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The Keynesian Illusion

Author(s): David K. Levine

Decontrsucting Keynesianism.

1. Introduction

The philosophy of Keynesianism has an intense appeal. The cure to economic ill is for the government to spend more money - and no reason to worry about how it is paid for. Not only does the Keynesian medicine cure our ills - it even tastes good going down. Austerity is a horrible mistake. The Great Recession could have been prevented if only the government spent more. It would have been infinitely worse if not for the stimulus that did take place. This is repeated by people whose opinions I respect: the jurist Richard Posner, the blogger Kevin Drum - and many others. And we all know that the underlying theory is that of John Maynard Keynes.

Let me give Richard Posner's explanation of Keynes from his New Republic article explaining how he became a Keynesian. 

Income spent on consumption, in contrast to income that is saved, becomes income to the seller of the consumption good. When I buy a bottle of wine, the cost to me is income to the seller, and what he spends out of that income will be income to someone else, and so on. So the active investment that produced the income with which I bought the wine will have had a chain-reaction--what Keynes calls a 'multiplier'--effect...For Keynes, in other words, it is consumption, rather than thrift, that promotes economic growth.

From this the conclusion that in hard times the government should stimulate demand - that each dollar it spends will increase economic activity not by one dollar but by one dollar times a multiplier so that the expenditure (in effect) more than pays for itself.

There are two parts of this: the story of the multiplier and the conclusion about government spending. The former seems like common sense: we all know that if a city builds a huge sports stadium local burger flippers will benefit from increased sales - and in turn they will buy more of other things such as haircuts and tattoos thereby benefiting hairdressers and tattoo artists. That seems to support the first part of the story. Support for the second part - and the evidence that held sway over the economics profession for decades - was the Great Depression and especially the end of the Great Depression. It is difficult these days to understand just how bad the Great Depression was - how vast was the number of prosperous middle class people who were reduced to paupers barely able to feed their families. We talk as if the "Great Recession" is somehow comparable - but it does not (in the U.S.) come close. And how did the Great Depression end? With World War II - just as Keynes seemed to recommend the government engaged in massive spending financed by borrowing and printing money - and voila - the Great Depression turned into the great prosperity.

The thing is that the Keynesian prescription - spend more and don't worry about the bills coming due - sounds a bit too good to be true, almost like a perpetual motion machine.

At which point I want to refer you to a drawing by M. C. Escher. It illustrates a canal with water flowing downhill and around several corners until it reaches a waterfall which runs a waterwheel, then flows around the canal downhill back to the top.

Escher Waterfall

This is an illustration of a perpetual motion machine - which of course we know is impossible. How do we know this? If we measure the angles carefully and do the calculations we will discover - of course - that the water is flowing uphill. And we might wonder if the reason that Keynes is so popular with those that do not do math is because they cannot measure the angles carefully. We might want to subject Keynes rather vague stories to some careful measurement. 

Another thing we might do with the Escher diagram is to try to build the machine - in which case we will discover it is impossible. As far as Keynes goes, we will come to that as well.

2. Keynes theory, insofar as there is one

I want to subject Keynes story to some scrutiny - to measure the angles carefully. I could do this using complicated math - and if I wanted to be at all realistic I would do just that, but it is his reasoning I am after and I can measure that with a simple example that is precise but avoids any math - it is the precision that matters.

I want to think here of a complete economy peopled by real people who produce and consume things. Let's say four of them: a phone guy who makes phones, a burger flipper, a hairdresser and a tattoo artist. Let's say that the burger flipper only wants a phone, the hairdresser only wants a burger, the tattoo artist only wants a haircut and the phone guy only wants a tattoo - around the circle in effect. We'll suppose that each can produce one phone, burger, haircut or tattoo and that each values the unit of what they want to buy more than the unit of what they can sell. That is, the hairdresser happily cuts hair if he can get a burger and so forth. What happens is clear enough: the phone guy produces a phone, trades it to the tattoo artist in exchange for a tattoo, who trades the phone to the hairdresser in exchange for a haircut, who trades it to burger flipper in exchange for a burger. All are employed, all get what they want - everyone is happy.

Now suppose that the phone guy suddenly decides he doesn't like tattoos enough to be bothered building a phone. Now the circle is broken and this is a complete catastrophe. Everyone is unemployed. Demand is insufficient. There isn't enough consumption - none at all in fact. And notice how this works: one person - the stupid phone guy who is causing the problem by not wanting to buy a tattoo - is "voluntarily unemployed" - he is lazy and doesn't want to work. The other three are "involuntarily unemployed" each one is willing to work in exchange for pay. The burger flipper would like to work making burgers if he can get a phone, the hairdresser would like cut hair if he could get a burger and the tattoo artist would like to work if he could get a haircut and yet all are unemployed.

Now to the multiplier. Suppose - instead of building a sports stadium - the government gives a phone to the phone guy. Why then he'll sell it for a tattoo (he doesn't have any use for a phone himself) the tattoo artist will use the proceeds to buy a haircut, and so around the circle. Full employment. Just put in one phone and you also get a haircut, a tattoo and a burger! That is the multiplier, and just what we see when the city government builds a sports stadium. Nothing mysterious here.

But...this what an economist would call standard competitive equilibrium theory - meaning there isn't a free lunch, and indeed we better ask - how did the government get a phone to give to the phone guy? One is reminded of the old economics joke:

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let's smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let's assume that we have a can-opener..."

Is the basis of Keynesianism that we should assume that the government has a phone to give away? Well maybe not. Maybe the government should follow Keynes advice and print some money (or bury it) and give it to the phone guy. Then the phone guy can buy a tattoo, and the tattoo guy can buy a haircut and the haircutter can buy a burger, and the burger flipper - ooops...he can't buy a phone because there are no phones. There are two possibilities. One is that the burger flipper realizes he shouldn't sell the burger because he can't buy anything he wants with the proceeds, and we are right back where we started with everyone unemployed. Or maybe he doesn't realize that and gets left holding the bag. There is a word for that kind of scheme - it is called a Ponzi scheme and sometimes they work - people do make mistakes - and sometimes they don't - and it seems like a poor excuse for economic policy that our plan is that we hope the burger flipper will be a fool and be willing to be left holding the bag.

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