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Keynesian spending policy is one of the most misunderstood areas of economics.   I do not consider myself a Keynesian and my own views are probably closer to the Monetarism and the Chicago School of Economics.  All the same, I do believe it’s important to understand the actual logic Keynes employed.

Keynes provided more insight into economics, than virtually any other 20th Century economist.   However, I do not believe one has to agree with Keynes’ prescriptions to understand the premise behind them.

Keynesian Policy During a Bust Cycle

Let’s start off with the part that most people understand.  Keynes advocated increased government spending and deficits during an economic bust where deflationary pressures are present.  A banking crisis would be the prototypical example.

In a banking crisis, there is an abnormally low supply of money flowing in the economy.  This is a result of credit contraction, as banks must shore up their balance sheets and cannot lend out to others.  This creates deflationary pressures in the economy, which then harm investment, and create high unemployment.

Keynes advocated using fiscal policy to solve this dilemma.  This could be in the form of increased government spending or could also come in the form of lower taxes.  Keynes might have even advocated both during a particularly brutal recession/depression.   Both measures would pump money back into the economy, stimulate private investment, and help drive down unemployment under Keynesian reasoning.

This differs from classical liberal thought which suggests that the market can fix the problem on its own over time.   There are of course drawbacks to Keynes approach; the most notable of which is that advocating heavy deficit spending could lead to sovereign debt issues down the line.

Keynesian Policy During a Boom Cycle

While many people understand Keynesian policy during bust cycles, its Keynesian policy during boom cycles that is particularly misunderstood.   If money supply is too low during an economic bust and fiscal policy is needed to pump more money into the economy, then it stands to reason that the exact opposite would be necessary in a boom cycle.

Under Keynesian theory, a boom cycle would likely result from excess debt (i.e. money) in the economy, which artificially increases the price of assets, creating high inflationary pressures.    In order to cool off the boom, one thing Keynes might advocate would be cutting government spending, running a government surplus, and paying off sovereign debt.   This would tend to have the effect of decreasing money supply in the economy and cooling off a bubble, while also allowing for a national government to have a more sustainable budget.

This is why the idea that Keynes advocated nothing but unbridled government spending is flawed.   Keynes viewed things in very cyclical terms and government deficits were meant to combat a situation where there is too low investment and money being used in the economy.   A bubble would call for cutting back government spending and paying off debt.

In Practice

Unfortunately, in practice, Keynesian policies are normally ignored during boom cycles.  We only see them advocated by politicians during bust cycles.  Politicians tend to advocate neo-liberal policies during boom cycles.

There’s a reason for this.  The incentive of a politician is different from that of a market participant.  Politicians always want to increase spending (i.e. increase services to constituents) and decrease taxes.   Likewise, they never want to do the reverse, which is often political suicide.  People generally like “free stuff” and not paying taxes.  The public doesn’t always consider the long-term consequences of these short-sighted economic actions.

Then there’s also the corporate side of this.   Corporations like for the government to stay out of their way generally.  This changes in an economic bust, as many corporations (particularly banks) stand on the verge of insolvency.  It’s at this point that many corporations love the government interfering in the marketplace.  For the corporations, they’d like to privatize the profits and nationalize the losses.  In other words, they want all the results of their risk-taking activities, but they want the public to absorb all the negative results.

For these reasons, Keynesian policies tend to only be enacted during bust times, in reality.  Or even worse, politicians find ways to spin normal economic environments or even boom cycles as “bust cycles”, and use this as an excuse to provide a “Keynesian stimulus.”   In this way, Keynesian policies are frequently abused in practice.   Moreover, one might argue that Keynes’ failure to consider the incentives of politicians is one of the major flaws in his economic prescriptions.

Was Keynes Right?

Personally, I’d suggest that there’s a considerable amount of evidence to back up Keynes’ basic reasoning here, but that his prescriptions are not always ideal and very difficult to implement in the real world.   Government policymakers do not set fiscal policy or tax policy based on economic cycles.   Governments also react slowly to developments (unlike private market participants) and deploy capital in very inefficient ways (since they look at political rather than economic considerations).

Even if governments were to follow Keynesian theory correctly, there’s still no guarantee that this would achieve the most efficient result.  Since governments typically use fiscal policy to pick winners and losers in given sectors of the economy, what normally happens is that the government, by its nature, creates maldistributions of capital, which can potentially make an economic downturn even worse (and even create more deflationary pressures).  Of course, Keynes realized that governments were not efficient allocators of capital, but believed that the greater evil was for an economy to artificially be operating below its productive potential.

In my view, Keynesian Economics is absolutely vital to understand, because Keynes’ insight into boom and bust cycles, fiscal policy and its effects on the economy, currencies, and trade (not mentioned in this blog) are so important to a total understanding of the economy.   But I don’t think one has to agree with his prescriptions or ignore some of the flaws in those proposed solutions, in order to appreciate many of the important insights he had.

Keynesian Policy in the Housing Boom

As I said from the onset, I am not a Keynesian, but find the general abuse of the term frustrating.   One common theme I hear is that the US has been following Keynesian policies for several decades.  I disagree with this.

We veered away from Keynesian policies in the ‘00s.  In 2002, we had a housing boom underway and high inflation. The Federal Reserve Bank, which does not look at housing prices in its inflation measures, dramatically underestimated CPI inflation.  So a narrative began that we were in a downturn, when in actuality, we were in a situation of rapidly increasing money supply and rising inflation.

In spite of this, the Bush Administration advocated lower taxes and more government spending.  This was particularly evident in the Administration’s push for war in Iraq, which dramatically increased military spending. In other words, Bush was advocating the ultimate anti-Keynesian solution.

In a boom cycle, Keynesian theory advocates running a government surplus and using fiscal policy to reduce money supply.  Instead, we saw a total breakdown of this and politicians not only failed to balance the budget, but actually increased the government deficit, pumping even more money into a credit-fueled boom.

For this reason, I don’t think it’s fair to blame Keynes for the recession that followed.  This is not to say it’s not fair to blame several supposed Keynesian economists who might have advocated policies that further inflated the boom, however.  Merely that Keynesian economic theory itself does not advocate this.