The Magazine

Where Keynes Went Wrong

What if government spending depresses instead of stimulates?

Nov 7, 2011, Vol. 17, No. 08 • By CHARLES WOLF JR.
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It is generally recognized that the conceptual underpinnings for so-called stimulus programs lie in the theory developed by John Maynard Keynes in the 1930s. That the practical results of these programs in recent years have been negligible, if not negative, while their costs have been high, may be sufficient grounds for avoiding them in the future.

Photo of Keynes in 1935

Professor Stimulus: Keynes in 1935


But what if the theory itself is flawed? For many economists, flawed theory would be a greater concern​—​surely more hurtful to professional pride​—​than ineffectual results from programs based on a valid theory. Moreover, it would mean no amount of effort to improve the design of stimulus programs is likely to help.

Before addressing questions about the theory, let’s briefly recap the costs and results of the stimulus so far.

Total stimulus costs have been high, but reckoning them accurately isn’t easy. They include $787 billion in federal spending that was legislated and appropriated in 2009 with the “stimulus” label attached to it. In addition, a proper accounting of the cost should include several other programs and outlays that, while not carrying the “stimulus” label, were designed to boost domestic spending or preclude reductions in spending that were otherwise expected to occur. These other programs include the following: TARP funding to relieve the impaired asset values and weakened balance sheets of financial institutions ($700 billion); bailout funds provided to support the auto industry ($17 billion); extension of unemployment benefits to support income and spending by unemployed workers ($34 billion); and temporary subsidies for the “cash for clunkers” program ($3 billion).

These other measures should be included in a full reckoning of stimulus costs because of their shared common purpose: to boost aggregate demand, or avoid its further decline as a consequence of the Great Recession.

All of these outlays, amounting to more than $1.5 trillion, are properly encompassed in Keynes’s central policy prescription: namely, to use public policy aggressively to stimulate “aggregate demand.” Those who have criticized the government’s stimulus efforts for being too small may not realize how large they have actually been.

What about the results of the stimulus package? Between the end of the second quarter of 2009 (when, incidentally, the Great Recession’s two-year negative GDP trend ended) and the end of the second quarter of 2011, nearly all the stimulus funding was disbursed. The result was that GDP increased from $12.6 trillion (in 2005 prices) to $13.3 trillion​—​an increase less than half the dollar-for-dollar injection of stimulus money! In the same period, gross private consumption rose by $400 billion, and gross private (nonresidential) fixed investment rose by $155 billion. In the same period, employment decreased by 581,000.

A simple accounting of costs and benefits​—​costs are high, benefits much lower​—​warrants skepticism about further recourse to stimulus spending. Still, it could be contended that, if the programs were better designed and better targeted in the future, results might justify the effort notwithstanding the recent record. This possibility warrants another look at the underlying Keynesian theory.

The core of the theory is “aggregate demand” defined in terms of two components: consumption demand and investment demand. In defining and measuring these components, Keynes acknowledged, with unusual and becoming modesty, his debt to a then-contemporary Russian-American academic, Simon Kuznets, who pioneered the development of a national accounting framework, which Keynes used in formulating his general -theory. (Kuznets received the Nobel Prize for economics in 1971; Keynes died before the prize, which is not awarded posthumously, was initiated.)

Insufficient aggregate demand was Keynes’s diagnosis of the Depression-era conditions of continued unemployment and stagnant economic growth. Consumption demand had sharply contracted owing to the Great Depression’s effect on employment and income, and investment demand was depressed because profitable investment opportunities depended heavily on consumption, which had been decimated by the Depression.

Keynes’s prescription for escaping this vicious circle was to stimulate aggregate demand by aggressively increasing government spending and/or lowering taxes. Unlike many of his current disciples, Keynes acknowledged the potential of lower taxes to stimulate demand. However, the room for remedial action through tax reductions was limited in the 1930s because prevailing taxes were already low. Consequently, in Keynes’s view, increased government spending was necessary to boost aggregate demand​—​what was referred to in that day as “pump-priming” and these days as “stimulus.”

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