Channelling Keynes the Right Way

Amity Shlaes has an insightful piece in Bloomberg today discussing Keynesian theories in today's economic world.

Every crisis has its heroes. For months now we've all been hearing about Walter Bagehot, whose 19th-century injunction to lend ``freely'' in a panic was cited by the Federal Reserve in its bailouts.

Now another Englishman, John Maynard Keynes, has been pulled on the stage. Keynes taught that spending, especially spending by consumers, is the way out of a slowdown. From last summer's small stimulus checks to the infrastructure projects under consideration by President-elect Barack Obama and congressional Democrats, almost everything the government has done or wants to do is justified by Keynes.

The theory that spending is the way out of a recession maybe attributed to Keynes however it really is more just simple economic logic. What made Keynes unique is his full hearted belief that anything that stimulated spending was a good idea in a recession. This is the notion now championed by Democrats, and it's the notion that Shlaes challenges.

There are three major subsets of spending: consumer spending, government spending, and business spending. A Keynesian would believe that a stimulus of any or all three would also stimulate the economy. That's why Democrats favor another stimulus check to consumers. Here is how Shlaes counters that notion.

One reason consumers don't want to spend is that they don't react instantaneously, as Keynes posited they would. They follow, rather, the theory of an economist oft-presented as the anti-hero of the moment, Milton Friedman. Friedman's permanent- income hypothesis said that consumers consider their entire future, and not just their mood, when they shop. If expectations of lifetime earnings drop, then so will spending. That too tracks reality. Many of us are beginning to wonder if we will ever get back the price we paid for our houses.

In other words, consumers don't spend more in response to a one time increase in their income. By this notion, the best way to stimulate consumer spending is through permanent cuts in their marginal tax rates. This would give consumers the belief that their long term earnings would go up as Shlaes indicats is necessary to stimulate consumer spending. The main problem with the stimulus check is that most consumers are far too leveraged. Any short term stimulus check is likely to go to paying down credit cards, car loans, or other loans. It wouldn't necessarily go to stimulate spending.

Here is how Shlaes addresses government spending.

But what about the larger stimulus plan, the kind President-elect Obama is considering? The idea is to revive Franklin D. Roosevelt's New Deal and create jobs by building new bridges or roads. Obama has also spoken of a kind of corps for the young, which, you get the sense, might be involved in some of these projects. That comes out of the New Deal and FDR's Civilian Conservation Corps.

Keynesians would say such moves will bring the economy to life, creating jobs and replacing crumbling infrastructure.

Point-to-Point

Others would argue that the productivity gains to be had from an infrastructure program also are significant. That's the view of scholar Alexander Field, who studied the New Deal and found that the private sector benefited enormously from its construction projects. After all, when the government supplies a bridge from Point A and Point B, the private trucking company can deliver goods between A and B faster. The project may be public, but its ``spillover'' yields profits too.

The best evidence for the infrastructure spending case comes not from a Democrat but from a Republican: Eisenhower's National Highway System. The rebuttal there is that emphasis on government in the 1950s made the decade a dull one that stifled innovation.

And you also have to ask: What is lost when Washington puts resources into such road projects? One problem is that a stimulus project and an earmark are dangerously similar. Sometimes the government will waste its resources on bridges that truckers won't use -- the new Bridges to

Nowhere.

Gloss Job

But the most telling fact about the new rush to spend is that its advocates have insisted on invoking the New Deal. They tend to gloss over the period when the phrase, ``We are all Keynesians now,'' was actually first uttered: the mid-1960s. (Uttered by Friedman, in fact, though he meant only that we all work in the terms of the Keynesian lexicon.)

The Great Society of that period was the ultimate Keynesian experiment, and it didn't work very well. One example is VISTA, the domestic Peace Corps from that period. VISTA had mixed results and has been renamed and reshaped many times since. Its full name, ``Volunteers in Service to America,'' fits perfectly as a description of the youth programs the Obama camp has described.

From my perspective, stimulating the economy through government spending is among the most dangerous and dubious ways to do it. First, if there is a public works project that should be done, then the government should do it. The government shouldn't spend on public works in order to stimulate the economy and hope they wind up being good public works projects. Second, increased government spending is also increased government: bureaucracy and all. There is now an increase in potential corruption. It also leads the economy on a path upon which the economy depends on the government. We want an economy in which the private sector leads. An economy dependent on the government spending is one in which the government leads.

What is usually missing from any formula of today's so called Keynesians is any emphasis on increasing business spending. Most of today's Keynesians believe that increases on other spending will evetually lead to increases on business spending. This may in fact be so under the right sort of an economic strategy, however there are plenty of ways to stimulate business spending directly. The easiest way is for the central bank, the Federal Reserve, to cut their short term rates in order to stimulate borrowing. Of course, this has already gone on, and so far, it has lead to little increase in business spending. That's because the uncertainty of the economy makes business unwilling to borrow no matter how low the rate is.

There is another even more effective way to stimulate business spending. That's to cut taxes on businesses. Cutting the corporate tax rate right now would likely do wonders for our economy. First, our corporate tax rate is the second highest, behind Japan, in the developed world. Second, unlike cutting borrowing rates, there is certainty in cutting the corporate tax rates. This improves the cash flows of businesses. With more cash flow, this leads directly to more business investment. Expansion leads to more jobs, and more jobs leads to an increase in consumer spending.

Cutting the corporate tax rate is Keynesian in the traditional sense of the word, however those that have taken it on more recently would never propose such a thing. That's because those with populist leanings have made Keynes their standard bearer. Since cutting the corporate tax rate cuts taxes on perceived fat cats, this is something today's crop of Keynesians would never propose.

Barack Obama has stated that he will do what works and not limit himself ideologically. Cutting the corporate tax rate has a real chance to stimulate the economy. It was an idea floated by McCain not Obama. It would be an idea that would face stiff opposition from his own caucus. It would also be one that would prove that he is serious about trying what works. If he was really serious about trying what works, he would also give an across the board marginal rate cut on top of it.