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Debunking the Myth of the Keynesian Government Boost

January 13, 2009 Leave a comment


As the recession has deepened, many of our economists (namely Krugman, Summers and the like) and elected officials have continuously argued that given the current dire circumstances, the only way to get the economy going is for the government to create demand by spending. The logic is that in a recession, the problem is that we have underconsumption; the magic pill for increasing consumption is government spending, generally in the form of public works projects. If resources like laborers are sitting on the sidelines (having been laid off), why not employ them in jobs building tangible public goods, enabling them to earn a living? Then, the government-spending multiplier will kick in, and the economy will grow again.

Robert Murphy in his refreshingly simple but thorough manner goes about picking apart the Keynesian argument in a recent Mises article. Murphy neatly sums up the Krugmanite point that “putting unemployed resources to work can only help, since prodding workers into producing even items of dubious value is better than letting them sit around watching Let’s Make a Deal.” He cites blogger Mark Thoma’s drawn-out explanation of the logic here. In debunking the Keynesian “idle resources” thesis, Murphy notes,

Even on its own terms, Thoma’s scenario fails because it is unrealistic. It is absurd to think that the government could come up with spending programs that would draw only on unemployed resources. Keynesian “macro” thinking ignores the complex capital structure of an economy. To build a bridge (as in Thoma’s example) requires a lot more than cranes and generic laborers. For example, gasoline will be burned in order to transport the newly employed workers to and from the work site. Nails, screws, steel, lumber, and other resources will be channeled into the new bridge, and at least some of these inputs will be diverted away from other private-sector uses, rather than simply leaving a state of idleness. Within the broad category of “labor” we find a similar situation, once we actually contemplate doing this project for real. If the city of Houston wants to build a new bridge, is it really the case that every last person even remotely involved with the project, will come from the ranks of the unemployed who are within commuting distance of the Houston bridge site? Surely the project will draw on engineers, construction foremen, and other skilled workers, who were still gainfully employed even amidst the recession, and who therefore will not be able to work on as many private-sector projects as they otherwise would have.

This issue is essential to understanding the way that the economy works. As I have mentioned before, no bureaucrat can ever plan for productive economic activity because he lacks the specialized knowledge, the ability to coordinate the activities and the profit motive of the business people who provide goods and services. He does not understand the capital structure of the economy. In the end, his central planning as always will fail.

As Murphy notes however, the Krugman’s of the world admit that during downturns, government spending is not about generating efficient economic activity, but rather acting on the assumption

that normal rules don’t apply. Ordinarily we’d welcome an increase in private saving; right now we’re living in a world subject to the “paradox of thrift,” in which private virtue is public vice. Normally we want to be careful that public funds are spent wisely; right now the crucial thing is that they be spent fast. (John Maynard Keynes once suggested burying bottles of cash in coal mines and letting the private sector dig them up — not as a real proposal, but as a way of emphasizing the priority of supporting demand.) [Emphasis added]

I just cannot understand this logic that when things get bad, somehow the laws of economic do not apply anymore. If the government can be so productive in using resources when times are bad, why not use resources when times are good as well? Can a country not prosper without a government boost? As we have seen, this is patently false given the success of all of the nations that have shed the yoke of socialism. Just look at Eastern Europe. In addition, if we as individuals were in financial trouble, would we spend money fast, or be careful in how we spent our funds, if we spent them at all? The same logic that applies to a man applies to the nation. During rough economic times, we need to ENCOURAGE SAVINGS, CUT SPENDING AND LOWER ALL BARRIERS TO POSITIVE ECONOMIC ACTIVITY (NAMELY TAXES). This will pave the way for real economic growth when the market corrects.

Murphy goes on to explain to the recalcitrant Keynesians that it is important to remember how we got into this situation, if we are to figure out the best way out of it. As Murphy puts it, following the low-interest-rate-fuelled boom, which created a mirage of wealth-generating activities ending in bust,

Once people in the private sector realized they had made horrible decisions during the boom years, they needed to stop business as usual and figure out how to make the best of a bad situation. Homeowners who had skimped on their savings for years (relying on booming house prices) had to slash spending to compensate for years of overconsumption, while entrepreneurs needed to decide which activities were likely to be profitable going forward, in light of the new information.

What had to happen is that workers and other resources that had been misallocated into housing construction and Wall Street investment banks, needed to be moved into other sectors. To repeat, this was and is a fantastically complex reshuffling, because even something as simple as producing a pencil requires the contributions of thousands of workers all over the world.

It’s not a simple matter of moving unemployed builders and hedge-fund managers into “booming” sectors X, Y, and Z, because (as we’ve seen above) these newly employed workers will require complementary tools and resources that were not laid off to the same extent. So the issue is, what is the best new outlet for all of these laid-off workers, such that — all things considered — the final mix of output goods best satisfies consumer desires? How can we be sure that channeling them into occupation X won’t actually do more harm than good?

This Austrian analysis of the problem shows that there was a major misallocation of resources that need to be channeled into productive sectors. However, the government is not the best authority to determine how to do this. According to Murphy,

In practice, the people in a market economy solve this fantastically complex problem by making profit-and-loss calculations, which in turn rely on market prices. For example, it is clear that a former Wall Street quant isn’t doing anybody a service by cranking out models that give mortgage-backed securities a gold star for safety. But what should this PhD do now? Should he go into academia and teach thermodynamics (which may very well have been the subject of his dissertation)? Or is his impressive education really a complete waste, and he would — at this point, given the economic realities — provide the most service by working the register at Wal-Mart?

Nobody knows the answer to this question. What happens during the recovery process is that the unemployed whiz kid initially looks for a job paying his former salary. As the months pass, he realizes that this is unrealistic, and he begins lowering his minimum price. Eventually, he finds an employer with compatible desires, and the two agree to a mutually beneficial arrangement.

Imagine that, letting the markets sort out the problems brought about by the government-created boom-and-bust cycle. Murphy notes that the Keynesians are wrong to assume that it is simply an issue of scared consumers causing the economy to contract. He argues:


On the contrary, the economy’s capital structure really was thrown into an unsustainable condition during the boom years, and it takes time for the mess to be sorted out. When the government runs up a deficit to fund “stimulus” projects, all that really means is that it is forcing taxpayers to pay for projects that they wouldn’t buy with their own money.

This is an aspect of the stimulus that really makes my blood boil. If it isn’t bad enough that the government is going to use precious resources inefficiently, and prolong the market-based recovery needed to start real economic growth again, the taxpayers funding these projects also don’t have really any say in them. Sure, we can vote out our elected officials. But as we have seen with all of the bailouts and the TARP money, even when sizable amounts of the populace have opposed government policies, we have not been able to stop them. It is immoral that the politicians can determine how best to use our hard-earned cash, and how much to burden our future generations with debt for these false stimuli. Let’s hope that we can not only vote out the bums during the midterm elections, but supplant them with people that have a sound understanding of economics and the Constitution.