Tuesday, August 9, 2011

Friedman, Keynes, and Whatever Comes Next

America's two great political parties have adopted two very different outlooks on fiscal policy.  Republicans have largely embraced the philosophy of Milton Friedman, a staunch libertarian and classic liberal, while Democrats have adopted the philosophical approach of John Maynard Keynes.   

Since Richard Nixon supposedly uttered the phrase 'We're all Keynesians, now' it seems that a great gulf has opened between the two major American political parties.  In actuality, the phrase was coined by the late economist Milton Friedman and later adopted by Nixon after removing the U.S. from the gold standard in 1971.  What Friedman meant was that in some sense all the politicians and economists employed Keynes' economic philosophy that government should spend more in hard economic times and cut back when times got better.  Friedman was a Keynesian himself before developing his own monetarist economic theories in the 1950's and 1960's.  Monetarist theory essentially argues that economic slowdowns can be countered by adjustments in the money supply (or credit markets).  When prices are deflating then an increase in the money supply is necessary and vice-versa when inflation is present.  In plain English this means that easy credit will lead to a growth in demand for products which will raise their prices.  Tighter credit markets will deflate demand and thus tamp down inflation.  This is what the Federal Reserve does when it adjusts interest rates.  Many conservatives have adopted a modified version of Friedman's approach to fiscal policy that focuses primarily on tax cuts.  The theory is that reducing taxes will put more money in the hands of consumers and businesses who will spend and invest it, thus leading to higher rates of economic growth.  This is what has come to be called 'supply-side economics.'

The flip side of monetary policy is traditional Keynesian fiscal policy.  Fiscal policy has to do with the level of taxing and spending done by governments.  The English Economist John Maynard Keynes argued that recessions can be controlled and their effects mitigated through government investment and spending policy.  Reducing taxes, investing in infrastructure, and spending money all have the effect of stimulating demand.  Thus, we refer to a package of government spending as a 'stimulus' package.  President Obama's package in 2009 included all three of these elements.  Keynes believed that economic growth (or demand for goods) needed to be maintained and rising unemployment levels had to be avoided to prevent economies from sinking into depression.  As businesses contracted in weak economies they would layoff workers who would then have less discretionary income, which in turn would lead to a weakening of demand for goods and services.  A downward spiral would begin until some hypothetical floor was reached.  Government, Keynes believed, is the only entity with enough spending power to replace what was lost through contraction.  So government should make up for the reduced spending in the economy even if it required deficit spending to put people to work (or keep them working) until the economy recovered sufficiently.  Then government should reduce its deficits and cut spending levels to bring its budget back into balance.  Rather than seeking a balanced budget over a single year, governments ought to pursue them over a longer time frame, perhaps 7-10 years.  This is what is known as 'demand-side economics.' 

The problem for both of these theories is the same...they only work in 'closed systems.'  The U.S. economic system is far from closed.  In fact, it is global in nature.  Infusing capital (stimulus) into the U.S. economy may accomplish less than expected because the funds don't stay in the U.S. economy.  They are exported to China, India, or wherever the goods being purchased are made.  One exception, however, would be infrastructure investments.  From the supply-side perspective, tax cuts don't achieve the desired effect because those who receive them don't spend the money in the U.S.  A corporation receiving a tax break may build a new factory in Mexico where labor is cheaper, thus removing that money from the U.S. economy.  At least if the government had simply spent it the funds would likely have stayed in the country.  We end up with a situation that both the Keynesians and Friedman's disciples won't like and that is both of them help economic growth in other countries while doing little to promote growth at home.

What we need is to develop an economic model that sees the world economy as an open system, recognizes the limitations of government intervention, yet eliminates political ideology from the equation.  We may also have to accept that much of our nation's growth over the past 30 years has been an illusion, or a bubble.  Real and sustainable growth rates are closer to 2% than 4%.  In other words, this may be the new normal.  

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