Keynesian theory is losing its grip

Here we have a very nicely turned argument about Keynesian economics. It even includes the need for value adding activity as part of the explanation which definitely puts it a cut above the rest of those paltry few and far between anti-Keynesian bits of writing I tend to see. By Martin Hutchison at Prudent Bear, titled, “The Non-Existent Keynesian Contradiction”. The supposed contradiction is explained in the opening para:

The Keynesian U.S. commentariat, which includes quite a high percentage of nominal Republicans, has been proclaiming a “contradiction” between the needs of economic policy. The need to cut government spending to reduce the deficit is supposedly balanced by ill-effects from declines in government employment—even the Wall Street Journal’s economics blog claimed that the U.S. unemployment rate would be 7.1% had governments (mostly state and local) not cut their workforce. In Britain, infinitesimal spending cuts are blamed for continuing economic stagnation, while the sharp rise in the value-added tax (VAT) is ignored.

I’m afraid even those who are trying to cut back on spending are only doing so out of the necessity of having to trim their outlays to what they can actually pay for, not because they see the economic value in a lower deficit. I am forever on about Say’s Law but unless you understand the Law of Markets, you are blind to what needs to be done and how one might gauge success. But here we have some good solid sense:

Only in the world of the FDR Keynesian Simon Kuznets, the inventor of GDP accounting, does an increase in public spending matched by a decline in private spending leave you in the same place, let alone push you forward.

In reality, much public spending is wasteful, producing output of lower value than the input, whereas private spending by definition only takes place if it produces a net gain in welfare for the spender or a profit for the investor. If a government hires an extra worker, that worker’s wages are included in GDP, whereas a private sector hire of a worker has no effect on GDP until that worker produces something. Thus even though the unproductive public sector worker produces a gain in reported GDP, he produces a loss in overall wealth, because productive private activities are sacrificed through higher interest rates to pay for his unproductive public sector existence. As I said, there are lag effects, the new hire will produce a GDP gain in the short-term because of the government-friendly way the accounting is done, but in the longer term the GDP losses will outweigh the gains. ‘Stimulus’ public spending over any but the shortest period produces a negative economic effect.

So what to do? Pure good sense:

The solution is similar in both countries. Britain needs more “austerity” not less, cutting spending in the unproductive sectors of the NHS, green energy and foreign aid. In addition to lowering the deficit, however, it should return some of the savings to the public through tax cuts, with a bias towards middle-income consumers, thereby renewing economic growth. At the same time, it should raise interest rates well above inflation, thereby reducing the subsidies to the banking system, restoring returns to Britain’s beleaguered savers, and increasing the availability of small-business finance.

In the United States, tax cuts are less necessary; the priority should be deficit reduction through public spending cuts, especially in eliminating the appallingly wasteful subsidies to agriculture, green energy and, through the tax code, to housing and charities, as well as cutting the country’s global defense commitments down to size. Again, interest rates should be raised, increasing the excessively low savings rate, closing the balance of payments deficit and deflating the dangerous bubbles in stock, bonds and commodities. The result will be a surge in GPP and, more important, in private sector employment.

As I said, there is no contradiction. Once the central functions of government have been carried out on a minimal basis, increasing public spending contracts true output and reducing it increases it. The contrary is an ideological shibboleth of the Keynesians and a statistical illusion of distorted GDP accounting.

It may not be until disaster finally overtakes us all that we will walk away from the Keynesian theory that surrounds us and economic theory will be able to break free of the grip that Keynesian theory has had on policy. But it must come since whatever it might say in our economic texts, the world behaves in an entirely different way.

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