A Nation in the Grip of Faulty Economics

Liberal columnist Dana Milbank recently criticized Republicans for their incessant attacks on Keynesian economics and, in the process, revealed how little he knows of the subject.

Milbank singled out Representatives Eric Cantor (VA) and Paul Ryan (WI) as well as Senator John McCain (AZ) for their criticism of the Obama stimulus spending and the resulting failure to produce jobs needed for economic growth. 
Perhaps these Republicans don't realize that some of their tax-cut proposals are as "Keynesian" as Obama's program. There's a fierce dispute about how best to respond to the economic crisis -- Tax cuts? Deficit spending? Monetary intervention? -- but the argument is largely premised on the Keynesian view that government should somehow boost demand in a recession.

To link tax cuts with government spending reveals how Milbank and many other liberals believe all of the nation's wealth belongs to the government, to be released to the private sector in the quantity and manner government deems fit. That is not good economics -- let alone Keynesian economics.

John Maynard Keynes (1883-1946), a British economist, sought to explain the Great Depression by expounding an economic theory based on the circular flow of money. The spending by Person A supports the earnings of Person B, who can then support the earnings of still others, which enhances the general economy as a whole. Thus, the Keynesian theory asserts that aggregate demand created by individuals, households, businesses, and government provides the most important driving force in an economy -- not the supply-demand dynamic of free markets which, Keynes asserted, lacks any self-balancing mechanism. 

When the Great Depression hit, people's natural reaction was to hoard their cash. Under Keynes' theory, this stopped the circular flow of money, keeping the economy at a standstill regardless of the existing supply of goods. Thus, Keynes argued, government should take steps to "prime the pump" by massively increasing the money supply as well as buying things (including infrastructure) in the market itself. This emphasis on demand in an economy also argued for redistribution of wealth because, Keynesians argued, sums of money given to the poorer segments of society will more likely be spent than saved, thus further promoting economic growth.

In spite of contemporary criticisms, Keynesian economics resonated within the prewar Roosevelt administration and other leftist governments of Europe, as it lent credibility to big-government intervention and control within the economy. By the end of World War II, nearly all other economic theories had been pushed aside. Not until the post-WWII inflationary spiral hit, with huge amounts of government-injected money chasing too few private-sector goods, did the dark side of Keynesian theory become clear.

Numerous books and articles have since exposed the weaknesses in Keynesian theory. For example, in 1959, Henry Hazlitt argued that Keynes failed to comprehend how saving, investment, and capital formation -- not temporary government-stimulated increases in aggregate consumer demand -- provided the foundation for sustainable employment and rising standards of living.

To get a free-market economy going again in a sustainable manner, that market must first create wealth, and then jobs follow. To understand why it happens this way, we must first understand what wealth is.

For all individuals or businesses, wealth is the sum of their total assets minus their total liabilities. Wealth is not the flow of income. For an individual, the size of one's paycheck is not a true measure of wealth. Wealth grows only to the extent one uses income to purchase assets and decrease financial liabilities.

How does a business create wealth? One or more individuals who begin a business acquire capital by some means and use that capital to create a product or service, which they sell to another person or business at a freely agreed-upon price. If the resulting income exceeds the cost of production, the business has created an asset it did not have before. Most businesses reinvest their assets to create still more of their product or service to obtain even more assets. To the extent that the sum of all assets possessed by the business exceeds its ongoing liabilities (the inherent costs of manufacture, cost of capital, acquired tax liability, etc.), that business creates and builds wealth. 

As thousands of enterprises increase their wealth, they must add additional workers to grow even more, and -- presto -- wealth creates jobs. Thus, if government seeks to assist free-market enterprises to create jobs, it must first create business wealth -- then jobs follow. How can government create wealth? There are three principal ways:

(1) Adopt policies which permit a company to acquire necessary capital to initiate or expand its asset creation;

(2) Reduce or avoid imposition of regulations which increase the cost of producing goods or services; and

(3) Reduce the inherent liability imposed by taxation on the resulting profits of the enterprise.

Thus, to the extent government utilizes resources at its command to increase business assets and limit or reduce business liabilities, wealth grows. As wealth grows, business activity expands, and the need for labor increases. As the supply of an unemployed labor pool diminishes in the face of increasing business growth, wages must go up as businesses compete for the work force needed. This is exactly the process that has made America an economic powerhouse for generations. Throwing money at individuals for a year or two will not do the job.

Clearly, Milbank and other big-government liberals have their economics upside-down. Freeing up capital, reducing cost-increasing regulations, and lowering taxes basically involve getting the government out of the way. It is the big-government reach of President Obama and congressional Democrats that now hampers the economy. With major uncertainties affecting health care costs, environmental regulations, taxation, and still-to-be-promulgated banking rules, entrepreneurs and businesses large and small are sitting on what saved capital they possess.

In such an environment, true Keynesian "stimulus" can only be counterproductive. Why?  Three factors dominate:

First, for a nation of over 300 million people, the amount of stimulus money needed to have any impact at all is huge. Only by using a seemingly existential crisis, as President Roosevelt did with the Great Depression or as Barack Obama exploited with the banking and real estate collapse of 2008, can Congress be convinced to open the public purse to appropriate unprecedented funds. This can be done only once, as the public inevitably recoils at the national debt incurred. Thus, we have a one-time (essentially a vote-buying) mega-pulse of money with no year-to-year sustainability because the rising national debt freezes incentive and political will to continue.

Second, in a very large, complex, and interrelated economy such as exists in the United States today, a one-time mega-pulse of money cannot get down to the lowest level required for domestic spending for months, if not years, because government cannot properly move large sums quickly. Further, if and when the flow of massive government funds eventually reaches the "retail" level, it creates a situation where too much money in individual hands begins chasing too few goods -- the classic cause of rampant price inflation.

Finally, and perhaps worst of all, the massive debt generated by the stimulus dollars pumped into the economy (including those used to create the large administrating bureaucracy) must be serviced and, at some point, be extracted from that same economy. When the inevitable inflation spiral kicks in and interest rates rise in response, ever-increasing debt service costs and any effort to clear the massive debt will severely limit ongoing government operation, require higher levels of taxation, or assure monetizing of the debt through currency devaluation -- all of which slow essential growth of wealth and impose a lower standard of living.

As Dana Milbank makes clear, we are now firmly in the grip of faulty economics with little optimism for the future unless, following the November elections, unfolding events -- including the exploding growth of government -- can be significantly reversed. If not, the years ahead will make the period of Carter-era stagflation seem tame.

Mr. McLaughlin retired as vice president of a company producing special-purpose military communications equipment. He lives in California and may be reached at j-c-mcl@nccn.net.
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