Keynesian Economics is Dead, Long Live Keynes (A Response to Paul Klugman’s Blog)

John Maynard Keynes was a Depression era economist.  He was most famous for his economic theory by which a government pulls an economy out of a slowdown (as we’re going through now) by spending more money.  In the Depression, this lead to the WPA and other such activities.

One would have thought that Keynesian Economics was thoroughly discredited.  Looking at the Depression itself, the downturn lasted for about 14 years despite all kinds of government projects.  While some still remember fondly the meager paycheck their father or grandfather received during that period from FDR, all of that government spending did not bring the economy out of the Depression.  There was also a market crash/recession in the 1920’s of similar magnitude to the 30’s crash that was over within a year in which there was no government involvement.

To avoid creating a financial perpetual motion machine, Keynesian stimulus requires the borrowing of money by the government.  Otherwise you’re just moving money around.  The trouble is that eventually the government must recover that borrowing through taxes.  It usually just results in a slow down later (look, for example, at the cash for clunkers deal of two years ago which resulted in an increase in car sales at first but then a slowdown when the program ended.)

Despite such evidence, Keynesian economics keeps rearing its ugly head.  Oddly enough, the more recent Laffer economics, which says that if you lower taxes it results in economic expansion and more government revenue, is often dismissed despite there being more evidence that it works (see the economies of the 1980’s, 1992-2000, and 2003-2008).

I saw a recent example in Paul Krugman’s blog in which he describes taxing one group of individuals to build a bridge, thereby expanding the economy. The post is here.  Please read this before continuing on.

I attempted to leave a comment on the post, but unfortunately character limitations prevented me from leaving a full reply.  Here, therefore, are my full comments for those interested:

Being the clever people you purport to be, you’ve made a critical mistake in logic.  Your example is like adding energy to power which would cause your engineering professor to fail you.

The “X” you spend on the bridge at time t is a specified amount of money.  The “X” you raise taxes is really looking at the rate of production of additional resources, i.e. people wouldn’t “make that much less money during the next period of time”, from t to t+delta t, “because their taxes were raised by X”.  The taxed individual would still be down by X dollars at time t, and therefore the net amount of money in the economy at time t would still be X, not the sum of X and a little less than X.  If you were to use taxes to take X from individual A and give it to individual B, it would just mean that individual B had the money instead of individual A and the amount of spending would be unchanged.

Now since individual A had X dollars at time t, and individual B did not, you can assume that individual A is able to create resources, probably through the building of a business and working long hours, and individual B is less able.  If you left X dollars with individual A, he probably would not sit on it like Scrooge McDuck.  He would probably use it to build his business so that he could produce 2X per period by the time 2t rolled around instead of just X per period like this year.

If you give it to individual B, he would probably spend it on beer and cheap women.  The beer seller would then have the X resources instead of individual B, since individual B would have consumed what he traded the X dollars for, so you would still have only X dollars in the economy.  If you left the money with individual A, he would have traded the X dollars for something worth almost X dollars, so the economy would have almost 2X worth of value in it (the thing worth X that individual Z created and the X dollars he paid to someone else to create it..

Worse yet, instead of having the 2X per year production from A, some of which goes to B and his friends in the form of salary,  you might only have 0.5X production since A figures, “Damn it all, they just take my money anyway. I’ll fire D and E and just do what I can by myself.”  You may also have zero X dollars in production each year if A decides to move to the business to Brazil and take his X per year producing business with him.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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