The Federal Debt

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Equally important, Keynes stood Adam Smith on his head with regard to debt. He argued that families and nations are different economic beasts altogether and that prudence for one could indeed be folly for the other. A family, Keynes said, must necessarily borrow from someone else, but a nation can borrow from itself, the debits and credits canceling each other out, at least macroeconomically. The national debt—that often necessary but always undesired evil of classical economics—therefore didn’t really matter.

There is no doubt that Keynes’s theory is a mighty work of a mighty intellect. Keynes published his seminal book, The General Theory of Employment, Interest, and Money , in late 1935, and it had an immense impact throughout the intellectual world. It is not hard to see why. Like Adam Smith and unlike all too many other economists, Keynes commanded the English language. Moreover, his theory appeared to solve many puzzles regarding how the Great Depression had come about and why it lingered so long. But as a prescription for handling the economy in the future, it has proved to have at least three fatal flaws.

The first is that Keynes still viewed the economic universe as economists had always viewed it, as a machine. Economics became a discipline in the eighteenth century, when Sir Isaac Newton’s intellectual influence was overwhelming. As a result, economists from Adam Smith on have looked to the Newtonian clockwork universe, humming along in response to immutable laws, as their model for the economic universe.

At the end of the nineteenth century, an Englishman named Alfred Marshall, trained as a mathematician and physicist, created what Keynes—Marshall’s pupil at Cambridge—approvingly called “a whole Copernican system, by which all the elements of the economic universe are kept in their places by mutual counterpoise and interaction.” Marshall’s conception was self-regulating and inherently stable. Keynes substituted one that required an engineer—government—for maximum efficiency. Keynes’s model has dominated economic thinking ever since, despite the fact that even enormously expanded and refined, it has proved inadequate at best and often quite useless in predicting events in the real world.

The reason is simple enough. The unspoken assumption of the economy-as-machine paradigm is that a given action with regard to taxes, spending, or monetary policy will have a given result, just as putting more pressure on the gas pedal always makes a car move faster. Unfortunately the basic parts of an economy are not bits of metal obeying the laws of physics but human beings, often unpredictable and always self-interested.

So the cogs in the American economy—you, me, and 250 million other human beings—are capable of interacting in ways unexpected by economists using mechanical models. That’s why a 1990 tax on luxury boats and airplanes, which was supposed to raise $16 million, raised $58,000 instead. People simply stopped buying boats and airplanes. Rather than raise revenue, the new tax caused ten thousand layoffs. To use the car analogy again, this time stepping on the gas pedal didn’t make the car speed up; it made the oil pressure drop.

The second flaw in the Keynesian system is that timely and reliable information on the state of the economy is essential if politicians are to make correct policy decisions. But even in a world filled with number-crunching computers this is not to be had. Final figures of even so basic a statistic as GNP come out three years after the period they measure. Preliminary figures, to be sure, are available in a few weeks, but they are highly unreliable and subject to gross revision. It’s a bit like driving a car whose dashboard instruments tell you only what the situation was an hour earlier.

The third flaw in Keynes’s theory lies in human nature itself, a powerful force in the real world that Keynes totally ignored. For the Keynesian system to function, it must be applied dispassionately. Taxes must be cut and spending increased in bad times. In good times, however, taxes must be increased and spending cut. That, in a democracy, has proved to be politically impossible.

One problem, of course, is that depression is always recognized in real time, but prosperity, like happiness, is most easily seen in retrospect. The 1980s, for instance, are increasingly becoming remembered as a time of plenty in this country, a decade when the GNP rose by 35 percent in real terms. But the newspapers of the day were filled with stories about farmers losing their land, the big three auto companies being taken to the cleaners by the Japanese, and the first stock market crash in nearly sixty years.

In an economy as vast as that of the United States, recession is always going to be stalking one region of the country or one sector of the economy, even while the overall trend is upward. Living day to day, ordinary citizens, politicians, and economic reporters alike have a natural tendency to concentrate on the trees that have problems, not the forest that is thriving.

The flaws, of course, were not apparent in the beginning, only the theory’s promise of making a world without depression possible. Economists took to it immediately. Within a decade it was the overwhelmingly dominant school of economic thought.