Sunday, February 21, 2010

Keynes refutes... himself

In response to the financial crisis, governments around the world have engaged in unprecedented fiscal and monetary measures to try to avert catastrophe. Since the bulk of these policies are generally deemed to be "Keynesian" in nature, I thought it might be interesting to re-evaluate what it is that Keynes actually prescribed for economic downturns. The Spring 1995, Volume 17, No. 3 issue of the Journal of Post Keynesian Economics, in a piece called "What Keynes Really Said About Deficit Spending," differentiates between the beliefs that have been ascribed to Keynes with that which Keynes actually advocated based on his writings. There is much wrong with Keynesian economics from a pure economic theory perspective (such as the supposed instability of the free market, the ability of extra-market institutions to improve upon the free market, etc.) but there is something more basic that is wrong about Keynesian economics that both economists and non-economists should understand. It is not enough to be an advocate of a certain policy on its own immediate merits, one must take into account the implementation aspects of that policy as well as the practical implications of its acceptance.

The authors summarize Keynes' policies for the capitalist economy when it appears unstable as follows.
1. As the normal circumstance of a capitalist system would result in insufficient private investment, where total investment is less than the amount of saving that would be generated at full employment, social investment would be necessary to maintain full employment. Further, since fluctuations in private investment are likely to occur, the investment plans of public and quasi-public entities should be designed so that they could be varied in a countercyclical pattern.
Throughout the article the authors emphasize that the misunderstanding people have about Keynesian economics is with its nuances, most of which people typically ignore. In the above summary, it is argued that far from advocating widespread and significant government investment in an economy during a downturn, Keynes specifically advocated social investment. The authors of the piece do not give examples of what they mean by social investment, but the idea is that it is investment in an industry that serves some type of general public benefit. Furthermore, government investment should vary in a counter-cyclical manner, meaning it should increase during a downturn and decrease during an upturn.

The non-economic problem with this admittedly more nuanced explanation of Keynes' beliefs is that from an implementation and practical perspective, those nuances mean almost nothing. A metaphor is now in order. Imagine a scientist comes up with the theory that if a man jumps off a building but flaps his arms fast enough, he will be able to fly rather than fall to his death. I guess it is theoretically plausible that if a man did flap his arms fast enough he might fly (though who knows exactly how fast that might have to be), but we can say very confidently that any man who tries to do this is going to fall to his death. So the nuance is that the scientist said the man has to flap his arms very fast, but practically speaking that isn't going to happen so the man will just fall to his death. What this means for Keynes is that his advocacy of only certain government investment at only certain times is irrelevant because the government as an institution is not built to differentiate between those distinctions.

We know the government differs from private business because it does not have a profit and loss mechanism. A private business makes money by offering a good to the public that the public in turn voluntarily purchases. If the public buys enough of the good, the business prospers. If the public does not buy enough of the good, the business might fail. The government on the other hand "makes money" through taxes, which means that the public is required to give up its money. There is no comparable voluntary component the way there is with a private business. If the government fails in a certain policy and runs a deficit, it need only increase taxes. Imagine a private business failing and then requiring that people hand over their money to keep it afloat!

As a result of these characteristics of the government, it will never come close to staying true to what Keynes might have said. Why just have social investment when you can have social and private investment, that way every interest group in society can benefit (and re-elect the individuals who enacted those "charitable" policies). Why increase social investment only during a downturn if you can increase social investment perpetually? Remember that the government bears little cost for these policies as a result of not being subject to the profit and loss mechanism that every other institution in society is subject to. If you didn't have to bear the cost of what you did, would you restrict yourself? Obviously not. So how can we (or more importantly Keynes, the 20th century's most admired economist) expect the government to do that?

Criticism of ubiquitous and perpetual government spending and deficits as an equivalent criticism of Keynesian economics might not be entirely fair given Keynes' nuanced thoughts on government spending and deficits, but at the same time Keynes does nothing more than refute himself by not thinking through the implementation and practical implications of what he suggested the government do in a downturn. It is therefore not unreasonable to consider modern day government policy as Keynesian, all those nuances notwithstanding.

Update from Taylor:

"you may wish to clarify that deficits dont occur when policies fail, but when expenditures outstrip tax revenues, and theyre made up for with borrowing, which is just future taxation"

Taylor is correct. I was making the assumption that a failed policy, similar to a "policy" that fails in a private business, is one that ends with a loss (in the case of government, one that ends with a deficit). Strictly speaking, a deficit occurs when expenditures outstrip tax revenues, whether or not one considers the policy to have failed.