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Keynesian Economics - A Flawed Economic Theory - By Roger Martinez

    In these times of great financial turmoil, American policymakers have abandoned the free market principles of our Founding Fathers in favor of the economic dogma put forth by the 20th century, British economist, John Maynard Keynes.  This is not the first time America has forsaken its capitalist heritage.  FDR embraced this economic policy with devastating consequences.   FDR's Keynesian influenced New Deal turned a deep but short-lived recession into a 13 year Great Depression.  Social Security and Fannie Mae were born of the New Deal, and these relics, along with their government dependents, continue to burden our economy today.

    What is so titillating, so irresistible about this doctrine that our policymakers fail to see its obvious shortcomings?  Why in times of economic peril do our leaders abandon free market capitalism in favor of this big government, big deficit course of action?  To answer this question one must first understand what Keynesian economics is and why it will never work.

What is Keynesian Economics?

    The Keynesian theory is based on the belief that aggregate demand is the engine that powers the economy.  The idea is that when one person spends money he provides the earnings for the person or entity from whom he bought goods or services.  This person or entity then spends money on another's goods or services providing this entity with earnings, and so forth across the economy creating a circular flow of earnings.  When crisis strikes, people and businesses hoard their money thereby choking off the earnings of workers and business downstream in the economy.  As factories and workers are idle, society is deprived of the potential wealth they could have created.

    This paucity of aggregate demand sets the stage for considerable government intervention and a perceived need to 'prime the pump.'  Keynesian economics advocates government spending and tax cuts (fiscal policy) and lower interest rates (monetary policy) to inflate demand and allow productive segments of the economy that would have otherwise remained idle, to produce wealth.  Furthermore, Keynesian Economics argues for the redistribution of wealth from wealthy to poor, as the poor are more likely to spend that wealth thereby generating even more economic growth.

    The Obama Administration's Keynesian saturated stimulus bill calls for: 

1. $145 billion in tax cuts for individuals making less that $75000 ($150,000) for couples

2. $43 billion for increased unemployment benefits

3. $39 billion for expanded healthcare benefits for the unemployed

4. $20 billion to increase food stamp benefits

5. $41 billion for school improvements, including better buildings, computer upgrades and teacher training.

6.$15 billion to increase the maximum Pell grant by $500 in 2009-10; plus, increases to the annual unsubsidized Stafford Loan limits 

7. $14 billion in tax credits of up to $2,500 a year for college students with an annual income below $80,000

8.  $6 billion for college building improvements

9.  $4 billion for more preventative care programs

10. $1.5 billion for improvements at community health centers

11.  $20 billion to computerize health care records.

12.  $6 billion to weatherize moderate income homes, making them more energy efficient.

13.  $4 billion for homeowners to take up to 30% of the cost of conservation measures as a tax credit, up to

       $1,500 per person.

14.  $300 million for consumers to replace old appliances.

15.  $500 million to help rural families secure mortgages.

17.  $16 billion in energy retrofits and improvements for those living

18.  $500 million to help rural families secure mortgages.

19.  $30 billion for highway and bridge construction projects.

20.  $10 billion for mass transit, including new lines, buses, trains and stations.

21.  $3 billion to expand congested airports.

22.  $1.15 billion for better land and sea ports.

23.  $4 billion for more police officers and equipment

24.  $500 million for better airport screening detectors.

25.  $31 billion to modernize public buildings, making them more energy efficient.

26.  $3.1 billion for improvements on public lands, including new roads, trails and facilities at national parks.

27.  $6 billion for broadband Internet access in rural areas.

28.  $400 million for flood control efforts, which include buying and preserving open land around the

         country

29.  $6 billion for communities to replace aging sewer lines.

30.  $4.2 billion for towns to purchase and rehabilitate foreclosed, vacant homes.

31.  $32 billion for a "smart" utility grid and renewable energy production

32.  $10 billion for science research facilities.

Source: "How Stimulus Affects You" money.cnn.com

It's hard to argue against this litany of good works. How does one publicly argue against health care and food stamps for poor children?  Certainly it is preferable to the alternative, the alternative being the creative destruction of Free Market Capitalism. 

    What would happen if the Free Market were left unfettered?  Insolvent banks would fail.  The management that ran them into the ground would be drummed out of the business and possibly imprisoned for gross mismanagement of their depositor’s life savings.  Forget about 8 figure bonuses, they would be lucky to stay out of jail.  Wary depositors and investors would carefully consider the integrity of the bank's management, its assets, and its lending habits before they entrusted their hard earned cash.  Autoworkers at the Big 3 would face massive wage deflation as the domestic automobile industry fought to stay viable.  Shareholders of American corporations would scrutinize the compensation of management forcing executives to be good stewards of their investors’ money.  The days of the $68,000 credenza on the company's dime would be over.  And parents (gasp!) would be responsible for providing for their children.  High spending states would be forced to trim their budgets without the influx of federal funds.       

One can see why this economic ideology is so popular to both policy makers and the public.  Obviously, we would much prefer to spend and consume our way out of this recession rather than living within our means, retraining or relocating for a new job, and expecting less from the government and relying more on ourselves.  Creating wealth by spending and consuming is a wonderful thing.  Unfortunately, that's not how it works.  Yet it's amazing how many modern economists and politicians don't get it. You can defy market forces in short run, but in the long run it reigns supreme (Supremacy of Markets.)

The Flaw of Keynesian Economics

    The flaw of Keynesian economics lies in its basic premise that demand leads to wealth.  We can no more demand or wish to be wealthy than we can vote ourselves rich.  Demand does not create wealth; capital does, both material and human capital.  A nation, just like and individual, becomes wealthy by the accumulation of income producing assets or what economists call capital formation.

    Think about your personal situation.  Would you become wealthy if you lived beyond your means indulging in egregious consumption?  Would you be able to retire young if you lived off your credit cards treating yourself to exotic vacations and sultry lap dances?  The answer is an emphatic “no.”  But you might retire wealthy if you lived below your means and invested your savings in income producing and wealth preserving assets.  The same is true for a nation.  If we lived below our means, the government would no longer have to borrow money to fund current expenditures.  The money it saved on interest could be used for more spending or even lower taxes.  Lower taxes would allow citizens and corporations to direct more of its earnings to capital formation leading to even greater wealth in the future.  One thing is certain; no one ever got rich paying interest on a depreciating asset.

    Deficit government spending is a good thing when it makes the country more productive and its citizenry more self-reliant.  The value of this added productivity should be greater than the total cost of the spending (including interest) and cheaper than private sector alternatives, and this is precisely what the Democrats will claim their near-trillion dollar stimulus achieves.  They will say that their clean energy initiatives will create millions of high paying non-exportable jobs and their infrastructure spending will increase the efficiency of transportation and heavy industry.  Let's assume their claims are true for the moment, and that's a big assumption.  What about their other spending initiatives?

    A significant portion of Obama's stimulus package is wealth transfer from future taxpayers to present day non-producers.  He plans to increase benefits for the unemployed by nearly $100 billion and this is in addition to the hundreds of billions of dollars already given to the unemployed.  Can someone please explain to me how paying people not to work produces sustained economic growth. The President's plan to give tax cuts to people who do not pay taxes is a not a tax cut at all but a welfare check.  Furthermore, the notion that we can get rich by giving poor people money that they can spend on knick knacks and trinkets is absurd.  That is precisely why they are poor.  Because they spend every dollar they get as soon as they get it instead of saving or investing it.  Do we really think that future generations are going to make good on treasury bills sold today for the purpose of subsidizing some present day inner city kid's purchase of an ipod. Well, if you believe that, I have a bridge in Brooklyn to sell you and also some more T-bills for the second round stimulus package.

    Keynesian economics fails because of an effect called "Crowding Out."  Simply put, for every dollar of government spending, private investment must be reduced by the same amount.  Since the government does not have a surplus of money to spend, it must sell treasury bills to finance this spending.  Thus, personal and corporate savings are used to buy these T-bills, and these funds are no longer available for private spending and private investment.  Thus any increase in government spending is exactly offset by a reduction in private investment and private spending. 

    Supporters of Keynesian economics will declare that government spending won’t reduce private spending because people and corporations are not spending.  That might be true if people were burying their money in their backyard or baking them into pies. If people are not spending, then they are saving or paying down debt, which means banks have more money to lend.  Again Keynesian supporters will cry that banks are not lending.  Untrue, banks are still lending if they believe they will get a good return on their investment.  They are not going to lend money for a Mob museum in Las Vegas, a bike path to nowhere, or other money losing propositions contained in the stimulus package.  Therefore, the only way to have an increase in domestic spending is to sell our T-bills to foreign investors, but the global net effect is the same.  Global private spending and investment must decrease by the exact cost of our T-Bills as this money is no longer available for private spending or investment (instead it is funding government spending).

In the Long Run

    The stimulus package will fail because it relies on a flawed economic philosophy that runs contrary to common sense.  If government spending is such a boon to the economy, why stop at a trillion dollars?  Why not two trillion or ten?  Why not a quadrillion?  Better yet, why not give every American man, woman, and child a trillion dollars.  We could all buy yachts, jumbo jets, and hire servants to feed and bathe us.  Imagine the economic growth we would create with all of our lavish consumption.