Saturday, May 26, 2012

The Behavioral economic case against Keynesianism

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.

2) Politicians are risk-averse, and the benefits from deficit reductions are abstract

There are two things we know about humans (and that includes politicians): We are in general riskaverse, meaning we don't like risk and we want to be compensated for taking on it (ie, we may make a high risk investment, but only if that high risk investment carries a chance of a high reward).
Reducing spending (or increasing taxes - that's another form of deficit reduction) means taking a risk. As a congressman, you have constituents who expect you to bring home the bacon to them - and you may not be able to convince them about the benefits of a vegetarian diet. If you face a decision on whether to increase spending, for example by given them an new park or school, or cut spending, you are more likely to opt for increasing spending, just because the return is more certain. You give people a park, school or something else, and you'll most likely be re-elected. On the other hand, voting for spending cuts, even when they make sense, is politically very risky.

Also, the benefits of deficit reductions are very abstract; they're hard to understand, hard to picture in front of you. Abstract rewards lead to bad decision-making; for example a big reason why smokers smoke is because while they know smoking causes lung cancer, they can't really imagine how painful lung cancer really is. "Lung cancer", to most people who haven't experienced it, is too abstract to be taken into account when making the decision on whether or not to smoke. Unsurprisingly, the reason many non-smokers give as for why they have chosen not to smoke is because smoking gives you yellow teeth, bad skin, hoarse voice etc - these consequences are not nearly as dangerous as lung cancer, but they're easier to picture (they're not abstract).

The dangers of the current fiscal policy too are to a large extent very abstract; we really can't imagine what a complete financial apocalypse caused by a US state bankruptcy would be like. It's too far from our perception of reality. We can't imagine the ATM's stop working, we can't see in front of us how martial law is declared in all 50 states as riots ensue and looting of shops becomes the only way to survive. This is something that willl eventually happen, much sooner than you think, if the US doesn't begin to take the deficit seriously.

Yet, in choosing between funding a park and winning re-election, and cutting spending and avoiding this abstract dystopic future, most politicians will choose the first options. Surely they'll be retired by the time the consequences of the deficit spending really begin to set in? And even when it does, it is far from certain that people will understand the connection between the action and the consequence; they won't understand that it was the fact that their congressman voted for a new park in their district (and all the other pork that they got) that drove the country towards bankruptcy, and so the congressman who did this is likely to get away scot-free.

Another difficulty lies in the old age of most senators and congressmen; many of them are old enough that by the time the US (or at least social security) goes bankrupt, they'll be 6 ft under the ground. It's not a coincidence that Paul Ryan is the guy behind the bold Roadmap to Recovery. He's a young man with small kids, and therefore he has high personal incentives to reduce the deficit: He will be around to face the music if nothing is done, and if nothing else his kids will too. I'm not saying that Congressman Ryan is selfish or that he is only trying to deal with the deficit for personal reasons - that would be absurd - but none the less, personal incentives certainly do affect how politicians vote.
These two reasons together - riskaversion and abstract returns from deficit reduction - is a big part of the reason why the Keynesian formula is so rarely followed: We spend during recessions, but we ignore the other part about saving during booms because the reason to save during booms isn't clear enough, and it's dangerous politically to suggest cutbacks.

3) Encouraging spending has long-term side effects

It is a common fact among economists that americans (and most other people as well) don't save enough. No matter what measure you use - whether "saving enough" means being able to keep your current standard of living when you retire, or whether you use the more technical measure of how close americans are to the optimal savings rate (the savings rate that will maximize GDP in the long term), Americans don't save enough.

Yet, during recessions, we hear politicians (and sadly some economists - I'm looking at you, Paul Krugman) proclaim the virtue of spending and how we must spend our way out of the recession (even though we pretty much spent our way into it in the first place). They claim that spending drives the economy, a claim that is ridiculous as it's really investment (savings) that drive the economy IN THE LONG TERM. Yes, increased spending can give a short-term economic boost, but in the long run a country's steady state is higher the higher the savings rate is (look up the solow model on wikipedia if you want to learn more). In the very long run, what really decides a country's growth rate is the rate at which it manages to innovate and become more efficient - technological progress, in short.

So what happens when you encourage spending? Let's assume a "good" scenario (from a keynesian perspective), where americans cut their savings rate from 5 % to 0 % - ie, they start consuming everything they earn, living paycheck to paycheck. Now imagine the recession ends. How do you get americans to start saving again? Keynesians may assume that the savings rate will go up automatically, but like I said in my first point, habits die hard. Most of us save a certain % of our income (or a certain amount of dollars) out of habit, and if politicians manage to convince consumers to stop saving, there is really no guarantee that the savings rate will go up after the recession is over. You see, convincing people to spend is relatively easy - spending is fun, remember. Convincing them to take up saving, after they've gotten used to living paycheck to paycheck, is certainly much harder. Saving requires a sacrifice, it requires us to accept delayed gratification. It's very possible that savings rates may remain low long afterwards, hurting growth and leaving consumers vulnerable to shocks.

We should also notice that if you're a spendthrift who has maxed out your credit card during the boom, to hear an authority figure (such as Paul Krugman, a respected economist) say that all you have to do - now that the recession is here - is to get another credit card and keep the party going may very well give you an excuse (let's face it, we all look for excuses to do things we think is fun that we know aren't good) to do so. Americans are already undersaving - why give people an excuse ("I'm doing it for the economy!") to save even less?

4) Curing a recession with the hair of the dog - not a good way to build confidence

I believe every business cycle is unique. Some people try to explain business cycles on monetary policy (austrians), others on animal spirits and lack of demand (keynesians), and some believe business cycles are caused by changes in the fundamentals of the economy (the real business cycle theorists). I'm personally convinced that the search for the "one and only" cause of business cycles is naive. Every recession has its own causes. That, however, is not the point I'm trying to make here.
I believe that the current downturn was mainly caused by bad monetary policy in the early 2000's, which led to an irresponsible increase in the money supply and in lending, which fuelled the property bubble. Sure the banks were irresponsible and the regulation should have been stricter, but without the cheap credit provided by the Federal Reserve, this would never have happened.
When the recession hit, the first response from the Federal Reserve was to do everything they had done in the 2001 recession all over again: They lowered interest rates, eventually they became even lower than they ever were during the last recession.

It didn't work very well this time.

I'm not surprised. What the Federal Reserve was trying to do was to cure the recession with the hair of the dog. Even though on a theoretical level this makes some sense, it is understandable that it is met with scepticism both from consumers and investors. What if the current low interest rates cause another recession in 8-10 years time? It's actually not unthinkable and you can understand why investors (including employers) may be reluctant to make long-term investments without being certain that the structural issues the economy has have been adressed.
I believe monetary policy works much better when the cause of the recession isn't monetary policy. It's just more credible that way, when a central bank has screwed up and been a part of causing a recession, that you don't rely on them too much to solve the problem. It may make theoretical sense in some macroeconomic model; but that's not what businessmen and consumers see. What they see is that the government (OK, so technically the Federal Reserve isn't part of the government, but you get my point) is trying to fix things the very same way they broke them the last time.

The same of course goes with deficit spending. The US was already running a deficit during the boom, and so when the government told consumers that everything would be alright if only the US would run an even bigger deficit, naturally they didn't buy it. Expectations didn't change. If you could avoid a recession simply by deficit spending and low interest rates, then the US would have never entered into a recession in the first place after all.

Getting out of a recession is very much about changing expectations. If you can't make employers believe that there is a light at the end of the tunnel that we're getting closer and closer to, then they're not going to hire. The same of course goes with consumers and all the other investors. You do not change expectations when you try to cure by the hair of the dog, and that is why investor and consumer confidence still hasn't rebounded. There has been no adressing the structural issues behind the crisis. And as long as Obama is in office, there won't be.

One word of caution: I would support monetary policy intervention in Europe right now, as the reason for the Eurozone crisis wasn't simply lower interest rates but rather it was caused by countries with very different economies naively believing that they could have the same currency and the same central bank. While monetary policy is far from a long-term solution (I've said it before and I'll say it again: The only solution that will work in the long term is the dissolution of the Eurozone), it is definitely worth a try if it can help countries like Ireland and Spain (Greece is a lost cause I'm afraid) avoid state bankruptcy.


This post can be seen a follow-up post to the post I wrote about whether behavioral economics threatens limited government. In this post, I went a step further and explained four ways in which behavioral economics can be used to make a strong case against keynesianism, and, in the end, against Obama.
While in order to get the full picture of Keynesianism (or any other economic idea), you need to analyze it from more than just the behavioral perspective, this is none the less an important perspective that I believe has been missed out on in the debate. The conservative movement lately has had an unfortunate tendency to reject academia and scientific research, instead of embracing the discoveries and looking at them through conservative glasses - which is what I as an intellectual conservative is trying to do.

I apologize for the length of this post, I hope you all learned something. Thank you for reading.

/ John Gustavsson

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