Keynesian failure: Stimulus package a national tragedy

Eric Shierman thb Keynesian failure: Stimulus package a national tragedy

by Eric Shierman

Keynesian Economics as Bloodletting

Bloodletting is the withdrawal of blood from a patient to cure or prevent illness. It was based on an ancient system of medicine in which the proper balance of bodily fluids like blood were considered necessary to maintain health. Despite making plenty of sense in theory for centuries, Bloodletting never produced any empirical evidence to justify its use, making the perfect metaphor for the Keynesian school of economics.

When John Maynard Keynes published his General Theory of Employment, Interest, and Money in 1936, his ideas were already well known and being implemented in the first FDR term under the experimental advice of Rexford Tugwell. Keynes argued that recessions were caused by excessive saving by the private sector that reduced “aggregate demand.” Keynes concluded that only the government could get the economy growing again by increasing its spending.

Foundational to Keynes’ theory is the spending multiplier. Without this multiplier, his theory could not overcome Frederick Bastait’s Broken Window Fallacy. To create a net increase in GDP, government spending must generate more economic activity by a factor greater than 1.

Secretary of Agriculture Tom Vilsack littered his speech in Portland last week to a select group of Oregon business leaders with several Keynesian claims. Using the spending multiplier, Vilsack was able to assure them that if Obama’s latest attempt at stimulus is passed, 5,500 net jobs will be created in our state. He pointed to how good food stamps have been for the agricultural sector. Food stamps have indeed been good for the agricultural sector, but how good are they to the overall economy? Vilsack is still sticking to a multiplier of 1.84. With all the technocratic precision a number like that implies, the lay person is almost intimidated from asking if there is any actual evidence to support his claim.

Economics having a reputation as a fairly rigorous, data-driven social science, you would think there would be empirical evidence for the Keynesian spending multiplier all over the place. There is none and never has been.

This was good enough for the conformist days of the 50s and 60s. Everybody read Paul Samuelson’s old economics textbook that laid out Keynesian theory like a catechism. First published in 1948, it remained unchallenged and unquestioned for decades.

Then something happened that contradicted the very core of Keynesian theory: stagflation. Anyone who has actually read Keynes’ General Theory knows you cannot have both a recession and inflation at the same time. By the end of the 70s, the Keynesian school was thoroughly discredited, its dominance toppled by Monetarism. Look at the economics departments of the world today; they are all Monetarists now.

If the economics profession has abandoned Keynes, why do politicians still embrace him? Former president of the Foundation for Economic Education Richard Ebeling has the best answer: “While the Keynesians dreamed dreams of mastering and manipulating the market economy through the miracles of ‘activist’ monetary and fiscal policy, ordinary politicians looking for ways to get elected and reelected, found in the Keynesian Revolution their own miracle.”

By 2009 Keynesian economists had become a rare breed at the leading research universities. With Christina Romer and a few of her Facebook friends all working at the Council of Economic Advisors, there just weren’t any respected Keynesian macroeconomic specialists left to provide a credible independent analysis when evidence was desperately being scrounged to sell Obama’s first attempt at stimulus. There were plenty of celebrity Nobel prize winners like Paul Krugman and Joseph Stiglitz who were once serous microeconomists, but they had long since pocketed their awards to move on to the more glamorous world of highly paid pundits.

A new found fad emerged that year, to empirically verify the Keynesian spending multiplier, but these attempts fell flat. The most generous came from UCSD’s Valerie Ramey who estimated that the multiplier could be no more than 1.4, and only if policy makers can time their spending perfectly to finance the projects with the highest return on investment (good luck with that). Serious problems with her methodology prevented it from publishing in a peer reviewed journal until after congress passed the stimulus bill. After fixing her mathematical errors, the multiplier deflated considerably to a window of 0.6 to 1.1. That is to say, if the stars align you basically break even, but real congressmen writing a real stimulus bill will likely contract GDP. Well how prophetic!

Harvard’s Robert Barro discovered that in the Keynesian moment that lives on in our historical memory the most, WWII, huge government military spending contracted GDP with a multiplier that was 0.7 at the most.

The study that did the greatest damage however came from a self described Keynesian, indeed the best and the brightest of them. Berkeley’s Christina Romer found the spending multiplier to be nearly 1 at best, but a multiplier from tax cuts to be 3! Like stagflation, if true, Keynesian theory cannot survive, even among policy makers, with such a devastating counterfactual. Its central premise is that government spending stimulates the economy twice as much as tax cuts, not the other way around.

Romer became Obama’s Colin Powell. She was forced to go out and defend the 2009 stimulus bill even though her professional experience cried out against it. Within the administration, Romer’s advice was discarded at nearly every juncture.

When we think of the politicization of science, our minds jump to salmon and CO2 levels. What about economic science? Romer was forced to use an inflated spending multiplier of 1.4 in her econometric formula she submitted to Congress. How different was that than Colin Powell being forced to present cherry picked WMD evidence to the UN Security Council?

If we would have been lucky enough to get a multiplier of 1.4 out of that $814 billion “Recovery Act” then national unemployment would indeed be below 8% as their model predicted. If what we really got was 0.9, then that would mean we now have a higher unemployment rate than we otherwise would have had if the 2009 stimulus bill never passed. That more than anything else is what the chart below shows. This is the econometric model the Obama administration submitted to Congress that year with the actual outcomes superimposed as red data points.

 

ARRA Unemployment Rate Graph 2011 05 Keynesian failure: Stimulus package a national tragedy

Implementing a stimulus package with a multiplier of less than 1 has proven to be a national tragedy, but the greatest tragedy of all is that we had solid economic science at the time warning us not to do it. That the 2009 stimulus was an absolute failure is universally acknowledged. When I read editorials today arguing that it failed because it was not big enough, I think of all those medieval doctors who attended their patients’ funerals thinking “if only I bled him more!”

Eric Shierman is a partner at Creative Destruction Investment Partners, writes for the Oregonian under the pen name “Portland Aristotle” on the MyOregon blog, and is the author of the forthcoming book: A Brief History of Political Cultural Change. His articles can be read at:http://connect.oregonlive.com/user/PortlandAristotle/posts.html 

 

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Posted by at 10:30 | Posted in Economy | 8 Comments |Email This Post Email This Post |Print This Post Print This Post
  • Rupert in Springfield

    The thing I always wondered about the “multiplier” is Keynesians got into utter denial when it does work and fabricate nonsense when it fails.

    Example of multiplier working – Reagan Tax Cuts. This could be looked at in a Keynesian fashion. Government “spends” by cutting taxes. This causes economic growth, thus more tax revenue is collected than that which was given up in the cuts. No one would argue the Reagan tax cuts did not have precisely this effect. Revenue close to doubled during his eight year term. Undeniably more tax revenue was created than otherwise would have been the case, thus clearly there was a “multiplier” viewed in the Keynesian way of looking at things.

    Example of multiplier not working – Green Welfare. Solyndra being the prime example, plenty of others in Portland. Government spends in the form of tax credits or direct loans. the money is essentially flushed down the toilet.

    Conclusion of Keynesian proponents – The direct opposite of what is observed. Obama continues Green Welfare programs despite little evidence this “jobs of the future program” works and most liberals are under the impression the Reagan tax cuts lead to high deficits, the exact opposite of what history shows us to be the case.

    Conclusion – Keynesian economics is a veneer for political orthodoxy. Keynes proponents are not concerned with the efficacy of the method at all. What they are concerned with is using it as a rationalization for ever increased government spending and thus solidification of the power base. Whether it works or not is entirely besides the point and to some extent Keynesian theory not working is more in line with political goals as it enables advocacy for more government involvement.

    Example – the most prominent Keynesian, Paul Krugman, was famously patting himself on the back a year ago for predicting the Obama stimulus would not work. The reason he gave for this was that it was too small to affect the overall economy. Yet a few months later, Krugman was out championing the Obama Jobs bill as a useful stimulus package that would get the economy going. At half the size of Stim1 it is impossible to argue that which failed because it was too small, will now succeed when tried again at half the size. Yet this is precisely what Krugman is arguing. Nothing makes clear the use of economics in general, and Keynesian economics in particular, more as a tool for political orthodoxy than a method of scientific analysis.

  • Bob Clark

    Wow!  Excellent article.  I think it is correct but with some major reservations.  Stimulus One largely went to existing career bureaucrats to create more studies without immediate use, lavished on existing union jobs (pay went up but jobs and spending remained the same), and political payoffs to companies like Solyendra.  So, indeed, I think Eric is right here the multiplier probably was less than one (The recipients saved the easy federal monies rather than spend it on hiring new folks).  But here is where judgement should be reserved: The recipeints of these easy federal monies are using them to some extent to whittle down existing consumer and business debt;  Therefore, what might otherwise take ten years to return to economic normalcy may only take five years because of Stimulus one (Deleveraging continues but the period of time it takes to run its course still may have been shortened.  We don’t know for sure yet).  This time around there is an extra constraint regarding the effectiveness of Keynesian economics, that being  the ability of the federal government to continue to borrow for assisting in financial deleveraging. The federal government itself is nearly, if not already, tapped out of its ability to borrow additional monies, especially considering S&P’s downgrade of U.S soverign debt.

    Here’s the immediate problem (reservation), though.  Removing 1 $trillion in current federal deficit spending would most probably result in an immediate surge of government job losses, causing a surge in unemployment and sharply reduced national income (just the direct effect alone).  Fighting the federal budget deficit through austerity is not going to work as it will only cause the budget deficit to enlarge further (this is playing out in Greece, today.  Austerity begets more austerity).  Therefore, I recommend we continue keeping interest rates low, freeze federal spending indefinitely, print currency the old fashioned way with a printing press rather than borrowing it from China and others to fill the existing federal budget deficit, and allow subsequent inflation to raise federal tax revenues towards frozen federal spending levels.

    I just listened to Herman Caine; and while I like his 9% income tax rate, 9% sales tax rate, and 9% corporate tax rate Plan; He is also advocating immediately slashing federal spending and imposing a balanced budget in his second year in office.  Hopefully, he’ll get push back to moderate this position if he gets elected.  He is a pretty impressive candidate I must say.

  • Anonymous

    Keynesian Economics has a new name…it’s Obamanomics.

  • HBguy

    RE: Your chart. If I’m reading it correctly, the two blue lines were 2009 projections of unemployment with and without the 2009 Stimulus plan, and the red dots are the actual unemployment rates that occurred.

    So, my question is, where are the dot’s showing actual unemployment without the Stimulus plan? It’s hard to compare projections with actual outcomes if the information used to make the projections is erroneous. Which turned out to be the case.

    Here, the fact that the actual unemployment was higher than prejections done in 2009 isn’t surprising, shocking or proof of anything in particular, since we discovered that the sudden downturn in 2008-09, and the continuing recession was much worse than anyone projected, expected, or knew. http://www.economist.com/blogs/freeexchange/2011/07/americas-economy

    Given that misunderstanding of the problems, the projections made in 2008-2009 on unemployment were obviously to optimistic, and those blue lines are irrelevant since they were based on such erroneous information.

    Maybe someone can find the model that projected those blue lines. If so, can they plug in the actual, now known, economic statistics and do a projection of how the stimulus may have effected unemployment? That would be interesting.

    As to Keynsianism being dead, I’d hazard a guess that aspects of Keynsian thought and theory are much more prevalent in the economic profession than global warming skepticism is among climatologists. And as one prominent economist points out, a lot of Keynsian theory has been adopted by today’s mainstream economists. http://www.econlib.org/library/Enc/KeynesianEconomics.html. So there is valid accepted  current economic theory that can support some stimulus spending.

    • http://www.facebook.com/eshierman Eric Shierman

      HBguy did you read the two links you just offered us?

      The Economist article shows how very accurate the GDP numbers were in 2008 when the stimulus bill was being crafted and the Obama campaign had its advisers running its numbers to make predictions for his stump speeches. Romer and Goolsbee’s assumptions were actually worst case scenario for everything except the spending multiplier. 

      In those days we were all expecting something truly devastating like the the 1980-82 recession where unemployment rose beyond 16%. The problem with this recession has not been how deep the GDP contraction has been; it has been the flat GDP growth that has followed it. Their forecast on what unemployment would have been without stimulus is therefore very credible. Again, since the latest science tells us that government spending restrains GDP growth, why be in denial like a medieval doctor assuming we should have spent more?

      I love that rather famous list of Keynesian beliefs by Alan Blinder. It is actually adapted from his introductory text book which is no more friendly to Keynes than I have been here. In fact many young progressives, taking their first economics 101 course might even recognize Blinder’s name since he is such a prominent Democrat. They really scratch their head when Blinder pours so much cold water on Keynesian orthodoxy. He does a particularly startling hatchet job on the minimum wage and its negative externalities, from which he utters the most wonderful line – that politicians are eager to listen to economists on macroeconomic matters where we know very little, but never listen to us on microeconomic matters where we know a very much. 

      So again I have to wonder if you actually read your own link. Blinder is talking about what “Keynesians” believe, and then he CONTRASTS it with what economists believe. Go back and read his 5th point. Perhaps you were attracted to this article by Blinder’s statement that the Monetarists have accepted the first three points. This is true, but they reject the Keynesian solution to those three points, which is what my article here was about. Again, even Romer’s own research rejected the stimulus bill she was forced to cheerlead for. 

      It is the case that Blinders article for Econlib was the nicest thing a Monetarist like him has said about Keynes pretty much ever. It is important to remember that he wrote this in 2008, before Ramey, Barro, and even Romer published empirical evidence that the spending multiplier cannot provide that wonderful free lunch politicians of both parties have been dreaming about for so long. 

  • Nothappy

    Without these bold plans our unemployment would be at 14%. Ask Pelosi if you don’t believe me.

  • wvhart

    During the Depression of 1920-21, Harding CUT federal spending by nearly 50% and the unemployment rate went down from 12% to 2% in less than 2 years…….I would also submit that the Keynesian policies actually started under Hoover (the largest peace-time deficits in the country’s history to that point), not FDR.

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