In a previous article, I wrote about the root cause of the global economic crisis, which is the imbalance between National Income and Output resulting from outsourcing of jobs overseas. Foreign workers are willing to supply labor, but they aren’t willing or able to buy products.
In that article, I introduced the chart called Circular Flow of National Input and Output. That chart described a pure free-market economy. I am reproducing the chart here but adding a box for Government. This new chart describes a mixed economy. (For a pure command economy, the product and factor markets would disappear and everything would flow through government.)
The Role of Government
The government is neither a household or a firm. Remember, firms use input factors to produce goods and services. Households consume goods and services and furnish the input factors the firms. The allocation of goods and services and factors happens in the markets. Money is used in the market to allocate goods according to supply and demand.
The role of government is to function in place of the markets. Factors are diverted by government, bypassing the markets, into production determined by a government planner. For example, the government diverts labor and materials to a construction company to build a bridge. The government operates the bridge which is a service provided to households.
People normally think in terms of the government collecting money through taxes and buying G.I. goods. What is really happening is the government is diverting land, labor and capital to produce whatever some central planner thinks is needed.
The Great Recession
As stated above, the root problem was the imbalance resulting from foreign workers from countries like China providing labor to the factor market, but not consuming in the product market. Another way to say this is that there has been an increase in supply in the factor market for labor without a corresponding increase in demand for goods in the product market. For several years, the U.S. consumer picked up the slack with increased demand for products. The U.S. consumers purchased goods using money borrowed from foreign workers who would not spend it themselves. But the bursting of the housing bubble and subsequent credit crisis put an end to that. Banks are no longer willing to lend as freely and consumers themselves are showing an unwillingness to overextend themselves. Once bitten, twice shy.
Because of the withdrawal of credit, the demand for goods and services plummeted which is what marked the Great Recession of 2007-2009. Firms, in turn, lowered the demand in the factor market meaning many U.S. workers were laid off and the unemployment rate soared to over 10% in the U.S. The irony is that the layoffs were worse in China where factories were closed and millions of Chinese workers left the cities to go back home to subsistence farming in the countryside. Commodity prices also collapsed because there was less demand for raw materials, another input to production.
The Keynesian Solution
The government response to the fall off in demand for goods and services was stimulus spending. This is the Keynesian solution. The logic is that if consumers won’t spend money, the government will spend it for them on their behalf. Of course, one of the problems with this is consumers won’t get their preference. They get what the government thinks they need. But that aside, the is another problem with trying to fix the problem with stimulus spending this time.
This chart shows stimulus spending from the government entering the product market which increases the demand for output. Responding to the demand, firms ramp up their production which causes an increase in demand in the factor market, meaning an increase in demand for labor and raw materials. Jobs are created. Households now have more income and can increase spending on goods and services. Eventually the government can withdraw the stimulus spending. Sounds like a good plan.
The Flaw in the Keynesian Solution
Infortunately the Keynesian solution to increase demand for output through temporary stimulus spending won’t work. The reason is because of the original problem that got us into this mess. Increased demand for labor means new jobs, but not new jobs for U.S. households. The new jobs will be in China and other cheap labor markets. U.S. firms will just re-hire all the Chinese workers that got laid off during the recession. The foreign workers and governments will continue to hoard dollars, which they lend to the U.S. by buying U.S. Treasuries. The borrowed money keeps the stimulus spending going, but the U.S. debt keeps piling up.
How long can this go on? Eventually the U.S. will owe their entire net worth. But long before then, interest payments on the debt will become too burdensome for the country to function. Imagine if 3/4 of your paycheck went to servicing debt. You wouldn’t have enough left to buy anything. You would probably declare bankruptcy long before then.
So what will happen? Will the U.S. government default on its debt like U.S. consumers did? But the government doesn’t really need to default. They can raise taxes to make interest payments and can even create money out of thin air. They own the national mint. However, the effect this would have on prices can not be good.
Conclusion
We learned the flaw with the Keynesian solution is that it does not address the root cause of the problem which is the imbalance between input and output. This solution is exactly like the original problem, except instead of consumers borrowing and spending, the government is doing the borrowing and spending. The debt still piles up. When you find yourself in a hole, the first thing to do is stop digging. Unfortunately, the people in charge are just digging the hole deeper because they don’t know what else to do.
The views expressed are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors or any organization.
