We’re All Keynesians, for Now

The word "Keynesian" is usually used pejoratively in the crowd I hang around with, intellectually speaking. It connotes to them, too much reliance on the government to stabilize the economy, leading perhaps to too much government over time, and less individual liberty that goes with that territory.

Even they would probably admit begrudgingly that the Keynesian approach gains in relevancy during a time of serious recession. One factor that always pulls you in that direction is that our national income accounts were based on the Keynesian spending categories of C + I + G +X -M.

Our economy is measured and reported on using these categories, which makes thinking in those terms almost inevitable. Doing so, however, doesn't necessarily lead you to the "bad" conclusions mentioned above, but you have to be careful.

Another factor that draws us to this way of thinking about the economy is that most of the economics textbooks used in college by those of a certain age also used Keynesian concepts heavily, following the example of Paul Samuelson's classic. Frankly, it was also easier to teach because it seemed so precise. It could be reduced to arithmetic and simple graphs.

For example, the 45-degree graph was very useful for drawing in the consumption line, the investment line, and so forth, with equilibrium always where the top line intersected with the 45-degree line, or where planned saving equaled planned investment drawn as a simplified version of that line. You could calculate the "multiplier" from the marginal propensity to consume or save.

The interest rate was determined precisely where the money supply (usually drawn vertically to indicate it was determined externally) intersected the demand for money-in this case Keynes' "Liquidity Preference" version of the demand for money. Once that intersection gave you an interest rate, you could see where it (drawn horizontally) intersected the "marginal efficiency of capital" to determine investment spending. Once you have investment, you can put it above consumption on the forty-five degree graph, or on its own graph along with saving (an upward sloping curve based on income). Then you can stack on Government spending in the first graph or add it to investment on the other graph, which now must have taxing added to saving, to get you the intersection of the top lines.

All this precision is seductive to the teacher and makes test papers much easier to grade, hence, another magnet pulling you toward a Keynesian framework.

After that you can start over with the Classical/Monetarist version of spending and income built around the equation of exchange: MV=PQ. Discussing total spending in terms of M times V is more useful if you wish to discuss monetary policy, but it doesn't seem quite as useful in thinking in terms of a pending recession. V is just reliable enough in the short run to assume that you can control MV just by controlling M.

You could also think of total spending in terms of the labor force (number of hours worked) times productivity (output per hour). That proved very relevant during the "new paradigm" boom of the late 1990s and during the early years of recovery when rapid growth of productivity crowded out employment growth as a driver of the expansion.

So, what about this recession we're in?  What will bring us out? We know that M will continue to expanding rapidly, but I don't know how long a shrinking V will offset it. We know that productivity growth trailed off after 2004 and has room to grow, but it's doubtful it will with demand weak and labor markets getting slacker.

Reverting to the default Keynesian framework seems more helpful, but also leads to much pessimism. Consumption, which has eased up to over 70 percent of total spending while I wasn't looking, declined in the third quarter 2008 and will probably continue to do so for a while.  Consumption is no longer sustained by capital gains in home prices or 401K balances. A positive "wealth effect" has turned sharply negative. Consumers need to save more, with the capital gains turning into capital losses, but saving more out of current disposable income means consuming less. Consuming less, trying to save more, lands you right smack in the middle of Keynes' Paradox of Thrift, which says that broad attempts to save more (be more thrifty) may result in less saving because of the resulting contraction of income. The paradox of thrift is a classic example of the fallacy of composition: what's good for individual consumers may be bad for consumers as a group.

If C isn't going to provide the stimulus any time soon, what about Investment? Well, we could invent a new, new thing, but it's hard to imagine investment spending spontaneously booming while consumption spending is shrinking. Skipping over Government spending a moment, what about net exports, an increase in exports greater than the increase in imports?

Net exports have been helping out in recent quarters, on several occasions growing by more that the net growth in real GDP. Also, on some occasions, it was not just a rapid expansion of exports that helped, but a contraction of imports as well. (Fewer imports don't help per se, but it means that more of the spending in other categories was on domestically produced goods and services generating income here rather than foreign produced goods and services that generate income abroad.)

The recent reductions in the trade balance has been helped by the prolonged decline in the dollar in foreign exchange markets, which made imports more expensive to us and our exports cheaper in foreign currencies. That dollar depreciation has recently reversed in what most people assume is a "flight to quality" in the financial crisis. If the dollar continues to appreciate rapidly, there will be some benefits, but the down side is losing valuable support for Real GDP.

This run down the Keynesian check list of spending categories is very discouraging. It's hard to see in the short term where the expansion impetus will come from other than government spending relative to taxes. I'm afraid fiscal policy will be the only game in town for a while. Having said that, some ways of stimulating the economy through fiscal policy are better than others, but that discussion is for another time.

A footnote:  Above I mentioned a Keynesian concept called the Paradox of Thrift, which is very relevant to our situation today.  Most families need to save more, but if most families do save more, the recession will worsen. There is another Keynesian concept that may be at work currently as well. That is what he called the "liquidity trap."  You have a liquidity trap when the demand for money is so elastic, or the curve is so flat horizontally that you can make interest rates decline further with further monetary expansion.  We may have elements of a liquidity trap today, but it's partly that lower interest rates don't seem to be stimulating the economy like they do in normal times. We have a "you can lead a horse to water but can't make him drink" problem. Of course, the solution is not less water, but more. Mr. Bernanke and Co. seem to be willing to keep pouring until something works.  It looks like it's going to take a while.

Comments (2)

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  1. Matthew says:

    Thank you very much!


  2. G says:


    As an Indian citizen, let me add my two-pence :

    Post-independence (1947), our first PM Nehru was the classic Keynesian socialist (came from an elite background, hated private industry, etc), who believed in Five Year plans (a la the Soviet system) and in huge investments of taxpayer money in everything from aeronuatics, electronics, telecom, banking, agriculture, etc. He followed principles of taxing the evil rich and giving all sorts of ridiculous tax-breaks to those in agriculture. He perpetrated the politics of appeasement (we got our butts kicked by the Chinese in 1962, Pakistan occupied 1/3rd of Kashmir in 1948 — he wanted a UN solution and guess what, things stand the way they were then) and bent over backwards to give special privileges to minorities and “backward class” people that ended up diving the nation to this day. Things become ridiculous to the point that foreign imports were banned in some case (Coke and Pepsi were banned from 1977 — 1990). This insanity pursued by the Congress party created an entitlement mentality in my country that drove it to the point of economic collapse in 1990 — it got to the point wherein actually gold bullion was airlifted to London to protect our nation from chaos and collapse. The govt then (led by the Finance Minister, Dr Manmohan Singh) reversed many socialist policies, were forced to open up our economy and invite foreign direct investment (FDI), adopt more business-friendly policies and, as a net result, we have had waves of innovation, prosperity and social mobility that is truly historic in such a rleativey short period of time.

    My point is, I fear for America because it is doomed to repeat mistakes that leaders in Eastern Europe, parts of Africa, South Asia, etc already committed in a post-colonial second half of the 20th century. I ran way from India because I wanted to escape the negativity and cynicism that socialism ushers in — it engages in perpetuating and promoting mediocrity. I came to the US to escape that sickness and ironically enough, I see a redux here of what I tried to run away from.

    I am not an economist but from a qualitative and real-life perspective, Bob, I am concerned for this nation.

    Where’s Reagan when we need him the most?!