Economic theory’s identity crisis: why Keynesianism must go

After writing ‘you cannot make an economy grow through public spending’ I received this touching statement of Keynesian faith in response:

‘In terms of a contribution to GDP public spending is as good as any other type of spending.

‘GDP = C + I + G + (X – M)

‘A dollar of public spending = A dollar of private spending = a dollar of net exports.’

How much havoc has been caused by this apparently innocuous national accounting identity. Yet our economies at the macro level are mismanaged by little else.

To begin, when first developed GDP was intended as a measure of value adding production. There were a series of rules put in place about how to make the calculation but the problem of the public sector has never gone away. Since most of what is produced by governments has no market test, it was difficult to find a means to calculate the contribution of government spending. So it just went in straight. Whatever a government spent was automatically included as part of GDP. The more governments spent, the faster an economy would appear to grow. We therefore deceive ourselves in looking at GDP to see what effect the stimulus has had

Second, the Keynesian faith is indeed based on the belief that ‘public spending is as good as any other type of spending’. I don’t say governments never create value, but after around the first twenty per cent, it is hard to find any addition to our national productivity anywhere in it and many reasons to think it actually makes us worse off.

Third, you cannot take this equation as a straightforward statement of how economies work. It is an identity, true by definition but explains nothing about the underlying dynamics.

The supposed policy that comes from the equation is that if GDP goes down, perhaps from a fall in private investment, and this fall in investment leads to an increase in unemployment, you can return your economy to a higher level of GDP and higher employment by raising government spending.

If you believe ‘a dollar of public spending = a dollar of private spending’ everything returns to where it was. Except we have transferred resources from private investment to government spending, a very bad trade.

Finally, if you use this Keynesian identity just as it is, there is no sense of the interaction amongst its elements. If G goes up there are effects on each of the other components, and there is no reason to think those effects will be beneficial. Crowding out of investment is just one of the many possible consequences.

Look at net exports, X-M. Is there any sense in stating if imports go down GDP will for that reason go up? There is no causal connection between lower M and higher GDP. I could easily imagine a fall in imports of capital equipment leading to a fall in GDP. You cannot use the elements independently but must have some theory of how they interact.

To use Y = C + I + G + (X – M) to instruct policymakers on what to do is the error of errors in economic theory. It has brought the world’s economies to the edge of catastrophe. Keynesian economics must go.

3 thoughts on “Economic theory’s identity crisis: why Keynesianism must go”

  1. Posted 14/06/2011 at 13:15 | Permalink

    I had a conversation with my 11 year-old son about economics at the weekend; he suggested a system whereby money was abolished, and “stuff” was just handed out. I won’t bore you with the ebb and flow of the conversation (particularly the bit where he accused me of not listening), but we did touch on Keynsian economics. He grasped it very quickly, and questioned some of the underlying assumptions straight away. Just goes to show, when you start over-laying academic knowledge on to basic understanding, sometimes the effect is a net negative, as in the devout belief in Keynsian theory Mr Kate touches on above.

  2. Posted 14/06/2011 at 13:36 | Permalink

    That one dollar of public spending is never equal to a dollar of private spending, for in getting to that dollar of public spending, one needs to overcome the friction of the State machine, the propagation delay in spending and the bad/inefficient choices made once a decision is made.

    That dollar of public spending costs more than a dollar of private spending unspent but taxed.

  3. Posted 14/06/2011 at 19:21 | Permalink

    Having previously started a comment with reference to the original work of Colin Clark, only to have the site cut off, I will give a conclusion.

    Because of the manipulative actions (fiscal and others) upon the inputs to “GDP,” taken to achieve political or other ends, to achieve (is that the right word?) a particular statistical result, a less manipuable reasonably determinative measure of “economic” activity is sorely needed.

    Doing so will undoubtedly discomfit the field of “journalism,” which relies upon repeating the bird-calls through out the political jungle, as well as poseurs in academics.

    But, it needs be done.

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