There are two things to remember about Keynes’s fiscal policy proposals: 1) government spending was always linked to the goal of full employment (the absence of both cyclical and structural unemployment) and 2) to achieve macro-stability and full employment, the government had to employ the unemployed directly into public works.
By contrast, most modern economists believe that 1) there is some natural level of unemployment that includes the structurally unemployed, which governments cannot generally tackle, and that 2) public employment is an inefficient use of public resources.
So, when the government is called to action, the economic profession has replaced Keynes’s “fiscal policy via public works” with a “leaky bucket pump-priming mechanism.”
How is the latter policy supposed to work? Instead of employing the unemployed directly, the idea is to generate large enough government expenditures to produce a level of economic growth that would, in turn, gradually reduce unemployment. For example, the government could spend money on various private sector contracts, stimulate different private industries, offer investment subsidies and tax cuts, and increase unemployment insurance payments, in hope that it will boost GDP sufficiently to reduce unemployment to desired levels. This is essentially the underlying logic behind President Obama’s stimulus package. But it is also a bit of a gamble.
Not all of these injections will be effective because the fiscal stimulus enters the economy through “a leaky bucket”. Some of the money will be lost in transit (because of administrative costs, for example) and much of it will have no direct job creation effects (e.g. the tax cut component of the recovery act). Nevertheless, despite this leaky bucket, the theory goes, sooner or later, large enough government expenditures will produce the kind of growth that would reduce unemployment.
What is the appropriate rate of growth? Some economists argue that it is 3%. This number comes from the famous Okun’s law (named economist Arthur Okun), which states that a 1% increase in unemployment would reduce GDP growth by approximately 3%. Okun cautioned that the GDP-unemployment link is very weak, but the relationship has been flipped and used as a policy guide to support various broad-based pro-growth policies. In other words, as long as government spending generates 3% of growth in actual GDP, it would manage to reduce unemployment by 1%. Not only is this a small and unimpressive effect, but it is also empirically dubious.
Academics-turned-policy-makers already see what a gamble it is to rely on a certain rate of growth to reduce unemployment. President Obama’s Chair of the Council of Economic Advisers, Christina Romer, recently reported that we may have to stomach rising unemployment well into next year, even as the economy recovers or until it hits 2.5% growth rate. This is quite a reversal from her original projections that unemployment will start declining after the third quarter of this year. By contrast, former Labor Secretary Robert Reich has argued that more like 4.5% of growth may be necessary to reduce unemployment.
The truth is that no one really knows how fast GDP needs to grow and how large government spending needs to be in order to bring the unemployment rate down. To a large degree, this is because we don’t know how leaky the bucket is. Will indebted households save or spend their tax cuts? Will the unemployed spend much of their unemployment insurance on mortgage payments? How long would layoffs and other cost-cutting measures last before private firms fix their own balance sheets and start hiring? How large a government injection into the private sector is necessary to improve profit expectations and employment conditions?
All of this is rather uncertain, which is why Keynes, never had any “leaky bucket” or “pump priming” idea in mind. For him “the real problem fundamental yet essentially simple…[is] to provide employment for everyone” (Keynes 1980, 267) and the most bang for the buck from fiscal policy would be achieved via direct job creation. This he called “on the spot” employment via public works.
As I have argued elsewhere, it is useful to think of Keynesian fiscal policy, not as aggregate demand management, but as labor demand management. Yes, Keynes believed that priming the pump would prevent severe depressions, but it couldn’t be counted on to bring the economy to full employment. This is in part because it tends to push prices and erode income distribution once the economy begins to recover. To dodge these problems, in all circumstances, government spending had to be targeted to the unemployed themselves. He urged that when the government couldn’t take the worker to the contract, it should bring the contract to the worker.
Commentators often call this a policy of “make work” but Keynes didn’t advocate digging holes, burying jars with money and digging them out, or any other similarly worthless projects. The key was to marry the two goals: to employ the unemployed directly and to make sure that they do useful things. Once they are put to work on a particular project, Keynes argued, “there can be only one object in the economy, namely to substitute some other, better, and wiser piece of expenditure for it” (Keynes 1982, 146). We might as well ask a very basic question: is there really a shortage of useful things to do?
If we insist on calling ourselves Keynesians again, and more importantly, if President Obama’s plan for economic stabilization should generate rapid reduction in unemployment, it would help to set fiscal policy straight. Instead of relying on “leaky fiscal buckets” we could return to “labor demand management” a la Keynes that provides immediate employment opportunities to the unemployed via bold and creative public works projects, which generate useful output and services for all.
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