Friday, August 26, 2011

Government Fairy Tales and Keynesian Economics

In early September, President Obama is going to disclose to the nation and world his newest plan for getting our economy back on track. Again.

My guess is that the president's proposals will endorse new government spending initiatives in an effort to stimulate aggregate demand in the economy. Assuming his proposals are indeed based on this old style Keynesianism, they simply won't work. But let's continue.

Although at this time we can't know what he'll propose, of course, we can guess. We should reasonably expect that he'll tell us he's going to do everything possible to get people back to work and the economy growing. And that the Republicans should endorse his efforts. The president will further advise that this effort will also require some additional government "stimulus" or "investment" spending programs of some kind.

Haven't we already seen this movie? As I recall, the original stimulus program a few years ago was billed as necessary to keep unemployment from getting as high as 8%. Today it's more than 9%.

Of course, the Republicans will have their credibility issues, too. They'll insist that they are going to bring fiscal discipline to the table, but that they will not be able to seriously discuss, let alone address, our all-too-expensive entitlement programs and other initiatives until after they win next year's election.

And if in the end the two sides manage to reach some kind of deal, which they probably will, they'll all proudly say that they will "pay-for-it" by reducing other expenditures to make room for the additional short term "stimulus".

Here's the fundamental problem with all this happy talk.

Our government's financial condition gets worse with each passing day. We already borrow 40 cents of every dollar we spend at the federal level. Thus, even if we "pay" for the next program's expenditures by reducing other planned spending, we'll simply be borrowing money to spend on different things. All signs point to our national politicians continuing to spend too much in the years ahead (What Austerity?).

We will still have an enormously huge debt overhanging our society. The politicians won't talk much, if at all, about what they propose to do about that elephant in the room.

The statistics are stark and telling. As individuals we are much too heavily in debt. Our financially weakened states are dependent upon the federal government for 30% of their spending. Meanwhile, the federal government is getting 40% of what it spends by additional borrowings.

So the president's position will be this; we have no money of our own to spend, but we'll stimulate our economy by borrowing and then spending even more money in the form of what we'll call "stimulus" or "investment" funds.

Keynesianism emphasizes the stimulus of aggregate demand. It's a fairy tale story which says that we can borrow and spend money to drive demand, which will then return to our economy more money than we borrowed and spent in the first place.

The political argument is that performing this Keynesian magic trick will drive our economy forward and deliver needed economic growth. But, of course, it will do no such thing!

Keynesian Economics vs. Regular Economics by Robert Barro, a Harvard economics professor, exposes this too-good-to-be-true fairy tale for what it is. He talks about the so-called economic "multiplier" effect of food stamp spending programs and concludes that this Keynesian "miracle" is pure nonsense.

Specifically, Agriculture Secretary Tom Vilsack asserts food stamps are an "economic stimulus" and that every dollar spent on food stamps will magically increase overall economic activity by $1.84. In other words, government borrows $1 for food stamps, and the economy benefits by $1.84. We can call this fiction the "no pain, all gain" plan.

Unfortunately, free lunch programs (aka Keynesian economics) will likely be a significant part of what the president will be selling us in September.

In comparison, here's the counterpoint. Self-described "regular economics" proponent Professor Barro sees it a bit differently, "The overall prediction from regular economics is that an expansion of transfers, such as food stamps, decreases employment and, hence, gross domestic product. In regular economics the central ideas involve incentives as the drivers of economic activity. Additional transfers to people with earnings below designated levels motivate less work effort by reducing the reward from working."

He goes on, "In addition, the financing of a transfer program requires more taxes--today or in the future in the case of deficit financing. These added levies likely further reduce work effort--in this instance by taxpayers expected to finance the transfer--and also lower investment because the return after taxes is diminished."

Then he adopts a somewhat conciliatory and normative approach, "This result does not mean that food stamps and other transfers are necessarily bad ideas in the world of regular economics. But there is an acknowledged tradeoff: Greater provision of social insurance and redistribution of income reduces the overall GDP pie." { It makes complete sense to separate normative from positive economics when discussing food stamps or similar programs.}

Later Professor Barro offers another example of "perverse incentives", or the law of unintended consequences, at work, "Ironically, the administration created one informative data point by dramatically raising unemployment insurance eligibility to 99 weeks in 2009--a much bigger expansion than in previous recessions. Interestingly, the fraction of the unemployed who are long term (more than 26 weeks) has jumped since 2009-- to over 44% today, whereas the previous peak had been only 26% during the 1982-83 recession. This pattern suggests that the dramatically longer unemployment-insurance eligibility period adversely affected the labor market."

Barro then wraps up his attack on Keynesianism, "There are two ways to view Keynesian stimulus through transfer programs. It's either a divine miracle--where one gets back more than one puts in--or else it's the macroeconomic equivalent of bloodletting."

Thus, when the president's new economic plan is revealed in September, let's listen carefully. Even if we choose to believe that his intentions are good, and not in any way based on politics or with an eye toward the 2012 election, it behooves us to understand the logic behind his proposals.

In the interim, here's hoping that not one of his proposals is based on fairy tale Keynesian macroeconomics and the free lunch syndrome. That wouldn't help us out of this mess. Not at all.

Thanks. Bob.

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