United States. That’s one reason median incomes have stagnated, while high-saving Asia has enjoyed surging growth. With scant domestic savings, U.S. investment has to be financed mostly from abroad. Governments run ever-growing welfare states on borrowed money. Even in the 1990s, when the United States was supposedly running surpluses, the unfunded liabilities of Social Security and Medicare were mounting. Now those are still mounting, and we’re running huge primary deficits too. But Keynesian economists keep telling us not to worry, and saying that it’s more important to promote economic recovery than to control the deficit.

The truth is that most of the real knowledge that macroeconomists have achieved in the past few decades has come at Keynesianism’s expense, by taking into account that people take the future into account. Krugman has coined a term which may serve as a concise mnemonic for these developments — he likes to write about the “confidence fairy.” Unfortunately, Krugman uses the term to mock the notion that the weakness of today’s economy has something to do with expectations for the future. But if we let Marx name “capitalism,” we may as well take Krugman’s snappy label for rational-expectations macroeconomics and run with it. Keynesian economics is myopic economics. It is economics for a world where people get their take-home pay and immediately spend most of it. It is economics for a world where people watch the government spending more money and don’t think about how the government is borrowing to pay for it and will have to raise taxes sometime to pay down its debts (or at least reduce the deficit). It is economics for a world where sellers go on mechanically charging the same prices, rather than cutting prices to get surplus goods out the door. Confidence-fairy economics recognizes that real people are not myopic. They think ahead, and that makes the Keynesian models break down.

Robert Skidelsky’s book Keynes: The Return of the Master, one of several books that try to spin the 2008 crisis as a vindication of Keynes, pulls a fast one by distinguishing the period 1951–1973, when Keynes was supposed to have been the “coach” for economic policymakers in the West, from the period after 1973, when the free-market Washington Consensus prevailed. He then cites various statistics about economic performance that favor the earlier period over the latter. But in the United States at least, the 1970s were the heyday of Keynesianism’s influence — in 1971, Richard Nixon, a Republican, said “We are all Keynesians now”— while the Eisenhower administration in the 1950s was not Keynesian, being committed to balanced budgets in spite of recessions which it saw as a cure for lingering wartime inflation. In academia, Keynesianism was dominant in the 1950s and waning in the late 1970s, but policymakers took some time to get the message. The Keynesian 1960s featured big fiscal and monetary stimulus that led into the stagflation of the 1970s. In Britain, Keynes’s native country, his legacy was decades of chronic economic weakness which saw Britain steadily lose its economic leadership, until Margaret Thatcher, a free marketer, halted the slide.

By the 1980s, the rout of Keynesianism was complete enough that even policies that could have been defended in Keynesian terms were not. Ronald Reagan and George W. Bush, like John F. Kennedy, were big-spending tax-cutters, but Reagan and Bush argued for their policies mainly in terms of their supply-side impacts, rather than defending them as Keynesian-style aggregate demand management. Nor did many macroeconomists offer Keynesian defenses of Reagan and Bush. This might have reflected the partisanship of Keynesian economists (i.e., they were Democrats who didn’t want to defend Republican presidents) but mostly I think it was in good faith and reflected the intellectual defeat of Keynesianism by the monetarism of Milton Friedman (among others) and the rational expectations of Robert Lucas and Thomas Sargent (among many others). Even the “New Keynesian” school that emerged in the 1980s, which provided new justifications for the Keynesian doctrine of sticky prices, was not so much about vindicating fiscal stimulus, or the old Keynesian models like IS-LM and AS-AD that lingered in undergraduate textbooks, but rather, sought to check an anti-Keynesian reaction that had gone too far, to the point that it would actually (for example) have discredited Milton Friedman’s explanation of the Great Depression as a consequence of contractionary monetary policy. (Friedman was Keynesian enough to think sticky prices were a factor in the macroeconomy.) But fiscal stimulus was decidedly out of favor before 2008, and for good reasons.

In troubled times, people sometimes turn to an old-time religion for solace. Since 2008, there has been something of an Old Keynesian revival, in which Krugman is the most influential figure. These advocates know they can’t compete on the plane of rigorous high theory and have turned in ad hoc fashion to a variety of common sense or behavioral explanations, or sometimes crude appeals to history like Skidelsky’s mentioned above, to make the case for stimulus policies such as those that have left the United States with (to repeat) 12 million unemployed and declining median incomes. What Marx once said of the two Napoleons who ruled France — “history repeats itself, the first time as tragedy, the second time farce” — summarizes the likely career of this second incarnation of Keynesianism.

The Long Run

Citizens and politicians should learn their lesson — that fiscal stimulus doesn’t work — and focus on dealing with long-run problems. Not only will fixing those problems benefit us in the long run, it’s probably the best thing we can do for the economy in the short run too. As shown, gross private domestic investment has recovered somewhat since the nadir of the Great Recession, but it’s still far below its 2006 peak; since 2009 it has been lower in real terms than at any time between 1999 and 2008 (pending final 2012 data). Investment is crucial to our future: it’s the source of capital that can make workers more productive and raise living standards. But more investment would also create more demand for workers right now. Why aren’t firms investing? Low interest rates should encourage investment. Even more, record-high corporate profits should encourage investment. Superficially, it’s ironic that corporate profits are doing so well under a relatively anti-business presidential administration, but this is actually just what we should expect. Investment is low, therefore capitalists face little competition and can make more money. But what’s good for some corporate incumbents is bad for the rest of us. There’s some force — but not much — in the Keynesian argument that investment is low because demand is weak and more capacity isn’t needed. Investment is oriented toward the future, sometimes the rather far-off future, and presumably there would be plenty of long-term projects worth financing with today’s cheap money if firms felt confident that the economy will get back to normal and taxes and regulations won’t expropriate them ex post. The great investment slowdown is a complex whodunit, but the guiltiest-looking suspect is political risk.

To encourage investment, the government needs to find a way to credibly recommit to letting investors keep their money if they succeed. Mainly, that involves appeasing the confidence fairy by making it clear how the country will pay its bills. Generally speaking, markets allocate resources better than governments, so the more government spending is held down, the better the economy does. The 1990s, a rare oasis of fiscal discipline and (as a result) a booming economy, are the example to emulate. But for a given trajectory of spending, it’s better to know how it will be paid for, so that private sector actors can plan around it, than for the economy to be burdened with the uncertainty that deficits create. All this is fairly easy to see, once you take off the Keynesian spectacles.


Nathan Smith is a professor of economics and finance at Fresno Pacific University. He is the author of Principles of a Free SocietyComplexity, Competition, and Growth; other articles; and blogs at Open Borders: The Case.

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