Business Cycles the Keynesian Approach to Recessionary

Business Cycles

The Keynesian approach to recessionary gaps is to increase government spending and lower taxes -- run a deficit -- in order to spur aggregate demand. In the Keynesian model, aggregate demand is affected by a number of different factors -- consumer consumption, business investment, government spending and net exports. During a recessionary gap, consumer spending and business investment are probably both down, which leaves the other two factors to prop up the economy. Government spending is an efficient way of directly putting money into the economy, thereby giving consumers more money to spend and businesses more money to invest (FRBSF, 2013). Knowing that the government is working hard to spur economic growth can also change the underlying psychology of the market.

Lowering taxes is another means by which government can spur growth under this scenario. Lowering taxes allows for more spending from both consumers and businesses, since both will have more money to spend. The approach of lowering taxes is less efficient than increasing government spending (Uchitelle, 2009), however, when there are other factoring contributing to the recession, such as higher consumer savings rates. When aggregate supply is higher than aggregate demand, lowering business taxes is not likely to spur investment because businesses are not using the capacity they have -- steps to spur exports would help close the AD-AS gap, but those policies take more time to come to fruition.

The neoclassical approach is to eschew government intervention. This approach holds that the market will self-correct. The approach does not specify how this will happen, just that the market is always right and better than the government (Yergin & Stanislaw, 1998). Whatever power the market has to achieve superior results, those results are achieving only in the long-run, on aggregate. Thus, there is no real solution under this approach to a recessionary gap. The common prescription is to lower interest rates, lower taxes and lower regulations. Lowering interest rates helps put more money into the economy. This is valuable if the economy needs the money, but when AS is higher than AD, the economy has no use for excess capital. Lowering taxes has a similar problem, although lowering taxes on consumers can spur AD, if consumers are not otherwise overleveraged and are willing to spend the fruits of these lower taxes. Lower regulations can spur business investment, but will only do so where AD is higher than AS.

2. The past recession lends clear support for the Keynesian position. Faced with specific conditions where consumers and businesses are unlikely to increase spending, government is left to intervene in order to spur economic growth. On a smaller scale, the same occurs following a natural disaster. With consumers and businesses having their wealth wiped out by a hurricane/earthquake/tornado, some will be able to spend on rebuilding but a great many will not. Government intervention in the form of funds to rebuild critical infrastructure and provide financial relief for victims helps to spur economic recovery in the area, complementing the private investment from those who can afford it.

There are fewer instances where the classical theory holds. Elements of the classical theory, such as the benefits of lowering interesting rates, lowering taxes and reducing regulation, all have been proven in the real world. The major issue that fails is the one stemming from 1950s anti-socialist ideology -- that government intervention is inherently bad and cannot help an economy. Lowering interest rates (and other forms of expansionary monetary policy) have enjoyed successes in many instances, especially during minor downturns. The recession sparked by the 9/11 terrorist attacks was managed through classical policy, though it should be noted that this approach does not directly contradict Keynesian policy prescriptions. Lowering taxes and regulations often serves to spur economic growth. Good evidence of this can be found around the world, where nations that have a high level of economic freedom tend to outperform nations with low levels of economic freedom. Singapore, for example, outperforms Malaysia, even though it has no resources and the latter is oil-rich. With a shared history and roughly the same cultural mix, there is no reason why Singapore should be so much wealthier, but its high level of economic freedom contributes to an environment that encourages commerce. This outcome can be attributed to classical economic policies, but it is also worth noting that it has occurred over the long run. Classical economic theory works well over the long run but is not nearly as well-equipped to deal with short run recessions as Keynesian policy, because classical theory takes certain policy options of the table on ideological grounds.

3. Some government intervention in the economy is partially political. One of the differences between intervention and non-intervention is on the timing of the response. Classical theory works best in the long run, but recessions are deep shocks that, in order to avoid adverse consequences such as the development of a chronically unemployed/underemployed class, need to be addressed with a greater sense of urgency. Once the classical approaches have been instituted, a stickier recession will need to be addressed with stronger, more direct action in the form of government intervention.

A case like the automobile bailout is different. That bailout was largely political in nature, because the job losses if those companies went under would have crippled the U.S. economy to a high degree. While in the long run the auto industry would be better off without intervention -- even if it means that the U.S. is down to only a single domestic provider -- in the short run the intervention was necessary to avert a full-scale depression. Moreover, there are national security implications to the auto industry that make a case for government intervention to protect those companies. Thus, it was probably not pure Keynesian theory that led to those bailouts, but a combination of factors including some non-economic ones. On purely economic principles, it is an easy case to argue that the moral hazard of bailing out the automakers might outweigh the short-run benefits to the U.S. economy.