Killing Keynes & Krugman Pt 6: The Clinton Economy & Keynes on Booms By Rick Kelo

Killing Keynes & Krugman Pt 6: The Clinton Economy & Keynes on Booms
By Rick Kelo

This article is the last article in a six part series.  I am writing these articles in layman's terms so any non-economist can easily follow along. They will break out as follows: 

1. Examples of Keynesian failures
2. Keynes' Flaws of Government Action in a Recession
3. Flaws of Stimulus
4. Government vs. Unemployment
5. Keynesian Bubble Creation
6. Keynes' Flaws of Government Action in an Expanding Economy (AKA Clintonomics)

In this article we will look at the flaws of Keynesian economics in an expanding economy.  This side of the coin is rarely examined because Keynesian economics usually only comes up during bad times.  Very simply the Keynesian theory during good times is to do the opposite from what the theory calls for during bad times.  

I am going to use Bill Clinton's presidency as an example of the results of Keynes' theories.  This is not because Clinton was a Keynesian necessarily, but two simple reasons:

1. Clinton's presidency took place during an economic expansion.  
2. Early in his presidency Clinton's policies mirrored many of the Keynesian suggestions.  During his later presidency he did the opposite.  

THE CLINTON ERA BACKDROP
Even in a continuously expanding economy the differences of Clinton's 2 different approaches during his presidency become easily apparent with a little examination.

Clinton came into office at the best possible time: America was riding the waves of not only the Reagan expansion; we had huge upcoming savings from the end of the Cold War; the Soviet collapse allowed America to export much of our inflation to newly developing Eastern European nations during this time period; the economy was in the 8th quarter of expansion recovering from the 1991 recession; the most recent several quarters prior to Clinton's swearing in had greater than 4% growth.

We are going to do something rarely done and look within that overall backdrop.

THE KEYNESIAN GOALS IN A BOOM PERIODKeynes' goal was to smooth out the boom/bust cycle, and Keynesian economics is part of a group of what are broadly called counter-cyclical policies.  

During a bust cycle the theory calls for reducing taxes and increasing government spending (even if it is totally wasteful spending) in order to put dollars in circulation and fill in the gap caused by lower private spending.  It also calls for increasing the money supply & lowering the interest rates during a recession to encourage investment.  However, there aren't any actual remarks about doing the reverse of the latter 2 items in a boom.  

So, we will only look at the directly prescribed Keynesian measures: during a boom Keynesian economics calls for reducing aggregate demand by raising taxes and cutting government spending.  Let's examine how well that works.

KEYNESIAN ECONOMICS ON TAX CHANGESKeynes was an advocate of spending by any means necessary, including debt spending.  He differed from his disciples who came later, though, in that Keynes himself wasn't as big an advocate of deficit spending.  In fact, if you read closely Keynes made numerous remarks that a nation should pay for things in a bust cycle out of savings.  In order to do that it's implied that a nation must save money during the good times.   The first method toward that goal is raising taxes.  

CLINTON TAX CHANGES
Clinton both raised taxes (8/1993) & lowered them (8/1997), which is what makes him a good example.  Once Clinton came into office he immediately raised taxes, (the Keynesian recommendation for an expanding economy), the result was a reduction in growth.  When Clinton later cut taxes, the non-Keynesian approach, the result was greater growth (graph below).

GDP YoY Change After 1993 Tax Increase (blue) & 1997 Tax Decrease (red) (Source)

KEYNESIAN ECONOMICS: TAX REVENUEAs we saw above raising taxes in 1993 harmed economic growth and sent us trending in the direction of contraction.  This was the result, but it also leads us to one flaw in Keynes' theories.  Keynes actually wanted the government to collect more tax revenue, so Keynesian economics calls for higher tax rates in a boom cycle.  Keynesian economics is flawed because higher tax rates do not necessarily produce higher revenue and they certainly don't maximize possible tax revenues.  The Laffer Curve, created much later, is in part based on some of Keynes' random comments.  It finally produced a model for predicting these effects.  Keynes made a few passing comments that this effect might exist, but then ignored it in the formulation of his ideas.  His disciples, as well, completely ignored this notion in its entirety.

CLINTON TAX REVENUE CHANGES
During the Clinton presidency lowering tax rates produced higher revenue.  (shown below)

Federal Tax Revenue as % of GDP in Response to Tax Changes.  Tax Increase (blue), Tax Decrease (red). (Source)

So here we identify another area where Keynesian methods (raise taxes) fail to maximize the result they intend (raise tax revenues).  The graph reveals that after the Clinton tax increase revenues averaged 10.89% of GDP.  After the Clinton tax decrease they averaged 12.35% of GDP.  This is a difference of 13% higher tax revenue as a percent of GDP in the period after a tax decrease than after the tax increase.

Tax revenues as a percent of the economy shows that government got a relatively larger piece of the pie from the tax cut.  Absolute tax revenue growth from the two tax changes was the same.  Tax revenue grew by 2.1% in both the 10 quarters following the 1993 tax increase and the 1997 tax decrease. 

KEYNESIAN THEORY OF CUTTING GOVERNMENT PROGRAMSKeynesian economics calls for eliminating government programs (specifically social programs) during a boom period.  The purpose is so the savings from those cuts can be stored away until a bust cycle.  This is another of the great flaws of Keynesian boom cycle policy.  Government deficit spending is very easy to turn on and very hard to turn off.  Once a spending program is put in place it is rarely abolished and the dependent constituency that grows attached to it will lobby to keep it alive even once the initial crisis that made it necessary is long since over.

The contradiction in Keynesian theory is that federal expenditures made up a smaller portion of GDP after the tax cut Keynesian theory does not recommend in a boom.  After the tax increase that Keynesian theory recommends federal expenditures make up a greater portion of GDP.  The method prescribed does not produce the result it is seeking.

Federal Spending as % of GDP After Tax Changes (Source)

CLINTON SPECIFIC CUTS
Government spending still grew each year under Clinton, however he did reduce the growth of government spending in some areas during his presidency.  From an economic standpoint this was Clinton's major accomplishment.  From a political standpoint it is very rare that this element of Keynesian economics passes into existence.  With Clinton being the only exception, government spending grows during bust cycles, then maintains those levels with modest increases during boom cycles.  For this reason the Keynesian approach of cutting government spending during a boom cycle is a good policy economically, but politics makes it so that it doesn't actually happen in the real world.  

Even Clinton never achieved a budget surplus.  The myth of the Clinton surplus was actually a large loan from the Social Security Trust Fund.  The proceeds of the loan were recorded as income, but debt from inter-governmental loans does not apply to the deficit/surplus equation.  So the money from the loan pushed America into "surplus" land, but if the debt of the loan was considered it was really still deficit land.

KEYNESIAN THEORY OF CONSUMPTION & WAGESWe covered the impact on GDP above, but let's look briefly at wages.  This is another area where Keynes' actual remarks in his theory are correct, but the resulting application of Keynesian economics in a boom period is not.  Let's examine it starting first with what Keynes actually said.  His remarks on wages are pretty limited to a basic observation about the supply/demand curve.  His precise statement is that lowering wages will lower unemployment.  Said in reverse, as is more often the case, raising wages can increase unemployment (think about the minimum wage debate for an example).  Unemployment was Keynes real focus so the time he spent on wages is pretty brief save to note he believed people resisted working for lower wages due to various reasons.

To Keynes the real issue of wages is an issue of unemployment and of consumption.  Those two things were his main focus.  Keynes felt that unemployment and inflation were opposites.  This is possibly the largest error in his theory, and the sole reason that the stagflation of the 1970s caused Keynesian economics to completely die off.  However, humans are destined to forget what we once knew, and several decades after being thoroughly discredited Keynesian methods began receiving attention again.

Now, the real central thrust of this for Keynes would have been that higher taxes discourages spending, thus lowering aggregate demand and lessening the boom cycle.  That is the theory, but in the real world what effect do higher taxes actually have on wages?  As you will see one unintended effect is that real wages are harmed.

CLINTON SPECIFIC WAGE CHANGESHere are the short results.  In the 10 quarters following the tax changes, wages of production level, non-supervisory employees grew as follows:

• 2.89% nominal wage growth after the 1993 tax increase
• 3.89% nominal wage growth after the 1997 tax cut
• That is 34% higher nominal wage growth following the tax cut vs. the increase

Now let's look at real wages and factor inflation in as well.  In the 10 quarters following the tax changes, wages for production level, non-supervisory employees compared to the Consumer Price Index grew as follows:

• 0.99% real wage growth after the 1993 tax increase
• 2.06% real wage growth after the 1997 tax cut
• That is 107% higher real wage growth following the tax cut vs. the increase 

So those are wages, but Keynes actual purpose in tax increases was to decrease consumption.  Wage growth is just an innocent bystander caught in the cross-fire.  In the 10 quarters following the tax changes consumption changed as follows:

• 5.6% consumption growth after then 1993 tax increase
• 6.5% consumption growth after the 1997 tax cut
• That is 16% higher consumption following the tax cut vs. the increase

So on this topic we find Keynesian theory correct: raising taxes slows consumption, but it does so by slowing wage growth.  It is not correct for the reasons Keynesian economics anticipates.  The morality of robbing people of their wage growth during a boom period (where most wage growth takes place) makes this an entirely different discussion.  When we consider the stagnation of non-supervisory, production level wages in America over the last 40 years, then we must seriously consider whether it is moral for government to ever artificially slow the growth of wages.