Charles Wolf writes in The Weekly Standard,  Where Keynes Went WrongWhat if government spending depresses instead of stimulates? 11/7/11

Excerpt:

Keynes assumed that the initial deficient level of aggregate demand would remain unchanged until the stimulative (“pump-priming”) effect of additional government spending kicked in. In other words, increased government spending, or its anticipation, would not further diminish pre-existing levels of consumer demand and investment demand. However, Keynes’s failure to consider the possibility of an adverse effect from government spending — that it might lead to still further decay in the prior levels of consumption and investment — was a fundamental flaw in the theory.

So how might government spending actually undermine its explicit purpose of boosting aggregate demand?

It is quite plausible that the behavior of consumers and investors might change as an unintended consequence of the increased government spending, and might do so in ways that would partly, fully, or even more than fully offset the attempted effort to raise aggregate demand.

That prior consumption demand might actually have been reduced as a result of recent government stimulus spending is suggested by two indicators: Since mid-2009, household savings increased by 2-3 percent of GDP, and household debt decreased by 8.6 percent ($1.1 trillion).

It is also plausible that investment demand might shrink as a result of increased government spending or its anticipation. This diminution might occur if investors have recourse to other investment opportunities that seem more profitable or less risky than those that would accompany or follow the attempted government stimulus. For example, such opportunities might lie in investing abroad where tax liabilities are less onerous, rather than investing at home; or investors might choose to invest in long-term instruments (30-year U.S. government bonds) while reducing investment in fixed capital or equities. These opportunities might seem rosier because of anticipated increases in future taxes, or because of increased regulatory restrictions that might (and did) accompany the increased government spending. In fact, such alternative investment opportunities are much more numerous and accessible now than in Keynes’s era.

HKO comment:

The stimulus effect performed poorly during the Great Depression, and is performing even worse during this recession.  There are other changes that impact this idea.  More Americans are investors as a result of the popularity of 401k’s and the requirement that they have a say in how their money is deployed.  Few people during the Great Depression had the level of mortgage and credit card debt they have today.

In addition to the expectation of higher taxes there is an accumulation effect of regulations that have stifled business investment.  Paying down debt reduces consumption, but it leaves us stronger.  It is a correction of the unsustainable stimulus we experienced from excessive debt.  We deluded ourselves to believe this time was different.

The author also noted that since income taxes were so low during the 1930’s a tax cut as a stimulus was not a viable option.  Today it is.

The obsession with Keynesian stimulus ignores significant differences in our modern economy and culture.  It is foolish to think it will work this time; especially when it failed the first time.  It is debatable whether it has ever worked.

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