LONDON – The “laws of holes” are as unforgiving as the laws of physics. If you find yourself in a hole and want to get out, the first thing you do is to stop digging. If you confront a number of holes to fix and want to know which to fix first, you choose the one which poses the greater danger. These laws are particularly true when applied to government finance.
When John Maynard Keynes talked of persistent under-employment, he did not mean that, following a big shock, economies stay frozen at one unchanging level of depressed activity. But he did think that, without external stimulus, recovery from the lowest point would be slow, uncertain, weak, and liable to relapse. His “under-employment equilibrium” is a form of gravitational pull rather than a fixed condition.
This is a situation that Alan Greenspan, the former chairman of the United States Federal Reserve, described as a “quasi-recession,” a better term than “double-dip recession.” It denotes an anemic recovery, with bursts of excitement punctuated by collapses. It is the situation we confront today.
Contrary to Keynes, orthodox economists believe that, after a big shock, economies will “naturally” return to their previous rate of growth, provided that governments balance their budgets and stop stealing resources from the private sector. The theory underlying this way of thinking was set out in the July Bulletin of the European Central Bank.
Debt-financed public spending, the ECB argued, will “crowd out” private spending by causing real interest rates to rise or by leading households to increase their saving because they expect to pay higher taxes later. Either way, a fiscal stimulus will not only have no effect; the economy will be worse off, because public spending is inherently less efficient than private spending.
The Bulletin’s authors do not believe that a “crowding out” of this type actually happened over the last two years. On the contrary, as they explain, if there are unemployed resources, extra government spending can “crowd in” private spending by creating additional demand that would otherwise not exist. Summarizing the evidence, the Bulletin finds that fiscal-stimulus programs in the eurozone have caused GDP to be 1.3% higher in 2009-2010 than it otherwise would have been.
Evidence for the positive impact of fiscal stimulus is even stronger in the US. In a recent paper, the economists Alan Blinder and Mark Zandl found that the total stimulus policy adopted in 2009-2010 (including TARP, the much-maligned financial-sector bailout scheme) averted another Great Depression. Fiscal expansion alone caused GDP in the US to be 3.4% higher over 2009-2010 than it otherwise would have been.
Yet the budget cutters have a fallback position. The problem with fiscal stimulus, they say, is that it destroys confidence in government finances, thereby impeding recovery. So a credible deficit-reduction program is needed now to “consolidate recovery.”
What is it about cutting the deficit that is supposed to restore confidence? Well, deficit reduction may lead consumers to believe that a permanent tax reduction is on the horizon. This will have a positive wealth effect and increase private consumption. But why on earth should consumers believe that cutting a deficit, and raising taxes now, will lead to tax cuts later?
One implausible hypothesis follows another. Fiscal consolidation, its advocates claim, “might” lead investors to expect improvement on the supply side of the economy. But it is unemployment, loss of skills and self-confidence, and investment rationing that are hitting the supply side.
We are told that the “credible announcement and implementation” of fiscal-consolidation strategy “may” diminish the risk premium associated with government debt. This will reduce real interest rates and make “crowding in” of private spending more likely. But real interest rates on long-term government debt in the US, Japan, Germany, and the United Kingdom are already close to zero. Not only do investors view the risks of depression and deflation as greater than those of default, but bonds are being preferred to equities for the same reason.
Finally, the reduction of governments’ borrowing requirements “might” have a beneficial effect on output in the long run, owing to lower long-term interest rates. Of course, low long-term interest rates are necessary for recovery. But so are profit expectations, and these depend on buoyant demand. No matter how cheap it is for businessmen to borrow, they will not do so if they see no demand for their products.
The ECB’s arguments look to me like scraping the bottom of the intellectual barrel. The truth is that it is not fear of government bankruptcy, but governments’ determination to balance the books, that is reducing business confidence by lowering expectations of employment, incomes, and orders. The problem is not the hole in the budget; it is the hole in the economy.
Let us assume, though, that the ECB is right and that fears of “unsound finance” are holding back economic recovery. The question still needs to be asked: are such fears rational? Are they not exaggerated in today’s circumstances (except, possibly, in countries like Greece)? If so, is it not the duty of official bodies like the ECB to challenge irrational beliefs about the economy, rather than pander to them?
The trouble is that the current crisis finds governments intellectually disabled, because their theory of the economy is a mess. Events and common sense drove them to deficit finance in 2009-2010, but they have not abandoned the theory that depressions cannot happen, and that deficits are therefore always harmful (except in war!). So now they vie with each other in their haste to cut off the lifeline that they themselves extended.
Policymakers need to re-learn their Keynes, explain him clearly, and apply his lessons, not invent pseudo-rational arguments for prolonging the recession.