Organizations and Markets

Keynesian Economics in Four Paragraphs

22 January 2009 at 2:13 pm Peter G. Klein 3 comments

Courtesy of Robert Barro:

[A]ssume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy’s total output expands by enough to create the airplane or bridge without requiring a cut in anyone’s consumption or investment.

The explanation for this magic is that idle resources — unemployed labor and capital — are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

What’s the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

Barro thinks a multipler of zero is a more plausible baseline assumption. Of course, if GDP is adjusted for quality, the multipler is most likely negative, as resource allocation is directed by government officials, not consumer demands. In prior work Barro has estimated wartime multiplers of 0.8, but this seems high based on Robert Higgs’s important work [1, 2]. More important, there the Austrian point that resources are heterogeneous, and the additional goods and services financed by government spending will tend to be in the “wrong” place in the economy’s intertemporal structure of production.  Keynes rejected the idea of capital heterogeneity, so this problem was lost on him.

Entry filed under: - Klein -, Classical Liberalism, Myths and Realities, Public Policy / Political Economy.