Last updated: September 06. 2013 5:46PM - 16 Views

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What a difference just a couple of years make when it comes to economic policy making and the hopes that spring from a new administration. When he came to office in January, 2009 Barack Obama promised a new beginning free from the wild gyrations of the market-driven economy that left the economy in a deep ditch. A new day would dawn, Americans were told, and wise planning on the part of government would turn an ailing economy around and lead to a revitalization of America. Remember that promise of holding the unemployment rate below 8 percent?

In essence, President Obama “bet the house” on the efficacy of a particular macroeconomic theory known as “Keynesian” economics. According to the belief of John Maynard Keynes, in times of economic distress (recession), the role of government is to revitalize a lagging economy via an increase in Aggregate Demand by engaging in temporary tax cuts and spending increases so as to “prime the pump” of consumer and business spending via a rise in current incomes. Then, given the government pump-priming efforts, natural market forces will take hold via multipliers — in essence a rippling effect, like a stone thrown into a pond — and the general economy will be off and running.

And so in February, 2009 a gigantic pump-priming stimulus package now estimated at about $830 billion was passed, with the promise that better days were ahead. Of course, as with all economic theories, politicians simply place their bets on the expected outcomes suggested by any particular theory and then hope for the best. Needless to say, actual economic outcomes have not been kind to Keynesians relative to the glorious days that were supposed to lie ahead.

Nowhere was that difference between lofty hopes and stark reality more vivid than last Friday’s employment/unemployment report for June. After an unexpectedly strong ADP jobs report on Thursday, markets were braced for a similarly outstanding Labor Bureau report on Friday. What markets (and anxious, unemployed Americans) got instead was a dose of statistical cold water, with just 18,000 jobs created for the month and a rise in the unemployment rate to 9.2 percent. Even worse, the unemployment rate was held down by more than 270,000 people dropping out of the labor force given the deplorable state of business hiring. But the bad news did not end there, with wages falling, the length of the average workweek edging down, and employment gains from the prior two months revised downward by more than 40,000. All-in-all, this was probably the worst employment report for well over a year, with no positive signs to hang one’s Keynesian hat on so as to spin a positive outlook for the future.

So, how could this macroeconomic theory be so badly off the mark and what might be an explanation for its obvious failings? While there is no definitive answer, given the very nature of the economics discipline, a reasonable explanation can be found in the writings of Milton Friedman. According to Friedman, the Keynesians are badly off the mark in terms of what motivates people and businesses to spend. It is not “current” income, but rather what he called “permanent” income. According to Friedman’s permanent income hypothesis, spending by people will be influenced by the average income they expect to receive during their lifetimes, not by a boost brought on by temporary tax cuts that have no lasting effect. So, as Freidman might have pointed out, the huge fiscal stimulus of February 2009 was doomed to failure and would not produce the much-anticipated multiplier effects since it did nothing to increase peoples’ spending proclivities given its lack of permanence.

With consumers unlikely to increase their spending, businesses would have little reason to anticipate a need for new employees and thus consciously hold down new hiring. Instead, they increased spending on plant and equipment in an effort to substitute capital for labor in this highly uncertain environment.

These thoughts, if they are reasonably accurate, have tremendous implications for the deficit/debt reduction talks currently taking place in Washington. Temporary changes — or worse yet, phony budget reductions which are little better than accounting gimmicks — by government to artificially create a deal will fail to produce the revitalization in expectations needed to convince businesses to expand hiring and place the nation on a more favorable, long-term growth path.

In the meantime, hopefully, the country has put behind it the simplistic niceties espoused by Keynesian economics and come to the realization that economic progress moving forward will likely require both pain and sacrifice.

Dr. James Newton serves as chief economic advisor to Commerce National Bank and is an auxiliary faculty member in economics and statistics at Ohio State University-Marion.


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