Understanding Keynes and His Famous Fiscal Stimulus Scheme

(This is the First Segment of a Three Part Series)

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Long run is a misleading guide to current affairs. In the long run we are all dead.

John Maynard Keynes

The first economist to offer a complete and peer-accepted explanation for the Great Depression was the British economist, John Maynard Keynes (1883–1946). His theory was simple: Aggregate Demand determines the overall level of economic activity, and that inadequate aggregate demand can lead to prolonged periods of high unemployment.

Keynes’ reasoning went something like this: wealth dries up during an economic Recession; first consumers and then businesses stop spending money, causing a vicious circle where more consumers, who are now without jobs, have no money to purchase goods and services. Next, with diminishing consumer demand, industry has to slow production and lay off more workers who also have no money to buy goods and services, which drives economic activity even lower.

In his book the General Theory of Employment Interest and Money (1936), Keynes created a simplified model of how the major pieces of a market economy fit together. By utilizing his model, economists for decades have played guessing games as to the impact of certain government policies on growing Gross Domestic Product (GDP) and alleviating unemployment in a recession. He theorized that the solution to an economic recession (or depression) was for the federal government to intervene with a massive amount of spending, artificially spurring the demand for goods and services that the private sector would be unable to generate on its own. Keynes believed that the Great Depression could have been shortened by massive government stimulus spending. During this period, unemployment was extremely high while production and international trade tanked. In short, economic activity was grinding to a halt. A key element in Keynesian theory was that government inflationary spending should be used to give consumer demand a short-term boost. Once stimulated, the economy would respond by spurring production and increasing levels of employment. Theoretically, pulling the economy out of a recession.

Free Money?

William Phillips (1914–1975), a New Zealand born economist, wrote a paper in 1958 titled The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957. As boring as the topic sounds, his theories regarding the relationship between inflation and unemployment have had a profound effect on modern economics. Expanding on Keynesian ideas, his research led him to develop the “Phillips Curve:” stated simply, the higher the rate of Inflation, the lower the unemployment in an economy.

The economic theories of Keynes and Phillips have become the backbone of modern economic policy — Why? Because governments love the idea of free money! All U.S. Presidents have embraced these theories. The logic goes like this: full employment means significantly higher tax revenues than high levels of unemployment. Therefore, if the private sector is unable to provide a nation with continuous full employment, then Keynes and Phillips instruct governments to spend vast amounts of inflationary money to “prime-the-pump.” This money is circulated through the economy and as a result of the Multiplier Effect, more and more money is generated until full employment is again achieved. The higher tax revenues pay for the new government spending and the budget is brought back into balance. To properly understand these concepts, I’ll illustrate with a few simple examples.

The Multiplier Effect from Stimulus, a Micro Perspective

The Government sends me an $800.00 stimulus check; I purchase an $800.00 Dell computer at a local store; the store makes a deposit at the bank and uses part of the money to pay bills and make payroll; and then orders another computer from the manufacturer. The factory increases production by one unit and uses the money to pay bills, meet payroll, and purchase parts from vendors. Everyone and every company who benefits fractionally from this purchase will subsequently spend their portion of the $800.00, and those who receive the money will spend a portion of it and so on and so on.

The government’s expenditure of $800 was a component of aggregate demand so it increased by $800; then, when I purchased the computer for $800, I increased consumer spending by $800, therefore, aggregate demand was increased by another $800.00. For simplicity, let’s say that of the $800 purchase price, $400 is sent to Dell to replenish the store’s inventory. Of that $400, let’s assume that $100 stays in the U.S. and $300 goes to Mexico or Asia for the manufacture of one unit. The $100 adds to our domestic economic activity, the $300 does not. Let’s just take a cursory glance at the first couple rounds of spending, federal government: $800, my computer purchase: $800, Dell’s domestic portion: $100, the stores expenses, including profit: $400. To summarize: $800 + $800 + $100 + $400 = $2,100. It doesn’t end there because the employees who receive a portion of the payroll will also spend their fraction of the total as will those who receive payment on bills and on and on and on. With each financial transaction from the original $800, domestic economic activity increases. Thus, the Multiplier effect. However, we must remember that so far, no new money was created. We only divvied up and circulated the original $800.

The Multiplier Effect from Stimulus, a Macro Perspective

For our next example, we have a hypothetical economy that is in a deep recession. The federal government responds by spending $1 trillion in economic stimulus. It does this by sending checks totaling $1 trillion dollars to every taxpayer as if it were a gift. Not all of this money, however, will increase economic activity in the United States. For example: 5.7% (our national savings rate) or $57 billion dollars will go into savings, leaving about $943 billion to spur economic activity.

Next, we need to take into account; U.S. taxpayers going on vacations to other countries, including cruises and U.S. taxpayers living abroad and/or purchasing properties abroad. We will look at these categories as a percentage of total U.S. consumer spending, which is reported at $11.7 trillion dollars. Therefore, once we have estimated our percentages, we can multiply them against our hypothetical $1 trillion-dollar stimulus. Americans spend about $158 billion on international travel and while there are no exact figures on Americans living abroad (and spending U.S. dollars) there are good estimates in the range of five to six million American “Expats” and overseas military personnel; so, if we extrapolate the average U.S. per capita income figure, reported at between $20,000 and $30,000, we can roughly determine the impact of these two categories at about 2.3% of total U.S. consumer spending. Therefore, we also need to deduct the 2.3% from our $1 trillion stimulus, which equals $23 billion; giving us a new sub-total of $920 billion dollars.

There is still one more category in which we need to account. Some of the money will be sent internationally to pay for imported products. As in the previous example, a portion of our computer purchase went to either Mexico or Asia. Likewise, perhaps an employee of the computer store, spent part of his or her paycheck on clothing that was manufactured in Southeast Asia. The portion of that purchase going overseas did not help stimulate the U.S. economy. Therefore, we need to further reduce the domestic economic impact of the stimulus by the total of imports which is about 17% of the U.S. economy. 17% x $1 trillion = $170 billion. So, if we reduce our previous sub-total of $920 billion by $170 billion, then we are left with a grand total of $750 billion. In other words, the domestic economic impact of the government’s stimulus package has been reduced by 25%.

Finally, as we saw in our last example; the money from my $800 stimulus check doesn’t circulate forever through the economy; with each new round of spending the exchange of money becomes incrementally smaller. Therefore, economists estimate the limit of the multiplier effect to be about five times the original amount. $750 billion x 5 = $3.750 trillion. Okay, so $750 billion dollars is added to consumer spending and as it permeates throughout the economy, it’s impact multiplies, but with each new financial transaction it will be diminished by 20%. However, as before, we still haven’t created any new money, we simply divvied up and circulated the $1 trillion — that if you remember, belonged to the taxpayers in the first place. In five rounds of spending we have gone from a total of $3.750 trillion to zero. I should also mention that a $1 trillion personal tax cut would accomplish exactly the same result as individual tax payers would have a commensurate amount of money in their wallets as a result of paying less in taxes.

For the purposes of our example it doesn’t matter if the actual spending provided $1 trillion worth of value to our overall society or even if it provided any value at all, just so long as it circulated broadly throughout the economy. Thus, the circulation of currency became an end in itself. I don’t mean to give the impression that currency floating around the country is as worthless as the wind blowing dust in circles. It clearly does have temporary value to the economy. Going back to our example, if I hadn’t purchased the computer with my stimulus check, then theoretically it may have sat forever on the store’s shelf. The store owner wouldn’t have had the revenue to pay employees, pay bills, pay taxes or replenish his inventory with another computer. However, by temporary I mean that once this money has circulated throughout the economy, there is no real-world evidence to prove that it would significantly continue to spur spending and investment beyond the original $750 billion and truly bring a meaningful or permanent end to the recession. I should also remind you that $250 billion, of the original $1 trillion dollars spent by taxpayers, had no impact whatsoever on the U.S. economy.

But it’s Good for the Politicians

Let’s say for example that without stimulus the recession would have lasted for three years; and, that at the start of the recession, the federal government immediately spent $1 trillion to stimulate the sluggish economy. For the next three years unemployment goes down as the money circulates throughout the economy. Then, at the end of three years the economy magically recovers and the President brags that his policy brought an end to the recession. In the meantime, the trillion dollars is added to our long term national debt. Remember the wisdom of the old business axiom: “Never go into long-term debt to solve a short-term problem because you continue to pay for it long after the problem is solved.” However, if the benefits of the stimulus coincide with the next election cycle, then the President’s party will be rewarded with a victory at the polls! A pretty good political incentive. Wall Street investors also love stimulus because of a fixation on short term profits. And remember that as taxpayers this was our taxpayer money to begin with and the debt is ultimately our debt.

Inflation and Interest Rates

Deficit spending alone does not necessarily cause inflation. For example, deficit spending during a recession may not be inflationary because the private sector demand for currency goes down at the same time that currency demanded from the public sector goes up. Inflation kicks in when the private sector begins an economic expansion simultaneous with the government’s new and insatiable demand for currency. Therefore, if the Federal Reserve Board (Fed) decides to keep interest rates low when the currency demanded by both private and public sectors is high, then the nation’s money supply will sky-rocket above GDP — resulting in inflation. Conversely, if the Fed restricts the nation’s money supply with high interest rates, then inflation will be kept under control. This, in effect, is where the Fed uses interest rates as a tool to make sure the money supply grows at about the same rate as the overall economy. However, it isn’t the private sector that causes the inflation, it is caused by deficit spending and the federal debt, in combination with low interest rates and other actions by the Federal Reserve Board that artificially expands the money supply.

It is the private sector and ultimately tax revenues that suffer when an economic boom is artificially curtailed by the Fed.

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