Sunday, November 30, 2008

Keynesian Economics: AWOL Over 25 Years

So, it appears that Obama is going to revive Keynesian economics and attempt a large-scale stimulus (in the half-trillion dollar range) in the to revive the economy. I certainly hope that it works, but share an old conservative misgiving – how are we going to pay for it all. After all, Keynesian economics is not simply an excuse for all-out profligacy. Properly applied, Keynsian economics calls for a whole lot more fiscal responsibility than we have been seeing lately.

Keynes in good times.

Classic Keynesian economics calls for keeping the budget balanced or with a slight surplus in good times. From the severe recession of the early '80's squeezed inflation out of the system until the current financial crisis, we have had approximately 25 years of prosperity and rapid growth, with only two mild recessions. According to Keynes, we should have been running balanced budgets throughout that time. Instead, throughout the 1980's and first half of the '90's, we ran huge, seemingly intractible deficits. In the latter half of the '90's, by a combination of rapid growth, increased taxes at the top as growth concentrated at the top, a booming stock market, and capital gains tax, we were able to shrink and finally erase the yawning deficits and begin running surpluses. Upon coming to power, the Bush Administration promptly cut taxes and restored the deficits, which since 2001 have been running high, with no one caring.

Then again, the main reason Keynesian economics calls for balanced budgets in good times is the belief that large deficits during economic expansion are inflationary. Yet since the end of the '80's disinflation, we have combined rapid growth, large deficits, and low inflation. So clearly Keynes was not infallible. But despite low inflation rates, there has been a price for high deficits. The price was most obvious in the '80's. During the '80's, restrictive monetary policies drove interest rates to all-time highs. The combination of high deficits increasing the national debt and skyrocketing interest rates raised debt service ever higher. The longer deficits remained high, the more of the federal budget was dedicated to debt service, and the less could be spent on anything else. Over time, debt service came to be larger than the deficit itself. During the Clinton surpluses, the US government began paying down the debt very rapidly and realizing an ever greater "solvency dividend" as debt service consumed less and less of the budget. Panicked Republicans, fearing Democrats would use the surpluses for social spending, hastened cut revenue and return us to deficits as soon as they came to power in 2001. Debt service has been less of a problem this time round, thanks to expansionary monetary policies and low interest rates. On the other hand, in the '80's, most of the national debt was in American hands and therefore was not an overall fiscal drain. Today, the Chinese hold more and more American debt, which poses a financial drain on the economy and gives China disturbing leverage over us. And now we are proposing increasing deficits and debt to unimaged height, with unknown effects.

Keynes during ordinary recessions.

Keynesian economics does call for deficits and stimulus during ordinary, mild recessions, such as the recession of the early '90's or following the dot-com crash. However, no great profligacy is needed. Rather, there are automatic, self-adjusting counter-cyclical tendancies within the system that can provide adequate stimulus during ordinary recessions. Tax revenues will fall as a result of reduced economic activity. Claims for unemployment insurance, food stamps, and other forms of aid will rise. These increased expenditures will provide a counter-cyclical stimulus with no need for any further action. Of course, a deficit will result, but if the government has maintained adequate fiscal discipline, the deficit will be modest and self-correcting when the economy improves. Any attempt to avoid the deficit by raising taxes or cutting spending will worsen the recession and should be avoided.

Many state constitutions have balanced budget requirements, which tend to have a perverse, pro-cyclical effect. In other words, if states do not maintain strong fiscal discipline in good times, during recessions they will be forced to either raise taxes when the state can least afford them or cut services when they are most needed. But if state governments understood this basic theory and had the discipline to follow it (and explain it to the public), they could achieve a counter-cyclical effect. Quite simply, in good times, state governments should resist the temptation to splurge or cut taxes and instead keep running surpluses to build up their cash reserves. When recession hits, states can then draw on their cash reserves and have a counter-cyclical effect (though on a smaller scale than the federal government).

Some parts of the Obama stimulus package, like extending unemployment insurance and food stamps or aid to states are ordinary countercyclical spending that will automatically diminish with economic recovery. Even the bailout, if successful, can be justified as a one-time countercyclical measure. This is why many people are advocating that the bailout take the form a stock purchase, so that if it suceeds, the government can sell the stock at a profit and use the proceeds to pay off the debts the bailout has caused. The bad news is that ordinary counter-cyclical measures, and even bailouts may still not be enough.

Keynes during severe downturns.

Of course, Keynes did not become famous for his recommendations during goods times, or even ordinary recessions. He developed his theories in response to the Great Depression, an economic catastrophe. Opinions differ on how severe the current economic crisis will be, but conventional economic wisdom holds that it will be more than ordinary counter-cyclical adjustments can handle. A large extrinsic stimulus, of the type Keynes recommended in the 1930's, is called for.

This leads to a paradox that even Keynes found troubling. The primary purpose of stimulus spending, under Keynesian theory, is to stimulate, rather than to actually build anything. Furthermore, the amount of spending should be calibrated by the amount of stimulus called for, rather than any extrinsic need. The practical upshot of this is that stimulus spending is more appropriate to the extent that it is useless, or at least superfluous.

Even the most profligate spenders are generally reluctant to blow money on a project precisely because it is useless. The Obama Administration, for instance, is proposing to spend on infastructure. It pitches this, not only as a stimulus, but as a useful investment in the future that will increase our future wealth. This is good investment logic, but not good Keynesian logic. If spending is being done for the sake of spending, then if the infastructural projects do not provide enough stimulus, then we should increase expenditures, even if it means wasteful duplication and useless bridges to nowhere. If the economy does get rolling again, Keynesian logic calls for halting infastructural spending, even if it means leaving half-finished highways everwhere. In other words, there is no guarantee that need for stimulus and need for infastructure have anything to do with each other. Which one will receive priority? Do we prefer unfinished projects, or ever-growing deficits? And this is to say nothing of Obama's health care plan, which is being pitched, not as a temporary stimulus, but a permanent project.

Now we've blown it. How do we pay for it?

If we had exercises financial discipline during the prosperous times of the 1980's and '90's, indeed, if we had kept the Clinton surpluses during the last six or seven years and paid down debt, we would not owe such huge sums to China and would not have to worry just how much more debt we could sell, or how much we could afford to service. The "good" news is that neither of those appear to be serious problems at present. In the current climate of uncertainty, investors are buying US treasury bonds even at a rate of zero for the sake of security. The bad news is that whenever the world economy does pick up, interest rates will rise, treasury bonds will have more competition, and there will be the devil (or the Chinese) to pay.

The Republican strategy since 1980 (whether intentional or inadvertent) has been to bust the budget in order to prevent Democrats from enacting social programs. And in this, if nothing else, they have succeeded beyond anybody’s wildest dreams. And now the bill is coming due.

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