Tuesday, November 9, 2010

The Downsides to Keynesian Economics

Whether you like him or not, John Maynard Keynes was undoubtedly the most influential economic mind of the 20th century. Whether or not you agree with his theories and worldview, it is impossible not to be impressed with the work of this man. His ideas caught on like wildfire and within a very short period of time, they were adopted as the basis for the economic policies of many States. And while developing his theories, he essentially founded the discipline of Macroeconomics.

I began my post with the paragraph above to make clear that I have a deep respect for Keynes and his many contributions to the field of economics. That being said, however, I now wish to address some of the shortcoming of Keynes theories, especially as they pertain to our new digital and globalized age. In writing this, I also intend to introduce some important macroeconomic concepts in simple, "non-jargony" language.

1) The Concept of a Multiplier

Much of Keynes ideas about the bonuses of Government spending comes from the idea of a multiplier. Let me attempt to illustrate, in simplicity, what a multiplier is with the following example:

You give me one dollar. I put ten cents of that one dollar in my piggy bank and then spend the remaining 90 cents buying two of my friend's Del Taco tacos. My friend then takes that 90 cents, puts nine cents of it into his piggy bank and then proceeds to give the remaining 80 cents to his friend who needed some change. I think you get the idea. Now lets assume that this same pattern continues i.e. saving 10% and spending 90% all the way until the last person receives only a few cents. How much economic activity did that on dollar generate? 10 dollars!!! That is the idea of a multiplier (of course this is not the best example because I only listed black market transactions, but we''ll save that for another day).

It is from this general concept that Keynes promoted the idea of a government spending multiplier. However, in today's globalized economy the government spending multiplier has some vital flaws. For the sake of this post, I will only illustrate one with this example:

Let's assume that I receive a 1,000 dollars as a direct result of government spending. The government is counting on me to save a small portion of it and then spend the rest in order for the multiplier to work. But now lets assume that as soon as I get my paycheck, I go buy a Sony Flat Screen TV. Now what has happened? No multiplier. At least not one that will stimulate the US Economy. My money has (essentially) gone to Japan. Now this is essential an example of "reductio ad absurdum" but it gets one of the major flaws with government spending multipliers across: the effectiveness of the theory fails to account for purchasing foreign goods--an event that is more and more frequent in today's world.

Stay tuned to read about stagflation and my thoughts on economic policy in the digital age. And remember that a model that has worked well in the past, is not always the best model moving forward. To be continued...