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The Keynesian experiment

It's become common to hear Republicans saying that Democrats' "Keynesian experiment," or in Paul Ryan's case, their "Neo-Keynesian economic experiment," has failed. You'd think that Keynesian economics was a big divide between the parties. But it wasn't and it's not.

In January 2008, George W. Bush signed $152 billion in tax-cut-driven stimulus. As the economy worsened, John McCain proposed $450 billion more in stimulus, this plan driven by a payroll tax cut. Now you've got Mitch Daniels proposing something similar.

The parties disagree on a lot of things, but they don't disagree over the idea that the government should act to increase demand when the economy sags. The theory behind a payroll tax cut (the government increases its deficit in order to get more money to people who can spend it so they will increase demand) and an infrastructure investment (the government increases its deficit in order to get more money to businesses who can spend it) is not theoretical, but practical: Do you think one is more stimulative than the other, and do you think one is more worthwhile than the other? Payroll-tax cut and an extension of unemployment insurance are even closer cousins.

Parties have trouble opposing things mildly. "The stimulus was a sensible idea, but imperfectly structured" is not a great election message. So instead we get sinister-sounding lines like "Neo-Keynesian economic experiment." That's good for convincing the base, and even some other voters, but the problem is that you've then convinced the base and some other voters of more than you've really meant to, and that ties your hands when you come into office and have to embrace some of those policies.

You saw an example of this with the individual mandate. Barack Obama opposed it during the primary campaign, in no small part because Hillary Clinton supported it. Then he got into office, looked at the policy, and realized he needed an individual mandate of his very own. But his arguments didn't go away: His critics on the left just used them against him. And where the policy was initially something thought up by Republicans and implemented by a Republican governor in Massachusetts and supported by many Republicans in the Wyden-Bennett health-care bill, Republicans have now made it radioactive for themselves because they needed to demonize it as part of attacking the Obama health-care bill. So now, even if they manage to somehow stop Obamacare, they've taken one of the key policies they could've used to prevent an eventual single-payer system off the table.

By Ezra Klein  |  September 9, 2010; 10:11 AM ET
 
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Next: Inequality and computers

Comments

The GOP twists economic concepts to fit its idealogy. To them, "Keynesianism" equals government spending, which is always wasteful, but not tax cuts, which are always beneficial.

Posted by: jduptonma | September 9, 2010 10:52 AM | Report abuse

The GOP also exaggerates the relative size of the stimulus, calling it "Keynesianism on steroids," etc. WWII was Keynesianism on steroids. The ARRA was half-hearted Keynesianism.

Posted by: jduptonma | September 9, 2010 10:55 AM | Report abuse

Of course politicians love Keynsian stimulus - it is a chance to shower goodies on their constituents.

Keynsian stimulus seems to work well when we are in a garden-variety recession - one that was caused by an inventory buildup or by the Fed tightening to quell inflation. A good example would be Reagan's tax cuts in the early 80s, which helped get us out of what was then the nastiest recession since the Great Depression.

The problem is that we are not in a garden-variety recession. We are in one of those rare events - recessions in the aftermath of an asset bubble. In those situations, Keynsian stimulus doesn't work very well. The Japanese have tried Keynsian stimulus for 20 years and have increased their government debt to 220% of GDP. FDR used Keynsian stimulus to cure a 3 year old recession and still had high teens unemployment 5 years later. And Obama's stimulus didn't do much at all (that bs 3 million jobs saved or created statistic aside).

I just wonder how much different the economy would have looked if we had used the 800B stimulus to give 16 million people a 50k a year job instead.

Posted by: sold2u | September 9, 2010 11:07 AM | Report abuse

"You'd think that Keynesian economics was a big divide between the parties. But it wasn't and it's not. "

You are minimizing some real differences here. Republicans by and large do not accept the "multiplier" effect that is so often used to justify Keynesian policy prescriptions, especially with regard to increasing government spending to increase aggregate demand. Instead, they (and the WSJ) cite the problem of Ricardian equivalence.

To the extent that they support tax cuts in a down economy, I believe the justification is something other than the classic Keynesian increase in aggregate demand. Hence the emphasis on permanent marginal rate reductions to change future income and wealth expectations instead temporary measures that will expire when things return to "normal". You can agree or disagree, but it's not Keynesian. To the extent Keynesian arguments are used, its to persuade other people whose votes and support are needed to go along with them.

Note also that neither party runs on the other part of Keynesian economics which is to increase taxes during a boom to pay down the debt and slow down economic growth.

Posted by: jnc4p | September 9, 2010 11:30 AM | Report abuse

"Keynsian stimulus seems to work well when we are in a garden-variety recession - one that was caused by an inventory buildup or by the Fed tightening to quell inflation. A good example would be Reagan's tax cuts in the early 80s, which helped get us out of what was then the nastiest recession since the Great Depression."

Completely, completely wrong. Reagan's 1981 Tax cuts were, (sayitwithmenow) Supply-side policy, not Keynesian stimulus. The idea was that you cut top tax rates on rich people to entice them to produce more stuff, NOT to stimulate demand.

If rich people produced more stuff, people would buy more stuff, thus demand would not outpace inflation. With higher growth due to rich people making more stuff, we would recoup all the lost revenue from those revenue cuts. Of course, none of that happened. 3 months after the tax cuts were passed, America entered what then was the worst recession since WWII.

I wouldn't go as far as too say that Reagan caused the recession (other dems would), but the idea that Reagan allowed Morning in America to happen is a huge myth that needs debunking.

Posted by: mezcalero | September 9, 2010 12:24 PM | Report abuse

Politicians by nature are absolute pragmatists. They deal with only the immediate problem, even if that causes more problems later. This is why big problems never ever get really solved, just postponed.

Posted by: tomcammarata | September 9, 2010 12:33 PM | Report abuse

"Completely, completely wrong. Reagan's 1981 Tax cuts were, (sayitwithmenow) Supply-side policy, not Keynesian stimulus. The idea was that you cut top tax rates on rich people to entice them to produce more stuff, NOT to stimulate demand."

Ezra is calling Keysinan economics stimulating aggregate demand through fiscal stimulus and deficit spending. And taxes were lowered for everybody, not just the rich.

"Of course, none of that happened. 3 months after the tax cuts were passed, America entered what then was the worst recession since WWII."

Which was caused by Volcker tightening to break the back of 70s inflation. If you think Reagan's tax cuts caused the recession that you need to re-take Econ 101. Reagan's tax cuts were a fiscal stimulus to offset a monetary tightening. Once inflation was brought under control, the economy expanded.

The point I was making earlier is that deficit spending can spur the economy when it is is a garden variety recession and that it doesn't work so well when the economy is in the aftermath of an asset bubble (like now)

Posted by: sold2u | September 9, 2010 12:37 PM | Report abuse

"Reagan's tax cuts were a fiscal stimulus to offset a monetary tightening."

Nope. If that were true, then Reagan's policy would have been self-defeating, since the idea was to get the Money supply DOWN to bring inflation down. The Fed's monetary tightening did not take effect, like I said, until roughly 3 months after Reagan's economic plan was signed into law.

I'm not arguing for or against stimulus, mind you. I'm just saying that demand stimulus was not the policy of the Reagan administration at all. Thanks for mentioning Volcker, since it's true that he's the one who induced the recession through monetary tightening.

Again, I'm not blaming Reagan for the recession. I hope you caught that. You just have your facts wrong about Supply-Side economics.

Also, I think you're confusing Keynesian economics with "Liberals' Big Government spending our money." Like Ezra says in the article, Keynesian policy can also take the form of Republican tax cuts.

Posted by: mezcalero | September 9, 2010 12:51 PM | Report abuse

Ezra, I agree with your assessment of the Republican AND Democrat parties being completely comfortable with Keynesian economics...Paul Ryan voted for EESA of 2008 (included TARP) and other bills that allows government to "stimulate" particular industries and the economy in general, so I don't know why he claims that he is not a Keynesian.

My question though to you is: in paragraph 3 of this post you seem to equate tax cuts and the government creating new currency (be it soft or hard money) to distribute to businesses and individuals as has having the same stimulating effect on the economy - if this is true, why?

Seems like the difference (and I realize that this is not a clear-cut issue due to a host of different factors like subsidization, gov't "loans", etc) is that one allows companies to keep more of their own capital to invest and grow and the other causes inflation, lowers interest rates, and devalues the assets and capital of businesses and individuals which actually causes the economy to retract or become stagnate.

Considering where we are at with lack of jobs, slowing of technological and scientific advances in the international community, lack of exports and production of goods, and devaluation of our dollar against foreign currencies and other standards of measurement, it would appear that the US is proving that so-called "stimulus" theory that works hand-in-hand with a fiat currency system (also a problem) regardless of the way that it is structured, isn't working so well for us.

Posted by: johncreath | September 9, 2010 1:00 PM | Report abuse

Who can do more with every dollar of GDP:

Choice 1: Successful businesses which are given dollars of stimulus money immediately and efficiently through tax cuts that result in delivery proportionally based on the business' respective contribution to the GDP.

OR

Choice 2: Allow a polarizingly partisan figure like Nancy Pelosi craft together legislation that spends the stimulus dollars in a myriad of ways that a typical legislative process entails, i.e. lobbyists knocking on the door and the biggest contributors winning the biggest awards.....

When people say the Democrats' Keynesian experiment failed, it is a statement that Choice #2 does not work very well regarless of what academia says the supposed Keynsian multipliers are....

Ezra - What don't you get?

Posted by: FastEddieO007 | September 9, 2010 1:20 PM | Report abuse

@mezcalero "Also, I think you're confusing Keynesian economics with "Liberals' Big Government spending our money." Like Ezra says in the article, Keynesian policy can also take the form of Republican tax cuts"

Republican's usually prefer tax cuts that reduce the marginal rates which, as you point out is consistent with supply side economic theory.

Tax cuts conforming with Keynesian economic theory would be temporary, in that once the economy is generating sufficient demand on it's own, they would be repealed to reduce the effect on the government budget and also to dampen demand.

As Ezra notes in this post, "temporarily" extending the Bush tax cuts may be fine as a compromise position, but the preference is to permanently reduce them.

(http://voices.washingtonpost.com/ezra-klein/2010/09/boehner_dont_throw_republicans.html)

Posted by: jnc4p | September 9, 2010 1:33 PM | Report abuse

"You'd think that Keynesian economics was a big divide between the parties. But it wasn't and it's not."

Only if you ignore the difference between spending and cutting taxes.


"Keynsian stimulus seems to work well when we are in a garden-variety recession - one that was caused by an inventory buildup or by the Fed tightening to quell inflation."
posted by sold2u

Maybe it does and maybe it doesn't. But one thing is for sure, massive additional debt doesn't work at all to correct problems brought on by massive debt and the bursting of a massive credit bubble.

Posted by: bgmma50 | September 9, 2010 1:34 PM | Report abuse

"Completely, completely wrong. Reagan's 1981 Tax cuts were, (sayitwithmenow) Supply-side policy, not Keynesian stimulus. The idea was that you cut top tax rates on rich people to entice them to produce more stuff, NOT to stimulate demand."

It's worth noting why Reagan believed what he did about supply side economics. His personal experience in the movie production business in Hollywood was that producers and directors would stop making movies (and in the process idle entire production crews including gaffers, carpenters, actors, etc) when they would hit a point where they were about to shift tax brackets and instead make the movies the following year. This was taken as evidence that if you incentivize people to produce more, you will in fact create more jobs and thus more demand ("supply creates it's own demand").

Two points:

1. I'm not sure how well the economics of Hollywood translate to the rest of the economy given the guild system in Hollywood that restricts labor supply and questionable substitution effects for specific directors, actors, etc.

2. To the extent that tax rates inhibit economic production, the biggest gains in behavior change have already happened with the Kennedy and Reagan tax cuts. The effects of changing marginal rates of 90% and 70% to something less than 50% is much greater than the effects of going from 33% to 36% or 39.5%.

I tend to believe Steve Pearlstein's rule of thumb that supply side effects really kick in once combined marginal rates exceed 50%.

"A quick back-of-the-envelope calculation suggests that balancing the budget solely on the backs of those making more than $250,000 a year would almost surely require pushing marginal income tax rates well above 50 percent. That's a level at which taxes begin to discourage people from working and investing. Almost certainly, it is a level that would prompt them to invest significant time and money to find new ways to evade taxes.

A lot of liberals make the argument that its okay to soak the rich because the rich have captured nearly all the income growth in the past couple of decades. There's no disputing that income inequality has increased. But it's also important to remember that there is only so much a progressive tax code can do to counteract the market. With the top 10 percent of households already paying 55 percent of the total federal tax bill, we're hitting against that limit. "

http://www.washingtonpost.com/wp-dyn/content/article/2009/04/16/AR2009041604462.html

Posted by: jnc4p | September 9, 2010 1:52 PM | Report abuse

@mezcalero and sold2u: Totally have to chime in with my thoughts on this one.

First, I think there's an enormous misunderstanding about the causes of, and the curing of, the recession in '79.

After stagflation in the seventies, the fed decided they could crush inflation through monetary contraction - a series a brutal rate hikes. It worked, and in 82 they backed off, and the economy returned to normal.

The point is, it was a recession caused and cured by monetary policy - Reagan's tax cuts were immaterial to that matter.

I think it's an important distinction, because here's the thing: committed Keynesians, for the most part, do not think that stimulus would be effective in that type of recession. Any reasonable Keynesian would admit that serious stimulus that led to a rise in interest rates would lead to a crowding out effect. In order to work, there needs to be significant underutilized resources in the economy, and the interest rate had to be pushed up against the zero lower bound. In other words, a lower rate of interest is needed than the Fed can actually provide, so stimulus spending doesn't bump up rates.

Stimulus spending in 79 would have been counterproductive - rates would have simply gone higher, choking off the additional demand. So it's a bit of a bizarre argument.

Posted by: strawman | September 9, 2010 1:55 PM | Report abuse

Obama wasn't looking at policy when he flip-flopped on the individual mandate, he was looking at politics. He saw it as the price of admission for industry co-operation, didn't think the public would mind, and that was one of the biggest political mistakes in history.

Posted by: michaelh81 | September 9, 2010 2:11 PM | Report abuse

Last few comments are awesome, thank you :)

Posted by: mezcalero | September 9, 2010 2:19 PM | Report abuse

Of course they're both trying to stimulate the economy.

Think voters would be a mite upset if theCongress stood on the sidelines with folded hands while the economy melted down?

This has zero to do with economics and everything to do with politics.

Posted by: joeyalphabet62 | September 9, 2010 4:15 PM | Report abuse

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