Scalpel or Hatchet?: Is Keynes relevent again?

You'd think that by the fourth time the debates throw out the same question, at least one candidate would be able to formulate an answer that actually addresses the question. Instead of talking about what a $700 billion bailout will force them to cut back on, both candidates resort to their respective government spending talking points. McCain says "spending freeze" which Obama predictably analogizes to a "hatchet" before introducing his "scalpel" strategy, cutting back on some areas of excess but allowing the flexibility to increase funding where needed. I want to raise the possibility that maybe cutting spending isn't the answer, but hopefully I'll say it in a way that actually does answer the question.

On this issue, I have to give my vote to Obama's scalpel, especially given the current state of the economy. Macroecononmists are familiar with the axiomatic formula Y=C+I+G. The formula tells us that Income (i.e. GDP, blunt measure of the strenght of the economy) equals Consumption plus Investment (in buildings, equipment, machinery, etc.) plus Government Spending. The Keynesian approach posits that when "C" and "I" are hurting (as they are), "G" (usually best reserved on the sideline) may be called upon to balance insufficient private spending in order to maintain a steady "Y." The balance is delicate because too much "Y" can cause inflation whereas too little "Y" results in high unemployment. Keynesianism is challenged because the government has a very difficult task in determining where to strike the balance, especially since data lags behind the time frame for decision-making. Normally economists agree that a combination of low taxes and small government works best, delegating that decision making to private markets (under the careful supervision of the Fed) to determine the correct level of spending.

That philosophy works well under normal economic conditions, but these are unprecedented times for the economy. "C" and "I" are largely dependent both on individuals' and businesses' ability to obtain money and on their comfort level to spend it. A credit freeze erodes consumer confidence and investment enthusiasm and makes it virtually impossible to obtain funds for those who would spend. Anecdotal evidence shows that currently many companies cannot borrow beyond even the next business day, forcing them to survive from day to day and rendering any long-term investment infeasible.

Deficits are generally seen as inherently undesirable, as reflected by both campaigns' promises to eliminate the deficit. While deficits are undesirable in a booming economy, in an economy such as the one at hand, a deficit can prove a useful tool to stimulate the economy where the private sector is utterly unable. Due to the credit freeze, the government is one of the few entities left with the means to borrow and invest. Unlike private institutions, the government enjoys a constant and compulsory source of revenue (taxes) and a reliable means of financing (Treasury Bonds). If the private sector cannot and will not spend, the government must, or else a credit freeze will cause a downward spiral in output ("Y") and put upward pressure on unemployment.

Additionally, public spending can prove useful in ways that private spending cannot. Investment in public infrastructure paves the way for more rapid recovery whenever the private sector does revive itself. Public spending is a means of overcoming the collective action problem articulated by Mancur Olson. Consider an investment such as advanced equipment for hands-on technology education in public schools, which would improve productivity for every business which has access to the school's students as a potential workforce. Knowing that all other businesses will benefit at no cost from the investment that any one business would have to make at a great cost, no one business has the incentive to invest on its own in advanced technology devices for schools. As a result, the private sector will rarely overcome the collective action problem and invest in technology education. Alternatively, all businesses in a locality can pool their money in the form of local taxes so that the government can upgrade the school's technology and improve the local workforce for them. Since everyone who benefits also contributes, public investment minimizes free-riding.

This was the philosophy behind the Tennessee Valley Authority during the Great Depression. The federal government used public funds to provide jobs for the construction of, among other things, a vast power grid which, once the Depression ended, served to enhance the entire region's capacity for economic development. Governments can make more liberal investments in public infrastructure during downturns because the investments inject revenue into the private sector and provide jobs to compensate for increasing unemployment without the risk of inflation that normally accompanies increased spending during normal times. Once the private sector picks back up, the government can retreat to an inferior position and pay off its debt with the surpluses of a strong economy.

Like the Roosevelt Administration, the next administration may be called on to find new and innovative ways to invest in public infrastructure if the financial crisis causes our economy to slip into a recession -- or worse. A McCain spending freeze would effectively bind the government's hands from moving government spending to areas where it doesn't already occur. In my mind, the flexibility of the Obama "scalpel" offers a much more promising method to trim waste while leaving the government unfettered to pursue new public spending initiatives when the economy demands it.

What might these public investments look like? As I mentioned before, investment in public schools shouts out for attention. The American economy of the future depends on student competency, superiority even, in science, math, engineering, and technology -- all subjects in which American students are rapidly falling behind the rest of the world. Further, public schools in this country exhibit unacceptable disparities in education and infrastructure. Federal funds offer a means to level the playing field and guarantee that education is the right of every child, regardless of neighborhood or economic background. Investment in new schools or physical upgrades to deteriorating schools can also pick up some of the slack in the faltering construction industry.

Public transportation too demands an immediate government response. The recent spike in gas prices highlighted our nation's helplessness in the face of the capricious, foreign controlled oil market. Despite the recognition of both parties of the need for oil independence, neither has proposed a comprehensive transportation initiative. Instead, we continue to pour money into highways, the cost of which continues to rise, in terms of depreciation, environmental externalities, and the opportunity costs of traffic congestion. Rail offers an efficient substitute to automobile travel. Its installation is expensive, but such a public sector infusion of money would funnel money into the private sector and provide new jobs, precisely what the economy may need in a deep recession.

Another public infrastructure project could be extending broadband networks into underserved rural areas. Connecting those areas into the global information network aids both in developing trade and entrepreneurship and enhancing education for those areas.

Finally, the one area of public investment that candidates are talking about is in scientific research. R&D is a risky investment that offers high social payoffs on the aggregate, but uncertain private gains on a case by case basis. A government infusion of grants for energy, medical, science, and technology research could produce productivity-boosting developments that both help the country out of a recession and lead to a reduction in prices to combat inflation.

The key to any of these investments is the ability to retreat from them once the economy picks back up. Investments will have to be made rapidly and efficiently with mechanisms in place to scale back once the private sector heats up; otherwise, inflation could result. I do not mean to say that the next administration will necessarily have to pursue a Keynesian interventionist policy, only that if these bizarre economic times demand as much, Obama's scalpel philosophy will be much more effective than the hatchet.

Then again, there is that $700,000,000,000 (I feel like only writing the number out can do it justice) bailout to consider. The government says that the bailout will pay itself off once the financial markets recover. Since the those assets are tied to people's abilities to pay off their mortgages, their solvency will depend on steady employment and wages. The Keynesian approach may not be the answer, but on its face it at least seems worth some consideration.