Big Distinction Between Keynesians and Classical Economists


This morning I was on Fox Business with Stuart Varney.  Alan Colmes was on pontificating on how we need a second stimulus to spur economic growth.  Of course, the first stimulus has been an abject failure, but why?  Economists such as Paul Krugman initially wrote that it wasn’t big enough.  On the other hand, economists like Greg Mankiw, Kevin Murphy, Gary Becker, John Cochrane, Luis Zingales, and Rahgu Rajan wrote that it would not work.

In all the arguing that is going on between Republicans and Democrats, Keynesians and Classical economists, it is important to understand where their views are grounded. Sometimes when each side talks, it sounds the same. Of course, always with economists they answer with a statement, “It depends”, and then go on to answer the question. Unfortunately, rigorous economic analysis cannot be distilled into a 30 second soundbite.

What does all this “it” depend on? It depends on the assumptions of the model. Hopefully, when publishing analysis, the economist publishes all the assumptions of the model, and the theory or reasoning about how they got there.

But if you know the philosophical make up of the speaker, you can make some assumptions about how they framed the problem in the first place. On the Keynesian side, they focus on the demand curve. They see economic stagnation as a function of slack demand. Pump up demand, pump up the economy. Hence their intense focus on government spending and government solutions to problems. They view the economy as a puppet that can be controlled. Pull a string, move a body part. Simple.

Classical economists focus on the supply curve. They see the marketplace far differently. There is no central control module, but instead the interactions of millions of individuals acting out of their own self interest controls the market. Each single transaction aggregates to form the supply and demand curves- and price transparency is the greatest single element of the equation. Free markets for free men.

Let’s look at this logically. What is easier to control, demand or supply? How can you control them?

With demand, there are only three things that can influence it. Taxes, subsidies, and price. If you tax demand, you will get less of it. If you subsidize demand, you will get more of it. Price moves up and down. If prices are higher, you get less demand, lower more. Of course, it’s tougher than that-there are other things like elasticity of demand that influence. For example, the demand curve for energy is a lot steeper than the demand curve for Hermes handbags. There is also a lot of randomness in demand curves.

Demand siders also believe central planning can do more for the market than decentralized markets. Hence, their religious belief in government spending to cure all that ails. Just put together a government program, spend the money and demand will spike. This spike in demand will cause supply to kick in, and the economy gets jump started. Keynes called it ‘priming the pump”.

Demand siders will talk about “targeted” tax cuts, special cut outs, and other segmentation ideas to spur economic growth. Generally, they don’t put a lot of pop into the economy.

On the supply side, it’s much different. Price is the biggest communicator. Once you know the price, you tailor the supply chain to meet it. Producers can control much of the randomness in their supply chains. This is why there is so much focus on supply chain management. Controlling what is called “bullwhip” in the supply chain saves producers big bucks in production. Taxes and subsidies influence the price, and influence the way the individual tailors their operations to meet the market. Supply can be random-but generally everyone can take out randomness (risk) out of the supply curve.

Supply siders don’t believe in central planning. They believe that decentralized solutions make for a more efficient marketplace. Every person in the world tries to maximize their gain. As they go through life, interacting with other people trying to maximize their gain, they bargains they derive are best for the entire macroeconomy.

Supply siders believe in blanket tax cuts, and less government spending. They believe government is inefficient, and the free unregulated marketplace can accomplish things quicker and cheaper. In accomplishing this task, the entities will make a profit. Profits are what drive them to act.

So far in the 20th and 21st Centuries, supply siders have been correct. Keynesism prolonged the Great Depression. Anytime we have had tax cuts, an economic boom has followed. Keynesians will argue that Clinton raised taxes and we had a boom. However, the macro effect of the internet making the economy more efficient had a greater effect. Recall, in 1994 we began to aggressively cut government spending, and government influence into the market place as well.

This brings us to today. What should we do? First, cut spending. It’s no secret that there is a lot of fat and graft in all government budgets, national, state and local. Second, privatize as much as we can. The Post Office would be a prime example of a government service that could be privatized. Third, cut taxes-especially taxes on productive capital. This will create incentives to earn a profit, and companies will hire and produce.

Keynesian stimulus is like drinking a shot of Red Bull to stay awake at 1am.  Works for a while but the effect peters out.  To have sustained economic growth, the only way is to decrease spending, privatize, and cut taxes.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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