Eldridge Economics Part 1 — Keynesian Economics Insufficient

March 1st, 2011 by Lee Eldridge

While Wisconsin politics and union protests dominate the news, there’s still an underlying and equally important story. The economy is struggling. Nothing new about that, but a few stories have recently caught my attention.

1. Supporters of the White House continue to insist that the stimulus bill was effective. Why? Because the CBO says that the bill created millions of jobs. But that’s not really what the CBO said. We’ll come back to this later.

2. New stories have been warning us that budget cuts (from the GOP) will hurt the economy and could send us into another recession.

3. And a twist on this same story, that a government shutdown will hurt the economy. And that hurting a fragile economy could have dire consequences.

All of these stories have a common component — the belief in Keynesian Economics. And whenever you point out the problems with Keynesian Economics, you get blasted as a lover of Trickle Down Economics. Here’s a quote from a conversation I had with some friends on Facebook yesterday: “That trickle you feel is Boehner pissing on your leg and tell(ing) you it’s raining.”

It will take me more than one post to get through some thoughts on the economy. I’m not proclaiming to be an economist. More of an econo-hobbyist. Here’s part one.

John Maynard KeynesKeynesian Economics
I will try not to bore you too much, and keep this as simple as possible. Keynesian Economics advocates a mixed economy, predominantly private sector, but with a large role of government and public sector. And for the most part, the theory is pretty simple. You can read more about it here on Wikipedia.

What we’ll focus on today is what Keynes viewed as the primary reason for a recession, and his recommendations for getting out of a recession. Keynes viewed a recession as a result of shaken consumer confidence that causes consumers to save instead of spend. Excessive savings (beyond typical savings during a normal economy) from consumers slows the exchange of money thus creating the recession.

Keynesian theory recommends stimulating the economy through government spending and/or adjusting the money supply (printing money and/or lowering interest rates). Our federal government has been engaging in increased government spending and expanding the money supply. Keynes was one of the first economists to advocate deficit spending as part of a fiscal policy to cure an economic contraction.

Keynesians believe that if you increase government spending during a recession, what you’re really doing is taking the consumer’s money that they were saving (and not spending due to shaken consumer confidence) and injecting it into the economy. And that every dollar spent in the economy is subject to the “multiplier effect”. Basically, that when a dollar is spent by either the public or private sector, it increases total spending by a multiple of that increase. So when the government spends a dollar, it increases GDP (gross domestic product) by MORE than a dollar. And increases in GDP lead to increases in employment. (This will be important when we discuss the CBO’s statements on the stimulus bill.)

And reversely, if you cut government spending through budget cuts or closing the government, you are reducing GDP, and ultimately reducing employment (increasing unemployment).

Theory vs Reality
I’m not in complete disagreement with Keynes. But more in it’s application. So let’s start with a simple example. Let’s say the multiplier is 2.5 times. So if the government spends $1, we add $2.50 to GDP. If the government spends $800 billion, we add $2 trillion to GDP (that’s $800 billions x 2.5).

So if you subscribe to this theory, you get the same outcome from the stimulus no matter what else is happening in the economy. Does the country have $1 trillion or $14 trillion of debt? Doesn’t matter. Is the federal government imposing thousands of new regulations on the business community or streamlining regulations for business? Is the government viewed as anti-business or pro-business? Doesn’t matter. Do we have strong exports or decades of trade imbalance? Nope, doesn’t matter. Are we importing billions of barrels of oil at $100 per barrel or are we energy independent? Still doesn’t matter.

This theory doesn’t account for the decrease in GDP when an extra dollar is taken out of the private sector. And this theory doesn’t account for the repercussions of borrowing money.

Nothing matters but the multiplier and how much additional money the government injects into the economy.

The problem is that the economy doesn’t exist in a vacuum. There are forces, including other government policies, that are impacting the economy simultaneously. I think it’s entirely possible that in a different economic climate, that the outcome of the stimulus bill could have been considerably different. Or at least viewed differently.

But that will have to wait. Still more topics to cover, and we’ll try to cover them soon. The CBO’s projections. Understanding the deficits. The stimulus package. And what role the government should play in the economy.

Until next time.

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One Response to “Eldridge Economics Part 1 — Keynesian Economics Insufficient”

  1. Why Liberals Love Keynesian Economics | Lee Eldridge Blogs on Sports and Politics Says:

    […] wrote two articles about Keynesian Economics back in March (Keynesian Economics Insufficient and The Stimulus and the CBO). I won’t rehash what we’ve already covered, but there is […]