What to Do About Keynesian Secular Stagnation

“I’m here from the government, and I’m here to help!”
Image Credit: FreeImages.com/Daniel Perry

In the preceding post The Keynesian Excuse: Secular Stagnation, I described the Keynesian revival of the secular stagnation idea to explain why Keynesian stimulus programs were not creating robust growth after the Great Recession. In this post I want to show that instead of the mechanisms used by Keynesians to explain continuing stagnation, the more fundamental explanations are government policies creating most of the mechanisms in the Keynesian explanations. If this is the case then much of the cure for secular stagnation could be as simple as eliminating the government programs creating the harm.     

The Causes of Economic Stagnation

At the very end of my last post, I gave a very fundamental reason for not following Keynesian prescriptions for eliminating secular stagnation. Modern economies are very complicated systems with millions of supply and demand relationships between producers and consumers of goods and services. The most fundamental problem any economy must solve is to balance the quantity of a good (or service) at a price the consumer desires with the quantity and price of the good the producer is willing to supply. If there is an imbalance between the consumer’s desired quantity and price with the producer’s, then the law of supply and demand tells us either a surplus or a shortage of the good will result.

If the good’s price is set below the equilibrium market price shown in the figure, the quantity of the good supplied will be less than the amount demanded and there will be a shortage. Many of the goods produced in an economy are intermediate goods used to produce other goods that are either intermediate goods themselves or final goods sent to the consumers. If there is a serious shortage of an intermediate good needed by a company, that company can no longer support all of its factories and workers and must shut down some work lines and lay off some workers.

On the other hand if a good’s price is set above the equilibrium market price, the amount of the good consumers are willing to buy is less than the amount the supplier produces and a surplus must be warehoused. This hurts the supplier in two ways. First, he must pay the costs of warehousing, and second he has expended the costs of producing the warehoused goods with no profit produced. If prices are artificially stuck there by government requirements, the supplier can no longer afford to produce what he has in the past and he must close down production lines and lay off workers.

In a free-market economy with no government intrusions, market forces will drive an initially badly set price back to the equilibrium market price where the supply and demand curves intersect. At this price the quantity demanded is precisely equal to the quantity produced, and the system can continue with no increase in unemployment. The quantity produced at the equilibrium market price is the maximum sustainable production.

Government intrusions into the economy most often have the effect of increasing a company’s production costs so that the price at which the company is willing to produce and sell a given quantity goes up. The entire supply curve is shifted to the right and its new intersection with the unshifted demand curve is at higher price and lower quantity. Production goes down, assembly lines are shut down and workers are layed off.

Government interaction with the economy through monetary policy can similarly be analyzed. For example, if monetary policy creates inflation, the real value of a consumer’s assets decreases and he/she can demand fewer goods. The demand curve shifts to the left to intersect with the supply curve at lower price and lower quantity. In fact the supply curve will also shift to the right towards a higher price for a given quantity since more dollars will be required to produce a particular quantity. This will decrease the quantity at the equilibrium market price even further. In an inflationary environment the velocity of money speeds up as everyone tries to get rid of their money before it loses its value. In a deflationary environment the velocity of money slows down as people try to hang on to their currency to allow its buying power to increase. This shifts the demand curve to the left. In the short-run sticky-prices in a deflationary environment will slow down any shift of the supply curve to place the intersection of the two curves at lower price and lower quantity. Any change in the value of money, inflationary or deflationary, will confuse the price signals between producer and consumer to slow down the system evolution toward a new equilibrium market price. A slower action of Adam Smith’s Invisible Hand then creates an extended period of lower production and higher unemployment.

Most ways in which government interacts with the economy are then destructive to production. If the economy produces less, consumers must be satisfied with less and most people are hurt. If the government continually interacts destructively under the mistaken belief they are actually increasing aggregate demand and thereby production, a secular stagnation of a nature different from that envisioned by the Keynesians results.

Our last big recession, granted the title of the Great Recession, is an excellent example of how government actions, not a free-market failure, created the start of stagnation. The recession itself was created by a combination of a Federal Reserve expansionary monetary policy inflating a housing bubble with government policies mandating the formation of sub-prime mortgages. The secular stagnation that was the “recovery” after the Great Recession has been maintained by a combination of economically unfriendly government regulations with taxes that are equally unfriendly to the economy. To get a sense of how hard the U.S. government has hit businesses with regulations, read The Burden of Economic Regulations; The Debilitating Effects of Obamacare; Economic Effects of the Dodd-Frank Act; and The EPA, CO2, Mercury Emissions, and “Green” Energy. To see how much U.S. taxes make U.S. companies uncompetitive on the world stage and even to some respect here at home, consider the posts Economic Effects of Current Tax Policy, The Ideal Tax Regime – 1, and The First of the BEPS Refugees.

In addition to the sins of the executive and legislative branches of government, we have those of the Federal Reserve. Although in past decades they have been guilty of generating a lot of deflation leading to the Great Depression, or of inflation leading to the stagflation of the 1970s, in recent years they have been able to keep the value of money relatively constant. Instead, through their Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE) program, they have inflated housing and asset bubbles, discouraged national savings, and assisted the executive and legislative branches of government to roll up national debt that has reached 103% of GDP. For a discussion of all this, read Current Economic Effects of the Federal Reserve, Quantitative Easing and Its Effects, Why Have ZIRP and QE Failed?, and Economic Damage Created by the Fed. From the research of Carmen Reinhart and Kenneth Rogoff we know that sovereign debt somewhat greater than 90% of GDP would cause governments to begin crowding corporations out of capital markets to service government debts, thereby causing smaller investments and less GDP growth. With our national debt around 103% of GDP, it would appear it is part of the explanation for our secular stagnation.

How to Start Up Economic Growth

If you are digging a hole, the first step in getting out of the hole is to stop digging. That old nostrum clearly is applicable here. I have already written about how a change to a lower flat tax would stimulate growth in The Ideal Tax Regime – 1, The Ideal Tax Regime – 2, The Rahn Curve and the Way Out of Economic Peril, and The Rahn Curve, Hauser’s Law, the Laffer Curve and Flat Taxes. It was noted in the last post cited that to get the biggest economic benefit from lower flat taxes, the government would also  have to lower its expenditures. The cutting of government spending is such a difficult subject that I will reserve its discussion to a later post.

Then there are all the government regulations that put businesses in strait jackets, making it difficult and more costly for them to make a profit. A very good start there would be to repeal the Dodd-Frank Act. Simultaneously, costs could be greatly reduced not only for companies, but for households as well if Obamacare were repealed and replaced with a more free-market friendly substitute.

Finally, there is the problem of a rogue Federal Reserve’s monetary policy. As I discussed in Whatever Will We Do About the Fed?, the experience of approximately a half-century of Keynesian monetary policies has shown they have helped create a vast array of different economic problems. We should be totally convinced by hard experience now that monetary policy is the wrong tool to use to generate economic growth directly and to lower unemployment. If the Federal Reserve were to limit itself to maintaining a constant value for the dollar with the use of a monetary rule, it would be contributing the most it possibly could to economic prosperity.

The Political Problem

The reforms proposed in the last section amount to huge changes in government and are a great deal for which to ask. They also require a large decentralization of economic power from the federal government to individuals, households, and companies. Because the American Left in general and the Democratic Party in particular see their mission as increasing government’s power to enable it to solve all important social problems, we can expect them to resist all of the proposals I suggested with all of their strength and commitment to the very end.

Because of this situation, a large part of the problem of removing ourselves from secular stagnation is political. Somehow conservatives will have to persuade at least some of our leftward brethren that increasing government power many times is actually counterproductive. In any complicated system, economic or social, this appears to be the case. Try to find a universal solution for a problem, and what often happens is the solution works well for one part of the system, and very badly for other parts. We can see this truth operational in Obamacare: it works well for the uninsured who receive subsidies, but it works very poorly for everyone else. Decentralized approaches to problem solving in systems so complicated that chaos theory is appropriate in describing them tend to work much better. Each part of the system solves its piece of the puzzle, using the solutions of other parts as constraints on its own solution. The solution of the Economic Problem by each component of a free-market separately is of this nature. Then all of the various local solutions can be consistent and coexist. At least as an educational aid in understanding these great truths, the eight years of Obama’s presidency will have been useful.

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