Is Keynsian Economics the Worst Thing That Has Ever Happened to Our Economy?

photorandy2023

2 years ago

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Keynes the master

Keynesian economics gets its name, theories, and principles from British economist John Maynard Keynes (1883–1946), who is regarded as the founder of modern macroeconomics. His most famous work, The General Theory of Employment, Interest and Money, was published in 1936. But its 1930 precursor, A Treatise on Money, is often regarded as more important to economic thought. Until then economics analyzed only static conditions—essentially doing detailed examination of a snapshot of a rapidly moving process. Keynes, in Treatise, created a dynamic approach that converted economics into a study of the flow of incomes and expenditures. He opened up new vistas for economic analysis.

In The Economic Consequences of the Peace in 1919, Keynes predicted that the crushing conditions the Versailles peace treaty placed on Germany to end World War I would lead to another European war.

He remembered the lessons from Versailles and from the Great Depression, when he led the British delegation at the 1944 Bretton Woods conference—which set down rules to ensure the stability of the international financial system and facilitated the rebuilding of nations devastated by World War II. Along with U.S. Treasury official Harry Dexter White, Keynes is considered the intellectual founding father of the International Monetary Fund and the World Bank, which were created at Bretton Woods.

What Is Keynesian Economics?

The central tenet of this school of thought is that government intervention can stabilize the economy

Just how important is money? Few would deny that it plays a key role in the economy.

During the Great Depression of the 1930s, existing economic theory was unable either to explain the causes of the severe worldwide economic collapse or to provide an adequate public policy solution to jump-start production and employment.

British economist John Maynard Keynes spearheaded a revolution in economic thinking that overturned the then-prevailing idea that free markets would automatically provide full employment—that is, that everyone who wanted a job would have one as long as workers were flexible in their wage demands. The main plank of Keynes’ theory, which has come to bear his name, is the assertion that aggregate demand—measured as the sum of spending by households, businesses, and the government—is the most important driving force in an economy. Keynes further asserted that free markets have no self-balancing mechanisms that lead to full employment. Keynesian economists justify government intervention through public policies that aim to achieve full employment and price stability.

The revolutionary idea

Keynes argued that inadequate overall demand could lead to prolonged periods of high unemployment. An economy’s output of goods and services is the sum of four components: consumption, investment, government purchases, and net exports (the difference between what a country sells to and buys from foreign countries). Any increase in demand has to come from one of these four components. But during a recession, strong forces often dampen demand as spending goes down. For example, during economic downturns uncertainty often erodes consumer confidence, causing them to reduce their spending, especially on discretionary purchases like a house or a car. This reduction in spending by consumers can result in less investment spending by businesses, as firms respond to weakened demand for their products. This puts the task of increasing output on the shoulders of the government. According to Keynesian economics, state intervention is necessary to moderate the booms and busts in economic activity, otherwise known as the business cycle.

There are three principal tenets in the Keynesian description of how the economy works:

• Aggregate demand is influenced by many economic decisions—public and private. Private sector decisions can sometimes lead to adverse macroeconomic outcomes, such as reduction in consumer spending during a recession. These market failures sometimes call for active policies by the government, such as a fiscal stimulus package (explained below). Therefore, Keynesian economics supports a mixed economy guided mainly by the private sector but partly operated by the government.

• Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.

• Changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices. Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending—consumption, investment, or government expenditures—cause output to change. If government spending increases, for example, and all other spending components remain constant, then output will increase. Keynesian models of economic activity also include a multiplier effect; that is, output changes by some multiple of the increase or decrease in spending that caused the change. If the fiscal multiplier is greater than one, then a one dollar increase in government spending would result in an increase in output greater than one dollar.

Stabilizing the economy

No policy prescriptions follow from these three tenets alone. What distinguishes Keynesians from other economists is their belief in activist policies to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems.

Rather than seeing unbalanced government budgets as wrong, Keynes advocated so-called countercyclical fiscal policies that act against the direction of the business cycle. For example, Keynesian economists would advocate deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. They would raise taxes to cool the economy and prevent inflation when there is abundant demand-side growth. Monetary policy could also be used to stimulate the economy—for example, by reducing interest rates to encourage investment. The exception occurs during a liquidity trap, when increases in the money stock fail to lower interest rates and, therefore, do not boost output and employment.

Keynes argued that governments should solve problems in the short run rather than wait for market forces to fix things over the long run, because, as he wrote, “In the long run, we are all dead.” This does not mean that Keynesians advocate adjusting policies every few months to keep the economy at full employment. In fact, they believe that governments cannot know enough to fine-tune successfully.

Keynesianism evolves

Even though his ideas were widely accepted while Keynes was alive, they were also scrutinized and contested by several contemporary thinkers. Particularly noteworthy were his arguments with the Austrian School of Economics, whose adherents believed that recessions and booms are a part of the natural order and that government intervention only worsens the recovery process.

Keynesian economics dominated economic theory and policy after World War II until the 1970s, when many advanced economies suffered both inflation and slow growth, a condition dubbed “stagflation.” Keynesian theory’s popularity waned then because it had no appropriate policy response for stagflation. Monetarist economists doubted the ability of governments to regulate the business cycle with fiscal policy and argued that judicious use of monetary policy (essentially controlling the supply of money to affect interest rates) could alleviate the crisis. Members of the monetarist school also maintained that money can have an effect on output in the short run but believed that in the long run, expansionary monetary policy leads to inflation only. Keynesian economists largely adopted these critiques, adding to the original theory a better integration of the short and the long run and an understanding of the long-run neutrality of money—the idea that a change in the stock of money affects only nominal variables in the economy, such as prices and wages, and has no effect on real variables, like employment and output.

Both Keynesians and monetarists came under scrutiny with the rise of the new classical school during the mid-1970s. The new classical school asserted that policymakers are ineffective because individual market participants can anticipate the changes from a policy and act in advance to counteract them. A new generation of Keynesians that arose in the 1970s and 1980s argued that even though individuals can anticipate correctly, aggregate markets may not clear instantaneously; therefore, fiscal policy can still be effective in the short run.

The global financial crisis of 2007–08 caused a resurgence in Keynesian thought. It was the theoretical underpinnings of economic policies in response to the crisis by many governments, including in the United States and the United Kingdom. As the global recession was unfurling in late 2008, Harvard professor N. Gregory Mankiw wrote in the New York Times, “If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. Keynes wrote, ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.’ In 2008, no defunct economist is more prominent than Keynes himself.”

But the 2007–08 crisis also showed that Keynesian theory had to better include the role of the financial system. Keynesian economists are rectifying that omission by integrating the real and financial sectors of the economy.

Keynesian Economics Theory: Definition and How It’s Used

Understanding Keynesian Economics

Keynesian economics represented a new way of looking at spending, output, and inflation. Previously, what Keynes dubbed classical economic thinking held that cyclical swings in employment and economic output create profit opportunities that individuals and entrepreneurs would have an incentive to pursue, and in so doing, they correct the imbalances in the economy.

According to Keynes’ construction of this so-called classical theory, if aggregate demand in the economy fell, the resulting weakness in production and jobs would precipitate a decline in prices and wages. A lower level of inflation and wages would induce employers to make capital investments and employ more people, stimulating employment and restoring economic growth. Keynes believed, however, that the depth and persistence of the Great Depression severely tested this hypothesis.

In his book The General Theory of Employment, Interest and Money and other works, Keynes argued against his construction of classical theory, asserting that, during recessions, business pessimism and certain characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.

For example, Keynesian economics disputes the notion held by some economists that lower wages can restore full employment because labor demand curves slope downward like any other normal demand curve.

Similarly, poor business conditions may cause companies to reduce capital investment rather than take advantage of lower prices to invest in new plants and equipment. This also would have the effect of reducing overall expenditures and employment.

Keynes argued that employers will not add employees to produce goods that cannot be sold because demand for their products is weak.

Keynesian Economics and the Great Depression

Keynesian economics is sometimes referred to as “depression economics,” as Keynes’ General Theory was written during a time of deep depression—not only in his native United Kingdom, but worldwide. The famous 1936 book was informed by Keynes’ understanding of events arising during the Great Depression, which Keynes believed could not be explained by classical economic theory as he portrayed it in his book.

Other economists had argued that, in the wake of any widespread downturn in the economy, businesses and investors taking advantage of lower input prices in pursuit of their own self-interest would return output and prices to a state of equilibrium, unless otherwise prevented from doing so. Keynes believed that the Great Depression seemed to counter this theory.

Output was low, and unemployment remained high during this time. The Great Depression inspired Keynes to think differently about the nature of the economy. From these theories, he established real-world applications that could have implications for a society in economic crisis.

Keynes rejected the idea that the economy would return to a natural state of equilibrium. Instead, he argued that, once an economic downturn sets in, for whatever reason, the fear and gloom that it engenders among businesses and investors will tend to become self-fulfilling and can lead to a sustained period of depressed economic activity and unemployment.

In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending to stabilize aggregate demand.

Keynes was highly critical of the British government at the time. The government greatly increased welfare spending and raised taxes to balance the national books. Keynes said that this would not encourage people to spend their money, thereby leaving the economy unstimulated and unable to recover and return to a successful state.

Keynes proposed that the government spend more money and cut taxes to turn a budget deficit, which would increase consumer demand in the economy. This would, in turn, lead to an increase in overall economic activity and a reduction in unemployment.

Keynes also criticized the idea of excessive saving, unless it was for a specific purpose such as retirement or education. He saw it as dangerous for the economy because the more money sitting stagnant, the less money is in the economy stimulating growth. This was another of Keynes’ theories geared toward preventing deep economic depressions.

Many economists have criticized Keynes’ approach. They argue that businesses responding to economic incentives will tend to return the economy to a state of equilibrium unless the government prevents them from doing so by interfering with prices and wages, making it appear as though the market is self-regulating.

On the other hand, Keynes, who was writing while the world was mired in a period of deep economic depression, was not as optimistic about the natural equilibrium of the market. He believed that the government was in a better position than market forces when it came to creating a robust economy.

John Maynard Keynes (Source: Public Domain).

Keynesian Economics and Fiscal Policy

The multiplier effect, developed by Keynes’ student Richard Kahn, is one of the chief components of Keynesian countercyclical fiscal policy. According to Keynes’ theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in gross domestic product (GDP) could be even greater than the initial stimulus amount.

The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Its concept is simple. Spending from one consumer becomes income for a business that then spends on equipment, worker wages, energy, materials, purchased services, taxes, and investor returns. That worker’s income can then be spent, and the cycle continues. Keynes and his followers believed that individuals should save less and spend more, raising their marginal propensity to consume to effect full employment and economic growth.

In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth. This appeared to be a coup for government economists, who could provide justification for politically popular spending projects on a national scale.

This theory was the dominant paradigm in academic economics for decades. Eventually, other economists, such as Milton Friedman and Murray Rothbard, showed that the Keynesian model misrepresented the relationship between savings, investment, and economic growth. Many economists still rely on multiplier-generated models, although most acknowledge that fiscal stimulus is far less effective than the original multiplier model suggests.

The fiscal multiplier commonly associated with the Keynesian theory is one of two broad multipliers in economics. The other multiplier is known as the money multiplier. This multiplier refers to the money creation process that results from a system of fractional reserve banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.

Keynesian Economics and Monetary Policy

Keynesian economics focus on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of the Keynesian arsenal for battling unemployment, underemployment, and low economic demand. The emphasis on direct government intervention in the economy often places Keynesian theorists at odds with those who argue for limited government involvement in the markets.

Wages and employment, Keynesians argue, are slower to respond to the needs of the market and require government intervention to stay on track. Furthermore, they argue, prices do not react quickly and change only gradually when monetary policy interventions are made, giving rise to a branch of Keynesian economics known as monetarism.

If prices are slow to change, this makes it possible to use money supply as a tool and change interest rates to encourage borrowing and lending. Lowering interest rates is one way that governments can meaningfully intervene in economic systems, thereby encouraging consumption and investment spending. Short-term demand increases initiated by interest rate cuts reinvigorate the economic system and restore employment and demand for services. The new economic activity then feeds continued growth and employment.

Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy.

Without intervention, Keynesian theorists believe, this cycle is disrupted, and market growth becomes more unstable and prone to excessive fluctuation. Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging businesses and individuals to borrow more money. They then spend the money that they borrow. This new spending stimulates the economy. Lowering interest rates, however, does not always lead directly to economic improvement.

Monetarist economists focus on managing the money supply and lower interest rates as a solution to economic woes, but they generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating the economy by lowering interest rates becomes less effective because it reduces the incentive to invest, rather than simply hold money in cash or close substitutes like short-term Treasurys. Interest rate manipulation may no longer be enough to generate new economic activity if it can’t spur investment, and the attempt at generating economic recovery may stall completely. This is a type of liquidity trap.

When lowering interest rates fails to deliver results, Keynesian economists argue that other strategies must be employed, primarily fiscal policy. Other interventionist policies include direct control of the labor supply, changing tax rates to increase or decrease the money supply indirectly, changing monetary policy, or placing controls on the supply of goods and services until employment and demand are restored.

Keynesian Economics and the 2007-08 Financial Crisis

In response to the Great Recession and financial crisis of 2007–2008, the Congress and Executive branch undertook several measures that drew from Keynesian economic theory. The federal government bailed out debt-ridden companies in several industries including banks, insurers, and automakers. It also took into conservatorship Fannie Mae and Freddie Mac, the two major market makers and guarantors of mortgages and home loans.

In 2009, President Obama signed the American Recovery and Reinvestment Act, an $831-billion government stimulus package designed to save existing jobs and create new ones. It included tax cuts/credits and unemployment benefits for families; it also earmarked expenditures for healthcare, infrastructure, and education.

These stimulus measures and federal interventions helped America’s economy recover, preventing the Great Recession from becoming another full-blown depression.

COVID-19 Stimulus

In the wake of the COVID-19 pandemic starting in early 2020, the U.S. government under President Donald Trump and then President Joseph Biden offered a variety of relief, loan-forgiveness, and loan-extension programs.

The U.S. government also supplemented weekly state unemployment benefits and sent American taxpayers direct aid in the form of three separate, tax-free stimulus checks.

The Bottom Line

John Maynard Keynes and Keynesian economics were revolutionary in the 1930s and did much to shape post-World War II economies in the mid-20th century. His theories came under attack in the 1970s, saw a resurgence in the 2000s, and are still debated today. Keynesian economics, recognizes the role of government finance in sparking aggregate demand. Federal spending and tax cuts leave more money in peoples’ pockets, which can stimulate demand and investment. Unlike free market economists, Keynesian economics welcomes limited government intervention and stimulus during times of recession.

Economics and World War II: Keynes Did Not “Get It Right”

What ended the Great Depression?

If you answered World War II, you’d be in agreement with most. Even the U.S. government officially endorses this stance, claiming that the wartime economic mobilization “cured” the Depression. This is because mainstream economic theory derives heavy influence from an economist named John Maynard Keynes. In his magnum opus “The General Theory of Employment, Interest, and Money,” Keynes argued that government intervention in the economy in the form of stimulus spending (including wartime spending) is the solution to economic recession.

Keynesian economists don’t argue that World War II ended the Great Depression without reason. Keynesian economics places heavy importance on a concept known as aggregate demand. In essence, aggregate demand is a measure of how much money an economy is spending at any given point. Gross Domestic Product (GDP) is the indicator used to determine aggregate demand, calculated by adding consumption and investment spending by individuals and businesses to the country’s government spending, and subtracting the trade deficit.

Keynesians assert that the higher aggregate demand is, the more money is changing hands. When money is spent, whoever is paid in turn has money to spend, and the spending continues: one man’s spending generates another man’s income. With more spending, more economic activity takes place. The effect compounds (or “multiplies”), resulting in what is known as the Keynesian money multiplier effect. Resources are mobilized, employment rises, and the economy flourishes. Government spending can potentially boost GDP by much more than the initial monetary amount. As such, Keynesians believe that in order to mobilize the economy during a recession, the government should spend money, either by pumping it directly into the economy or through giving consumers and businesses more income to spend.

The problem with the Keynesian story is that economics isn’t that simple. The economy is made up of individuals trading money, goods, and services. Individuals are self-interested. Consequently, any given trade in a capitalist market is a result of two people acting in a way they believe will improve their own conditions and satiate their desires. However, blind spending is not inherently good; where the spending is directed matters.

Then, what was the relationship between the Great Depression, its recovery, and World War II?

First, it’s important to review how exactly the Great Depression started. When speculating about the causes, people tend to point out symptoms such as declining consumer confidence, stock markets plunging, and bank panics and failures. However, these are just that: symptoms. It would be like blaming a plane crash on the plane falling out of the sky. To actually investigate the causes, it’s prudent to recognize the fact that the Great Depression was an economic “bust”, or decline in economic activity, preceded by a “boom”, a strong increase in economic activity.

Malinvestment, or economic investment in an unsustainable fashion, is often agreed upon to be the cause of the Great Depression. Malinvestment is usually caused by government intervention in the economy to unnaturally stimulate investment. Interest rates in equilibrium are generally determined by the intersection point of demand for investment and supply of savings in an economy. However, when the central bank engages in credit expansion, interest rates drop and the supply of loanable funds increases, making investment easier without a corresponding increase in savings. Indeed, this is what happened. The money supply increased by about 28 billion dollars during the 1920s. Economists Barry Eichengreen and Kris Mitchener in a paper conclude that “the credit boom view provides a useful perspective on The Great Depression.”

Monetary expansion, which creates investment, typically results in that investment being unsustainable, given the lack of savings to back it up. This eventually results in an economic crash. In 1929, lack of stability was revealed within the grain industry, where massive investment had already taken place. After European competition lowered the profitability of wheat in the US, stock prices crashed. The economic effect compounded, bank panics took place, and “a large-scale loss of confidence led to a sudden reduction in consumption and investment spending.”

This illustrates how recessions start and end. The culprit is malinvestment; overconfidence, often driven by loose central bank monetary policy, allows unsustainable investment into certain economic projects. When monetary policy is tightened or some other event shatters confidence, the crash results.

Then, what actually ended the Great Depression?

Economist Robert Higgs challenges the view that wartime expenditure was responsible. Instead, he argues that the economy was already in recovery from the Great Depression’s malinvestment before the war. Wartime spending disrupted this recovery, to the detriment of the average consumer. However, high expectations for the economy after the war restarted genuinely productive economic activity, allowing swift and true economic recovery.

This is not what Keynesians thought as World War II drew to a close. Many forecasted that the end of wartime spending would result in mass unemployment and economic catastrophe. Indeed, GDP fell… in terms of government spending. However, private economic activity was not deterred, and the predicted economic collapse never came about. The Great Depression of 1946 simply didn’t happen.

Wars don’t help economies. They destroy. People die, resources burn, and infrastructure topples. The economic activity created by wartime spending is wasteful. Rather than contributing to genuine economic growth in service of consumer demand, it simply shifts the economy in a random direction, using up resources in the process.

John Maynard Keynes himself argues that any economic activity is better than none at all. He cited the Treasury burying money and letting workers dig it up as a worthy potential economic project in service of increasing employment and aggregate demand. But the fallacy in such thinking is obvious. If every worker in the United States were to be employed in the U.S. army as a foot soldier, full employment would be the result. However, no one would produce food or maintain infrastructure. Society would instantly collapse. The type of employment in an economy matters. Full employment should not be the goal; good employment should be the goal.

Unfortunately for our economy, disciples of Keynes habitually take this hyperfixation on aggregate demand to heart, and not just when it comes to World War II. Take Paul Krugman. After the deadly attacks on the World Trade Center in 2001, Krugman was quick to respond. Within three days, he had an article published in the New York Times claiming that “Ghastly as it may seem to say this, the terror attack – like [World War II], which brought an end to the Great Depression – could even do some economic good.”

His argument was simple. The economy was coming off the back of a technology-based recession (note that Krugman explicitly predicted the recession wouldn’t happen back in 1998). Economic activity and business investment were low. Then, the attack took place. In his own words, “all of the sudden, we need some new office buildings.” Voila, money is spent in the process of rebuilding, and as a result of the Keynesian multiplier, the economy improves.

The fallacy in the argument is clear: ignorance of opportunity cost. According to Keynesians, idle economic capacity is bad, and any mobilization of these resources and labor is good. In its most basic form, Krugman’s Keynesian argument is a blatant case of the broken window fallacy. Krugman assumes that the resources and labor used to recover from the attack would otherwise be sitting around uselessly. However, the resources used to repair the tremendous damage from the attacks could’ve been used elsewhere, on new buildings rather than rebuilding old ones. Even resources idle at the moment could be used in later projects. Hospital beds and resources could’ve been saved for people who already needed them, rather than filling them up with injured victims of the attacks. All of this extra economic activity has an opportunity cost: alternative uses they could’ve gone towards.

Unfortunately for Krugman, the Twin Towers didn’t stimulate the economy well enough. In 2002, he wrote another New York Times article where he argued for the creation of a housing bubble to offset the technology recession. Yes, you read that right. He’s referring to the one that popped in 2008. In order to get business investment going again, lower interest rates could stimulate mass investment into housing. According to Krugman, in order to encourage business investment, the Federal Reserve ought to lower interest rates to stimulate mass investment into housing. In his own words, “[Fed Chairman] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”

The fallacy in his argument is once again clear. “Get resources moving; don’t worry about where they’re going. The economy can figure that out later.” But, is wasteful spending really an improvement over less spending? It clearly isn’t if the wasteful activity is unsustainable malinvestment into a sector of the economy. In the case of the housing bubble, that came in the form of incentivizing risky mortgage loans, and greater housing construction. The issue was that the ease of investing into the housing market was not based on genuine long-term demand for housing, but short-term confidence propped up by access to easy money.

Unfortunately for the average American, Greenspan did create the housing bubble. The result was the largest economic recession in American history at the time, other than the Great Depression itself. Yet, it wasn’t large enough for Krugman to get the memo. In 2011, he decided that in order to fix the result of reckless spending, the solution was more reckless spending, this time on an objectively useless economic project. That project was a fake alien invasion.

In Krugman’s own words, “If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the alien threat… this slump would be over in 18 months. And if we made a mistake and discovered that it was fake, we’d be a better [economy nonetheless]…” Nevermind the fact that the 2008 recession proved the unsustainability of just throwing money at some sector of the economy and stimulating mass investment into it. Two years later, in 2013, he doubled down on his earlier claim, saying “This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coal mines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing… unproductive spending is still better than nothing.”

Once again, the fallacy in his argument is clear. Wasteful spending on a fake alien invasion would divert resources and investment to the fake alien invasion, where they could have otherwise been used for genuinely productive economic activity. As the U.S. economy clearly discovered in 2008, when confidence is broken (likely in this hypothetical case by the revelation that the alien invasion was not real), the consequences can be disastrous. Investment stops, but the resources have already been used up in the collapsing sector. A recession follows.

Thankfully, Congress did not initiate the spending on this fictitious crisis. Unfortunately, however, the thinking underlying such a policy recommendation is still popular among economists today. Opportunity cost and the sustainability of spending are overlooked in the quest to maximize aggregate demand. A massive housing bubble is not sustainable. Wasting resources on a fake alien invasion is not sustainable. When the propped-up demand for housing falls or the alien invasion is uncovered as fake, jobs created in the bubbles will be lost. Wasted resources will either have to be scrapped or redirected towards actual productive uses. As we saw in 2008, this process is a potentially massive economic recession.

The ultimate lesson to be derived from all of this is that allocation matters. War is neither sustainable nor productive. Wars do not create. They ravage and annihilate. Wartime spending creates wasteful economic activity in service of death, destruction, and desolation. Wasteful stimulus spending creates malinvestments which ultimately destabilize the economy. Markets, saving, entrepreneurship, and natural investment should drive economic activity, rather than the despotic monetary planning that is Keynesian economic policy.

Where Keynes Went Wrong

It is generally recognized that the conceptual underpinnings for so-called stimulus programs lie in the theory developed by John Maynard Keynes in the 1930s. That the practical results of these programs in recent years have been negligible, if not negative, while their costs have been high, may be sufficient grounds for avoiding them in the future.

But what if the theory itself is flawed? For many economists, flawed theory would be a greater concern—surely more hurtful to professional pride—than ineffectual results from programs based on a valid theory. Moreover, it would mean no amount of effort to improve the design of stimulus programs is likely to help.

Before addressing questions about the theory, let’s briefly recap the costs and results of the stimulus so far.

Total stimulus costs have been high, but reckoning them accurately isn’t easy. They include $787 billion in federal spending that was legislated and appropriated in 2009 with the “stimulus” label attached to it. In addition, a proper accounting of the cost should include several other programs and outlays that, while not carrying the “stimulus” label, were designed to boost domestic spending or preclude reductions in spending that were otherwise expected to occur. These other programs include the following: TARP funding to relieve the impaired asset values and weakened balance sheets of financial institutions ($700 billion); bailout funds provided to support the auto industry ($17 billion); extension of unemployment benefits to support income and spending by unemployed workers ($34 billion); and temporary subsidies for the “cash for clunkers” program ($3 billion).

These other measures should be included in a full reckoning of stimulus costs because of their shared common purpose: to boost aggregate demand, or avoid its further decline as a consequence of the Great Recession.

All of these outlays, amounting to more than $1.5 trillion, are properly encompassed in Keynes’s central policy prescription: namely, to use public policy aggressively to stimulate “aggregate demand.” Those who have criticized the government’s stimulus efforts for being too small may not realize how large they have actually been.

What about the results of the stimulus package? Between the end of the second quarter of 2009 (when, incidentally, the Great Recession’s two-year negative GDP trend ended) and the end of the second quarter of 2011, nearly all the stimulus funding was disbursed. The result was that GDP increased from $12.6 trillion (in 2005 prices) to $13.3 trillion—an increase less than half the dollar-for-dollar injection of stimulus money! In the same period, gross private consumption rose by $400 billion, and gross private (nonresidential) fixed investment rose by $155 billion. In the same period, employment decreased by 581,000.

A simple accounting of costs and benefits—costs are high, benefits much lower—warrants skepticism about further recourse to stimulus spending. Still, it could be contended that, if the programs were better designed and better targeted in the future, results might justify the effort notwithstanding the recent record. This possibility warrants another look at the underlying Keynesian theory.

The core of the theory is “aggregate demand” defined in terms of two components: consumption demand and investment demand. In defining and measuring these components, Keynes acknowledged, with unusual and becoming modesty, his debt to a then-contemporary Russian-American academic, Simon Kuznets, who pioneered the development of a national accounting framework, which Keynes used in formulating his general theory. (Kuznets received the Nobel Prize for economics in 1971; Keynes died before the prize, which is not awarded posthumously, was initiated.)

Insufficient aggregate demand was Keynes’s diagnosis of the Depression-era conditions of continued unemployment and stagnant economic growth. Consumption demand had sharply contracted owing to the Great Depression’s effect on employment and income, and investment demand was depressed because profitable investment opportunities depended heavily on consumption, which had been decimated by the Depression.

Keynes’s prescription for escaping this vicious circle was to stimulate aggregate demand by aggressively increasing government spending and/or lowering taxes. Unlike many of his current disciples, Keynes acknowledged the potential of lower taxes to stimulate demand. However, the room for remedial action through tax reductions was limited in the 1930s because prevailing taxes were already low. Consequently, in Keynes’s view, increased government spending was necessary to boost aggregate demand—what was referred to in that day as “pump-priming” and these days as “stimulus.”

Moreover, whether the stimulus was to be provided by public works (“infrastructure”), by employing workers to dig holes and then fill them, or by other means didn’t matter to the theory. With ample idle resources—specifically, unemployed labor and idle plant and equipment—it was assumed that the only missing ingredient was sufficient demand to jump-start the economy. One dollar of additional government spending would wend its way through the economy as first-round recipients spent most of what they received, second-round recipients, in turn, spent most of what they received, thereby raising the income and ensuing spending of the next recipients, and so on. The total effect would thus be a multiple of the initial increase in spending. If, for example, the proportion of government’s increased spending that was spent by recipients was, say, 50 percent, the multiplier effect through the full economic circuit would be $2 for each dollar of increased spending; if the proportion were 60 percent, the multiplier would be 2.5.

The similarities between the Depression era and the current circumstances of our post-Great Recession are obvious. So, where’s the flaw?

All economic theories involve assumptions. The critical question is whether the assumptions are realistic. If there is uncertainty about the answer, the follow-on question is: How much will it matter if the assumptions are wrong?

Keynes assumed that the initial deficient level of aggregate demand would remain unchanged until the stimulative (“pump-priming”) effect of additional government spending kicked in. In other words, increased government spending, or its anticipation, would not further diminish pre-existing levels of consumer demand and investment demand. However, Keynes’s failure to consider the possibility of an adverse effect from government spending—that it might lead to still further decay in the prior levels of consumption and investment—was a fundamental flaw in the theory.

So how might government spending actually undermine its explicit purpose of boosting aggregate demand?

It is quite plausible that the behavior of consumers and investors might change as an unintended consequence of the increased government spending, and might do so in ways that would partly, fully, or even more than fully offset the attempted effort to raise aggregate demand.

Consider “Ricardian equivalence”—a conjecture advanced by David Ricardo a century before Keynes’s general theory and thus something Keynes was aware of, or should have been aware of. Ricardian equivalence suggested that consumers might reduce their spending to prepare for the tax increases they’d face in the future to pay for government spending financed by borrowing in the present. In recent years, Ricardo’s conjecture has been applied and tested in a formal model developed by Robert Barro.

That prior consumption demand might actually have been reduced as a result of recent government stimulus spending is suggested by two indicators: Since mid-2009, household savings increased by 2-3 percent of GDP, and household debt decreased by 8.6 percent ($1.1 trillion).

It is also plausible that investment demand might shrink as a result of increased government spending or its anticipation. This diminution might occur if investors have recourse to other investment opportunities that seem more profitable or less risky than those that would accompany or follow the attempted government stimulus. For example, such opportunities might lie in investing abroad where tax liabilities are less onerous, rather than investing at home; or investors might choose to invest in long-term instruments (30-year U.S. government bonds) while reducing investment in fixed capital or equities. These opportunities might seem rosier because of anticipated increases in future taxes, or because of increased regulatory restrictions that might (and did) accompany the increased government spending. In fact, such alternative investment opportunities are much more numerous and accessible now than in Keynes’s era.

Failure to consider the potentially adverse effect of government spending on the preexisting level of aggregate demand was and remains a disabling flaw in Keynesian theory—then and now. If the theory’s underlying logic is flawed, it can be expected that policies and programs based on it will fail. They have in the past. They should be avoided in the future.

Resources

imf.org, “What Is Keynesian Economics?” By Sarwat Jahan, Ahmed Saber Mahmud, and Chris Papageorgiou;

investopedia.com, “Keynesian Economics Theory: Definition and How It’s Used.” By The Investopedia Team;

econreview.berkeley.edu, “Economics and World War II: Keynes Did Not ‘Get It Right’.” By Denyse Chan;

rand.org, “Where Keynes Went Wrong.” By Charles Wolf, Jr.;