This article by Nancy Folbre discusses the merits of Keynesian economics today.  The basic Keynes concept discussed is this.

A recession causes businesses to hoard cash and households to hoard cash because of economic uncertainty.  Job losses result.

Keynes would certainly agree that current unemployment rates reflect a recession-induced shortfall in the demand for labor. The evidence for this claim has been deftly summarized by Paul Krugman, citing studies by the Economic Policy Institute and the Roosevelt Institute.

A Keynesian solution is that the government step with spending to kick start demand, filling the gap for the private sector, which then increases job growth.  Businesses and households start spending.  The resulting economic revenue then pays back the stimulus in spades.

Conservative economists like Robert Barro of Harvard University insist that increased government spending will have little positive effect, and that increased deficits will create bigger problems than they solve.

Let’s assume, for the moment, that Keynes was right in his 1920′s and 1930′s era, that the government stimulus as a kick start/gap filler is far better than letting the economy flounder without it.

Today, the government spending leaks overseas because of globalization combined with our trade deficit.  So there is substantial “slippage” because the resulting demand is not for U.S. goods and services but for Chinese goods and services.

There is also job creation slippage.  Because of capital mobility, the government spending can easily create jobs elsewhere, not here.

In today’s global economy, however, employers have less incentive to collaborate with workers than they once did. Multinational firms can easily relocate to low-wage, low-tax havens. With one click of a mouse, shareholders can move their capital out of the United States into mutual funds invested entirely in emerging markets, including China.

In other words, the cross-class coalition that supported strong state participation in the United States economy in the post-World War II has come undone.

A partial counter is to strengthen “Buy American” legislation so taxpayer spending stimulates demand in the U.S.  We achieve the in-house stimulus effect through restrictions on the money, because the environment has changed.  This reduces the payback slippage.  It is not protectionist, it is simply smart investing.  And dumb to do otherwise.

The Folbre article does not come to this solution that I just stated.  She just says that Keynes would be disappointed that we did not do more stimulus.  That solution does nothing to address the “leakage” and “slippage” issues.

She also states this contradictory thought:

If Keynes were around today, I think he would emphasize a supreme irony of Neoliberalism: No country has taken better advantage of free trade than China, with its controlled currency and strong industrial policies, including huge public investments in renewable energy technologies.

China taking advantage of “free trade”?  Hardly.  They take advantage, to be sure, but through mercantilism.  A so-called throw-back policy, which just so happens to be dominant in the world today… even as our political and opinion leaders think free trade actually exists today.

The Very. Smart. People. in Washington have their "protectionism" narrative, rooted in the debates over the 1930′s.  Basically, it goes like this.  "Yikes.  You’re a protectionist.  You want to return to Smoot Hawley.  Aiiieeee!"

This is the 21st Century.  Every country manages trade, as Dan DiMicco of Nucor pointed out.  Every country but us.   

Peter Orszag is Obama’s choice for budget director.  He was the head of the Congressional Budget Office.  In his Senate Budget Committee confirmation hearings today, he said this:

In its current slump, Mr. Orszag said, the economy is producing far less than its potential. Without action by Congress, he said, “the gap between how much the economy could produce each year and how much is actually being produced amounts to roughly $1 trillion a year.”

Aggregate demand is needed to purchase the output of the economy.  Aggregate demand can come from four sources: (1) consumption; (2) investment; (3) government spending; and (4) net exports. 

Folks, we have net imports.  Mucho net imports. 

I posted former Bush Adviser N. Gregory Mankiw’s comments here in November.

The economy’s output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. (citing Keynes).

With net imports, our economic output will be too low.  The government stimulus will be eroded or overwhelmed by the net outflow.  And our economy will produce far below capacity.

Ideology and "belief" should go in the garbage.  We need a National Trade Strategy.

Getting out of this crisis involves identifying who was right and who was wrong.  We have had little accountability so far.  The Rubinites are back in charge and we can only hope (and pray) that they have changed, because they were destructively wrong before.  Phil Gramm is wounded by his silly statements during the presidential campaign ("Nation of whiners").  And it is hard to identify anything that Paulson and the Bushies did right.  Accountability really should go further.  Where are the people that got it right?  Doesn’t someone want to give them a job in government?

I wondered a few months ago "What Economic School of Thought Will Prevail?" noting that Keynesian economics dominated until the 1970′s when Friedman’s monetarism gradually took over.  Monetarism focused upon controlling the money supply and "letting the market work" and avoiding "excessive regulation", which translated into "anything goes."  Greenspan, with his Ayn Rand objectivism, has been the poster child for avoiding excessive regulation.  Robert Rubin and Lawrence Summers drank this KoolAid, with only slightly different flavoring.  Rubin continues relatively un-reformed, saying that he would have done nothing different at CitiBank as of last April.

I hoped Behavioral Economics would enter the fray, to take over from the fictional and destructive Rational Economic Man.  But the winner seems to be Keynes, whose thoughts do take into account the irrationality of the people whose collective activities make up the market.

Greenspan-ism can no longer vie for the title because Greenspan himself admitted his fundamental beliefs were wrong. 

“In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.

“Absolutely, precisely,” Mr. Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” …

Those that continue arguing that markets and economies will work all by themselves are simply uninformed… they haven’t received the memo from the boss.  Without rules, we have predatory capitalism, unstable capitalism, irrational capitalism.

Robert Sidelsky discusses Keynes more in an article today.

People are irrational, the Rational Economic Man does not exist, and the question becomes "what rule-based systems work?"

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. 

Conventions are habits or social norms.  We are creatures of habit of course, with very little ability to be truly objective.

Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

There has been a lot of ruin recently.  I don’t know how conventional it has been.

Conventions are really a nice way of saying "herd behavior."

Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

The "free trade" types follow the herd.  They are resistant to contrary information.  Even though Keynes said that net exports are a fundamental part of aggregate demand needed for an economy to run at capacity.  The free traders tried to upend that maxim by saying trade deficits make us more efficient.  But merely saying things a lot does not make it true.

A first principle of the new economics is that it must be reality based, not fiction based.  The Rational Economic Man should be banished.  The free trade theory has been implemented to make the U.S. the unilateral free traders in a world where others did not do so. 

A national economic and trade strategy is needed, identifying fundamental components of an economy that we need, and enacting policies designed to build that economy.

You can’t even demagogue a "national economic and trade strategy" as socialism anymore, because of the bailout of the "Masters of the Universe."

The dynamics of the Great Depression, the New Deal, Smoot Hawley, and John Maynard Keynes are all the rage.

Wacko free traders are hyperventilating, again, about "protectionists" wanting to re-enact Smoot Hawley tariffs.  I’ve not seen a Smoot-Hawley tariff increase proposed in the past 20 years, at least.  Oh well.  If there’s not a boogey man to see, you make one up.

It’s too bad we’re not seriously talking about reforming trade policy.  Net exports are in the tank… i.e. trade deficits.  Tough to increase demand when you’re buying record amounts more than you sell.

Paul Krugman is using his NY Times blog to slap down Keynes’ critics.  On November 29, Amity Shlaes wrote in the WSJ that the New Deal dampened employment because it raised wages.

Krugman responded, the same day, in his blog:

Funny she should mention that — because the effect of wage changes on employment was the subject of a whole chapter in Keynes’s General Theory. … And what Keynes had to say then is as valid as ever: under depression-type conditions, with short-term interest rates near zero, there’s no reason to think that lower wages for all workers — as opposed to lower wages for a particular group of workers — would lead to higher employment.

Suppose that wages across the US economy had been, say, 20 percent lower than they actually were. You might be tempted to say that this would make hiring workers more attractive. But to a first approximation, prices would also have been 20 percent lower — so the real wage would not have been reduced. So how would lower wages lead to higher demand for labor?

Well, the real money supply would have been larger — but the normal channel through which this might increase demand, lower interest rates, was blocked by the zero lower bound. Yes, there would have been a slight Pigou effect: real private sector wealth would have been higher, because cash under the mattress (or wherever) was worth more. But on the other hand, real debt burdens would also have been higher, probably exerting a contractionary effect. Overall, there’s no good reason to think that lower wages would have helped raise employment.

Today, Krugman goes after George Will, who wrote in the Washington Post:

Obama’s “rescue plan for the middle class” includes a tax credit for businesses “for each new employee they hire” in America over the next two years. The assumption is that businesses will create jobs that would not have been created without the subsidy. If so, the subsidy will suffuse the economy with inefficiencies — labor costs not justified by value added.

Krugman rephrases Will’s argument:

That is, if the private sector wouldn’t have created a job on its own, that job shouldn’t have been created — whereas the real choice is between having workers doing something and being uselessly, destructively unemployed.

And then says Keynes has already disposed of the money-wage argument in 1936, as pointed out in the response to Shlaes.  And Krugman is not beyond mocking:

Why do people still fail to get Keynes, after all these years? Keynes might have said that it’s the inherent difficulty of the concepts:

For—though no one will believe it—economics is a technical and difficult subject.

Keynesian economics dominated from the 1930′s to around 1970.  It held that the state can stimulate economic growth and improve stability in the private sector through actions such as interest rates, taxation and public projects.

Milton Friedman’s economics focused upon monetarism.  The argued that government attempts to manage the economy were fruitless, and that regulation produced bad results.  Friedman’s theories gained increasingly strong support since the 1970′s, with the first big boost in Reagan’s administration.

Now many Republicans have abandoned the no-government-involvement approach, at least to the extent that there is no longer a Republican consensus on economics.

The decision to spend $700 billion to bail out shaky financial institutions, in part by partial nationalization of some of the nation’s biggest banks, turned conservative economics on its head. Many Republicans went along out of a sense that desperate times call for desperate measures, but the actions shattered the economic consensus that has guided the party and has left many conservatives deeply disillusioned.

What will be the result?  I suppose we are moving back to Keynes with the stimulus packages.  But will a new consensus arise?

In international trade, Ricardo was supplanted by Krugman who has probably been supplanted by Gomory.

The Gomory-Baumol (2000) multiple-equilibrium model of international trade has overthrown the neoclassical Ricardian contention that global free trade will produce optimal outcomes for all participating national economies and the world.  

But Gomory has won no Nobel Prize, and Ricardo’s backward free traders still hold some sway.

Sign on the the Fixing America’s Economy document now.