What's Wrong with Keynesian Economics?

February 27 2006

What s Wrong with Keynesian Economics?

In a famous passageat the end of his major economic work, the economist JohnMaynard Keynes wrote:

"The ideas of economists andpolitical philosophers, both when they are right and whenthey are wrong, are more powerful than is commonlyunderstood Practical men, who believe themselves to bequite exempt from any intellectual influences, are usuallythe slaves of some defunct economist."

Long after thosewords were written, Keynes was himself that influentialdefunct economist. His thinking, admittedly oftenover-extended in the hands of his adherents, cast a long andgenerally malign shadow.

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

It arguedthat involuntary unemployment was caused by inadequateaggregate 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 deficitfinancing when recession threatened, thus mitigating joblosses, and contraction of demand (through budget surpluses)to prevent inflation during an economic upswing.

Inpractice, Keynesian economics gave a major impetus togovernment efforts to 'fine-tune economies withinterventionist policies and to rising governmentexpenditure as expansion in recessions was not matched bycutbacks in recoveries.

We can observe the long shadow ofKeynesianism in Robert Muldoon s public works spending,stop-go policies and Think Big programme, and in the wayfinance minister Michael Cullen talks about the economiccycle, 'automatic stabilisers , fiscal tightening andloosening, curbing household spending, and tax and savingsissues. Dr Cullen has described himself as "an old-fashionedKeynesian".

Even Reserve Bank governor Alan Bollard hasrecently fallen into the trap of blaming households andbanks rather than monetary policy for causing inflationthrough 'excessive spending, borrowing and lending.

Majorflaws in Keynesian economics were increasingly identified inthe economic literature of the 1960s as problems of timing,political will-power, adaptive expectations, and the neglectof market institutions were exposed. The stagflation of the1970s demolished the idea that inflation was caused byexcess demand.

In respect of inflation, there is nownear-universal agreement that a sustained increase in thegeneral level of prices can only have monetary origins(through central banks printing money). Keynesiandemand-pull and cost-push considerations cannot permanentlyincrease prices.

Globalisation -- the closer integration ofthe world economy -- has also made much of Keynesianeconomics irrelevant. It essentially assumed a closedeconomy, one not open to international trade and capitalmovements. How demand for the goods and services producedby a small, open economy could ever be inadequate was neversatisfactorily explained by Keynesian theory.

Theinfluence of Keynesian ideas was apparent in Dr Cullen scomment to parliament s Finance and Expenditure Committeelast week that a higher level of savings in New Zealandwould mean lower interest rates. It wouldn t: changes indomestic savings levels could not possibly alter interestrates in the huge international capital market. New Zealandgovernment stock is sold globally and its price isdetermined globally.

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

"Tax cuts do not help the economy bygiving 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 eitherreduces a surplus or increases a deficit. Instead, certaintypes of tax cuts can help the economy by changing the"price" of productive activity. For example, lower incometax rates mean that the relative price of working hasdeclined. Lower tax rates on dividends and capital gainsmean that the relative price of investing has declined."

Modern economic thinking has moved a long way fromKeynesianism. It has rehabilitated the notion thatinvoluntary unemployment results from the failure ofeconomies to adjust flexibly to government- ormarket-induced shocks. The supply side of an economy -- itsproductive capability and efficiency -- not the demand side,is what matters most. The emphasis today in growtheconomics is on the institutions, policies and incentivesthat encourage production.

Maintaining economic stabilityis seen as best assured by a non-inflationary monetarypolicy and flexible markets, not fiscal fine-tuning.

Themost important features of fiscal policy (in the absence ofa debt problem) are not operating deficits or surpluses butthe level and quality of government spending and thestructure of the tax system.

Keynes contribution toeconomics is not completely forgotten; his work reminds us,for example, that prices and wages can be 'sticky and thatmarkets take time to adjust. But his insights relate mainlyto the short term and seldom constitute a case forgovernment activism. For insights into longer-run issues ofgrowth and prosperity we must look elsewhere.

RogerKerr is the executive director of the New Zealand BusinessRoundtable

ENDS
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