CRAZY GOVERNMENT SPENDING!

27 06 2010

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(an almost apolitical post)

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What’s with that, anyway?  Everyone knows that if a family or business spends way too much money and gets too far into debt, it runs a very great risk of going bankrupt, right? So isn’t a government — in the case to be addressed here the government of the United States — in the same danger?

Nope. Why not? False analogy.

There is a crucial difference between one family’s deficit spending, and that of the government of a large country: The family’s spending is too small to affect the  prevailing market conditions around it in any way,

but the spending of a national government can be big enough to change that intensity of activity across a nation’s whole economy.

This was the first great insight of the founder of the species of economic analysis of whole societies (commonly called macroeconomics) now being followed by the Obama administration. The founder of this approach to macroeconomics was John Maynard Keynes, and his approach to large-scale economic analysis is called Keynesian economics.

Mr. Keynes’ second great insight, born out of his study of  the Great Depression, was simply that

Markets do not have any automatic mechanism to self-correct in the short run.

This means that they are prone, under extreme conditions, to go into “death spirals”: A sudden large decrease, for example, in overall business activity all across a large market like that of the United States can produce a widespread fearful expectation on the part of many consumers and investors within that market that greater decreases will be forthcoming. They therefore cut back on their spending, in the case of the consumers, and hoard their capital, in the case of the investors. Likely result: less business activity, just as feared! And that round of decline is likely in turn to produce yet more fear, leading in turn to even less spending and investing, producing yet another frightening decrease in economic activity.

This cycle can go on for a long time, until a new overall equilibrium is reached at a some low level of production and spending. This overall process, once started by an initial severe recession, can lead to a years-long Depression that threatens to become permanent.

Keynes’ third great insight was that

the government of a nation suffering such a death spiral is often in a unique position to interrupt it,

because: 1) governments  are not as prone to acting out of  panic as people are; and 2) governments often have such strong assets, in the form of taxes due or expected, that they are actually able to borrow and spend enough money to increase economic activity across the whole society. If enough is spent, a reverse, upward expectation/action spiral can be generated that can head off the development of a severe recession into an economically-crippling Depression. Moreover, as the stimulated economy recovers, the government’s tax revenues will grow, allowing it to pay back much of what it borrowed to finance the stimulus

(Keynesian macroeconomics also recognizes a similar kind of harmful upward spiral in economic activity / expectations that can lead to excess, even runaway, inflation. For that situation Keynes called for the enactment of higher taxes to damp down “irrationally exuberant” economies.)

Keynesianism thus provides a complete methodology for evening out the business cycle, which all flavors of economists recognize is intrinsic to capitalism.

A Bit of Recent History

From 1941 to 1979 Keynesianism was the standard macroeconomic model followed  in advanced countries, and its prescriptions were frequently and successfully applied to decrease the intensity of recessions.

Around 1979-1981, though, there was a  shift among US economists and decision-makers to another approach to macroeconomics that had been a very minority position among economists up to then. That shift probably came about largely due to Keynesianism’s apparent inability to fix the unprecedented problem of “stagflation” which was then bedeviling the United States. Sadly, throughout the 1970s the Congress and the Federal Reserve Bank had been unwilling to halt the upward spiral of prices and wages by raising taxes (as the Congress could have done) and/or tightening the money supply (as the Fed could have done).

Then Paul Volker became Fed Chairman and tightened the hell out of the money supply, provoking a very severe recession in 1981 that eventually choked off inflation.

Since Voelker had been able to handle inflation so well just by adjusting the money supply, the view gained ground that major periods of dysfunction of the country’s economy could always be ended by monetary adjustments alone. There was no need, ever, for Keynesian stimulation, a vocal body of economists led by Milton Friedman declared.  That view, called Monetarism, was accepted by many, and so at last ended its long exile as a minority position within economic thought.

Monetarism gradually lost a bit of its authority over the two decades after 1981, however.  I’m not sure why. I believe that waning of influence happened because monetarism proved ineffective at handling some substantial economic fluctuations.

Except for the recession of 2000-2001, however, from 1982 to 2008 the USA enjoyed a long period without either much inflation or any major recessions. Concurrently, the American Right tirelessly argued in every forum that the nation’s (and world’s) economy almost never truly need major macroeconomic correction anyway. The “invisible hand” of the marketplace could be counted on to make all upsets temporary.

Relax, There’s Nothing to Worry About!”

Most people who thought about such things came to agree with Greenspan’s trust in the invisible hand, what with that long period of  stability and all; and  Allan  Greenspan, popular Federal Reserve Chairman for  many  years, was a strong figure who could be cited as agreeing with the “hands off” crowd to those who doubted. We were back to the good old days prior to 1929, when everyone “knew” that, though endless lternating booms and busts might be intrinsic to a free market economy, such an economy would always return to equilibrium at a robust level of economic activity in the end.

Then came 2007-2008!

The housing bubble collapsed, a bunch of “derivative” financial instruments based on it became valueless, and that was followed by a recession so deep it took the jobs of millions of us and scared the hell out of the rest. Certain banks and investment houses had become so big that just the prospect of their failure frightened wealthy people and other banks into withdrawing their funds from the investment market in droves.

What effect would the actual bankruptcy of those financial institutions have? Would investment of new capital in old and new businesses dry up permanently? The Bush administration concluded that those huge institutions had to be rescued from bankruptcy at a cost of hundreds of billions of public dollars in order to prevent economy-wide investment paralysis from happening.

Meanwhile, many economists and others began to use the old-fashioned word “Depression”, which in my 45 years of adult life I’ve never before heard opinion leaders dare to utter during any US recession.

Let’s Try Keynes!

A change of administration occurred, and with it came another way of looking at the problem: “Hey, President Obama and lots of economists then said, “The big banks have been saved, but capital is still frozen. And the figures show that this recession has already become worse than anything we’ve experienced since 1930! Can we take the chance of doing nothing more, and a second Great Depression developing, when we have another recovery tool we haven’t used yet? ”

(Recall again that, once it had started, the last Great Depression ended only after 11 years, when the extraordinarily stimulatory Second World War came along.)

Keynesian fiscal stimulation by injection of government money into the economy  — hence a LOT of government borrowing — followed, as the Obama administration set out to apply the Keynesian prescription.

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Here’s a short explanation of Keynesian stimulation along the same lines as the above, but written by an actual EXPERT:

http://www.californiachronicle.com/articles/view/92595

And here’s an excellent and thorough description of Keynes’ theories, their current applicability, etc.

http://en.wikipedia.org/wiki/2008%E2%80%932009_Keynesian_resurgence

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Upshot

The effort of the Obama administration to “fix” the US economy was not a mere panicky act of throwing money at the problem. It was done in accordance with one of the standard macroeconomic theories of this century. It was an effort to intervene in the economy at a time when our most recent market/economic crash has definitively demonstrated that the “leave the market alone no matter what” approach can lead to frightful chaos.

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As of July, 2010

The jury is still out at this writing as to whether the stimulation worked. Paul Krugman, prominent Keynsian economist and New York Times commentator, said at the time it was adopted that it was too small. As of this writing, it looks like stimulation worked to head off another Depression, but not to prevent a serious recession. Maybe Krugman was right.

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3 responses

28 06 2010
Efrem

Leonard,

An extremely informative post. Thanks for breaking down into layman’s terms what has and still is happening.

We don’t make anything in this country any more. We’d rather import everything. So in that regard, I think this recession, and especially its affects on the working class, will last far longer than the Great Depression did, as there aren’t now nor will there be in the near future, any jobs for the unemployed to claim.

29 06 2010
nightman1

Thank you, faithful reader. Agreeing with what you say is this Nobel-prize winning economist, Paul Krugman, in this column:

29 06 2010

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