Friday, May 15, 2009

Demand-Side Dementia: Symptoms and Prognosis of the Keynesian Madness

I've written before about the Keynesian obsession with consumer "mood." Keynesian economics focuses on consumer spending as the key factor in economics -- consumption being the "demand side," as opposed to the "supply side" of capital investment.

In a recession, the Keynesian naturally wants to put the consumer on the couch, shrink his head and figure out how to get him spending money again. Hence, Conor Clarke's dispute with Martin Feldstein:
This is an argument based on Ricardian Equivalence -- the theory that it doesn't matter whether the government uses debt or taxation to finance its spending, since, if the government uses debt, the perfectly rational robot-people will lower their present spending in anticipation of higher future taxes. . . . That households "will recognize" the budget constraint and "will reduce" their present spending accordingly suggests a mechanism as predictable as night following day.
What's going on here is Clarke's criticism of Feldstein's argument that Obama's proposed tax increases, which wouldn't become effective until 2011, will discourage consumer spending in the near term.

If what you're doing is try to figure out the impact of policy on consumer decision-making, then Feldstein's speculation -- about the consumer reducing spending now because he comprehends that government deficits will require higher taxes in the future -- is worthy of Clarke's mockery of "rational robot-people."

The problem with both Feldstein and Clarke's approach, however, is the assumption that consumer behavior is:
  • (a) controlled by a "mood" independent of underlying economic reality; and
  • (b) more important than the behavior of investors.
In truth, it doesn't matter whether consumers are rational or irrational. The consumer's ability to spend money is limited by how much money he has to spend. He may have money saved, he may be earning money as wages, he may borrow money, and/or he may liquidate some of his assets. But one way or another, he must have money before he can spend money.

Surveys of consumer confidence are useful in near-term economic forecasting -- for example, if what you're trying to do is predict retail sales during the Christmas shopping season. Yet no matter how irrational consumers may be, their "confidence" is not entirely independent of their means.

More importantly, the demand-side obsession gets causality backward. Economic growth boosts consumer confidence, not the other way around. Discussion of the consumer "mood" is therefore irrelevant to the project at hand: Developing government policy to promote recovery in the wake of a massive market collapse.

In this situation Keynesian policy prescriptions are like sending a gunshot victim to group therapy where he can discuss his feelings about his sucking chest wound.

The Keynesians seem to believe that the economy is suffering from a self-esteem problem. This isn't that kind of recession. We have sustained a traumatic wipeout of asset value, the result of which is a capital shortage, and you can't make capitalism work without capital.

The policies of the Obama administration and Democrats in Congress are the exact opposite of what should be done to address this situation. Rather than enacting policies that would encourage capital formation and productive investment, they are siphoning capital out of the market via unprecedented levels of deficit spending.

Martin Feldstein and Conor Clarke are both wrong. The near-term impact of deficit spending and higher taxation on consumer "mood" is irrelevant to why the Keynesian formula won't work. It won't work because this huge increase in government spending -- whether paid for by taxation, borrowing, or inflation -- sucks money out of the private sector at a time when the private sector desperately needs an infusion of capital.

It Won't Work. The Fundamentals Still Suck. Economics Is Not a Popularity Contest.


  1. Stacy - both you and the good Lord K. are/were wrong.
    What consumers think is important.

    The "multiplier" in *REAL* terms is pure B--- Sh--. The emperical data shows that when govts' adopt Keynesian policies what happens is that the nominal economy grows -but the real economy shrinks. This has been true in France, Germany, Italy and most glaringly UK!
    What the economic jargon means is that the so callec "multiplier" lowers production while raising prices. The "nominal"economy is the economy measured by the monetary unit($ here). The real economy is the economy measured by tons of steel, pounds of sowbelly...
    For a while simple folk think Keynesian policies work because they have more money. They soon realize that the TV set that was $100 is now $150; and they can not afford it. They the rebel or revolt. Ane if lucky they get a Maggie or a Ronnie.

    Rod Stanton
    Cerritos Cal

    PS Just for Stacy if you can cut it off.
    I told you I had a string of letters after my name. 2 relate to my degree in Econ. All exjarheads who kill with guns are not ignorant. I may be dumb but well educated.

  2. Keynes realized late in life that much of his economics was badly in need of revision, or so he wrote Hayek. I talked to a real participant in the WPA once and asked him quite a few questions about his experience. He was paid $5 per week on Friday. He took the money home to his mother. His mother gave him back a dollar and put the other four in a Tomato Sauce Can and dug it down in the backyard of their house. Not very stimulating, No?
    Keynes had poor people all wrong. When poor people get money they put it away for a rainy day. They're not stupid.

  3. What would you say to those who would say that they are infusing capital into the system via TARP and such? I know it's roundabout, taking money from one pocket to put it in another, but I think that would be their argument.

  4. "When poor people get money they put it away for a rainy day. They're not stupid."

    Not anymore. Now they spend 99% of their household income on OxyContin, basketball jerseys, Mountain Dew, and the cable bill.


  5. Phil,
    Yes I agree that our culture has changed considerably since the 1930's. The poor of the 1930's were a much larger and transitory part of the population than today. The poor of today are a smaller and more enduring population. Of course, the man in the WPA I talked to was no longer a poor man. My point is that Keynes made highly unscientific assumptions about human behavior that now underlie mathematical economic models that pose as a science.

  6. Actually with the creation of behavioral economics modern macroeconomic models are based off of real human behavior. What keynes tried to say was that in the short run prices are sticky i.e. wage contracts which cause SRAS to be upward sloping not vertical. The stagflation which you are refering to of the 1970's was not caused by keynesean policies which cause ,demand pull inflation, but by opec and the higer cost of imput prices, oil, and higher inflation expectations from the fed because "the desire of Arthur Burns to have Nixon reelected" (Ken Rogoff). if you look at the IS-LM model which integrates short run stikyness, a reality of the world we live in, tax-cuts and gov't spending have the same effect of increasing income which includes C, consumption, and I, investment.