The Free Thinker

If This is the Best Case They Can Make for Keynesianism...

... it must be even wronger than I thought. Krugman writes:

Financial markets are cheering the deal that emerged from Brussels early Thursday morning. Indeed, relative to what could have happened — an acrimonious failure to agree on anything — the fact that European leaders agreed on something, however vague the details and however inadequate it may prove, is a positive development.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States.

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed.

Krugman is conflating two quite different ideas here: (a) that the government (or the central bank) has to bail out banks to prevent a collapse of the financial system, and (b) that most governments need to retrench right now. Not only are the two ideas quite separable-- the government could bail out the banks and increase spending; or it could do neither-- but if anything, they are philosophically opposed. A comprehensive interventionist might advocate both; a libertarian would support neither. TARP is at this point not, I think, especially controversial among economists, so it's interesting that Krugman stakes out an anti-TARP position here. I'm glad of it: I think the anti-TARP view deserves more of a hearing than it has gotten. But how he would justify conflating TARP and austerity, I have no idea.

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks.

Some economists weren’t convinced. One caustic critic referred to claims about the expansionary effects of austerity as amounting to belief in the “confidence fairy.” O.K., that was me.

But the doctrine has, nonetheless, been extremely influential. Expansionary austerity, in particular, has been championed both by Republicans in Congress and by the European Central Bank, which last year urged all European governments — not just those in fiscal distress — to engage in “fiscal consolidation.”

And when David Cameron became Britain’s prime minster last year, he immediately embarked on a program of spending cuts in the belief that this would actually boost the economy — a decision that was greeted with fawning praise by many American pundits.

Now, however, the results are in, and the picture isn’t pretty.

This is ridiculous. First, one distinction which it's essential to make is that between (a) countries that could have borrowed more, such as the United States, at least in the short run, or Germany; and (b) countries that lost access to financing or were on the verge of doing so, like Greece, Italy, Portugal, Spain, and Ireland. The latter were compelled to adopt austerity, not on their own terms but on those imposed by the markets, and the sovereign debt crisis hurt them in other ways too. The former had flexibility to design austerity in the way that would do them the least harm. So it's fair to use the example of Britain, but not Greece, Latvia, etc.

Second, the results are certainly not in-- yet. The European debt crisis seems to have been resolved, finally, but only just. There's been no time for it to take effect. And in general, austerity is a policy oriented towards the longer term. One doesn't expect it to help over the long term, but over three, five, ten years. In the East Asian crisis of 1998, austerity was pursued, and the recession was very deep and painful; but there was a strong rebound a couple of years later; in Japan after the crash of 1989, Keynesian stimulus was pursued, and the recession became more or less permanent.

It would be much more reasonable to say that "the results are in" on the path that was taken in America, namely, not-austerity, but Keynesian stimulus, "and it ain't pretty." Stimulus has had more time to work. The European sovereign debt crisis is much less of an issue here. And Keynesian stimulus is supposed to work in the short run; that's the whole point. Of course, Krugman claims that America has pursued austerity, but that just underscores the uselessness of this conceptual framework. With deficit spending at 10% of GDP for three years, this is as Keynesian a fiscal policy as we've had in decades. If we were deficit-spending 20% of GDP and it didn't work, the Keynesians could always say, hey, it should have been 30%. Of course, the Keynesians can also deny that it didn't work: they can say it did work, because things would have been even worse. If they were worse, they can say they would have been even worse than that. If we were deficit-spending 20% and unemployment were 15% instead of 9%, well, they could say that if we had been deficit-spending only 10% of GDP, unemployment would have been 20%. Why they expect anyone should believe their counter-factuals when none of them foresaw the crisis is a mystery. More conservative, free-marketeer, rational-expectations type economists are more epistemically modest. All we know is that the economy has a natural tendency towards full employment, and the best bet is that if policy had been neutral (admittedly that's hard to define) it would probably have reverted to trend (admittedly that's also hard to define) in a few years. By that standard, Keynesian stimulus seems to have made things worse, and certainly hasn't helped much; and the marginal effect of Keynesian stimulus would probably have been even more harmful, since the marginal benefit of just about anything falls, and the marginal cost rises, as you get more of it. But that's just the best guess.

Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared.

Maybe the most telling thing is what now passes for a success story. A few months ago various pundits began hailing the achievements of Latvia, which in the aftermath of a terrible recession, nonetheless, managed to reduce its budget deficit and convince markets that it was fiscally sound. That was, indeed, impressive, but it came at the cost of 16 percent unemployment and an economy that, while finally growing, is still 18 percent smaller than it was before the crisis.

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different.

If you’ve been reading accounts of the financial crisis, or watching film treatments like the excellent “Inside Job,” you know that Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position.

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver.

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph.

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

"Iceland let the banks go bust and expanded its social safety net." OK. But far more importantly, to-the-exclusion-of-everything-else importantly, Iceland has a floating currency and could devalue. Real wages could fall. For a tiny economy like Iceland's, trade is crucial. We always knew that improving competitiveness by devaluation can help a lot in a crisis.The East Asians did it in 1998, too. That's monetarism, not Keynesianism.

One supposes Krugman would use the best available arguments in favor of "the path not taken." If this is it, I was right to be dismissive.

Keynes the Heretic, 2

It can be unfair to take someone's most famous dicta out of context and rebut them. But then, Keynes triumphed partly through clever soundbites. For example, consider two of them.

1. "In the long run, we are all dead."

This claim is false.

What could I possibly mean by that?

I do not mean, here, that we shall all be resurrected at the last day, though in another context I would say so. Rather, one must understand how "long run" and "short run" are used in economics. Long run means a time period over which all factors can be adjusted. For example, it might refer to the time period over which wages, or the capital stock, can equilibrate after a shock. In the short run, something is fixed. For example, one might say that short-run supply is upward-sloping, but long-run supply is flat, meaning that in the short run, entrepreneurs cannot adjust their capital stocks, so they will expand labor only and produce inefficiently, but in the long run entrepeneurs can get capital and labor right.

Estimates of the short run tend to be two years or less; of the long run, five years or more, with 2-5 years sometimes vaguely called the "medim run." Of course, this depends on the particularly characteristics of a given market. But a period of say, twenty years, would always be called the long run. Well, guess what? In twenty years, most of us will still be alive.

The serious point is that "in the long run, we're all dead" is used as an excuse for focusing on the short run. The rebuttal "no, in the long run, most of us are still alive" might serve as a useful reminder of where economic policy should really focus.

Possibly there was a dark double entendre here. Living in a time of revolutionary turmoil, perhaps Keynes half-meant: "In the long run, if we don't give people jobs soon, there will be a communist revolution, and I and all the other bourgeois capitalists will end up in front of a firing squad. We need policies that can ease the short-run pain long enough to avert revolution, and never mind the ultimate cost." OK, but if that's what Keynes meant, why is he so influential now, when capitalist legitimacy is secure?

2. "When the facts change, I change my mind. What do you do, sir?"

It is true only in a superficial and misleading sense that people should change their minds when the facts change. If the light changes from green to red, I change my belief from "The light is green" to "The light is red." But the two beliefs are not really contradictory. We might illustrate this by adding an implicit time-qualifier to each statement, so that my beliefs are (a) "The light is green at time t1" and (b) "The light is red at time t2." And of course, I do not abandon belief (a) when belief (b) appears.

So it is not always the case that one should change one's mind when the facts change. Of course, if you have theories that make predictions extending into the future, and if the future falsifies those predictions, you should modify or abandon those theories. It is a mark of a good theory, however, that it does not need to be modified or changed when new facts appears, for it has anticipated them, or at least, it has not anticipated the contrary.

The epistemology of this Keynesian dictum, then, is irresponsible and complacent. It suggests a person who is always inventing new theories to fit new facts, and discarding them as easily, and feeling no compunction about it. Theorists must aim higher than that.

While Keynes often appealed to "the facts" in order to rebut the classical economists, it is naive to think there are facts without theory. The raw data of experience is always interpreted through the lens of theories, and a person who thinks he relies on "just the facts" is merely a person too naive to recognize that he uses theories, and therefore unable to think critically about the theories he is using. Keynes seems sometimes to go astray because of this just-the-facts fallacy. For example, the concept of "propensity to consume," plays an important role in Keynesian theory, tacitly supposes that consumption is a function of income alone. A theorist starting from individual rationality would know better, and Milton Friedman and others later showed that consumption depends mainly on lifetime rather than current income.

Keynes the Heretic

J.M. Keynes' admiring biographer, Robert Skidelsky, writes in Return of the Master:

In my biography of Keynes I called him an 'unusual economist.' I would now go further. Deep down, he was not an economist at all. Of course, he could 'do' economics-- and with the best. He put on the mask of an economist to gain authority, just as he put on dark suits and homburgs for life in the City. But he did not believe in the system of ideas by which economists lived, and still live; he did not worship at the temple; he was a heretic who learned how to play the game. In former times he would have been forced to recant, perhaps burnt at the stake. As it was, the freedoms of the exigencies of his times enabled him to force himself on his church. Only a person of colossal self-confidence, outstanding intellect and passionate concern for his countrymen and humankind could have set himself the task of rewriting a large chunk of the Western intellectual tradition. Yet this is what Keynes set out to do. One can only marvel that he got as far as he did. He mesmerized and fascinated his contemporaries; for thirty years after his death they lived in his intellectual and moral afterglow. But to the technicians who inherited his mantle his ideas seemed strangely alien to the main themes of their subject. They tried to assimilate them, but found it difficult and made a mess of it; and the next generation gave them up altogether. Orthodoxy won out; the economic temple was shaken, but still stood.

I find this very astute, though my attitude towards it a bit different. I might substitute "blinding egoism" for "colossal self-confidence," and it was a crisis of self-confidence, rather than the "freedom" of his times, which gave Keynes his opening. "Burnt at the stake" is gratuitous hyperbole: orthodoxies rarely do such things to heretics; I am almost tempted to say that genuine orthodoxies never do; certainly orthodox economists never have. It is far more typical for heretics to burn orthodox at the stake. This claim will be opaque to the typical modern person as regards the history of religion, but it is obvious enough in economics, where all the ideologically motivated murder has been the work of disciples of heretics like Marx, and never of Hayekian free-marketeers. But the word "heretic" is right on. "Heresiarch" would be even better, though perhaps general audiences would not understand it.

Let me draw attention to the fact that there is such a thing as "Keynesian economics," but one never (or hardly ever) speaks of "Marshallian economics" after Alfred Marshall, "Friedmanian economics" after Milton Friedman, "Arrovian economics" after Kenneth Arrow, "Fisherian economics" after Irving Fisher, or even "Smithian economics" after Adam Smith; Frank Knight, David Ricardo, J.S. Mill, Gary Becker, Francis Edgeworth, William Stanley Jevons, John von Neumann, Vilfredo Pareto, and Robert Lucas are others who I think shrewd insiders would probably rank as equal in brilliance with Keynes. (Actually it's subtler than that; some really informed people would probably rank them much superior, while many economists would give Keynes a small edge in deference to convention, but anyway. There is one other "economist," if he deserves the name, that has a school named after him: Karl Marx. But Karl Marx was so thoroughly wrong, and by now everyone knows it, that economists just ignore him. Keynes still has influence.)

Is it just that Keynes is more famous? I don't think so. It's that the most important contributions of Smith, Marshall, Fisher, Knight, Ricardo, Edgeworth, etc. are just mainstream economics. Their ideas were often very original. But one may say they fit into the existing framework of economic thought, and their ideas are now thought without reference to their originators. I think the heart of the matter is this: their ideas made sense, and that was what made them orthodox, for that is what an orthodoxy does, it makes sense. It may insist on certain mysteries (in economics the word "assumptions" is sometimes an allusion to these), but it does not force faulty logic on anyone. For that matter, it does not force its mysteries on anyone either. Frank Knight is an interesting case here, for he, too, was an irreverent and thorough skeptic about homo economicus, a radical who urged people (sarcastically?) to vote Communist, yet because of his humility and discipline he remained a representative of orthodoxy, the teacher of Milton Friedman, George Stigler, James Buchanan and Paul Samuelson.

Skidelsky said that Keynes' successors "tried to assimilate [his ideas], but found it difficult and made a mess of it." Not exactly. Keynes' ideas themselves were a mess. Hicks, Samuelson, and others made an order of them, to some extent; they codified and clarified and formulated and explained; but in the end this intellectual edifice dissolved. It was the proverbial house built on sand, or as economists sometimes say, a theory built without microfoundations. "New Keynesians" like Greg Mankiw salvaged what was worth salvaging; reactionary Keynesians today like Paul Krugman, Joseph Stiglitz, or George Akerlof are merely using Keynes' still-great name as cover for arrogant and politically-motivated revisionisms that would not stand up to critical scrutiny without it. The economics profession, I aver, simply responded to Keynes in the wrong way. It treated him as an oracle when it should have treated him as a provocateur.

I plan to back these claims up with a series of quotes from the General Theory (but I might not follow through, since there is always other business). But here's one to start with (from p. 164 of my edition):

For my own part I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principles I have described above, will be too great to be offset by any practicable changes in the rate of interest.

So essentially, Keynes seems to be advocating state control of the commanding heights of the economy. The government, not the private sector, should build factories. Why? Because the volatility of financial markets makes them unsuitable for allocating capital to its most productive uses. An economist as brilliant as Keynes is reputed to be would know better than to write this. Many countries have tried policies a bit like this since, especially in the Communist bloc and the Third World. The results are uniformly wretched: the capital is wasted, the products are lousy. Hayek, Mises, or I suppose Frank Knight could have guessed this in advance. They knew that the state is certainly not in a position to determine the best uses to which capital can be put; it lacks the data, which is fundamentally the subjective experience of consumers, and is revealed by the response of budget-constrained consumers to the price mechanism, and no other way; and anyway, it lacks the incentives to manage capital well. Meanwhile, Keynes much exaggerated the inefficiency of private financial markets. Indeed, I would be surprised if any important economist today would endorse this passage.

Keynesianism on Crack

"Why the President Must Come Up with Demand-Side Solutions, and Not Go Over to the Supply Side" (Robert Reich)

The White House is mulling a temporary cut in the payroll taxes businesses pay on wages. White House advisors figure this may appeal to Republican lawmakers who have been discussing the same idea. It would, in essence, match the 2 percent reduction in employee contributions to payroll taxes this year, enacted as part of the deal to extend the Bush tax cuts.

Other ideas under consideration at the White House include a corporate tax cut, accompanied by the closing of some corporate tax loopholes.

Can we get real for a moment? Businesses don't need more financial incentives. They're already sitting on a vast cash horde [sic] estimated to be upwards of $1.6 trillion. Besides, large and middle-sized companies are having no difficulty getting loans at bargain-basement rates, courtesy of the Fed.

In consequence, businesses are already spending as much as they can justify economically. Almost two-thirds of the measly growth in the economy so far this year has come from businesses rebuilding their inventories. But without more consumer spending, there's they won't spend more. A robust economy can't be built on inventory replacements.

What Robert Reich seems never to have imagined is that the market has an ability to adjust naturally. Even when demand is not growing for the time being, there is still an immense amount of it out there. If companies have so much cash, they could use it to invest and compete for market share, and earn a better return on capital than the zero or less that they get on cash. This would boost demand and create jobs. If this is not happening-- if companies prefer hoarding their cash to investing it-- we can infer that there's something that makes businesses doubtful about whether they will enjoy the returns on their investment.  What this might be is not far to seek.  We're running deficits of 10% of GDP.  The government has no plan to bring this under control.  There seems to be a bipartisan refusal to contemplate raising taxes on the middle class.  Instead, two big tax hikes on the rich-- for ObamaCare, and the expiration of the Bush tax cuts-- are already scheduled.  Meanwhile, ObamaCare is leading to a sort of breakdown in the rule of law as Obama keeps issuing exemptions to favored states and companies in order to mitigate the damage done by the law, and also in the form of bailouts and other forms of intervention.  This creates new methods of de facto confiscation by the government: not just taxes and regulation, but political favors to competitors.  Where is all this heading?  Until that picture becomes clearer, it's best to keep one's money is as liquid a form as possible.

Supply-side economics doesn't work. It's been tried for thirty years, to no avail. And now, when our continuing economic crisis is so palpably being driven by inadequate demand, it's more bogus than ever.

What on earth is Reich talking about?  The past thirty years (before 2009) have been widely lauded as the "Great Moderation," during which we enjoyed consistently stable prices and low unemployment.  They may not have been paradise, they may not have been the best we can do, but they were certainly far better than what we have now.  We need to get back to that.  If Reich is writing off the last thirty years as "to no avail," what does he want, and why does he think it's possible?  Even Keynesians are supposed to understand that their prescriptions apply only in the short run.  Do Keynesians denounce such parodies of their doctrines?

Pundits on the right are converging on a story. Here's John Podhoretz:

By now it is clear to everyone that the Obama administration bungled the 2009 stimulus package. The dispute now is over the reasons for its failure. The conventional wisdom is coalescing around a view crystallized in a column by Mr. Conventional Wisdom himself, Charlie Cook of the National Journal: “The administration’s initial response, the much-maligned economic-stimulus package, was far too modest and unfocused.”

Cook is a rational analyst, so it is striking that he is able to advance an argument that is, on its face, nothing short of demented. The idea that the 2009 stimulus, which cost $840 billion, could have been less “modest” and more “focused” does violence to the facts of very recent American history and to the arugments made for the stimulus by its advocates at the time.

Even at its “far too modest” size, the stimulus was, by leagues, the costliest such effort in American history. Its astounding price tag was justified during the debate over its passage by the fact that there was a genuine economic emergency that had to be addressed. And the mere fact of addressing it with enormous public resources was, we were told, enough to do the trick almost on its own. The central point of taking emergency measures, we were told, was precisely not to focus them but to cause them to wash over the economy as a whole.

How many times during that emergency were we reminded of the supposed wisdom of John Maynard Keynes, who wrote in 1930 that it was enough to employ a man to perform any task at hand to create the conditions for macroeconomic growth? Simply “to dig holes in the ground,” Keynes wrote, “paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.” This is the famous “multiplier effect” we also heard so much about, according to which $1 in government spending would blossom into $3 of value for the entire economy. In effect, we were told by the most enthusiastic believers in the magic of the multiplier effect, that for $840 billion in spending, we’d get more than $2 trillion in economic activity.

It’s also important to remember that the stimulus wasn’t the first bite at the apple... The notion that Congress could have passed a stimulus bill twice the size of the one that did—Paul Krugman’s idea—was then and is now preposterous. Obama’s stimulus was as large as it could possibly have been, and the parlous results indicate it was vastly larger than it should have been.

The growing consensus is that Obama’s economic policies have failed, and precisely in the ways that those skeptical of the stimulus predicted.

And Martin Feldstein is blunt but, I think, fair:

The policies of the Obama administration have led to the weak condition of the American economy. Growth during the coming year will be subpar at best, leaving high or rising levels of unemployment and underemployment.

The drop in GDP growth to just 1.8% in the first quarter of 2011, from 3.1% in the final quarter of last year, understates the extent of the decline. Two-thirds of that 1.8% went into business inventories rather than sales to consumers or other final buyers. This means that final sales growth was at an annual rate of just 0.6% and the actual quarterly increase was just 0.15%—dangerously close to no rise at all. A sustained expansion cannot be built on inventory investment. It takes final sales to induce businesses to hire and to invest.

The picture is even gloomier if we look in more detail...

How has the Obama administration contributed to this failure to achieve a robust and sustainable recovery?

The administration's most obvious failure was its misguided fiscal policies: the cash-for-clunkers subsidy for car buyers, the tax credit for first-time home buyers, and the $830 billion "stimulus" package. Cash-for-clunkers gave a temporary boost to motor-vehicle production but had no lasting impact on the economy. The home-buyer credit stimulated the demand for homes only temporarily.

As for the "stimulus" package, both its size and structure were inadequate to offset the enormous decline in aggregate demand. The fall in household wealth by the end of 2008 reduced the annual level of consumer spending by more than $500 billion. The drop in home building subtracted another $200 billion from GDP. The total GDP shortfall was therefore more than $700 billion. The Obama stimulus package that started at less than $300 billion in 2009 and reached a maximum of $400 billion in 2010 wouldn't have been big enough to fill the $700 billion annual GDP gap even if every dollar of the stimulus raised GDP by a dollar.

In fact, each dollar of extra deficit added much less than a dollar to GDP. Experience shows that the most cost-effective form of temporary fiscal stimulus is direct government spending. The most obvious way to achieve that in 2009 was to repair and replace the military equipment used in Iraq and Afghanistan that would otherwise have to be done in the future. But the Obama stimulus had nothing for the Defense Department. Instead, President Obama allowed the Democratic leadership in Congress to design a hodgepodge package of transfers to state and local governments, increased transfers to individuals, temporary tax cuts for lower-income taxpayers, etc. So we got a bigger deficit without economic growth.

A second cause of the continued economic weakness is the president's emphasis on increasing tax rates. Although Mr. Obama grudgingly agreed to continue the Bush tax cuts for 2011 and 2012, his budget this year repeated his call for higher tax rates on upper-income individuals and multinational corporations. With that higher-tax cloud hanging over them, it is not surprising that individuals and businesses do not make the entrepreneurial investments and business expansions that would cause a solid recovery.

A third problem stems from the administration's lack of an explicit plan to deal with future budget deficits and with the exploding national debt. This creates uncertainty about future tax increases and interest rates that impedes spending by households and investment by businesses. The national debt has jumped to 69% of GDP this year, from 40% in 2008. It is projected by the Congressional Budget Office to reach more than 85% by the end of the decade, and to keep rising after that. The reality is even worse since ObamaCare alone will cost more than $1 trillion in its first 10 years. The president's boast that his health legislation would not "add a dime" to the national debt was possible only by combining that increased spending with proposed new taxes and with projected cuts in Medicare spending that will never occur...

The economy will continue to suffer until there is a coherent and favorable economic policy. That means bringing long-term deficits under control without raising marginal tax rates—by cutting government outlays and by limiting the tax expenditures that substitute for direct government spending. It means lower tax rates on businesses and individuals to spur entrepreneurship and investment. And it means reforming Social Security and Medicare to protect the living standards of future retirees while limiting the cost to future taxpayers.

Martin Feldstein seems to have more faith in stimulus in general than Podhoretz, but thinks the "multiplier" is less than one (or less than zero, depending on how you define it). Which also looks bad for Keynesian theory. And Jonah Goldberg piles on:

"Now, my administration has a job to do as well, and that job is to get this economy back on its feet," President Barack Obama declared on July 14, 2009, in Warren, Mich. "That's my job, and it's a job I gladly accept. I love these folks who helped get us in this mess and then suddenly say, well, this is Obama's economy. That's fine. Give it to me."

OK. It's yours.

The unemployment rate then was 9.5 percent. It's now 9.1 percent, well above the 8 percent cap that the administration advisers projected under the stimulus bill. But that's not the amazing part. According to a White House report written by economic advisers Jared Bernstein and Christina Romer in January 2009 in support of the bill, if we had passed no stimulus package at all, the unemployment rate would have topped out at around 8.8 percent in the last quarter of 2010.

If only.

Instead, we got Obama's vital "investments." Since his speech in Warren, we've spent another $2.8 trillion in borrowed money. Presumably, we could have cut the unemployment rate by four-tenths of a percentage point more cheaply than that?

Meanwhile, we've accrued a total of $3.7 trillion in debt on Obama's watch, while losing 2.8 million jobs. That doesn't sound ideal either.

But what do I know?

The more salient point is that Obama acts like he knows everything. From Day One, this White House has been cocksure about how to get us out of the economic ditch. In every major relevant speech, Obama has stuck with a consistent message: We know what to do and the Republicans don't. "I will not sacrifice the core investments we need to grow and create jobs," Obama insisted yet again in his April budget speech...

No president "runs" the U.S. economy, but this president talks like he does more than any I can remember. And yet, none of his economic promises or predictions has panned out.

Obama deserves all this for his failure to deal with the long-term budget deficit if nothing else. But Keynesian theory also deserves it. In particular, the "multiplier" idea needs to bite the dust. Keynes argued that if the government spends $1, someone will get that $1, save say 10%, spend $0.90, someone else will get that $0.90, save say 10%, spend $0.81, so the total spending will be a lot more more than the original $1. Wrong. (a) Savings don't just disappear, in a healthy economy they will be invested. (b) Savings rates are endogenous, and if people see that the government is borrowing on an enormous scale, they'll save more to offset the anticipated tax increases. In the short run, since some people are credit-constrained, more government spending may raise total spending, in the short run. But it might leave it constant, or even-- because other people, who are not credit-constrained, anticipate paying more than their fair share of the extra future taxes and raise savings by more than the government raises spending-- reduce it. In any event it is not likely to raise it by much. And in the long run it just distorts the economy and makes us poorer. If there are ways to spend that raise long-run GDP, fair enough. It might be a good idea to concentrate that spending in bad times. But generally, fiscal stimulus just doesn't work. We shouldn't really have expected it to.

THE HILL POLL: Independents prefer cutting the deficit to spending on jobs

This headline presumes Keynesian economics, that is, it presumes that government spending creates jobs. But Keynesian economics is theoretically and empirically weak. It's just as likely that Ricardian equivalence holds, and that cutting spending, and thus reassuring private investors that future tax or inflation rises can be avoided, will lead to the creation of net jobs.

The public is correct in seeing the last two years of slump as proof that stimulus doesn't work.

Jonathan Alter:

The GOP plan for job creation: cutting taxes and deregulation. We tried that in 2001 only to experience the weakest decade of job growth since the ’30s.

"The weakest decade of job growth since the '30s" is misleading. In 2000, employment was super high. It could ease a bit without causing a lot of economic pain. The fact that unemployment stayed low for most of the '00s suggests that not everyone who took jobs in the late 1990s, when some probably thought they'd have few other chances to get good jobs, really wanted them. Once it started to look like full employment was the new normal, some people may have decided they didn't need to work just then so badly after all, particularly at a time when household net worth was rising.

The main thing, though, is spending. Whether taxes are high or low matters much less than whether spending is high or low. If the government cuts taxes while raising spending, it soaks up capital that could have gone to private companies which are much more efficient about making goods and creating jobs. The key to the 1990s prosperity was government spending discipline. The trouble with the '00s was first the crescendo, then the explosion, of government spending. What the US economy needs is (a) open borders, (b) spending cuts, and (c) easy money (to reverse the deflation that we've suffered in the past couple of years, if housing prices are taken into account), in that order of importance.

How Obama Can Save His Presidency

So the new conventional wisdom seems to be that Obama's presidency is on the road to, not disaster, but failure.  He has failed to persuade the country of the merits of his health care reform, and a decline in the polls and a series of setbacks at the ballot box now make it seem likelier than not that the reform will not pass, despite the huge preponderance the Democrats have enjoyed since 2008.  He and the Democratic Congress passed a bill usually mis-described as a "stimulus" bill, basically a big-government boondoggle that attempted to micromanage the economy back to health.  A year later we're still in the worst recession since World War II, and the public seems to be drawing the reasonable conclusion that the stimulus was a failure.  Of course, you can always claim, as Obama apologists must, that we would have been even worse off without the "stimulus," but an argument that depends on a counter-factual claim that something that hasn't happened in decades (an even worse recession) would have happened, is a weak argument.  Sometimes an appeal is made to historical analogy with the Great Depression, but the interpretation of the Great Depression which this historical analogy relies on-- the free-market economy spontaneously wrecked itself; Hoover the small-government free-marketeer let it plunge into depression; FDR the interventionist got us out of depression-- is a fantasy.  In the real world, the main damage in the 1930s was done by contractionary monetary policy; FDR helped put a floor under the fall with better bank regulation; but the interventionism of both Hoover and Roosevelt consistently made matters worse; and FDR didn't get us out of the depression, though there was a partial recovery from 1933-37 which was erased by a new crash in 1937-38; in fact, employment and GDP remained depressed until WWII.  Since fiscal stimulus didn't prevent, or get us out of, depression in the 1930s, the analogy provides no basis for the claim that the absence of fiscal stimulus would have led to depression today.  If policy has played a role in the limited recovery or at least stabilization which has occurred at all-- and it is tenable that the economy would have stabilized or even rebounded if politicians had done nothing-- the policies that have helped are (a) the TARP, the initiative by Bush, and Paulsen, that might have saved the banks, and (b) the Fed's expansion of the money supply.  (If Scott Sumner is correct that Fed policy has really been contractionary-- I'm inclined to think he is-- then with a better Fed we might have largely avoided this recession altogether; but that has little to do with Obama.)

Voters seem to have concluded that Obama's big-government push is hurting the economy, and they are probably right.  A vague agenda of "hope" and "change" may be smart politics (at a time when disillusionment with the Bush legacy was widespread, but the grounds for alienation are various and incompatible, so that only a "blank screen" for people to project their contradictory hopes onto is the only way that the alienated majority could be made into a transient electoral bloc) but it is bad macroeconomic management, because it creates gratuitous uncertainty.  It made sense for business to put off investment until they knew whether health care reform would raise the costs of employing people, or whether cap-and-trade would raise the costs of manufacturing stuff.  And it would be nice to get some idea how the US plans to close its gaping fiscal deficit, because if it's going to do so by confiscatory taxes on the rich, it doesn't make any sense for the people who are in a position to get the economy moving to work hard and take risks to be, sometime in the future, the rich who pay the confiscatory taxes.  Keynesianism has an inherent populist appeal: people need jobs, so the government should go out and make them.  It's Bastiat's broken-window fallacy writ large.  Some ordinary people, and lots of journalists, have fallen for the "stimulus" fallacy; under the label "jobs bill" a new round of stimulus may get more public support.  But it now looks as if the American people have seen through Obama's misguided economic policies and will sharply curtail or overthrow the Democratic majorities in Congress, thus killing most of Obama's agenda politically.  Clinton encountered a similar setback and responded by becoming a born-again Eisenhower Republican.  But this was easier for Clinton because he had really been a centrist all along.  Obama seems to be a genuine man of the left, even perhaps rather far left.  He is not a fanatic or a dogmatist-- he is too much of a lightweight for that-- but idealism is part of his character and part of his motive for holding public office.  He seems to regard the mere hurly-burly of politics with distaste, even if he engages in it. 

So here's my suggestion for how Obama can save his presidency.  Forget health care: dropping that would be a good way to signal to the American people that he's listening to them.  Forget stimulus: anything he does in the direction of more government spending will just confirm the growing negative image of him.  He needs to start with something new.  Something that is consistent with liberal right-mindedness, yet which is not a big-government boondoggle.  Something that will enable him to make an asset again of his appealing life story, and to translate his personal appeal into a political agenda.  Something that has a bipartisan appeal, which he can call on leading Republicans to support, and have a right to expect their cooperation.  Something that clearly expands freedom rather than narrows it.  Something that can revive the economy.  Something that can shore up our long-term fiscal position.  Something that is patriotic and in tune with America's deepest traditions.  Something that is important enough to shape America for decades, and to justify all the enthusiasm of Obama's supporters in 2008.  Something that can expand the base of the Democratic party.  Something that can repair America's tarnished image in the world.

That something is immigration reform.  It has the merit of being a complete change of subject, of leaving behind the ruins of Obama's first year in office and starting fresh.  Obama could hardly be accused of left-wing extremism, for he would be doing something Bush tried to do.  Moreover, he could probably count on the support of his old rival, John McCain.  If successful, an immigration reform enacted by Obama would probably win the loyalty of many Hispanics to the Democratic Party for years to come.  It would revive the economy by buoying housing prices with new demand.  It would also fuel investment, as immigrants are disproportionately entrepreneurial.  It would be very popular abroad, since its most immediate beneficiaries are foreigners.  Its egalitarianism would please liberals, its expansion of freedom would appeal to libertarians and conservatives of conscience.  It would be highly fitting for Obama, the first black president, the son of an immigrant himself, to enact it, and it would give him a way to make a virtue out of his habit of talking about himself all the time.  To nasty suggestions that immigration will lead to more crime or will somehow debase the culture, he could respond in a personal way by saying that he understood that some people felt threatened by people like himself who looked different and had roots in faraway places, but that he had learned from his own experience how people of all races and all faiths could participate in the American dream.  It would be not only relevant but humble, as he could put himslf on a level with the despised "illegal immigrant" of nativist legend, shifty-eyed and criminal and hostile to American culture, and be the incarnate refutation of it.  (The appeal would not be very compelling as a logical matter but I think it would work, and anyway he could back it up with plenty of hard facts as needed, as facts are always against the nativists in these disputes.)

I think it would work, even politically.  He'd renew vague idealists' support for him.  He'd alienate some constituencies, e.g., the unions, but engaging in fights with some parts of his coalition would make him look brave and principled and serious.  He'd give his fans abroad a reason to put his halo back on him.  He'd give Democrats a reason to hope for their future.  The Democrats might still lose in 2010, but after successful cooperation with, or an overreach by, a Republican Congress, voters might look favorably on Obama in 2012.  Even if he failed-- in passing immigration reform, or in getting re-elected-- he'd at least seem, in retrospect, a noble figure, rather than an inscrutable fad.

Publicity for "Economic Contractions in the United States: A Failure of Government"

From my co-author Charles Rowley, in the Daily Telegraph: "Adam Smith would not be optimistic in today's economic world: Adam Smith once commented that "there is a great deal of ruin in a nation". He meant that bungling governments imposed only a limited check on the economic performance of a Great Nation."  This article accompanies the launch of Economic Contractions in the United States.  For regular readers of this blog I'll stop to point out my... differences of emphasis... as appropriate:

As Nathanael Smith and I show in our study of US economic contractions, Adam Smith would be much less sanguine were he confronted by today's financial crisis and the US government's response. Indeed, it is not impossible that the US will experience the kind of economic collapse from first- to third-world status experienced by Argentina under the national socialist governance of Juan Peron.

"Not impossible" is so weak that it makes the claim innocuous, I suppose, but this seems like an exaggeration, and it seems to conflict with the 7th chapter of Economic Contractions, where we predict that "profligate deficit-spending and interventionism" will produce disillusionment and a conservative revival (p. 97)-- a prediction that events seem to be bearing out.

The US economy suffers from a growing culture of indebtedness that has increasingly contaminated the federal government since 2001 and has spilled over dramatically into private household behaviour. The combination of the ill-conceived fiscal-furnace fired by President Bush and the US Congress and the reckless monetary-furnace fired by Alan Greenspan and Ben Bernanke throughout the period 2001-2007, created unsustainable housing market and stock market bubbles whose collapse brought on the financial crisis and economic contraction of 2008-2009.

I would put the charge in more measured terms.  Fiscal policy under George W. Bush was less expansionary (smaller deficits as a share of GDP) than under Ronald Reagan, even though the US was at war in the Bush years and not in the Reagan years.  (At a time when Obama and the Democratic Congress are redefining "reckless" in the upward direction at a rate of $100 billion a month or so, it seems strange to use the term for the Bush administration, though the Bush administration should certainly have known better.)   And while interest rates stayed low in 2003-04 for too long after recovery had begun, they then rose steeply, so "throughout the period 2001-2007" seems to make the charge too broad.  Even the low interest rates of 2003-04 seem more like a serious technical mistake combined with having the wrong Fed policy rules-- housing should have been included in the CPI-- than "reckless."  And dating the problems to 2003-04 would seem to absolve Bernanke and concentrate responsibility on Greenspan. 

What led to the bubble was that (a) fiscal and monetary policy were expansionary at the same time for the first time since the 1970s, and (b) house prices were-- we argue, mistakenly-- excluded from the price index, causing the Fed to see "low" inflation at a time when house prices were rising at well over 5% per year.  What I find ironic is that, in a sense, the crisis is Osama bin Laden's revenge.  Bin Laden wanted to deal a devastating blow to the US economy.  Determined to deprive him of this victory, Bush and Greenspan adopted expansionary fiscal and monetary policies that lifted the economy out of what could, and maybe should, have been a deep recession in 2001.  As a result, they inflated a debt bubble and made the next crisis sooner and deeper.  Fortunately, al Qaeda was ruined by the war in Iraq, so bin Laden's victory is Pyrrhic.  But if the government had let the 2001 recession play itself out naturally, there might not have been any 2008 crisis.

The policy responses to the debt bubble demonstrate crude political consideration rather than economic understanding. If excessive government indebtedness is a major source of the problem, why increase the government debt? Why encourage households to go yet further into debt?

The prognosis is catastrophic if projected government policies are not cut back. According to the White House's own estimates, the federal budget deficit in 2009 will be $1.6 trillion, approximately 11.2pc of the overall economy, the highest on record since the end of the Second World War. In 2019, the national debt will represent 76.5pc of the US national economy, the highest proportion since just after the Second World War. In such circumstances, the international reserve status of the US dollar will not survive. As it fades, so interest rates on government securities will rise and the real burden of servicing the debt will increase. In such circumstances, the US economy will teeter on the edge of a black hole.

Hmm... why bring in "the international reserve status of the US dollar?"  I don't remember anything about that in the monograph.  Do we have-- does anyone have-- a theory relating government debt to the viability of a reserve currency?  Personally, if there were some way to transition out of a dollar regime without global chaos, I think it might be nice not to own the world's reserve currency: I think being able to print the world's reserve currency causes a form of "Dutch disease," undermining the competitiveness of our industries and fueling excessive growth of government.  Also, why would more debt cause the US economy to "teeter on the edge of a black hole," rather than, say, acting as a drag on growth and depressing living standards for decades-- as it has arguably done in Japan?  Government debt in Japan and Italy is way above 76.5% of GDP; both countries have suffered malaise rather than crisis.

Prosperity and full employment in the US will only be restored by a return to laissez-faire capitalism. Our study outlines a radical, but politically feasible, approach. Monetary policy should be expansionary. But, on the micro-economic side, tariffs and other trade barriers should be repealed unilaterally; a "Right-to-Work" Act should reduce the minimum wage and curtail the powers of unions; and business regulation should be reduced. Individual banks and their counterparties should not be bailed out, although the system should be protected by ensuring that failing banks are wound up in an orderly fashion – this is the only way to restore market discipline.

A little late not to bail out individual banks, no?  Rather say that laws and policies should be rewritten so as to prevent future bailouts (except of insured deposits through the FDIC).  And is it really "politically feasible" for "tariffs and other trade barriers [to] be repealed unilaterally?"  Maybe!  I wouldn't rule out the possibility that bold, visionary political leadership can make the politically impossible possible -- after all, Obama seems to have made people dislike unions and appreciate the health care status quo! -- but that is as much as to say that the range of the "politically feasible" is very broad.

Rowley and I found enough to agree on to put a book together, but he might have a tendency to overclaim. 

MORE: "Barack Obama accused of making 'Depression' mistakes: Barack Obama is committing the same mistakes made by policymakers during the Great Depression, according to a new study endorsed by Nobel laureate James Buchanan." (Daily Telegraph):

"Endorsed by Nobel laureate James Buchanan."  That's brilliant marketing.  But it's not false advertising, for here is Buchanan's Frontispiece:

A comprehensive and coherent assessment of the current economic contraction, one that largely rebuts attribution of failure to capitalism or the market. The targets become practicing politicians of all parties, whose cumulative mistakes have now hurt us all. We have learned some things to reduce the severity of the current contraction. But we have made no progress toward putting limits on political leaders, who act out their natural proclivities without any basic understand of what makes capitalism work.

Anyway, here's what Edmund Conway of the Telegraph has to say:

His policies even have the potential to consign the US to a similar fate as Argentina, which suffered a painful and humiliating slide from first to Third World status last century, the paper says.

There are "troubling similarities" between the US President's actions since taking office and those which in the 1930s sent the US and much of the world spiralling into the worst economic collapse in recorded history, says the new pamphlet, published by the Institute of Economic Affairs.

In particular, the authors, economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute, claim that the White House's plans to pour hundreds of billions of dollars of cash into the economy will undermine it in the long run. They say that by employing deficit spending and increased state intervention President Obama will ultimately hamper the long-term growth potential of the US economy and may risk delaying full economic recovery by several years.

Excellent.  The title of the Telegraph piece may slightly overplay the 'Depression' analogy -- while we do identify some similarities with policies from the Depression era, monetary policy is (no thanks to Obama) just the opposite, and we haven't seen anything like the crazy tax hikes of Hoover and FDR yet though there are some ominous signs -- but this last paragraph nicely captures a central argument of the book.  Conway continues:

The study represents a challenge to the widely held view that Keynesian fiscal policies helped the US recover from the Depression which started in the early 1930s. The authors say: "[Franklin D Roosevelt's] interventionist policies and draconian tax increases delayed full economic recovery by several years by exacerbating a climate of pessimistic expectations that drove down private capital formation and household consumption to unprecedented lows."

Heh.  If Rowley and I get credit for debunking the myth that FDR's Keynesian New Deal got us out of the Great Depression, that would be as unfair as Columbus getting credit for debunking the myth that the world is flat.  To our cost, this myth remains potent at the popular level, but among economists I don't think even Paul Krugman would defend it.  Rather, Keynesians claim that WWII got us out of the Great Depression.  This is also debatable -- "GDP" grew, but should bombs and guns and tanks count as GDP, when they don't contribute to human happiness; or if they do count as GDP, don't we need some more appropriate way of measuring the economy's contribution to human well-being, which would likely put paid to the odd notion that WWII was an economic golden age? -- but it has no bearing on the episode Rowley and I deal with, namely the 1930s.  It's rather odd that at this late date anyone can make headlines with what ought to be a truism, namely that the New Deal exacerbated, rather than "got us out of," the Great Depression, but if that's still news to a lot of people, then those headlines need to be made.  Conway continues:

Although the authors support the Federal Reserve's moves to slash interest rates to just above zero and embark on quantitative easing, pumping cash directly into the system, they warn that greater intervention could set the US back further...

And then proceeds with quotes from Rowley and Buchanan, already quoted above in this post.  I'm glad that the message is clear that we support quantitative easing.  On that point we're basically Milton Friedman-type monetarists.  Too bad our advocacy of immigration reform and Social Security reform doesn't seem to be making it into the reviews so far!

How Keynesianism Survives

"Why the Stimulus is Helping the Economy, But Not Obama" (Time)

Proving a negative is always a challenge, but there's mounting evidence that the controversial $787 billion stimulus bill is achieving one of its major goals: shortening the recession. Economists at Goldman Sachs say that the bill, officially called the American Recovery and Reconstruction Act, has resulted in a 2%-3% boost to annual GDP in the second and third quarters of this year, turning what could have been a worsening recession into potential growth. For President Barack Obama, whose poll numbers have dropped precipitously from around 65% to around 50% as Americans have become worried about government spending and health-care reform, that should be good news: he fought hard against Republican opposition to push the bill through Congress as one of his first legislative acts, and the fact that it's working should be a vindication.

But it's not that easy. Recent polls show widespread disapproval of the stimulus bill: 51% of Americans polled last month by USA Today and Gallup said they thought the government should be spending less under the plan, while 44% said they thought the government was spending the right amount, or should be spending more. If anything, it seems, the stimulus plan is hurting the President even as it helps the country.

The most obvious reason for that disconnect is jobs: despite the signs of a turnaround, unemployment remains stubbornly high at 9.7%, with employers cutting 216,000 jobs in August. While jobs always trail economic rebounds, the unemployment number is higher than economists thought it would be, even in the worst case scenario forecast by the Treasury department's "stress tests" last spring. The point is not lost on Republicans, some of whom have argued lately that no more of the stimulus money should even be spent. "The metric of this bill was job creation," says Don Stewart, spokesman for the Senate's top Republican, Mitch McConnell, "and it hasn't done that."

Still, one would think that the mere infusion in six months of $88 billion into the economy — that's how much the government has spent so far...

Journalists, it goes without saying, are not very smart (maybe they suppress it because it impedes their ability to slice a complex world into neat stories) but a cruder, more flagrant example of the post hoc ergo propter hoc fallacy would be hard to find than the above.  It seems quixotic, or Sisyphean, to remind people of the truism of economic history that it's normal for the economy to recover, that it always does so, even-- nay, especially-- when the government does nothing.  The last time the US government did nothing in a recovery-- in the recession of 1920-21-- the recovery was especially robust.  Again, in 1997-8, when the IMF forced East Asia to adopt austerity measures in the midst of recession, it earned itself the contempt of East Asians but rapidly restored growth to its former booming rates for another decade.  By contrast, Keynesian policies failed in the US in the 1930s, in Japan in the 1990s, and dragged post-WWII Britain down from being the world's economic leader to a desperate, stagflation-ridden basketcase in the generation after the British economics profession surrendered to Keynes, before it was rescued by Thatcher.

So how does Keynesianism survive?  Because of articles like the above, because of journalists committing the post hoc ergo propter hoc fallacy, while economists like Brad DeLong and Paul Krugman, who want bigger government because their values are different from the mainstream and want to use their technocratic credentials to sell big government to people who would not support it if they understood its true effects, back them up.  Keynesian economics is like fortune-telling: shrewdly vague, it exploits a perennial fallacy, namely people's chronic inability to understand that the economy can recover on its own.

In this case, the journalist provides the key fact that makes the "stimulus worked" case implausible: only $88 billion has been spent, just over 10% of the whole stimulus package, and only about 0.6% of GDP, and all of that after the worst of the crisis-- October 2008-- had already been mitigated.  By contrast, Ben Bernanke's Fed has bought hundreds of billions of dollars of private and federal debt, and the Bush administration "spent"-- albeit with a fair prospect of recovering-- $700 billion or so through the TARP program.  If any stimulus is working, it's that of Bernanke and Paulson, which was not mere Keynesian spending-for-spending's-sake but a timely intervention by highly competent technocrats (we won't see such expert competence from neophyte Obama, but fortunately, we might not need it) targeted to the specific problems at the heart of systemic failure.  That's not to give unqualified approval to Paulson.  He's a tragic hybrid of hero and anti-hero: he probably did save the US from a more shattering crisis, but the fallout from the Paulson Plan is likely to be a more politicized financial sector and hugely increased incentives and opportunities for rent-seeking for years or decades to come.  There's something to be said for the House GOP who voted against him, too.

For now, the American people seem to be displaying a sensible incredulity about the "stimulus is working" message.  But don't count on it to last.