Sunday, January 31, 2010

Keynes on Government Stimulus, Digging Holes

This is part five of our discussion of John Maynard Keynes and his 1936 book The General Theory of Employment, Interest and Money.  So far, we have uncovered some very interesting ideas buried in the famous economist's most well known work.  Here is what we discussed in parts 1-4:
For part five, we thought it was high time to discuss government stimulus.  John Maynard Keynes is often credited with originating the ideas for the various government stimulus efforts that are currently being employed by almost all of the major nations of the world.  But how accurate is this really?  As we will see below, it is quite fascinating to read what Keynes actually said about certain government stimulus efforts.

All quotes below can be verified for their accuracy by referencing the full text, which is available online for free here.

Chapter 22, Section III
The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

This is the basic game plan employed by Keynesians, or in other words, every central banker.  Booms should not be stifled and busts should be battled with government stimulus.  The opposing view presented by Austrian Economists is that booms lead to busts and thus booms should be prevented from getting out of control in the first place.

Chapter 8, Section IV
In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump. And, furthermore, since “financial prudence” of this kind continued to be exercised through the slump by those great corporations which were still in a position to afford it, it offered a serious obstacle to early recovery.

Keynes says that the massive excesses created by the boom were enough to cause an inevitable slump.  This inevitable slump became the great depression.  One would think that it would logically follow that we should try to prevent booms from getting too out of hand (the Austrian argument) but based on the first quote in this article, Keynes clearly did not feel this way.

Chapter 8, Section IV
…in Great Britain at the present time (1935) the substantial amount of house-building and of other new investments since the war [since the end of WWI in 1918] had led to an amount of sinking funds being set up much in excess of any present requirements for expenditure on repairs and renewals, a tendency which has been accentuated, where the investment had been made by local authorities and public boards, by the principals of “sound” finance which often require sinking funds sufficient to write off the initial cost some time before replacement will actually fall due; with the result that even if private individuals were ready to spend the whole of their net incomes it would be a severe task to restore full employment in the face of this heavy volume of statutory provision by public and semi-public authorities, entirely dissociated from any corresponding new investment…Yet is not certain that the Ministry of Health are aware, when they insist on stiff sinking funds by local authorities, how much they may be aggravating the problem of unemployment.

A housing boom that led to a massive bust.  Where have we heard this story before?  Keynes was against the government efforts of his time to spend money to stimulate the housing market.  He said it aggravated unemployment.  Name one central banker who holds this position.

Chapter 10, Section VI
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

To the layman (aka those with common sense) the above argument strikes one as utter insanity.  Thankfully, we have prominent economists such as nobel laureate Paul Krugman who advocates such ideas.  Krugman even featured this passage on a recent blog post.  So rest assured, the above makes total sense.  Forget the fact that Henry Hazlitt debunked this theory in 1946 with his work Economics in One Lesson.  Hazlitt called this the broken window fallacy.

Economics in One Lesson by Henry Hazlitt:
A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sun. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace the window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

A very basic economic concept known as opportunity cost describes this as well.  How can this possibly be overlooked by anyone that claims to be economist?

Regardless, people such as Paul Krugman conveniently forget one important aspect of Keynes's argument:

Chapter 16, Section III
“To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.

"Paid for out of savings" is the crux.  A country such as China, with their massive reserves, may actually benefit from government stimulus.  This is only true because the source of the stimulus is savings.  The US has major deficits and thus stimulus efforts are not coming out of savings but out of debt.  This is a big difference and most central bankers are conveniently ignoring this fact.
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