Keynesian Death Spiral

In Wednesday’s Wall Street Journal, Kevin Hassett explains the economic logic against fiscal stimulus (“Stimulus Optimists vs. Economic Reality”). It’s a superb piece.

The more powerful one believes fiscal stimulus to be, the more adept the Keynesian policymaker must be. If the stimulus has powerful positive effects when added, it will have powerful negative effects when withdrawn. Hence, the application of stimulus and its withdrawal must be precisely timed. An economist would ask from whence the knowledge to do this would come.

As Hassett notes, however, stimulus has not two but three stages. It may boost growth when added, but must slow growth when withdrawn. The third stage comes when taxes (current or future) must be paid to fund the stimulus. That stage is always negative in its effects. Thus, Hassett concludes that “the total impact of the Keynesian policy is negative over its life.”

The case for fiscal stimulus is even weaker in the aftermath of a major financial crisis, such as we have experienced. Downturns, measured by employment, are longer in the wake of such crises. Hassett cites the Reinhart and Rogoff estimate of an average duration of 4.8 years. Short-term stimulus becomes very problematic in the wake of such crises.

“…Aggressive stimulus sets off a kind of Keynesian death spiral in which nervous politicians adopt repeated stimulus packages in order to avert near-term distress, the cumulative effect of which can be ruinous.”

(Though Hassett does not note it, Keynes was aware of the problem. He described it as the bismuth/castor oil cycle. The patient inevitably dies.)

Hassett’s analysis fits the current situation very well.

About Gerald P. O'Driscoll 16 Articles

Affiliation: Cato Institute

Gerald O’Driscoll is a widely quoted expert on banking and monetary policy. Previously the director of the Center for International Trade and Economics at the Heritage Foundation, O’Driscoll was senior editor of the annual Index of Economic Freedom, co-published by Heritage and The Wall Street Journal. He has also served as vice president and director of policy analysis at Citigroup, and vice president and economic advisor at the Federal Reserve Bank of Dallas. He has also served as staff director of the Congressionally mandated Meltzer Commission on international financial institutions.

He is widely published widely in leading publications, including The Wall Street Journal. He has appeared on national radio and television, including Fox Business News, CNBC and Bloomberg. With a dozen years experience as a university professor, O’Driscoll speaks regularly at academic conferences and universities.

O’Driscoll holds a B.A. in Economics from Fordham University, and an M.A. and Ph.D. in economics from UCLA.

Visit: Jerry O’Driscoll's Page

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