The simple version of Keynesian economics suggests that if the economy is suffering from too little economic activity and high unemployment there are some policy options.  Specifically Keynes suggests there are three general kinds of policy options:

1. The central bank (The Fed in the case of the U.S.) could lower interest rates and create money by buying bonds on the open market.  This is called stimulative monetary policy. It is supposed to work by making private sector borrowing more attractive and more profitable so that businesses in particular increase their spending on business investment goods like equipment and factories.
2. The government could increase it’s budget deficit by borrowing more money and cutting taxes.  This is fiscal policy by tax cuts. It works by putting more cash in the hands of households and firms (increases their after-tax income) who then increase their spending.
3. The government could increase it’s budget deficit by borrowing more money and directly spending the money itself, either by direct transfer payments to needy individuals, or by buying things like new dams or construction projects, or by hiring the unemployed itself. This is fiscal policy by spending.

There’s nothing to stop a country from pursuing all the above options simultaneously if it chose.  But not all of these options are equal in either effectiveness.

NOTE: This is old-style John Maynard Keynes style Keynesianism, not the  “New Keynesian” theories that have dominated some academic circles in the last couple decades. It’s also based on the real thing, not the caricature that it’s opponents paint which is usually without foundation. 

NOTE 2: It’s really not a good idea to try to simplify Keynes.  When you do, you’re likely to over-simplify and really miss powerful insights and nuances.  Nonetheless, I will plunge ahead with full knowledge of the risk.

The real richness of Keynesian theory though lies not just in these prescriptions, but the analysis of when to use which one, whether it is likely to work, and under what conditions.  The first option, monetary policy, is to be preferred in cases of  mild recessions when interest rates are “normal” and the slowdown is largely for mild, temporary factors such as an outside economic shock. Monetary policy is quick and easy to implement. It’s also relatively easy to reverse course when the time comes.

Keynes had two key insights about monetary policy though that are highly relevant to our present situation.  Monetary policy can be become impotent if interest rates drop to near zero and we get into a liquidity trap.  This is when people and firms become fearful of the future and come to expect continued weakness or even GDP declines and deflation.  In a liquidity trap, people just sit on money rather than spend or invest it.  Monetary policy is relatively ineffective in such cases. We have been in a liquidity trap since late 2008 and that’s why the record 3 years of a virtually zero Fed Funds interest rate and The Fed’s QE1 and QE2 programs haven’t worked. Liquidity traps aren’t common, but they do exist and they aren’t extinct.  We were in one in the 1930’s Great Depression and Japan has struggled with one for the last 15+ years.

Keynes also had insights about the two fiscal policy approaches, tax cuts vs. increased spending.   In particular, tax cuts will only be effective to the degree that households and firms actually spend the money.  If they use the money to pay down debts or to save, then it really won’t improve conditions.  Later research in the 1950’s and 1960’s strengthened these insights. Later research showed that it also makes a big difference who gets the tax cuts and whether they think the tax cut is permanent.  Temporary tax cuts are much less effective than permanent ones because people tend to save them more.  Also, high-income individuals tend to save more of the tax cut (proportionally) than more desperate lower-income folks. Finally, later research showed that when a recession comes about because private debt got too high, then tax cuts are least effective.  Notice a pattern here?

The fiscal policy “stimulus” efforts that we have pursued since the Great Recession began have been very, very heavily tax-cut oriented.  Bush’s original stimulus effort in early 2007 in an effort to “nip the recession in the bud” was all tax cuts.  The Feb. 2009 stimulus bill of Obama (the ARRA) was between 40% and 50% tax cuts.  The meager effort passed in Dec 2010 was all tax cuts. And now, the proposal is again very tax cut heavy.  Not only have the fiscal stimulus efforts been heavily tax cut-based, but the cuts have temporary cuts targeted at either high-income folks or only offering a meager amount to low-income folks.  Further, we still have a huge private sector debt overhand that people want to pay down before they spend more. In sum, the dominant response which many have labeled as “Keynesian” really hasn’t been what John Maynard Keynes suggested. Many have asserted that “Keynesian policies don’t work” and cite our weak economy despite several fiscal policy stimulus attempts as proof.  But that’s not really a valid test.  It’s like claiming some physician is a total quack because you took pills like he recommended but you didn’t take the exact same pills as he recommended. You took something else. Now you’re still sick.  It’s not the physician’s prescription that failed, it’s your refusal to follow the prescription and the diagnosis that failed.

Critics will counter with a “yes, but there was still some spending stimulus in the Obama bills and our failure to fully recover is proof the fiscal spending as stimulus prescription is quackery.”  But have we really had an increase in government spending anywhere near large enough to fill the gap?   Let’s look at some trends (courtesy of Brad Delong):

We simply have not expanded government purchases as a share of potential GDP in this downturn:

The graph shows the relative changes in share of GDP of four key portions of GDP: exports, business equipment investment, government purchases, and residential construction. (everything in the graph is scaled relative to 2005 -that’s why the lines all meet at o in 2005).  The whole Keynesian idea is that if exports, business equipment investment, or residential construction go down then government purchases should go up and vice versa.  That hasn’t happened at all.  Instead, government purchases has consistently declined since 1995!.  In other words, actual changes in government purchases have not only not been a stimulus, but they have been contractionary.  Government spending policy has been contractionary for over 15 years!  We didn’t notice it because strong increases in business equipment investment and housing were doing the stimulating prior to 2006. In the period 1995-2000, it was probably appropriate in a Keynesian sense to have declining government purchases and a contractionary policy – it was countercyclical to the dot-com boom and the housing boom.

But after 2007, residential construction collapsed. For awhile in 2009 both business equipment investment and exports declined sharply.  The only appropriate Keynesian response would have been a very, very large government purchases program.  But we didn’t do that.  Instead, the so-called 2009 stimulus bill was barely enough new spending at the federal level to offset the declines and cuts at the state and local levels. Overall, government spending did not increase. It went neutral for a couple years. But in late 2010, we resumed the march to contractionary policies.  The ARRA wound down.  State and local governments accelerated their budget cuts. And Washington became pre-occupied with imaginary threats of impossible debt crises at some point 10 years from now.

To continue the earlier physician and disease metaphor, we did try a little of the prescription but we took too little.  It’s as if we went to the doctor, the physician diagnosed a very severe infection and prescribed heavy doses of anti-biotics.  We went home took a lot of aspirin instead and only a couple of the anti-biotic tablets.  Now folks want to blame the doctor and his “failed prescriptions” when we didn’t take them.  None of this is what Keynes or 1960’s style Keynesians would have recommended. To conclude that Obama has tried Keynesian policies and they have failed is dead wrong.  The policies have largely failed to stimulate and re-ignite growth, but they weren’t Keynesian.