The Keynesian Emperors Have No New Clothes!

The Emperor has no new clothes!    
Image Credit: Wikimedia Commons/Vilhelm Pedersen (1820-1859)

Given all their failures in suggesting successful economic policies around the world, one would have thought Keynesians would have been generally scorned by now, their doctrines almost universally rejected. I remember thinking this back in the late 1970s when stagflation discredited the neo-Keynesians. However, the neo-Keynesians quickly adapted their theories by using the monetarist ideas of Milton Friedman, which indicated changes in aggregate demand due to inflationary expectations. In the process of making such major changes to their theories, the neo-Keynesians became the New Keynesians.

As a result of these changes, the New Keynesians were able to persuade policy makers they still had the most correct explanations for an economy’s behavior. They were able to continue their intellectual dominance, both in universities and in government policy, which they have enjoyed with only short interruptions since the 1930s Great Depression. However, mounting Keynesian policy failures are suggesting the fine intellectual clothing they assume they are wearing is actually leaving them quite naked. Look, Mommy! The Keynesian Emperors have no clothes!

The New Keynesian Ideological Nakedness

I have written about Keynesian theoretical errors in a number of posts, so I will only summarize those errors here. These major errors, together with links to the posts where they are more thoroughly discussed, are the following:

1. Keynesians mistake the chaotic social system that is the economy with a system that can be stimulated with arbitrary government spending. Such government fiscal stimulus programs generally unbalance innumerable supply-demand relationships for various goods and services, which always reduces economic output. See the posts Central Planning for Chaotic Social Systems, How to solve Problems in Chaotic Social Systems, and Chaotic Economies and Adam Smith’s Invisible Hand,
2. Keynesians place less value on maintaining the constant value of money, than on “stimulating” the economy with easy money policies. These kind of monetary policies can greatly weaken two of money’s functions in the economy: to be a store of value, and to be a unit of account. All this is discussed in the posts The Federal Reserve and Monetarism, The Ideal Monetary Policy, Quantitative Easing and Its Effects, Why Have ZIRP and QE Failed?, and Economic Damage Created by the Fed.
3. Keynesians value the increase of aggregate economic demand above the encouragement of savings. Savings, as a deferment of consumption to release economic assets for investment, always is the source for investments. Investments in turn are used to replace worn-out and obsolescent equipment and to increase the country’s productive capacity. This is examined in the posts Quantitative Easing and Its Effects, Why Have ZIRP and QE Failed?, and The Importance of Personal and National Savings.
4. Because taxes are needed to fund government spending programs, Keynesians tend to favor larger tax rates than are optimal for the economy. This subject is explored in the posts Economic Effects of Current Tax Policy; The Ideal Tax Regime – 1; The Rahn Curve and the Way Out of Economic Peril; The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes; and Big Corporations Abandoning the U.S. at an Increasing Rate.

Some of the evidence of the counterproductive effects of Keynesian policies can be seen in the very low U.S. growth rates since the end of the Great Recession. Despite all that was spent on the fiscal stimulus of Obama’s American Recovery and Reinvestment Act of 2009 ($831 billion), despite the almost doubling of the National Debt during the Obama administration (see plot below between 2009 and 2016), and despite almost

eight long years of both short-term and long-term real interest rates held effectively at zero by the Federal Reserve, the U.S. GDP growth has averaged just a little more than two percent during that period.

The recovery from the Great Recession of 2007-2009 has been the worst since the Great Depression of the 1930s, as recorded in the yellow curve of the graph above. If you want to compare the relative efficacies of Keynesian economics versus neoclassical economics, compare Obama’s yellow curve with the blue curve from Ronald Reagan’s administration. Additional evidence is given by the quarterly annualized changes in non-farm employment of several recoveries starting from the beginning of the recessions. Again, compare the steepness of the slope from Reagan’s blue curve versus that of Obama’s red curve.

Some of the latest indications of the very poor quality of our economy are shown in the jobs report from last week. The addition of new jobs each month has been up to now one of the very few bright spots among the economic data. However, in May employers added the fewest new jobs in almost six years. Only 38,000 new jobs, the fewest since September 2010, were added, many fewer than the the 158,000 non-farm jobs predicted by the economists. In addition, nearly half a million people dropped out of the labor force, decreasing the labor force participation rate by 0.2 percent to 62.6 percent, which is near to its 38 year low. To be sure, some of these dropouts are due to retirements by the baby boom generation, but many have been because of discouraged workers ceasing to look for new jobs.

People Who Have Been Noticing New Keynesian Nakedness Lately

The recent rather disastrous news on new jobs seems to have triggered even more questioning of the Keynesians’ view of reality. For example in The Death of a Virtuous Cycle, Michael Lebowitz quotes Mark Twain to the effect

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

Leibowitz is most concerned by the effect of Keynesian doctrine on savings rates, the source of all investments. In a mature economy like ours, the most important role of investments is to increase productivity, so that we can all enjoy a larger GDP to divide among us. In his essay Leibowitz shows the percent growth of productivity for a number of countries for three different periods: Pre-Crisis 2000-2007, post crisis 2010-2014, and for the past two years, 2014-2016. Almost all of these countries utilize Keynesian policies, with the exception of three (China, Brazil, and Russia) that practice policies even farther to the left. I reproduce his plots below.

Notice how almost all of the changes between pre and post crisis, marked by black dots are negative. Taking the difference between pre crisis and the last two years, the change is even more negative. Leibowitz explains these falls in productivity as due to a long-term drop in the savings rate. To show this for the United States, he plots the savings rate as a percent of disposable income versus time using data from the St. Louis Federal Reserve Economic Database (FRED). This plot is shown below.

Another post questioning the Keynesian world-view is a Wall Street Journal editorial by Marie-Joseé Kravis, What’s Killing Jobs and Stalling the Economy. In this essay Kravis emphasizes economically toxic regulations, including the Dodd-Frank Act regulations and state licensing laws, which poison the economic environment to discourage the formation of new companies. I have discussed the economy-stultifying effects of these regulations in the following posts:

• The Burden of Economic Regulations
• The Debilitating Effects of Obamacare
• Economic Effects of the Dodd-Frank Act
• The EPA. CO2, Mercury Emissions, and “Green” Energy

The Keynesian Protestation About How Fine Their Clothes Are: Secular Stagnation

Of course, the Keynesians themselves will protest they are wearing the very finest in ideological clothing; and if we perceive them as naked, then it is because we are not smart enough to recognize their ideological superiority. However, they are faced with the very same kind of problem the Keynesian economist Alvin Hansen faced in the late 1930s and 1940s: they have to explain why the application of Keynesian policies is not producing good economic results.

When faced with explaining why Franklin Roosevelt’s New Deal was not creating robust growth, Hansen invented the idea of secular stagnation, which said the economy was stagnating because businesses could not find profitable ways to invest and grow the economy. The stagnation was secular because it was long-run and not cyclical. In point of fact he was correct about the problem companies had finding ways to make money by investment; but he assumed it was a market failure, not a failure of government policies as in fact it was. You can read about some of these government failures in Why Did the Great Depression Last so Long?

Faced with exactly the same problem as Hansen, modern day Keynesians are dusting off his old idea to perpetuate the thought that it is market failure, not government failure, causing the problem. In fact this is a problem almost the entire world is facing, which is not surprising since most countries are using Keynesian policies, not free-market policies. Because they believe the stagnation is caused by failures of the free-market, these Keynesians insist the only way to exit secular stagnation is with government stimulus programs — of course. However, since the stagnation actually has been created by government stimulation policies, it is hard for many to buy that the way out is to apply more of the same. To do so would validate Albert Einstein’s definition of insanity.

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