When markets descend into one of their occasional freak-outs, customers can get too spooked to spend, and react by hoarding their money, says Keynesian economics. While hoarding may be a sensible move from the perspective of any given customer, in the aggregate it’s very bad news for the economy. The reason is that vendors were counting on getting that money and using it to pay their workers and their suppliers. Without that money, those vendors will soon have to lay off some of their workers — and those laid-off workers will in turn be forced to start hoarding their own money, which in the aggregate will lead to still more layoffs, and so on.
According to Keynesian economics, in this situation markets simply aren’t capable of self-correcting. That’s because vendors and customers are locked in an Alphonse-Gaston “no, you first” stalemate. It’s a chicken-and-egg problem: Vendors won’t hire more people (no matter how low their tax rates) until they’re convinced that customers are ready to spend. But customers won’t be ready to spend until they’re convinced that times are better and businesses are hiring.
The only thing that can break this stalemate, say the Keynesians, is a temporary program of aggressive government spending. Ideally, this spending should be on projects that will make the whole society more productive, such as building roads, repairing bridges, and the like.
Ezra Klein has a nice sound-bite summary of all this in yesterday’s Washington Post:
Keynes … taught us that although markets are usually self-correcting, they occasionally enter destructive feedback loops in which a shock to, say, the financial system scares business and consumers so badly that they hoard money, which worsens the damage to the system, which further persuades other economic players to hoard, and so on and so forth.
In that situation, the role of the government is to break the cycle. Because businesses and consumers have stopped spending, the government breaks the cycle by spending. As clean as that theory is, it turned out to be a hard sell.
The first problem was conceptual. What Keynes told us to do simply feels wrong to people. “The central irony of financial crises is that they’re caused by too much borrowing, too much confidence and too much spending, and they’re solved by more confidence, more borrowing and more spending,” Summers says.