Stimulus Failure: A Costly Lesson on Keynes and Say’s Law?

Lynne Kiesling

Macroeconomics and I have never gotten along, and for years I couldn’t figure out why — I’ve just never understood much of the underlying logic, why the analyses start where they do and make the assumptions they do (the only exception to this is my undergrad class with William Hart at Miami when we worked through Malinvaud’s Theory of Unemployment Reconsidered). By nothing more than tenacity and stubbornness I managed to pass enough macro to be accepted into the economics guild.

This recession and the policy debates in it are clarifying some ideas that resolve my cognitive dissonance, the largest of which is the central role of consumption in Keynesian economics. This focus on consumption as the first step in the causal link that leads to underemployment in equilibrium seems to invert the causality of value creation embedded in all other economic models, which start with the production of compelling value propositions that attract customers. This shift in focus to consumption pivots on how Keynes’s model, and Keynesian models, treat Say’s Law. The Keynesian interpretation of, and rejection of, Say’s Law provides the justification for focusing on aggregate demand in general, and consumption in particular, as policy levers during business cycles.

In August Steve Horwitz wrote a clear analysis of the interpretations of Say’s Law, and it’s a good place to start. After quoting Say’s Treatise on Political Economy, he notes that:

… Say was making the claim that production is the source of demand. One’s ability to demand goods and services from others derives from the income produced by one’s own acts of production. Wealth is created by production not by consumption. My ability to demand food, clothing, and shelter derives from the productivity of my labor or my nonlabor assets. The higher (lower) that productivity, the higher (lower) is my power to demand.

This is different from, and more nuanced than, the terse “supply creates its own demand” interpretation that Keynes placed on Say. It’s also not very different from Smith, Ricardo, or Mill in their articulations of the central role of productive activity in creating value, and hence economic growth. Steve goes on to discuss how Say’s Law and its operation in real economies also depends on money markets and how the banking system operates, and how Say’s Law does still admit the possibility of underemployment in equilibrium; my summary here does not do Steve’s argument justice, so I encourage you to read it yourself.

This prelude sets up a blog post from Robert Higgs on Friday that lit a light bulb of comprehension for me with respect to the current policy proposals to “create jobs” to increase consumption to increase aggregate demand to end the recession. Bob points out that if you take the domestic national income accounting relationship (Y=C+I+G), and if you look at data on consumption and government spending, they are both above pre-recession levels. Consumption as the laggard in aggregate demand is not driving the recession. Nor is government spending, which is clearly high.

The economy remains moribund not because consumption spending has failed to recover and not because government spending has failed to increase, but because the true driver of economic growth—private investment—remains deeply depressed. Gross private domestic fixed investment fell steeply after the second quarter of 2007, and in the second quarter of 2011 it remained 19 percent below its pre-recession peak.

After going into some important detail on private domestic investment, Bob returns to the theme that has animated all of his work (if you haven’t read Crisis and Leviathan, you should!), a theme that I think has a lot of explanatory power in this recession:

Private investors, despite the full recovery of real consumer spending and the increase of real government spending for final goods and services, remain apprehensive about the future of new investments, especially new long-term investments. I have argued repeatedly during the past three years that an important reason for this apprehension and the consequent reluctance to make new capital commitments is regime uncertainty—in this case, a widespread, serious fear that the government’s major policies in areas such as taxation, Obamacare, financial reform, environmental regulation, and other areas will have the effect of depriving investors of control over their capital or diminishing their ability to appropriate the income that the capital generates.

Note also that Greg Mankiw made a similar argument on Sunday in his New York Time column. Policies that focus on increasing jobs to increase consumption get the causality the wrong way around. And, as Steve Horwitz said in the post that got me thinking about this over the weekend,

You want recovery?  Forget consumption.  Ask yourself what sorts of policy changes would make entrepreneurs and investors feel like they know what to expect over the medium and long run and convince them that they will be able to keep the fruits of their labor and investments.  Hint:  the president’s jobs plan ain’t it.

Frankly, I think the important factor for long-run growth is innovation and technological change rather than investment in existing factors of production to produce existing value propositions … but the policies that facilitate innovation are correlated with policies that facilitate investment, so I’ll leave their arguments as they stand.

6 thoughts on “Stimulus Failure: A Costly Lesson on Keynes and Say’s Law?

  1. What does this tell you about balance sheet recessions though? Unless I’m missing something, all these factors describe economic activity independent of leverage (or at least at constant leverage ratios). The massive pre-recession indebtedness of global economies and subsequent deveraging seems sufficient to explain all that has happened since, without getting into production functions and relative rates of technological innovation.

    Without doubt, we were overleveraged, and the correction we’re now going through is painful, but necessary. The political challenge seems to be that the best long-term medicine is short-term political suicide and the best short-term politics is long-term poison. The argument for Keynesian stimuli in a balance sheet recession has always seemed to me to be more about balancing the political & economic than solely an economic issue; if it provides some capital stability as debt levels fall to bridge the gap, it may be a way to split the baby. Devil clearly in the details, but I don’t know how to assess Keynes wisdom independent of the politics of deveraging. Would you agree?

  2. Sean, I don’t think you need any Keynesian model to understand deleveraging and the re-pricing of risk that we’ve seen in the past three years. In fact, I think an Austrian model is a more parsimonious and straightforward framework for understanding why that happens — the policies of encouraging homeownership and using monetary policy in ways that distorts credit markets and has led to malinvestment patterns. Deleveraging is part of adapting to the (negative) consequences of that distortion-driven malinvestment, and it’s a complex process because both capital and labor are heterogeneous, so there are a lot of margins on which that adaptation has to occur … and we have to let that adaptation occur.

    I suspect that your question arises because you are thinking of deleveraging as a primary driver of the diminished investment, which I think makes sense. The question is at the margin, given that deleveraging is happening and is the response back from the distorted malinvestment, what policies are going to be most conducive to productive activity and value creation that will ultimately be measured in national income statistics.

    Note that I didn’t say word one in there about inadequate consumption, and in fact your question about deleveraging is also more a question of investment than consumption, although of course they are connected.

  3. Thanks, Lynne. My point wasn’t why we over-levered, nor why we are responding the way we are to a reduction in access to capital – I agree that both of those can be understood purely on the basis of econ theory. My point was rather that the government response to an economy that has just gone through a (over-leverage-induced) contraction is as much political as economic. The former is too often in conflict with the latter, but it seems that targeted pump-priming (coupled with structural reforms) seems the best we can hope for from any democratic system of government that depends on voter support in the not-too-distant next electoral cycle.

    However, it seems that the only tools gov’t has to drive fundamental, LT economic growth are from structural reforms to free up entrepreneurial activity and investments in infrastructure where those tools aren’t sufficient. The former necessarily has a time constant before the innovation follows (especially in the big, capital-intensive industries where it’s needed most). And the latter is pretty Keynesian. So it seems to me that – again, only in the case of B/S recessions – it does seem there is a role for public investment to facilitate a transition to a more economically robust future, if only to minimize the disruption otherwise caused by a rapid ST shock to the economy.

    That said, there is definitely a part of me that would welcome a good, Austrian shock & awe policy, if only to give capital markets certainty that all balance sheets are now properly valued (I’m looking at you, BofA!) and all investments now have a credible upside…

  4. Sean, thanks for that clarification. We are suffering a political response trying to control and manage an organic economic response to a politically-driven inducement of distortionary malinvestment, IMO.

    I think a lot of damage is often done due to the hubris associated with the political belief that they can “drive” economic growth. What makes you think that the public investment will be “the right” investment, or even a good investment? A lot of the studies of how the ARRA money has been spent, even when focused on infrastructure, indicates that it’s ended up in low-marginal-value activities, or has simply substituted for either private investment or public money from some other account (i.e., crowding out). And don’t even get me started on green tech subsidies and Solyndra …

    You can also analogize to the “commanding heights” events of the 1970s-1990s, where the post-Soviet countries that followed the short, sharp shock approach have ended up with much higher growth and living standards than those who took the glide path approach (or countries like Russia and Ukraine that have stuck with the oligarch approach). Yeah, it’s painful, but we’re resilient and adaptable after so many generations of evolution, and we have mountains of historical data to show that the countercyclical policy cushion medicine is more poisonous than the malinvestment disease.

  5. Aye, there’s the rub! No idea how to get a philosopher king who guarantees the right investment – but I’m not sure how you effect an oligarch-style shock & awe in a democratic process. As Churchill said, democracy is a lousy system except for the alternatives.

  6. It’s funny, I’ve been having these exact same thoughts over the last few months, triggered by all the “green jobs” nonsense, and infused by reading the Kauffmann Foundation report on job creation.

    I never really bought into macroeconomics, but instead, tend to think, well, like a biologist, since that’s what I am. My thinking brought me to the same place, more or less. If you think of the economy as an ecosystem, everything starts with production.

    As I visualize it, the simple day-to-day activities of human, specialized, trade-based societies produce a net “wealth surplus,” that people can try to capture by offering new things or services up for trade. Under most any circumstance, some set of people have the resources to take a crack at this, so there’s a steady-state process of small business formation, as Kauffmann found from the data. People will do this automatically if they think they have a ‘fair’ shot at capturing a net return on investment, and being allowed to keep it. The same is true for expanding a venture that’s already underway.

    With Obama, people contemplating business investments see a tilting regulatory playing field that are reducing the odds of success, paired with a social dynamic that vilifies successful entrepreneurs, and tries to claw back their profits through punitive taxation. Only an idiot would take risks in a setting like this, or people with enough money to lose that they can approach it like a craps table: make 50 bets, and hope one pays off big enough to cover the others. And since, as Kauffmann documents, start ups, and small-business expansions are responsible for such a disproportionate share of new job growth, it doesn’t take a lot of discouraged people from causing a significant downturn in job creation.

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