Friday, February 27, 2009

Keynesianism redux

With the current administration embracing Keynesianism it helps to take a look back at what the philosophy is. Here is the essential bit from wikipedia:
Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes, and therefore advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government, to stabilize output over the business cycle.

...Keynes contended that aggregate demand for goods might be insufficient during economic downturns, leading to unnecessarily high unemployment and losses of potential output. Keynes argued that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation.
In a nutshell this means that when times are bad government should spend more to pick up the slack and then ease off in good times. It sounds rather intuitive and like a good theory. But here is the problem: you usually don't know you are in a recession until after it actually occurs. These things are extremely difficult to anticipate. What ends up happening is that by the time government begins to respond to the economic downturn and spending money the recovery is usually already underway and it just ends up juicing an economy already on the upswing.

This may sound like a good thing -- if some growth is good, more is better -- but there is a case to be made that it contributes to more pronounced fluctuations in the economy. Take a look at this graph:

Notice how the swings became less volatile after around 1982. Now, Keynesianism was the predominant economic philosophy after World War II, with Republican Richard Nixon declaring in 1971 that "I am now a Keynesian in economics."

Then Ronald Reagan changed course with an embrace of the free market in the early 1980s and we can see the impact in the graph. Now, maybe it's all a coincidence, but I doubt it.

Food for thought as we again head down the Keynesian path.

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