Shockingly, Europe is going on an austerity binge, wrecking large swaths of the sacred welfare state in the process. These actions have been interpreted as a repudiation of Keynesian economics, for instance in the New York Times’s recent “Europe Seen Avoiding Keynes’s Cure for Recession.” Certainly all nations would do well to avoid Keynes’s prescription of deficit spending and debt to fend off recessions, but in fact Europe is following Keynes to the letter. Instead, it is the United States that has abandoned Keynes to pursue what might be called “Bear Economics,” which I will return to below.
To review, the principle of Keynesian stimulus is that during a recession, total demand — the sum of private and public demand net of international trade flows — is well below potential output, so the obvious mechanical solution is to push up total demand. One might try protectionism — shutting off imports that compete with domestic producers — but that’s properly regarded as suicidal. One might try outlawing all saving, forcing consumers to spend more — again, not a wise course. Government could ramp up spending financed by increased borrowing — an option that politicians are happy to choose, as Keynes realized — and, voila, total demand rises.
The kink in the rope is that when governments increase their borrowing to increase their spending, the money borrowed doesn’t come from thin air (unless the Fed monetizes the debt, a complication we have so far largely avoided). No, when government borrows more, that leaves less saving available for those consumers who want to borrow and spend, and less for those businesses that want to borrow to invest.
In short, the simple mechanics of Keynesian stimulus breaks down because government spending rises at the expense, dollar for dollar, of private spending. It’s like taking a dollar out of your right pocket, putting it in your left pocket, and pretending you’ve an extra dollar to spend.
In the Great Recession, Europe binged on Keynesian economics just as the United States did — with equally poor results. Despite this failure, economies in both Europe and the Unites States have stabilized, albeit at low growth levels with high unemployment. At this point, Keynesian policy requires a second step: governments must now reduce their deficits and, preferably, eventually run surpluses to pay off the government debt run up during the recession.
Europe’s economy has largely stabilized, or so most analysis suggests. It’s now time to pay the fiscal piper and get budget deficits under control. That is what Germany has done. That is what France and the UK are attempting to do. That is what the markets are demanding of Greece, Italy, Ireland, Spain, and so on. This is Keynesian economics, Chapter Two.
If Europe is staying true to Keynes, what is the United States doing? According to President Obama and his team, the economy has stabilized and is poised for a strong recovery. That the economy has stabilized and is stuck in first gear is apparent. Whether it is poised for a strong recovery is a matter of widespread doubt, highlighted most recently by the Fed’s reluctant return to quantitative easing to try to achieve what deficit spending failed to — igniting a strong recovery.
To stay true to Keynes, Obama and friends should be pushing hard for major spending reductions much as Prime Minister David Cameron is doing. Obama, of course, has set up a massive tax hike on Jan. 1, 2010, but even this will barely make a dent in the budget deficit. A deficit of about 10 percent of the economy needs to get down to 3 percent in a hurry. Even the tax-hiker-in-Chief can’t get there through taxes.
If not Keynesianism, what theory is President Obama pursuing? There are no comparables in the textbooks, but there are in real life. Consider the basic outline of the policy — borrow extensively and continually, well beyond what is safe or prudent, to create an artificial sense of prosperity for as long as it can last. Anyone who watched the financial meltdown of 2008–2009 will recognize this as the behavior that brought down the great investment house of Bear Stearns, and then Lehman Brothers, and then nearly all of them.
Much like the president, Bear Stearns was once highly touted. Fortune magazine recognized it as the nation’s “Most Admired” securities firm. The key to Bear’s profits early in the decade was cheap debt. It was able to borrow astronomical sums at relatively cheap rates and invest these sums, earning high rates of return, all while holding relatively little equity. Toward the end of 2007, Bear had a net equity position of $11.1 billion supporting $395 billion in net assets, producing a leverage ratio of 35.5 to 1. Disaster was only a matter of time, and time was short.
President Obama’s central economic policy is fiscal stimulus, which is a fancy term for building the national debt ever higher. Despite the stabilization of the economy, Obama shows no signs of reducing the deficits any time soon, neither in his most recent budget or his own statements, which is all the more extraordinary when one considers the growing demands of the electorate for restraining spending.
Thus, it is not Europe that has abandoned Keynesian policies. Europeans are following Keynes and prudent policy by forcing through wise and wrenching reductions in government outlays along with higher taxes. The tax hikes are unwise, but at least they are consistent with the policy.
It is the United States that has abandoned Keynes, and it is doing so at precisely the wrong time. The initial pursuit of Keynesian stimulus was wrongheaded and doomed from the start, as the evidence now shows. Obama pursued Keynes’s policies when he should not have. But now Keynesian policy says to cut spending and reduce the deficits, and the president has abandoned Keynes for Bear Economics. If allowed to continue, this is sure to end badly for the United States — just as it did for Bear Stearns.
— J. D. Foster is the Norman B. Ture senior fellow in the economics of fiscal policy at the Heritage Foundation.