Another Nail In the Keynesian Coffin

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The coffin of Keynesianism has so many nails in it now that it is practically surfaced in steel. The notion that government deficits "stimulate" demand, has been proved wrong so many times, and in so many ways, that you would have to be Paul Krugman to still believe in it. However, in its April 28 news release on 1Q2011 GDP, the BEA drove yet another factual wooden stake into Keynesianism's vampire heart - a stake that no one seems to have noticed. What happened should also serve as a warning to Republicans that are still in the grip of the Keynesian superstition.

The BEA reported that its first estimate of 1Q2011 real GDP growth was 1.8%. This represented a dramatic fall from 4Q2010 growth of 3.1%. What no one seems to have noticed is that the slowdown occurred in the face of another large dose of Keynesian stimulus.

Part of the leverage that Republicans had during the negotiation of the compromise on the Bush tax cuts was that the Democrats (Keynesians all) were concerned that Obama's $814 billion "stimulus" program was winding down. The Republicans ultimately got Obama to agree to extend the tax cuts for high earners for an additional two years in return for additional "stimulus", in the form of a one-year, two percentage point cut in the payroll taxes paid by workers.

In 1Q2011, this stimulus amounted to about $110 billion on an annualized basis, or about 0.73% of GDP. Given the Keynesian belief in "multipliers", the result should have been to increase 1Q2011 real GDP growth significantly over that of 4Q2010. Instead, the real growth rate fell, thus providing one more real-world confirmation that Keynesian stimulus doesn't work.

The real mystery is not that stimulus doesn't work, but why anyone would ever expect it to. After Obama signed the compromise bill on December 17, 2010, one of the first things that the Treasury did was to revise its borrowing plans upward to compensate for the reduction in tax revenue that it knew was coming on January 1, 2011. Additional bonds were sold, and extra money was withdrawn from the economy before the payroll tax cut showed up in workers' paychecks. If there was any impact upon demand at all, it was to reduce it.

Fiscal stimulus always works this way - additional bonds must be sold before additional money can be spent or tax cuts implemented. What Keynesian economists miss is that if there are multipliers for government spending, there are also multipliers for bond sales. Because stimulus consists of bond sales followed by spending, the two sets of multipliers cancel each other out - at best. Fiscal stimulus can never produce any net increase in total demand.

Does this mean that tax cuts cannot stimulate the economy? No, it does not. Just as Keynesian stimulus has failed every time it has been tried, "supply side" tax cuts have worked every time they have been tried. Unfortunately, in the negotiation of the tax compromise bill, the Republicans managed to agree to the one tax cut that provides no supply-side benefit whatsoever.

To stimulate GDP growth, a tax cut has to cut the marginal tax rates upon which the decision makers in the economy base their decisions to work and, above all, to invest. Because the Social Security tax applies only to wage income, and then only up to a "cap" of $106,800/year, this tax does not have a significant impact upon the decisions that drive the economy. Accordingly, cutting the Social Security tax would be expected to produce no benefit, and the 1Q2011 GDP numbers show that no benefit is exactly what this tax cut produced. Interestingly enough, in opinion polls taken at the time that the tax bill was passed, the only element of the package that the public did not support was the Social Security tax cut.

For FY2011, the corporate income tax is expected to bring in 1.3% of GDP. Accordingly, for the same "cost" as the payroll tax cut (0.73% of GDP on a "static analysis" basis), it would have been possible to cut the corporate income tax rate from 35% to about 15%. Doing this would have had an enormous supply-side impact, particularly if the tax cut were permanent. That the Republicans in Congress did not even propose this shows that they are still in the grip of the Keynesian superstition that "putting money in people's pockets" via rebate-like tax cuts stimulates the economy. The Republicans fell for Keynesian stimulus in 2001 and early 2008, and they fell for it again in late 2010. This is not the path to prosperity, or to electoral victory in 2012.

There was more bad news in the BEA's report on 1Q2011 GDP than just a re-re-re-reconfirmation that Keynesian stimulus doesn't work. The BEA itself attributed the slowdown in growth vs. 4Q2011 to "a sharp upturn in imports" and "a larger decrease in Federal government spending", but this is Keynesian analysis and it misses the point. The real cause was mentioned almost as an aside, at the end of the report.

As it turns out, nominal GDP actually grew faster in 1Q2011 than it did in 4Q2010 - at an annual rate of 3.7%, vs. 3.5%. What made the difference was that inflation accelerated and consumed 1.9 percentage points - more than half - of the nominal growth. In contrast, inflation subtracted only 0.4 percentage points from the 4Q2010 real growth rate.

We have a word to describe the combination of falling real growth and rising inflation. That word is "stagflation". This was what Keynesian policies produced in the 1970s, and it is what Keynesian policies are producing now. Let's hope that the Republicans figure this out before the 2012 elections.


Louis Woodhill (, an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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