Economics: Why Keynesian Economics Doesn’t Work

Whenever the economy tanks, people in Washington argue that the government should inject money into the economy to stimulate growth. If you think government is enormous now, Obama is agitating for even greater stimulus spending for trillions more in entitlements and make-work projects.

After the “Big Bang stimulus” totaling $4.7 trillion, unemployment remains at 9.1% and the economy has grown an anemic 1.3% (summer 2011 data). But the stimulus hasn’t failed, they say, the government just needs to spend a lot more and keep doing it until it works—the beatings will continue until morale improves.

The problem is, spend a trillion here and a trillion there and soon we run into some pretty big money.

What Is It and Where Did It Come From?

The idea of big government spending as national savior got started in the 1930s when the country was in the throws of the Great Depression. English economist John Maynard Keynes argued that the government could boost the economy if it borrowed money then spent it.

According to this theory, now known as Keynesian Economics, money would find its way into people’s wallets and then they would spend the money. This was supposed to “prime the pump” as money began circulating through the economy. One dollar spent is another dollar earned by someone else. (This is called the multiplier effect).

Following the Keynesian paradigm, Obama and the past Democratic Party-dominated Congress increased spending through the extension of unemployment benefits, the health care takeover, bailouts of financial  institutions, bailouts of homeowners, increases in other entitlement spending and the funding of hundreds of billions of dollars for special interest projects. Since domestic consumer spending accounts for 2/3 of the U.S. economy, all this government spending should have spurred demand, which in turn should have created more jobs to meet the production requirements to meet this new demand. This demand-side economics has not created jobs.

Keynesian theory looks good on paper and it would be the magic spell for flagging economies everywhere if it didn’t have this one glaring logical fallacy. It overlooks the fact that the government can’t inject money into the economy without first taking it out. The theory only looks at half of the equation. As the government puts money in the right hand, it borrows money from the left hand. Government spending clearly benefits those people who receive the money, but there is no net increase in productivity and no increase in the national income (GDP).

GDP will appear to grow as long as the money doesn’t run out. Once the recipients have spent the money, the growth fizzles. The economic reaction is unsustainable because the private sector understands that the government “stimulus” stimulates nothing in the long term, so they will not invest in new products or new hiring.

How Does It Affect the Economy?

The Keynesian response is to say that there will be an increase in the overall available cash, which increases consumer spending rather than the money sitting idle. That’s wrong because the money doesn’t sit idle. Why? Because of a key economic axiom: savings=investment

When people are not spending, they are saving, but they don’t keep their savings in a cookie jar. It is in the bank, in real estate, in stocks and other various instruments, including U.S. Treasury issues.

But when the government gives money to someone to spend, that money is taken from someone else who doesn’t get to spend it.

This can come in two forms: taxation and/or borrowing. The results of taxation are obvious. The effects of  borrowing are not so obvious. When the government borrows, it “crowds out” other types of investments. The government’s demand for money is high and generally the interest rates rise on the law of supply and demand. Higher interest rates translate to higher costs for businesses and consumers which can slow down  growth. Investors and entrepreneurs are then less likely to borrow and so new ideas, services and technology which do provide sustainable employment, don’t appear.

Under the current circumstances of 2011, the crowding out phenomenon has not happened because the Federal Reserve injected trillions into the economy through two rounds of quantitative easing, or QE. QE is when the Federal Reserve buys back its bonds. The Fed’s own demand for bonds raises the price of the  bonds, which in turn lowers their annual percentage yield. Since long term and medium term rates follow the Treasury bonds, these rates fall as well. This sounds like a good deal except “their ain’t no such thing as a free lunch,” as the late Milton Friedman said. The big flood of dollars without the increase in productivity is inflationary and the dollar loses its value. Inflation is here.

Nevertheless, businesses should be borrowing like mad but they’re not.

Excessive and ridiculous regulations, uncertainty about health care, corporate tax rates and cap and trade and other unlegislated environmental laws are terrible conditions for businesses and they will remain sitting on their cash in these terribly uncertain times until the heat dies down.

Keynesianism Has Failed: The Evidence

Keynesianism is a failure. Let’s look at the evidence.

During the Great Depression, Herbert Hoover increased taxes dramatically including the top tax rate from 25% to 63% (tax the rich), he imposed harsh protectionist policies such as the Smoot-Hawley Tariff Act, significantly increased intervention in private sector and most importantly from the Keynesian perspective, he boosted government spending, which he financed with debt, by 47 percent in 4 years.

Hoover entered office in 1929 with a small surplus and left office with a deficit of 4.5% of GDP. Growth went down and unemployment went up.

FDR followed the same approach. Top tax rate went to 79% [tax the rich], and government intervention became more pervasive and invasive. Keynesians, especially those in the Obama administration, point out that GDP did indeed grow under the New Deal, proving that stimulus works; and it will work again if the
government spends enough.

Looking at the graphs below, we can see that, under FDR, GDP remained pretty flat and unemployment remained staggeringly high until 1940. As Robert Reich is fond to saying repeatedly, “it’s not the deficit we  need to worry about; it’s jobs.”

A Word About FDR and WWII Spending Keynesian enthusiasts will point out that from 1940 on, GDP grew and unemployment went down rather dramatically. I agree.

The biggest jump in debt, employment and GDP came from mobilization and participation in WWII, all financed by the government through debt and the taxpayer. As long as the war carried on, all these factors would continue to grow.

We need to remember several key points about this. First, GDP came from the manufacture of armaments and everything that went along with that. Resources are limited so in order to keep the war effort going, there was a lot of rationing, including, but not limited to, anything involving metals, plastics, nylon, rubber, gasoline, sugar and flour.

Two, the war effort employed millions of active duty and civilian members in every imaginable sector.

Three, unemployment increased after the war as hundreds of thousands of returning soldiers started looking for work.Four, and this is especially important for the years following 1945, was that after the dust settled, the United States was the last man standing. With infrastructure, factories and resources all but destroyed in Europe and in parts of East Asia, the world was America’s customer. It was not the WPA, or even the war effort, that got the US out of Depression. It was America being open for business when no other country could supply all that was needed by the rest of the world. Private sector and free market to the rescue.

Five, defense spending trickles throughout the commercial sector, and technological innovation comes from it that offers ongoing benefits to industry and consumers alike–the gift that keeps on giving.

And six: providing for the common defense is about the only thing the Constitution mandates the government to spend money on.

But when the government spends money on entitlements and special interests that produce nothing, as in O’s stimulus package, then sustainable growth and job creation will never happen, any more than it did with FDR’s WPA.

Another example: in 1972 Gerald Ford gave tax rebates that did nothing to grow the economy because  the money did nothing to improve economic output.

On the international front, Japan tried to use Keynes to stimulate their stagnant economy but the only thing that went up was Japan’s debt, which had doubled during the decade.

Where Might This Economic Thinking Lead America?

The last point about the Keynesian approach is that government spending hurts economic output by misallocating resources. That is, the government chooses what gets developed in the economy rather than the free market which consists of businesses and consumers who decide what they want to buy.

If sound reasoning and all the data show that Keynesian is foolish economics, why does Obama want to keep trying the same approach over and over again? I don’t think that Obama has changed his mind about fundamentally transforming America. I think he is taking advantage of the recession to push his socialist agenda into place.

Either that or he is absolutely nuts.

SOURCE: Conservative Politics in the Progressive Era

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