Keynesian medicine for a sick economy

John Maynard Keynes was a very smart man.  Bertrand Russell, who was no dummy himself, said that whenever he argued with Keynes, he felt he was taking his life in his hands and generally emerged feeling like a fool.

John Maynard Keynes

Prior to Keynes, the accepted thinking among economists was that the working of the free market always brings things into balance, and the best cure for recessions is to leave things alone and allow the balance to restore itself.  What Keynes noticed that his predecessors didn’t was that the economy could come into balance at a high level of unemployment and low level of economic activity, and stay there for a very long time.

A economic crash creates a domino effect.  When people lose their jobs, they stop spending money, which means that business is bad, which means that more people lose their jobs.  Bank failures beget bankruptcies, and bankruptcies beget bank failures.  Recovery can be slow, because businesses aren’t going to hire people unless there are potential customers.

Keynes thought governments could help speed up recovery by putting people to work on public projects, by cutting taxes, by running temporary budget deficits to put money into circulation, and by trying to push down interest rates so people could more easily borrow to buy things and businesses could more easily borrow to expand.  He thought government to stop the cascading effect of depression by creating social safety nets, such as unemployment insurance and deposit insurance.

The second part of his philosophy was that when times were good, governments should pay down their debt and try to keep inflation under control.

His ideas came to be accepted wisdom during the 30 or so years following his death in 1946, and recessions during that period were milder than in the pre-Keynesian era.  However, the first part of his philosophy was more popular than the second part.  The Clinton administration raised taxes and reduced civilian spending when times were good, but this was the exception rather than the rule.

A lot of smart people think the sick U.S. economy needs a stronger dose of Keynesianism than President Obama or the Democrats have been willing to propose.  I think the Keynesian medicine may not have as strong an effect as in the past.

We are coming down from an over-stimulated economy.  Under President Bush, the government cut taxes, especially in the upper brackets, while increasing government spending.  Government debt mushroomed, and consumer debt and the U.S. trade deficit continued their long-term upward trend.  This is something that could not go on forever, and so it stopped.  This limits the effectiveness of any stimulus.  People who get any extra money over and above what they need are going to use it to pay down debt.

We live in a global economy.  If we import increasing amounts of goods from foreign countries, any increased consumer spending is as likely to benefit foreign manufacturers as our own.

So it looks as if we have two bad alternatives.  One is to do nothing and let the economic stagnate.  The other is to try things that may have little effect.

I think we need to maintain the social safety net.  I don’t think we can cut off unemployment compensation for the long-term unemployed when there are five job-seekers for every job opening.  I think the federal government has to provide state aid to keep local government functioning.  You don’t foster a vibrant economy by laying off school teachers, closing public libraries and raising state college tuition. Budget problems have forced at least 38 of Michigan’s 83 counties, and an unknown number in other states, to give up paved roads.

Beyond that, I think we as a nation need to invest in things we need for our future – in infrastructure, education and scientific research.  And what better time to do it than now, when so many people are out of work and when interest rates are at near-record lows?

I think that what the country needs is the kind of “investment recovery plan” suggested last week by Columbia University economist Jeffrey Sachs in the Financial Times of London.

A proper US investment recovery plan has five parts. The first is a significant boost in investments in clean energy and an upgraded national power grid. These should be promoted through guaranteed price subsidies to clean energy to be financed by gradually rising carbon taxes, as the clean energy capacity comes on line during the coming decade. The alternative cap and trade system is cumbersome, unnecessary and politically dead.

The second is a decade-long program of infrastructure renovation, with projects such as high-speed inter-city rail, water and waste treatment facilities and highway upgrading, co-financed by the federal government, local governments and private capital. Such projects are complex, requiring government leadership in land management, project design, public-private co-operation and partial subsidy or credit guarantees. New tools can help, such as a national infrastructure bank – championed last year before plans were strangely downplayed.

The third component is more education spending at secondary, vocation and bachelor-degree levels, to recognize the reality that tens of millions of American workers lack the advanced skills needed to achieve full employment at the salaries that the workers expect. The unemployment crisis is largely a structural crisis of job skills. It is hitting young workers – many of whom should still be learning – and older workers who lack a degree.

The penultimate part of the plan is boosting infrastructure exports to Africa and other low-income countries. China is running circles around the US and Europe in promoting such exports of infrastructure. The costs are modest – essentially just credit guarantees – but the benefits are huge, in increased exports, support for African development and a boost in geopolitical goodwill and stability.

The fifth and final element should be a medium-term fiscal framework that will credibly reduce the federal budget deficit to sustainable levels within five years. This can be achieved partly by cutting defence spending by two percentage points of gross domestic product, meaning ending the Iraq and Afghanistan occupations and cutting wasteful weapons systems. Other measures should include gradually phasing out the tax subsidy on high-end health insurance, taxing Wall Street bank profits and bonuses, raising high-end marginal tax rates and, if necessary, introducing a small value added tax. Public investment costs could be financed mainly by public tolls, gradually rising carbon taxes and by repayments of international loans to finance the export of infrastructure.

via FT.com.

I’m not prepared to argue for every detail of Sachs’ plan, but this is the way we should be thinking.  Ten-year U.S. Treasury bills offer interest rates of just over 3 percent.  What better time to engage in productive investment than now?

Click on Robert Reich on John Maynard Keynes for a 1999 biographical sketch and tribute to his thought.

Click on The political genius of supply-side economics for an analysis of the past 30 years of U.S. economic policy.

Click on Roads to Ruin: Towns Rip Up the Pavement for a Wall Street Journal report on U.S. counties reverting from asphalt to gravel roads.

Click on China’s New Deal: Modernizing the Middle Kingdom and Should China and the U.S. Swap Stimulus Packages? for a comparison of the Chinese and American economic recovery policies. As the second article points out, the traditional Keynesian recipe fits China’s situation much better than it does ours.

Click on Boehner’s Recipe for Creating Jobs: Do Nothing and Obama Shines a Bright Light on Boehner’s ‘Ideas’ on Jobs for discussions of the lack of a credible Republican alternative to current policies.  As with so many things, our two political parties offer a choice between the inadequate and the counterproductive.

Click on Critics Still Wrong on What’s Driving Deficit in Coming Years by the Center on Budget and Policy Priorities for the source and context of the deficit chart.

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