In a striking turn in the unedifying history of business-cycle economics, John Maynard Keynes's masterpiece, The General Theory of Employment, Interest and Money (1936), was ignored by liberal and conservative macroeconomists alike until the collapse of the banking industry last September, and the ensuing economic depression, revealed that Keynes's book provided a better guide to our economic crisis than Milton Friedman's monetarism, Real Business Cycle theory, or even the New Keynesian Economics (which in fact bears little resemblance to Keynes's economic theory). Liberal economists like Paul Krugman quickly embraced Keynes.
But Krugman's passionate support for the Administration's health-care program suggests that he has not absorbed one of the central elements of Keynes's theory, which is the role of uncertainty in depressing investment spending and, both by depressing investment and by increasing passive savings, in depressing consumption spending as well. (I elaborate on the role of uncertainty in depressions in a forthcoming article in Challenge magazine, entitled "Uncertainty Aversion and Economic Depressions: Analysis and Implications"). When uncertainty in the sense of risk that cannot be calculated rises, it tends to make businessmen and consumers alike freeze--they hoard money rather than spend it, whether spending on investment in the case of businessmen or sending on consumption in the case of consumers. That is the prudent response to increased uncertainty, because by holding off on spending the businessman or the consumer buys time to gather information about his options, or simply wait for the situation to clarify itself, and also accumulates cash with which to deal with emergencies to which an uncertain economic environment can give rise. We see these tendencies at work today, in the huge excess reserves accumulated by the banks, the decline in new bank loans, the massive layoffs by employers uncertain about the demand for the goods and services they produce, the decline in business deals, and the sharp increase in the personal savings rate.
But by taking these precautionary actions (or inactions), businessmen and consumers are deepening the economic downturn and retarding recovery. The government's aim should be to reduce uncertainty and increase confidence in the future of the economy. Poorly designed as it was, the $787 billion stimulus package enacted in February was a justifiable anti-depression measure because, long before any of the appropriated money was spent, it boosted confidence in the government's determination to arrest the depression.
But even by today's standards, $787 billion is a lot of money. It added appreciably to a national debt already swollen by the Bush Administration's profligate spending and tax-cutting, by the bailout programs, and by the dive in federal tax revenues caused by the fall in incomes. The greater the national debt, the greater the worry about an aftershock to the depression when the time comes to pay back, in one way or another, the additional debt incurred to fight the depression.
I therefore thought it a mistake, as I have noted often in the blog, for the Administration to embark, without waiting for the recovery from the depression, on ambitious social programs that are likely to add substantially to the national debt. These programs, if enacted, will increase the likelihood of a severe aftershock.