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Would Keynes Have Supported The Stimulus Bill?

By Arnold Kling Monday, February 23, 2009 Filed under: Big Ideas, Economic Policy T e economis!s ! a! you ear less abou! are ! ose " o o##ose ! e bill because o$ ! eir reading o$ %o n Maynard Keynes& In my opinion the sophisticated Keynesian view is still that the stimulus wont work. Tyler Cowen, Axel ei!onhu"vudon #iscal $timulus% 'ongress as #assed a (s!imulus bill,) bu! 'ongress as $ailed !o enac! a s!imulus& To unders!and o" ! a! is so, i! is use$ul !o re*e+amine some $undamen!al !ene!s o$ macroeconomics and Keynesian ! oug !& Many ,arie!ies o$ Keynesian macroeconomis!s e+is!, and some o$ us belie,e ! a! ! e ! e -bama adminis!ra!ion.s ou!sourcing o$ economic decisions !o /ouse 0#ea1er 2ancy Pelosi as resul!ed in a #olicy ! a! is li1ely !o "or1 #oorly, i$ a! all& T is essay "ill gi,e some o$ ! e is!ory o$ macroeconomic ! oug ! since Keynes& A! ! e end, I "ill re!urn !o ! e issue o$ ! e s!imulus bill& T ere are !"o main o##onen!s !o Keynes& Classicals belie,e ! a! mar1e!s are sel$*correc!ing& &onetarists belie,e ! a! s!able mone!ary gro"! is su$$icien! !o 1ee# mar1e!s $unc!ioning "ell& T e reason ! a! ! e 3emocra!s "an! !o delay ! e s!imulus is ! a! ! ey "an! mos! o$ ! e s!imulus !o !a1e ! e $orm o$ s#ending increases, " ic canno! be andled e$$ec!i,ely ! is year& Ta+ cu!s could !a1e e$$ec! more 4uic1ly& T e classical ,ie" is ! a! an increase in unem#loymen! is na!urally !em#orary and sel$*correc!ing& 5nem#loymen! re#resen!s a sur#lus o$ labor& In a mar1e! sys!em, " ene,er some! ing is in sur#lus, i!s #rice $alls& T e dro# in #rice increases demand and decreases su##ly, un!il ! e sur#lus is elimina!ed& Accordingly, a dro# in "ages s ould be su$$icien! !o res!ore $ull em#loymen!& In ! e classical ,ie", a $iscal s!imulus 6meaning an increase in ! e go,ernmen! budge! de$ici!7 "ould be unnecessary, because de,ia!ions $rom $ull em#loymen! "ould ne,er be large or long*las!ing& Keynes made !"o argumen!s agains! ! e classicals& Firs!, e sugges!ed ! a! "ages are no! as $le+ible as needed !o elimina!e unem#loymen!& 0econd, e sugges!ed ! a! e,en i$ "ages $ell, ! is "ould #roduce de$la!ion, and de$la!ion "ould reduce business s#ending on in,es!men!, leading !o lo"er demand $or labor& T us, cu!!ing "ages "ould be some" a! li1e a ca! c asing i!s !ail8i! "ould no! end a de#ression& Mone!aris!s "ould be "illing !o acce#! ! e ,ie" ! a! a de#ression "ill no! be sol,ed by "age cu!s& /o"e,er, a mone!aris! ,ie" "ould be ! a! as long as ! e money su##ly gro"s su$$icien!ly, ! ere "ill be in$la!ion& 9i! in$la!ion, ! e lac1 o$ $le+ibili!y o$ "ages "ill be neu!rali:ed by ! e $le+ibili!y o$ #rices& An increase in #rices "ill ser,e ! e same #ur#ose as a decrease in "ages, in ! a! i! "ill unleas ! e $orces o$ su##ly and demand !o elimina!e unem#loymen!& According !o mone!aris!s, a $iscal s!imulus "ould be unnecessary because s!able money gro"! and modera!e in$la!ion "ould al"ays be su$$icien! !o a,oid a large recession&

Agains! ! e mone!aris!s, Keynes ga,e !"o argumen!s& -ne is ! a! in an economy " ere #rices are $alling, #eo#le " o s!ic1 ! eir money in a ma!!ress can earn a #osi!i,e re!urn& 9 en ne"ly crea!ed money ge!s s!uc1 in ma!!resses, i! $ails !o genera!e in$la!ion& T is is ! e li4uidi!y !ra#& T e o! er argumen! is ! a! e,en i$ ne"ly crea!ed money el#s !o lo"er in!eres! ra!es, in,es!men! demand may no! be sensi!i,e !o in!eres! ra!es& Ins!ead, in,es!men! is de!ermined by (animal s#iri!s,) meaning ! e "illingness o$ en!re#reneurs !o ma1e a lea# o$ $ai! and #urc ase ca#i!al e4ui#men! in ! e $ace o$ an uncer!ain $u!ure& More sa,ing al"ays lo"ers ! e demand $or curren! consum#!ion goods& 9 en animal s#iri!s are su$$icien!, consumers " o "is !o sa,e $or $u!ure needs 6re!iremen!, $or e+am#le7 $ind en!re#reneurs "illing !o in,es! in #ro;ec!s ! a! "ill yield re!urns in ! e $u!ure& /o"e,er, " en animal s#iri!s are no! su$$icien!, ! e desire !o sa,e is no! ma!c ed by a desire !o in,es!& In ! a! case, ! e dro# in s#ending on curren! consumer goods is no! o$$se! by an increase in s#ending on in,es!men! goods& Ins!ead, aggrega!e demand $alls, economic ac!i,i!y slo"s do"n, and unem#loymen! rises& Milton Friedman and the Challenge to Fine Tuning In ! e <9=0s, Keynesian economics "as $ully mains!ream, ens rined in !e+!boo1s& Macroeconomis!s o$ ! a! #eriod belie,ed ! a! ! ey could con!rol macroeconomic $luc!ua!ions "i! grea! #recision, based on ma! ema!ical e4ua!ions ! a! "ere $i! !o is!orical da!a& T e s!a!is!ical !ec ni4ues #roduced " a! "ere called macroeconome!ric models, or macro models $or s or!& T e #recise #olicy ad;us!men!s "ere 1no"n as ($ine !uning&) 0!ar!ing in ! e la!e <9>0s, many economis!s began !o see ! e mar1e!.s sel$*correc!ing mec anisms as su#erior !o go,ernmen! managemen!, and cer!ainly su#erior !o ! e no"* discredi!ed ?$ine !uning&. T is #recise, (engineering) ,ie" o$ macroeconomics "as a!!ac1ed $rom a number o$ direc!ions& 0ome Keynesians belie,ed ! a! ! e macroeconome!ric a##roac le$! ou! some im#or!an! Keynesian ideas, suc as (animal s#iri!s&) -n ! e o! er side, Mil!on Friedman argued ! a! ! e macroeconome!ric models "ere no! nearly reliable enoug !o su##or! ($ine !uning&) /e "arned, #ar!icularly in is <9=> #residen!ial address !o ! e American Economic Associa!ion, ! a! a!!em#!s !o use in$la!ion !o reduce unem#loymen! "ould #ro,e !o be sel$*de$ea!ing as "or1ers began !o reali:e ! e need !o demand "age increases in an!ici#a!ion o$ ig er #rices& -,er ! e <@ years $ollo"ing is address, economic e,en!s #layed ou! in a "ay ! a! ,indica!ed Friedman and discredi!ed ! e $ine !uners& Firs!, in$la!ion accelera!ed& 0econd, s!ar!ing in <9><, Presiden! 2i+on !ried !o im#lemen! ! e $ine*!uners. solu!ion $or in$la!ion, " ic "as "age and #rice con!rols& T is $ailed, leading !o dread$ul economic #er$ormance, "i! bo! unem#loymen! and in$la!ion a! ig le,els& Finally, a! ! e end o$ ! e decade, Presiden! 'ar!er a##oin!ed Paul Aolc1er as c airman o$ ! e Federal Beser,e Board and ga,e im a manda!e 6subse4uen!ly rein$orced by Presiden! Beagan7 !o $ollo" Friedman.s ad,ice and !rea! in$la!ion as a mone!ary # enomenon& Aolc1er under!oo1 con!rac!ionary mone!ary #olicy, resul!ing in a s!ee# recession bu! a long*!erm reduc!ion in in$la!ion& The Age of Monetarism 0!ar!ing in ! e la!e <9>0s, ! e economics #ro$ession s"ung in ! e direc!ion o$ classicalism and mone!arism& Many economis!s began !o see ! e mar1e!.s sel$*correc!ing mec anisms as su#erior !o go,ernmen! managemen!, and cer!ainly su#erior !o ! e no"*discredi!ed ($ine !uning&) T e macroeconome!ric models used $or ($ine !uning) "ere seen as based on s#urious correla!ions& T e macro models "ere discarded by academic economis!s, al! oug ! ey remained in use by a $e" #ri,a!e $orecas!ing $irms and by go,ernmen! agencies, including ! e Federal Beser,e Board&

9i! in ! e economics #ro$ession, a consensus emerged ! a! embraced mone!arism& A broad s#ec!rum o$ economis!s endorsed ! e ,ie" ! a! s!able money gro"! ! a! is consis!en! "i! modera!e le,els o$ in$la!ion 6#rices rising by abou! 3 #ercen! #er year7 oug ! !o lead !o s!able economic ac!i,i!y, "i! ou! re4uiring $iscal s!imulus or o! er measures aimed a! ($ine !uning&) T is mone!aris! consensus e,en e+!ended !o is!orical analysis o$ ! e Crea! 3e#ression& Many economis!s came !o s!ress mone!ary $ac!ors, suc as ! e colla#se o$ ban1s, as im#or!an! causes o$ ! e 3e#ression& T e consensus no" is ! a! " a!e,er im#ro,emen! !oo1 #lace under Presiden! Fran1lin 3& Boose,el! 6and ! e im#ro,emen! "as no! su$$icien! !o elimina!e ! e large e+cess o$ unem#loymen!7 "as due no! !o 2e" 3eal #rograms bu! ins!ead re$lec!ed is #olicies !o s!abili:e ban1s and end ! e gold s!andard& T ere is a general ,ie", eld by bo! Keynesians and non*Keynesians, ! a! ! e <930s did no! cons!i!u!e an e+#erimen! "i! $iscal s!imulus, because de$ici! s#ending "as !oo small !o ma1e any di$$erence& The Shoc of !""# T e e,en!s o$ 200D a,e des!royed ! e mone!aris! consensus ! a! #re,ailed $or ! e #rior ! ree decades& Ins!ead, ! e economics #ro$ession seems !o a,e bro1en u# in!o a number o$ di$$eren! cam#s& 0ome economis!s, #rimarily $rom ! e 5ni,ersi!y o$ ' icago, remain classical in orien!a!ion& T a! is, ! ey belie,e ! a! mar1e!s "ill sel$*correc!, and ! ey o##ose $iscal s!imulus on #rinci#le& -! er economis!s are no" "illing once again !o !a1e seriously macro models, "i! ! eir #recise (mul!i#liers) ! a! #redic! ! e resul!s o$ $iscal s!imulus& /o"e,er, ! e many ! eore!ical and s!a!is!ical $la"s o$ macroeconome!rics, " ic caused suc models !o be discarded a genera!ion ago, con!inue !o #lague ! is a##roac & Te+!boo1 macroeconomics as no descri#!ion o$ ! e sor! o$ $inancial colla#se ! a! !oo1 #lace in 200D& In!ui!i,ely, "e belie,e ! a! ! e $lig ! $rom ris1 and ! e de*le,eraging o$ $inancial ins!i!u!ions as a con!rac!ionary e$$ec!& /o"e,er, ! is is no! a mec anism ! a! is embedded in basic macroeconomic ! eory or in macroeconome!ric models& T e e,en!s o$ 200D a,e des!royed ! e mone!aris! consensus ! a! #re,ailed $or ! e #rior ! ree decades& Ins!ead, ! e economics #ro$ession seems !o a,e bro1en u# in!o a number o$ di$$eren! cam#s& 0ome economis!s "an! !o !a1e a Keynesian ,ie" ! a! di$$ers $rom ! a! ens rined in ! e !e+!boo1s& For e+am#le, in ! e ne" boo1 Animal $pirits, leading be a,ioral economis!s Ceorge A& A1erlo$ and Bober! %& 0 iller argue ! a! ! e crisis o$ 200D canno! be unders!ood by ! in1ing abou! ! e economy as only de,ia!ing slig !ly $rom ! e classical model& Ins!ead, ! ey sugges! ! a! ! e $inancial colla#se re$lec!s a loss o$ con$idence, caused in #ar! by corru#!ion and bad $ai! and by ma;or c anges in (s!ories&) 6An e+am#le o$ ! e la!!er is ! e $ac! ! a! ! e (s!ory) o$ ousing un!il recen!ly "as ! a! ouse #rices ne,er decline&7 A1erlo$ and 0 iller e+#lain ! e inabili!y o$ labor mar1e!s !o sel$*correc! as due !o norms o$ $airness and !o money illusion, so ! a! "or1ers are no! "illing !o acce#! "age cu!s e,en ! oug #rices are declining& Ano! er non*!e+!boo1 analysis ! a! is in a Keynesian s#iri! is based on ! e ideas o$ ! e la!e /yman Mins1y& Mins1y sa" $inancial mar1e!s as going ! roug # ases o$ ris1 !olerance& In a lo"*!olerance # ase 6 edge $inance7, $irms $inance in,es!men! ou! o$ #ro$i!s& As con$idence im#ro,es, ! ey #roceed !o a medium*!olerance # ase 6s#ecula!i,e $inance7, in " ic $irms are "illing !o borro" !o $inance in,es!men!& In a ig *!olerance # ase 6Pon:i $inance7, $irms are e,en "illing !o borro" !o $inance in!eres! #aymen!s on #re,ious borro"ing& 9 en ! is las!, unsus!ainable # ase colla#ses, ! e economy re,er!s !o edge $inance& 9e can see ! a! suc a cycle "as a! "or1 in ! e ousing mar1e!8by 200= and

200> ! e "ea1es! borro"ers lac1ed ! e income !o re#ay ! eir loans& Ins!ead, ! ey "ere con!inually re$inancing, in a Pon:i sc eme ! a! de#ended on e,er*rising ouse #rices& T e colla#se o$ ! a! Pon:i $inance as caused a re,ersion !o ! e lo"*!olerance # ase o$ ! e $inancial cycle& For a Stimulus$ Against %elosi&s Bill I$ you $ollo" ! e ne"s media, you may ! in1 ! a! ! e economics #ro$ession is di,ided in!o !"o cam#s: ! e ma;ori!y, " o $a,or ! e s!imulus billE and a minori!y, " o are agains! any s!imulus& In $ac!, ! ere are many o$ us " o su##or! ! e idea o$ a s!imulus bu! " o 4ues!ion ! e Pelosi bill& -ne grou# o$ s1e#!ics is concerned abou! ! e s!a!e o$ ! e ban1ing sys!em& Tyler 'o"en, 4uo!ed abo,e, is in ! is cam#& T eir ,ie" is ! a! "i! a dys$unc!ional $inancial sys!em, $iscal s!imulus may no! "or1& Ins!ead, "e need !o $irs! $igure ou! o" !o $i+ or "or1 around ! e ban1ing crisis& As someone "i! in ! is grou#, I belie,e "e need !o "or1 around ! e ban1s, because "e are in a edge $inance # ase, " ere $irms need !o $und in,es!men! ou! o$ #ro$i!s& In!ui!i,ely, "e belie,e ! a! ! e $lig ! $rom ris1 and ! e de*le,eraging o$ $inancial ins!i!u!ions as a con!rac!ionary e$$ec!& /o"e,er, ! is is no! a mec anism ! a! is embedded in basic macroeconomic ! eory or in macroeconome!ric models& Ano! er grou# o$ s1e#!ics is concerned abou! ! e !iming o$ ! e $iscal s!imulus& E,en some economis!s on ! e le$!, including Alice Bi,lin and %e$$rey 0ac s, a,e made ! e #oin! ! a! ! e long*!erm s#ending in ! e s!imulus bill is ina##ro#ria!e and e,en coun!er#roduc!i,e $rom a s!imulus #ers#ec!i,e& I s are ! is concern& Presiden! -bama said ! a! is goal is !o a,e >@ #ercen! o$ ! e s!imulus !a1e e$$ec! be$ore ! e end o$ 20<0& Ins!ead, I "ould argue ! a! "e s ould a,e <00 #ercen! !a1e e$$ec! by ! en, and >@ #ercen! !a1e e$$ec! by ! e end o$ 2009& T e reason ! a! ! e 3emocra!s "an! !o delay ! e s!imulus is ! a! ! ey "an! mos! o$ ! e s!imulus !o !a1e ! e $orm o$ s#ending increases, " ic canno! be andled e$$ec!i,ely ! is year& Ta+ cu!s could !a1e e$$ec! more 4uic1ly, bu! ! e 3emocra!s "an! !o old !a+ cu!s !o a minimum& Te+!boo1 Keynesian economics says ! a! a s#ending increase "ill s!imula!e more #o"er$ully ! an a !a+ cu!, because #ar! o$ a !a+ cu! "ill be sa,ed ra! er ! an s#en!& /o"e,er, ! is same !e+!boo1 analysis says ! a! a s!imulus no" is more #o"er$ul ! an a s!imulus ! a! 1ic1s in !"o years $rom no"& E,en ! oug ! e mul!i#lier $or a s#ending increase may be ig er ! an ! a! $or a !a+ cu! ! a! is enacted at the same time, "e can be cer!ain ! a! ! e (mul!i#lier) $or a !a+ cu! in 2009 is grea!er ! an ! e mul!i#lier $or a s#ending increase in 20<<& T ere is a general ,ie", eld by bo! Keynesians and non*Keynesians, ! a! ! e <930s did no! cons!i!u!e an e+#erimen! "i! $iscal s!imulus, because de$ici! s#ending "as !oo small !o ma1e any di$$erence& Finally, I a,e a concern abou! ! e (#ublic c oice) as#ec!s o$ ! e s!imulus bill, meaning ! e #oli!ical dis!or!ions ! a! ma1e i! an ine$$ec!i,e s!imulus& I$ ! e only goal o$ ! e bill "ere !o s!imula!e ! e economy, ! en ! e $ocus "ould be on !rying !o ge! ! e larges! #ossible im#ro,emen! in em#loymen! $or a gi,en increase in ! e de$ici!& A !radi!ional s!imulus #ro#osal, going bac1 !o ! e <9=0s, is a !em#orary in,es!men! !a+ credi!& 9i! suc a credi!, ! e go,ernmen! in e$$ec! #ro,ides ma!c ing $unds $or $irms ! a! under!a1e in,es!men! " ile ! e !a+ credi! is in e$$ec! 6say, ! roug Marc o$ 20<07& T is "ould lead !o s#ending increases ! a! are a mul!i#le o$ " a! ! e go,ernmen! con!ribu!es& Ano! er #ro#osal, " ic Ceorge Mason 5ni,ersi!y.s Bryan 'a#lan as sugges!ed, is a cu! in ! e em#loyer #or!ion o$ ! e #ayroll !a+& T e e+!ra 1ic1er ere is ! a! i! reduces ! e em#loyer.s cos! o$ labor, ! ereby s!imula!ing iring& I ! in1 an addi!ional 1ic1er is ! a! ! is "ould res!ore #ro$i!abili!y in ! e

non$inancial sec!or, el#ing !o boos! in,es!men!& Ins!ead, ! e s!imulus bill is direc!ed largely a! s!a!e and local go,ernmen!s& T ere is a lo! o$ r e!oric abou! ma1ing sure ! a! "e do no! lay o$$ co#s or !eac ers& Bu! ! e $ac! is ! a! millions o$ #ri,a!e sec!or "or1ers are being laid o$$, " ile #ublic sec!or layo$$s so $ar a,e been $e"er ! an one undred ! ousand& T e need $or s!imulus is in ! e #ri,a!e sec!or, bu! ! e #oli!ical $ocus o$ ! e bill is on enlarging ! e #ublic sec!or& Many economis!s are "illing !o o,erloo1 ! e $la"s in ! e legisla!ion and !o sanc!i$y Pelosi.s bill as a s!imulus bill& -! er economis!s re;ec! Keynesian economics al!oge! er& T e economis!s ! a! you ear less abou! are ! ose o$ us " o o##ose ! e bill 'ecause o$ our reading o$ Keynes& Arnold Kling 'as an economist on the staff of the (oard of governors of the Federal )eserve System and 'as a senior economist at Freddie Mac* He co+hosts ,con-og$ a popular economics (log*

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