Does Keynesian Policy Still Work?

            Keynesian economic expansion, the main tool of economic management used by all Western governments since 1932, is starting to become much more difficult.  But before I explain why, I should perhaps explain exactly what I mean.  First of all, let me admit that the theories of John Maynard Keynes are about much more than just using deficit spending to pump up a sluggish economy.  They are also about running a deliberate budget surplus to slow down an inflationary economy.  In fact, Keynes’ theory encompassed a total system of rationing aggregate demand to insure that the spendable income in circulation always matched the amount of goods in production.  But the part that was most widely adopted was the expansion.  Roosevelt used it, Hitler used it, and from the post-war recovery through the Cold War, all Western powers used it continually.

            When I was in college in the late 50s (or was it the late Pleistocene) Keynesian theory was still debated.  Liberals would merely cite the fact that the U.S. had been using this method since 1932, and real GDP and real income had probably tripled over that 25 year period, and the country had not gone broke.  Contrary to conservative predictions, the U.S. economy was sounder than it had ever been.  In my Econ 101 class, the conservatives did not attempt to refute the empirical evidence that it had in fact worked (i.e. It had paid for getting us out of the depression, paid for winning WWII, paid for post-war reconstruction, and was then paying for the Cold War. And though debt had increased exponentially, the debt to income ratio, the real measure of credit worthiness, was about the same as before.)  But they stubbornly claimed that it theoretically shouldn’t work.  After all, how can you spend yourself rich? And then the instructor explained how you can, under certain circumstances, do precisely that.  It can only be done when the economy is sluggish.  You must have high unemployment and unused industrial capacity. 

            If, during a time of high unemployment and unused industrial capacity, the government uses its ability to borrow vast amounts of money cheaply and spends that money to hire people or purchase goods and services that will cause people to be hired, then unemployment will drop.  And the new employees will spend their earnings, which will cause others to be hired. And employers will buy more equipment for the new hires to use, and shippers will buy more trucks to haul the increased production, etc, etc.  As this effect cascades through the economy, at every stage where wages are earned or profit is made, some portion of that wage or profit is returned to the government in taxes. So by the time the cycle plays out, most of the original amount spent by the government will have been reclaimed—but not all of it.  The remainder will simply be added to the national debt, which will be larger than before.  But though debt will have grown, the size of the economy obligated to service that debt will have grown even more. And since the true measure of the economic health and credit worthiness is debt/income ratio, the country is no worse off.

            Conservatives would argue that it can’t work, because you can’t get something for nothing.   But you are not really creating wealth out of thin air. What you are doing is reclaiming a wasted resource, namely, the unused labor of unemployed people, and the unused capacity of partially idle factories.

             One must appreciate that wasted labor is a huge loss to any economy, and a great moral evil as well.  If I own a silo full of grain and no one will purchase my grain today, I can store it and sell it next year. Grain can be stored.  But, as Pius X pointed out in his encyclical Rerum Novarum, human labor cannot be stored.  If it cannot be sold every day, it is lost forever, both to the individual and to society.  So recovering labor that would otherwise be wasted can be a source of vast, new wealth for any society that finds a way to do this.  It converts desperate welfare recipients into tax-paying citizens and prosperous consumers. So even if Keynesian expansion were to involve risks (which it does), the risks are well worth taking.

            But back to the Econ 101 class:  The conservatives would insist that this cycle can’t just go on forever.  The instructor would reply, “Why not?”   Being a liberal, I had always taken the pro-Keynesian side.  But eventually, even I could not avoid asking, “Is there a point where this expansion is no longer possible?”   The instructor answered, “It would all come to an end if you ran out of natural resources.”   He explained that for the system to work, each new level of debt must be matched by expansion of real GDP to service that debt.  But as the economy expands, consumption of resources also expands.  When you reach a point where resources are already stretched to the limit, then no expansion is possible.  And it eventually becomes dangerous to incur increased indebtedness if there can be no expected increase in GDP to service that debt.

I asked how close we were to reaching this resource crisis.  The instructor replied that we would have no shortage of anything for hundreds of years—except oil.  (At that time, the U.S. was still a net exporter of oil.)  I asked how much oil we still had.  He said that, at our present rate of consumption, we had at least enough for forty years, and we discover more every year.   But he added that we would not be consuming at our present rate—we were doubling our rate of use every ten years. And when you do that, you soon run out no matter how much you start with.    All this took place back in 1958.

            Now fast forward to 2011.  I think that one of the reasons that all Western governments seem reluctant to spend the amount necessary to boost their countries out of recession is that there is a growing perception that the global economy may be reaching a resource-imposed limit, and that further deficit spending might not actually deliver any expansion.

            In reaching this conclusion, I discount completely that reluctance of congressional Republicans to back any Obama spending program. Besides this being a partisan effort to undermine a Democratic president, conservatives have a long history of knee-jerk opposition to deficit spending, unless it was to provide tax cuts to billionaires.  In 1932, Roosevelt inherited an economy with a 25% unemployment rate.  By 1936, by using Keynesian expansion he had reduced it to 10%.  But then conservatives in Congress persuaded him to cut spending and balance the budget.  It was a disastrous decision.  By 1937, unemployment was back up to nearly 25%, and if it weren’t for WWII, this depression might have gone on forever.  But in 1936, no one in the country thought we were running out of resources. Congressional Republicans had demanded a balanced budget for purely ideological reasons. And this ideology continued all through the 40s, 50s, and 60s.   Finally, under Nixon, we had a sitting Republican president who openly admitted to being a Keynesian.  But by then, the thrust of Keynesian expansion had shifted.  Instead of running a deliberate deficit by spending money to hire people, the Republicans prefer to do so by handing out tax cuts to the very wealthy.  So what of their moral outrage at deficit spending?  Apparently, money spent to provide a job so an unemployed man can feed his family is morally abhorrent and irresponsible—but money spent to provide more tax cuts to a billionaire is a wise and shrewd policy.  Republicans did not invent the idea of using tax cuts instead of spending. This was first done by President Kennedy, though his first choice would have been to spend more, not to tax less.   But using tax cuts is a very risky kind of Keynesianism because you don’t get much bang for the buck. Since most Republican tax cuts spend most of the money giving cuts to the very rich, very little of this money is ever spent.  The pretext is that it will be invested, and that this will create jobs.  But even if it does, the effect is not immediate, as would be the case if people were hired directly. And when jobs are created, they will likely be created in some other country.   It’s like flying over some wealthy gated community and throwing bales of hundred dollar bills out the door.   Any result in increased employment is pretty iffy, yet the increased indebtedness of the country is immediate and certain.

            So the reluctance of the congressional Republicans is a purely partisan ritual. When Bush II took over from Clinton, he inherited a budget surplus. Bush immediately introduced, and congressional Republicans passed tax cuts for upper income Americans which turned this surplus into a deficit.  And then of course, Mr. Bush tried to fight two wars without raising taxes to pay for them.  So much for the GOP outrage at deficit spending.

            But what impresses me is that Western European countries that have calmly and quietly used Keynesian expansion for 75 years are now becoming skittish about pursuing it any further.  Have they concluded that we are now up against a resource limit, and that further expansion won’t work?  Consider the history of our current recovery.  The economy had crashed and the price of oil crashed.  We spent a lot of government money. The economy started to pick up, but then the price of oil immediately went back up, which stalled the recovery.  With a stalled recovery, the price of oil went back down a little.  So, if we were to have another stimulus and another round of “quantitative easing,” wouldn’t the same thing happen again?   If the amount of oil needed to sustain the level of global economic activity we are trying to reach is greater than the amount we can produce, then the limit has finally been reached, and more spending won’t change it much.

            Personally, I believe that a sort of Keynesian expansion might still be possible.  But it would have to be very narrowly targeted.  It would have to be like a rifle shot—not like a bomb.  If the government were to employ people directly in tasks that would immediately reduce oil use, such as hiring an army of long term unemployed to weatherize old houses, that might work because the increase in economic activity would be matched by an increase in fuel efficiency.  If a “cash for clunkers” program were used, it might work if the cars traded in and junked were all gas guzzlers, and the cars replacing them had very high fuel efficiency.  (But of course, part of the deal would have to be the prohibition on manufacturing or selling any new gas guzzlers.)  In any country, only a popular president with a solid, “rubber stamp” majority in Congress could employ such initiatives quickly enough and accurately enough to do any good.  I don’t see that as likely anytime soon in the U.S., or even anywhere in Europe or in Japan.   So perhaps the Keynesian days are over.


Epilogue:   I originally wrote this piece on 7/5/11.    Today, on 2/16/12,  an Associated Press piece in the Waterloo Courier is entitled:  JOBLESS CLAIMS AT 4 YEAR LOW.   In the Wall Street Journal today, on the front page, above the fold, is a column head saying:  OIL RISE IMPERILS BUDDING RECOVERY.   I rest my case.