The President, the deficit, and Keynesian theory

During last week’s scare session on the sequester, the president said something very revealing about himself (via Peter Kirsanow):

Lay offs and pay cuts means (sic) that people will have less money to spend at local businesses. That means lower profits. That means fewer hires. So every time that we get a piece of economic news over the next month, next two months, next six months, or as long as the sequester’s in place, we’ll know that that news could have been better if congress had not failed to act. (Emphasis added.)

This paragraph reveals, in a nut shell, how the president sees the economy. “Local businesses” don’t make decisions on their own. Their “profits” and “hires” are driven solely by consumer demand, and nothing more. This is known as the Keynesian school of economics. Under the Keynesian theory, the economy is driven entirely by what consumers, businesses, and government spend (otherwise known as aggregate demand). In particular, government spending benefits the economy through purchases and hires, with that money rippling through the economy multiple times over (in fact, the measure of this rippling is called the “multiplier effect”). The more direct the spending is, the larger the effect.

This last part is critical to the Keynesian theory, because it explains Keynesian politics. For Keynesians, government spending is always better than consumer spending (because consumers save some, that money “leaks” out of the economy). Thus, tax cuts, which under the Keynesian school effects only consumption, is never better than government spending. Likewise, tax increases are always less damaging than spending cuts. Thus, Keynesian adherents are drawn towards permanently growing government, and an ever expanding tax burden.

Of course, there is much that Keynesian theory completely ignores – such as the incentives firms face when they choose to do business. Because Keynes himself was rebelling against a pre-Depression “Walrasian” consensus, he ignored much of the microeconomic theory regarding how businesses respond to costs. Due to this, there are no impediments to production in the Keynesian world; it reacts to demand, period.

As one might expect, Keynesian theory had no response to the events of the 1970s, where dramatic increases in resource costs had dramatic effects on business production (a.k.a., aggregate supply). It was to bridge this dramatic gap in economic theory that the “supply-side” school was born. Supply-siders focused on uncertainty, taxes, regulations, and other cost to businesses, and how they impact both production decisions at the microeconomic level and growth at the macroeconomic level.

In short, the taxes that Keynesians felt were least troubling (income and investment taxes, because they do not affect consumption directly) were exactly the ones supply-siders found most troubling (because they reduced the incentives to provide capital to business, and thus increased business costs of financing). Other taxes and regulations that would impact mainly firms were of great concern to supply-siders, but largely thought benign by Keynesians.

In short, the economic arguments that divide the two parties are largely driven by these differences in economic views. Naturally, the government-friendly Democrats move more towards Keynesianism, while business-friendly Republicans drift closer to supply-siders.

Moreover, this explains, at least in part, the president’s insistence on new tax hikes despite the old tax hikes only coming two months earlier. For this president, tax hikes are always better than spending cuts.

It’s not about cynical politics or tactics (or, to be precise, not just those); the president really believes this stuff.

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3 Responses to The President, the deficit, and Keynesian theory

  1. Ora says:

    Makes me want to slap tax hiking politicians. What dim bulb decided it was a bright idea to help the overall economy by taking away a larger portion of people’s money via tax increases? That, Mr. Obama, is why people will have less to spend!

  2. Ken Reynolds says:

    I studies Keynesian economics at Penn more years ago than i care to remember, but one thing that sticks today is the multiplier of tax revenues that goes with economic growth. In addition to the $10 trillion increase in the market value of stoocks since Obama came into office 5 years ago, look at the incredible increase in tax revenue projections for next year…….$2.7 trillion …..published this past week….lots of good things are going on!!!!!

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