Sunday, December 19, 2010

Tail of Two Ideologies – Keynesian Economics

The previous post framed the question of a tax compact around the fact that each party has their respective ideologies.  The Democratic ideology is based in Keynesian economics.  Republican fiscal ideology is wrapped in something called “supply side economics”.  So, let’s take Keynes first.  In the next post, I will review the supply siders.

To start, Keynes says that government can correct a recession by expanding government. This expansion is financed through debt.  Governments are supposed to repay the debt during good economic times.  In the posts on David Stockman, it was noted that the United States has run a deficit in 38 of the past 40 years.  Additionally, the overall amount of national debt will equal the Gross Domestic Product in the next few years.  In 2010 the interest on the national debt will be $209 Billion or 6 percent (up from 1 percent in 2009) of the Federal budget. 

With regard to Keynes, the real question is whether it can and should be used in all economic downturns.  It is in its overuse that it serves as a candidate for ideology status.  In this blog, I raise two questions about it.   First concern, can it be expected to work in a recession resulting from a structural downturn?  In our case, the balance sheet of most American households have been hit hard by the mortgage crisis causing people to increase their saving by abnormally high amount, which, according to Keynes, lowers the multiplicative effect of government expansionary efforts (or in other words, more savings means less expansion).

In the posts on the Stimulus Program it was noted that it failed to stimulate.  One possible explanation is that the program was designed incorrectly and relied too much on some of Keynes’ main ideas.   I speculated that the type of recession was structural in that it was tied to the mortgage crisis (this reduced assets levels), and not tied to consumption, as Keynes would suggest.  One concern that follows from this is the view that the United States may be approaching its maximum debt level that it can carry before the benefits of expansionary borrowing become diluted and less effective.

Another concern is whether government deficit spending has been overused to the point that its beneficial effects have been diluted and is not as effective as it once was.  In other words, is there some inelasticity in the economic tool that was not considered by our policy makers in this most recent crisis?  The answer is ‘maybe’ as David Brooks reported on a recent National Bureau of Economic Research that examined stimulus efforts in 44 countries.  The report argued that fiscal stimulus can be quite effective in low-debt countries with fixed exchange rates and closed economies, and countries like the United States with high debt and floating exchange rates, are generally not as effective with stimulus measures.

The main reason for calling Keynesian ideas an ideology is that they are over used.  Paul Krugman, a Nobel Prize winning economist, advocates that the size of the stimulus was inadequate and should have been significantly larger in order to stimulate the country out of a recession.  Not only would the proposal complicate the country’s problems with debt, but it also would increase the risks of inflation, which is anti-stimulative.

The point is that the evidence does not exist to support Krugman’s proposal.  People who advocate this solution for this particular recession are essentially acting on faith, and that fact alone qualifies it as ideology. 

Keynes’ ideas are tools.  As a tool, people need to understand when Keynes’ ideas should be used and when they should not be used.  The election was not about ideology, but about making the country work, and for that we need tools.

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