It often happens that flawed theories put into practice reveal their internal inconsistencies. We see this playing out in the case of Keynesian stimulus and the U.S. economy, and the stimulus defenders are at a loss.
By any measure, the Keynesian debt-based stimulus pushed into the economy in recent years has been extraordinary. Typically prescribed in doses of from 1 to 2 percent of the economy, from 2008 to 2009 the federal budget deficit jumped by 6.7 percentage points — yet the unemployment rate is and will likely remain in the upper 9 percent range well into 2011.
Deficit spending has to be financed, and in financing a budget deficit one of two things has to happen — either fewer funds are available to finance private borrowing, or more funds must be imported from abroad along with more goods and services. Either way, total demand for domestic goods and services doesn’t change; only the composition of demand changes.
Nobel prize–winner Paul Krugman has been a leading advocate of demand stimulus and attempted to use the fact that corporations are sitting on large cash reserves to defend Keynesian stimulus:
There’s now a lot of talk about the fact that U.S. corporations are sitting on a lot of cash, but not spending it. I don’t find that particularly puzzling: with huge excess capacity, why invest in building even more capacity. But almost everyone seems to agree that if we could somehow get businesses to spend some of that cash, it would create jobs.
Which then raises the question: how can you believe that, and not also believe that if the U.S. government were to borrow some of the cash corporations aren’t spending, and spend it on, say, public works, this would also create jobs?
Nobel prize–winner-in-waiting Greg Mankiw responded to Krugman by arguing that the difference between business investment and government’s deficit spending is that the debt from the latter must either be repaid or, at least, be serviced indefinitely, implying higher distortionary taxes in the future:
Businesses may be reluctant to invest in an economy that they expect to be distorted by historically unprecedented levels of taxation in the future. The more the government borrows, the higher taxes will need to go, the more distorted the future economy will be, and the less attractive is investment today.
Higher taxes would certainly be distortionary. Even so, with all the uncertainties and worries businesses have about the future, somehow potentially higher tax rates at an unknown point in the potentially distant future hardly seems a major worry for corporate CEOs examining their investment plans today.
Mankiw is left with this rather weak riposte to his steady antagonist because Mankiw, too, has been a supporter of Keynesian policy, albeit a less enthusiastic and more humble one. The problem for both Krugman and Mankiw is they forget that corporations may sit on a lot of cash, but they do so by making it available as savings to the financial system, to intermediate it to those who need it more. The cash is never idle — it’s just working where it’s needed more. There is a certain conservation of savings involved, analogous to the conservation of energy principle in physics.
As it happens, unfortunately, government is soaking up a lot of this corporate cash through deficit spending. This deprives other private borrowers of the funds and/or causes the United States to import more savings from abroad than it otherwise would. And therein lies the rub. Absent the higher debt resulting from this misbegotten Keynesian experiment, the nation’s capital stock would be higher and/or our indebtedness to the rest of the world would be lower, either of which would benefit the economy in the years to come. As matters now stand, thanks to Krugman-esque stimulus, all we will have to show for our efforts is the higher mountain of debt.
– J. D. Foster is Norman B. Ture senior fellow in the economics of fiscal policy at the Heritage Foundation.