Failed Policies and Depression Economics

In the September 7th Republican Presidential Debate, Rick Perry said, “Keynesian policy and Keynesian theory is now done.”  It was a curious remark, revealing the strange bubble American politicians often live in. The implication wasn’t just that the stimulus package from early 2009 hadn’t worked, but that it had actually made matters worse. And today, we hear similar opinions being expressed by people who should know better (see Paul Krugman on Tyler Cowen).

There are now plenty of examples which show how austerity has not worked, and how Keynesian policies, when tried, actually have worked. Keynesians do not say that without stimulative spending, the economy will never grow again. What they do say is that there will be an unnecessarily long period of high unemployment and general suffering that could be diminished with increased government spending. Quoting Krugman : “We said that as long as the economy remained deeply depressed, even a huge rise in the monetary base would not be inflationary, and that even huge budget deficits would not send interest rates soaring. And we said that fiscal austerity would be contractionary, not expansionary.” All of this has been true.

Examining government policies and the resulting outcomes is never easy in terms of identifying cause and effect. But one of the reasons worldwide downturns are illuminating for economics is that we can view how different countries with different institutions and fiscal policies had different outcomes.

I will go through some of them.

1.) When David Cameron formed his government in the United Kingdom in 2010, the immediate plan was for ‘expansionary austerity’, a term that is every bit as senseless as it sounds. The idea was that the government had to credibly cut spending immediately to produce two results: first, to prevent the bond markets from fleeing UK debt and sending the cost of borrowing to very high levels that would edge the country towards default; second, to actually spur economic growth by increasing “confidence.” The first reason shows a profound misreading of events. Those in the Conservative party looked to the Euro Zone, saw countries like Greece and Ireland, and thought that to calm bond markets in the near future, they had to practice austerity. They had little understanding of the fact that the shared currency was a key reason Ireland and Greece were in such dire straits, and that austerity had only made matters worse in those counties. Paul de Grauwe has been most articulate in explaining this.

The second reason, that “confidence” will somehow be the savior in the face of massive spending cuts, has been the most intellectually lazy belief. This is the “confidence fairy” that Paul Krugman often refers to. How exactly will private sector confidence be boosted, and what would that entail? Well, since government spending is lower . . . .the private sector will feel more compelled to come in and fill in the gaps, since public debt will be on a more sustainable path. Huh? I don’t actually understand the argument myself.

The result of these disastrous policies is that the United Kingdom, if we are to look at output, has faced it’s worst recession . . . ever. That includes the Great Depression. See the blue line in the following chart, courtesy of http://www.niesr.ac.uk/:

http://www.niesr.ac.uk/

2.) Ireland, which has suffered so much in the last 5 years, has cut spending massively in the face of a miserable economic environment and huge debt overhang. One may argue that Ireland, in being apart of the Euro Zone, simply had no choice but to cut spending since bond markets were not allowing them to borrow. This may be the case. But the evidence shows that bond markets are still not willing to lend to Ireland. The ECB/IMF/EU’s solution then, rather than to lend freely to Ireland, was to slash spending. Some people, like Tyler Cowen, were seemingly willing to call Ireland a success story in the middle of 2011, due to small upward movement in GDP. How you can call this an example of why austerity can work is beyond comprehension. Furthermore, it was just that, a blip. See the the most recent GDP report: http://www.cso.ie/en/media/csoie/releasespublications/documents/latestheadlinefigures/qna_q32011.pdf

3.) Latvia, where the unemployment rate reached 20.5 at one point. I will leave this to the CEPR: http://www.cepr.net/index.php/publications/reports/latvias-internal-devaluation-a-success-story

4.) In the United States, the recession ended in the middle of 2009, as the ARRA had gone into full swing, and the country began growing again even as the private sector was weak. By the end of 2010, the economy was again adding jobs, and has been on a consistent basis. The basic idea is that as the private sector delevers and pays down debts, if the government does not correspondingly increase spending, the overall economy will lose more jobs and grow more slowly than it otherwise would have. The federal government was thus filling in the hole left by the private sector. State and local governments were, in contrast, cutting spending. This is why the stimulus as passed was not as big as it should have been. Net government spending increased for a time, but not nearly enough to match the severity of the economic climate. Richard Koo’s work has focused on this. See David Leonhardt for a concise view of the facts.

Since 2011 when stimulus money had essentially been exhausted, government has been a net drag on the economy as state and local governments have slashed spending and employment. Employment reports since 2011 have generally been very weak (where beating expectations only meant that expectations were very low), and GDP growth was also very weak throughout 2011. The logical explanation is that government austerity (at the state/local level if not at the federal level) led to weak growth in both output and employment since balance sheets of households were still very weak. Some government policies like extending unemployment insurance benefits and payroll tax cuts helped mitigate some of these effects.

January’s Employment Report has been the first genuinely good employment report of the recovery, showing significant private payroll additions in a broad swath of industries and a meaningful uptick in the prime-age employment-population ratio (I prefer this to the unemployment rate). One good month does not yet make a trend, though I certainly hope it is. The CBO and others, however, forecast a rise in the unemployment rate by the end of the year.

Regardless, I do not see how this means that Keynesian doesn’t work. Looking at the key insights: Interest rates for 10-Year Treasuries are hovering around 1.8 percent in the face of large deficits, the economy grew very slowly last year in the face of deep state and local government cuts. If the private sector has completed repairing their balance sheets, then the economy should be expected to grow even if government spending fades. But I think this is still wishful thinking at this point. If federal payroll tax cuts and extended unemployment insurance benefits are not extended, and if all of the Bush tax cuts expire in January, we may see employment reports revert to being very mediocre, as they did last year. Furthermore, Europe’s problems still loom very large. All of this makes the case for increased federal spending in 2012, and vindicates Keynesian policies. I would prefer that we learn from the failed examples of austerity rather than go through it ourselves only to see how much worse off we are. It is a mystery how some like Tyler Cowen see the first genuinely good employment report 2.5 years after the recession officially ended as a sign that Keynesian economics is discredited.

The main threat to our current recovery is learning the wrong lessons.