Risks of Keynesian thinking

Voiceover: In the last video we had a little bit of review of classical economics and then we talked about how Keynesian thinking was a departure, especially, and why it might have made sense in the context of the Great Depression, where the economy was operating well below its potential. What I want to do - It may be true anytime that the economy is operating well below its potential. What I want to talk about in this video is how Keynesian thinking can sometimes be dangerous. One thing I do want to emphasize over the course of this video is Keynesian policies are often associated with people on the left, with policies on the left, democrats in the United States. The republicans also, for the most part, especially mainstream republicans, especially the last several administrations, they have practiced what can only be described as Keynesian policies. When the economy started to recede, they tried to stimulate it by shifting aggregate demand to the right somehow and we'll talk about that they tried to do it in a slightly different way, through tax cuts, instead of government spending increases, but it was Keynesian in its underlying thinking. Now just as a bit of a backup, I'm going to talk a little bit more about that cycle that we talked about in the last video. If you have person A, person B, person C, and person D or maybe their firms. B supplies A, A supplies D, D supplies C, and C supplies B, and for the sake of simplicity, we said that they're all supplying 2 units of their good and service to each other. Let's just say that C has a bad dream, feels pessimistic, ate something bad and all of a sudden isn't feeling good about the future and wants to buy less, just out of caution. Maybe he wants to hoard a bit of cash, just in case C needs it. He buys a little bit less from D, but D says, "Gee, my business is bad, now I can't afford "as many goods and services," buys less from A, A does the same thing from B, and then B's business is bad, so buys less stuff from C, goods and services from C, and now C feels like they're psychic, even though we see that it was actually a self-fulfilling prophecy, that C's pessimism actually led to that reality actually occurring. In a worst case, it actually could get worse and worse. C could say, "Wow, I was pessimistic and I was right. "My business actually did get bad." Maybe it even got worse than C had expected and then C could then say, "I'm going to buy even less. "Maybe I'm only going to buy a half from D now," and then D says, "Maybe I'm only going to buy a half "from A," and that cycle could go down and down and down until each of them are just buying exactly just what they need to get by, even though they all could be producing more, the economy could be producing more and could be wealthier and they all could be way better off. This is, at least in my mind, a pretty good description of what happens in a depression, especially the Great Depression. So there might be a rationale to say, "Hey, look, "why doesn't the government come here at some point "in this economy and stimulate demand?" Why doesn't the government come here? Let's say B is already buying 1 from C, the government comes and says, "Hey, I'll buy another 1 "from C," and then C says, "Hey, things are good again. I can buy 2 from D," D can buy 2 from A, and then A can buy 2 from B and then B can buy 2 from C and so things have gotten back to their potential state. The economy is revving. In an ideal state, the government would say, "Hey, my work is done now. "I can now take a step back and I don't want "to overheat the economy. "I don't want to push aggregate demand too far "to the right and cause inflation," so they will take a step back. The danger here is that this is not so easy for governments to do. This was some type of stimulus, some type of government spending. Although maybe it was a tax decrease, so maybe B could've increased their demand, but either way, once you do a policy like this, and let's say it was government spending, it's very hard to unwind. This government spending might have been for a project that some people like, it might have employed many, many people. Those people are voters. They're not just going to sit there while you cancel this government project. There's a risk that maybe there is a justification for a Keynesian policy, but when it's time to undo that Keynesian policy, to undo that stimulus, it's very hard to do it. It's kind of a sticky policy. What you might have is when times are bad, you do Keynesian stimuli, but when times are good, you're not willing to undo it and if that Keynsian stimuli involves more and more deficit spending or more and more government spending, then the government size is just going to grow relative to the economy, or the deficit is just going to grow relative to the economy and you're never going to unwind it, because unwinding is unpopular. I want to be clear that this is true of both the left and the right. In the stereotypical sense, the left might say, "Hey, let's do a Keynesian stimulus by spending more," so the government spends more and let's hold our revenue constant, our tax revenue, let's hold it constant. Obviously, the government would have to borrow more money to fund this, or sometimes they might even increase taxes if they actually wanted to be more purist about it, but this is the variety that you see and this would be a true stimulus. This is using the fiscal lever to put more demand in the economy, but in the right you often see the other side. You see taxes being lowered, essentially saying instead of the government spending it, why don't we let people decide where to spend it and they might spend it in a more efficient way, but it's going to be a stimulus, because spending is held constant. Then you have the double where you do both sides of it, where you lower the taxes, you lower the inbound revenue, and you increase spending. This is true, this has been done by both republican and democratic administrations. Lowering taxes, but then going and starting a hugely expensive war and obviously this would increase deficits. There might even be a justification for doing any of these, a Keynesian justification if the economy truly is operating well below its potential. The tough thing is it might be justified, you actually don't know exactly where that potential is and you might not be able to unwind this once you get to your potential and then you might overheat the economy, might lead to inflation, and that actually might undermine the productivity of the actual economy. The other negative of a Keynesian mindset is what happens over the long run. In the short run this might make a lot of sense. Let's prime the pump, let's get the cycle to happen in the right away again, but in the long run, it's essentially just trying to get people to consume and consume more. You'll often hear, when the economy slows down a little bit, you'll hear the president, you'll hear politicians say, "Hey, we're just trying "to get people to spend more "through some combination of these Keynesian policies. "We're going to lower taxes, we're going to increase "spending,"but you'll never hear them say, "Hey, we want people to save more, "so that we can invest more, "so that in the classical sense we can increase "our total productive capacity." The US has gotten a free pass on this, because the US has been doing, essentially, the deficit spending has been able to do the Keynesian stimuli and that's why the US consumer keeps spending more and more, saving less and less. The government is doing the same thing, but the US has also been getting investment because it's the foreigners who've been saving and then plowing that money and they've been, essentially, investing in the US, so that the US could increase its productive capacity, but that is a risk for a country if it's not blessed with that free pass that the US has gotten for the last several decades is that when you have some resources, so in a given year, you have some resources. Let's say it's your time. You could either hunt and eat rabbits or you could spend your time to invent new rabbit trapping devices. This is the hunting and eating the rabbits and this is spending some time to go and figure out ways to be more productive at hunting rabbits, building some bow and arrows or something like this. You always have a tradeoff between consumption and investment. Keynesian policies, they're all about, hey, let's get consumption as high as possible and that might be a good idea in the short run, especially if we are operating well below our potential, well below our full capacity utilization, but it could be a risk in the long run, if you don't get the free pass, because you might have underinvestment and in the classical sense, you're never able to move your potential to the right.