Economic Management Without Keynesianism

December 16, 2011

(This item originally appeared in on December 16, 2011.)

Last week, we talked about “Keynesianism,” which is really the application of two policies in the face of recession: expanded government spending, and some form of “easy money” policy. A brief perusal of the newspapers shows that these Keynesian ideas account for about 90% of the economic policy discussions today.

These can have some apparent short-term positive effects – but so does morphine. From a broader and more fundamental perspective, their effects are negative. The expanded government spending tends to go toward total waste, and causes larger deficits and a larger debt load. This often soon leads to higher taxes, which are an economic negative. All forms of “easy money” eventually amount to a form of currency devaluation, even if that is not their overt goal. In effect, this makes wages decline, because wages are paid in a currency of declining value. How can a country become wealthier by causing wages to decline? It doesn’t work.

“Keynesianism” is really today’s version of Mercantilism, which has been around in some form probably for millennia, but became more codified in Europe beginning around 1600.  In contrast to the Keynesian approach has been the “Classical” approach, which tends to favor as little government waste as possible, balanced budgets to avoid the consequences of excessive debt, low and efficient taxes, and stable money.  From our broader and more fundamental perspective, all of these policies improve the long-term functioning of the economy.

However, the Classical group has, historically, been rather silent about what to do during a recession. This is when the Keynesians grab the stage with their deficit-spending and money-jiggering proposals. In the past, the Classical group has tended to rely on “it will get better eventually” arguments, which indeed have some merit but are often completely insufficient for the situation at hand.

Often, it doesn’t get better eventually. Why is that? Usually, it is because of some fundamental issue that is not being addressed, or perhaps is getting worse. For example, if a recession has been caused by an explosive increase in tariffs, then obviously nothing is going to “get better eventually” unless the problem – high tariffs – is remedied by lowering tariffs.

Often it is the Classical group itself that is creating new problems. Worried about the decline in tax revenue and resulting deficits caused by recession, they often have an excessive focus on the supposed virtues of a balanced budget, and raise domestic taxes radically. This causes the economy to deteriorate still further, and the budget situation often then becomes worse rather than better.

Sometimes there are currency issues. If the currency is going through some kind of trauma, then things are not going to automatically get better unless the currency issue is addressed and solved.

Sometimes there are systemic problems, often related to the financial system. There could be issues with things like price controls, cartelism, inflexible labor arrangements, and other regulatory things. Today, we have a number of other long-standing issues that have begun to cause immediate difficulties, for example relating to excessive compensation for government employees, and a grotesquely overpriced and ineffective healthcare system.

So, a more enlightened Classical approach would be to identify the problems, and then solve them. This fixes and improves things on a fundamental level, which is much better in both the short and long term than trying to kick the can with a “stimulus” injection of Keynesian morphine. It is also much better than ignoring the fundamental issues and making a series of doctrinaire “it will get better eventually” arguments, which will simply fail if the fundamental issues are not addressed, or are in fact getting worse.

In addition to the fundamental issues that are perhaps directly related to the economic downturn, there are some other options available. For example, today’s problems, in the U.S., have little to do with changes in the tax code. The most recent tax code changes, the 2001-2003 Bush tax cuts, were generally positive. Although some people blame them for the expanded government deficit, in fact this tax code produced revenue of 18.5% of GDP in 2007, almost the exact average for the period since 1950, and the same as the 18.4% of GDP received in 1995. The more recent decline to 14.4% of GDP estimated for 2011 is mostly due to the recessionary environment, and corresponding high unemployment.

Federal expenditures for 2011 are estimated at 25.3% of GDP. This has been inflated somewhat by expenditures related to the recession, such as payments for unemployment insurance. The difference between revenues and expenditures is thus estimated at 10.9% for 2011, a very large number. However, if revenues increased naturally due to recovery, returning to about their 18.5% historical average, and expenditures decreased a few points to perhaps the 19.6% of GDP spent by the Federal government in 2007, then we would have a deficit of only 1.1% — which was, actually, the Federal deficit in 2007.

Thus, I would say that we do not have a major deterioration in the tax system today in the U.S., compared to the relatively prosperous 1990s for example. This is very different than Greece or Japan, both of which have pounded their economies with big tax increases in recent years. And they wonder why things don’t automatically get better. (Tax rates have risen at the state and local level in the U.S., so things are not quite all rosy.)

However, as we have seen among a couple dozen flat-tax adopters over the past decade, the positive effects of transitioning to a much more efficient and beneficial tax system are so great that they can do a lot to resolve economic difficulties. You still have to identify and fix the existing problems, but major fundamental improvements like a tax reform can add huge benefits which are much more “stimulative” than all of the Keynesian remedies put together.

So, a good Classical approach would be both to fix the existing problems, and also to address some broader issues, such as tax reform, which are not really causing the present difficulties but offer great opportunities for improvement.

If you chew over these issues for a while, it becomes apparent that there are so many things to do, fixing and improving the fundamental operating conditions of the economy, that a “do nothing” approach seems completely nonsensical.

Today, in the United States, I would say that the present recession is related to excessive debt mostly among individuals and the government (the “debt supercycle”); an inevitable repricing of real estate – and perhaps equities and bonds as well — to more normal levels; a grossly bloated, overcomplicated, corrupt and parasitic financial industry which is fundamentally insolvent; regulatory issues related to the financial industry; issues related to excessive sovereign debt, particularly in Europe and Japan today but possibly relating to the United States within a few years; and an excessive reliance upon Keynesian “easy money” policies which will probably cause more overt problems before all this is done.

You could add a few other things which have come to the fore recently, such as: long-standing issues relating to healthcare and pensions for the now-retiring Boomer generation; excessive costs for university education; excessive healthcare costs across the board; and absurd compensation for many government employees. I would say these issues are not directly related to the present economic difficulties, but the time has come to address them nevertheless.

This is the first step: identify the problem. Then you solve the problem. Economics doesn’t have to be any more complicated than that.

Once you begin focusing on identifying and solving real problems, then causing new problems with Keynesian morphine becomes totally repugnant. Don’t we have enough problems already?