“It Ain’t Necessarily So” George and Ira Gershwin, Porgy and Bess (1935) 

It is an article of faith among conservatives that government deficits automatically carry the threat of inflation. Milton Friedman once noted that inflation is everywhere and always a monetary phenomenon. The relationship between deficits and money creation is not absolute and the short-run relationship between money creation and inflation is also not absolute.

  Inflation is a sustained increase in the price level, not an increase in any specific price or a singular increase in the price level that does not continue. These distinctions are important because inflation requires money creation to continue. When the economy is operating at less than full employment levels, neither money creation nor deficits necessarily carry the threat of inflation.

 Recent published research (The Journal of Economic Perspectives, 3rd Quarter 2010) examined the relationship between large deficits and inflation in industrial economies since 1970. Let me quote from their conclusion: “We find that large deficits are not associated with higher inflation contemporaneously, nor are they associated with the emergence of higher inflation in subsequent years.”

Conservatives have been warning of the inflationary wolf since 2009. The pressing problem is unemployed resources not hypothetical inflation.

Federal Spending and Employment

Over the last few months much ink has been spilled over the effectiveness of federal government spending in stimulating job growth and employment. I propose to spill more ink. No sentient resident of Washington State can deny the influence of federal spending on job creation. The development of hydropower on the Columbia River, naval bases (Bangor, Whidbey Island) and ports (Bremerton, Everett) and the role of defense contracts in the growth of Boeing all attest to the regional employment effects of federal government spending. Government spending creates jobs.

But regional job creation is not the same thing as national growth in employment. It is possible that more economic activity here leads to less activity elsewhere, so the net effect is zero, possible but not likely under our current economy. It is even possible that the government expenditures totally displace private expenditures in the affected region.

  If the economy is operating at full employment, increased federal government spending financed by borrowing or taxes just transfers spending and resources from one use to another, and there is no overall increase in employment or output. This phenomenon is known as “crowding out”. Evidence of crowding out through government borrowing would be a rise in real interest rates. Ten year rates are now less than 2% (virtually zero in real, inflation adjusted terms). There is no indication that private borrowers are being discouraged by higher interest rates. However, if there is excess capacity and unemployed resources, increased government spending financed by borrowing (deficit spending) utilizes these resources and increases total output. Current data indicates the economy is operating at less than its potential.

Let’s return to the notion of “crowding out”. This is another way of illustrating the concept of opportunity costs or the foregone uses of resources when they are reallocated to a specific use. At the macro level this cost is only apparent when resources are alread fully employed and a new expenditure pattern develops.

At full employment, increased government expenditure would require a transfer of resources from one set off private uses to another set of uses. This could be accomplished by raising taxes, thereby reducing private consumption and investment and freeing resources from current uses. Increased government expenditures would just result in a transfer of real resources with no increase in real output.

Now let’s assume the expenditure is financed by borrowing from the public (domestic or foreign).Once again, the previous level of domestic investment was consistent with full employment and nothing real has changed other than the composition of output. Under full-employment conditions nothing real changes with changes in government expenditures and revenues. The GDP is unchanged. All effects are compositional, more scientists and fewer pole dancers.

If the economy is operating at less than full employment there are unused reserves of labor and other resources available. Increased government expenditures can lead to increased real output as government expenditures mop up unused or underutilized resources.

 Under this condition it makes no sense to raise taxes to finance the increased activity because increased taxes will reduce expenditures and total expenditures are already insufficient to generate full employment. The efficient option is to borrow the funds from savers. The private loans to the government will come out of excess reserves of the banking system and not crowd out private lending. Therefore increased public spending will increase total spending and employment QED.


There is one potential fly in this expansionary ointment. Economists of The Rational Expectations School argue that the government can’t expand output regardless of the level of employment or the means of financing. They adhere to a version of something called Ricardo Equivalence (Let it be stated that Ricardo did not hold to a strict interpretation of this concept. Like most true believers, the modern supporters of the view have gone well beyond the master’s views.). According to the equivalence principle the current generation recognizes the future tax burdens associated with deficit spending and adjust their current level of saving upward so as to meet the future tax burden. Therefore the drop in current consumption expenditures offsets the increase in government expenditures and there is no stimulative effect to increased government expenditures.

  Obviously raising taxes to pay for government expenditures is offset by decreased private expenditures. You can’t win! Fortunately for fiscal policy, the empirical evidence for this effect is wanting. During the 1981 to 1984 period when deficits increased dramatically there was not a compensating savings offset. So the deficits were expansionary and helped speed the recovery from a severe recession. Reagan’s results were Keynesian in principle.(Herbert Stein noted this at the time with the proper sense of irony). When the Federal Budget went from surplus to deficit under Bush there was no corresponding uptick in saving. In fact the savings rate fell.

As an aside, Alan Greenspan estimated, at the time, that about 20% of the Reagan tax cuts would be recouped through revenue gains. He was too pessimistic. Later estimates placed the figure closer to 30%. Thus a $100 billion tax cut would only increase the deficit by $70 billion. So much for the supply-side arguments, they should rest in peace.

“A regulatory climate that does not appreciate that the financial developments over an extended period of good times will tend to breed the financial environ- ment that leads to the likelihood of crisis and hard times, will not serve this economy well.
                               ” Hyman Minsky (1975)

Federal Spending and Employment

Over the last few months much ink has been spilled over the effectiveness of federal government spending in stimulating job growth and employment. I propose to spill more ink. No sentient resident of Washington State can deny the influence of federal spending on job creation.

The development of hydropower on the Columbia River, naval bases (Bangor, Whidbey Island) and ports (Bremerton, Everett) and the role of defense contracts in the growth of Boeing all attest to the regional employment effects of federal government spending. Government spending creates jobs.

But regional job creation is not the same thing as national growth in employment. It is possible that more economic activity here leads to less activity elsewhere, so the net effect is zero. Possible but not likely under our current economy.

If the economy is operating at full employment, increased federal government spending financed by borrowing or taxes just transfers spending and resources from one use to another and there is no overall increase in employment or output. However, if there is excess capacity and unemployed resources, increased government spending financed by borrowing (deficit spending) utilizes these resources and increases total output. Current data indicates the economy is operating at less than its potent

Taxing Evidence 

President Nixon once noted that, although honesty isn’t always the best policy, it should be tried now and then. When it comes to taxes, politicians fall back on ideological/philosophical bromides and seldom refer to the data. Now and then it is worthwhile to look at the data. In particular, what actual evidence supports a relationship between capital gains tax rates and economic growth? I’ve selected the capital gains tax because it has it has the most quasi-religious ideology attached to it. Since the political ascendency of supply-side economics (mid 1970s), politicians have focused on marginal tax rates for ordinary and capital gains income. They have asserted that economic behavior is highly sensitive to minor changes to the tax rates. Much of this discussion has been economics by assertion (hysterical evidence) rather than to actual data (historical evidence).

Academic economists have remained largely immune to the more extreme supply side arguments, i.e. any assertion by Arthur Laffer. Why? The reason is simple: the data do not support the assertions. One would expect the data to reveal a strong negative relationship between the capital gains tax rate and economic growth. As rates go down, the “job creators” would engage in a feeding frenzy of new investments and economic growth would soar. Conversely, increases in the rate would dramatically reduce investment and economic growth would slow to a crawl. Statistical investigations of the macroeconomic data for the last 50 years do not reveal this asserted behavior.

There are, at least, two explanations for these results. First, other economic factors overwhelm the tax rate affect. The tax rate affect may exist but is not strong; the noise drowns out the signal. A second reason may be that capital gains taxes are poorly targeted and reward behavior that isn’t related to real investment and growth. Growth requires investment in plants, equipment and people; not the financial churning that characterizes much of the activity in stock and bond markets, let alone real estate. Many financial transactions have little to do with risk taking investment in productive assets, but are eligible for the capital gains tax rate. For example, I can go to my broker and purchase $1000 worth of stock from a seller and, if I hold it long enough and the value of the stock increases, I can sell it and be taxed at the capital gains rate rather than the income tax rate. I’ve been rewarded for taking financial risk but the risk is not directly related to the creation of real productive assets. Lucky me! Only if the stock is an initial public offering (IPO) or is newly minted by an existing firm to raise capital, is a stock transaction related to real investment.

Finally, even though the real economic benefits of the capital gains tax are ambiguous at best, it does have one clear effect: it widens the income and wealth gaps between the rich and poor. Over a 20 year period from 1991 until 2011, 80% of capital gains income went to 5% of the population. Actually the result is even more skewed. The top 0.1% of income earners garnered 50% of the total capital gains income. So the tax slices the pie without encouraging its growth.

I am not writing this piece as a partisan ideologue. I am not a member of either major party. I do believe, as did President Nixon, that honesty should be tried now and then. This means that assertions should be buttressed by actual facts. Ideology should not triumph evidence.

Entitlement Blues

The late economist Herbert Stein (Chairman of the Council of Economic Advisors under Nixon,  a founder of the American Enterprise Institute and an avowed Rockefeller Republican) once noted that something that is unsustainable cannot continue. It is asserted by those in the know of both right and left political persuasions that the current federal budget path is unsustainable and entitlements are the problem.

In particular the Medicare and Medicaid programs are on a long-run path to swallowing the whole budget. (Social Security also has a problem but it is modest by comparison.) The medical expenditures are driven by the nation’s demography and the medical sector’s increasing treatment costs. Both of these elements are outside of the formal budgeting process. Our population will continue to age. No one has made a convincing argument yet as to how to slow down the rate of medical inflation.

The Ryan/Republican approach is to shift the costs off budget by increasing the share of the costs paid for by the beneficiaries. The Obama Administration and the Democrats hope to shift some of the costs to the supply side of the medical market place. Neither approach directly deals with the demographic and cost inflation. The burdens are just redistributed. A real solution remains politically elusive.

This Ryan Won’t Fly-Part 1

Back in the days when economists had a sense of humor and irony Herbert Stein noted that something that is unsustainable will not continue. This unalterable fact is true of federal finances as currently constructed. The budget has a structural deficit of about 4%+ of GDP and this structural component will grow if the spending/taxing relationship is not changed. The Debt/GDP ratio will have to be reduced and stabilized. Empirical research indicates a ratio of around 60% is necessary for long-run economic stability. We are currently at 80% and moving towards a three digit level within the next few years. The recession is only partially responsible (about 60% of the current deficit can be attributed to the slow economy).

Currently there are three fully formed budgetary proposals designed to put federal finances on a sustainable path and reduce deficits and federal debt. They are : The Bowles-Simpson plan put forward by the President’s Commission on Fiscal Responsibility and Reform, the Rivlin-Domenici deficit reduction plan proposed by the Bipartisan Policy Center and the “Path to Prosperity” fiscal plan proposed by Congressman Ryan. And recently the Obama Late Entry Plan. I take it as a political truth that only bipartisan support will generate a plan that has any chance of legislative enactment, and bipartisan support indicates the public has the stomach for the plan’s distribution of pains and benefits.

This eliminates two extremes: A plan that claims to attack  the fiscal crisis by only cutting spending (The Ryan Plan )or a plan that solves the problem by only raising revenues (I’m speaking of both of these as a share of GDP). The current fiscal gap is roughly 10% of GDP.Under the current structure of taxes and expenditures. This gap would close to around 5% if the economy were operating at a full employment level of output. Any plan must reduce this structural gap to claim it will achieve fiscal sustainability.

The trick is to move toward a sustainable fiscal balance without jeopardizing the recovery. The adoption of a plan will not in itself immediately stimulate the recovery. It will improve the nation’s balance sheet overtime and provide a foundation for more economic stability. It accomplishes this by stabilizing and gradually reducing the Debt/GDP ratio at the 60% range, and reduces the potential “crowding out” effect of increasing federal debt held by the public. This does not assure balancing of the budget, at least not, annually. The ideal solution (I think) involves cyclical balancing of the budget with a virtual balance at around 5% unemployment and surpluses at output levels that generate unemployment a lower levels.

In the real world a politically acceptable solution will involve increased taxes, and program cuts (this will involve actual reductions in the growth rate of entitlement spending, actual reductions in Medicare and Medicaid. Pain for all is the politically acceptable solution.

A balanced plan also implies some growth in the federal share of the GDP. Demographic trends augur for an aging population and this means increased medical care per capita. Demography is destiny.There is no extant evidence that medical costs for the elderly will decline in absolute terms, or for that matter in relative terms. This means that the current and future generations will have to save more (either through increased personal savings or increased taxes) to cover growing medical expenses. Geriatric care is the elephant in the closet, and the elephant is growing. We can offset some of this burden through economic growth but growth is unlikely to offset all of it. We can try and offset the growth in medical federal medical liabilities trend by reducing government expenditures on other programs. That will buy some time but unless you can envision defense spending and non-defense discretionary spending trending to zero, the budget will increase. The interest on the debt is the other item that seems primed for inexorable growth absent serious fiscal discipline.

The Ryan approach throws all the burden of hunting elephants to the expenditure side of the budget. Over time discretionary spending declines by 91% as a share of the budget and Medicare and Medicaid spending are significantly reduced The burden of all these cuts falls on the majority of the population.

Nothing real has changed. The elephant is still growing demography and medical cost trends guarantee this result. The cost is shifted to the consumers of medical services. (Additionally, The Affordable Care Act is also repealed) Let me suggest that all of this is politically impossible, but the fight will slow down the search for real alternatives.

The federal budget deficit is not the real focus of the Ryan Plan. He wants to reduce the share of Federal spending to GDP to its post WW2 average of around 18% and just cuts spending growth to get there. The deficit is not eliminated until 2030 under his favorable economic growth assumptions. A discussion of these assumptions will follow in the next installment of the Ryan flight plan.

These spending cuts and medical cost redistributions will be combined with higher income earners sacrificing pre-Bush tax rates. This is the most regressive fiscal revision in US history.

Cliff Notes

The length of a recession is officially measured by the National Bureau of Economic Research (NBER) as the time from the previous peak in economic activity to the nadir (trough). This recession, known as The Great Recession, lasted 18 months according to the NBER, from December 2007 until June of 2009. Seems like forever. The recovery has been phlegmatic compared to typical post war recessions.  The cause(s) of this recession were not typical and were characterized by a severe financial crisis. Academic research indicates that the private deleveraging process required to recover from a crisis of this type typically takes several years (See Rienhart and Rogoff “This Time is Different: Eight Centuries of Financial Folly” 2009). We are doomed to a typical recovery. Our potential recovery is complicated by perceptions of the risks associated with our high level of public debt, particularly federal debt.

 It is obviously naïve to expect politicians to clarify issues surrounding the present state of the economy They have not disappointed.. The role of political philosophy colors the debate. Ideology prevents reasonable discussion and the weighing of evidence. The mavens of the left overstate the benefits of intervention and those of the right deny the possibility of benefits and see only negative consequences. How about a discussion based on logic and/or evidence rather than quasi-religious beliefs?

Simply put the “fiscal cliff” is a combination of tax increases and expenditure cuts designed to reduce the deficit by about 50% immediately. If this combination sounds like the European approach to their fiscal crisis, that’s because it is. We can observe how well it’s doing there. Why should we be different? There is no reason why. The Congressional Budget Office (CBO) estimates the effect of making the leap as a one-half percentage point reduction in the growth rate( or about $80 billion a year in GDP loss) with a high probability of a recession in 2013. So the price is lost output and increased unemployment. The economy returns normal growth (from a lower base) by 2015 according to projections. The gain is a lower cumulative deficit in the ensuing years. But the accumulated output loss adds insult to injury and insures that this accumulation will take years to overcome. The price is too damn high.

Larry Summers and Christina Romer have argued convincingly (April 2012) that more stimulus now with a real long-term plan for fiscal rectitude will achieve greater growth at less short-term cost. Makes sense to me. Sometime you have to strengthen the patient before performing the surgery.

More fiscal stimulus at this time with continued Quantitative Easing by the Federal Reserve has the possibility of giving the economy the jolt it needs to continue its revival even though global growth is slowing down. This prescription is the only game in town. Krugman and some other lefties have argued for a more aggressive monetary policy by the Fed. They would like the Fed to raise the target rate of inflation (currently 2% per year to 3 or 4%). They argue that raising the explicit target would encourage more consumer and business spending as there would be an expectation of more inflation, hence a fear of depreciating currency. I sympathize with this argument but it is not without risk. Once in place, inflationary expectations are hard to reverse, and there is a danger of overshooting the target. Let me just note at this time that the tighter monetary policy necessary to reduce inflation is not without significant costs.

Robert’s Rules of Order

The Supreme Court has spoken and the political din is in full campaign mode. Dickens was half right. This is the worst of times for the democratic process. Partisanship has removed all rationality from the discussion of America’s health care system and the Affordable Care Act in particular.

Let’s be clear about the basic parameters of the system. Everybody has access to medical care. About 15% of the population is uninsured and have inadequate access to regular care but can receive care at emergency rooms. This is very expensive and the cost is shifted to those covered by insurance. The result is higher cost for those insured and greater morbidity for the uninsured. A Dickensian result. Everybody is worse off.

One component of the ACA proposed to extend Medicaid coverage (administered by the states and aimed at the poorest segments of the population) and offered, as a sweetener, to cover all of the costs for the first three years  The level of support would decline to 90% by 2020 and remain at that level. This provision was invalidated by the Court due to the penalty provision, so the states have the option of not extending coverage. Some governors have expressed an unwillingness to extend coverage under the rubric of avoiding future costs.

The states may avoid the costs but society won’t. It is an unforgiving law of economics that all bills get paid. It is just a matter of who pays, when and how? Medicaid expenditures explicitly recognize and cover these costs. Those states refusing the extended coverage aren’t reducing these costs; they are just shifting these costs to those covered by insurance. It means higher premiums for the insured. These costs are “hidden,” but no less real.

All of this roiling is another sorry example of the political system’s unwillingness to recognize that all balance sheets have two sides and hiding costs do not eliminate them.

Bad Conventional Wisdom, Then and Now

“By 1960, progressive income taxation on the one hand

and income support measures for the poor on the other

hand were accepted by all but the most unreconstructed

conservatives.”

Herbert Stein, Presidential Economics. Third Revised Edition 1993

(Chairman, Council of Economic Advisors under Nixon)

 Since 1980 a whole lot of deconstruction has been going on, particularly in the Republican Party. Mr. Stein, who was chairman of the Council of Economic Advisors (CEA) in the Nixon Administration and a founder of the American Enterprise Institute, considered himself a Rockefeller Republican. This brand of fiscally moderate, internationalist Republicanism is all but extinct. There may be a member or two of the species still alive in Maine but it’s not clear a breeding pair has survived.

Since 1980 a strident quasi-religious brand of conservatism has fully captured the Republican Party. They’ve rediscovered all the bad advice that Andrew Mellon gave Hoover and made it part of their dogma. The empirically based conservatism of Milton Friedman is no longer part of the received wisdom.

They claim that we are heading down the Grecian path to fiscal ruin while extolling the austerity policies that guarantee decline. There is not a shard of evidence demonstrating that austerity is an effective way out of the current economic problems facing the Greeks or the rest of west. Iceland has the one crisis  economy that is actually generating some heat and their policy is determinedly anti-austerity.

It’s been over four years (Dec ember 2007) since the recession officially began and three years (June 2009) since the recovery officially started. It is the first major financial crisis since the Great Depression and involves all of the major western economies. Even the German banking system is fragile.

The US is recovering very slowly and Europe is stagnant. At the current pace of recovery it will be years before we regain a semblance of a fully employed economy. How did we get here?

Our sustained prosperity of the 1990s was framed by monetary and fiscal policies antithetical to the current conservative cant. Taxes were raised early in the recovery process and monetary policy accommodated the real expansion. The result was an unequaled experience with 108 months of uninterrupted expansion, falling unemployment rates, stable prices and falling federal deficits.

Clearly the monetary and fiscal policies of the period were consistent with uninterrupted prosperity. At the very least policy didn’t get in the way. At the same time structural changes were occurring. Manufacturing was continuing its relative decline, internet industries were enjoying birth and growth, and the financial sector was undergoing growth and deregulation.

Until the current serious financial crises, post WWII history of business cycles indicated that monetary and fiscal policies in the western economies has been consistent with shorter, less extreme business cycles than pre-WWII experience. This is a modest claim, but indicates monetary and fiscal policy as practiced in the US has been more beneficial than its conservative critics claim.

These critics have now left the reservation and are preaching a version of fiscal and monetary austerity that is theoretically and empirically bankrupt given the current circumstances. This bizarre advice has been followed by the Euro Zone countries and the results are apparent. The southern tier of countries has gone from recession to depression. The Irish and British economies are returning to recession and their debt loads are increasing. The German economy is heading towards a stall speed. It’s all pain and no gain. At some time common sense will triumph ideology. In the meantime unemployment will increase and debt will increase. This state of affairs can only be characterized as economic sadism.

Evidence

“However beautiful the strategy, you should occasionally look at the result.”

Winston Churchill

Sooner or later arguments over policy must actually refer to the real world. England,Portugal, Ireland ,Spain and Greece have adopted policies favored by traditional conservatives in the US. Some of the countries are in crisis because of government squandering financed by borrowing, others by real estate and financial bubbles in the private sector (England, Ireland, and Spain) It may be useful to examine the preliminary results of following these policies. Is fiscal austerity a path to prosperity when starting from a position of financial crisis and severe recession?

The short answer is no. All of the countries listed are in deep recession (in fact one could argue that Greece is in a depression) and recovery is not at hand. Recovery is a complicated process and requires two sets of policies. The first one is aimed at recovery and the second one focuses on sustainability. Once you dig out, you want to stay out.

The shovels are monetary and fiscal policies designed to increase total spending and encourage sustained growth. This task is trickier than it sounds because one must account for the affect of actions on the spending response of the general population to policy actions. This induced effect imposes limitations on the effectiveness of policy. It is possible but not entirely plausible, that private sector, consumers in particular, could take actions that offset fiscal stimulus or fiscal contraction. Evidence for this would be private saving varying inversely with the budget surplus or deficit. This would indicate that changes in consumer spending would act to offset government fiscal policy. This argument is made by some conservative economists. All that is lacking is evidence. The growth in deficits during the Reagan and Bush2 Administrations were not accompanied by increased personal savings rate but by more consumption.

It seems clear that if private sector actions do not fully offset the effects of increased public expenditures or tax cuts the federal actions will increase or decrease total spending, hence GDP. Historical evidence suggests that monetary and fiscal policy do make a difference but not immediately and not of the magnitude once thought. Tax cuts are not totally spent, federal expenditures are generate less additional spending than once thought and the creation of bank reserves do not immediately increase lending by significant amounts. Evidence has tempered views on policy effectiveness. But, less effective does not mean ineffective.

Those who argue that economic healing can only occur through a natural process (Austrian Economists in particular) do not have evidence on their side. If one reviews the evidence on the rate of economic recovery from the Great Depression among the western economies the evidence is strong for proactive intervention. Countries that left the gold standard recovered faster, and those countries that were most expansive in their monetary and fiscal actions recovered more rapidly. The United States and France were among the slowest to recover and followed the most conservative monetary and fiscal policies.

Ben Bernanke the Chairman of the Federal Reserve is a student of the Great Depression and was profoundly influenced by Milton Friedman and Ana Schwartz’s history of monetary fluctuations (A Monetary History of the United States 1867 to 1963). That study provides ample documentation of the Federal Reserve’s policy errors during the Great Depression. In their view, the Fed’s initial monetary restriction in the 1929-33 time period converted a recession into the Great Depression. Their continued conservatism hampered the ensuing recovery. The Chairman’s own academic research has reinforced the Friedman/Schwartz study.

It must be admitted that many of the New Deals economic proposals were economically incoherent ( a view shared by Keynes) and represented  experimentation without theory. But many of the infrastructure and direct employment programs were stimulative, they were just insufficient. For example, the deficits in Reagan’s first term averaged about 4% of GDP. The New Deal peacetime deficit only averaged about 2.6% of GDP. How far we’ve come.

Hunting the Elusive Keynesian

“This long run is a misleading guide to current affairs. In the long run

we are all dead. Economists set themselves too easy, too useless a task

if in tempestuous seasons they can only tell us that when the storm

has passed the ocean is flat again.”

John Maynard Keynes (A Tract on Monetary Reform. 1923)

Much has been made of late by journalists and letter writers of all political persuasions about fiscal and monetary policy. Discussions in the popular press and among the talking heads on cable news networks have failed to properly identify the real Keynesians. I hope to remedy that shortcoming. After this discussion you will be able to identify the crafty Keynesians among you. You can then take appropriate defensive measures.

 Keynesian analysis focuses on the short run. This is a period of time when productive capacity and productive resources, including the labor force, can be treated as fixed. The fundamental macroeconomic problem is keeping this capacity fully utilized.

The Keynesians propound a theory of total spending (aggregate demand) and its relationship to total output, employment and the price level. It is fluctuations in this spending that is responsible for the underemployment of resources. It is asserted that aggregate demand is not inherently stable, nor does it necessarily tend to levels that assure full employment. Therefore, policy intervention is necessary if society is to maintain high levels of output and employment.

They argue that monetary and fiscal policy can reduce the amplitude and duration of business cycles and thereby reduce average levels of unemployment and loss output. All of these issues have been examined empirically, and although the results are mixed, I think the preponderance of results favor the Keynesian view. Why should this be so?

When these aggregate demand fluctuations occur, real output and employment are significantly affected but nominal wages and prices are sticky and adjust slowly (The evidence supports this.).If aggregate demand is falling and price and wage adjustments lag, then output and employment must vary. Economic adjustments are adjustments in prices and quantities. Stickiness in one set of variables shifts the adjustment to the other variables.(During the Great Depression nominal wages fell less than prices, hence real wages increased in spite of record levels of unemployment. (This phenomenon has been studied exhaustively with no clear conclusions as to why).

 During the current Great Recession real estate prices have fallen, but these are fixed assets. The prices of things we consume daily and produce currently have fallen very little as measured by the consumer price index (cpi). Wages have also remained stable in nominal terms.

At one time (the 1960s) professed Keynesians were so confident of their paradigm that they spoke confidently of using monetary and fiscal policy to fine tune the economy. The real world, particularly the stagflation of the 1970’s, ended this level of policy hubris.

The putative effectiveness of fiscal policy (expenditures and taxes) is dependent upon a particular theoretical assertion particular to the Keynesian paradigm. This effectiveness is dependent upon something called the “multiplier effect”. This effect is a posited relationship between changes in the level of government expenditures or taxes and induced spending by the private sector on the part of consumers and businesses (the effect also holds for changes in private investment and exports) If the induced effects are positive the change in government expenditures (or taxes) has a magnified effect on total societal spending. This induced effect is the “multiplier”.

It is important to note that the multiplier effect is only real when there are unemployed resources in the economy. If the economy’s resources are fully employed the effect of increasing government s share of total spending is to transfer resources among uses (and increase the price level) and not increase total output. This “crowding out” indicates a zero value for the fiscal policy multiplier in real term. Empirical studies do not support large values (significantly >1) for the multiplier. But it is greater than zero. Again, if wages and prices are sticky the employment and output effects will be greater.

That actual fiscal policy is less effective than theoretical fiscal policy is not an argument against any fiscal policy. Many medicines work better in the lab than on patients, and better in clinical trials than in practice. They are still prescribed. It may be that a larger dose is necessary for a given goal.

Fiscal policy is not enacted in a vacuum. Its effectiveness is enhanced by an accommodative monetary policy. Changes in federal expenditures and/or taxes may affect the level of interest rates that counter policy goals Thus, in the absence of monetary intervention fiscal policy may be blunted.

Keynesians regard monetary policy as an asymmetrical policy option: Good against inflation, ineffective against recession or depression. It can constrain excess demand but not create demand. Once again the evidence is mixed. Although, I think the Friedman/Schwartz investigations of monetary behavior during the Great Depression argues otherwise. The banking panic of the early thirties and subsequent system wide contraction of credit transmogrified a severe recession into The Big One. A strong recovery did begin after banking reform in 1933 and continued until 1937 when the application of misguided economic orthodoxy engendered a severe contraction.

Milton Friedman famously said (31/Dec/1965/Time Magazine) “We are all Keynesians now and nobody is any longer a Keynesian”. Everybody has purchased some portion of the apparatus and some portion of the theory, but no one believed it all. This is clearly true for the mainstream. On the fringes there are some true believers and some atheists. The true believers, like most true believers, believe in a version of Keynesianism beyond what Keynes believed. Keynes believed in monetary and fiscal policies as stabilizing devices not as a rationale for the relative expansion of the role of central government.

Economic Malpractice

               Someone once defined insanity as repeating the same behavior and expecting different results. We are now in the midst of an economic policy debate in which conservatives are preaching a reasonable facsimile of an economic policy that failed in 1937.

               By the spring of 1937 the moderate expansionist policies of the Roosevelt Administration had aided the economic recovery. Profits, wages and industrial production had reached 1929 levels. Even so, unemployment was still at 14.3% . Unemployment had peaked at 25% in 1933. We had been in a very deep hole and were digging our way out.

               At that moment, the Roosevelt Administration suffered an attack of economic orthodoxy and fiscally retreated in an attempt to balance the budget. Roosevelt had not fully digested the Keynesian prescription for fiscal policy during periods of high unemployment

It was the wrong medicine at the wrong time. The result of this return to fiscal orthodoxy was a 37% drop in manufacturing output to 1934 levels. Unemployment surged to 19% by 1938.

Conservatives are, once again, preaching a return to fiscal orthodoxy in the midst of recovery. Why should the medicine work this time? The economic version of a colon cleansing may make sense during a period of inflation but is not the proper prescription for continuing recovery.

Fiscal Fitness

Much is written these days concerning the federal budget, deficits, debt and fiscal prudence. The relationship of the budget to the level of economic activity is not well understood by many of the writers. I hope to subtract from the current confusions.
Once we opted for an income tax (1913) as a source of revenue, the revenue side of the budget became more sensitive to the business cycle. As the progressivity of the income tax increased, this sensitivity increased. Economic expansions and contractions moved segments of the population among the various income tax brackets and increased the sensitivity of government revenues to the ebbs and flows of economic activity. The transfer payment components of the budget, such as unemployment compensation, also behave in a countercyclical manner, increasing during recessions and declining during booms. Social Security payments are also mildly countercyclical, expenditures don’t decline during recessions or increase during booms, whereas revenues into the fund increase during booms and decrease during recessions. The same is true of Medicare. In summary, the inherent logic of the federal financing system is counter-cyclical and therefore stabilizing to the macro economy. This seems to me to be desirable. We do not want a budget structure that enhances rather than constrains the cyclical variability of our market economy.
 A balanced budget at this stage in the recovery would be counterproductive. One need only review the record on the Roosevelt Recession of 1937 to see what premature prudence (that’s about as racy as economics gets) can do to a strong recovery, let alone a slow recovery. In the post WW2 period up to 1960 the federal budget was roughly balanced, with years of deficits balanced by years of surplus. In a Keynesian world that was how it was supposed to work. He advocated cyclically balanced budgets with surpluses during booms and deficits during downturns. He underrated the ability of democratic governments to enshrine structural deficits. Since the 1960s deficits have been the rule and have become structurally embedded in the federal financial system. This has also been true in Western Europe. On the spending side we have the entitlement system with Medicare and Medicaid posing serious problems in the short-and medium term, and Social Security posing a long-term problem. Our unfunded obligations exceed $60 trillion
. On the revenue side the tax structure that emerged from the Bush Administration is inconsistent with balanced budgets or surpluses under any known economic projections and unfunded mandates were expanded. Both political parties share in this dilemma. A realistic financial solution that is politically feasible will involve revenue increase and expenditure constraint. The ugly politics involves how the pain is to be distributed.
Maybe it’s our fault. Economic growth has allowed us to postpone the date of unsustainability for a very long time, and we’ve made few demands of our legislators other than bringing home the bacon. But as Herbert Stein once observed, something that is unsustainable will not continue.
The cure  will result in a budget that generates a surplus during booms and deficits during recessions and a balanced budget in a Goldilocks economy. This behavior says nothing about the share of federal revenues and expenditures to the GDP. That is a philosophical argument dealing with the role of government in society.
 Expansive welfare states in Europe have government shares well in excess of 40% of their GDPs and they provide greater services to their constituents than we do. They are also quite prosperous and have shown the ability to grow at rates comparable to us. In the west economic performance and government size are not strongly correlated. Sorry.

The Profile

I’m a septuagenarian (born in 1936) and a product of a Seattle public school education from grade school through graduate school. I was raised in a middle-class environment. I don’t remember lacking even during WW2. Being active in sports and playing in the streets was a way of life. We didn’t get a television set until 1949, too late to profoundly affect my reading and physical activity habits.

At the age of 14 I discovered the Century Athletic Club and it was a life changing experience. I’ve been a gym rat ever since and exercise still plays an important part in my life.

After finishing school in 1965 I taught at the University of Colorado, Denver Center, worked as a consultant in Kirkland, Washington and Santa Barbara, California. My final employment was in Anchorage, Alaska as a Petroleum Economist for the Department of Natural Resources. After official retirement in 1991 my wife (Laurel) and I settled along the Kalama River Road in Kalama, Washington. She continued working as an environmental consultant while I did some adjunct teaching at Linfield College and Clark Community College.

Since 2005 I’ve avoided meaningful employment and lived the good life along the river with Laurel and written occasional op-ed pieces and hectoring letters for the local paper (The Longview Daily News).I view this blog as a logical extension of my op-ed proclivities.