Why Keynesianism Works Better in Theory Than in Practice
Thursday, December 1, 2011
The term ‘Keynesianism’ as it is commonly used contains two distinct theses. One thesis is mostly true, the other is not. Therein lies the secret to understanding America’s perilous condition.
Years of economic turmoil have re-ignited the debate about Keynesianism. As the financial crisis caused mass unemployment, Keynes appeared to have been proven right; Keynesians took over policymaking and implemented Keynesian fiscal and monetary policies to combat unemployment and a shrinking economy. But after three years of large-scale, Keynesian-inspired deficit spending, high unemployment persists and public confidence in Keynesian policy is shaken. As the United States is stagnating and as Europe is crashing down, critics of the Keynesian experiment in turn feel vindicated.
So who was right?
To get a handle on that question, it is important to understand that the phrase “Keynesianism” as it is commonly used contains two distinct theses. One thesis is mostly true. The other is mostly not.
The first definition of “Keynesianism” is a theoretical explanation for recessions, a diagnosis of the illness. The free market will periodically fail to utilize all the capacity in the economy due to an inability to generate sufficient aggregate demand. In 2008, we witnessed a particularly dramatic example of this as consumer demand and industrial production plummeted as a result of a crisis in the financial sector. Keynes was once again proven right.
The diagnosis may be correct, but the medicine most commonly associated with it has been shown to be surprisingly impotent.
The second definition of “Keynesianism” is a policy recipe for coping with recessions, a cure for the disease of recessions. The promise is that the public sector can bring the economy out of recessions through deficit spending.
It might seem natural that Keynesian theory implies Keynesian policy; indeed, the two were intimately linked during the first decades of Keynesianism. However, decades of historic experience alongside advances in macroeconomics have shown that Keynesian fiscal policy is not as effective as predicted by Keynesian theory. The diagnosis may be correct, but the medicine most commonly associated with it has been shown to be surprisingly impotent.
The reason for this disconnect is that the economy turned out to be more complex than assumed by simpler Keynesian models. One of the three motivations for awarding Milton Friedman the Nobel Prize was “for his demonstration of the complexity of stabilization policy." Note that Friedman challenged the effectiveness of Keynesian fiscal policy, not Keynes’s insight about the importance of aggregate demand for recessions. Thus Milton Friedman wrote, "in one sense, we are all Keynesians now; in another, no one is a Keynesian any longer…We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions."
Not the first disappointment of Keynesian fiscal policy
Three-quarters of the public conclude that the stimulus failed.
By the late 1970s, the failure of Keynesianism in demand management led economists to become increasingly skeptical of active fiscal stabilization policy. Macroeconomic theory advanced beyond the old, simple Keynesian models by attempting to take into account the decision-making of individuals. In 2011, some of this work was awarded the Nobel Prize in Economics.
Economists did not turn against Keynesian policy purely for theoretical or even ideological reasons, but rather because of the disappointing experience from pervasive deficit spending over a long period in a large number of countries. An influential 2003 study examined Keynesian policies in 91 countries in the postwar period and found that “governments that use fiscal policy aggressively induce significant macroeconomic instability.”1,2
Economists still recognized some use for Keynesian policies, but no longer viewed them as unambiguously beneficial. When asked if “fiscal policy can be an effective stabilizer,” the majority of U.S. graduate students in economics “agreed with some reservation.”3
A minority of economists took matters further, claiming that Keynes was wrong not only about fiscal policy, but also about the importance of aggregate demand. This “real business cycle” theory explained recessions, including the Great Depression, by reference to aggregate supply alone. This critique of the Keynesian theory of recessions was, however, a minority opinion even prior to the 2008 crash. For instance, Milton Friedman and Anna Schwartz’s monetarist explanation of the Great Depression, in which poor monetary policy played the role of chief culprit, is fundamentally a story of aggregate demand and remains the standard reference in the literature. The economic profession never abandoned Keynes’s insight regarding the importance of aggregate demand for recessions, it only became more skeptical of his prescription for solving the problem.
At some point, deficit spending starts doing more harm than good by adding to fear and uncertainty.
The 2008 crash shocked the country into briefly disregarding the disappointing Keynesian track record. But the crash itself only confirmed the Keynesian diagnosis, while proving nothing about the effectiveness of fiscal policy for curing the recession.
Nevertheless, the Obama administration chose a strong dose of Keynesian medicine, confidently predicting that unemployment would be lowered to 6 percent by the end of 2011. As we now know, this promise was not fulfilled, with unemployment currently at 9 percent. This has, fairly or not, once again soured American voters on Keynes, with three-quarters of the public concluding that the stimulus failed.
Of course, the high unemployment rate alone does not prove that the stimulus failed. It may be that unemployment would be 15 percent without it, as former House Speaker Nancy Pelosi has suggested. On the other hand, the poor health of the patient cannot be ignored when evaluating a Keynesian cure which in practice has a spotty track record.
Another argument, most notably made by Nobel Prize winner Paul Krugman, is that the high level of unemployment simply proves that the stimulus was too small. But by any objective measure, the fiscal stimulus was very large. Total government spending ballooned from approximately $4.5 trillion before the crisis to $5.5 trillion per year thereafter, adjusted for inflation.4
If borrowing and spending 150 percent of GDP fails to achieve growth, why, that merely proves Japan should have borrowed and spent 300 percent of GDP!
Total government deficit spending during the three years since the crisis was $4 trillion. This $4 trillion—not just Obama’s $0.8 trillion “Recovery and Reinvestment Act”—is the total amount of Keynesian stimulus poured into the economy. Comparing deficit spending before and after the recession, post-recession spending has been larger by about 6 percent of GDP each year.
These are massive numbers, larger than the relative magnitude of the New Deal. If Keynesian fiscal policies have failed, it is unlikely to have been because of insufficient deficit spending.
It is worth noting that Paul Krugman has used the same explanation for the failure of Japanese stabilization policy, i.e. that the failure of aggressive Keynesianism to achieve growth proves that deficits were too small.
In the decade following the 1991 crash, Japanese deficit spending was on average 5 percent of GDP per year, and 7 percent of GDP in the decade that followed. Japan’s debt increased from normal levels to a staggering 233 percent of GDP today, far higher than in every other advanced country, including Greece. None of this managed to stimulate growth.
In this vulgar form, Keynesianism is turned into a non-falsifiable theory. If borrowing and spending 150 percent of GDP fails to achieve growth, why, that merely proves Japan should have borrowed and spent 300 percent of GDP!
Macroeconomic theory advanced beyond the old, simple Keynesian models by attempting to take into account the decision-making of individuals.
This is not Krugman’s only explanation. Recently he complained, “Much of it [the stimulus] consisted of tax cuts, not spending. Most of the rest consisted either of aid to distressed families or aid to hard-pressed state and local governments. This aid may have mitigated the slump, but it wasn’t the kind of job-creation program we could and should have had.” This would have been more convincing if Krugman had not written in 2009 that aid to state governments was, “among the most effective and most needed parts of the plan. In particular, aid to state governments, which are in desperate straits, is both fast—because it prevents spending cuts rather than having to start up new project —and effective, because it would in fact be spent.”
The argument that we might be even worse off without the stimulus is nevertheless valid. Unfortunately, we might never know, as macroeconomics currently lacks the tools to measure counterfactuals. Economists who study the business cycle are at a disadvantage because they lack controlled experiments and they are dealing with an unusually complex, interrelated system.
Still, a doctor whose remedy frequently fails can always say that things would have been even worse without it, but at some point he also has to be open to the possibility that his prescription is wrong.
Remember that the estimates of the number of jobs “created or saved” by the stimulus that we have seen used by the Congressional Budget Office, Mark Zandi, and others are not direct measurements. Rather, they are based on simulations where the effectiveness of the program is assumed a priori by applying a so-called multiplier to deficit spending. As Stanford University economist John Taylor points out: “You learn virtually nothing about the efficacy of a stimulus package if you use the same models to evaluate its impact ex post that you used to predict its impact ex ante.”
Economists did not turn against Keynesian policy purely for theoretical reasons, but rather because of the disappointing experience from pervasive deficit spending over a long period in a large number of countries.
Not all observers appreciate just how brittle macro models are, both those critical and supportive of the stimulus. Jacob Weisberg wrote in Slate magazine about opposition to Keynesianism: “Some of the congressional Republicans who are preventing action to help the economy are simply intellectual primitives who reject modern economics on the same basis that they reject Darwin.”
It is silly to equate opposition to Keynesian policies with rejecting the science of evolution. Science is obviously far more uncertain when it comes to the effectiveness of deficit-financed stabilization policy than it is regarding the origin of species.
Keynesians do have indirect evidence in support of their claim of there being a positive spending “multiplier,” i.e. that each dollar spent by the government during a recession grows the economy by more than one dollar.
In a recent survey paper, the multiplier of government purchases estimated mostly using non-experimental methods was put at between “0.8 and 1.5,” lower but not incompatible with the 1.6 numbers used by Obama administration economists.5 The main problem here is that no multiplier has ever been estimated using a controlled experiment, the gold standard of the social sciences.
One quasi-experimental estimate that can be considered reasonably reliable is an evaluation of historic U.S. military spending by Harvard economists Robert Barro and Charles Redlick, who estimated the multiplier to be “0.6–0.7.”6 They argue that the high estimates reached by many other studies and used by, for example, the Obama administration, the Congressional Budget Office, and economic research firms such as Mark Zandi’s are mistaken, caused by “reverse causation,” and have a tendency to “generate unrealistically high multipliers.”
The crash itself only confirmed the Keynesian diagnosis, while proving nothing about the effectiveness of fiscal policy for curing the recession.
Barro and Redlick also believe that this defense multiplier is higher than for other forms of government purchases, which are in turn higher than the multiplier for transfers. This is important, as most of the U.S. stimulus spent so far has not been on (relatively) effective government purchases such as infrastructure, but rather on extremely ineffective transfers to households.
John Taylor has argued that only a small fraction of the president’s $0.8 trillion program went to purchases.7 Instead, it mostly went to various social policy programs and lump-sum tax credits to households. Since nervous households spent little of this money, the stimulus was ineffective.
Why did the Keynesian medicine fail?
One reason that Keynesianism does not work as well in practice as in theory is the role played by expectations and fear. As deficits grow, the public becomes more worried about the future of the economy and responds by saving more. At some point, deficit spending starts doing more harm than good by adding to fear and uncertainty.
Harvard's Kenneth Rogoff and the University of Maryland’s Carmen Reinhart have found that countries with high government debt-to-GDP ratios have weaker economic growth above a certain debt threshold.8 It appears that deficit spending in Greece and elsewhere in Europe at some point started adding to economic uncertainty rather than mitigating it. A powerful argument made by Keynesians is that the stimulative impact of fiscal policy is bigger than average in a deep recession, such as the one that we are in now. But, similarly, the negative effect of Keynesian deficit spending on uncertainty may be bigger during times of crisis, if future solvency becomes an issue.
By any objective measure, the fiscal stimulus was very large. Total government spending ballooned from approximately $4.5 trillion before the crisis to $5.5 trillion per year thereafter, adjusted for inflation.
Rogoff writes that “too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.” He instead views the crises as a “Great Contraction,” a crisis caused by too much borrowing and a subsequent tightening of credit. If so, the problem in the economy was misdiagnosed by Keynesians. To use a rough analogy, Keynesians concluded that the disease of the economy was a severe cold, when the economy in fact was afflicted with pneumonia, a disease with somewhat similar symptoms but a different underlying cause, therefore requiring a different cure. If the problem in the economy is excessive leverage, the wrongly prescribed remedy of deficit spending will not only fail to help, it might make things worse by adding to already high economic uncertainty and volatility.
Some economists have vehemently denied that fiscal (and regulatory) uncertainly play a significant role in delaying recovery from the recession. Again, it is worth quoting Paul Krugman, who has written that “deficits don't matter” and that they “are no threat at all.” This view is based on the observation that interest rates on U.S. debt remain low.
But because of America’s long-established safe-harbor status, low American interest rates do not necessarily prove that things are fine. It may be that investors are buying U.S. debt not because they trust the solvency of the U.S. government so much, but because the bonds look safe compared to every other asset. Thus, during both the 2008 crash and the debt-ceiling crises of 2011, interest rates fell and the dollar strengthened. Even when Standard & Poor’s unexpectedly downgraded American debt, interest rates on the downgraded debt did not increase. Ironically, as the downgrade increased overall uncertainty, investors fled to what they perceived to be relatively safe assets such as American debt.
Meanwhile, the downgrade led to stock markets dropping substantially, a clearer indication of overall uncertainty regarding the future economy than the interest rate on bonds. This drop in stock prices during the debt-ceiling debate and following the S&P downgrade is a hard-to-ignore sign that uncertainty about future deficits influences the real economy, even if it does not show up in an unambiguous way in interest rates.
The lessons of the latest round of Keynesianism
A doctor whose remedy frequently fails can always say that things would have been even worse without it, but at some point he also has to be open to the possibility that his prescription is wrong.
The disappointing result of the latest deficit spending experiment is no cause to discard Keynes’s ideas wholesale. Some of the disappointing results of Keynesianism are related to the Obama administration’s mismanagement. For all its rhetoric, too little was spent on genuine investment. Regulatory expansion, in particular healthcare and environmental regulation, could have waited until the economy had recovered. The president could have calmed markets and ensured himself a more robust recovery by doing something about the long-term deficit trajectory.
At least the crises have taught us some lessons. We may need to lower expectations about the size and predictability of Keynesian multipliers. If limited resources are used for fiscal stimulus, spend the money on relatively effective tools such as infrastructure instead of wasting most of it on impotent transfers. Most importantly, keep your powder dry. By maintaining fiscal health in good times, you have more room to spend in bad times before debt and deficits become out of control and start to cause a crisis of their own.
The failure of deficit spending in fixing the crises is no reason to abandon Keynesianism as a paradigm. John Maynard Keynes’s brilliant insights about the macroeconomy remain valid. During the crises, Keynesianism once more demonstrated its usefulness not only as a diagnostic tool, but as the central intellectual framework for discussing the business cycle.
Tino Sanandaji is an affiliated researcher at the Institute of Industrial Economics and holds a PhD in public policy from the University of Chicago.
FURTHER READING: Sanandaji and Arvid Malm write “Obama’s Folly: Why Taxing the Rich Is No Solution.” Philip I. Levy describes “The End of Comfortable Keynesianism.” Tim Kane contributes “Macro vs. Growth.” John H. Makin reveals “Three Dangerous Myths About Monetary Policy.” Arthur Herman questions “The Ultimate Stimulus?” Nick Schulz asks “How Effective Was the 2009 Stimulus Program?”
1. Fátas, Antonio, and Ilian Mihov, 2003. “The Case for Restricting Fiscal Policy Discretion,” Quarterly Journal of Economics 118(4), pages 1419-1447.
2. Taylor, John B., 2009. “The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy.” Prepared for the Annual Meeting of the American Economic Association, Session “The Revival of Fiscal Policy.”
3. Colander, David, 2005. "The Making of an Economist Redux," Journal of Economic Perspectives, 19(1), pages 175-198.
4. Bureau of Economic Analysis. The numbers are in 2011 dollars.
5. Ramey, Valerie, 2011. “Can Government Purchases Stimulate the Economy” Journal of Economic Literature, 49(3), pages 673–685.
6. Barro, Robert and Charles Redlick, 2011. “Macroeconomic Effects of Government Purchases and Taxes,” The Quarterly Journal of Economics, 126 (1), pages 51-102.
7. Taylor, John (2011) “An Empirical Analysis of the Revival of Fiscal Activism in the 2000s,” Journal of Economic Literature, 49(3), pages 686–702.
8. Reinhart, Carmen and Kenneth Rogoff (2010) “Growth in a time of debt,” American Economic Review, vol. 100(2), pages 573-78.
Image by Rob Green | Bergman Group