Friday, July 17, 2009

Another Flaw of Keynesianism

It recently came to my attention that Keynesianism has a second flaw beyond what I deem "the Keynesian fallacy."

(The Keynesian fallacy is the belief that the circulation of money is the prime determinant of the health of the economy; if money circulates a lot, it creates wealth).

It recently occurred to me that Keynesianism has another fallacy associated with it: the belief that capital goods and labor are completely fungible (or as William Anderson puts it, "homogenous").
Therefore, whenever aggregate demand is too low, the solution is simply to increase aggregate demand, rather than to consider whether the specific demands and productions are miscoordinated or whether production is geared up to meet demand. For example, if there is a glut of rubber tires, the goal becomes to find a way to use all those tires rather than to divert production of tires towards the production of something that is more in demand.

So as a result, you hear statements about how government stimulus will definitely help the economy without costing anything or without crowding out private investment, because there are so many idle resources that will go to waste if they are not used, which the government can use. And, according to this way of thinking, as long as we have high unemployment, there is excess labor so there is no danger of the government diverting resources by employing people.

Generally, this theoretical framework can be summed up by this quote from Dean Baker:

The Post is also worried about the deficit, telling readers that there is a limited supply of capital in the world and that we are borrowing too much. Actually, for practical purposes there is not a limited supply of capital in the world when the United States and most of the other wealthy countries are seeing double-digit unemployment. We can pretty much spend whatever we want without coming up against resource constraints. (Unemployment -- means excess labor supply, get it?)

This, of course, is based on the assumptions that (a) labor is the only resource constraint, and (b) all labor is fungible.

The fact of the matter is that (a), there are raw materials and technological constraints that government can push us to the limit of, regardless of employment, and (b) that a glut in labor does not necessarily mean that there are no labor shortages in certain sectors.

Definitely government can crowd out the use of raw materials, technological infrastructure, and land, even when there is high unemployment. Moreover, government could wind up exacerbating unemployment problems if the stimulus creates demand for jobs that require skills that in short supply. This could, in turn, reduce production at other levels, thus causing the labor glut in other sectors to get worse as demand for jobs declines in that sector.

For an example of the first problem, let's say that the government spends money on building asphalt bike paths and on building new highways into largely untraveled areas (like the famous "bridge to nowhere") in the hopes of getting more settlement in those areas. That could deplete our supplies of the raw materials needed to make asphalt, and thus cost jobs that are involved in making other goods that require those same raw materials. Alternately, the spot the government takes for its road might have been used to build a factory, or some other facility that society might find more useful. This is not to say that spending money on repairing roads or on building new roads in necessarily bad (although what the federal government's role should be in such things is an issue in its own right), but it is untrue to suggest that it is costless and does not represent a drain on other potential uses of resources. In any case, any such project would need to be justified on its own terms, quite apart from its effect as a stimulus.

For an example of the second, let's say that the government decides to put the unemployed to work. There is a glut of people skilled in construction. Therefore, the government sets about trying to create more office buildings to put lots of construction workers back to work. What if, however, it turns out that these buildings also need engineers, and that, due to lots of people with a mathematical background getting into the financial industry instead of engineering (due to the recent investment bubble), there is a shortage of qualified engineers (building houses requiring fewer engineers than building large office buildings), meaning that increasing construction will take the engineers out of other occupations that require them? Then these industries will not be as successful and will lay people off, as they cannot find the number of engineers that they need in order to produce goods and employ people in the other positions in their business.

The obvious solution, of course, would be to get more people to become engineers. But (a) not everyone has the aptidue to become an engineer, and (b) there will be a delay because it takes time to train someone in that field.

In the absence of government intervention, there will still be some maldistribution of resources, as the market process may take time to get things into equilibrium (after all, learning certain professions takes time in any system). But the problem is that the government intervention, being isolated from direct market signals, is as likely to exacerbate a shortage as to solve one.

The problem with Keynesianism in regards to supply and demand ultimately boils down to the fact that it oversimplifies supply and demand into one homogenous mass, therefore eliminating a key element of the economy: diversity of resources. This causes Keynesian policy to become largely about coordinating the overall level of supply and demand, and to assume that all economic problems can be solved by adding or subtracting consumption. This, in turn, leads to all of the nonsense where simply increasing the number of exchanges is seen to be the same things as creating actual goods, which brings us back to the original "Keynesian fallacy."

That is all.

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