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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Moreover, whether the stimulus was to be provided by public works (“infrastructure”), by employing workers to dig holes and then fill them, or by other means didn’t matter to the theory. With ample idle resources​—​specifically, unemployed labor and idle plant and equipment​—​it was assumed that the only missing ingredient was sufficient demand to jump-start the economy. One dollar of additional government spending would wend its way through the economy as first-round recipients spent most of what they received, second-round recipients, in turn, spent most of what they received, thereby raising the income and ensuing spending of the next recipients, and so on. The total effect would thus be a multiple of the initial increase in spending. If, for example, the proportion of government’s increased spending that was spent by recipients was, say, 50 percent, the multiplier effect through the full economic circuit would be $2 for each dollar of increased spending; if the proportion were 60 percent, the multiplier would be 2.5.

The similarities between the Depression era and the current circumstances of our post-Great Recession are obvious. So, where’s the flaw?

All economic theories involve assumptions. The critical question is whether the assumptions are realistic. If there is uncertainty about the answer, the follow-on question is: How much will it matter if the assumptions are wrong?

Keynes assumed that the initial deficient level of aggregate demand would remain unchanged until the stimulative (“pump-priming”) effect of additional government spending kicked in. In other words, increased government spending, or its anticipation, would not further diminish pre-existing levels of consumer demand and investment demand. However, Keynes’s failure to consider the possibility of an adverse effect from government spending​—​that it might lead to still further decay in the prior levels of consumption and investment​—​was a fundamental flaw in the theory.

So how might government spending actually undermine its explicit purpose of boosting aggregate demand?

It is quite plausible that the behavior of consumers and investors might change as an unintended consequence of the increased government spending, and might do so in ways that would partly, fully, or even more than fully offset the attempted effort to raise aggregate demand.

Consider “Ricardian equivalence”​—​a conjecture advanced by David Ricardo a century before Keynes’s general theory and thus something Keynes was aware of, or should have been aware of. Ricardian equivalence suggested that consumers might reduce their spending to prepare for the tax increases they’d face in the future to pay for government spending financed by borrowing in the present. In recent years, Ricardo’s conjecture has been applied and tested in a formal model developed by Robert Barro.

That prior consumption demand might actually have been reduced as a result of recent government stimulus spending is suggested by two indicators: Since mid-2009, household savings increased by 2-3 percent of GDP, and household debt decreased by 8.6 percent ($1.1 trillion).

It is also plausible that investment demand might shrink as a result of increased government spending or its anticipation. This diminution might occur if investors have recourse to other investment opportunities that seem more profitable or less risky than those that would accompany or follow the attempted government stimulus. For example, such opportunities might lie in investing abroad where tax liabilities are less onerous, rather than investing at home; or investors might choose to invest in long-term instruments (30-year U.S. government bonds) while reducing investment in fixed capital or equities. These opportunities might seem rosier because of anticipated increases in future taxes, or because of increased regulatory restrictions that might (and did) accompany the increased government spending. In fact, such alternative investment opportunities are much more numerous and accessible now than in Keynes’s era.

Failure to consider the potentially adverse effect of government spending on the preexisting level of aggregate demand was and remains a disabling flaw in Keynesian theory​—​then and now. If the theory’s underlying logic is flawed, it can be expected that policies and programs based on it will fail. They have in the past. They should be avoided in the future.

Charles Wolf Jr. holds the corporate chair in international economics at the RAND Corporation and is a senior fellow at the Hoover Institution at Stanford University.

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