Wednesday, March 9, 2011

The resistance to being labelled a Keynesian economist

Here is an example of the resistance that professional economists show to adhere to the standard keynesian prescriptions for an economy with ample spare capacity (and high unemployment). Justin Yifu Lin, Chief Economist of the World Bank, writes in an article entitled "Beyond Keynesianism and the New Normal":

"The above risks to a sustained recovery are directly or indirectly related to the simultaneous existence of large excess capacity in the high-income countries. In my view, a global push for investment along the line of Keynesian stimulus is the key for a sustained global recovery; however, the stimulus needs to go beyond the traditional Keynesian investment...But how can the Ricardian trap be avoided, i.e. an outcome where the government stimulus fails to boost aggregate demand because economic agents expect future tax increases to pay for larger deficits and thereby increase savings? To avoid the Ricardian trap, it is important to go beyond conventional Keynesian stimulus of “digging a hole and paving a hole” by investing in projects which increase future productivity."

So in the presence of large excess capacity he is in favor of policies intended to increase demand. But he is concerned that the standard policies (e.g. increase government spending) will not work this time. And this is because the private sector might undo the actions of the government by saving more (to pay for future taxes). The proposed solution is to direct government spending to activities that increase productivity so that output and incomes grow (and this helps keeping private spending up and tax revenues).

No one can disagree with the statement that if the government can choose between different spending projects, they should select the one with the highest return (in terms of productivity and income). But we need to understand that the advise for the government to invest in productive investment applies at all times (good and bad). What is different when there is spare capacity is that "pure demand" policies can bring the economy closer to potential in a shorter period of time. By doing so they will be increasing the overall output and income of the country. And this additional income is the source of potential increases in private spending and tax revenues. This is the intuition behind the Keynesian recipe for times of high unemployment, which is consistent with the concerns of Justin Yifu Lin. Of course, if in addition we find projects that improve productivity, innovation, human capital, even better. But there is no need to keep searching for such projects when we are producing below our potential.

Antonio Fatás
on March 09, 2011 |   Edit