Free Markets, Free People

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.

~
Dale Franks
Twitter: @DaleFranks

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.

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31 Responses to The Death of Keynesianism (Updated)

  • 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.

    I was the only one in the class who thought so. It was the height of seventies liberalism, and Jimmy Carter’s stagflation had not yet hit. We had suffered through a downturn and Nixon’s odious wage-and-price controls, but it was still widely believed that government spending could stimulate an economy out of recession.

    This always sounded silly to me. 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 think we reached our stupidity limit in the 1970s in much of the private sector, as a lot of businessmen just refused to go along with the gag. Expansion of a business is much more risky when inflation and interest rates are volatile and might be too high to endure.

    But before that happened, I looked at the conventional wisdom as expressed in my Econ class, and rejected it as untenable. Eventually, of course, the rest of the world cottoned on too, and Milton Friedman was given the respect he deserved.

    Since then, we’ve seen many other aspects of economics that explain why Keynesian economics in particular, and collectivist varieties that grow the public sector in general, simply don’t work in the long term. Public choice theory and the theory of rational expectations are good examples.

    I do still think that pure monetarism has some holes. In particular, I think it’s inadequate at taking rapid technological progress into account. But it sure beats the heck out of Keynesianism, especially the perverted, self-serving variety favored by today’s ruling class.

  • Keynes would have never supported the kind of deficit spending during economic booms that happened under Reagan or Bush the Younger.   That was insane.  He wanted surpluses in booms so you could afford to stimulate the economy during downturns.  He was far more conservative than what gets called Keynesian now.  He would be appalled by the high debt to GDP ratios we see in the industrialized world.  Keynes was a brilliant genius, but what gets called Keynesian is not what he would have supported.

    • Keynes was a brilliant genius, but what gets called Keynesian is not what he would have supported.

      Yeah, sure, and I bet Marx would have been horrified had he lived to see Stalin, Pol Pot, Castro, and Hugo Chavez.

      Which is irrelevant. In both cases, they came forth with economic theories that work in some fanciful ideal world, but don’t work in the real world because they don’t take actual behavior of real people into account.

      But since you didn’t have the brains the rest of us had to see that at first, and you are congenitally unable to face your own limitations, you continue to blather on as if your simplistic and often wrong understanding of economics actually meant something.

      Don’t you have some papers to grade or something? Or do you just absolutely have to come here and spout off to make yourself feel better by lecturing to people who know more about this subject than you are even capable of knowing?

      •  
        “What is the worldly religion of the Jew?” Marx asked. “Huckstering. What is his God? Money.” Communism, according to its founding father, “would make the Jew impossible.” –Jean-François Revel
         

    • That is a masterful restatement of the 16th paragraph of my post, sir.

      • That’s about all he is good at, restating other peoples’ work as if he were adding something of his own to the discussion.

    • <i>Keynes would have never supported the kind of deficit spending during economic booms that happened under Reagan or Bush the Younger. </i>

      In your typically dishonest way, you left out the deficit spending under Obama which far dwarfed that of Reagan and Bush 43 and would continue to do so, if the “irrational” “emotionally-driven” Tea Partiers had not overturned the political landscape in 2010 — which you, typically, missed as well.

      Also, you typically neglect to mention the Reagan and Bush 43 came into office after severe economic downturns following Democrat administrations. Bush 43 was looking at the simultaneous collapse of the dotcom bubble and the repercussions of 9-11. As the economy recovered, Bush did reduce the deficit. Today we could balance the budget if we simply returned to 2005 spending levels. Of course with your brilliant pragmatic centrist candidate, Obama, that’s impossible.

      • We replaced the “failed economic policies of Bush” with the “even worse economic policies of Obama.”
        It’s the standard choosing the “evil of the two lessors” and Obama’s “Kung Fu” is worse that Bush’s, but since Bush isn’t and can’t be President again the comparison gains me nothing, except the satisfaction of knowing that both the candidates for President in 2008 were good for nothin’.

    • “Keynes would have never supported the kind of deficit spending during economic booms that happened under Reagan or Bush the Younger.”

      But he would have supported it under Democratic Presidents?  

      ” Keynes was a brilliant genius”

      Is there some other kind?

      • Well, you have your “tarnished” genius, who can be brilliant with a little Brasso and some elbow grease….

      • If “deficits during down times” are any indication, we’ve only had three good economic years since the 1940’s.

      • Glad you got him….my musket is fouled and I can’t get the next round to seat.

    • Reagan’s spending was due to a Democrat Congress. Republican’s pushed the line item veto specifically to solve that problem.

      • And the non-impounding of funds that the Dems foisted on Nixon when he declined to spend money.
        And Baseline budgeting (courtesy, again, the Dem’s) during Carter’s regime.
         

  • Keynes, like Maltus, was brilliant and contributed important insights.
    Keynes, like Maltus, was dead wrong about his most famous work.
    One reason for Keynes’ failure was that it required a tock for every tick.  Politicians never do the tock.
    Duh.

  • Can i stick a knife in Keynesonian theory as practised by the dems. It isnt dead yet. Per the dems rallying cry “It will work, we just need to throw more money at it”
     
     

  • 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.
     
    I think the problem here is that a form of its policies are attributed to helping to end the Great Depression under FDR.  The timeline of those policies and the actual recovery, alone, call that into question.  But none the less it is romanticized as such.

    • I think it was a UCLA study that showed that FDR’s policies extended the Great Depression until 1943. It was FDR’s wage controls that were key to over pricing labor, and keeping unemployment high.

      I don’t think WW2 spending ended the Depression. Rather, WW2 distracted those who were killing the economy.

      • By operation of the Law Of Substitution, FDRs wage controls were also the well-spring of perks…like employer-paid health insurance.
        And we see how that worked out…

  • Dale, good post.  This has been a good discussion.
    As expected Krugman does not agree with you guys:
     

    Start with the economics. We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond.
    The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further. Pay no attention to those who invoke the confidence fairy, claiming that tough action on the budget will reassure businesses and consumers, leading them to spend more. It doesn’t work that way, a fact confirmed by many studies of the historical record.

    http://www.nytimes.com/2011/08/01/opinion/the-president-surrenders-on-debt-ceiling.html?_r=1&partner=rssnyt&emc=rss
    Also as expected many on the left see this debt limit deal as catastrophic for the country.  But dems never see less government spending as good.
    http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=102×4944548
    The Unions aren’t happy
    http://www.huffingtonpost.com/2011/08/01/debt-ceiling-deal-unemployment_n_915375.html

    The deficit-reduction deal that emerged late Sunday runs the risk of exacerbating two opposite problems at the same time: It cuts enough government spending to imperil a weak economy, yet not enough to spare the United States from the prospect that its credit rating will be downgraded.

    http://www.huffingtonpost.com/2011/08/01/deficit-reduction-plan-economic-recovery_n_915423.html

  • 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.

    No argument with any of that. But I think the problem with the “elegant theory” of Keynesianism goes even deeper.

    The theory of rational expectations is infused with game theory concepts, and that’s my own math background, so perhaps I put too much stock in it. But I look at Keynesianism, and see both parties – the bureaucrats trying to tweak the economy and the business decision makers who actually make investment decisions and produce the changes in outcome.

    Game theory says that when there are multiple players in a game (which doesn’t necessarily have to be a competitive “game”, just a situation where both sides make decisions and they interact), and some of the players have fixed strategies, the other players will adjust their strategies to produce optimal results. Thus, if a Keynesian boom/bust adjustment cycle were as predictable as it needed to be to succeed, it’s a foregone conclusion that some members, perhaps most of them, would adjust their own decision making to compensate. For example, when money becomes cheap, they can borrow it at low interest rates and put it in real estate, or hard metals, or other tangible items. That doesn’t really do much for stimulus. Then, when money gets tight, the prices of those items go up, they can sell, presumably taking a nice profit just on timing the cycle.

    The more that’s done, the more “stimulus” would be needed for a certain amount of economic effect. It’s like a drug that the patient acclimates to. The dosage has to be increased to get the desired effect. Eventually, the acclimatization may make the drug completely ineffective.

    So I maintain that even with perfect philosopher kings, Keynesianism would still fail because it doesn’t take some fundamentals about human behavior into account.

    I plead guilty on leaning too heavily on Galbraith for my own understanding of Keynesianism. He was so dreary to get through that I never looked that deeply into primary sources written by Keynes or contemporaries. I read Hazlitt’s Failure of the New Economics, and it made sense, so I stopped there.

    • “Tweaking the economy” can lead to mal-investment if price signals are distorted. I suspect massive Chinese lending to us to keep their currency down led to a lot of mal-investment we are now seeing:
      Low interest rates coupled with cheap Chinese imports means mal-investment in housing. (Investors aren’t going to invest in a new US factory when China is killing the price, but housing would look much better.)
      Conversely, China’s low currency would suck in foreign investors and lead to mal-investment in manufacturing for export, for example, probably a lot of labor intensive textiles should now be made elsewhere rather than in China, but the low currency would send a bad price signal to investors that China is still competitive. I think Chinese inflation, especially of wages, is just the market forcing a stealth revaluation…
       
      My two cent.
       
      disclosure: I hold RMB.

      • And this of course is only one factor in the mess we are in, not the overarching reason. But its part of the idea that the government can “steer” the economy successfully.

  • Umm…Japan, for the past 22 years.

    • And yet I read comments from educated Democrats who breezily talk about how the economy is going to pop back, so we won’t need those spending cuts after all.
      I guess when you work in a university or the bureaucracy, the economy must seem to be doing well.

      • I guess when you work in a university or the bureaucracy, the economy must seem to be doing well.

        http://reason.com/poll/2011/07/08/public-employees-stand-alone-i
         
        A new Rasmussen national telephone survey found that 72% of likely voters believe a free market economy performs better than an economy managed by the government. Only 14% favor the government management approach, and 14% are not sure.
        A survey finding that most Americans favor free markets may not come as a surprise to many; however, the survey also revealed a startling difference for public sector workers among which nearly half favor government management of the economy. In other words only 14% of likely voters favor government management of the economy compared to 53% of public sector employees. Among private sector employees 75% favor free markets over government management of the economy.

  • “Since Keynesianism essentially requires the administration of wise philosopher-kings to administer it,”
    Are you saying Hu Jin-Tao isn’t a wise philosopher-king?

  • “Are you saying Hu Jin-Tao is”n’t a wise philosopher-king?

    Barry “DA ARROGANT ONE” Obama sure isnt.

  • Dale FranksKeynes 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.

    My education in economics consists of only a single semester of Econ 101 back in the day, so I’m hardly an expert, but the above makes some intrinsic sense in that it is what a reasonable person might do when faced with an economic “downturn”.  For example, if I lost my job, I would likely live to some extent on credit (deficit spending) to tide me over until I could find a new job.  This doesn’t require any predictive power on my part, but rather a response to some pretty clear “market signals”. 

    O’ course, if I followed the other half of the Keynesian prescription, I’d have a tidy nest egg saved away so that I wouldn’t have to borrow very much, and of course I would try to reduce spending as much as possible relative to my income.* This is where Keynesism fails in the real world is that politicians don’t do these things: they overspend when times are good, then overspend some more when times are bad.

    —-

    (*) As it happens, this isn’t hypothetical as my wife got downsized and we are cutting spending as much as we can.

  • Sigh.
    In real-life social science, just because a hypothesized cause and effect doesn’t empirically show up in 100% of scenarios doesn’t mean you have disproved its existence. Saying this is kind of like saying you have disproved gravity because of the existence of hard vaccuum, or that you have disproved drag because you have discovered jet propellant and takeoff velocity.
    I’m pretty sure that the effects of debt are relativistic, and, in a related manner, depend on interest rates to actually impact anything in the real world. The 90%-100% number is a statistical aggregate subject to the conditions of – well, the entire rest of the economic macroverse during the examples in question. I’m not taking a position on whether it’s right, or whether it’s wrong, but I suspect that if most of the world’s GDP was concentrated in states at >200% debt loads that 90% would correspond with robust growth just fine.
    A lot more likely is that the slow growth is the cause and the very high debt loads are the effect.
    But leaving that aside, the point here is that it is crude and probably a net loss to knowledge to say that “Keynesian economics is dead” simply because you’ve found a set of conditions – high debt load – where you hypothesize that its policy prescriptions might not work – possibly even not, “not work”, but have secondary negative consequences.
    China’s gigantic $2 trillion stimulus during the 2008 recession seems to have done the trick for them quite nicely. Anyway, most people that go on to denigrate “Keynesian economics” go on to throw out the very idea that government spending can ever succcessfully generate economic growth in response to a private contractionary cycle.
    I doubt you’d sign onto that ship. So you’re unwise to conflate “There’s a problem with using deficit spending with public deb rates approaching 100% rates of GDP” – with “we’ve disproved that government spending can counteract the effect of private-sector contraction”. Most people are too stupid to disentangle these two concepts. And while the first statement can be a basis for continued discussion – personally, I’m all for unilateral and periodic debt 30% haircuts to more or less permanently resolve this problem – the second one is creating a lot more havoc, precisely because it is not open to empirical question.

    • *shrug*

      Keynesian economics works well enough within certain parameters. I’m thinking that, like 1945-1950, or 1975-1980, we’re finding another one of those parameter.

      We’ll know if I was right soon enough.