Monthly Archives: November 2011

Why I’m a Democrat (part II) — Belief in Keynesianism

One year until the most exciting event on the calendar!  No, not the Superbowl or the season finale of Survivor.  I’m talking about the Presidential election!  The President will have a tough sell with high unemployment still plaguing the country, so he will have to make a continued case for his vision of Keynesian-style stimulus to help create more jobs and get the country back on track.

Who was this John Maynard Keynes, and why were his views so influential?  Keynes was a British financier who was most famous for his views during the 1930s that challenged the “neoclassical” orthodoxy that downturns in markets would self correct during reasonable time periods (reasonable, because, as Keynes once put it, in the long run “we’re are all dead”).  Keynes suggested that once an economy went off-the-tracks, a long term crisis in consumer demand could develop that would keep a country mired in the economic doldrums for years.

The solution, for Keynes, was 1). government spending that would put people back to work and enable them to feed increased consumer spending with their new incomes, and 2). broad based tax cuts that would free up wealth for increased consumer spending.  Just like a student taking out a loan to enhance their own future productivity, this spending would be financed through deficit spending until the point at which the economy was again on its feet, at which point responsible legislators would run budget surpluses to pay down the debt.

Two potential downsides exist to the Keynesian approach, which is why such policies are not one-size-fits-all measures.  Injecting money into the economy through deficit spending can cause two normally contradictory phenomena to occur.  The first phenomenon involves upward pressure on interest rates.  As the government borrows money, the “demand” for money increases, increasing interest rates. If interest rates rise, than the availability of private credit can shrink, which “crowds out” crucial private business investment.  Economists who have criticized the merits of the New Deal have often pointed to this effect as one of its chief problems.

The other major pitfall with Keynesian economics is the potential for inflation that is brought about by economic expansion.  Notice gas prices going up this last spring when  it appeared the world economy would start expanding at a more rapid pace?  This is the type of demand-pull inflation that occurs when suppliers increase prices in anticipation and as a consequence of increasing demand.  In other words, inflation occurs as a product of successful policies that create the demand necessary for expansion.

Keynes saw flexible monetary policies as an important supplement to the fiscal policies he advocated.  Through a variety of policies (such as printing money or changing the rate at which money is loaned to other banks), the Federal Reserve Bank has a strong influence on both interest and inflationary rates, both of which reflect the demand-for-money as a whole.  Higher inflation rates indicate a decreasing demand for money (money is literally becoming cheaper) while higher interest rates indicate an increasing demand (it is harder to borrow and easier to save money).  Prudent Fed policies can serve to offset some of the potential side effects of government spending.

In today’s economy, however, neither high interest rates nor high inflation represents a current problem, as they are both at generational lows.   Traditional “monetarist” economists, led by Keynes old nemesis Milton Friedman, would normally advocate pushing interest rates down further to help spur borrowing and investment in the private sector.  However, since we remained mired in a liquidity trap — a situation in which reducing the interest rate is rendered largely impossible due to its current low rate — the Federal Reserve has little to offer in way of solutions.

Attempting to cultivate a small amount of inflation is actually the best bet, as it would encourage people to spend rather than save money (the opposite of inflation, deflation, would be absolutely catastrophic in the current recession, despite what the libertarian loonies and Rick Perrys of the world say about “debasing the dollar“).  The Federal Reserve actually pursued a looser monetary policy through what it called “quantitative easing” — basically giving away $600 billion currency to banks, but thus far inflation remains, from the viewpoint of a Keynesian, frustratingly low.

With the ability of the Federal Reserve to encourage growth through higher inflation or lower interest rates hampered, direct monetary stimulus and tax cuts are the only action the government can take to encourage economic growth.  The Obama administration has tried both, through a highly visible stimulus package and a largely invisible tax cut (not to mention the deal the President cut last year with Republicans that maintained the “Bush tax cuts” an additional two years).

Did the Obama administration’s Keynesian policies work?  You betcha, but not to the degree that the economy turned around and began expanding at a rapid pace.  What occurred was an expansion of federal spending that only slightly more than counteracted the contraction of spending at the state level that was due to lower revenues.   The large majority of studies on the effects of  the stimulus package point to its effectiveness in saving and creating jobs.

The problem is that Republicans continue to block any further efforts on the part of the Obama administration to spend money on job creation. The alternative, however, is the anti-stimulus austerity approach Republicans have been championing over the last three years.  Sadly, some of this has and will come to pass this year as a result of the deficit deal cut in the summer and the impending “super committee” decisions that will be reached later this month.  Deficits do matter, but economic recovery matters more and concentrating on the former can and has only hurt the latter.

Taking his cues from another Keynes rival, Frederick Hayek, Mitt Romney actually suggested two weeks ago that the best policy would be to let the markets “bottom out.”  At least one candidate was being honest about Republican economic prescriptions.  He should try campaigning on the slogan: “it’s about time to let things get worse!”

As a Democrat, I would like to see things get better. Realistically, though, the choices on economic policy next year will pretty much be between politically-stymied Keynesianism and an anti-Keynesian Republican turn toward austerity.   So, maybe the election won’t be about hope and change this time around and maybe “it could be worse” isn’t the best sales pitch for the Democrats.  But it could be worse with Republicans at the helm.