The Collegian
Friday, March 29, 2024

Keynesianism revisited

After taking the United States off the gold standard in 1971, Richard Nixon uttered his now infamous and oft-mocked saying, "We're all Keynesians now."

Keynesianism would later run into a road-bump called stagflation, and be tossed to the backburner of the metaphorical economic theory stove. Here in 2008, Keynesianism appears to be surging toward a comeback. The members of President Obama's economic team are calling for a stimulus package nearing a trillion dollars. So why the sudden change?

Obama's economists are relying on what is termed in economic speak the "Keynesian multiplier." The idea of a government spending multiplier that in turn increases economic growth provides the underpinning of Obama's stimulus package. If the multiplier was 1 then increasing government spending by 1 unit would lead to a 1 unit rise in GDP. Obama's economic team is arguing that the multiplier will be much higher, around 1.5. This means that GDP will increase even more than the rise in government spending. Fundamentally, Keynesians believe that capital and labor are available and the private market is simply broken and cannot put them to proper use.

So this theory of multipliers sounds all well and good, but what does the data suggest? Unfortunately, it shows a much more negative picture. Robert Barro, a renowned Harvard economist, researched eras of high government spending in U.S. history and tested to see what the multiplier effect actually was in those periods. During World War II, unquestionably the largest example of government spending in American history, the multiplier was only around 0.8. Peacetime examples were even gloomier, with the multipliers residing near zero. Similar IMF studies in 2004 and 2006, as well as a paper published by the National Bureau of Economic Research in 2008, echoed a general pessimism toward the effectiveness of government spending generating growth.

Obama is also claiming that his package will create millions of new jobs and curb unemployment. This assertion can be tested by history as well with a look at FDR's New Deal, which attempted to increase employment as well. A cursory analysis of this time period will show that FDR's policy temporarily curbed unemployment from a 25 percent rate in 1933, to 14.3 percent by 1937. Much of this early success was erased by 1938, however, when the unemployment rate surged back up to 19 percent. Roosevelt's own Treasury Secretary, Henry Morgenthau, rejected Roosevelt's approach saying, "We have tried spending money ... and it does not work."

Even if the Keynesian multiplier does exceed expectations, the stimulus package is embedded with many problems. For the approach of government spending to work, the money needs to be used productively to achieve growth. Damaging reports from the CBO exposed that only $29 billion of the spending portion of the package is scheduled to be spent in the current fiscal year. This is particularly damaging given the notoriously long lag phases traditionally associated with fiscal policy. Furthermore, a monstrous $87 billion is supposed to be allocated to Medicaid. Maybe I am missing something, but it's tough to see how health care spending promotes economic growth. Apparently, Obama's economic team believes there is a "health care multiplier," too. The tax cut portion of the package does not include any permanent tax relief, choosing instead to use the failed approach of rebate checks. Temporary tax cuts have long been considered ineffective, most recently in the embarrassing stimulus package signed into law last February.

Instead, Americans need permanent tax relief and investment incentives. Many economists are rallying around ideas to encourage banks to lend and businesses to invest. Reductions in the capital gains and business tax are needed badly as well. This would attract business and investment to America and launch us out of the current difficulties we are facing. The deficit hit would likely be less than the one we are currently facing. President Obama's desire to "fix" our economy is admirable, but it's going to be tough if he uses the wrong tools.

Contact columnist Jarrett Dieterle at jarrett.dieterle@richmond.edu

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