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.