“Keynesian Death Spiral”

by Jerry O’Driscoll  

In Wednesday’s Wall Street Journal, Kevin Hassett explains the economic logic against fiscal stimulus (“Stimulus Optimists vs. Economic Reality”). It’s a superb piece.

The more powerful one believes fiscal stimulus to be, the more adept the Keynesian policymaker must be. If the stimulus has powerful positive effects when added, it will have powerful negative effects when withdrawn. Hence, the application of stimulus and its withdrawal must be precisely timed. An economist would ask from whence the knowledge to do this would come.

As Hassett notes, however, stimulus has not two but three stages. It may boost growth when added, but must slow growth when withdrawn. The third stage comes when taxes (current or future) must be paid to fund the stimulus. That stage is always negative in its effects. Thus, Hassett concludes that “the total impact of the Keynesian policy is negative over its life.”

The case for fiscal stimulus is even weaker in the aftermath of a major financial crisis, such as we have experienced. Downturns, measured by employment, are longer in the wake of such crises. Hassett cites the Reinhart and Rogoff estimate of an average duration of 4.8 years. Short-term stimulus becomes very problematic in the wake of such crises.

 “…Aggressive stimulus sets off a kind of Keynesian death spiral in which nervous politicians adopt repeated stimulus packages in order to avert near-term distress, the cumulative effect of which can be ruinous.”

(Though Hassett does not note it, Keynes was aware of the problem. He described it as the bismuth/castor oil cycle. The patient inevitably dies.)

Hassett’s analysis fits the current situation very well.

11 thoughts on ““Keynesian Death Spiral”

  1. When the stimulus is imposed, there is some positive short-run increase in GDP. When the stimulus is removed, there is an approximately equal and opposite reduction in GDP – Kevin Hassett

    This is false. In theory, by the time fiscal stimulus is removed, the confidence fairy has calmed the nerves of anxious investors — every dollar less fiscal spending is matched by an increase in private spending and GDP remains constant. There is an asymmetry.

    It’s like crowding out in reverse, and so it is weird that anti-Keynesians make this kind of criticism. Supposedly, fiscal stimulus doesn’t increase spending because “every dollar has to come from somewhere,” and so every dollar of fiscal stimulus is a dollar less in private spending. The net increase in spending: zilch. Keynesians claim this is false because in a depressed economy there are idle resources, and so fiscal stimulus is not replacing, but rather filling in the gap left by a fall in private spending. But when it comes to withdrawing fiscal stimulus, private spending is supposed to “crowd-out” public spending — idle resources are not idled once again. Thus there is no “equal and opposite reduction in GDP.”

    You might disagree with this theory, but it is what it is, and that isn’t what Hassett describes. Granted, a lot of Keynesians are so blinded by their love of government spending that they also fail to recognise this asymmetry, so it is easy to go unnoticed, but I am pretty sure it was always there to begin with.

  2. Lee,

    I think Hassett was making an internal critique, an “even if” argument. Okay, he is saying, let’s accept the popular “Keynesian” view that a stimulus always stimulates. Then you have this timing problem and the risk of a Keynesian death spiral. You are getting a bit away from the taking-head-Keynesianism and closer to Keynes himself, Lee, when you start talking about confidence and expectations. Jerry flagged the difference between Keynes and the talking heads, actually, with his reference to Keynes’s bismuth/castor oil cycle.

    I really like the phrase “Keynesian death spiral.” The theory of Big Players points in a similar direction. The reliability of expectations in financial markets is endogenous to the policy regime and reduced by discretion and instability of rules. I would now list also *ambiguity* in the rules as with Dodd-Frank. When we are more uncertain, herding and “contra-herding” are more likely. The current situation seems pretty gloomy in part because we have damaged knowledge production in markets.

  3. In essence, the short-term benefit is considerably less than, and does not justify, the dire long-term consequences. Like my mother done told me, “Always consider the long-term results of your actions!”

    In our personal lives the same rule holds true. Pyschologists have discovered that impulse control, a long-term view, and deferment of gratification, all are better predictors of life success than good grades or a high IQ. Consider Dr. Walter Mischel’s famous “Marshmallow Test:” A class of four-year olds at a Stanford preschool were told by their teacher that the bowl of marshmallows on the front desk was for them to eat. Then, answering a staged phone call, he said he had to leave for a few minutes, but those who wanted a marshmallow could take one. But, he added, if you wait till I return, you can have two. An observor kept score of who took one.

    Twelve years later, in high school, those who had waited were performing significantly better than those who opted for one quick-fix marshmallow. Daniel Goleman suggests that such emotional control is a trait that can be learned, leads to better decision-making skills, and is a “meta-ability” that determines how well people can utilize their other mental capacities.

    The most “intelligent” high IQ individuals (like our recent Treasury Secretaries from Goldman Sachs) may thus adopt policies that a common person would have the sense to reject, and all because they lack the balance of taking a long-term view. Under their Keynsian theories, by attempting to “spend us out of a recession,” they will leave us and our children with half a marshmallow instead of two.

  4. Roger is correct and I encourage Lee to read the Hassett piece. It is an internal critique. “Keynesian” policy has impossible informational requirements. Keynes was at least aware of the problem.

    The informational problems with discretionary fiscal policy were what lead Hayek to question the wisdom of counter-cyclical policy. Friedman developed that critique into his theory of the lags in monetary policy. (Recall his earlier work had questioned the efficacy of fiscal policy, leaving monetary policy the only game.)

  5. I did read the piece. I am broadly in agreement with Hasset. Indeed, I would say he is not critical enough of fiscal stimuli, though perhaps that was just because he had to limit himself to only a handful to points for brevity.

    However, my point was that the quote I criticised was not an internal critique of Keynesianism. At best, it was an internal critique of popular or crude variants of Keynesianism.

  6. A curious thread: 1) Lee correctly points out that Kevin Hassett misconstrues Keynes’s theory; 2) then Roger says that Hassett was making an “internal critique,” which turns out to be a critique of “Talking Head Keynesianism”; and 3) Lee concedes that he’s “broadly in agreement with Hassett.”

    No doubt there are difficult judgments that must made in the timing of public expenditures. But it’s worth pointing out that the “automatic stabilizers,” e.g., unemployment benefits, the progressive income tax, etc., play a useful role within the Keynesian scheme of things.

    By the way, is this the same Kevin Hassett who co-authored “Dow 36,000”?

  7. Greg,

    I think fiscal stimuli are undesirable under almost all circumstances. A situation in which I would support a fiscal stimulus is so improbable that it hardly bears mentioning except as a theoretical curiosity. So you can count me in with Hassett and O’Driscoll as an opponent of more fiscal stimulus.

    I disagree that Hassett’s claim — quoted in my original comment — is an internal critique of Keynesianism. It is, however, an internal critique of “Talking Head Keynesianism.” I think Hassett should have been more clear on this point, supposing he recognised the distinction at all. Personally, critiquing “Talking head Keynesianism” seems rather pointless to me; it is too easy a target, and more serious Keynesians will simply dismiss the argument as setting up a straw man.

  8. There is the issue of Keynes vs. the Keynesians, brought up by both Roger and Lee. It also comes up in today’s “Capital” column by David Wessel, in which he attributes the liquidity trap to Keynes. It is an idea Keynes considered and rejected.

    Keynes believed in the efficacy of monetary policy. He understood and worried about the lags in monetary policy. He was a late convert to counter-cyclical fiscal policy, and then only as a fill-in until private investment kicked in.

    The real source of intellectual support for counter-cyclical fiscal policy (“pump-priming”) came from the Old Chicago School. This included such figures as Lloyd Mints, Paul Douglas and Henry Simons. The history is dealt with admirably by J. Ronnie Davis in The New Economics and the Old Economists (Iowa State University Press, 1971).

  9. There can be no withdrawal problem because increased government spending can only destroy actual production, and reduced government spending can only increase it.

    The withdrawal symptoms experienced by social parasites deprived of their loot is due to their poor foresight, not to the policy itself.

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