Is There Really a "Keynesian Case"?

Despair overtakes Paul Krugman. It is so bad that he wants "to stick a pencil" in his eye, which not only would hurt a lot, but also just might blind him and make him even more despairing.

Why this deep, dark depression? It seems that pundits do not "understand" the so-called Keynesian Case, that special set of circumstances which, according to all True Believing Keynesians, justifies government spending sprees, printing of money, and borrowing into oblivion. As Krugman writes:

I’ll be frank: the discussion of fiscal stimulus this past year and a half has filled me with despair over the state of the economics profession. If you believe stimulus is a bad idea, fine; but surely the least one could have expected is that opponents would listen, even a bit, to what proponents were saying. In particular, the case for stimulus has always been highly conditional. Fiscal stimulus is what you do only if two conditions are satisfied: high unemployment, so that the proximate risk is deflation, not inflation; and monetary policy constrained by the zero lower bound.

That doesn’t sound like a hard point to grasp. Yet again and again, critics point to examples of increased government spending under conditions nothing like that, and claim that these examples somehow prove something.

In other words, Krugman is demanding that we meet him on what he considers to be HIS ground. He then takes issue with Tyler Cowen's criticism of "fiscal stimulus" when Cowen uses the experience of Germany in the early 1990s:

1. This was not an effort at fiscal stimulus; it was a supply policy, not a demand policy. The German government wasn’t trying to pump up demand — it was trying to rebuild East German infrastructure to raise the region’s productivity.

2. The West German economy was not suffering from high unemployment — on the contrary, it was running hot, and the Bundesbank feared inflation.

3. The zero lower bound was not a concern. In fact, the Bundesbank was in the process of raising rates to head off inflation risks — the discount rate went from 4 percent in early 1989 to 8.75 percent in the summer of 1992. In part, this rate rise was a deliberate effort to choke off the additional demand created by spending on East Germany, to such an extent that the German mix of deficit spending and tight money is widely blamed for the European exchange rate crises of 1992-1993.

In short, it’s hard to think of a case less suited to tell us anything at all about fiscal stimulus under the conditions we now face.

While Krugman never is going to admit that one can legitimately criticize his positions, nonetheless I do believe it is instructive to look into this "special Keynesian Case," better known as the "Liquidity Trap." Because I include Krugman's explanation above about this particular set of circumstances, and even though he does not identify it as a "Liquidity Trap," that is what he is describing.

My counter arguments will feature Murray N. Rothbard, who was the best-known Austrian economist of the late 20th Century after F.A. Hayek. In fact, Rothbard deals directly with the "Liquidity Trap" theories both in America's Great Depression and his tome, Man, Economy and State. In America's Great Depression, he has this to say about the "Keynesian Case":

What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers' goods prices falling faster than do consumer goods' prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned "classical" speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from "speculative" hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.

Understand that Rothbard and Krugman are arguing from two very different vantage points. Krugman sees deflation as tragic because he believes that it will lead to a downward spiral in which falling factor prices mean lower absolute incomes, and lower incomes mean less aggregate demand, and the beat goes on.

Rothbard, on the other hand, believes that deflation can be positive because it means that the true relative values of the factors are getting into balance, and are shaking off the distortions that occurred during the inflationary booms. Deflation, in Rothbard's view, means that the previous malinvestments are being cleansed from the system, and that a recovery based upon real values of factors can begin.

Obviously, the two cannot be farther apart. Krugman sees everything in aggregates (Y = C + I + G + [X-M]), while Rothbard views the economy as being a complex web of capital, labor, and other factors in which entrepreneurs are moving resources in ways that they anticipate consumers will desire. For good measure, Rothbard also attacks the entire Keynesian concept of "Liquidity Preference," which is a nice way of saying that during deflation, money increases in value relative to other factors, so that people want to hold more money. Rothbard writes:

The final Keynesian bogey is that people may acquire an un­limited demand for money, so that hoards will indefinitely in­crease. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani be­lieve that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consum­ing, whatever their expectations. Of necessity, therefore, the de­mand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding.

Indeed, Rothbard believes (and so do I) that there really is an alternative explanation for what Krugman calls a "Liquidity Trap," and that further borrowing and spending by government only will exacerbate the current situation. Like Krugman, I tend to despair, but I am fearful because I believe government is spending and borrowing too much, not to little.