Bartlett: In Defense of Keynes

Bruce Bartlett penned an op-ed for the WSJ in which he defends Keynes while attacking the nature of the allegedly ‘demand stimulating’ tax rebates being pushed in pending fiscal policy legislation in Washington:

The underlying theory for the rebate idea traces back to the British economist John Maynard Keynes. He believed that spending was the driving force in the economy. It didn’t matter whether the spending was done by businesses on capital equipment, by governments on public works, or by consumers — spending is spending in the Keynesian model, and all of it is stimulative.

In Keynes’ defense, his theory was developed during a severe, world-wide deflation. Spending of all kinds was paralyzed by a lack of liquidity, and the Federal Reserve had difficulty injecting money into the economy because so many banks had closed. Under these circumstances, deficit spending by governments made sense as a means of getting money into circulation and overcoming deflation.

Bartlett is right about this, and he also praises Milton Friedman’s "permanent income" hypothesis that questioned the likely effectiveness of tax rebates in 1975. But there’s another critical piece to the puzzle, which was Robert Mundell’s observation in 1971 that Keynes developed his General Theory at a time when the global economy was rapidly disintegrating, with most countries becoming "autarkic" (that’s an economist’s word for isolated and self-contained; consdier the common root in autism). In a world of closed economies, policy makers in each country could be reasonably confident that lowering real interest rates to a level more supportive of economic activity, whether by monetary or fiscal means, would have the intended effects. That’s because the possibile outcomes for both monetary and fiscal policies were constrained at the country level. However, once the global economy began to reintegrate after WWII, the "Keynesian" nostrums of the Depression era began to fail, and fail miserably.

For example, in the 1970s, the Fed was lowering real USD interest rates through easy monetary policy, in an attempt to stimulate domestic employment. However, tax rates on economic activity in the U.S. had risen–and were expected to continue rising–to levels that were prohibitive to additional domestic investment. As a result, foreign economies with more favorable conditions for investment were able to attract most of the financial capital that was created through the Fed’s easy monetary stance. In the 1970s, although many emerging markets participated in the boom, the most notable beneficiary was Japan. Today, the most notable beneficiary is China, although the number of countries enacting favorable economic policies has multiplied dramatically since the 1970s (in this hemisphere, Canada is a wonderful example, as are parts of Latin America). And of critical importance is that since late 2006 when the Democrats won a Congressional majority, expectations have been growing–in our little shop anyways–that tax rates are set to rise and perhaps continue rising, and that the Fed will be called upon (incorrectly, just as in the 1970s) to support the domestic economy in the face of foreign tax competition. The result of such a course can only be domestic stagflation, unless other countries were to dramatically reverse course on economic policy, which looks like an extremely remote possibility to us.  And if USD policy is exceedingly lax, the dollar’s status as a global reserve currency could become increasingly shaky over time.

How does this domestic-global paradox work? Let’s look at China for example. Due to its dollar peg, we can assume that short term interest rates on reserves in China is equivalent to the Fed’s target rate in the U.S., 4.25%. Given a misallocation of capital in residential real estate and other assets in the U.S. that has to be unwound, and (most importantly) given the expectation of higher U.S. tax rates relative to the rest of the world, let’s assume the U.S. growth rate for the next 10 years is roughly 2% per annum. We’ll assume somewhat conservatively that China’s will be 7.5% per annum. A 4.25% rate will clearly be more supportive of growth in China than the U.S.

So what is a superpower to do? Obviously there are a few courses to choose from. One is to try to force China to break its currency peg to the USD. This one continues to be a favorite of those policymakers who prefer that their domestic policies not be subject to the stress of foreign competition. Another is to hope for (or encourage) policies in China that will force down its expected growth rate, something that has happened in Japan since the late 1980s. The other, which happens to be the only one over which U.S. policymakers have control is to support the expected rate of growth in the U.S. economy. Doing so means nothing short of significant, if not radical, overhaul of the federal tax code. There are a lot of people who benefit from the tax code’s complexity. Significant changes to the tax code always bring the lobbyists out in droves (for a real world example, if you happen to know a lobbyist for the 401(k) industry, ask them what their position was on social security reform a few years ago). And radical overhaul would require sensible transition management. But it’s clearly the more peaceful and prosperous of the paths outlined above.