Econ 101: That Old-Time Keynesian Theory

The solution to the current economic downturn as put forth by the majority in Congress and touted by most of the news media is for the federal government to enact a massive “stimulus package.”

This stimulus package will be weighted towards federal government spending with some redistribution of income labeled a tax cut. The theory behind the program is fairly straight-forward Keynesian (named after John Maynard Keynes) macroeconomics. The hypothesis is that the recession is being caused by a lack of demand, particularly consumer-demand. As consumer sentiment falls, consumers save and this drop in demand causes companies to lay off workers, leading to further declines in demand, and so on in a vicious cycle. This is what has been called the “paradox of thrift.” The only way to stop this is for government to increase its spending, which will increase total demand, increase employment and save us from our own saving.

While the recent Nobel Laureate, Paul Krugman, has recently expounded this scenario in a New York Times article, one might also consider what another Nobel Prize winning economist, Gary Becker, has written of the spending plan:

“Some of this infrastructure spending may be very worthwhile …but however merited, it is difficult to believe that they would provide much of a stimulus to the economy. Expansion of the health sector, for example, will add jobs to this sector, but it will do this mainly by drawing people into the health care sector who are presently employed in jobs outside this sector,” Becker wrote. “This is because unemployment rates among health care workers are quite low, and most of the unemployed who had worked in construction, finance, or manufacturing are unlikely to qualify as health care workers without considerable additional training. This same conclusion applies to spending on expanding broadband, to make the energy used greener, to encourage new technologies and more research, and to improve teaching.”

Other Nobel Prize winners have attacked the roots of Keynesian economics.

Friedrich Hayek held the view that business cycles are monetary phenomena that affect the investment cycle. In 1928, he correctly predicted the coming of the Great Depression, arguing that the stable prices were covering up a large inflation of credit and misdirection of investment caused by over-expansionary monetary policy that would lead to economic turmoil.

In a 1975 Italian lecture, Hayek said: “ … Keynes gained acceptance for the fatal idea, namely, that unemployment is predominantly due to an insufficiency of aggregate demand.” In his 1974 lecture upon winning the Nobel Prize in Economics, Hayek stated he regarded the Keynesian theory of the relationship between employment and aggregate demand “as fundamentally false.”  In that lecture he also said that the correct explanation of extensive unemployment is “the existence of discrepancies between the distribution of demand among the different goods and services, and the allocation of labor and other resources among the production of those outputs.”  These conditions cannot be corrected by increasing government spending.

Another Nobel Prize winner, Milton Friedman, wrote in a famous dialogue with Walter Heller in 1968, “The fascinating thing to me is that the widespread faith in the potency of fiscal policy … rests on no evidence whatsoever.” Friedman was famous for his argument that fiscal policy was ineffective in altering employment and that monetary policy had short run effects on real economic variables and long run effects only on prices.

In “The Counter-Revolution in Monetary Theory,” he wrote about the effectiveness of fiscal policy:  “The ‘monetarists’ rejected this proposition and maintained that fiscal policy by itself is largely ineffective, that what matters is what happens to the quantity of money.”

In a 2006 Wall Street Journal interview, Friedman said of Keynes: “Now Keynes, in the ‘General Theory of Employment, Interest and Money,’ set forth a hypothesis which was a beautiful one, and it really altered the shape of economics. But it turned out it was a wrong hypothesis.”

Today there is enormous momentum for a massive “economic stimulus” plan that is based upon the presumption that the Keynesian model is correct. Yet clearly there is not a consensus among economists that government spending of more than $550 billion will have even a short term positive effect on the economy, much less a positive long term effect.

To give the size of the increased spending some perspective, the total of federal government outlays was $590.9 billion in fiscal year 1980. In order to have a chance of the increased spending affecting the current recession, it must take place within the next few months. This means that, rather than the spending being allocated based on the benefits of the project being greater than the costs, it will be allocated based upon whether the project is “shovel ready.”  The political floodgates are open and the lobbying for projects and programs will be fierce. There is nothing in the political process that naturally leads to an efficient use of the dollars that are up for grabs.

The tax cuts in the package will be in the range of $275 billion. There is considerably more consensus on tax cuts having a positive impact on the economy. The reason is that one does not have to rely on a belief in Keynesian economics.

Tax reductions can create an incentive to produce, and hire workers in the process. Reductions in the marginal tax rates on income earnings, but particularly reductions in corporate income taxes will certainly result in greater output. The United States has one of the highest corporate income taxes in the world. Lowering the rate will make it less expensive to produce in the U.S., and create jobs and economic activity.

However, transfer payments disguised as tax cuts, such as the Bush administration’s effort at fiscal stimulus in 2008, do not create any incentive to produce, which is why there was no positive effect on the economy from last year’s plan. Any tax cut must be related to incentives for production, not consumption. 

In 1992, Gregory Mankiw of Harvard University and former Chairman of the Council of Economic Advisors wrote an article entitled “Macroeconomics in Disarray.” This title may be descriptive of the current situation, which should give us pause about adopting without question an economic stimulus package that will increase the already massive federal deficit and will not likely provide us with a stronger economy in return.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College. He is also a Business & Media Institute adviser.