Where Keynes Went Wrong

November 11, 2011

It is generally recognized that the conceptual underpinnings for so-called stimulus programs lie in the theory developed by John Maynard Keynes in the 1930s.  And though his theories have been broadly developed throughout the past century and touted by leading economists as revolutionary, the poor performance of policies based on his theories in resolving the recent recession should give cause for reassessment.  In doing so, it is first important to look to the real costs of the recent stimulus package, says Charles Wolf, Jr., a senior research fellow at the Hoover Institution.

  • In addition to the $787 billion in "stimulus" money, the Troubled Asset Relief Program funding ($700 billion), bailout funds for the auto industry ($17 billion), the extension of unemployment benefits ($34 billion), and the "cash for clunkers" program ($3 billion) bring the total cost of the package to $1.5 trillion.
  • Between the end of the second quarter of 2009 and the end of the second quarter of 2011, nearly all the stimulus funding was disbursed with the result that gross domestic product (GDP) increased from $12.6 trillion (in 2005 prices) to $13.3 trillion.
  • In that same period, gross private consumption rose by $400 billion and gross private (nonresidential) fixed investment rose by $155 billion; employment decreased by 581,000.

These results paint a negative picture of the impacts of the stimulus package's effects in the American economy.  The fact that $1.5 trillion in spending resulted in a GDP increase of a mere $700 billion suggests that American taxpayers received less than 50 cents on the dollar of investment.  This seems to contradict the results predicted by Keynes, who predicted that increases in aggregate demand should realign the economy into full-employment equilibrium and lift it out of the recession.

In looking to Keynes' theories for some explanation of the package's meager results, it is prudent to reexamine the assumptions his model made.  In so doing, one of his assumptions, that increases in government spending would not adversely affect investment or consumption, stands out as overly optimistic.  It is possible that the borrowing necessary to finance the stimulus package sent the message to consumers that they should save rather than spend.  Similarly, it is possible that many investment opportunities were ignored by potential investors who did not want to inject cash into the heavily regulated American market.  These adverse effects perhaps explain the poor results of the stimulus package, and should remind policymakers to consider the assumptions upon which Keynes' theories rely.

Source: Charles Wolf, Jr. "Where Keynes Went Wrong," Weekly Standard, November 7, 2011.

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