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.