Fatal Flaws of Keynesian Economics

Fatal Flaws of Keynesian Economics
By Ron Ross on 7.22.11 @ 6:08AM

It's now clear that the federal government's massive stimulus spending has not achieved its objectives. Why hasn't it? It's important that we have answers to that question.

The stimulus was premised on the economic model known as Keynesianism: the intellectual legacy of the late English economist John Maynard Keynes . Keynesianism doesn't work, never has worked, and never will work. Without a clear understanding of why Keynesianism cannot work we will be forever doomed to pursuing the impossible.

There's no real mystery about why Keynesianism fails. There are numerous reasons why and they've been known for decades. Keynesians have an unrealistic and unsupportable view of how the economy works and how people make decisions.

Short-Run Focus

Keynesian policy advocates focus primarily on the short run -- with no regard for the future implications of current events -- and they assume that all economic decision-makers do the same. Consider the following quote by John Maynard Keynes: "But the long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again."

After passage of the stimulus package, Lawrence Summers , Obama's chief economic advisor at the time, often said that the spending should be "timely, targeted, and temporary." Although those sound like desirable objectives, they illustrate the Keynesian focus on the short term. Sure it would be convenient if you could just spend a bunch of money and make the economy get well, but it's not that simple.

The implication of a Keynesian perspective is that you can hit the economy a few times with a cattle prod and get society back to full employment. Remember that so-called "cash-for-clunkers" program? Maybe it accelerated some new car sales by a month or two, but it had no lasting impact.

The "Chicago School" is the primary source of serious research and analysis related to the Keynesian model. Two Chicago School conclusions, in particular, make it clear where Keynesian policies run aground. The two theories are the "permanent income hypothesis" and the theory of "rational expectations."

The "permanent income hypothesis" was how Milton Friedman termed the findings of his research on the spending behavior of consumers. The MIT Dictionary of Economics defines the permanent income hypothesis as "The hypothesis that the consumption of the individual (or household) depends on his (or its) permanent income. Permanent income may be thought of as the income an individual expects to derive from his work and holdings of wealth during his lifetime."

Whether consumers and investors focus mostly on the short run or the long run is basically an "empirical question." A convincing theoretical case can be made either way. To find out which focus actually conforms closer to reality, you have to gather evidence.

Not Evidence-Based

Much of the difference between the two schools of thought can be explained by differences in their methodologies. Keynes was not known for his research or empirical efforts. Keynesianism is definitely not an evidence-based model of how the economy works. So far as I know, Keynes did no empirical studies. Friedman was a far more diligent researcher and data collector than was Keynes. Friedman fit the theory to the data, rather than vice versa.

The Keynesian disregard for evidence is reflected in their advocacy for more stimulus spending even in the face of the obvious failure of the what's already been spent. At a minimum, we are due an explanation of why it hasn't worked. (Don't expect that to be forthcoming, however).

Failure to Consider Incentives

Another of the Chicago School's broadsides against Keynesianism is the theory of "rational expectations." It's a theory for which the 1995 Nobel Prize for Economics was awarded to Robert Lucas of the University of Chicago. As economic theories go, it is relatively straightforward. It essentially states that "individuals use all the available and relevant information when taking a view about the future." (MIT Dictionary of Modern Economics) The rational expectations hypothesis is the simple assertion that individuals take into account their best guesses about the future when they make decisions. That seemingly simple concept has profound implications.

The Chicago School's research led them to conclude that individuals are relatively deliberate and sophisticated in how they make economic choices. Keynesians and their liberal followers apparently think individuals are short-sighted and simple-minded.

An elemental but too often overlooked reality about our economy is that it is based on voluntary exchange. Voluntary exchange is an even more fundamental feature of our economy than is the market. A market is any arrangement that brings buyers and sellers together. In other words, the primary purpose of a market is to make voluntary exchange possible.

Voluntary exchange leaves large amounts of control in the hands of private individuals and businesses. The market relies on carrots rather than sticks, rewards rather than punishment. The actors, therefore, need to be induced to move in certain desired directions rather than simply commanded to do so. This is the basic reason why incentives are such an important part of economics. If not for voluntary exchange, incentives wouldn't much matter.

In designing economic policy in the context of a market economy it becomes important to take into account what actually motivates people and how they make choices. If you want to change behavior in a voluntary exchange economy, you have to change incentives. Keynesian policies do not take that essential step.

The federal government's share of GDP has gone from 19 percent to 24 percent during Obama's time in the White House. A larger government share of GDP ultimately necessitates higher taxes or more debt. In and of themselves, higher taxes retard economic growth because of their impact on incentives. The disincentive effect of higher taxes illustrates why big government is far costlier than it first appears.

It's no accident that Keynesianism is so popular with liberals. It blends well with their unquenchable thirst for expansive government. It doesn't work for the economy but it works for them. The obvious failure of Keynesianism is further evidence of the bankruptcy of liberalism.

Keynesianism is essentially all the Democrats have. It's a one-trick pony. That one trick hasn't worked and now Dems are floundering with nothing more to offer.

All but one member of the president's original economic team has exited. According to liberal columnist Ezra Klein , "Lawrence Summers and Christina Romer were two of the most influential Keynesians in the country. Obama didn't just have a team of Keynesians. He had a Keynesian all-star team."

Now the president has a Keynesian all-gone team. It will be a brighter day for the country when Keynesianism itself is gone for good.