What's Wrong with Keynesian Economics?

What’s Wrong with Keynesian Economics?

In a famous passage at the end of his major economic work, the economist John Maynard Keynes wrote:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood … Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

Long after those words were written, Keynes was himself that influential defunct economist. His thinking, admittedly often over-extended in the hands of his adherents, cast a long and generally malign shadow.

Keynesianism was a response to the world depression of the 1930s, now widely recognised to have been triggered by ill-conceived US monetary policy and worsened by beggar-thy-neighbour protectionism.

It argued that involuntary unemployment was caused by inadequate aggregate demand – what is spent on goods and services – rather than by policy errors or an inflexible economy. Keynes’ remedy was the expansion of demand by deficit financing when recession threatened, thus mitigating job losses, and contraction of demand (through budget surpluses) to prevent inflation during an economic upswing.

In practice, Keynesian economics gave a major impetus to government efforts to ‘fine-tune’ economies with interventionist policies and to rising government expenditure as expansion in recessions was not matched by cutbacks in recoveries.

We can observe the long shadow of Keynesianism in Robert Muldoon’s public works spending, stop-go policies and Think Big programme, and in the way finance minister Michael Cullen talks about the economic cycle, ‘automatic stabilisers’, fiscal tightening and loosening, curbing household spending, and tax and savings issues. Dr Cullen has described himself as “an old-fashioned Keynesian”.

Even Reserve Bank governor Alan Bollard has recently fallen into the trap of blaming households and banks rather than monetary policy for causing inflation through ‘excessive’ spending, borrowing and lending.

Major flaws in Keynesian economics were increasingly identified in the economic literature of the 1960s as problems of timing, political will-power, adaptive expectations, and the neglect of market institutions were exposed. The stagflation of the 1970s demolished the idea that inflation was caused by excess demand.

In respect of inflation, there is now near-universal agreement that a sustained increase in the general level of prices can only have monetary origins (through central banks printing money). Keynesian demand-pull and cost-push considerations cannot permanently increase prices.

Globalisation – the closer integration of the world economy – has also made much of Keynesian economics irrelevant. It essentially assumed a closed economy, one not open to international trade and capital movements. How demand for the goods and services produced by a small, open economy could ever be inadequate was never satisfactorily explained by Keynesian theory.

The influence of Keynesian ideas was apparent in Dr Cullen’s comment to parliament’s Finance and Expenditure Committee last week that a higher level of savings in New Zealand would mean lower interest rates. It wouldn’t: changes in domestic savings levels could not possibly alter interest rates in the huge international capital market. New Zealand government stock is sold globally and its price is determined globally.

There has been similar confusion in the tax debate. A Keynesian view emphasises the role of tax cuts in boosting aggregate demand. But as Dan Mitchell, a tax specialist at the Heritage Foundation in Washington, recently wrote:

“Tax cuts do not help the economy by giving people more money to spend. Any money “injected” into the economy with tax cuts is offset by the money “withdrawn” from the economy as the government either reduces a surplus or increases a deficit. Instead, certain types of tax cuts can help the economy by changing the “price” of productive activity. For example, lower income tax rates mean that the relative price of working has declined. Lower tax rates on dividends and capital gains mean that the relative price of investing has declined.”

Modern economic thinking has moved a long way from Keynesianism. It has rehabilitated the notion that involuntary unemployment results from the failure of economies to adjust flexibly to government- or market-induced shocks. The supply side of an economy – its productive capability and efficiency – not the demand side, is what matters most. The emphasis today in growth economics is on the institutions, policies and incentives that encourage production.

Maintaining economic stability is seen as best assured by a non-inflationary monetary policy and flexible markets, not fiscal fine-tuning.

The most important features of fiscal policy (in the absence of a debt problem) are not operating deficits or surpluses but the level and quality of government spending and the structure of the tax system.

Keynes’ contribution to economics is not completely forgotten; his work reminds us, for example, that prices and wages can be ‘sticky’ and that markets take time to adjust. But his insights relate mainly to the short term and seldom constitute a case for government activism. For insights into longer-run issues of growth and prosperity we must look elsewhere.

Roger Kerr is the executive director of the New Zealand Business Roundtable

ENDS

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