Why Keynesianism Failed

Victor V. Claar, Ph.D. Hope College Acton University June 11, 2008

Remarks based on . . .
Chapter 7 of Economics in Christian Perspective: Theory, Policy and Life Choices by Victor V. Claar and Robin J. Klay. IVP Academic, 2007.

John Maynard Keynes

British economist, 18831946 Fatherand namesake of Keynesian macroeconomics Began with his 1936 book, The General Theory of Employment, Interest, and Money

Pre-Keynesian Macroeconomics
Classical Macroeconomics The first classical macroeconomists worked primarily in the 18th and 19th centuries Included
Adam Smith David Ricardo J.S. Mill

The Classical View

Markets work well (Smiths invisible hand) Economies fluctuate, and growth rates will both rise and slow over time Government intervention cannot improve upon the spontaneous ordering of markets in their movements of resources from lessvalued to more-valued uses

Doubt Shadows Classical Macro

Great Depression, 1929-39 In 1933, the US economy operated at about 70 percent of capacity 25 percent unemployment in the same year

Doubt Shadows Classical Macro

Doubt Shadows Classical Macro

Extreme pessimism about the selfcorrecting power of market forces State ownership and planning began to look increasingly attractive as an alternative While classical macro suggested the depression would end, it offered no quick fixes

Keynesian Economics
Stresses the inherent instability of an market economy, and the need for active policy intervention to achieve . . .
Full employment of resources Sustained growth

Keynesian Economics
The intuition Recession and high unemployment are due to insufficient spending in the private sector by:
Firms, on new capital and equipment Consumers, on goods and services

Keynesian Economics
The remedy The appropriate role of government is to step in and shore up the gap in spending, using deficit financing if necessary That is, if people are hurting today, and we have the power to relieve their suffering through policy, then we must do so

Obvious Keynesian Downsides

Critics of Keynes knew such actions while pain-reducing in the shortrun, would inevitably lead to two longer-term macro problems:
Inflation Slower rates of long-term growth

Keynes had already admitted as much in his Tract on Monetary Reform (1923), but In the long run we are all dead (p.65).

Inertia of Keynesian Thought

Gained inertia, and by the 1950s had evolved into the mainstream in macroeconomic thought Major Keynesian figures include
John Kenneth Galbraith (Harvard) James Tobin (Yale)

Famous misquoting of Milton Friedman in Time:

We are all Keynesians now. (Dec. 31, 1965)

But Keynesianism Has Failed

Keynesian policy recommendations have proved to be bad advice Further, Keynesianism has failed as an accurate macroeconomic model So why has it failed on both counts? Lets look at each

Why Keynesianism Failed

Keynesian economics is bad policy advice because of
Crowding out

=> Slower long-term growth of the economy

A poor mix of goods during recession, and excess capacity in some industries after the recession ends Potentially poor timing of actions

Why Keynesianism Failed

Keynesian economics oversimplifies macroeconomic dynamics
In the Keynesian view, it should be possible to reduce unemployment by increasing government spending on goods and services (and/or increasing the money supply)

=> there should be an empirically observable tradeoff between inflation and unemployment

The Phillips Curve

This expected inverse relationship between unemployment and inflation rates is named for New Zealand economist A.W. Phillips

The Breakdown of the Phillips Curve 9 9

9 9 Inflation Rate (%) 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 9 Unemployment Rate (%) '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99 '99

Inflation and unemployment rates in the U.S.,

The Breakdown of the Phillips Curve

What had the Keynesians missed? Simply put, for active policy to be effective, it must be unanticipated When Keynesian-style policy actions are anticipated, people take actions that frustrate the policymakers intentions The policy ineffectiveness proposition

The Policy Ineffectiveness Proposition

Keynesians believed they could stimulate demand for good and services, and that firms would then hire, for example, more workers at an unchanging wage rate But if workers anticipate such actions, and understand that they create inflation, theyll begin asking for higher wages Faced with higher labor costs, firms wont be able to hire back workers and increase output after all

Why Did Keyness Ideas Catch On?

1. Very bad, never before seen, economic times 2. Politicians embraced Keynesian ideas quickly because they promised a silver bullet, and also gave them another argument for why we need them 3. Sir John Hicks interpreted the General Theory for the profession, and later confessed he may have misunderstood

Why Did Keyness Ideas Catch On?

4. The trend increased the mathematical rigor in economics probably a useful development on balance, though the Keynesian models lacked serious microfoundations 5. It wasnt until the start of the 1940s that early monetarists began to realize that money was an active factor in the downswing of the early 1930s 6. Keyness peers were either too easily swayed or not vocal enough in their reservations

Has Keynes Suffered an Ideological TKO?

In the 1970s we got in serious trouble by being good Keynesians when we increased the money supply in response to a slowdown caused by OPEC oil shocks => rapid inflationary spirals What are we doing today as oil prices rise? Have we learned our lesson?

Intended federal funds rate

Change and level
Change (basis points) Date 99 99 April 99 March 99 January 99 January 99 99 99 December 99 October 99 September 99 99 99 June 99 9 9 ... 99 .9 ... ... ... 9 9 9 9 9 9 99 .9 99 .9 99 .9 ... ... ... ... 9 9 9 9 9 9 9 9 99 .9 99 .9 99 .9 99 .9 Increase Decrease Level (percent)

Has Keynes Suffered an Ideological TKO?

What is the motivation behind the stimulus checks we are receiving in the U.S.? One could argue that it is a supply-side effort if one believes that government spending will fall (i.e., that it really is a tax cut) But otherwise, this is a Keynesian attempt to use government spending to purchase more good and services; but at least we are deciding what to buy on the

Has Keynes Suffered an Ideological TKO?

Basic Information on the Stimulus Payments

UpdatedApril17,2008

You've heard about it. Now find out how to get yours. What is it? It's an economic stimulus payment that more than 130 million households will receive starting in May. It's not taxable, and it won't reduce your 2007 or 2008 refund or increase the amount you owe when you file your 2008 return.

Conclusion
Has Keynesianism failed? Yes Is it still alive and well as a policy crutch? Yes