An Introduction to Keynes & Fiscal Policy "Construction teams still work around the clock in China's largest city...In a telling shift, however, construction workers are putting up fewer of the office and apartment buildings that had sprouted like weeds in the boom years...Instead they are working on municipal projects...part of China's enormous spending program aimed at preventing the economy from weakening too seriously." -- NYT April 3, 1999 Overview Clearly something needed to be done as the economy continued its slide into Depression, but if we were to see any substantial shifts in macroeconomic policy, we first needed to see a shift in the prevailing economic theory. Until the Classical model could be successfully challenged, the guidelines for policy officials would be maintenance of the gold standard and a balanced budget. John Maynard Keynes provided the theoretical basis for a reconsideration of macroeconomic policy in his 1936 book, The General Theory. The centerpiece of the Classical view had been Crowding-out, and it was to be replaced by the Keynesian multiplier. The essence of the multiplier is captured in the following quotes. First we have the historian Gerald Johnson's description of how the panic in 1929 produced a shock wave that rippled through the economy.i When the panic of 1929 suddenly wiped out the whole value of many stocks and sharply reduced the values of others, a great number of people who had thought themselves rich, or at least well off, found themselves with much less than they had thought they had, or with nothing at all. By [the] millions they quit buying anything except what they had to save to stay alive. This drop in spending threw the stores into trouble, and they quit ordering [new products] and discharged clerks. When orders stopped the factories shut down, and factory workers had no jobs. More recently, Dave Barry provided a humorous take on the multiplier. Some of you... may have decided that, this year, you're going to celebrate it the old- fashioned way, with your family sitting around stringing cranberries and exchanging humble, handmade gifts, like on "The Waltons". Well, you can forget it. If everybody pulled that king of subversive stunt, the economy would collapse overnight. The government would have to intervene: it would form a cabinet-level Department of Holiday Gift-Giving, which would spend billions and billions of tax dollars to buy Barbie dolls and electronic games, which it would drop on the populace from Air Force jets, killing and maiming thousands. So, for the good of the nation, you should go along with the Holiday Program. This means you should get a large sum of money and go to a mall.ii On a more serious note, when China was faced with a dramatic drop in demand for its exports in the slowdown in the later 1990s, its policy makers clearly were Keynesians as they shifted demand from exports to government. Construction teams still work around the clock in China's largest city...In a telling shift, however, construction workers are putting up fewer of the office and apartment buildings that had sprouted like weeds in the boom years...Instead they are working on municipal projects...part of China's enormous spending program aimed at preventing the economy from weakening too seriously.iii 1 They did the same in response to the collapse in export demand in the Great Recession of 2008. China on Sunday night announced an aggressive $586 billion economic stimulus package, the largest in the country's history, at a time when it is struggling with increasing social unrest due to factory closings and rising unemployment. In a wide-ranging plan that economists are comparing to the New Deal, the government said it would ease credit restrictions, expand social welfare services and launch an infrastructure spending program that would include the construction of new railways, roads and airports.iv Keynes' ideas were simple and based on the premise that the prevailing Classical theory, while maybe adequate as a guide to the long run, was not valuable to policy makers who could not afford to operate in that time frame. Keynes said as much when he suggested, "In the long run we are all dead." To Keynes, the Great Depression demanded a reassessment of the assumptions of the Classical model. Where Classical economists focused on flexible prices, Keynes focused on inflexible prices. Where Classical economists focused attention exclusively on aggregate supply and the long run, Keynes focused on aggregate demand and the short-run. Where Classical economists assumed markets worked efficiently and would quickly eliminate any imbalances, Keynes recognized that markets sometimes move too slowly to eliminate imbalances. In the labor market where the imbalance between supply and demand would be unemployment, Classical economists believed unemployment would simply "disappear" like imbalances in any market. Unemployment is simply a surplus, and we know from our analysis of supply and demand that a surplus would push the market price lower and eliminate the surplus. Keynes believed in the power of markets, but he thought the labor market was different and wages could get "stuck" and unemployment would not disappear. Keynes believed wages would not adjust downward quickly because people take their pay personally and they would resist, at least initially, any pay cuts. Just think about how you would react to your boss announcing a 10% cut in wages effective on Monday: either you take the 10% cut or you are fired. Would you simply agree to the cut, or would you fight the cut and accept unemployment? Keynes thought many would fight the cut and the result would be persistent unemployment. The good news is the existence of these unemployed workers and excess capacity with those idle factories meant employment could expand without putting any upward pressure on wages or prices because neither workers nor firms had any bargaining power. Where the Classical economists say any increase in Aggregate Demand (AD) generates higher prices, Keynes expected workers would be “thrilled” to work at the existing wage if there was any work for them and businesses would be “thrilled” to sell additional output at existing prices. In Keynes’ depressed world, an increase in AD would increase output rather than prices. Keynes also questioned the assumption of flexible interest rates and suggested interest rates could get stuck at non-market clearing rates. In difficult economic times, if firms had laid off workers and had machines sitting idle, a drop in interest rates would not prompt firms to buy new machinery or build new factories as suggested by the Classical economists. You would also see households respond to the tougher, more uncertain economic times by increasing their savings. When you are worried about having a job next week, you are saving more for that “rainy day.” In this environment, even if the central bank pushed interest rates down to zero, we may find banks unwilling to lend money to consumers and businesses or these consumers and businesses unwilling to borrow to finance their spending. The result is that a decline in interest rates would not generate the aggregate demand needed to put the unemployed back to work. This is precisely what we saw in 2008-2009 as the US economy slipped into a deep recession and banks became more restrictive with their lending, something we examine more closely in the final unit. There is not much good news here, but there is some. In the depressed economy of the Great Depression in the 1930s – and also the Great Recession in the early 2010s –idle resources mean that any increase in aggregate demand will not necessarily push prices higher. If the government decides it needs to increase 2 it’s spending to offset the decrease in spending by consumers and producers, then this will not cause inflation by pushing wages and prices higher. It also means that if the government needs to borrow money to finance its spending, this increased borrowing will not drive up interest rates. In this environment the economy’s problem is pretty simple – there is not enough aggregate demand to keep workers working – and thus Keynes focused attention on aggregate demand and the need for the government to respond to shifts in aggregate demand with the appropriate monetary or fiscal policies. This situation, where output can expand without any upward pressure on wages and prices is represented in the AS-AD diagram below. The AS curve is horizontal because workers will be happy to work more hours for the same wage and firms will be happy to sell more of their "stuff" at the same prices. This very different view of the supply-side of the economy had a dramatic effect on the macro policy prescriptions. As Keynes saw it, if the private sector could not be relied upon to provide adequate demand, then the government could step in as the "demander of last resort" and borrow funds to purchase goods and services. Diagram 1 The Keynesian AS - AD Model In theory the government could get the economy moving again by stimulating aggregate demand, and it could do that with either monetary policy – pushing money into the system to drive down interest rates to “encourage” business and households to borrow that money to buy “stuff,” or it could simply buy “stuff” on its own. Instead of enticing you to buy a new car with low interest rates the government could simply buy a new road or reduce your taxes and hope you spent the tax cut on stuff. Of these possibilities, Keynes believed in a situation as extreme as the Great Depression, the best solution was fiscal policy, so now we will turn our attention to that.