Diary

Another Critique Of Keynesian Stimulus

Courtesy of Ike Brannon and Chris Edwards. A key passage follows:

Keynesians thought that fiscal stimulus would work by counteracting the problem of sticky wages. Workers would be fooled into accepting lower real wages as price levels rose. Rising nominal wages would spur added work efforts and increased hiring by businesses. However, later analysis revealed that the government can’t routinely fool private markets, because people have foresight and they are generally rational. Keynes erred in ignoring the actual microeconomic behaviour of individuals and businesses.

The dominance of Keynesianism ended in the 1970s. Government spending and deficits ballooned, but the result was higher inflation, not lower unemployment. These events, and the rise in monetarism led by Milton Friedman, ended the belief in an unemployment-inflation trade-off. Keynesianism was flawed and its prescription of active fiscal intervention was misguided. Indeed, Friedman’s research showed that the Great Depression was caused by a failure of government monetary policy, not a failure of private markets, as Keynes had claimed.

Even if a government stimulus were a good idea, policymakers probably wouldn’t implement it the way Keynesian theory would suggest. To fix a downturn, policymakers would need to recognize the problem early and then enact a counter-cyclical strategy quickly and efficiently. But U.S. history reveals that past stimulus actions have been too ill-timed or ill-suited to have actually helped. Further, many policymakers are driven by motives at odds with the Keynesian assumption that they will diligently pursue the public interest.

The end of simplistic Keynesianism in the 1970s created a void in macroeconomics that was filled by “rational expectations” theory developed by John Muth, Robert Lucas, Thomas Sargent, Robert Barro and others. By the 1980s, old-fashioned Keynesian was dead, at least among the new leaders of macroeconomics.

Well, it has come back to life. But only because we appear to be determined to forget the mistakes of the past.

Actually, scratch that. Not “we.” Better to say “some.” Better still to say “mainly the Obama Administration and its Congressional Democratic allies.”