Keynesian economics vs. Austrian economics
Thank you for challenging me to this debate. I gladly accept.
An important point of Keynesian economics is that it only explains short-run fluctuations in the economy and why some of an economy's resources, it's labor and capital, would go unused. Many critiques of Keynesian economics rest upon a confused notion of what Keynesian economics tries to explain. Keynesian economics does not try to explain most long-term (several years or more) unemployment. Keynesian economics also does not explain economic growth or even wage determination. Keynesian economics explains why, for a short period of time, large amounts of a nation's resources would go unused, despite the productive capacity being almost unaffected.
We will start with a basic proposition of macroeconomics, the quantity theory of money. The quantity theory of money is expressed in the accounting truism MV=PY. "M" is the money supply. "V" is the velocity of money, or the amount of times a dollar changes hands in a given year. "P" is the price level, the average price of any given good sold in the economy. "Y" is the amount of transactions.
Another basic proposition of Keynesian economics is "price stickiness", or the tendency for prices and wages to not adjust to clear markets. Many of the models of Keynesian economics are built upon this assumption and model the behavior of the macroeconomy when prices are unable to adjust to clear the market. The assumption is that, instead of adjusting prices, firms and wage earners will change output instead.
The evidence for this is numerous empirical studies by Alan Blinder and others during the rise of the so-called "New Keynesian" school of economics, which sought to examine the "microfoundations" or the behavior of individual firms, workers, and investors that would explain the behavior in the macroeconomy. In surveying businesses, Blinder found that most businesses adjust their prices as often as twice a year, and many businesses do not adjust their prices even once per year. There are numerous reasons for this, but the basic reason given by business managers is a failure of price coordination. This failure can be illustrated with the following thought experiment.
Imagine an economy with two firms that both charge enough to make a profit 30$. Now imagine that demand for their products falls by one half. Without adjusting nominal prices, they only make a 15$ profit.
Now if both firms reduce their nominal prices, the supply of real money balances (the money supply divided by the price level) will increase and both firms can make a real profit of 30$. However, if only one of them reduces their prices then the supply of real money balances does not increase, and therefore the firm will only make 8$ profit.
This failure of price coordination can cause firms to not adjust their prices. This can also cause unions to not reduce their own wage demands, for they realize that only if other unions reduce their own nominal wage demands can their real wages increase.
Now what happens if aggregate demand falls, given price stickiness? Recall the quantity theory of money, MV=PY. Necessarily, If "P" is fixed, and either M or V are reduced, then "Y" will have to fall as well.
So another obvious question is can aggregate demand fall throughout the economy? It absolutely can.
To see how, consider a rational consumer. Our consumer has a choice of consumption today vs. consumption tomorrow. His choices are constrained by what economists call a "budget constraint", which is determined by factors such as wage income, asset income, and wealth. He also has a choice of what kind of assets to hold, either bonds (which we will define as any non-liquid, interest bearing assets) or liquid money. If his wage income increases today, he will consume more today, but he will not consume everything, he will save some in the form of increased assets. If his asset income increases tomorrow, he will spend some tomorrow but borrow from banks against this expected asset income.
Now what would happen if our consumer's wealth were to suddenly decrease? His debts are denominated in currency, and so if his wealth decreases (like if the value of his home were to suddenly plummet, or the value of his stock portfolio were to decrease), he will still have to pay the same nominal amount of debt but his real income will have suddenly decreased. Therefore, our consumer will either default or will increase his demand for liquid money.
Now this is not a problem at the individual level. However, at any given time the amount of money in the economy is fixed. If suddenly everyone's demand for liquid money were to increase, then necessarily the velocity of money would decrease, and therefore total output would decrease.
There are many government policies that could solve this problem, by increasing aggregate demand. The most common way is for central banks to increase the money supply, thereby reducing interest rates and therefore making businesses more likely to borrow money to purchase capital, hire workers, etc.
There are, however, some exceptions to this rule. When nominal interest rates are near zero, then bonds and cash become perfect substitutes for individuals and banks. They yield the exact same return, namely zero. When this happens, any increase in the money supply will mean that banks will simply hold the cash rather than invest in bonds as they become perfect substitutes.
At this point, the government needs to increase planned expenditures somehow. This will cause the amount of income at any given interest rate and given money supply to increase by increasing the velocity of money.
In conclusion, we have seen that Keynesian economics provides an empirically plausible and theoretically sound explanation of recessions and provides many useful remedies to said recessions.
Thank you for challenging me to this debate. I wish you and all our readers a Happy New Years. I will use this round for opening statements.
Keynesian Economic Theory (KET hereafter or KT) is built on the principle that productive activity is influenced by aggregated demand (total spending in the economy) and that demand does not necessarily equal aggregated supply. Instead, it is influenced by a host of factors sometimes behaving erratically; including, but not limited to, inflation, employment, and productivity.
Advocates of Keynesian Economics favor a mixed economy between the private sector and the public sector and with strong government intervention during a recession. The KET has stood as the policies of FDR and Obama.
Con 1: Economic Stimulus
Keynesian Economists believe that there should be a strong government involvement in offsetting the effects of a depression or a recession by stimulating the economy. We saw examples of government stimulation during the Great Depression and the 2008 Great Recession. However, when government attempts to stimulate the economy, it creates economic uncertainty that paralyzes business decisions. During the Great Depression, John Keynes wrote :
You are engaged on a double task, Recovery and Reform…. Even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old "spoils system" have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.
These failures are easily manifested in simple graphics :
The Keynesian theory that government needs to be involved in stimulating the economy has failed. Throughout the past, we have seen stimulus packages fail and unemployment sky rocket, despite record-setting government spending.
Con 2: Austerity
Austerity measures is defined as a state of reduced spending and increased frugality in the financial sector. These measures refer to the measures taken by government to reduce expenditures in an attempt to shrink their budget deficit. 
These measures apply to solving debt crisis and are characterized by lower spending via reduction in the amount of benefits and public services. Because spending is lower, times of Austerity are period of low or reduced government spending, they are often at a point of low taxes as well.
According to John Keynes, “The boom, not the slump, is the right time for austerity at the Treasury.”  Contemporary Keynesian economists argue that budget deficits are appropriate when the economy is in recession, to reduce unemployment and help spur GDP growth.
However, I believe that Keynes is wrong. I believe in low taxes and low government involvement within the economy. Consumers contribute ~70% of the GDP whilst investors contribute ~10-15%. These consumers and investors feel more secure when both spending and taxes are low. When these groups feel more secure, they spend more and thus stimulating the economy:
"Writing in the Wall Street Journal, Alesina points to the reason for these findings: Spending cuts “signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts people’s behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time."
Here is some empirical evidence for this:
"I’ve studied every 3-year peace-time period since the U.S. founding in 1790, and in cases when federal spending declined, real GDP over the same years grew by 11%, on average, not materially different from the average growth rate recorded in periods of rising spending. Government spending cuts have not been bearish for growth. From 1840 to 1843 U.S. federal spending was cut by 51% while real GDP grew by 11%; from 1866 to 1896 spending declined 38% as GDP grew by 9%; from 1874 to 1877 spending fell 20% as GDP advanced by 9%; from 1899 to 1902 spending dropped by 20%, but GDP rose by 13%; finally, between 1921 and 1924 spending decreased 43%, yet GDP climbed by 23%. No 3-year spending cut has occurred since 1949, and since then, GDP growth has slowed."
So, in reality, austerity measures are best all the time – especially in times of economic downturn for at least 3 reasons: first, if you want to stimulate the economy, you need to have consumer confidence (which we see austerity measure bring); second, investors are a huge part of stimulating the economy and helping businesses to grow feel more safe and comfortable when spending and taxes are both low; and third, it helps offset the debt that helps create these crises.
For these two contentions, I feel that Keynesian economics is officially dead. I am so busy during the holiday season that I have not been able to write out a full opening statement. In the next round, I will expand on these two contentions and add a few more.
 Quoted on http://debate.org......
 Ibid. Thank you Ron-Paul for these two quotes from your debate.
:"Keynesian Economists believe that there should be a strong government involvement in offsetting the effects of a depression or a recession by stimulating the economy."
This is only true some of the time. While the two most important recessions in recent memory were largely demand-driven, 99% of all recessions in the past 6,000 years were supply driven. Such recessions include famine, disease, etc. Increased demand through printing money or spending by the government would not have increased economic output during such scenarios. Only recessions where there are large amounts of unemployed workers and underutilized capital can be cured through increased demand.
Now, regarding the gentlemen's use of Keynes himself, I want to make two points
1: Economics is not about who came up with what. While historians can use the writings of Keynes himself to make judgments about certain topics, economics is primarily concerned with conceptual analysis and empirical evidence, not primary sources.
2: The quote the gentleman gave only talks about reform, not stimulus or recovery. Actions of government like FOMC operations and fiscal stimulus are very different from financial regulatory reform like Dodd-Frank, Glass-Steagall, and the myriad of other regulatory reforms undertaken during the Roosevelt administration. Despite being left-of-center on some macroeconomic issues, I myself am sympathetic to the case against regulation of the banking industry. There is no good reason, for instance, that American banks ought not be able to participate in the securities market. Such regulations put our banks at a competitive disadvantage to other banks and make it more difficult for businesses to obtain the banking services that they need.
Now my opponent gives 5 examples that demonstrate the failure of Keynesian economics. I want to address them one at a time.
:"During the 1930s, New Deal lawmakers doubled federal spending--yet unemployment remained above 20 percent until World War II."
1: Unemployment in the United States dropped every year from 1933 to 1937, And GDP grew every year from 1933 to 1937, exactly at the same time that the government increased deficit spending. Curiously, in 1937, the US government dramatically cut deficit spending. At the same time, unemployment increased and the economy entered into recession. So on a superficial level, the case against fiscal stimulus is looking weak.
2: This is not strictly economics. From this analysis we cannot know how much of the change in output was due to government spending, due to increased real money balances, debt deflation, etc. For that we need an econometric model.
Greg Mankiw's "Macroeconomics" gives a simple set of econometric models that help illustrate the more complicated aspects of Keynesian economics. By my own back-of-the-envelope calculations, the increased government deficit spending during the 1930s was responsible for an increase of 2% in GDP. By Okun's law, this would only reduce unemployment by about 1%.
:"Japan responded to a 1990 recession by passing 10 stimulus spending bills over 8 years (building the largest national debt in the industrialized world)--yet its economy remained stagnant."
Again, by my own calculations, fiscal multipliers are about $1.30 for every increase in government spending, taxes held equal. The deficits of the "lost decade" period by Japan were, for the magnitude of their recession, quite modest. Japan lost almost 1.5 trillion dollars in output, from a 5.3 trillion pre-recession peak.
:"In 2001, President Bush responded to a recession by "injecting" tax rebates into the economy. The economy did not respond until two years later, when tax rate reductions were implemented."
First, very basic keynesian theory predicts that tax cuts will not work as well as increases in government spending. The reason for this is that government spending increases economic output directly. However, tax cuts do not. Before any of a tax cut is spent, some of it is saved. This can be demonstrated through a simple Keynesian Cross model, or even better through an IS/LM model that also takes into account how increased interest rates will reduce investment.
Second, however, pioneering research into the microeconomics of investment consumption by economists like Irving Fisher, Franco Modigliani, Milton Friedman, and others have yielded one basic, but extremely important insight: The marginal propensity of persons to consume does not depend merely on current income. Rather, consumers are forward looking and examine the trade-offs between consumption and saving. If consumers receive a temporary one-off boost in their income through a stimulus check, they are unlikely to spend that money and will instead save it. This is because consumers will optimize consumption over time, and part of that includes spreading consumption out over many years through saving or borrowing.
Third, finally, Bush's own economists do not say that the recovery would not have happened without tax cuts. Bush's chairman of of his council of economic advisors said that his 2001 and 2003 tax cuts created 1.5 million jobs and increased GDP by 2 percentage points.
:"In 2008, President Bush tried to head off the current recession with another round of tax rebates. The recession continued to worsen."
This might be a problem for Keynesian economics circa 1930, but we have much more nuanced models of consumer behavior that explain this.
:"Now, the most recent $787 billion stimulus bill was intended to keep the unemployment rate from exceeding 8 percent. In November 2009 it topped 10 percent."
Simple ignorance on the part of Obama's economic team.
:"These consumers and investors feel more secure when both spending and taxes are low."
The argument we are having is over short run economic fluctuations, not economic growth per se. There is a strong consensus among economists on what causes economic growth. Further, it is not necessarily the case that investors are more confident when spending and taxes are low. If taxes are low, but there are large budget deficits, investors will face very large borrowing costs because deficits crowd out investment in the long run. Investors will only invest when the marginal productivity of capital is more than the rental price of capital. at the margin, when interest rates increase, some investors will not invest. Therefore, low taxes can easily cause an economy to contract.
:"Here is some empirical evidence for this:"
Austerity can help in the long run, when interest rates are free to equilibrate supply and demand for savings. However, in the short run, this does not happen.
Having responded to my opponent, I want to reiterate the simple theoretical case for Keynesian economics.
MV=PY, or Money times velocity equals price times quantity of transactions. Necessarily, if prices are not free to adjust, decreases in money supply or velocity will cause decreases in output. Decreases in velocity are equivalent to decreases in aggregate demand for goods and services. Decreases in demand for goods and services can be caused by an increase in demand for liquid assets, like cash, and these increases can be caused by any number of factors.
In conclusion, Keynesian economics is theoretically and empirically sound.
I have to give credit to Drs Thomas Sowell, Paul Krugman, and N. Gregory Mankiw. On economic matters, These three gentlemen are easily the three most influential authors I've ever read.
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