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Friday, February 20, 2009

The Waterloo of Keynesianism (Military and Domestic)

Note: In part, this post is an answer to a query by Mark Hatlie.

While it is perilous for any historian to predict the future, we may well be headed for the Waterloo of Keynesianism (both military and domestic) and that is a good thing.

Crudely put, Keynesianism (so named for the British economist John Maynard Keynes) is the theory that government’s can speed long-term recovery by running high deficts so as to stimulate aggregate demand or investment. It is the entire basis of Obama’s stimulus plan. To some extent, Keynesian ideas were the basis of Bush’s massive bailout and big spending policies, most especially his now forgotten “stimulus checks.”

The popularity of the Keynesian theory is something a puzzle (at least to me). Few ideas more defy ordinary common sense. Taken in today’s context, it seems akin to telling an individual who has recklessly run up a hundred thousand dollar credit card debt to spend even more on fixing a driveway or garage (infrastructure). For some reason, such advice (which would be considered utter lunacy when applied to individuals) is widely accepted as the best method of economic recovery when taken by governments.

Probably no event is more commonly cited as a Keynesian spending success story than World War II. Variants of this thesis can be found among across the political spectrum. On the right, neocon Conrad Black argues that World War II “had restored prosperity after the free market had failed.” On the left, Paul Krugman similarly writes: “There's nothing magic about spending on tanks and bombs rather than roads and bridges. The reason World War II worked more effectively than the WPA [in terms of promoting economic growth] as that it was *bigger.*”

While Krugman might prefer that this “bigger” spending be on roads and bridges, rather than bombs, this does not change the fact he still accepts the overall premise that spending on wars can be good for the economy. If this is true, one wonders why he never praised Bush’s bloated military budgets. If anyone should have greater reason to call this theory into question, it is antiwar historians. Fortunately, one has.

In a seminal article for the Journal of Economic History, Robert Higgs convincingly challenged the Keynesian theory of World War II as put forward by Krugman, Black and others.

While unemployment disappeared during the war, it was hardly a step forward. Moving men and women from the unemployment lines to the killing fields of Anzio did not represent economic progress in any meaningful sense. During the war, Americans at home suffered from rationing, shortages, more accidents on the job, longer hours, and many other measures of economic deprivation. Moreover, as Higgs points out, “real personal consumption declined. So did real private investment. From 1941 to 1943 real gross private domestic investment plunged by 64 percent; during the four years of the war it never rose above 55 percent of its 1941 level; only in 1946 did it reach a new high.”

According to Higgs, genuine prosperity did not begin to return until the last months of 1945 and 1946. This prosperity occurred under a policy of reverse Keynesianism which included massive reductions in spending because of demoblization, rapid steps toward price decontrol, and scaled back deficit spending.
Higgs sums it up:

World War II, the so-called Good War, has been a fount of historical fallacies. One of the greatest – and one of the most pernicious for subsequent policymakers – is the notion that prosperity prevailed during the war. Although Americans might have been dying in the Pacific and European theaters of war, people on the home front actually benefited from the war, because it propelled the economy at long last out of the Great Depression. This view of the war would be sufficiently egregious if it were true, but despite the claims of historians for the past half century, it is not true.

In my view, Obama's best hope to bring lasting recovery is to let the economy go through a short, but sharp, readjustment. He needs to remove the malivestments, not perpetuate them. Obama can facilitate this readjustment to a more sustainable level by cancelling the bailout, cutting spending, and pruning deficits. Another worthy goal would be to dismantle the Federal Reserve which helped to create this mess through its easy credit policies.

Most of all, however, Obama should end our costly empire by closing down our overseas bases and bringing home the troops. Only then, can we start to get our financial house in order and move towards genuine economic well being.


Blogger JVB said...

Good post. But Obama -- although he seems open to more ideas than Bush was -- is just as unlikely to change such policies.

8:39 AM  
Blogger David T. Beito said...

I agree. There is probably more continuity (including appointment)between this Democratic administration and any other Republican admininistration that I can think of.

11:23 AM  
Blogger Junior said...

Instead of embracing this concept (and following through on the pre-election promises he spewed), Mr. Obama seems intent on continuing what Mr. Bush started.

In better times, at least we had few distractions to prevent logical discussions on why, exactly, we were in Iraq in the first place and why we are in 130 countries in a time of peace (in the broader sense, that is). Now we have the problem of an inherently faulty financial system collapsing all around us to keep our attention away from these events which continue to bleed us dry from a financial and moral level.

There is your hope and change.

9:03 PM  
Blogger David T. Beito said...

A major test will be Obama's budget (which I believe is due this week).

9:11 AM  
Blogger Christian said...

"The popularity of the Keynesian theory is something a puzzle (at least to me)."
Let's say two economists approach a politician with two different solutions to a depression. One economist says that the government caused the depression and further intervention into the economy will exacerbate the problem. The second economist says that the free market caused this problem and you, the politician, must do something to help the ecconomy. Which economist's solution would a politician want to use? Hence, its popularity among the ruling elite.

Also keep in mind that the Keynesian approach creates a lot of jobs for economists to guide the economy and that most people don't understand any economic theory at all. Hence, it's popularity among the masses.

10:28 AM  
Blogger Richard said...

"... contra Krugman,..."

Um, I think contra was the wrong word right there, as Krugman seems supportive of such spending, not opposed to it.

12:51 PM  
Blogger MattDC said...

Krugman did praise the Iraq war as new WPA on his blog ("An Iraq Recession?" January 29, 2008):

"The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we’re spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly."

2:21 PM  
Blogger Steve said...

Maybe I have been spending too much time at lewrockwell.com/blog, but when I see someone recommending Keynesianism, it strikes me as if they are recommending we apply some bloodletting to a sick patient. Every bit as barbaric.

A fitting part of this comparison is that overdoing it on the bloodletting is how George Washington died. Maybe Keynesianism is how this country will die.

4:42 PM  
Blogger liberty said...

"it seems akin to telling an individual who has recklessly run up a hundred thousand dollar credit card debt to spend even more on fixing a driveway or garage"

Actually, that is a bad analogy. The individual and the economist have different needs in terms of their own recovery; so it would more akin to saying to someone who recklessly ran up debt that they should borrow to purchase a suit to go on a job interview.

However, the fallacy of Keynesianism (which, when viewed like that, does make some sense), is that in fact, you are borrowing from yourself, not from someone else.

When the government borrows, it either borrows from the private sector, or it borrows from overseas, which still crowds out private sector borrowing and spending, directly and indirectly through the currency.

The fallacies of Keynesianism are its aggregation technique (which does not distinguish private and public spending, institutions and incentives, and looks at totals like "demand" and "investment" instead) and in its static picture which ignore crowding out, and other indirect consequences (the "what is not seen.")

The most common sense obvious fallacy is the idea that through this miracle of aggregation (slight of hand) you can somehow increase output in the economy while reducing output: e.g. while digging holes and filling them up again instead of producing goods.

The way that this is passed off as sane is that it is assumed that without the magic wand of government the people digging/filling would have been unemployed; and if you put them to work then they can buy stuff and get business going again.

However, as usual it is a mistake of a static analysis: they may be unemployed today, but the only way to get the private sector going is to not destroy it through government spending. Keynes assumed spending is good but savings is bad, yet savings is required for investment.

All the fancy hand tricks of government don't change the fact that institutions of the public sector make for inefficient production, while the private sector is innovative and efficient.

10:57 AM  
Blogger Richard said...

Reversal of present policies requires the election of non-Keynesian fiscal conservatives in the primary and general election to stack the deck no matter which party wins what. The Dems have fewer to offer here but they are out there and should be supported by anyone to get the current nuts out of our "free" market. As for the GOP, only the ones that advocated that restraint under Bush can really be quasi-trusted, and they are few.

As to mirroring our post WWII success, remember we also maintained bases overseas after WWII and still do, though I doubt the need of those bases vs. the presence in Korea, Iraq, and Afghanistan(given the nut jobs trying to create nuclear blackmail nearby each). Although Russia has been somewhat belligerent lately.

11:27 AM  

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