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Even Keynes Wouldn't Like This Bailout

By Josh Hendrickson - December 23, 2008 12:00 AM

The conventional wisdom on the current financial crisis is that macroeconomic theory has little to say. I am not sure where this idea originated, but there is much that can be explained from existing theory especially in regards to policy. The work of Robert Barro, Charles Plosser and John Long as well as Nobel laureates such as Milton Friedman, Franco Modigliani, Finn Kydland, and Ed Prescott have much to say about the impact of macroeconomic policy.

Unfortunately, with a few notable exceptions, the work of these economists has received scant attention during the current crisis. Nonetheless, their work remains important in explaining the futility of much of the current policy prescriptions. Equally disturbing is the return of self-professed Keynesians with policy prescriptions that are wholly inconsistent with both Keynes and modern macroeconomic theory.

Real Business Cycle Theory

The term "real business cycle" was coined by John Long and Charles Plosser in the 1980s when they sought to explain how much of the fluctuations in the business cycle could be explained by an economic model that lacked money, adjustment costs, sticky prices, and a variety of other frictions that were ? and still are -- often used in other such models. Their model demonstrated that a significant amount of fluctuations could be explained with such a simple model. Similarly, Ed Prescott and Finn Kyland developed a business cycle model that built on the neoclassical theory of economic growth and found that their model also explained a significant amount of fluctuations. This model remains the building block for many business cycle models that economists use today.

A common misconception with regards to these models are that they claim that money plays no role in the business cycle and that prices are always perfectly flexible, which are clearly not claims that are based in reality. However, such criticism is unwarranted. The authors of this theory each explicitly explain that their work is not designed to refute the elements of theory that they have excluded from their model, but rather to identify the magnitude of economic fluctuations that can be identified in the absence these restrictions.

These models have important implications for policy. For example, if a substantial portion of economic fluctuations can be explained by real factors, then policy is limited in correcting downturns in the business cycle. In other words, during an economic downturn, as resources are reallocated and markets adjust it is possible that the natural rate of unemployment will increase thus limiting our ability to stem rising unemployment through the use of discretionary policy.

The Permanent Income Hypothesis

The Permanent Income Hypothesis developed by Milton Friedman and the Life-Cycle Hypothesis developed by Franco Modigliani share a common theme. Namely, these theories state that consumption behavior is determined by the expected level of lifetime income rather than simply current income. In other words, individuals smooth consumption over the course of their lifetime. The implication of this theory is quite simple. Consumption will only respond to changes in the level of permanent income. Thus, one-time stimulus checks and tax rebates will have little to no effect on current consumption. John Taylor recently pointed this point out in an op-ed in the Wall Street Journal in which he detailed the lack of response of consumption to the recent stimulus package. Thus, if we want to stimulate aggregate demand in the economy, we need to cut taxes permanently. Doing so will not only stimulate aggregate demand in the short run, but also might help the long-run growth path of the economy.

Barro's Theory of Government

The work of Harvard's Robert Barro has been important to our understanding of how output reacts to changes in government expenditures. Barro's work emphasizes the fact that temporary increases in government spending have much larger output effects than do permanent changes. The implication of Barro's theory is that a temporary stimulus through government expenditures, perhaps in the form of infrastructure improvement projects, would do more to stimulate the economy than plans to develop an entire "green" industry to create the jobs of the future that only permanent government subsidies can provide.

The So-Called Keynesians and A Path Forward For Policy

Perhaps somewhat ironically, the implications drawn from the theories outlined above are quite consistent with the policies advocated by Lord Keynes. Namely, that tax cuts and temporary government spending is necessary to stimulate the economy. Nevertheless, there are many so-called Keynesians who have been out there promoting policies that are quite the opposite. They have been promoting the re-capitalization of banks, forcing banks to lend, automotive bailouts, and a push toward developing "green" jobs. These attempts to micromanage the supply side of the economy are not consistent with Keynesian stimulus or that of modern macroeconomic theory. Further, they do not and will not promote recovery or economic growth. We cannot centrally plan our way to prosperity.

Ultimately, the path forward for economic policy must not only be to stimulate aggregate demand, but also to allow for a higher future growth path for the macroeconomy. This cannot be done through simple stimulus checks, recapitalizing banks, forcing banks to lend money, and automotive bailouts. Rather, it can be done with temporary stimulus from the government, permanent tax relief, and the recognition that fiscal policy has its limitations.

Many economists may choose to argue the finer points of these theories and which we should use for developing policy, but one cannot dispute that macroeconomic theory has much to say about the ability of economic policy to correct the current economic downturn. Unfortunately, such theory has been missing from the recent discussion and debate.

Joshua Hendrickson teaches economics at Wayne State University. He also maintains the blog entitled, "The Everyday Economist" (

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