Obama and Keynesian Economics

The Obama administration has adopted a traditional Keynesian approach to economic management for restoring full-employment and sustained growth, an approach that is premised on government spending and loose monetary policy, a policy that was touted at Group of 20 (G-20) summits.

Although several G-20 member countries dissented from Obama’s Keynesian fervor, the Obama administration pushed ahead, raising government expenditures from an average of 19%-20% during the Bush era to an average of 25% in 2009-2010, and the federal deficit from an average 2%-3% to 10%-13%.

The US application of Keynesian economics is popular with academics and policymakers. Classroom models assume a frictionless world where government spending could be used in a most flexible way as a counter-cyclical policy instrument.  However, as the Greek debt crisis and the California and Illinois fiscal deficits plainly illustrate, it is one thing to increase spending and another to roll it back. In the same vein, it is very difficult to increase taxes significantly to finance a large deficit.

Hence, President Obama’s US$1.5 trillion deficit is caught between two powerful forces: there are forces that would oppose big cuts in government spending; it is unrealistic to think of reducing government expenditures from 25% to 20% of GDP. Moreover, as the tax compromise of December 2010 illustrates, it would also be similarly unrealistic to think about raising taxes from 18% to 25% of GDP in order to close the fiscal deficit.

There is little disagreement among economists about the necessity of government spending. There is, however, significant disagreement as to the size and composition of public expenditures.

In the late 18th century, Adam Smith classified public spending into productive and non-productive expenditures. Expenditures on social infrastructure, police, judges, courts, hospitals, and universities could be classified as productive expenditures; however, expenditure expansion beyond levels deemed efficient in areas such as more civil servants, large pay increases for civil servants relative to private sector compensation, or large peace-time increases in military spending could be seen as un-productive spending.

There is also disagreement about the wisdom of running large fiscal deficits to remedy what Keynes called effective demand failure. Keynesians have created what is coined the paradox of savings and the notion of under-consumption – namely, the economy has hoarded too much output; only the government can force a dis-hoarding by hiking up demand. In 2011, it is difficult to believe that lots of crude oil, sugar, wheat, corn, and cotton are being hoarded and that only government can create demand for such hoarded goods.

US fiscal and monetary policies have resulted in considerable uncertainties. Commodities prices are drifting upward with no bound; considerable distortions are being created by negative real interest rates; significant wealth redistribution is under way; speculation in financial markets has intensified; exchange rates have become increasingly volatile, with depreciation amounting to an equivalent tariff on trade.

Although core inflation may be stable, commodity and food prices are at historic levels. Increasing US government debt raises future uncertainties. How would the US government service a public debt that could approach 100% of GDP? There are three options: massive tax increases, default, or what is equivalent to a Ponzi scheme, namely resorting to inflation. All of these options have brought economic growth to a screeching halt in countries that have tried them.

Establishing sustainable growth and full-employment in such an unstable environment would be a novelty indeed; namely, if this were the case, then an economy suffering from high unemployment could simply print money and increase government deficits. Famous economists, prior to Keynes’s General Theory (1936), demonstrated that the scale and durability of the 1929 depression was in part due to considerable government intervention through easy money, large fiscal deficits, and distortive labor laws that prevented a return to sustainable growth.

Extracted from: “Obama Comes First” by Hossein Askari and Noureddine Krichene, Asia Times Online, Feb 4, 2011

Comment: Can increased government spending really pull an economy out of a recession? In theory, it seems logical that increasing aggregate demand will help to generate output, employment and income.  The question is where does the government gets the money to spend? High fiscal deficits will have to be financed by borrowing internally and/or externally resulting in a growing public debt that could threaten the stability of the financial system and/or crowd out private investment. Monetising the debt (by printing money) will result in high inflation that could also destabilise the economy. The debate continues….

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