Arnold Kling on Keynesian economic policy

Without a taboo against deficits, deficit spending tends to become habitual. It is politically corrosive, because no constituency expects to be the one to have to sacrifice when the limits of borrowing have been reached.

The main argument against a balanced budget amendment is that it would tie the hands of Congress in dealing with economic downturns. Keynesian orthodoxy says that deficits are appropriate in a recession. The orthodox Keynesians are both loud and numerous within the economics profession. However, they may be wrong. Below is a list of reasons.

1. The historical record does not clearly support the Keynesian view. There are many instances in which fiscal expansions did not produce economic expansions and in which fiscal contractions did not produce economic contractions. For example, see some of the literature cited in a recent article by Robert Murphy, particularly footnote 5.

2. The macroeconometric models that are trotted out to support Keynesian policies are highly suspect. (See “The Soothsayers of Macroeconometrics.”)

3. The Keynesian rationale for deficits would imply that when the economy is not in recession, a balanced budget or surplus is in order. However, the United States has run deficits nearly every year since the Keynesian framework was adopted in the 1960s.

4. As is well known, the Congressional Budget Office projects increasing deficits starting in about 10 years, as the full force of Baby Boom retirements hits the budget. From there on, the CBO projects ever-widening deficits. Yet no Keynesian is coming forward to suggest that perpetual deficits are appropriate. We are not always going to be in a recession. Why is there no plan to balance the budget?

5. Technically, according to the National Bureau of Economic Research Business Cycle Dating Committee, the most recent recession ended in June 2009. In theory, the rationale for deficit spending ended on that date as well. Of course, economic conditions today are not very satisfactory. But if it is necessary to run deficits whenever conditions are “not very satisfactory,” when will we not run deficits?

Arnold Kling.

This entry was posted in Uncategorized. Bookmark the permalink.

36 Responses to Arnold Kling on Keynesian economic policy

  1. Token

    Without a taboo against deficits, deficit spending tends to become habitual.

    Who could anticipate that the media would return to a model of hyper partisanship where the group thinkers would see their collective interest as a group was became more important than getting their personal interest of getting a story, thus breaking a key mechanism for the taboo?

  2. “But if it is necessary to run deficits whenever conditions are “not very satisfactory,” when will we not run deficits?”

    Er, it’s an excuse. It’s the economic equivalent of “the dog ate my homework”. Never mind that a T-bone steak “accidentally” made its way into the middle of the homework…

  3. stackja

    If Keynesian is the solution why is there still a problem?

  4. The annoying thing is that their feeble attempts to hide their agenda are transparent to anyone who bothers to look, and yet, due to apathy, few people see it.

  5. Bruce

    Arne has one friend in this world of deficit loving totalitarian control freaks:

    The place for Keynesians is North Korea

    - Marc Faber

    I don’t usually do homage to Dr Doom, but I think I will agree with him this once.

  6. TerjeP

    Those that support the Keynesian view do tend to offer a solution to long term deficits. They call it higher taxes. As such I suspect they think their hands are clean.

  7. Skuter

    Some more good stuff from Arnold Kling

    I am a big fan of his views on macro. Particularly his concept of patterns of sustainable specialisation and trade. Growing aggregate spending and employment are symptoms of growing prosperity, not causes…they should never be targeted as ends in themselves. We need to put good institutions in place to encourage healthy patterns of specialisation and trade. We should not target aggregate levels of anything as a primary goal of economic policy.

  8. Skuter

    Another good macro article here
    In my view, market monetarism is vastly preferable to Keynesianism, however it suffers from some of the same defects, namely a focus on an aggregate quantity – that is, nominal GDP. Whilst rule-based targeting of nominal GDP may be an institution that contributes to PSST, meeting a nominal GDP target should never be the be all and end all of economic policy. Hopefully the RBA will not throw out the baby with the bathwater and discard inflation targeting (that is, preserving the value of the currency).

  9. Entropy

    Quite so,skuter.
    The problem is that the very measure of GDP is designed in Keynsian terms.

    But I don’t know what the answer is. Alternatives to GDP measurement are inevitably developed by agenda driven ideologues, so I end up with the conclusion that GDP is a useless measure of economic performance. It is just less useless than most of the others.

  10. John Mc

    Those that support the Keynesian view do tend to offer a solution to long term deficits. They call it higher taxes. As such I suspect they think their hands are clean.

    And they usually deny that tax increases affect productivity, or have any chance of lowering revenue due that loss of productivity.

  11. Jim Rose

    the United States has run deficits nearly every year since the Keynesian framework was adopted in the 1960s

    is that deficict gross or net of interest and bond repayments? there was a primary surplus in the 1950s and 1960s in the USA to pay down the massive war debt. at the end of World War II, outstanding federal debt was slightly larger than GDP

  12. Aliice

    stacja asks

    If Keynesian is the solution why is there still a problem?

    Errr… because the central banks stuffed up by working for the private banks?

  13. Skuter

    Alice, central banks are, in some sense a creature of the commercial banks.

  14. Aliice

    whoever said this is a dill
    “the United States has run deficits nearly every year since the Keynesian framework was adopted in the 1960s”

    a) a Keynesian framework was in place before that
    b) pretenses at a Keynesian framework only after the early to mid 1970s but in reality a diminishing role for Keynesianism with the rise of central bank powers
    c) nothing is any better now

  15. Aliice

    Skuter – I agree. Central banks are supposed to be a creature of government but they have become a creature of banks.

    Couldnt agree more.

  16. JC

    In my view, market monetarism is vastly preferable to Keynesianism, however it suffers from some of the same defects, namely a focus on an aggregate quantity – that is, nominal GDP.

    Skute…

    A few points. Monetary policy must always look at the aggregate whichever form is implemented. Interest rate settings, quantity of the money supply, inflation/interest rate targeting. All should react to the aggregate.

    The other point is that NGDP targeting helps stabilize the relationship between the sectors of the economy. If you think about it the GFC actually caused a rupturing of relationships between the sectors.

    Here’s the question you should ask though. Would NGDP targeting be an improvement on the current system of interest rate/inflation targeting? I think it would because it could avoid the weaknesses we have in the current system, which I think caused the GFC… or most of it.

    The large CBs misread a change in relative prices coming from the commodities corner and raised rates believing that what we were seeing was inflation when in fact there were bottlenecks caused by sustained demand from the developing world. Commodity price increases as a result of a change in relative prices are disinflationary.

    Not understanding this is what we ended up with. and it’s the GFC.

  17. Aliice

    Terje I know you dont want more taxes but could you trade off lower fines, fees eg tip fees and rates and water and electricity for a little more in tax?

    Its local councils and other semi govt institutions charging us now. A government fee is another word for a tax isnt it?

    I suspect you differentiate ie somehow a government user fee is fine but a tax is not? What if changes in policy nets it out as zero in your pocket Terje? ie you pay higher tax and get an equal reduction in government fees elsewhere?

    You are supposed to be completely indifferent according to theory yet you are not.

  18. Aliice

    Central banks reactions to Commodity prices caused the GFC JC?
    I really though it was an overblown unustainable housing market in the US back by worthless toxic CDs sold round the world.
    Apparently the central bank didnt notice the changes in prices going on there (relative to value).

    Maybe I dont understand it and the GFC was all caused by a very small rate change by the central banks reacting to commodity prices.

    What commodity prices JC and how big was the central banks reaction you speak of and how big (or rather small) was the interest rate change you mention?

    Who would have thought such a small rate change would explode the world?. Not me. Because it didnt. I think you are trying to rewrite the history books in arrears.

  19. Aliice

    Arnold also asks
    “5. Technically, according to the National Bureau of Economic Research Business Cycle Dating Committee, the most recent recession ended in June 2009. In theory, the rationale for deficit spending ended on that date as well. Of course, economic conditions today are not very satisfactory. But if it is necessary to run deficits whenever conditions are “not very satisfactory,” when will we not run deficits?

    Of course you will not run deficits when things are satisfactory and everyone is doing well enough to pay tax (not on unemployment benefits). Thats the problem with the budget – the economy, not bad management.

  20. JC

    Central banks reactions to Commodity prices caused the GFC JC?

    I think so. They over-reacted to the upswing in commod prices from about 2005 to 2007 and tipped everything over.

    I really though it was an overblown unustainable housing market in the US back by worthless toxic CDs sold round the world.

    The sub prime market was a specialist part of lending. Things needn’t have been so bad if the CB’s had reacted in such doctrinaire fashion to both the rise in commod prices and then to the fall in NGDP. They were asleep at the wheel. The Fed has more or less admitted to it last week. Read the comments about the minutes hat were released about that period.

    Apparently the central bank didnt notice the changes in prices going on there (relative to value).

    There was a problem, sure, but it didn’t need to bring the entire house down. Look how shallow the early 1990′s recession turned out to be.

    Maybe I dont understand it and the GFC was all caused by a very small rate change by the central banks reacting to commodity prices.

    We had rises in commod prices brought about through a change in relative prices. The CB’s misread that as inflation, which to them meant the developed world economies were heating up. They weren’t, as the disinflationary impact of that was being caused by demand from the developing world.

    What commodity prices JC and how big was the central banks reaction you speak of and how big (or rather small) was the interest rate change you mention?

    What commod prices? Oil, Iron ore, coal grains. Alice were you in a coma from alcohol poisoning in that part of the decade and missed it?

    Who would have thought such a small rate change would explode the world?. Not me. Because it didnt. I think you are trying to rewrite the history books in arrears

    It was a small rate change? There were significant rate changeswith the Fed tightening from 2004 onward and more importantly the CB’s were signaling continued rate increases even after the Lehman collapse.

    Go read the public announcements until October(ish) 2008.

    The market only fell around 4% a few days after proceeding the Lehman collapse. Lehamn fell the same eventful weekend that Merrill Lynch was acquired… and the markets fell around 4%! The collapse began after the market read that the Fed was going to do shit all about it. The ECB of course was in a stupidity trance.

  21. Ian

    Gotta love Kling’s reference to Tennessee Ernie Ford’s “Sixteen tons”.

  22. Skuter

    Interest rate settings, quantity of the money supply, inflation/interest rate targeting. All should react to the aggregate.

    JC, I must take issue with this statement. Monetary policy, if it is not going to destabilise the economy must not be reactive but rather proactive. Now a key point raised in my second link is the lag in publishing GDP data and the revisions that occur, even to nominal GDP. I think aggregate price indices are rubbish. Many people have raised the issues associated with new goods and improved quality as to why ‘inflation targeting’ is flawed, but overall, for mine, preserving the value of the currency should be the minimum goal for monetary authorities if we are going to have comparative stability and rising prosperity. The a growing level of aggregate spending is a symptom of prosperity, not the cause…

  23. JC

    Skute:

    I think monetary policy is both reactive and proactive actually. It reacts to the past because the past may/will influence future events. This happens because we’re human and what we’ve seen happen will influence future behavior. CB’s have to react to past events too as that will influence how they see things going forward.

    In my mind macro policy is simply monetary policy by another name and it’s the central bank’s job in our current set up to take responsibility in this area.

    You suggest that monetary policy should be proactive. Well look at the proactive ability of the worst central bank in the world .. perhaps the second worst after Zimbabwe. Take a look at the proactive stance of the ECB raising rates in July 2008 and then reversing themselves a month of two after that. Then again last year when they raised rates by 25 basis points signaling further tightening and then changing course about 4 weeks after. How did that proactive stance work out?

    You agree that inflation targeting is flawed. It’s so badly flawed that it helped cause a very deep recession when the CB’s misread inflation from 2006 onwards. It’s so flawed it’s fucked.
    If you want to maintain the value of a currency you don’t do it by getting into a deep recession because the ultimate result of that will either be what happened in 29/32 or you simply end up with a Keynesian reflation policy similar to what we saw in the 70′s.

    If you think that NGDP is difficult to estimate then create a futures market and have the CB target that like Sumner has suggested. It won’t prevent recessions, but it would stop the central banks from fucking up really big time.

    Inflation/interest rate targeting is flawed on so many levels I don’t know where to start. Is the CPI a good inflation measure? Why isn’t housing part of it then?

    Here’s what Sumner says about “inflation” (today in fact).

    A few remarks:

    1. Economists often discuss whether the CPI measures inflation accurately. But how can that discussion mean anything when economists have never even explained what the term ‘inflation’ means in an economy where product quality changes rapidly, and where new products are constantly introduced. Is it the amount of extra income one needs to maintain constant utility? If so, then we need to define utility. And suppose happiness surveys show no increase in happiness over 50 years. Would that mean RGDP did not rise?

    2. There are many types of price indices—it’s not at all clear which one is the “right one.” I used to do lots of posts talking about how the government claimed housing prices rose 8% after 2006 and Case-Shiller said they fell 35%. Can they both be right? Sure, because inflation is a vague and poorly undefined concept, so any measure is fair game.

    3. If you have what looks like a demand-side recession (a deep fall in NGDP) and are puzzled that inflation has not fallen as much as you think it should have, then you should first examine the stickiness of hourly nominal wages. If they didn’t fall, then sticky wages is your explanation. If they did fall sharply, then some other factor explains the stickiness of inflation. This might be higher VAT taxes, higher import prices, or some other sort of adverse “supply shock.”

    4. If you have an adverse supply shock, then inflation should rise. If inflation falls despite an adverse supply shock, then you have both an adverse supply shock and an adverse demand shock. Both would be contributing to higher unemployment.

    5. When I was researching neoliberalism back in 2007 I found that Greece had the least market-oriented economy in the entire data set (of 32 countries.) If the government is running much of the economy, various government policies may introduce a degree of price stickiness. Tim Duy has a post that discusses one example. And Tyler responds. I think Tyler’s right about the unreliability of Phillips Curve models, but I’d make the following observation, FWIW:

    Tim’s graph shows inflation falling from about 3% to 4% before the recession to about minus 1% today. In the Great Depression in America inflation fell slightly more than twice as much, from zero to minus 10%. Does that difference surprise me? No, America in the early 1930s was far more market-oriented than Greece. I’m not surprised that a monetary shock in Greece that was much smaller than in America can produce Great Depression levels of unemployment in Greece. BTW, interwar price indices were much more weighted toward flexible price goods like food and manufactured goods—not services.

    There are many other problems with inflation. The bottom line is that it’s not a well-defined variable, and there is no reason to expect it to be a good indicator of demand conditions in an economy.

    I’ll add my two cents worth on interest rate targeting. CB’s can either control the price or the quantity of the base, but they can’t do both although they pretend to with interest rate targeting. What they are in fact doing is taking a bet that a certain interest rate level will produce a certain level of demand for money and consequently influence v. That is sheer nonsense.

    CB’s should stop trying to manage monetary policy through interest rate settings and attempt to set policy at a predetermined level of NGDP.

    If you believe wages are sticky then NGDP has to be the way forward.

  24. JC

    JC, I must take issue with this statement.

    Skute, by the way, you can take issue any time you want as it’s great having a discussion with you even though we disagree on this.

    You’re one of the most thoughtful and respected commenters here.

    I just think you’re wrong on this little point. :-)

  25. Skuter

    Cheers JC, I just had to go to bed last night.
    And I love to engage in these discussions too. I love ranting about macro, monetary economics, banking, etc. My views are quite eclectic, I know, hence why I kind of expect to be taken to task. It’s helpful as I get to roadtest my views and sharpen my arguments. I think we can both agree though that Keynesianism is bullshit! Personally, I think it is the road to hell.

  26. Elizabeth (Lizzie) B.

    It is politically corrosive, because no constituency expects to be the one to have to sacrifice when the limits of borrowing have been reached.

    Yes, and it can all end in tears when the constituency of dependence no longer gets paid. The political corrosion of ‘tax the rich’ becomes the mantra voiced in the troubled streets. Carried to its extreme, the creation of wealth collapses as the economy is plundered for more handouts.

    For us non-economists who so far have used a market-based common sense to arrive at our disparaging conclusions about the Keynesian approach, the above is an interesting debate on how to adjust the settings to achieve a better outcome. But when what is being analysed, ‘inflation’ and ‘GDP’ for example, are so definitionally slippery and seem to carry inherent ideological bias, a mere observer might think it is all fairly fraught – a case of doing ‘the best we can do’ with the tools we currently have. And something more of an art than a science.

  27. MattR

    It is politically corrosive, because no constituency expects to be the one to have to sacrifice when the limits of borrowing have been reached

    This in the Herald Sun today.

    http://www.heraldsun.com.au/news/victoria/the-alfred-hospital-forced-to-axe-300-operations/story-e6frf7kx-1226560426696

  28. Jc

    I think we can both agree though that Keynesianism is bullshit! Personally, I think it is the road to hell.

    Lol… I can’t see how anyone could call themselves an economist and believe that swill.

  29. Skuter

    I can’t see how anyone could call themselves an economist and believe that swill.

    The sad thing ,JC is that I think you and I are the minority. Maybe not here at the cat, but in the broader economics profession, and indeed in the general community, almost certainly. I’d like to think that’s changing, but I’m not optimistic…

  30. Tel

    Without a taboo against deficits, deficit spending tends to become habitual. It is politically corrosive, because no constituency expects to be the one to have to sacrifice when the limits of borrowing have been reached.

    This is another one of those fundamental trust things, just like abortion, euthanasia, and operating a nuclear reactor. If we could be confident would consistently make an effort to bring deficits under control, we could easily forgive the occasional splurge for a justifiable reason. The problem is that time and again, past and present governments have demonstrated they can’t be trusted, don’t keep their promises, and are perfectly happy to dump their problems onto future generations.

    We have a really deep trust problem in our society, and I think it’s getting worse.

  31. Tel

    Carried to its extreme, the creation of wealth collapses as the economy is plundered for more handouts.

    The problem is that once the plundering is underway, you get a bunch of military tough-guys taking control and end up like North Korea. That’s a dead-end situation.

  32. Tel

    The sub prime market was a specialist part of lending. Things needn’t have been so bad if the CB’s had reacted in such doctrinaire fashion to both the rise in commod prices and then to the fall in NGDP. They were asleep at the wheel. The Fed has more or less admitted to it last week. Read the comments about the minutes hat were released about that period.

    I think the toxic waste went a lot deeper than just the subprime market, there are just too many mortgages in default right now for any other explanation. Real estate tends to be reflective (long term) of how other parts of the economy are doing because people who are doing well in life often want a bigger, nicer house. That’s why a real estate led recovery is basically impossible…

    US industry has faced increasing competition on many fronts, for a long time. Their choices are to get competitive (i.e. offer less easy benefits to unions), or isolate themselves and stagnate (trade barriers), or start wars and get maximum leverage out of their military dominance (imperial style).

  33. Aliice

    JC

    You say

    ” There were significant rate changeswith the Fed tightening from 2004 onward and more importantly the CB’s were signaling continued rate increases even after the Lehman collapse.”

    From what cash rate to what JC?.

    They were small changes. NO way you could call them large when I paid my first house of at 11%, 10% and down to 8%.

  34. Jc

    Alice

    Get off the gin bottle. We’re talking about the US/GFC. Stay off the booze or don’t talk to me. Is that too much to ask?

  35. Aliice

    JC

    I agree with one thing. The Fed was asleep at the wheel but not because they tightened a little after 2004 but that they didnt tighten more and fuelled the housing bubble.
    As for house prices being sustainable in the US. Revisit the bursting of Japans property bubble in the 90s. In the doldrums for ten years plus. Yes a property market that is overblown can crash the economy when it corrects. The fed should have tightened more than they did earlier than they did.

  36. Aliice

    JC says
    “Get off the gin bottle. Stay off the booze or don’t talk to me. Is that too much to ask?”

    Dont make me part of an invention in your own mind. Nothing to do with me. Dont keep insulting me or I wont talk to you. Sounds like a good deal to me.

    Dont you really mean to say “agree with my view or dont talk to me. Is that too much to ask?”

Comments are closed.