Thursday, January 13, 2011

The Keynesian Dilemma

There is not the slightest doubt about the basic truth of the Keynesian economic proposition. It is that, given the large size of modern government budgets in relation to a nation's economy, inequality between the two sides of a government's budget, because they have opposite effects on the economy, can be used to offset opposite imbalances in the economy. The Keynesian formula, then, is that governments should run deficits during recessions, to raise the level of consumer purchasing power and thereby counter the recession, and run surpluses during the boom phase of the business cycle, to lower the level of consumer purchasing power and thereby counter inflationary pressures.

Keynesian policy, however, faces an obvious political dilemma, which Keynes himself pointed out, which can be called the "Keynesian dilemma": It is politically easy during a recession to increase government spending and cut taxes, but it is politically difficult during the high parts of the business cycle to adopt the reverse fiscal action, i.e. cuts in government spending and/or increases in taxation, that can be necessary to prevent serious inflation.

Governments around the world have often not used their full fiscal powers against recessions because they have been uncertain about persuading their populations to accept the appropriate reverse fiscal action following a recession. The dilemma is nothing less than how to reconcile democracy with intelligent management of the economy. This reality is very different from conservative portrayals of government as inherently evil and the people as inherently wise.

Given the consequences of recessions, in severe social dislocations and widespread suffering, there is no socially responsible alternative to Keynesian policy.

On the other hand, skepticism about large use of the Keynesian instrument during recessions can have a rational component, namely doubt that the nation has the political maturity to adopt the appropriate reverse fiscal action following a recession.

If progressive social policies are to be maintained and advanced, then the emphasis in reverse fiscal action, beyond terminating temporary stimulus measures, has to be, not on reductions in public social spending that protects and advances well-being and equity in society, but on increases in taxation, which reduce private spending.

With the required political leadership, however, there is a way of cutting through the "Keynesian dilemma": The most effective approach is to legislate increases in taxation far in advance by implanting automatic formulae in the national tax system, with the tax increases taking effect, not by the calendar, but according to specified points in the upper phases of the business cycle, with adjustments as may be needed.

The Obama adminstration and the Democratic Party might have gotten into less political trouble if, while the Democrats still controlled both houses of Congress, they had packaged their stimulus measures, not with mere proposals or discussion, but with actual enactment of such tax legislation.

Such legislation might, indeed, be repealed or amended in some destructive way. But political responsibility could then be fixed.


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