Paul Krugman made a kind of bet in April 2013 — a bet he lost. He didn’t put up any real stake, but his defeat weakens the case for fiscal stimulus and strengthens the case for what he calls “austerity.”
The story begins in late 2012. The Federal Reserve had begun its third round of monetary expansion following the economic crisis of 2008. Keynesian economists were sounding an alarm about the deficit-cutting measures — a combination of tax increases and spending cuts — that were scheduled to take effect at the start of 2013. Rapid deficit reduction, they warned, would harm the economy. A letter from 350 economists referred to “automatic ‘sequestration’ spending cuts everyone agrees should be stopped to prevent a double-dip recession.”
David Beckworth, a professor of economics now at Western Kentucky University, and I challenged this view. In an op-ed for The Atlantic’s website, we wrote that the Federal Reserve could offset any negative effect that deficit reduction might have on the economy.
We did not deny that the federal government’s decisions on spending and taxes could affect the economy in certain ways. Increased tax rates could reduce incentives to work, save, and invest, as conservatives warned, and so could slightly inhibit long-term economic growth. No central bank could counteract this effect. Infrastructure spending could in theory raise the country’s productive capacity, as liberals stressed: an effect no central bank could replicate.
Both of those examples involve changes in productivity. The familiar Keynesian story about the impact of deficit spending in a depressed economy does not concern such changes. Instead, increases in deficits are held to increase the total amount of dollars spent throughout the economy, and by more than the increased amount of deficit spending. Spending exhibits a “multiplier effect” as people who receive the money spend some of it, and those who receive that additional spending do the same. That increased spending would in part take the form of higher inflation and in part of higher output. Reducing deficits would have the reverse effect, deepening an economic slump.
Beckworth and I argued that whether these stories played out in real life would depend on the conduct of the central bank. If, for example, a central bank targeted inflation rigidly and with perfect effectiveness, so that inflation was always 2 percent, then no amount of deficit spending would alter the total amount of economic activity. If higher deficits threatened to raise inflation to 2.1 percent, the central bank would tighten and total spending would be unchanged. If, more realistically, the central bank aimed for a range of inflation and usually stayed within it, then any stimulative effect of higher deficits, or contractionary effect of lower ones, would be severely constrained.
It’s worth noting, to forestall confusion, that the central bank can offset the effects of fiscal policy even if no central banker has that specific intention. In the example above, the central bank need only stick to its inflation target regardless of what other parts of the government are doing. It’s also worth noting that fiscal expansion and contraction can have local effects. Some studies, for example, showed that states or counties that received a lot of stimulus money did better than states or counties that received less. That’s not at all surprising, and tells us nothing about how much the stimulus benefited the economy as a whole.
The upshot of the argument was that the positive effects of fiscal stimulus and the negative effects of fiscal contraction are wildly exaggerated and could be nonexistent. Had there been no stimulus legislation in 2009, for example, the Fed would surely have engaged in more quantitative easing. And the Fed would be able to keep the number of dollars spent growing at roughly the rate it wanted in 2013, whatever happened with sequestration.
Which, as it turned out, was not much. Republicans and Democrats enacted a deal on New Year’s Day of 2013 that averted some tax increases but merely delayed sequestration of federal spending by two months. In February, Krugman, the Nobel Prize–winning economist and New York Times columnist, wrote that sequestration would probably cost 700,000 jobs.
In April, the liberal economics writer Mike Konczal resurrected an op-ed that Beckworth and I had written for The New Republic in 2011 making the same basic argument about the power of monetary policy, which is associated with a school of thought sometimes called “market monetarism.” He wrote: “We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action. . . . At the same time, the country has entered a period of fiscal austerity.” Citing a weak report for economic growth in the first quarter of 2013, he said that the early results looked bad for the two of us.
Krugman concurred with Konczal, writing that “we are in effect getting a test of the market monetarist view right now” and “the results aren’t looking good for the monetarists.” Twenty minutes after that post, he wrote a more general comment about some of his favorite subjects. He explained that “again and again” events had proven his analyses and predictions right while showing his opponents in economic debates to be “knaves and fools.”
Even at the time, there was reason for skepticism about the Konczal-Krugman claim. The preliminary report about growth in the first quarter of 2013 did not show a slowdown. Bentley University economics professor Scott Sumner pointed out on his blog that the growth of spending was roughly the same as it had been, and output growth higher than it had been, during 2012.
After further revisions to the data, we can now say fairly conclusively that growth accelerated at the start of 2013. Output (as measured by real GDP) grew by 0.1 percent in the fourth quarter of 2012 and by 2.7 percent in the first quarter of 2013. The growth rate for spending throughout the economy (measured by nominal GDP) went from 1.6 to 4.2 percent. Between the fourth quarter of 2011 and the fourth quarter of 2012, economy-wide spending grew by 3.5 percent. Between the fourth quarter of 2012 and the fourth quarter of 2013 — in the midst of “austerity” — it grew by 4.6 percent.
Remember: It was Krugman who made this a “test.” A slowdown in growth would invalidate the market-monetarist view and vindicate the Keynesian one. For knaves and fools everywhere to be vindicated, growth merely had to hold steady. It did better than that.
We can step back from this test, though, as Beckworth has done. He notes that by Krugman’s measure, we have had “austerity” — that is, fiscal tightening — from 2010 on. Look at a graph of total spending throughout the economy over this period, though, and this austerity is undetectable: There is steady spending growth.
Compare the U.S. with Europe, and the monetary-offset view again triumphs. The euro zone, Beckworth points out, has gone through roughly the same amount of fiscal tightening as we have but performed much worse. The difference is that Europe has had a much tighter monetary policy.
It is, of course, possible that the economy would have grown even more over the last several years if federal spending had been higher. But Krugman’s “test” did not involve such counterfactuals. He was so confident in his Keynesianism that he suggested that growth would slow because of sequestration. Looking at the record, it seems that his confidence was misplaced.