Can Government Spend Us Into Prosperity--Evaluating Keynes

New Yorker magazine economics writer John Cassidy defends the father of orthodox macroeconomics, John Maynard Keynes, in The Demand Doctor, (The New Yorker, October 10, 2011, link here). As an AP Macroeconomics teacher, I can confidently state that I and all other AP Macroecon instructors teach Keynesian theory. That is, we show how society benefits from creating "aggregate demand." Governments manufacture aggregate demand by cobbling together large public works projects or, less directly and less powerfully, giving money back to the people in the manner of tax cuts. Despite my or perhaps because of my familiarity with the theory of aggregate demand, a month before Cassidy's article was published I predicted Obama's Keynesian stimulus would fail (link here). Keynes' method of attacking unemployment through public works projects is more controversial than ever. Conservatives blame the Obama stimulus for the worst stretch of unemployment since the Great Depression: 54 months of unemployment at 7.5% or worse (link here), and only 47% of Americans have full-time jobs.

If today the same proportion of Americans worked as just a decade ago, there would be almost 9 million more people working. Just in the last year, almost 2 million Americans have left the labor force. With a majority of the population not holding a full-time job, it isn't surprising that economic growth has been so weak.  In June, the number of Americans who wanted to work full-time, but were forced into part-time jobs because of the economy, jumped 352,000 to over 8 million.(Mike Flynn, Breitbart.com, link here)

Liberals argue that Obama's stimulus was a success. If the government had not intervened, we would have entered another Great Depression. This argument fails to persuade me, since it can never be proven one way or another. We cannot go back in time and try a laissez-faire policy, though an uninterested federal government allowed the economy to work itself right out of depressions (or "panics" as they were called) throughout the 19th century. Liberals and Keynesians employ a much better argument by examining the size of the stimulus package. Cassidy writes

He would also have noted that the stimulus was—especially compared with the devastation it meant to address—rather small: equivalent to less than two per cent of G.D.P. a year for three years. Even this overstates its magnitude, given that much of the increase in federal spending was offset by budget cuts at the state and local levels. In its totality, government spending didn’t increase much at all. Between 2007 and the first half of this year [2011], it rose by about three per cent in real dollars.

In other words, the biggest Keynesian spending project ever, worth $825 billion, was too small. We should have spent more than a trillion dollars. Economist Larry Summers calls for another trillion on infrastructure (source here). I wonder if those that advocate for such things figure what might happen if we had a national debt that was even bigger than $16 trillion and what that might do to the economy. According to writer Bill Bonner, even "if America taxed 100 percent of all household wealth, it would not be enough to put its balance sheet in the black" (link here). (Well, never mind; an extra trillion dollar stimulus didn't happen and probably won't any time soon.)

Economist Larry Summers worries about unemployment. If only the stimulus of 2009 was bigger or he could do it twice

Source: New York Times

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What else went wrong?Cassidy also argues that the government needed to solve the banking and housing problems. "Following the crisis of 2008, both the Bush and the Obama Administrations moved promptly to shore up the banking system, but they neglected to deal with the housing debacle."

I think these excuses are poor, and the culprit can be found elsewhere. The Obama stimulus failed. (The president promised six percent unemployment by 2012 and a reduction of poverty.)  Why didn't it work? The answer may have more to do with a faulty tenet of Keynesian theory--the multiplier. Cassidy writes

a recent working paper published by the National Bureau of Economic Research looked at data going back to 1980 and found that government investments in infrastructure and civic projects had a multiplier of 1.8—pretty close to Keynes’s estimate [of two].

Well, maybe not. Cassidy discards the research of Robert Barro, saying his work doesn't apply in a recession.

Echoing the arguments that Keynes’s opponents at the Treasury made during the nineteen-thirties, conservative economists like Robert Barro, at Harvard, argue that it [the muiltiplier] is close to zero: for every dollar the government borrows and spends, spending elsewhere in the economy falls by almost the same amount. Whenever individuals see the government boosting spending or cutting taxes on a temporary basis, Barro maintains, they figure that these policies will eventually have to be paid for in the form of higher taxes. As a result, they set aside extra money in savings, which cancels out the stimulus.

Equally powerful is the work of  Stanford and German professors Cogan et al (link here) in their article New Keynesian versus Old Keynesian Government Spending Multipliers, which argues that old Keynsian  models used multipliers that were six times too high. Spending projects lower unemployment much less than was previously believed.