Recently, I wrote a post on behavioral economics, and I discussed the implications this relatively new economic science has on limited government. For those who read the post, you'll remember I concluded that behavioral economics is not in itself a threat to limited government, even though nearly all behavioral economists are left-winged.
Today, I'm taking it one step further. In this post, I'm going to make a behavioral economic case against Keynesianism
Like I said in my last post on this subject, a big problem with behavioral economists is that they tend to focus entirely on the free market and the private sector. Behavioral economics is about studying how human behavior affects the economy, and more specifically it is mostly about studying anomalies and irrational behavior (that standard economic models say shouldn't exist). Behavioral economists correctly identify a lot of irrational behaviors in human beings that negatively affect the economy (like the tendency not to save enough for retirement, or the tendency to buy a new house just because everyone else is). However, they forget that these very same things apply just as much to politicians; hence relying on politicians to solve problems that occur in the marketplace is far from a foolproof solution.
I am going to make four arguments, based on behavioral economics, as to why keynesianism doesn't work. Let's get going with the first one:
1) Bad habits die hard.
Keynesianism states that the government should attempt to run budget surpluses during the boom, and then spend said surpluses (and even borrow money if necessary) during recessions. In other words, going on a spending splurge when the economy is doing badly is OK, as it will increase aggregate demand. You just have to make those spending splurges temporary and all will be fine. The problem is, when government increases its spending, it's always and everywhere a permanent increase (data supports this; I don't think government spending has been reduced a single time during the past 40 years or so).
Let's say we're in a recession, and the government decides to spend an extra one trillion dollars annually for a couple of years. Now let's say that three years later, the economy has recovered, and the original raison d'etre for the increased spending is gone. Regular economics says that now, the government will simply reduce spending, and everything will go back to normal. This, however, never really happens in the real world. Why?
Behavioral economics gives us a clue about why spending is so rarely reduced during booms, even though it's always increased during recession. The reason? Habits die hard.
Humans rely on habits to make life easier for us. We don't think for a long time before picking up our favorite cereal; we just pick the one we're used to picking, out of habit. This isn't always rational, but it's a fact of life anyway.
Politicians do this too. They don't sit around for hours analysing how much spending is optimal; they spend as much as they have a habit of spending (remember, most politicians are not economists, and so often they don't really have the knowledge necessary to make optimal decisions). Spending an extra trillion for a couple of years soon turn that extra trillion of spending into a habit; it creates a dangerous precedent. What was supposed to have been a temporary measure to increase aggregate demand, soon becomes a permanent part of every future budget.
Behavioral economics teaches us that we often continue with habits even after they stop making sense; we don't evaluate them nearly often enough. Nowhere is this as obvious as with politicians and their spending habits.