Keynes wasn’t all wrong. He just wasn’t all right.

Keynes’ General Theory of Employment, Interest and Money revolutionized economic thought in 1936 and ignited a debate that continues to this day. Prior to Keynes, classical economists correctly believed that economies have self-correcting mechanisms that maintained prosperity and full employment. Keynes argued that the propensity of firms to invest could be too low compared with that of household savings, leading to recurring depressions. Keynes believed that through government fiscal policy, i.e. lower taxes and higher spending, that the government could help the private sector and restore full employment. Politicians seem to have forgotten the part of the policy about lower taxes for the most part.

Keynesians point out as empirical evidence that under massive government spending we went from the Great Depression to the greatest economic expansions in history and the elimination of depressions. Before WW II, eight recessions turned into depressions. After WW II, there have been ten recessions and none have turned into depressions. The consensus of economists is that WW II ended the Great Depression. Keynesians believe this was due to massive spending on defense, leading to the notion that "wars are good for the economy." This makes sense because government makes up the largest share and overall government spending trends monotonically upwards. That’s the nature of government and a consequence of entitlement programs. Government employment and spending are impervious to economic cycles. As government spending becomes a larger share of overall spending, it has a stabilizing effect. Since 1929, government spending as a percent of real GDP has risen from 5% to 28% this year according to the administration’s budget. Pre WW II spending was in the range of 5-10% of GDP. Since the end of the war it generally has ranged from 15-20%. A case can be made based on the empirical evidence that this is the “natural rate” of Keynesian spending required to eliminate depressions and therefore additional spending is not required to achieve that effect. This is contrary to what has been part of the justification for the administration’s stimulus package.

The recessionary cycle can be thought of in terms of the circular flow of money through the economy. In a normal economy there is a high level of employment and earners spend normally. Earnings become spending, spending becomes earnings, and back and forth in a continuous cycle. When something shakes consumer confidence, consumers hoard money and the cycle is slowed or interrupted. Prior to Keynes, this would have triggered a recession and potentially a downward economic spiral into depression. At this point no amount of expansion of the money supply restarts spending. The only alternative is for the government to intervene through increased direct spending. Since depressions can (?) no longer happen, let’s talk about recessions.

The Keynesian approach to avoiding recessions is to first loosen the money supply in an effort to boost consumer confidence. Loosening the money supply is usually done in several ways. The most common is for the Federal Reserve to buy U.S. debt from commercial banks. The money that commercial banks collect from the sale of these government securities increases the amount they can lend. Lowering credit requirements and cutting the prime lending rate are other typical strategies. If none of those work, the only alternative is for government to spend in order to “prime the spending pump.” That can be a problem when the well is dry, as it is today.

One would think that in the face of the largest real increase in government spending, ever, that consumer confidence would be trending strongly upwards. Instead, after a short run-up in the afterglow of Obama’s election, reality has set in among consumers and confidence is trending downwards again. Generally, it takes the recognition of a bottom, which may be different for each of the main actors, to restart the cycle. Consumers derive confidence and hence begin spending based on their employment outlook, namely job security. Producers need orders before they create jobs. Investors bottom fish, scavenge, or stay on the sidelines until they think the risk of being out of the market is worse than the risk of being in. The consumer, producer, and investor are not fooled by stimulus spending, particularly when funded by record deficits. The linkage between a loose money supply and rising or high consumer confidence is weak.

Since Keynesian policies are usually trotted out during recessions they tend to generate massive debt and rising inflation. In addition, the spending programs that are created in the recession tend to become permanent as well as the debt. Real government spending in Dollars has increased every year since 1929 with few exceptions, mostly post-war reductions in military spending. This is why Keynes is so popular with big government proponents. Real Keynesians reel government spending back during good times. The Clinton administration and his Republican congress are the only ones to have done this over an extended period of time. The end of the Cold War and the peace dividend didn’t exactly hurt either.

Economics is a social science that tries to explain irrational trade-offs with rational models. One can not calculate the amount of spending and duration needed in order to achieve the desired goal of moderate recessions and no depressions at full employment with any certainty. That is why the Fed tweaks interest rates in 25 to 50 basis point steps, up or down, and then waits to see what happens.

Of course the best indicator of any economic theory in trouble is when multiple schools emerge with fixes: Neo-Keynesians, New-Keynesians, and Post-Keynesians. Neo-Keynesians ruled into the 70’s but were attacked by monetarists such as Milton Friedman. New-Keynesians responded by trying to apply micro-economic and neo-classical principles in order to explain Keynesian economics in general and to explain the 70’s specifically. (Note: no one can explain the 70’s). Post-Keynesians think Keynes is misrepresented by the Keynesians and New-Keynesians. Need I say more?