There is plenty of room for empirical debate with respect to the efficacy of fiscal policy in general, whether monetary policy is a better tool, or what constitutes spending that will make us more productive in the future.Martin Kennedy, Keynes, Keynesianism, ARRA, stimulus, fiscal policy, Tennessee

Martin Kennedy

English

Research Papers in Economics

t is unclear whether we are all Keynesians,
or even mostly Keynesians, now as some
have suggested. Keynesianism is a some-
what elastic concept. It is safe to say that
most economists believe the economy can be
stimulated in the short run via deficit spending.
It is also safe to say that the recently passed fed-
eral stimulus, the American Recovery and Rein-
vestment Act (ARRA), has enabled states,
otherwise constrained, to engage in Keynes-
inspired fiscal stimulus. States, unlike the fed-
eral government, must balance their budgets
annually and so don't have as powerful a fiscal
policy lever to pull in an attempt to counter a
downturn. The recently passed federal stimulus,
$787 billion in spending, includes $144 billion
that has gone directly to state and local govern-
ments for "fiscal relief." This relief means that
states will be able to engage in a sort of deficit
spending, using expansionary fiscal policy, via
the federal government.  
In Tennessee, for example, the budget deficit in
the current fiscal year that runs through June
2009, before the ARRA money, is projected to
be just north of $1 billion out of a budget that is
just over $29 billion. The roughly $4.5 billion in
relief coming to Tennessee from Washington
will enable the state to balance the budget with-
out dramatic cuts in spending this year and for
the next two fiscal years. So for the next 30
months, the state should be able to maintain
spending levels and thereby help stabilize aggre-
gate demand and mitigate the rising rate of
unemployment. In short, the federal government
is borrowing on behalf of state governments.
Theoretically, at least according to classical the-
ory, the economy is self-correcting: markets are
efficient; prices, wages, and interest rates adjust
downward in response to a demand shock, and
full employment returns.  
Markets adjust sluggishly, countered Keynes. 
The long run is a misleading guide to cur-
rent affairs. In the long run we are all dead.
Economists set themselves too easy, too
useless a task if in tempestuous seasons
they can only tell us that when the storm is
past the ocean is flat again.
So wrote John Maynard Keynes in 1923. His
influence has been dramatic—for the five
decades following that statement and again
today. Beyond asserting that markets don't
by Martin Kennedy
ARE WE KEYNESIANS?
There is plenty of room for
empirical debate with
respect to the efficacy of
fiscal policy in general,
whether monetary policy is
a better tool, or what
constitutes spending that
will make us more
productive in the future. 
Tennessee’s Business  Vol. 18, No. 3 May 2009
continued on page 12
I
11adjust in the real world quite as quickly as they
do on a classroom chalkboard, Keynes thought
that below full-employment equilibrium was
possible.  Firms might not engage in investment
projects or begin hiring even as interest rates
and wage rates drop if aggregate demand is
weak. Unwilling lenders could "trap liquidity"
in a time of low interest rates and great uncer-
tainty. Falling prices lead people to hoard
money and reduce consumption. Reducing con-
sumption is rational in a period of deflation, but
ultimately, and paradoxically, savings could
actually begin to fall as an economy deteriorates
and incomes fall: the so-called paradox of
thrift.      
Active fiscal policy, engaging in deficit spend-
ing, could insure sufficient aggregate demand
and serve to counter a downturn, according to
Keynes. Government spending would compen-
sate for reduced consumption and investment
spending. Such action would "prime the pump"
of economic activity. Fiscal policy, according to
Keynes, should be countercyclical in nature,
running deficits to counter a downturn but pay-
ing down the debt when growth resumed. Key-
nesian fiscal policy, properly understood, is
focused on the short run. It should be viewed as
a mechanism to smooth the business cycle
rather than a long-run strategy to enhance
growth. A recent survey of Ph.D. economists
found that 85% agreed that the federal budget
should be balanced over the course of the busi-
ness cycle.
The recently proposed Tennessee budget, actu-
ally a plan for the next several annual budgets,
seems to have embraced the smoothing con-
cept. The Bredesen administration is using the
federal money as a means to mitigate, not elim-
inate, spending cuts. There would be nothing
smooth about having to cut $1.1 billion this
year, and there would be nothing countercycli-
cal if projected spending were not adjusted. In
short, the governor's multiyear plan recognizes
that the stimulus, as the concept should imply, is
temporary. The proposed budget for the 2009-
2010 fiscal year is about 1.5% lower than last
year's budget. Without the ARRA funds, it
would have been about 8.5% lower, reflecting
the reality that state tax revenue is down by
roughly that amount. Another way of looking at
it is that state agencies planned for cuts of about
15% before the ARRA funds and now will cut
by just 3.5%.    
State spending in Tennessee grew faster than
personal income between 2003 and 2007, but it
would be hard to suggest that the current budget
proposal is imprudent or that it relies on unreal-
istic expectations of revenue growth. Wiscon-
sin, which has a slightly lower population than
Tennessee, is looking at a $5 billion deficit this
year and higher taxes in the near future as are
residents in California, Illinois, New Jersey, and
New York. Tax hikes are contractionary and
would mitigate the stimulatory impact of the
ARRA funds. The administration in Nashville is
anxious to close what it sees as tax loopholes
and might tinker around the edges with fees in
the next couple of years, but we shouldn't
expect any tax increases.  
There is plenty of room for empirical debate with
respect to the efficacy of fiscal policy in general,
whether monetary policy is a better tool, or what
constitutes spending that will make us more pro-
ductive in the future. There is ample room for
ideological differences with respect to the role
and size of government at the federal level. Most
of the ARRA money is not going to the states. At
the federal level, the deficit is projected to be a
whopping 12% of GDP this year. The Obama
administration's projections show a deficit of 5%
of GDP and falling five years out, when growth
will be robust and unemployment low. The Con-
gressional Budget Office projections show a
growing deficit five years out. Their GDP growth
estimates are not as optimistic as the administra-
tion's. One wonders what Keynes would have
thought about running deficits, in good times and
in bad, in peace and in war, which we began
practicing in the early '80s.  
As for Tennessee, the budget response is a prob-
lem of constrained optimization. It is not a
question of what Tennessee should do in some
theoretical sense but rather what the budget
should look like given the sharp and now
extended recession as well as how the state
should respond to the ARRA funding out of
Washington. There seems to be bipartisan sup-
port for the Bredesen administration plan to use
the money to mitigate the impact of the reces-
sion, to prevent drastic cuts at the state level,
and to adjust spending over the next two fiscal
years. There will be no initiatives, like universal
pre-K education, that require a substantial and
permanent commitment of funds. Neither will
there be any tax increase. 
Martin Kennedy is an assistant professor of
economics at MTSU.
One wonders what
Keynes would have
thought about
running deficits, in
good times and in
bad, in peace and
in war, which we
began practicing in
the early '80s.
Tennessee’s Business  Vol. 18, No. 3 May 2009
continued from page 11
12

So Are We Keynesians or Not?

http://frank.mtsu.edu/~berc/tnbiz/stimulus/kennedy.pdf

So Are We Keynesians or Not?

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