The Faulty premise of Keynesian Economics

The theory of Keynesian economics was created by John Maynard Keynes in the 1930s. Keynesian economics is built on the principle of aggregate demand, which states that aggregate demand is the sum of consumer spending, investment (business) spending and government spending. Keynes’ aggregate demand is basically net spending within the economy. Keynes further states that aggregate demand is not static, and that it can increase and decrease, which is also true. If spending never increased nor decreased the economy would never grow or go into recession, this is pretty basic stuff. Whereas this basic principle of aggregate demand is true, Keynes completely misapplies this principle in his economic theory.

Keynes argued that only government spending could end a recession.

Keynes posited the theory that in an economic downturn, investment spending would go into an endless downward spiral leading to an ever deeper and unending recession. Keynes argued that the only way out of an endless recession, once one set in, was if the government stepped in and replaced the lost consumer and investment spending with increased government spending by running budget deficits. Whereas it is true that consumer and business spending will decrease at the beginning of a recession, it will not drop indefinitely without the exertion outside forces being applied. The problem here is that this theory was proven false before Keynes had even stated it. The government had never before increased spending during times of recession, yet it had never been mired in an endless recession either.

Is there comparable examples of Keynesian economics versus Lessie Faire economics?

Two comparable recessions that were close together in which the government used two very different cures were the 1920-1921 recession and the Great Depression that started in 1929, but lasted until 1940. In the 1921 recession, which Warren Harding had inherited from Woodrow Wilson, unemployment rates jumped into double digits and there was price deflation, much like the Great Depression. In 1920 federal spending was $6.4 billion, and by 1922 it had been cut nearly in half to $3.3 billion, the exact opposite of what Keynesian economics called for, leading to unprecedented economic growth during the roaring twenties. During the Great Depression Herbert Hoover and Franklin Roosevelt applied Keynesian principles by increasing spending to dramatic levels, per Keynes’ advice, and the economy was never worse. If the Keynesian economics were correct, the results would have been the exact opposite in both cases. According to Keynes, the unending recession should have started in 1921, and America should have quickly recovered in 1929.

Keynes believed that saving money was bad for the economy.

Keynes criticized the idea of saving money, believing that if someone saved money, it would sit stagnant outside of the economy and be unable to stimulate economic growth. The money one man saves is borrowed by another man to either buy consumer goods, be invested by a business or borrowed by the government through the purchase of savings bonds. Keynes didn’t realize that money in savings went towards his aggregate demand. By not accounting for the fact that money put in savings go back out into the economy, Keynes was missing a large part of economics in his theories.

Keynes didn’t account for monetary policy.

Keynesian economics completely focuses on fiscal policies of taxes and spending, while not considering monetary policy, which is half of the equation. One could argue that monetary policy is even more important than fiscal policy, as recessions have historically followed interest rate hikes at the Federal reserve. Even the Great Depression and the stock market crash in 1929 were preceded by interest rate hikes. In January of 1928 the Federal Funds rate was 3.5%, by August of 1929 it was at 6.%. Drastic interest rate increases like this are almost always followed by recessions. The Federal Reserve continued to follow an overly tight monetary policy from 1929 to 1933 in which it contracted the money supply by 33%. Bad monetary policy not only led to the Great Depression, it made recovery nearly impossible. The fact that Keynes came up with economic theories during the depression without accounting for the impact of monetary policy is astonishing.

Any money the government spends has to come from somewhere.

Whereas Keynes did state that the government should borrow money to stimulate the economy, he didn’t seem to understand that the money had to first come from somewhere. The fact that any money the government spends has to come from one of three places:

  • The government can raise taxes – The government can take more money from individuals to pay for it’s spending programs, but at best, this would lead to a net zero in economic growth. Raising taxes as a way of fixing the economy would be the equivalent of taking $20 out of your left pocket and putting it in your right pocket and acting like you are now richer because of the exchange.
  • The government can borrow money – Every dollar that the government borrows it has to pay back with interest, which is a net loss, especially when that money is borrowed from foreign sources.
  • The government can print more money – The government can print more money, but this would lead to inflation, which is basically an unseen tax. Inflation steals people’s savings and robs from lenders, as the money they loaned was worth far more than what they will receive back. Nothing would undermine business loans more than lenders knowing that they would lose money in the process. You cannot have a good economy without a sound currency.

The government cannot borrow increasing amounts of money indefinitely.

The governments ability to borrow money is limited to the number of people willing to lend it to them. At a certain point the government won’t be able to find new lenders or they will have to increase interest rates in order to attract new lenders. According to Keynesian economics the government needs to run large deficits to offset losses in aggregate demand to pull the economy out of a recession. The problem is that once the recession passes, couldn’t drastically reducing government spending, which would drop aggregate demand, send the economy into another recession? If government spending is a key component to driving the economy, as Keynes stated, could the government ever reduce spending without adversely effecting the economy?

Once government programs are started, they are very hard to get rid of.

A key component of Keynesian economics is that once the recession has passed, government spending should be reduced back to pre-recession levels. This portion of the equation is generally disregarded by those that follow his theories today. The problem with the post recession scale back is that those benefitting from the new stimulus programs will fight tooth and nail to keep the government funds flowing. A good example is farm subsidies and price supports. These subsidies were put in place during the 1930s to help the beleaguered farming sector during the dust bowl, the problem is that nearly ninety years later, those subsidies are still with us.

Government spending supplants private sector investment.

Every dollar the government spend has to come from somewhere, as discussed above. Whenever the government spends a dollar, that is one less dollar that is available to private enterprise. For example, if an individual spends $10,000 on U.S. savings bonds, that is $10,000 that he cannot lend to private enterprise or invest in some other manner. Since government spending isn’t added to the economy, it only replaces private investment, government spending would need to be at least as efficient as private sector spending to be effective.

Government spending actually slows down the economy

Harvard economist Robert Barro tested the theory that government spending has a multiplier effect, and he found the exact opposite to be true. Barro tested the Keynesian theory by looking at times when governmental spending saw a massive increase. To test the theory he looked at the large changes in military purchases that were driven in times of war. He first looked at World War II expenditures and found that each additional dollar that the government spent only equated to eighty cents in additional GDP. To further test his theory, he looked at World War I, the Korean War and the Vietnam War, and he found the same eighty percent correlation. The indication is clear, government spending lead to lower GDP growth and wealth destruction. By squeezing out private enterprise and causing wealth destruction, government spending slows down the economy rather than stimulating it.

Government programs can have massive unintended consequences

Three economist from Texas A&M and MIT did a study on the Car Allowance Rebate System better known as “Cash for Clunkers” to see if it actually stimulated the economy. The program ran for two months in 2009 and gave new car buyers up to $4500 if they were trading in vehicles that got less than 18 miles per gallon on a new vehicle that had fuel efficiency of at least 4 mpg higher than the vehicle being traded in. The program was not only meant to stimulate new purchases of Automobiles, but to reduce overall fuel usage of American vehicles. The researchers found that 60% of buyers under the program would have bought a new vehicle in the two months that the program ran without the incentive and that the remaining 40% would have purchased a new vehicle within eight months of the program ending. The program did not result in any new car purchases, it just resulted in some buyers purchasing cars a little earlier. The program resulted in several unintended consequences however:

  • Researchers found that buyers purchasing cars under the program spent, on average, $5000 less than they would have absent the program due to the fuel efficiency requirements. This actually led to the automobile sector losing $4 billion in revenue because of the program.
  • The program led buyers to purchase more cars made by foreign manufacturers. The top ten vehicles that were traded in under the program were all made by American Manufacturers, whereas eight of the top nine cars bought under the program were made by foreign producers. The program actually benefitted foreign producers over domestic ones.
  • The program hurt people of modest means by driving up the prices of used cars due to the requirement that traded in vehicles had to be destroyed as part of the program, taking many high quality used vehicles off of the market.
  • The program was not environmentally friendly because of its vehicle destruction rules were wasteful and they didn’t allow for proper recycling of the “clunkers”. The program led to an additional 3 million to 4.5 million tons of toxic residue being sent to landfills.
  • Studies have found that it is actually better for the environment to keep older, less efficient cars on the road throughout their usable lifecycle than to replace them with new more efficient models due to the pollution of creating new automobiles.

Considering that cash for clunkers was a $3 billion program, which is small when compared to the over $4 trillion budgets, the negative effects were quite stark.

Conclusion

As can be seen, Keynesian economics leaves too many economic factors out to create a sound economic theory. By only focusing on fiscal policy while ignoring monetary policy, unintended consequences, and the realities that government programs tend to grow over time, Keynesian economics make for unworkable policies. Over eighty years later Keynesian economics has been discredited except in the minds of its most dogmatic followers.

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