The Death of Keynesianism (Updated)
Sen. Dick Durbin is an angry man, because he sees the debt deal as the death of Keynesian economics. For some reason, he appears to see this as a bad thing. In his comments today, discussing the debt ceiling deal, he noted:
“I would say … that symbolically, that agreement is moving us to the point where we are having the final interment of John Maynard Keynes,” he said, referring to the British economist. “He nominally died in 1946 but it appears we are going to put him to his final rest with this agreement.”
That’s a bit of hyperbole, but even if true…well…so what?
Lord Keynes had some valuable insight into how fiscal and monetary policy can work inside certain parameters, but outside those parameters, it fails. And I have no doubt whatsoever that even Lord Keynes would recognize that, once a country has accumulated enough debt, the debt itself becomes a drag on economic growth, and attempting to inflate your way out of it by piling on more debt is a solution worse than the disease.
We’ve actually learned quite a lot about how the economy works since the General Theory was published in 1936, not the least of which were the limitations of Keynesian theory in the 1970s. Keynes famously noted that politicians are almost always influenced by the opinions of some long-dead economist. Like John Maynard Keynes.
Keynesian economics should be dead. If nothing else, the existence of stagflation in the 1970s should have shown that Keynsian policy prescriptions were ultimately unworkable. Indeed, the very existence of Stagflation shows that several central tenets of Keynesianism are simply flat wrong. The response to this is usually that the 70s were an aberration due the oil shocks of the Arab Embargo, and the subsequent price hikes enforced by OPEC.
I am, of course, quite well aware of this. I did, after all, live through it.
I am also aware that Keynesianism regarded inflation and recession as being mutually exclusive--an idea that fostered a reliance of the Philips Curve, and constant seeking by the Fed to find the NAIRU. I am further aware that the Fed’s response to the oil shocks was a highly expansionist monetary policy that ultimately kicked off a wage-price spiral in a recession, rather than causing an economic expansion. Apparently, we found the limit at which expansionist policy ceased to be expansionary, and became merely inflationary.
What solved that problem was Paul Volcker’s Fed adopting an explicit Monetarist policy at the Fed to essentially ignore interest rates and concentrate on money supply growth. As hard as it may be to believe now, markets would almost shut down on Thursdays waiting for the M1, M2, and M3 numbers from the Fed. We mostly ignore that Thursday money supply release now. It took a fair amount of pain, and back-to-back recessions in 1981-82 with 11% unemployment to solve the inflation problem, but it did wring inflation out of the economy.
What we learn from all this is that Keynes had some serious policy limitations in the real world. I believe that we are currently discovering more of those limitations.
We’ve actually learned quite a bit about how economies actually work in the 75 years since The General Theory was published. Over the last decade, for instance, a body of peer-reviewed work has been developed (PDF) that shows that an excess of government debt serves as a drag on the economy, shaving at least a full percentage point off of annual GDP growth. And we’ve learned that this negative economic effect has a non-linear effect on economic growth as debt increases. I would submit that in light of this, that no matter how workable Keynesian theory may be in a regime of moderate public debt, with judiciously applied counter-cyclical monetary and fiscal policies, that it simply falls apart as the debt approaches 100% of GDP. One of the key problems is, of course, that we’ve rarely seen the high levels of public indebtedness we’re currently experiencing, so prior to this decade, much of the work in this area was theoretical, except for data from highly indebted emerging countries, which may not be entirely applicable to mature economies.
Sadly, we’re collecting that empirical data now.
I’d also point out that we also don’t have to rely solely on 1970s stagflation to note the failure of Keynesian predictions in the real world. One merely has to look at the wide-spread Keynesian predictions in the immediate Post-WWII era that massive budget cuts to pay down the war debt, coupled with the demobilization of 12 million soldiers, would lead to a return of the US to a depression economy. Of course, no such depression occurred. Quite the opposite, in fact.
It was clear, even a decade after the General Theory was propounded, that it was…incomplete.
One more thing that relates the current level of indebtedness is that attempting to apply Keynes over and over again–but only the deficit spending part–is that, in effect, you’re arguing that the Keynesian solution is to spend, spend, spend, not matter what the level of debt.
There’s simply no evidence at all that even Keynes would have bought into that sort of argument. Indeed, quite the opposite is true. Lord Keynes never argued for increasing public spending as a matter of course, but rather tempering spending with budget-cutting at the appropriate time. Properly applied, even Keynesianism tends towards a balanced budget over time. What we’ve done over the past three decades isn’t Keynesianism, it’s a perversion of it. We’ve spent like drunken sailors attempting to stimulate the economy, but we’ve never actually gotten around to cutting budgets and paying down the debt in the good times. We’ve simply accepted the new level of increased spending as the baseline.
My argument is that we’ve reached beyond the outer bounds where Keynes is applicable. However relevant his observations may be in a regime of limited public debt and counter-cyclical fiscal and monetary policy–which we’ve never really applied by the way, as we’ve ignored the budget-cutting bits–we’ve simply passed the point at which his policy prescriptions can be relied upon, even if they are correct in other contexts.
If Keynesianism is dead, it’s mainly because we’ve killed it.
UPDATE: From Billy Hollis in the comments:
One of the main reasons I have disdain for experts that are part of the political class is the Honors Economics course I took in 1975-76. The professor (an excellent one, and one of the few non-collectivist professors in the department) had us read and contrast John Kenneth Galbraith, who was the leading Keynesian proponent of the time, and Milton Friedman. Galbraith sounded like nonsense to me, and Friedman seemed logical and reasonably clear…
Pumping up the money supply artificially increases demand, trading present good stuff for future bad stuff (inflation, high interest rates, etc.). The only way you can believe that such a technique works in the long term is to assume people are stupid and will fall for the same short term thinking every time you try it.
I’d respond that what JKG called Keynesianism…wasn’t.
Keynes said that in recessions or depressions, the government should use deficit spending to pump more money into the economy. This extra spending would increase the money supply, and stimulate the economy. In addition, the government could cut taxes, allowing people to keep more of what they’d earned.
In good economic times, he said the government should operate at a surplus. That would keep the economy from heating up too fast, and set aside a store of money to be spent in the recessionary times. It would also reduce the money supply, and erase the inflationary pressures bought about by increasing the money supply during the recessions. Taxes could also be raised to help make up the previous budget shortfalls.
So, in a perfect world, the budget would balance, over the course of a business cycle. You’re still trading present good stuff for future bad stuff, but in relatively tiny increments. You really aren’t supposed to do it $14 trillion at a time.
What we had in the 1970s–and since–was half of Keynes. The easy bit. The bit that allowed us to spend, spend, spend, with nary a thought of ever applying fiscal austerity in the good times. Austerity is hard and unpopular. It’s easier just to spend money as a way to buy votes.
Since Keynesianism essentially requires the administration of wise philosopher-kings to administer it, democratically-elected polities have failed at implementing it.
Even more than that, Keynesianism essentially requires the ability to rather precisely target both the timing and amount of stimulus needed to ameliorate a recession, and the timing and amount of austerity to apply in an expansion to wring the expansionary and inflationary pressures out of the economy. But, absent a philosopher king who can operate in synch with the state of the economy, things begin to break down.
Timing the changes in fiscal and monetary policy are, at best, difficult in a democratic state. Messy political deals have to be made and legislation gets held up while waiting for amendments to satisfy some special interest, without which, too few politicians are willing to vote in favor. On the monetary policy side, the effects of policy changes aren’t realized for 8-16 months after a policy change, such as a change in interest rates. And, in either case, no one actually knows what the state of the economy is right now. At best we know what the state of the economy was last month, or three months ago, when the statistics were compiled.
Even at the best of times, with political players of unquestioned integrity, the immense difficulty of knowing the precise timing and amounts of expansionary or contractionary policy that is needed is a daunting task.
Theoretically, Keynes theory is elegant, and explains much about money-based economies. In practice, it’s so difficult and messy to try and implement, and so filled with negative incentives for the politicians who are asked to administer it, that it has simply proven unworkable.
Like communism, the fact that it’s never been properly implemented, or achieved the claimed result, raises serious questions about whether, in the messy world of real people, it ever can be.