Why Keynesianism Failed

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Why Keynesianism Failed

• Victor V. Claar, Ph.D.
• Hope College
• Acton University
• June 11, 2008

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Remarks based on . . .
Chapter 7 of Economics in Christian Perspective
Theory, Policy and Life Choices by Victor V.
Claar and Robin J. Klay. IVP Academic, 2007.
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John Maynard Keynes

• British economist, 1883-1946
• Fatherand namesakeof Keynesian macroeconomics
• Began with his 1936 book, The General Theory of
  Employment, Interest, and Money

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Pre-Keynesian Macroeconomics

• Classical Macroeconomics
• The first classical macroeconomists worked
  primarily in the 18th and 19th centuries
• Included
• Adam Smith David Ricardo J.S. Mill

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The Classical View

• Markets work well (Smiths invisible hand)
• Economies fluctuate, and growth rates will both
  rise and slow over time
• Government intervention cannot improve upon the
  spontaneous ordering of markets in their
  movements of resources from less-valued to
  more-valued uses

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Doubt Shadows Classical Macro

• Great Depression, 1929-39
• In 1933, the US economy operated at about 70
  percent of capacity
• 25 percent unemployment in the same year

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Doubt Shadows Classical Macro
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Doubt Shadows Classical Macro

• Extreme pessimism about the self-correcting power
  of market forces
• State ownership and planning began to look
  increasingly attractive as an alternative
• While classical macro suggested the depression
  would end, it offered no quick fixes

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Keynesian Economics

• Stresses the inherent instability of an market
  economy, and the need for active policy
  intervention to achieve . . .
• Full employment of resources
• Sustained growth

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Keynesian Economics

• The intuition
• Recession and high unemployment are due to
  insufficient spending in the private sector by
• Firms, on new capital and equipment
• Consumers, on goods and services

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Keynesian Economics

• The remedy
• The appropriate role of government is to step in
  and shore up the gap in spending, using deficit
  financing if necessary
• That is, if people are hurting today, and we
  have the power to relieve their suffering through
  policy, then we must do so

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Obvious Keynesian Downsides

• Critics of Keynes knew such actions while
  pain-reducing in the short-run, would inevitably
  lead to two longer-term macro problems
• Inflation
• Slower rates of long-term growth
• Keynes had already admitted as much in his Tract
  on Monetary Reform (1923), but In the long run
  we are all dead (p.65).

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Inertia of Keynesian Thought

• Gained inertia, and by the 1950s had evolved into
  the mainstream in macroeconomic thought
• Major Keynesian figures include
• John Kenneth Galbraith (Harvard)
• James Tobin (Yale)
• Famous misquoting of Milton Friedman in Time
• We are all Keynesians now. (Dec. 31, 1965)

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But Keynesianism Has Failed

• Keynesian policy recommendations have proved to
  be bad advice
• Further, Keynesianism has failed as an accurate
  macroeconomic model
• So why has it failed on both counts? Lets look
  at each

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Why Keynesianism Failed

• Keynesian economics is bad policy advice because
  of
• Crowding out
• gt Slower long-term growth of the economy
• A poor mix of goods during recession, and excess
  capacity in some industries after the recession
  ends
• Potentially poor timing of actions

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Why Keynesianism Failed

• Keynesian economics oversimplifies macroeconomic
  dynamics
• In the Keynesian view, it should be possible to
  reduce unemployment by increasing government
  spending on goods and services (and/or increasing
  the money supply)
• gt there should be an empirically observable
  tradeoff between inflation and unemployment

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The Phillips Curve

• This expected inverse relationship between
  unemployment and inflation rates is named for New
  Zealand economist A.W. Phillips

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The Breakdown of the Phillips Curve

• Inflation and unemployment rates in the U.S.,
  1970-2000

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The Breakdown of the Phillips Curve

• What had the Keynesians missed?
• Simply put, for active policy to be effective, it
  must be unanticipated
• When Keynesian-style policy actions are
  anticipated, people take actions that frustrate
  the policymakers intentions
• The policy ineffectiveness proposition

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The Policy Ineffectiveness Proposition

• Keynesians believed they could stimulate demand
  for good and services, and that firms would then
  hire, for example, more workers at an unchanging
  wage rate
• But if workers anticipate such actions, and
  understand that they create inflation, theyll
  begin asking for higher wages
• Faced with higher labor costs, firms wont be
  able to hire back workers and increase output
  after all

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Why Did Keyness Ideas Catch On?

• Very bad, never before seen, economic times
• Politicians embraced Keynesian ideas quickly
  because they promised a silver bullet, and also
  gave them another argument for why we need them
• 3. Sir John Hicks interpreted the General Theory
  for the profession, and later confessed he may
  have misunderstood what it was stating

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Why Did Keyness Ideas Catch On?

• The trend increased the mathematical rigor in
  economics probably a useful development on
  balance, though the Keynesian models lacked
  serious microfoundations
• It wasnt until the start of the 1940s that early
  monetarists began to realize that money was an
  active factor in the downswing of the early 1930s
• 6. Keyness peers were either too easily swayed
  or not vocal enough in their reservations

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Has Keynes Sufferedan Ideological TKO?

• In the 1970s we got in serious trouble by being
  good Keynesians when we increased the money
  supply in response to a slowdown caused by OPEC
  oil shocks
• gt rapid inflationary spirals
• What are we doing today as oil prices rise? Have
  we learned our lesson?

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Has Keynes Sufferedan Ideological TKO?

• What is the motivation behind the stimulus
  checks we are receiving in the U.S.?
• One could argue that it is a supply-side effort
  if one believes that government spending will
  fall (i.e., that it really is a tax cut)
• But otherwise, this is a Keynesian attempt to use
  government spending to purchase more good and
  services but at least we are deciding what to
  buy on the behalf of policymakers

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Has Keynes Sufferedan Ideological TKO?

• Basic Information on the Stimulus Payments
• Updated April 17, 2008
• You've heard about it. Now find out how to get
  yours.
• What is it? It's an economic stimulus payment
  that more than 130 million households will
  receive starting in May. It's not taxable, and it
  won't reduce your 2007 or 2008 refund or increase
  the amount you owe when you file your 2008 return.

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Conclusion

• Has Keynesianism failed?
• Yes
• Is it still alive and well as a policy crutch?
• Yes