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Would Keynes Have Supported The Stimulus Bill?

Monday, February 23, 2009

The economists that you hear less about are those who oppose the bill because of their reading of John Maynard Keynes.

In my opinion the sophisticated Keynesian view is still that the stimulus won’t work.
—Tyler Cowen, “Axel Leijonhufvudon Fiscal Stimulus

Congress has passed a “stimulus bill,” but Congress has failed to enact a stimulus. To understand how that is so, it is useful to re-examine some fundamental tenets of macroeconomics and Keynesian thought. Many varieties of Keynesian macroeconomists exist, and some of us believe that the the Obama administration’s outsourcing of economic decisions to House Speaker Nancy Pelosi has resulted in a policy that is likely to work poorly, if at all. 

This essay will give some of the history of macroeconomic thought since Keynes. At the end, I will return to the issue of the stimulus bill.

There are two main opponents to Keynes. Classicals believe that markets are self-correcting. Monetarists believe that stable monetary growth is sufficient to keep markets functioning well.

The reason that the Democrats want to delay the stimulus is that they want most of the stimulus to take the form of spending increases, which cannot be handled effectively this year. Tax cuts could take effect more quickly.

The classical view is that an increase in unemployment is naturally temporary and self-correcting. Unemployment represents a surplus of labor. In a market system, whenever something is in surplus, its price falls. The drop in price increases demand and decreases supply, until the surplus is eliminated. Accordingly, a drop in wages should be sufficient to restore full employment. In the classical view, a fiscal stimulus (meaning an increase in the government budget deficit) would be unnecessary, because deviations from full employment would never be large or long-lasting.

Keynes made two arguments against the classicals. First, he suggested that wages are not as flexible as needed to eliminate unemployment. Second, he suggested that even if wages fell, this would produce deflation, and deflation would reduce business spending on investment, leading to lower demand for labor. Thus, cutting wages would be somewhat like a cat chasing its tail—it would not end a depression.

Monetarists would be willing to accept the view that a depression will not be solved by wage cuts. However, a monetarist view would be that as long as the money supply grows sufficiently, there will be inflation. With inflation, the lack of flexibility of wages will be neutralized by the flexibility of prices. An increase in prices will serve the same purpose as a decrease in wages, in that it will unleash the forces of supply and demand to eliminate unemployment. According to monetarists, a fiscal stimulus would be unnecessary because stable money growth and moderate inflation would always be sufficient to avoid a large recession.

Against the monetarists, Keynes gave two arguments. One is that in an economy where prices are falling, people who stick their money in a mattress can earn a positive return. When newly created money gets stuck in mattresses, it fails to generate inflation. This is the liquidity trap.

The other argument is that even if newly created money helps to lower interest rates, investment demand may not be sensitive to interest rates. Instead, investment is determined by “animal spirits,” meaning the willingness of entrepreneurs to make a leap of faith and purchase capital equipment in the face of an uncertain future. 

More saving always lowers the demand for current consumption goods. When animal spirits are sufficient, consumers who wish to save for future needs (retirement, for example) find entrepreneurs willing to invest in projects that will yield returns in the future. However, when animal spirits are not sufficient, the desire to save is not matched by a desire to invest. In that case, the drop in spending on current consumer goods is not offset by an increase in spending on investment goods. Instead, aggregate demand falls, economic activity slows down, and unemployment rises.

Milton Friedman and the Challenge to Fine Tuning

In the 1960s, Keynesian economics was fully mainstream, enshrined in textbooks. Macroeconomists of that period believed that they could control macroeconomic fluctuations with great precision, based on mathematical equations that were fit to historical data. The statistical techniques produced what were called macroeconometric models, or macro models for short. The precise policy adjustments were known as “fine tuning.” 

Starting in the late 1970s, many economists began to see the market’s self-correcting mechanisms as superior to government management, and certainly superior to the now-discredited ‘fine tuning.’

This precise, “engineering” view of macroeconomics was attacked from a number of directions. Some Keynesians believed that the macroeconometric approach left out some important Keynesian ideas, such as “animal spirits.” On the other side, Milton Friedman argued that the macroeconometric models were not nearly reliable enough to support “fine tuning.” He warned, particularly in his 1967 presidential address to the American Economic Association, that attempts to use inflation to reduce unemployment would prove to be self-defeating as workers began to realize the need to demand wage increases in anticipation of higher prices.

Over the 15 years following his address, economic events played out in a way that vindicated Friedman and discredited the fine tuners. First, inflation accelerated. Second, starting in 1971, President Nixon tried to implement the fine-tuners’ solution for inflation, which was wage and price controls. This failed, leading to dreadful economic performance, with both unemployment and inflation at high levels. Finally, at the end of the decade, President Carter appointed Paul Volcker as chairman of the Federal Reserve Board and gave him a mandate (subsequently reinforced by President Reagan) to follow Friedman’s advice and treat inflation as a monetary phenomenon. Volcker undertook contractionary monetary policy, resulting in a steep recession but a long-term reduction in inflation.

The Age of Monetarism

Starting in the late 1970s, the economics profession swung in the direction of classicalism and monetarism. Many economists began to see the market’s self-correcting mechanisms as superior to government management, and certainly superior to the now-discredited “fine tuning.” The macroeconometric models used for “fine tuning” were seen as based on spurious correlations. The macro models were discarded by academic economists, although they remained in use by a few private forecasting firms and by government agencies, including the Federal Reserve Board.

Within the economics profession, a consensus emerged that embraced monetarism. A broad spectrum of economists endorsed the view that stable money growth that is consistent with moderate levels of inflation (prices rising by about 3 percent per year) ought to lead to stable economic activity, without requiring fiscal stimulus or other measures aimed at “fine tuning.”

This monetarist consensus even extended to historical analysis of the Great Depression. Many economists came to stress monetary factors, such as the collapse of banks, as important causes of the Depression. The consensus now is that whatever improvement took place under President Franklin D. Roosevelt (and the improvement was not sufficient to eliminate the large excess of unemployment) was due not to New Deal programs but instead reflected his policies to stabilize banks and end the gold standard. There is a general view, held by both Keynesians and non-Keynesians, that the 1930s did not constitute an experiment with fiscal stimulus, because deficit spending was too small to make any difference.

The Shock of 2008

The events of 2008 have destroyed the monetarist consensus that prevailed for the prior three decades. Instead, the economics profession seems to have broken up into a number of different camps.

Some economists, primarily from the University of Chicago, remain classical in orientation. That is, they believe that markets will self-correct, and they oppose fiscal stimulus on principle.

Other economists are now willing once again to take seriously macro models, with their precise “multipliers” that predict the results of fiscal stimulus. However, the many theoretical and statistical flaws of macroeconometrics, which caused such models to be discarded a generation ago, continue to plague this approach.

Textbook macroeconomics has no description of the sort of financial collapse that took place in 2008. Intuitively, we believe that the flight from risk and the de-leveraging of financial institutions has a contractionary effect. However, this is not a mechanism that is embedded in basic macroeconomic theory or in macroeconometric models.

The events of 2008 have destroyed the monetarist consensus that prevailed for the prior three decades. Instead, the economics profession seems to have broken up into a number of different camps.

Some economists want to take a Keynesian view that differs from that enshrined in the textbooks. For example, in the new book Animal Spirits, leading behavioral economists George A. Akerlof and Robert J. Shiller argue that the crisis of 2008 cannot be understood by thinking about the economy as only deviating slightly from the classical model. Instead, they suggest that the financial collapse reflects a loss of confidence, caused in part by corruption and bad faith and by major changes in “stories.” (An example of the latter is the fact that the “story” of housing until recently was that house prices never decline.) Akerlof and Shiller explain the inability of labor markets to self-correct as due to norms of fairness and to money illusion, so that workers are not willing to accept wage cuts even though prices are declining.

Another non-textbook analysis that is in a Keynesian spirit is based on the ideas of the late Hyman Minsky. Minsky saw financial markets as going through phases of risk tolerance. In a low-tolerance phase (hedge finance), firms finance investment out of profits. As confidence improves, they proceed to a medium-tolerance phase (speculative finance), in which firms are willing to borrow to finance investment. In a high-tolerance phase (Ponzi finance), firms are even willing to borrow to finance interest payments on previous borrowing. When this last, unsustainable phase collapses, the economy reverts to hedge finance. We can see that such a cycle was at work in the housing market—by 2006 and 2007 the weakest borrowers lacked the income to repay their loans. Instead, they were continually refinancing, in a Ponzi scheme that depended on ever-rising house prices. The collapse of that Ponzi finance has caused a reversion to the low-tolerance phase of the financial cycle.

For a Stimulus, Against Pelosi’s Bill

If you follow the news media, you may think that the economics profession is divided into two camps: the majority, who favor the stimulus bill; and a minority, who are against any stimulus. In fact, there are many of us who support the idea of a stimulus but who question the Pelosi bill.

One group of skeptics is concerned about the state of the banking system. Tyler Cowen, quoted above, is in this camp. Their view is that with a dysfunctional financial system, fiscal stimulus may not work. Instead, we need to first figure out how to fix or work around the banking crisis. As someone within this group, I believe we need to work around the banks, because we are in a hedge finance phase, where firms need to fund investment out of profits.

Intuitively, we believe that the flight from risk and the de-leveraging of financial institutions has a contractionary effect. However, this is not a mechanism that is embedded in basic macroeconomic theory or in macroeconometric models.

Another group of skeptics is concerned about the timing of the fiscal stimulus. Even some economists on the left, including Alice Rivlin and Jeffrey Sachs, have made the point that the long-term spending in the stimulus bill is inappropriate and even counterproductive from a stimulus perspective. I share this concern. President Obama said that his goal is to have 75 percent of the stimulus take effect before the end of 2010. Instead, I would argue that we should have 100 percent take effect by then, and 75 percent take effect by the end of 2009.

The reason that the Democrats want to delay the stimulus is that they want most of the stimulus to take the form of spending increases, which cannot be handled effectively this year. Tax cuts could take effect more quickly, but the Democrats want to hold tax cuts to a minimum.

Textbook Keynesian economics says that a spending increase will stimulate more powerfully than a tax cut, because part of a tax cut will be saved rather than spent. However, this same textbook analysis says that a stimulus now is more powerful than a stimulus that kicks in two years from now. Even though the multiplier for a spending increase may be higher than that for a tax cut that is enacted at the same time, we can be certain that the “multiplier” for a tax cut in 2009 is greater than the multiplier for a spending increase in 2011.

There is a general view, held by both Keynesians and non-Keynesians, that the 1930s did not constitute an experiment with fiscal stimulus, because deficit spending was too small to make any difference.

Finally, I have a concern about the “public choice” aspects of the stimulus bill, meaning the political distortions that make it an ineffective stimulus. If the only goal of the bill were to stimulate the economy, then the focus would be on trying to get the largest possible improvement in employment for a given increase in the deficit. A traditional stimulus proposal, going back to the 1960s, is a temporary investment tax credit. With such a credit, the government in effect provides matching funds for firms that undertake investment while the tax credit is in effect (say, through March of 2010). This would lead to spending increases that are a multiple of what the government contributes.

Another proposal, which George Mason University’s Bryan Caplan has suggested, is a cut in the employer portion of the payroll tax. The extra kicker here is that it reduces the employer’s cost of labor, thereby stimulating hiring. I think an additional kicker is that this would restore profitability in the nonfinancial sector, helping to boost investment.

Instead, the stimulus bill is directed largely at state and local governments. There is a lot of rhetoric about making sure that we do not lay off cops or teachers. But the fact is that millions of private sector workers are being laid off, while public sector layoffs so far have been fewer than one hundred thousand. The need for stimulus is in the private sector, but the political focus of the bill is on enlarging the public sector.

Many economists are willing to overlook the flaws in the legislation and to sanctify Pelosi’s bill as a stimulus bill. Other economists reject Keynesian economics altogether. The economists that you hear less about are those of us who oppose the bill because of our reading of Keynes.

Arnold Kling was an economist on the staff of the board of governors of the Federal Reserve System and was a senior economist at Freddie Mac. He co-hosts EconLog, a popular economics blog.

Image by Corbis/Darren Wamboldt/The Bergman Group.

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