Keynes was right?

by Russ Roberts on December 30, 2011

in Stimulus

The title of Krugman’s latest op-ed is “Keynes was Right.” Let’s see the evidence. Krugman begins:

“The boom, not the slump, is the right time for austerity at the Treasury.” So declared John Maynard Keynes in 1937, even as F.D.R. was about to prove him right by trying to balance the budget too soon, sending the United States economy — which had been steadily recovering up to that point — into a severe recession. Slashing government spending in a depressed economy depresses the economy further; austerity should wait until a strong recovery is well under way.

Unfortunately, in late 2010 and early 2011, politicians and policy makers in much of the Western world believed that they knew better, that we should focus on deficits, not jobs, even though our economies had barely begun to recover from the slump that followed the financial crisis. And by acting on that anti-Keynesian belief, they ended up proving Keynes right all over again.

It’s hard to ignore deficits when the interest rate you can borrow at is rising steadily and investors become nervous that they’re not going to get their money back. Sure Greece and and Ireland and Portugal and Spain are worried about jobs, too. But even if you believe in the Keynesian idea of implementing deficit spending it’s hard to do when it gets harder and more expensive to borrow money:









So maybe it’s not a loss of faith in Keynesianism but rather a reality check that has much of the Western world worrying about deficits. Krugman concedes this possibility later on. I’ll get to that in a minute. Krugman continues:

In declaring Keynesian economics vindicated I am, of course, at odds with conventional wisdom. In Washington, in particular, the failure of the Obama stimulus package to produce an employment boom is generally seen as having proved that government spending can’t create jobs. But those of us who did the math realized, right from the beginning, that the Recovery and Reinvestment Act of 2009 (more than a third of which, by the way, took the relatively ineffective form of tax cuts) was much too small given the depth of the slump. And we also predicted the resulting political backlash.

Those of us who did the math? Yes, Krugman wanted a bigger stimulus. But others did the math and got a different answer. Here is a story from Planet Money in late January of 2009 where Alan Blinder does the math:

“So, here’s the way Keynes would have done it,” Blinder says, sketching points on a blackboard in his office.

The Keynesian formula is straightforward. First, you estimate how much the economy should be producing — given all the people and factories and offices. Blinder’s guess is $15 trillion. Then you look at what the economy is actually producing. He puts that at $14 trillion.

The government shouldn’t have to spend the entire trillion-dollar shortfall. That’s because of something called the “Keynesian multiplier.” Every dollar the government spends produces more than a dollar in spending throughout the economy. If the government pays you to build a bridge, you spend your paycheck on rent and food and so on, and then your landlord and grocer have money. Using Keynesian math, you can figure out exactly how much the Obama administration should spend.

Blinder taps his chalk, winding up his calculations. “That would lead you to conclude that you needed about $650 billion as a stimulus,” Blinder says. “Voila! That’s the kind of number they’re talking about right now. You see it in the newspapers every day, a number in that range.”

And then there’s the nice dig at the tax cut. The tax cut was a tax rebate actually. It didn’t change rates or incentives. But in the Keynesian worldview, shouldn’t that help?

Krugman continues:

So the real test of Keynesian economics hasn’t come from the half-hearted efforts of the U.S. federal government to boost the economy, which were largely offset by cuts at the state and local levels. It has, instead, come from European nations like Greece and Ireland that had to impose savage fiscal austerity as a condition for receiving emergency loans — and have suffered Depression-level economic slumps, with real G.D.P. in both countries down by double digits.

This wasn’t supposed to happen, according to the ideology that dominates much of our political discourse. In March 2011, the Republican staff of Congress’s Joint Economic Committee released a report titled “Spend Less, Owe Less, Grow the Economy.” It ridiculed concerns that cutting spending in a slump would worsen that slump, arguing that spending cuts would improve consumer and business confidence, and that this might well lead to faster, not slower, growth.

So in Krugman’s view, Greece and Ireland are tanking because they cut spending, not because they have dysfunctional economic systems. And we should conclude that if the US cuts spending we’ll have huge drops in GDP? Maybe you want to hold a few things constant before you draw that implication. But I wonder how much Greece and Ireland have really done. Savage fiscal austerity? Really? If you’re going to make that kind of claim, you should provide at least a data point or two. Does anyone out there know what has actually happened. If yes, please email me.

They should have known better even at the time: the alleged historical examples of “expansionary austerity” they used to make their case had already been thoroughly debunked. And there was also the embarrassing fact that many on the right had prematurely declared Ireland a success story, demonstrating the virtues of spending cuts, in mid-2010, only to see the Irish slump deepen and whatever confidence investors might have felt evaporate.

Amazingly, by the way, it happened all over again this year. There were widespread proclamations that Ireland had turned the corner, proving that austerity works — and then the numbers came in, and they were as dismal as before.

Yet the insistence on immediate spending cuts continued to dominate the political landscape, with malign effects on the U.S. economy. True, there weren’t major new austerity measures at the federal level, but there was a lot of “passive” austerity as the Obama stimulus faded out and cash-strapped state and local governments continued to cut.

I love this. Passive austerity? That means no austerity actually other than pretending to talk about it. And the “alleged historical examples” is not exactly an accurate description of the work of Alberto Alesina.

Now, you could argue that Greece and Ireland had no choice about imposing austerity, or, at any rate, no choices other than defaulting on their debts and leaving the euro. But another lesson of 2011 was that America did and does have a choice; Washington may be obsessed with the deficit, but financial markets are, if anything, signaling that we should borrow more.

OK, it’s a little bit late in the column, but here Krugman concedes that maybe Greece and Ireland pursued austerity out of necessity. So maybe politicians didn’t give up on Keynesianism. They just lost the tools to implement it because of their past indiscretions. The question is what all this implies for the US:

Again, this wasn’t supposed to happen. We entered 2011 amid dire warnings about a Greek-style debt crisis that would happen as soon as the Federal Reserve stopped buying bonds, or the rating agencies ended our triple-A status, or the superdupercommittee failed to reach a deal, or something. But the Fed ended its bond-purchase program in June; Standard & Poor’s downgraded America in August; the supercommittee deadlocked in November; and U.S. borrowing costs just kept falling. In fact, at this point, inflation-protected U.S. bonds pay negative interest: investors are willing to pay America to hold their money.

The bottom line is that 2011 was a year in which our political elite obsessed over short-term deficits that aren’t actually a problem and, in the process, made the real problem — a depressed economy and mass unemployment — worse.

The good news, such as it is, is that President Obama has finally gone back to fighting against premature austerity — and he seems to be winning the political battle. And one of these years we might actually end up taking Keynes’s advice, which is every bit as valid now as it was 75 years ago.

 So Krugman’s lesson is that we have nothing to learn from Europe–they gave up on Keynesianism maybe because they had to but we’re not in the same situation. We aren’t close to defaulting so we should go back to Keynes. So why is Keynes still right? Because Europe, forced to implement austerity, is stagnating.
I’ll repeat what I said earlier–maybe austerity (if it really is being practiced in Europe rather than “passive” austerity) isn’t the only reason Europe is struggling. Maybe they are governed poorly and have spent their public monies badly. I don’t really have the confidence that Krugman does that we’re so different. Surely there is some amount of money we could borrow and spend badly that would test Keynesianism one more time and maybe lead us down the same path as Greece et al. Krugman isn’t worried at all. I’d still like a little more evidence that the strategy actually works.
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Gavin Reddin December 30, 2011 at 2:53 pm

Here is the data on Ireland for you…

Is it any wonder that Krugman failed to mention it. I am from Ireland and it certainly is true, as our late Minister for Finance at the time of the ‘austerity’ measures said, we are cutting back to 2007 spending levels, which was the height of the boom. The public sector is still the highest paid in Europe.

Mogden December 30, 2011 at 3:26 pm

The Federal policy to borrow more than 10% of GNP per year is about as austere as Caligula’s wedding bacchanal.

Invisible Backhand December 30, 2011 at 4:18 pm

Forgot to turn comments off again Russ.

SmoledMan December 30, 2011 at 4:42 pm

Why not just cancel the entire debt? There is nothing sacred about it, let’s just start over.

Henri Hein December 30, 2011 at 5:20 pm

I have no truck with any argument that uses 1937 as a validation of Keynesianism. So many things happened in that year that we should be careful drawing any conclusions from it. Revenues went up by 39.5%, possibly the largest tax increase in the nation’s history and certainly the largest one I know about. Even most Keynesians agree tax increases are a bad idea during a slump.

Do we have different terms for austerity that includes tax increases and austerity that focuses on spending reduction? They are very different policies, and lumping them together only adds confusion, IMO.

Chance December 30, 2011 at 5:58 pm

Mayhaps banks fleeing Euro bonds had to put their money somewhere and could only buy US Treasuries thus driving the rate Uncle Sam pays down? It seems like Krugman is taking Keynesian theories and picking observations of data that plug nicely into the theory to use as examples about why the theory works. It seems like Keynesian models can/should only be tested on a global scale now as economies (worse perhaps, central banks and governments) are intertwined.

Furthermore, I’ve still yet to hear a good answer from the slavish Keynes devotees about why we should implement the spending aspects of the theory if we didn’t invent the savings aspects of it during the good times?

Vuk Vukovic December 30, 2011 at 6:25 pm

Regarding the graph, I found an even better one with bond spreads rather than yields, precisely showing the underestimation of risk in the eurozone economies, where they were all treated with the same zero-risk status like Germany. Maybe someone thought that was a good thing?

Craig December 30, 2011 at 7:30 pm

I’m glad you addressed this column.

I saw the title and didn’t even know where to start.

Kurt Montandon December 31, 2011 at 3:56 am

It’s fascinating how that chart doesn’t include the U.S., where interest rates for buying government debt are effectually negative.

Just … fascinating. It’s almost like including the U.S. would entirely invalidate your point.

Protesilaos Stavrou December 31, 2011 at 4:46 am

Krugman is all wrong about Europe as he sees only one side of the story, namely austerity (you accurately argue against his approach) as if all other issues were fine.
To be able to understand the whole picture one needs to consider the (very high) amounts of private and public debt prior to 2008, all across Europe and most importantly the flawed institutional framework of the EU (that many neglect).
The EU and the Eurozone are not a single state like the US is. They are a collective of states, that have agreed on a series of issues to harmonize and coordinate much of their economic actions. Yet they lack a coherent institutional structure a genuine state has.
It is one thing to argue against austerity once all other related issues are dealt with. It is totally a different issue to omit all important parameters for the sake of arguing in favor of an ideology (Keynesianism) that has done more harm than good by perpetuating the same policies that brought us into this mess.

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