The Keynesian Fixation

Zachary Goldfarb presents a series of charts and concludes,

Put it all together and household debt has weighed on the economy in a way many people don’t appreciate, but there seems to be progress toward addressing it.

Pointer from Mark Thoma.

In my view, Goldfarb is presenting symptoms and suggesting that they are causes. This is a characteristic of what I call the Keynesian fixation. Note that in macroeconomics the position that I criticize is the mainstream position. New readers should be aware that mine are outlier views.

To a Keynesian, economic activity consists of spending. Spending causes jobs, and jobs cause spending. When you look at economic data, that is your focus. Is spending going up or down? If it goes up, then we will have more jobs and more spending. If it goes down, then we will have fewer jobs and less spending.

The alternative approach that I propose is to look at economic activity as the formation of patterns of sustainable specialization and trade (PSST). As entrepreneurs create businesses that exploit comparative advantage and specialization, jobs and spending increase. When existing patterns of trade become unsustainable, jobs and spending decrease. See this paper and this paper.

For example, when hurricane Sandy hit New York, the Keynesian fixation was to look at the destruction in terms of how it would affect spending. Would people spend less, because of lost wealth? Or would they spend more, because of the need to rebuild? Mayor Bloomberg wanted to run the New York marathon less than a week after the hurricane hit, because he did not want the city to miss out on the all the spending that comes with the marathon.

My view is that what matters are the patterns of specialization and trade, which depend on the transportation infrastructure. I over-estimated the damage to that infrastructure, and so I thought that there could be significant long-term shifting of jobs out of Manhattan. However, if only a tiny portion of the transportation infrastructure suffered damage that could not be repaired in a couple of weeks, then the PSST story would say that employment in the area should not be affected.

To take another example, the “fiscal cliff” does not trouble me. If you hold the Keynesian fixation with spending, then it appears that a sharp reduction in government spending and/or increase in taxes will cause a recession. If you think in terms of PSST, it probably will make little or no difference. And, as I wrote two years ago,

Government spending plummeted by nearly two-thirds between 1945 and 1947, from $93 billion to $36.3 billion in nominal terms. If we used the “multiplier” of 1.5 for government spending that is favored by Obama administration economists, that $63.7 billion plunge should have caused GDP to fall by $95 billion, a 40 percent economic decline. In reality, GDP increased almost 10 percent during that period, from $223 billion in 1945 to $244.1 billion in 1947.

After the second World War, the U.S. economy easily created new patterns of specialization and trade. I think that one reason is that the war increased mobility, as soldiers met others from different parts of the country. Instead of remaining in their communities of birth, men moved in order to take advantage of new opportunities. Regardless of whether this was an important factor, it should be obvious that if we could cut government spending by 25 percent and thrive, then going over the fiscal “cliff” would be a non-event.

If I were assembling charts on the economic outlook, I would focus on secular factors: declining labor force participation among less-educated men, which indicates that new patterns of trade are reducing the value of their work; the increasing “tax” represented by the cost of providing health insurance to workers in large enterprises; the significant shift in the distribution of wealth toward Washington, DC, which makes secondary businesses such as restaurants and real estate services more profitable in the nation’s capital and less profitable elsewhere. Or consider the charts on household income and benefits from Gary D. Alexander, showing many categories of workers facing marginal tax rates of over 100 percent.

We should be trying to understand what is causing the breakdown in patterns of specialization and trade that prevailed at the end of the 1990s. We should be trying to understand what is impeding the formation of new patterns of specialization and trade today.

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18 Responses to The Keynesian Fixation

  1. DW says:

    I was hoping for a “most charitable view” paragraph in there.

    Are there no instances where PSST is less effective than the spending/jobs framework? Why might Keyesnians think PSST is bunk?

  2. Joe Cushing says:

    Agreed with everything. The reason the public doesn’t know about this is because of the whole dispersed cost, concentrated benefits problem. Politicians need an excuse to spend money on those who have loud voices to put them in office. This is true whether the politician believes the excuse or not. Meaning that those who believe and act on the truth don’t get elected because if you tell people you are going to cut spending on them, they spend millions of dollars to get your not elected or thrown out of office. This is the pragmatic argument for anarchism. It’s the cycle of doom that leads from freedom to tyranny to collapse to freedom. Keynesianism is grease for the wheel in this cycle.

  3. Dallas Weaver says:

    It seems that it is often the implicit assumptions in both mental and mathematical (economic) models are the biggest source of problems. In the case of a lot of Keynesian thinking, it seems that there is an implicit assumption at “a job” = “a job”. This may have had some validity back in the 20’s when you could take a stable boy and put him on an assembly line with 2 hrs training. Now days, you can’t think about taking a dry wall hanger high school dropout and have him program and operate a computer controlled milling machine without many years of training (assuming he has the math capability — math not just arithmetic ).

    Times have changed and a job ≠ a job.

    Also if Dr. King is correct, all the “New Urbanism” thinking with their local walking/cycling communities and more restricted mobility ranges dictated by “mass transit” instead of “personal transit” — aka cars — will result in less sustainable specialization when you can only easily go from station A to B, when the specializations requires going from location X to Y (both arbitrary variables).

    In other words, “New Urbanism” would create a “feel good” economic disaster.

    I don’t worry about it when I note that the private “computer chauffeur” type Google cars, with cost/performance tied to Moors law, will triple the road lane capacity (eliminating congestion) and drop the fuel consumption by 40% (drafting at 2 inches between cars), allowing full location X to Y fast transit. Automated driving will be a mass reality before the California bullet train gets built or our cities are rebuild according to the visions of the New Urbanism visionaries. The only real issue is all the money and resources that will be wasted on obsolete things like bullet trains.

    • Ken says:

      Good point on reduced mobility that comes with Urban development planning. Much of such planning reminds me of planners trying to solve the coming horse manure problem in the late 1800s, proclaiming that horse manure would be 6ft deep in city streets within decades.

  4. AADL says:

    PSST are among the drivers of production and the economy. PPP (pure public parasites) and NCP (new class parasites) are the drivers of the “public sector,” which is a parasite on the economy. PPP are politicians and bureaucrats. They would be doing something productive in a free society. NCP work in government jobs that monopolize what would be private sector jobs in a free society. Examples of the latter are police and firemen.
    A reduction in state spending is always a good thing and leads to more private production, c.p.. So the Keynesian cliff is a lot of hogwash.

    • Joe Cushing says:

      Agreed: and I would add that people who work for private companies that are dependent on the state as part of your NCP group.

  5. roystgnr says:

    If you think in terms of PSST, it probably will make little or no difference.

    This seems like an odd claim. Taxes are generally of the form “If you undertake this trade, you must pay the government X”, so increasing them ought to change which trades are sustainable. Government spends to buy specialized goods and services, so reducing that spending ought to change which patterns of specialization are sustainable.

  6. Fonzy Shazam says:

    I like and agree with this post, but it leaves me curious and wanting for discussion on the tax policy part of the Fiscal Cliff. In response to roystgnr, the reduced spending should improve PSST since government is distortive, but yes, where is the tax considerations?

  7. Lee Waaks says:

    I was recently taken to task for ignoring the fact that Keynesians emphasize investment over spending. If I understand his point, Keynesians want to prime the pump with government spending so business will get back to investment spending. Of course, the spark that creates the ignition is a chain of consumer spending initiated by the government. Having said all that, I think George Reisman’s argument against “consumptionism” in his book _Capitalism_ (free online), destroys this point of view and takes Keynes down with it. I believe it is superior (but may include within it) the PSST approach. See pp. 694ff.

  8. Daniel Kuehn says:

    I am not really getting the “charitable view” in this post.

    I have always appreciated your highly Smithian take on things. However, I’ve never understood your insistence that nobody else thinks like that.

  9. Phillip Hansen says:

    I am pretty keynsian, but that is not the reason I wanted to post a question. What I am curious about is how PSST interacts with the invisible hand- it seems like if you set up a PSST model, it will give you locally optimized solutions. That is to say, even if there is market pressure to change the pattern, as long as the existing pattern is better than the immediate alternatives, the inefficient pattern will persist. There is no mechanism for getting to a global optimum.

    Am I off-base with this?

    • Arnold Kling says:

      Phillip, the way I see it, patterns of trade will be disrupted on a trial-and-error basis. There is nothing that guarantees an optimum. And an optimum is only an optimum for an instant–as technology and other conditions change the optimum changes.

      • Phillip Hansen says:

        Thanks for your reply. I agree that the world looks very much PSST historically. However, with local optima the case against government manipulation seems much weakened. If supply and demand don’t change the established patterns at the margins (barring a shock large enough to move close to another attractor point) then why should small distortions imposed by policy make any difference?

  10. BradK says:

    I got up to the Sandy example and thought you went off the rails. The appropriate example for me is the recession. The business cycle you were describing was swept away in a tidal wave.

    Your “fiscal cliff” discussion also appears to me to go off the rails. Spending makes sense now when interest rates are at 0% and QE is going full bore and not making much of an impact. It doesn’t make sense all of the time. Keynesians believe in counter cyclical government spending. When the private sector is healthy, then government spending does not represent the best choice. It’s time for the gov to get out of the way.

    Of course, there is always a baseline of government functions. The core of the debate is what those functions should be. i.e military, social security, healthcare, education and infrastructure.

  11. William Whyte says:

    Hi Arnold – in the interests of the most charitable view approach, I’d like to see you address in here the concepts of the zero lower bound. Krugman and the other New Keynsians are clear that increased government spending is not always a good thing, and can (and almost always will) lead to crowding out. Their argument is that the low interest rates on government debt at the moment show that there’s no other plausible place for the money to go, and that implies that activity funded by government debt is likely to be more productive, and less crowding-out, than under other circumstances, and that using increased government debt to allow paying-down of private debt (as is happening at the moment) will speed the recovery by allowing aggregate demand to recover. The contrast with 1945, as I understand it, is that in that case aggregate demand was high anyway due to troops returning home, and so government deleveraging allowed government demand to be replaced by private demand.

    I’m not saying I fully agree with or even fully understand this, but it’s pretty clear to me from reading Krugman, Simon Wren-Lewis, etc, that this is what they think and that it’s fairly internally consistent. I respect your fair-mindedness and I’d like to see your thoughts on this version of the argument, rather than the slightly straw-mannish version you engage with above.

  12. Ajay says:

    I’ll give you my theory as to what is “impeding the formation of new patterns of specialization and trade today.” This was supposed to be the internet decade, but it has been held back by the lack of micropayments. Without a good way to monetize the internet, all the change that should have happened is stillborn, as companies are left only with advertising, which doesn’t monetize well in most cases, with Google search ads as the exception. So the internet has killed off certain information businesses, like recorded music or the newspaper, but it has not created the new markets that will replace those antiquated markets, only because the techies are too dumb to deploy micropayments as of yet. This is a giant hammerlock on growth and new PSST, as all the internet can be used for is the destructive part of creative destruction, without much creation yet.

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