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.