Keynesian Theory: Fighting a Splash with Water

I’m not a big fan of assigning hard to pronounce proper names to basic concepts. I can only pronounce or even begin to understand either Boson Particles or Schrodinger’s cat thanks to the Big Bang Theory. Theories such as Ekpyrotic Universe, I would be better off trying to properly pronounce after a heavy night of drinking and getting slugged in the jaw a few times. However, as I watch the debate about the role of government in dealing with the countries current economic hardships, I think having a decent understanding of Keynesian theory helps to understand the good intentions of this theories proponents. That way, we can better mock and ridicule them.

Image a pool of water, it could be a swimming pool, perhaps a small fishing pond, it could even be the Pacific Ocean as long as you scale up the other aspects of this analogy accordingly, it doesn't really matter, it just has to be relatively placid. The water represents all the factors of the economy, from jobs, to retail exchange, to investment. When the water is calm, everything is fine, moving along with subtleties and undercurrents. The occasional ripple in the water represents a small adjustment in the markets. Perhaps “Jim’s Liquor, Guns, and Ammo” went out of business when their core demographic met with a sudden spike in suicides. Overall, everything is calm.

Now picture a major disruption to the market. Take the 2007 recession for instance. Too much money getting dumped into retail investments created a huge bubble that finally popped, causing a huge loss of wealth. In our pool of water example, it would be the equivalent of taking a huge stone and tossing it in the middle of our pool. The more money and other factors involved in the disruption, the bigger the stone that is breaking the crest of the water. This water directly underneath the stone is displaced causing strong transfers of water around the stone and throughout the pool, just as the collapse of the retail market disrupted fortunes of people who had money directly tied in with property, then rippled through the rest of the economy.

Some ardent supporters may take offense and argue that true Keynesian would prevent the stone from being dropped in the first place, by establishing government organizations that oversees and regulates the mortgage industry and promotes proper housing development. To which I say, HUD already exists, it spends billions manipulating the market, and it arguably made my proverbial stone much bigger by artificially inflating the housing market with subsidies and tax incentives.

When the Housing market crashed, lots of people with money tied up in real estate, mortgage lenders, and the financial firms that held those mortgages got hit big time. Severe ripples and splashes emanated from the impact spot and hit the construction industry and developers quickly. These ripples continued to spread over the entire pond making the recession hurt with almost no regard to what industry or part of the pool you were in. What the Keynesian theory attempts to do at this point, is to fill the initial hole in such a way that there are no ripples caused by the splash of a stone being dropped in it. A Keynesian would do one of two things to make it better and to fight the splash, supplement the money flow (try to keep the water in our pool flowing the way it did before the rock hit) or refocus demand so that aggregate demand stays the same (pour in water to the pool at the same time it’s splashing out).

The problem with the former idea is that it would require so much interference to so many parts of the pool well before stone hit that the pool would no longer be recognized as a pool. The inherent freedom of the water would instead become a bed of metal pipes with hardly any water actually running through it. This is the communist economic system that if everything is planned and structured then it is impossible for the stone to disrupt anything.

The issue with the latter idea is that even if you replace the water in the hole created by the stones impact, the disruption to the pool is still going to be violent and affect everything and now you are adding another element that could just as easily prolong the effect of the waves since you have to pour the water in, and the water you are pouring in has to come from somewhere, probably scooped up from a quieter part of your pond wasn't being effected by the initial splash as badly to begin with. In short, you are messing up everything else in the pool to make the big splash seem less bad.

This is the approach we took in 2009. Spend a bunch of money that we got from god knows where and start pouring it in the hole that was made by the splash. Financial institutions got hit hard and fast but then were filled up, secondary industries still felt waves and waves of disruption, tons of water splashed out of the pool and will take some time to trickle back in and return things to normal. And the proponents of this approach, when asked why there is still such a mess and turbulence in our pool simply say, “We didn't use enough water.”

What is the alternative? The prominent counter is the Austrian Economic theory. This theory takes a “S#*% happens” approach. Stones will come and go, waves and ripples will be felt, as long as your water is well educated and free to pursue a new current you will have less of a manufactured swimming pool regulated by a bunch of idiots running around with buckets trying to change the tide as they lose track of splashes caused by a stone dropping by accident and when a bucket is dipped in on purpose. Rather, you would have a beautiful lake were a splash may instead be caused by a fish, revealing that over time our pool of water may bring more to offer then just a drink.