The Economic Role of Government

As I tell my students, it is a legitimate and defensible position to argue that the government should not try to manage the macroeconomy. For a variety of reasons (such as corruption, incompetence, and the influence of special interests), it is conceivable that policy makers and implementers will make things worse, not better. If one chooses this position, however, then one cannot complain about high unemployment, high inflation, or a lack of economic growth.

Prior to the Great Depression, the predominant school of economic thought, classical economics, suggested that macroeconomic problems would correct themselves. If unemployment increased, the response would be a decrease in wages until employers were willing to hire them again. Similarly, inflation (a general increase in the level of prices) would cause people to buy less (as prices rose). Reduced demand for products then would cause prices to fall. The biggest problem with classical economic thought, however, is that it is based on assumptions that are rarely true. (For example, it assumes people have full information, which is almost never the case.) Several decades of subsequent economic thought have been devoted to explanations of flaws in the simplistic classical rationale. (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded 42 times to 67 Laureates between 1969 and 2010 to highlight and honor those achievements.)

John Maynard Keynes, a British economist, popularized the notion that the government can and should play an active role in managing the macroeconomy. Keynes acknowledged that classical thought might have applicability over an extremely long time period, but “in the long run we are all dead.” If people wait for the macroeconomy to correct itself, they may not live long enough to see the changes. The severity and prolonged duration of the Great Depression convinced most people of the validity of Keynes’ insights. During the Great Depression, prices were falling, but that did not motivate an increase in purchases and employment as classical economics predicts. Even if people had income, they were reluctant to spend it because of uncertainty about the future.

Mainstream economics since the Great Depression is Keynesian economics. The overwhelming majority of economists around the world believe it is appropriate for the government to take actions to promote economic growth and to maintain low unemployment and low inflation. The debate in the United States is not whether the government should try to achieve these goals. Instead, the discussion is about what the government should do. Essentially, Republicans argue that public policies should primarily benefit businesses and the wealthy because they are the job creators. Democrats respond that making the wealthy richer will not cause them to hire more workers unless there is a significant increase in the demand for goods and services. Democrats favor policies with broader benefits because they believe increasing the overall demand for products will increase employment. Very few people argue that the government should do nothing to reduce unemployment, maintain stable prices, and promote economic growth. Indeed, the mood of the country is “they have not fixed the economy, so throw the bums out.”

If President Obama loses the 2012 election, it will be because he did too little to improve the economy, not because he did too much. Reports from the Congressional Budget Office (CBO), a government agency whose professional economists provide non-partisan analysis to legislators, consistently confirm that the American Recovery and Reinvestment Act (ARRA), the much criticized stimulus spending program, created jobs, increased employment, and reduced the unemployment rate from what would have occurred in its absence. It is a fair criticism to say some politicians steered ARRA funds away from the most economically beneficial projects toward other favored objectives. But that is a failure of the political system and the implementation of the suggested policies, not of Keynesian economic theory.

Why do economists disagree so much on whether fiscal stimulus works?

The September 24 article "Much ado about multipliers" in The Economist magazine asks "Why do economists disagree so much on whether fiscal stimulus works?":

IT IS the biggest peacetime fiscal expansion in history. Across the globe countries have countered the recession by cutting taxes and by boosting government spending. The G20 group of economies, whose leaders meet this week in Pittsburgh, have introduced stimulus packages worth an average of 2% of GDP this year and 1.6% of GDP in 2010. Co-ordinated action on this scale might suggest a consensus about the effects of fiscal stimulus. But economists are in fact deeply divided about how well, or indeed whether, such stimulus works.

The debate hinges on the scale of the “fiscal multiplier”. This measure, first formalised in 1931 by Richard Kahn, a student of John Maynard Keynes, captures how effectively tax cuts or increases in government spending stimulate output. A multiplier of one means that a $1 billion increase in government spending will increase a country’s GDP by $1 billion.

The size of the multiplier is bound to vary according to economic conditions. For an economy operating at full capacity, the fiscal multiplier should be zero. Since there are no spare resources, any increase in government demand would just replace spending elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can increase overall demand. And if the initial stimulus triggers a cascade of expenditure among consumers and businesses, the multiplier can be well above one.

The multiplier is also likely to vary according to the type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger impact on spending than one for the affluent, since poorer folk tend to spend a higher share of their income.

Crucially, the overall size of the fiscal multiplier also depends on how people react to higher government borrowing. If the government’s actions bolster confidence and revive animal spirits, the multiplier could rise as demand goes up and private investment is “crowded in”. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get “crowded out”. And if consumers expect higher future taxes in order to finance new government borrowing, they could spend less today. All that would reduce the fiscal multiplier, potentially to below zero.

Different assumptions about the impact of higher government borrowing on interest rates and private spending explain wild variations in the estimates of multipliers from today’s stimulus spending. Economists in the Obama administration, who assume that the federal funds rate stays constant for a four-year period, expect a multiplier of 1.6 for government purchases and 1.0 for tax cuts from America’s fiscal stimulus. An alternative assessment by John Cogan, Tobias Cwik, John Taylor and Volker Wieland uses models in which interest rates and taxes rise more quickly in response to higher public borrowing. Their multipliers are much smaller. They think America’s stimulus will boost GDP by only one-sixth as much as the Obama team expects.

When forward-looking models disagree so dramatically, careful analysis of previous fiscal stimuli ought to help settle the debate. Unfortunately, it is extremely tricky to isolate the impact of changes in fiscal policy. One approach is to use microeconomic case studies to examine consumer behaviour in response to specific tax rebates and cuts. These studies, largely based on tax changes in America, find that permanent cuts have a bigger impact on consumer spending than temporary ones and that consumers who find it hard to borrow, such as those close to their credit-card limit, tend to spend more of their tax windfall. But case studies do not measure the overall impact of tax cuts or spending increases on output.

An alternative approach is to try to tease out the statistical impact of changes in government spending or tax cuts on GDP. The difficulty here is to isolate the effects of fiscal-stimulus measures from the rises in social-security spending and falls in tax revenues that naturally accompany recessions. This empirical approach has narrowed the range of estimates in some areas. It has also yielded interesting cross-country comparisons. Multipliers are bigger in closed economies than open ones (because less of the stimulus leaks abroad via imports). They have traditionally been bigger in rich countries than emerging ones (where investors tend to take fright more quickly, pushing interest rates up). But overall economists find as big a range of multipliers from empirical estimates as they do from theoretical models.

These times are different

To add to the confusion, the post-war experiences from which statistical analyses are drawn differ in vital respects from the current situation. Most of the evidence on multipliers for government spending is based on military outlays, but today’s stimulus packages are heavily focused on infrastructure. Interest rates in many rich countries are now close to zero, which may increase the potency of, as well as the need for, fiscal stimulus. Because of the financial crisis relatively more people face borrowing constraints, which would increase the effectiveness of a tax cut. At the same time, highly indebted consumers may now be keen to cut their borrowing, leading to a lower multiplier. And investors today have more reason to be worried about rich countries’ fiscal positions than those of emerging markets.

Add all this together and the truth is that economists are flying blind. They can make relative judgments with some confidence. Temporary tax cuts pack less punch than permanent ones, for instance. Fiscal multipliers will probably be lower in heavily indebted economies than in prudent ones. But policymakers looking for precise estimates are deluding themselves.

John Maynard Keynes has been dead for 60 years but still managed to help us avoid a second Great Dep

In the September 24, 2009 Salon book review "John Maynard Keynes: Don't call it a comeback," Andrew Leonard says "The legendary economist has been dead for 60 years but still managed to help us avoid a second Great Depression."

The sudden present-day prominence of John Maynard Keynes, an economist who passed away 60 years ago and whose theories have been mercilessly ridiculed by conservatives for at least three decades, calls to mind the famous 1981 Rolling Stone magazine cover story on the Doors' Jim Morrison: "He's Hot, He's Sexy, and He's Dead."

We've witnessed quite the turnaround. From at least the 1970s on, Keynes' star was in eclipse, while Milton Friedman and the free market theorists of the Chicago School of Economics seized the commanding heights of economic discourse. To even mention Keynes was to be dismissed as hopelessly out of touch with state-of-the-art theory. Hadn't you heard? The government governs best when it governs least!

And yet today, you can't click your way three links through the econoblogosphere without stumbling into a flame war between reenergized triumphalist Keynesian supporters of government intervention in the economy and bewildered, angry market fundamentalists who have just watched their painstakingly constructed world crumble around them. Just a few years ago the heat of the debate would have been unthinkable -- Keynes seemed to have about as much relevance to current economic policymaking as Winston Churchill does for the Middle East peace process.

But global economic crises that obliterate the notion that markets are intrinsically self-correcting and efficient have a way of shaking things up. As the University of Chicago's Robert Lucas (who most explicitly does not fall in the pro-Keynes camp) said last October, "Well I guess everyone is a Keynesian in a foxhole ..." Meaning, basically: When shit happens, people want help. And since Keynes is the most illustrious proponent of the idea that government should help get economies back on track when they ride off the rails, his reputation is on the serious upswing.

Few people are better situated to comment or explain Keynes' current fashionableness than Lord Robert Skidelsky, author of the newly published "Keynes: The Return of the Master" -- which comes complete with the possibly overdone sub-headline: "Why, Sixty Years After His Death, John Maynard Keynes is the Most Important Economic Thinker for America."

Skidelsky has devoted the bulk of his creative life to Keynes. He spent decades producing a three-volume biography of the economist that won numerous awards and has already been abridged once -- into a merely 1,000-page tome! The new book, clocking in at a slender 220 pages (including notes), is thus a distillation of a distillation, shoehorned onto the recent economic crisis. Ironically for an author who spent so many years laboring over his definitive account, "The Return of the Master" feels a bit hasty, written as if with one eye focused on the headlines and Paul Krugman's latest blog post.

But that's OK. There is nothing awkward or opportunistic about speedily resurrecting Keynes in the wake of Wall Street's implosion -- it is, on the contrary, entirely appropriate. Keynes would not be surprised at the mess we are in today. While so many leading economists failed to predict or even conceive of the possibility of market failure on such an enormous scale, Keynes wouldn't have blinked an eye. One of his fundamental propositions was that the future was inherently unknowable, that we live in a constant state of "irreducible uncertainty." Shocks, depressions and recessions are bound to happen. The question is: What to do about them?

Anyone who followed the shouting earlier this year over the pros and cons of the Obama stimulus is familiar with the basic contours of that debate. Republicans, taking their cues from conservative economists, argued that the economy would recover on its own, and that government spending now would be equivalent to robbing the future, "crowding out" private investment, guaranteeing huge deficits and, eventually, crippling inflation. Democrats, taking their cues from Keynes, argued that we were trapped in a vicious cycle catalyzed by what the great economist called the "paradox of thrift." Individuals, worried about the future, abruptly began to save instead of spend, creating a "demand shock" that forced businesses to cut production and lay off workers, which further dampened consumer demand and caused the spiral of doom to accelerate. If government hadn't stepped in to break that cycle -- by unilaterally creating demand to jump-start the economy -- we would have run the risk of letting a recession metastasize into a depression.

Skidelsky's pithy summary:

When shocks to the system occur, agents do not know what will happen next. In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin.

Skidelsky deftly summarizes and explains basic Keynesian economics and how they apply to our current travails. He argues that the main reason we haven't already slipped into a second Great Depression can be attributed to the fact that the world's governments followed Keynes' maxim -- they acted. He also provides a nice capsule explanation of how Keynes was overshadowed by Friedman -- but anyone who has read Paul Krugman's recent New York Times Magazine piece, "How Did Economists Get It So Wrong?" will find the material familiar.

But to focus on the nitty-gritty of how Keynesian economics contradicts Chicago school efficient-market theory or is fulfilled by the Obama stimulus is to miss one of the key points that Skidelsky strives to make. Keynes, whom Skidelsky calls "the wisest and most intelligent economist of the last century," was in some ways a reluctant practitioner of the dismal science. He could just as easily have been a philosopher or a historian -- his interests were wide-ranging, his mind as agile and as easily distracted as a hummingbird. For Keynes, the challenge was not to come up with a comprehensive model of how "the economy" worked, but to ensure that human beings were able to live "wisely, agreeably, and well." The economy was but a means to that end. "To make the world ethically better," writes Skidelsky, "was the only justifiable purpose of economic striving." We fail, morally, when "we worship ... economic growth for its own sake, rather than as a way to achieve the 'good life.'"

To understand Keynes requires a detour into ethics and philosophy and a willingness to ponder such statements as "it cannot be readily assumed that what we desire is desireable." Such discourse, to put it bluntly, is not often found in the policy recommendations of contemporary economists, nor does it fit into their math-heavy models. But for Keynes, it was essential -- he wanted everyone to be able to live "the good life" -- and he did not equate that goal, necessarily, with the accumulation of wealth. If Keynes were alive today, suggests Skidelsky, he would agree with those critics of Wall Street who believe finance plays far too great a role in the economy. He would regard the machinations of hedge fund operators and investment bankers as chaff in a giant casino where all the players are dominated by the crass desire for money rather than by the imperative of living a meaningful life.

To your run-of-the-mill market fundamentalist, questions of ethics are irrelevant. Capitalism works by satisfying consumer needs and wants. Government should stay out of the way. But Keynes is on the comeback trail because our present-day predicament shows this to be manifestly untrue.

Let me give the microphone to Skidelsky. In a paragraph and a half, he asks a set of questions that are at the heart not just of his book, but of our existence on this planet.

Keynes looked forward to a saturation of wants. But he did not see this as a natural, but an ethical terminus. Wants were to be controlled not by the size of the stomach, but by a generally accepted conception of "sufficiency" for the good life.

In terms of arithmetic, he was almost spot on in his predictions of growing wealth, but attitudes have changed less than he expected. Although real incomes in rich countries have doubled in the last thirty years, the populations of these countries work harder than ever and are no happier. This raises the question of why they are still on the growth treadmill. Is it because capitalism needs constantly to expand markets, and ensnare by advertising more and more people into useless consumption? Is it because economists have ignored the fact that, as societies become wealthier, positional goods -- goods which satisfy not our needs, but our longing for status -- become more and more desirable? Is it because globalization has made affluence too insecure and too uneven in its spread for most people in wealthy societies to ease off work? Or is it because we lack any agreed idea of the good life in the name of which we can say "enough is enough"?

If Keynes were alive today, these would be questions he would be asking. And after reading "Keynes: The Return of the Master," one can only conclude that we would be well-served to have him out and about, confounding the status quo with his impertinence.

Should the government do anything to prevent economic declines?

Economic declines eventually end without government intervention, but it may take an unacceptably long period of time. The British economist John Maynard Keynes popularized the idea that the government should play an active role in managing the economy. Keynes admitted that an unassisted economy may correct itself in the long run, but “in the long run we are all dead.” We may not live long enough to see the improvement in the economy.

Recessions are caused by insufficient overall spending on newly produced goods and services. Increases in unemployment reduce national income, which in turn reduces aggregate demand further. This deepens the economic decline and may lead to a depression. The length and severity of the Great Depression led most economists and public policy analysts to conclude that it is appropriate for the government to intervene in the economy to try to reduce the severity of recessions and prevent depressions.

See also "Recessions & Depressions: Questions & Answers."