The Enduring Keynesian Charm

Was Lord Keynes Right or Wrong?

Keynesian Economics, is used to represent a classic view that argues, that private sector activity sometimes leads to distortion of macro economic conditions.

Years of economic turmoil have re-ignited the debate about Keynesianism. As the financial crisis caused mass unemployment, Keynes appeared to have been proven right.

But even after years of financial stimulus(read Keynesian-inspired deficit spending) high unemployment persists and public confidence in Keynesian policy is shaken. As the United States is stagnating and as Europe is crashing down, critics of the Keynesian theory feel vindicated.

This presents one of the most daunting paradoxes of modern  day economics. Is Keynes right or is he proven wrong. The answer probably lies in dissecting the Keynesian thought and removing the diagnosis from the treatment. While all modern economists will agree  “free market will periodically fail to utilize all the capacity in the economy due to its inability to generate sufficient aggregate demand”  In 2008, we witnessed this situation, where consumer demand and industrial production plummeted as a result of a crisis in the financial sector. Bang on diagnosis, Keynes was proven right.

Now comes the difficult part, the solution. In Keynesian thought , the perfect  solution to this Keynesian problem is Keynesian policy . A recipe, that heavily relies upon public deficit spending to pull the economy out of recession. Academically, the solution seems perfect. The state must own and correct any macroeconomic distortion in the larger interest. An inherent magnanimity in humans, lends this belief to them. While they, at a personal level would not want to sacrifice resources, they are socially motivated to do so. The idea that the state must act as Robin hood , appeals to them. This probably stems from their belief that diversion of funds away from private happens at Zero cost.  Politicians love it because it lends credence to their actions. They seem virtuous of the fact that they are not buying votes but “stimulating economy”.

While it may make politicians believe their vice is virtue and satisfies the collective magnanimity of the voters, Keynesian policy fails. Not once but every time it has been applied, probably because an Economy, turns out to be more complex that what Keynesian model assumes it to be.          

Why does Keynesian Policy fail?

The Keynesian policy remedy is based on assumption that every unit of money spend by government during recession, generates more than a one unit of money.  Various experiments have put this multiplier at 0.855 to 0.1.15% depending upon the state of economy, the quantity of stimulus and its administration. But even if we assume the best multiplier ratio, the policy has nearly failed in all its symptomatic manifestation, always.

The failure can be attributed not so much to policy but its administration. During the recession, most of the public administered stimulus is diverted, not towards effective government spends such as infrastructure, but rather on extremely ineffective transfers to households and lump sum tax credits.

Another serious problem that this perfect solution faces is: if governments spend more, where does this extra money comes from? The money either comes from borrowing or increased taxation, both of which pull the money out of public hands and prove as a drag to the “aggregate demand”. Borrowing increases the deficit. As deficits grow, the public becomes more worried about the future of the economy and responds by saving more. The money which was supposed to flow in economy gets collected in bank accounts or gets diverted to save heaven commodities like gold. At some point in time this stimulus starts hurting the economy more than it helps it.

Not only can these mis targeted stimulus boost aggregate demand, they help foster an environment of fear. Again, fundamentally economic growth cannot be driven by boosting demand, but only by increasing output, which is an incentive of increased economic activity. Te people can never spend more than what they produce to increase the “aggregate demand”.

But then why does Keynesianism survive?

The only reason that Keynesian economics has survived for so long not because it works, or even makes any sense, but because it justifies what liberal politicians readily want to do – spend with reckless abandon, run bigger and bigger deficits so they don’t have to explicitly pay for it with higher taxes today, and run up the national debt, which will be someone else’s problem later. 

While a band aid solution may look easy, it is not always the best.