How I Think About Keynesian Economics By Arnold Kling

By the way, my panel appearance on jobs is now up on C-span (I start about 45 minutes in. Also, I saved some of my thoughts for the Q&A, which starts about 64 minutes in.)

In this post, I want to try to explain Keynesian economics to people who are inclined not to believe it. That is, to people who think “If the government spends money, it has to come from somewhere else, so Keynesian economics is just an example of fallacious reason that comes from observing the seen and ignoring the unseen.”

It helps to think of economic activity as outsourcing. That is, if you iron your own shirt, that is not economic activity. If you outsource ironing by paying someone else to do it, that is economic activity. If you eliminate ironing by buying permanent press shirts, that is also economic activity (Nick and I call the cost-saving innovation Economics 2.0).

A recession is a decline in economic activity. People are not outsourcing as much as they did when the economy was booming. Economists have noticed during this recession that global trade figures have plummeted. Indeed. That illustrates a decline in outsourcing, a decline in economic activity. In Adam Smith’s terms, the extent of the market has declined. Not because of explicit trade barriers, but because….well, I would say it is because the market needs to recalculate, but that is not a very Keynesian notion. Keynes would have said it is because consumers are attempting to hoard, and businesses do not have the “animal spirits” needed to convert this hoarding into investment.

The thinking behind Keynesian economics is that when you are in a recession, if the government runs a bigger deficit, recipients of the money will want to increase their economic activity. This will draw people out of non-market activity (unemployment) and into the market. The newly-employed will want to outsource more of the satisfaction of their needs, and this will create a virtuous cycle (the multiplier).

Imagine that all of us were chefs, each with a different specialty. In good times, I patronize others’ restaurants and other people patronize mine. That is economic activity. In a recession, for some reason we stop going out to eat. I don’t enjoy eating my own cooking every meal, but I don’t think I can afford to go out. Since I am not patronizing your restaurant, you think you have to cut back on eating out, also. Economic activity declines.

Thinking about the economy in these terms, the idea of using government deficits to boost economic activity makes perfect sense to me. The reason that I am doubtful about Keynesian policies today is that I think that recalculation is important. Nobody, least of all the government, knows the best way to align the work force to satisfy needs. The recalculation problem has to be solved gradually, by trial and error. It is as if we had a bubble in Mexican restaurants, and now it is not clear whether they need to be replaced by more Indian food, more French-Asian fusion cooking, or whatever. I do not think that central planners in Washington know the answer any better than the market. So I am not confident that a Keynesian approach is going to get us very far this time.