I have a lot of friends. Among my friends are people from every color of the political spectrum, and all of them have an opinion about President Obama’s Economic Recovery Plan. From conversations at school, tweets I’ve received on twitter, facebook wall posts, and emails, I have discussed this issue with my friends. Some know what they’re talking about, some don’t. I would guess that less than 1 in 10 people understand both sides of the debate, and even fewer know why this isn’t a yes or no answer. My understanding of macroeconomic theory, its application in the US in the last 7 decades, and my observations of the current state of the economy today impel me to share my views and opinion. Unfortunately, I can’t do that in a tweet, but must explain myself fully. If you care to join for the ride, I guarantee you will learn something…
You see, if you support the bill, you, whether you know it or not, are in support of Keynesian Economics. If you are against it, whether you know it or not, you are in support of Free Market Economics. And here is the cold, hard, sad truth: scholars on each side of thought think they’re right, and scholars on each side of thought have been critically wrong at least once in the last half century. Lets use this as a starting point.
Macroeconomics is the concept of the role of the government and governments to aid, assist, and/or manage an economy. Both of the big ideas in macroeconomics consider the management of the money supply. Why? Available money is usually spent, and therefore, re-spent many times. This is called the economic multiplier. The re spending of money represents the total demand (or spendable money) of all the people in the country, and is called aggregate demand. That demand (money) will be satisfied, so a supply of product must be able to meet demand, and to meet that supply, firms must hire, which means low unemployment, and low unemployment is generally the measure of a healthy economy.
Follow me so far? Ok, lets talk more about the multiplier.
If every person saved an average proportionate amount of their income and spent the rest, every dollar in the economy is partially saved and partially spent many times. If on average we saved 3% of every dollar (which is my 401k contribution right now) that means that we each spend 97% of every dollar. The first person to receive the dollar spends $.97 and keeps $.03, the second person spends $.949 cents and keeps $.029, the third spends $.921 and keeps $.024, and so on, until the dollar has been completely saved. The sum of the spending of that dollar is the multiplier. I calculated a multiplier using a 3% savings rate and a 30% tax rate and I got a result of 3.11. In other words, if that were the US multiplier, each dollar in the US economy, after taxes, is worth 3.11 dollars in annual demand.
(Please note: calculating the true multiplier is far more complex as you must consider imports and exports and all taxes. My 3.11 was using a simple calculation.)
Alright, not too hard, right? Now, that you know the basics of macroeconomics, lets get into the differences between the two schools of thought.
Keynesian Economics come from the inventor of Macroeconomics, John Keynes. Keynes suggested that careful planning on the part of the government could control the demand of an economy, which as I said above, results in its prosperity. A recession is basically slowed demand, which means slowed output, which means higher unemployment. If the government wants to reduce unemployment and therefore rebound from a recession, it needs to increase demand. How? By spending money into the economy. That money is respent through the multiplier into a total increase in aggregate demand. Using my 3.11 multiplier, 1 trillion dollars is a 3.11 trillion dollar increase in aggregate demand. This is the control of fiscal policy, the Keynesian’s key tool to economic management. The Keynesian belief is that in bad times, when the private sector is saving money due to loss of confidence and fear of the recession, the government should spend money to boost the economy out of the hole. The consequence is deficit spending, which must be paid for through debt. In good times, the government should increase taxes to repay the debt and consequentially prevent a boom time at the cost of paying back the last recession’s debt. The long-term result is short recessions and no boom times but no depressions and long-term high levels of employment.
Free Market Economies are an offshoot of the original concept of pure capitalism from classical economics plus some new ideas. Unlike pure capitalism, the government does have a role, first, to ensure a competitive environment (prevent monopolies), second, to keep taxes low (which increases the multiplier and thus aggregate demand), and third, to control monetary policy. The adjustment up or down of the central bank’s interest rate is the free market economist’s main tool. Like the Keynesian equivalent, fiscal policy, monetary policy increases or decreases the money supply (which is then subject to the multiplier) by letting the private sector, and not the government, take on debt and increase spending during down times. Why? Because supposedly, the government can’t pick the best ways to spend money, but the private sector can. With cheaper lending, firms can take on value-added projects for cheaper and thus hire workers and decrease unemployment. Once the economy rebounds, the interest should be raised so firms only invest in the highest value projects and not the inefficient projects. So yes, the two theories have directly opposite results on the private and public sectors depending on the economic conditions.
So now, we’ve got both big theories in our heads… now for the history.
Before the invention of macroeconomic theory by Keynes after WWI and during the depression, a policy like free markets were in effect… and the world boomed. But, the unregulated markets took advantage of the freedom, greed set in, and boom! Great Depression. Roosevelt was advised by Keynes and others like him to spend, and spend he did, and relief was had, but it was not complete. The WWII ended the Great Depression because Government spent like mad, and that money, with the multiplier, resulted in the huge growth of the economies of all the capitalist governments of the time. Keynes became a hero for helping the allies win the war through careful management of the economy, and made a case for careful management from then out. Keynes died shortly thereafter.
And so in the USA, Keynesian economics took hold, and peaked with Kennedy/Johnson who achieved statistical unemployment with steady growth. Johnson balanced the budget and wanted to raise taxes more to set aside government savings for the next slow time, but the congress wouldn’t let him… after all, they had elections to win. So the growth continued… faster and faster. Fueled, no pun intended, by the oil embargo and a President who didn’t understand economics, that growth stopped. Nixon & Carter tried to spend their way out of a recession, but couldn’t. All across the world, Keynesian economies were suffering similarly.
In the 80’s, it was generally believed that Keynes’ ideas saved us from war but not from the forces of the economy, and so a new approach was taken to fix the current woes. Reagan, and his counterpart in Great Britain, Margaret Thatcher, shoved free-market economics down our throats. The transition was hard, but by reelection time, we had growth again. Huge tax cuts, huge government spending cuts (but still a deficit), a more proactive central bank (Federal Reserve), and a couple years resulted in a growth again. Clinton took office with nothing to do but continue to ride the tide. Under G. W. Bush, the Federal Reserve pushed interest rates very low to spur growth during the post-9-11 downturn, and didn’t bring them back up. Growth… faster and faster. And again, the bubble burst. Here we are today.
So, there is your overview of macroeconomic theory and short history. Now, what about today?
As of today, 70 years of economic policy can be summed up as two ideas that both epically failed. The 1970’s recession and the post-housing bubble recession of today each proved a theory wrong. So, both theories have been proven failures… or have they? I say not and instead common denominator to the failures: government inaction during good times as a result of greed. You see, our government had a role as the agent of macroeconomic policy to be responsible about our nation’s growth. Each economic theory dictated things to do when times are good and things to do when times are bad. Our governments followed the “when times are bad part” even when times were good.
Our government wanted unending growth… faster and faster. In their tenures, each economic theory was used to wind an economy up from the ground and then push it harder and harder despite a warning label on the box. Doctors warn us that taking medicine regularly makes it increasingly ineffective on a our bodily systems. When the current dose doesn’t work, we get more. When the drug doesn’t work anymore, we change it. Doctors also tell us to not take drugs when we’re not sick, or the speed at which the drug becomes ineffective increases. The last 70 years saw a government heavily drug its economy with higher and higher doses, even when it wasn’t sick, and twice, the drugs stopped working. Instead of raising taxes (Keynesian) or raising the interest rate (Free Market) when times were good, the government ignored the call to enact the fair-weather policies their economists told them to. And the economy, which is a living breathing thing, being forced to do something unnatural, needed a reset. Our government, made of both republicans and democrats, an extension of us, because of the greed we all shared, made these recessions happen… no economic theory is to blame.
Where do we go from here?
Free Market Economics imply that there is nothing that can be done. The key tool, the control of the interest rates, was dulled and ineffective when some interest rates were lowered to zero last year. From here out, Free Market Theory is dead weight, mainly because the predicted result of low rates, increased borrowing is not occurring. George Bush and his economic team enacted odd policies to try and save the economy in a way that scared both Keynesian and Free-Market Economists. Time will tell if they worked. For the most part, an entire nation is begging for government intervention, something very much against Free-Market Economics. People don’t understand the consequences of government intervention and going back to Keynesian Economics. It isn’t easy, and there is no such thing as a quick fix. Republicans, who are generally Free-Market, are favoring tax cuts but those cause deficits just as easily as spending. This crisis, unlike the 1970’s recession, has to do with completely unavailable credit, even though rates are at all-time lows, so as far as I, the casual observer, sees it, further support of Free Market Economics could result in ten years of stagnant, if not worsening, conditions much like ten years of further support of Keynesian Economics did in the 1970’s. I don’t know if a full switch back to Keynesian-ism is wise, especially in a very globalized world that we live in today. These questions can’t be fully answered in my scope of knowledge, nor do I think anyone can.
So, what is the opinion on the Obama plan? I refuse to answer that for you… I leave it up to you to decide. But when you make your decision, know that there is no right answer anymore, and that either side you pick has been both wrong and right and tarnished by greed and subject to the epic failure of government, and that I beg you to please cease the harsh if not downright mean commentary you aim toward people who may be on the other side of the line but are just as lost as you.