What Obama Needs to Explain --- Keynes

It’s a pretty quiet week, so for the moment, let’s continue our discussion of systems we live with. A while back we discussed the proper definitions for the basic political and economic systems under which our communities are organised (http://greytheory.blogspot.com/2009/04/capitalism-is-socialism.html).

This time, let’s talk about John Maynard Keynes. I’ve discovered that most people who want to discuss the economy, the federal deficit, interest rates, taxes, and government spending do not know who Keynes was. I’m not exactly sure how you can have a well thought out opinion on these topics without being able to at least identify the leading economic theorists:

1. Adam Smith – The Wealth of Nations
2. Karl Marx – Das Capital
3. John Maynard Keynes – The General Theory of Employment, Interest, and Money

The theory we need to dig into here is Keynesian economic policy. If you don’t know, Keynes was the guy who pulled us out of the Great Depression. His theory kept our economy strong for fifty years beyond that, until our government failed to follow the rules.

Before the Great Depression, the American economy was governed by classical economic theory. The classical theory held that the short term is unimportant because in the long run the economy is in balance; full employment, no inflation, etc. This laissez faire theory espoused that the economy will operate fine if the government leaves it alone.

The classical theory was proven wrong with the Crash of 1929. When Franklin Roosevelt came to the presidency, he turned to Keynes. Keynes’ famous reflection on the classical theory was that “in the long run, we’re all dead.” The short term IS important; we all live in the short term, not the long run.

Keynes was proven right in the 1930s, in the 1970s, when Volker pulled us out of Nixon’s recession, and now with the Great Recession of 2008. Fortunately, Obama is a Keynesian, but I’m worried that due to Republican stoppage of government, he’s backing away the Keynesian policies that have thus far kept us out of the Great Depression #2.

So, what is Keynes’ theory?

Short Term Keynesian theory deals with the business cycle. The higher the peak of a cycle, the deeper the trough will be. Keynes tries to calm the waves by minimizing the troughs and peaks in the cycle. Peaks and troughs are caused by increasing and decreasing net spending in an economy.

There are three ‘parties’ who spend money: (c) consumers, (b) businesses, and (g) government.

Spending = Spending(c) + Spending(b) + Spending(g)

In a country of 300 million people, it takes forever to change the spending habits of consumers and businesses, but the government can change its level of taxation and spending almost instantaneously. It’s up to the government to maintain balance in the economy.

When in recession, we need more spending, in a growth period, we need less spending. In recession the government will deficit spend, spending fictional money by creating debt. In growth, the government will pay off the debt created during the recession.

Where Keynesian economic has failed is in the failure of government to pay off the debt during good times. We’re so afraid of raising a tax that we use only monetary policy to balance the economy when we should be using fiscal policy and paying off the debt.

If you look at what Obama is doing, it’s this: He’s cutting off the trough by spending fictional money and raising the country’s debt. But, at the same time, he’s proposing to cut the deficit in Fiscal Year 2011, thus slowing the coming peak and paying down the debt so we can deficit spend during the next recession. I just hope he remembers Keynes in 2011.

Next, we’ll get into long term Keynesian theory.