The dangers of Keynesian economics

Dec 27, 2010

Los Perros, Nicaragua

No market news. Every market in Christendom was closed for the 25th.

Still, the crackpot theorists and muddled meddlers never seem to take a holiday. Robert Shiller should have been embarrassed to write the following words. The New York Times should have been embarrassed to print them.

---------------------- FREE Webinar with Ajit Dayal - Limited Seats! ----------------------
Find out what 2011 has in store for the Indian stock market... Register Now for our FREE Webinar with Ajit Dayal as Chief Guest. The Webinar airs on 10th January, 2011 at 5.30 pm. Register NOW!

But today's economic intelligentsia knows neither shame nor common sense. You be the judge:

"It has long been known that Keynesian economic stimulus does not require deficit spending. Under certain idealized assumptions, a concept known as the "balanced-budget multiplier theorem" states that national income is raised, dollar for dollar, with any increase in government expenditure on goods and services that is matched by a tax increase.

"The reasoning is very simple: On average, people's pretax incomes rise because of the business directly generated by the new government expenditures. If the income increase is equal to the tax increase, people have the same disposable income before and after. So there is no reason for people, taken as a group, to change their economic behavior. But the national income has increased by the amount of government expenditure, and job opportunities have increased in proportion."

"Economists embraced this multiplier because it seemed to offer a solution to a looming problem: a possible repeat of the Great Depression after wartime stimulus was withdrawn, and when new rounds of deficit spending might be impossible because of the federal government's huge, war-induced debt.

"It turns out that this worry was unfounded. The Depression did not return after the war. But in the early 1940s, economists justifiably saw the possibility as their biggest concern. Their discussions have been mostly forgotten because they didn't have much relevance for public policy - until now, that is, when we again have a huge federal debt and a vulnerable economy.

Okay. The feds spend more money and increase taxes to pay for the spending. This has a multiplier of "one" - or so they say - meaning, you get one times the benefit.

Why do we bother to challenge it? The idea is delusional claptrap. No need to shout it down. It whispers 'nonsense' to anyone who will listen.

All we have to do is imagine what really happens:

A small, isolated town is in a slump. The mayor has read enough Keynes, Samuelson and Shiller to be dangerous. He increases both spending and taxes. He hires 20 people and raises taxes to pay their salaries. The 20 go to work, say, cutting the grass or painting the town hall. Now, they have income...which they spread among the town's bars, brothels and banks. Presto! GDP goes up!

But where does the money come from? It comes from the taxpayers. On the one hand, the taxpayers have more - because the mayor is spending money. On the other, they have less, because taxes are higher. Since - in theory -- they are only paying as much more in taxes as they receive in extra income, the lawn cutting and painting seems to be 'free' extra GDP.

Wait a minute. If this were so, why not hire everyone in town and triple or quadruple taxes? Why not? Because it doesn't work. It would only work - and only in theory - if the extra work undertaken by the government were equal in value to the work undertaken by the private sector. Otherwise, each person diverted out of the private economy merely becomes a zombie worker - producing something that may or may not be worthwhile.

What about just hiring the jobless people? That would increase income, right? And then you wouldn't be taking anything away from the private economy, right?

Wrong. You still have to take away money. And if you raise taxes by the amount of money you put into the system, you are taking the money away from the private economy. The public sector grows, compared to the private sector. The gross amount of extra taxes may be no higher than the gross amount of extra spending, but the private sector surrenders more of its income in order to pay for the spending by the government.

Adding more zombies only makes it appear as though income has increased - as in a war-time, full employment economy. In fact, keep multiplying wealth according to the "balanced budget multiplier theorem" and you will soon have none left.

*** "Why am I down here?" a Dear Reader who lives in Nicaragua asked a leading question.

"Because the US is going to Hell in a handcart.

"I read the Daily Reckoning. And I know you're always trying to figure it out. And you come up with some pretty complicated analysis...

"But I just look at it simply. And the way I see it, America has bills to pay and she can't pay them. Not without printing up more and more money. I think I read in your write-up that the annual deficit is now about the same as the amount of taxes collected. So, it might be 10% of GDP. But it's 100% of income tax collections; something like that.

"You can imagine how long I would last if I tried to do that...

"So, right now, Ben Bernanke is printing money and he says it's because he's trying to get the economy going. And maybe it is. But it won't be long before he's printing money just to keep the government in business.

"And then, when investors finally get wind of what is going on, they're going to drop the dollar and US bonds. And I don't mean just Mom and Pop investors. I reckon the Chinese and the Japanese will do the same thing.

"And then we're going to see the Fed chase its tail. It will print money to pay the bills. The value of the money will fall. So, it will print more money. And it will get to spinning faster and faster...until the tail goes faster than the dog, if you know what I mean. The dollar will fall even faster than the Fed prints up new money.

"Of course, I don't know any better than you do how this will all play out. But I damned sure don't want to be in the US when this all comes to pass. Besides, the weather is better down here."

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Recent Articles

A New Infrastructure Boom March 26, 2019
Selva Freigedo talks about the potential in 5G network and how it could transform the way we communicate.
A 40 Somethings Guide to YouTube Hits March 20, 2019
Vivek dwells into a new YouTube phenomenon.
As the Economy Slows Down, Maruti and Two-Wheeler Companies Cut Production March 19, 2019
The country's largest car maker has cut production by more than a fourth.
In Supporting Demonetisation, RBI Behaved Like an Old Uncle Not Willing to Take a Stand March 13, 2019
The minutes of the meeting of the RBI Board which happened before demonetisation have been released.

Equitymaster requests your view! Post a comment on "The dangers of Keynesian economics". Click here!

1 Responses to "The dangers of Keynesian economics"


Dec 27, 2010

i fully agree with him. i also have a date with the destiny. it will be some time in 2012. why 2012? all the dooms day specialists have been predicting end of the world in 2012. my opinion is it will BE the end of the world of US economic supremacy. and FED is taking it in that direction. but it will also be the begining of the new era of golden period of asian supremacy. so not to fear but to prepare.

Equitymaster requests your view! Post a comment on "The dangers of Keynesian economics". Click here!