Alan Blinder and Mark Zandi’s Keynesian black box

As that OECD study suggested, failure of Keynesian models to account for expectations is a serious flaw.  The so-called stimulus spending was financed with borrowed money, so the government will eventually have pay it back or let taxpayers face higher interest expenses forever.  As the neo-Keynesian Harvard economist Greg Mankiw notes:

“That means higher future taxes, on top of the future tax increases that President Obama already will need to impose to finance his spending plans. . . . It is plausible that . . . businesses may be reluctant to invest in an economy that they expect to be distorted by historically unprecedented levels of taxation in the future.  The more the government borrows, the higher taxes will need to go, the more distorted the future economy will be, and the less attractive is investment today.”

To turn Mankiw’s point about around, spending cuts reduce fears of future tax hikes and thus stimulate the economy today.  The IMF Research Bulletin in March 2006 cited several studies that found reductions in government spending “can have expansionary effects, since they can contribute to a consumption and investment boom owing to altered expectations regarding future taxation.”

As the 1984 OECD report noted, the failure of Keynesian models to account for supply-side incentive effects is another fatal flaw. CEA Chairman Christina Romer, in a 2007 study with her husband David, found “that a tax increase of one percent of GDP lowers GDP by about 3 percent.”  They investigated whether the effect was mainly due to demand (spending) or whether “tax changes could have large supply-side effects.” The evidence suggested that “the important effects of tax changes . . . are on incentives and productivity rather than on disposable income.”

In January 2009, the Obama administration embarked on a nearly random $849 billion spending spree on the basis of a flakey forecast from a for-profit forecasting group.   Alan Blinder now abuses the same source to support his own Robin Hood policy preferences.   Fool me once shame on you.  Fool me twice…

Alan Reynolds is a senior fellow with the Cato Institute and the author of Income and Wealth.