Keynesian Frustration

In the last few days, I've dusted off my copy of Keynes's General Theory of Employment, Interest and Money, which is still without a doubt the most influential economic book of all time (though you wouldn't know it based on the rhetoric coming from television talking heads), and I've started to reread it.  What's really come into focus is the fact that not a single one of Keynes's supposed "critics" has actually bothered to understand, or even read, Keynes.  I have no clue how conventional wisdom about Keynes became that deficits don't matter (an idea that actually came about under Reagan-era supply siders), government spending is always a good thing, and government should control the economy.  That kind of nonsense not only is nowhere to be found in Keynes, but there's no way a literate person having taken a basic economics class could possibly come to that conclusion from anything in Keynes's work.

None of that is to say that Keynes explains everything, or that Keynes is perfect.  The General Theory was written at a very specific time, and in response to a very specific problem-- a deflationary cycle with persistently high unemployment.  Keynes came under fire during the inflationary 1970's, where supply shocks drove up inflation, while the economy itself was somewhat depressed, and it's certainly true that Keynes's work doesn't have a ready-made explanation for that scenario... but that's in large part because inflation was hardly a problem when Keynes was writing.  Indeed, deflation was the bigger problem in the 1930's, so it makes sense that tackling the possibility of stagflation was not at the front of Keynes's mind.  Before Keynes, classic economics had relied on a maxim called Say's Law.  The exact formulation is disputed, but the basic formulations are that "products are paid for with products" and "supply creates its own demand".  

Keynes's brilliant insight was that a general shortfall of demand can exist, and can explain recessions.  Understanding this is essential to understanding the problem we have now.  Quite simply, interest rates set by the Fed are at the zero lower bound, but unemployment is above 9%, and inflation is low.  Meanwhile, corporations are sitting on huge piles of cash that they aren't putting to work to hire workers because... there isn't enough demand for their products.  The deeper explanation for that comes from some later work by a Taiwanese economist named Richard Koo (and is echoed by a wide variety of people, from the founder of the giant macro hedge fund Bridgewater Associates, Ray Dalio, to Nobel Prize-winning economist Paul Krugman).  Koo argues (and I tend to agree) that we're in what he calls a "balance-sheet recession".  In short, in the run-up to the financial crisis, households in the US became overindebted.  They borrowed against their homes and figured they could always refinance.  Once the bubble burst, the value of people's homes collapsed, but the debt was still there, and refinancing was no longer an option.  So consumers across the board started saving to pay down debts.  But when a huge chunk of the population is saving instead of spending, demand across the economy falls.  As that demand falls, businesses struggle and lay off workers.  And those workers, still in debt, lose their source of income and can't pay down their debts fast enough.  Indeed, totals savings FALL (this is another unique discovery of Keynes's- the Paradox of Thrift).  As a result of this excess saving and lack of demand, the whole economy slides into an extended, painful recession, and lowering interest rates by the Fed to encourage investment has minimal effects because there's no reason for businesses to invest (even at very low costs) when there is insufficient demand for their products.

So how do we get out of this balance-sheet recession? Well, here's where the most-hated portion of Keynes's work kicks in.  It's an accounting truism that aggregate demand (GDP) is the sum of consumption, investment, government spending and net exports.  With consumption depressed as people pay down debts (which explains why tax cuts are rather ineffective at stimulating demand in this particular situation) and investment lagging (there's no reason to invest when companies have excess capacity as is, even if interest rates are super-low), the only real way to stimulate demand is for the government to directly make purchases to jump-start the economy.  By putting people to work on, for instance, repairing bridges, building high-speed rail, and building an infrastructure for national wireless internet, the government can both improve productivity in the future and put people to work now.  The salaries from those jobs help workers pay down their debts, at which point they will have the ability to start spending again.  Once that happens, government can cut back on its purchases as the private sector picks up the slack.

Unfortunately, we have a political system in which no one has read Keynes.  And even though we're in a world in which his models are working more or less flawlessly, we're stuck in a hole that we would be able to get out of if only our decision-makers believed in ladders.