The core of Keynesian economic policy is that the government must come in and replace reductions in private sector demand with public sector demand, therefore bringing overall demand back to its previous level. One of the many flaws in this thinking is in assuming that the previous level of demand was “correct” and getting us back to that level is the appropriate policy response.

Take the example of the housing market and the government response. The primary response of Republicans in Washington has been to offer tax credits and other incentives to replace the drop in demand for housing. Witness Senator Johnny Isakson’s recent comments on why we need to extend the $8,000 homebuyer tax credit: “If you take that kind of business out of what’s already a very weak housing market, you do nothing but protract and extend the recession.”

This analysis could not be more wrong. The tax credit largely acts to keep housing prices from falling further. However, that is how markets are supposed to clear in an environment of excess supply. If there’s too much housing, the way to address that is to allow housing prices to fall, which attracts buyers back into the market.

We should also recognize that the tax credit does not help the buyer, it helps the seller, by allowing the seller to charge that much more for the price of the home.

Perhaps the worst impact of the policy is that it encourages the continued building of homes, only adding to the over-supply, which itself will “protract and extend the recession.” Witness the recent news that housing starts in the US just hit a nine month high. While these levels are still low in historic terms, and housing inventories are declining, we still have an excess of housing. The damage done by creating a false floor to housing prices is that builders don’t respond to inventory, they respond to prices, and as long as there is a positive gap between prices and construction costs, builders will build. The tax credit only serves to widen that gap between prices and construction costs.

Back to Keynes: the central flaw in the thinking behind the tax credit proposal is its assumption that we need to re-inflate the housing bubble. The previous level of housing demand, from say 2003 to 2006, was not driven by fundamentals; we had a bubble. There will be a correction in the housing market. Our choices are to either take that correction quickly and move on, or to prolong that correction, maybe even make it worse, by trying to create a false floor to the market.