<blockquote>
'Keynes' solution, devised for the peculiar circumstances of 1920s Britain, was thus only partially tried at that time and did not succeed. In Franklin Roosevelt's United States, the other contemporary example, the exchange rate was not really a problem; the U.S. ran a large balance of payments surplus throughout the decade and accumulated massive gold reserves. By 1933 the U.S. economy appeared to Keynesians have stabilized at a suboptimal level, but in fact there was nothing stable about it — a series of policy blunders by Herbert Hoover and the Fed in 1930-32 had turned a moderate recession into a major disaster, pushing output far below any conceivable equilibrium. Thus the very sharp economic rebound of 1933-34 was entirely natural, and would probably have restored full employment by about 1936. The recovery was wrongly credited by FDR's policymakers to Keynesian spending and government meddling. In fact FDR's policies, taking effect by late 1934, had the effect of slowing recovery, adding burdens of additional unionization, wasteful spending and anemic capital markets to the economy and prolonging the downturn...
...
The benefits of stimulus are cast into further doubt by a new paper by Lauren Cohen, Joshua Coval and Christopher Malloy, of Harvard Business School: “Do Powerful Politicians Cause Corporate Downsizing?” All three authors entered into the study more or less convinced Keynesians, so they expected to find that promotion of local politicians to positions of power, where their pork-sourcing capabilities were exceptional, would result in stimulation to the local economies of their districts. The authors focused on the 232 instances over the last 42 years where a senator or congressman ascended to the chairman of a powerful congressional committee. As you would expect, during the year following the appointment, the successful legislator's state experienced a 40-50% increase in its share of federal earmark spending and a 9-10% increase in total state-level government transfers, which persisted through the legislator's chairmanship. Hence if stimulus was effective, you would expect a significant increase in economic activity in that state's private sector accompanying that chairmanship.
In fact, the researchers found the opposite. In the year following a new chairmanship, the average firm in the new chairman's state cut back capital spending by 15% and significantly reduced R&D expenditures. In the median new-chairman state, receiving an additional $200 million per year in earmarks and federal transfers, capital expenditures fell by $39 million a year, R&D expenditures fell $34 million a year and payouts to investors increased $21 million a year. Bearing in mind that the new chairmanship simply resulted in shifting government funding from one state to another, no changes in interest rates or capital market conditions were involved.
...
...The reaction of the Obama administration to the current difficulties, of devising yet more stimulus and spending to increase the budget deficit still further, is thus wholly counterproductive. The U.S. economy will be paying the costs of this misguided policy for a decade to come.'</blockquote>
The Verdict on KeynesBy Martin Hutchinson
May 31, 2010
SourceA substantial gap has now opened up between the U.S. and the EU on fiscal policy. Spain's parliament Thursday passed by one vote an $18 billion austerity package that included a 5% pay cut for civil servants, while on the same day U.S. Treasury Secretary Tim Geithner continued to lecture the Europeans on the need for more stimulus. However we now have a considerable amount of new evidence on the Keynesian stimulus theory and the reality is clear: it works very rarely, and in most cases is highly counterproductive.
In its simplest form as understood by leftist politicians and many of the dozier members of the general public, Keynes' theory is nothing more nor less than a fallacy. It fails to recognize that the stimulus money has to come from somewhere, and that withdrawing it from circulation will have an opposing effect on jobs that may cancel out the Keynesian effect of the spending. The Congressional Budget Office's scoring of the jobs created by the stimulus, for example, estimates the Keynesian multiplier for each item of spending and from this estimates job creation. It neither corrects its estimates by reference to newly released unemployment data, nor takes account of the economic effect of the government borrowing that funds the stimulus spending.
Keynes himself, a subtler economist than many of his followers, did not take account of the effect of interest rates on conditions generally, but he also did not recommend “stimulus” spending in every downturn. In his view, only when the economy had become trapped in a suboptimal equilibrium, with some available resources unused and output below the full employment level, should a burst of government spending be used to get it out. Such a suboptimal equilibrium is theoretically impossible under classical economics, but Keynes, recognizing the real world in the labor market if not the capital market, postulated that in a world with strong unions wages might be sticky on the downside, in which case the labor market could equilibrate at less than full employment.
That appears to be what happened to the British economy in the 1920s. Britain returned to the Gold Standard in 1925 at a parity against gold and the dollar that was overvalued. Stanley Baldwin's 1923 election loss had ruled out the simple solution, a modest Imperial Preference tariff to balance the playing field somewhat against the high tariffs of the United States and most European countries. Thus the only solution for Britain in 1925 as for Latvia in 2008 and Greece in 2010 was to reduce wage levels to a competitive level. This was happening slowly, when the 1929 Great Depression kicked in and made matters worse. Keynes' solution of additional government spending was tried by the 1929-31 Labour government, to which he was close. However the extra spending made the payments deficit worse. In 1931 the capital markets, such as they were, seized up for Britain as they did for Greece in March 2010, and the Labour government fell. The new National Government took Britain off the Gold Standard, devaluing the pound by about 20%. Add an Imperial Preference tariff and a sharp cutback in government spending, and the problem was solved – by Neville Chamberlain, using methods largely opposed by Keynes.
Keynes' solution, devised for the peculiar circumstances of 1920s Britain, was thus only partially tried at that time and did not succeed. In Franklin Roosevelt's United States, the other contemporary example, the exchange rate was not really a problem; the U.S. ran a large balance of payments surplus throughout the decade and accumulated massive gold reserves. By 1933 the U.S. economy appeared to Keynesians have stabilized at a suboptimal level, but in fact there was nothing stable about it — a series of policy blunders by Herbert Hoover and the Fed in 1930-32 had turned a moderate recession into a major disaster, pushing output far below any conceivable equilibrium. Thus the very sharp economic rebound of 1933-34 was entirely natural, and would probably have restored full employment by about 1936. The recovery was wrongly credited by FDR's policymakers to Keynesian spending and government meddling. In fact FDR's policies, taking effect by late 1934, had the effect of slowing recovery, adding burdens of additional unionization, wasteful spending and anemic capital markets to the economy and prolonging the downturn until Admiral Tojo solved the problem in December 1941.
The problem with Keynes' solution to recessions is that it requires unemployment to be the principal problem in an economy, with finance flowing sufficiently freely, trade close to balance and inflation sufficiently quiescent so that none of those factors pose a problem. In Britain in 1929-31, trade and finance were both problems. In the U.S. in the 1930s, finance became a problem, albeit one created by the Roosevelt administration itself through the Glass-Steagall Act's de-capitalization of the investment banks. In Britain in the 1970s, trade and inflation were both dangerous problems that prevented Keynesian stimulus from being effective.
Probably the most successful recent example of Keynesian stimulus was in late 2008 China where high domestic savings, a budget surplus going into the downturn and a growing balance of payments surplus enabled stimulus to produce a remarkable economic bounce – albeit one that may now have led to overheating since the initial downturn was so minor.
Outside China, the conditions for successful Keynesian stimulus were not there. The 2008 financial crisis had made finance availability very tight and the banks very cautious. Hence adding to government spending, mostly in countries where budget deficits were already larger than they should have been, starved small business of the finance it needed. In the United States, for example, bank finance for small business, its main outside source of funding, has dropped by over 25% since September 2008. In consequence, according to figures prepared by Intuit, the small business sector is currently creating about 25% of the new net jobs, compared to a normal figure in the 70-80% range. Of the major OECD countries, Britain also implemented major fiscal stimulus, running its budget deficit up to 13% of GDP, as did Japan, pushing its public debt above 200% of GDP. Neither benefited noticeably from the spending and both were left with major budget/debt and problems once the frenzy had passed.
The benefits of stimulus are cast into further doubt by a new paper by Lauren Cohen, Joshua Coval and Christopher Malloy, of Harvard Business School: “Do Powerful Politicians Cause Corporate Downsizing?” All three authors entered into the study more or less convinced Keynesians, so they expected to find that promotion of local politicians to positions of power, where their pork-sourcing capabilities were exceptional, would result in stimulation to the local economies of their districts. The authors focused on the 232 instances over the last 42 years where a senator or congressman ascended to the chairman of a powerful congressional committee. As you would expect, during the year following the appointment, the successful legislator's state experienced a 40-50% increase in its share of federal earmark spending and a 9-10% increase in total state-level government transfers, which persisted through the legislator's chairmanship. Hence if stimulus was effective, you would expect a significant increase in economic activity in that state's private sector accompanying that chairmanship.
In fact, the researchers found the opposite. In the year following a new chairmanship, the average firm in the new chairman's state cut back capital spending by 15% and significantly reduced R&D expenditures. In the median new-chairman state, receiving an additional $200 million per year in earmarks and federal transfers, capital expenditures fell by $39 million a year, R&D expenditures fell $34 million a year and payouts to investors increased $21 million a year. Bearing in mind that the new chairmanship simply resulted in shifting government funding from one state to another, no changes in interest rates or capital market conditions were involved.
The Harvard researchers were at something of a loss to explain this effect; they postulated that some public spending directly replaces private spending, some crowds out private companies by hiring employees or driving up resource prices, but a third effect is the uncertainty created by government involvement. They came to the conclusion that overall policymakers should “revisit” their belief that federal spending can stimulate private economic development.
In summary, the conditions under which Keynesian stimulus works almost never apply; they may not even have applied in the cases in which Keynes himself recommended it. If finance is readily available, budgets are in balance and there are no other constraints, it is largely neutral, substituting for private activity, although it may have a net negative effect through creating additional uncertainty and absorbing scarce resources. However, if finance is scarce or the budget deficit large, stimulus' effect is wholly negative because it absorbs scarce financial resources and increases the likelihood of a damaging market panic. Without ever having asked any Greek citizens their opinion, I am quite sure that the vast majority of them now bitterly regret their government's “stimulus” activities of 2008-09.
Similarly, the correct response for a government that finds “stimulus” has caused markets to question their fiscal health is that pursued by Portugal, Spain and the new Cameron government in Britain: sharp fiscal retrenchment. Just as stimulus may depress output, as it clearly did in Japan in 1998-2001 and since 2008, so retrenchment may increase growth, freeing up resources for the private sector and leading to new job creation in small business, which now finds finance more readily available. The reaction of the Obama administration to the current difficulties, of devising yet more stimulus and spending to increase the budget deficit still further, is thus wholly counterproductive. The U.S. economy will be paying the costs of this misguided policy for a decade to come.
In summary, we should enjoy Keynes' witty aphorisms and respect his intellect. We should however avoid following his policy recommendations.