Keynesian Economics

Why was Keynesian economics in fashion in the 60's but is out of fashion now? In these days we hear little about 'fiscal policy' and little about consumption as the bedrock of the economy, but from the mid-1930's until the 1980's, those terms, and the Keynesian model of economics was what everyone referred to, until even the Republican President, Richard Nixon said, in 1971, "We are all Keynesians now."

Supply-side economics has replaced Keynesian economics as the fashion of the day. Supply-siders argue that tax cuts to capital, and to investors, will stimulate the economy, so they justify cutting the tax on capital gains from the highest bracket a taxpayer pays to a flat 15%, less than half the top bracket rate. They also justify cutting taxes on income at the high-end of the income scale, in other words, cutting taxes on likely investors. The result has been that tax policy and economic policy have accelerated the increase in inequality, both in income and in wealth, so that economic inequality today is higher than it has been at any time since 1929.

Economic theory matters: Keynesian economics argues for just the opposite tax and income policy: if taxes are to be cut, they should be cut most for those with the lowest incomes--because they will spend most of their extra money on consumption. This is why the 50's, 60's and early 70's saw a dramatic drop in inequality, initiated by the famous Kennedy tax cut, which immediately boosted discretionary spending of consumers and stimulated the sixties boom.

Why did Keynesian economics lose fashion? Stagflation in the late 1970's made people realize that Keynesian economic policy didn't work in all instances. You could raise government spending, or cut taxes to stimulate consumption, or you could lower government spending, or raise taxes (something no politician likes to do) if faced with inflation, but the quiver of Keynesian economics was limited when you faced both inflation and recession simultaneously, and when both were caused by supply restraints (the escalating price of oil).

Monetarists, led by Fed Chairman Volcker offered an answer. Unlike Keynesian economists, monetarists don't concern themselves much with demand (or supply) for goods and services; only with the supply and cost (demand) for money. If you have too much money relative to goods, you have inflation; Volcker's remedy: price money out of the market by letting interest rates rise until inflation falls. It did, in 1982, after one of the sharpest recessions since the Great Depression.

In fact, the Fed (Federal Reserve Bank system) carried out a policy that had the same effect as would a Keynesian economics policy of sharply raising taxes, or dramatically cutting government spending: it squeezed inflation out of demand. The utility of the strategy was as much political as economic: the Fed was doing this to us, not a greedy government, so Reagan was re-elected.

Reagan's ascension to the White House brought in supply-side economists, including radicals who believed in the Laffer curve: if you cut taxes, they maintained, you will increase government revenue, especially if you cut taxes to stimulate investment. It didn't work; Reagan's (and Bush I's) deficits reached records--until GW Bush's. No one speaks of the Laffer curve today, but the Bush II administration seems to act as if it still subscribed to it. Even with the Democratic Congress, it continues to advocate both high-end tax cuts and more spending.

While Keynesian economics focuses on consumption, and on the effect that government taxing and spending policies can have on it (the "demand-side" of the economy), supply-side economics concerns itself largely with stimulating investment. This may have been one element in a huge increase in per-worker productivity (breaking unions may have been another), but while corporate profits and investment returns have skyrocketed, wages have remained largely stagnant. [Productivity increased from a base 100 to about 182 from 1972-2005, but wages fell from base 100 to about 90]. This has meant that a few, the investors, have ended up with almost all the gains the economy has made, while workers at the bottom of the income pyramid have actually lost a lot of ground, and those in the middle have seen their share of national income shrink.

From a supply-side point of view, cuts to the taxes of the investor class should just continue, but that will, at very least, increase inequality. However, Keynesian economics would caution that we need to look to the role of consumption, above all. Investors can invest in new, more efficient technologies, and in producing new, "better," more fascinating goods, but if people generally do not have money to buy them, then fewer goods will be sold. This is why higher wages, government programs that employ those now unemployed (or discouraged from looking for work), and lower taxes on low income workers (as in cutting property and sales taxes and making up the difference by raising taxes on dividends and the highest brackets) would actually stimulate the economy, as it did in the 1960's.

The perspective of Keynesian economics that is most needed now is that consumption does not come out of nowhere; it comes from people's wages and salaries and other earnings, and consumption is the greatest and most stable engine of the economy. Government taxing and spending can be managed to add or subtract stimuli to consumption and investment. Note here that the Iraq/Afghan wars and defense build up are a massive stimulus to the economy, but because of low wages, and international competition, it has only fueled a moderate recovery which filled corporate coffers, and maintained employment, but hardly boosted it.

Investment, depended upon by supply-siders is much more variable than consumption, and is ultimately dependent upon it: if people have less money, they will buy fewer goods and services, despite the investment in newer and better.

When investors and the owners of corporations end up with larger and larger shares of national wealth, they may stimulate a luxury market, but not the kind of mass consumption that raised the United States to be the greatest economy in the world. And note: while overall consumption is relatively stable, the consumption of luxuries is the least stable of any component in the economy, even less so than investment; it depends upon the perception of the wealthy that they will have more money next year. But if the average Joe, (the bottom four quintiles of income) shares only 20% of the nation's income (true as of 2005), and if wages and salaries account for only 45% of income (source: In These Times, Jan-Feb, 2007, "Slicing up at the Long Barbecue"), then mass consumption can only be sustained by massive borrowing.

Problem is: neither the nation, nor individual workers can borrow indefinitely. While the overall rate of savings is slightly negative, the top quintile has a savings rate of 23%, meaning that everyone else must be borrowing wildly, while the rich are getting richer--and not consuming.

So, while supply-side analysis might indicate that the US is doing most things right--lowering costs to investment, allowing investors to keep more of their money, Keynesian economics would indicate that, no, things are not right: wages are stagnant or falling and the nation is borrowing more than it's producing. Borrowed money may be the only element that is keeping the economy afloat.

Demand-side economics would point out that C + I + G = GDP, but that C (consumption) is barely rising; not falling mostly because G (government) is running huge deficits (borrowed from abroad). I (investment), even if encouraged by all the tax-breaks in the world, is not enough to maintain the whole equation.

Keynesian economics became unfashionable about the same time that the conservative counter-revolution came to power, replacing it with supply-side, or Friedmanesque (from Milton Friedman) economics. The latter empowers the rich, and disregards everyone else; it's what you would expect of an ideology which justifies the rule (and further enrichment) of the selfish class.