The Keynesian myth will carry on

Some oppose budget cuts, but history shows deficit spending doesn’t fuel recovery

Last November, Paul Krugman met Larry Summers in Toronto for a public debate. The issue: whether America faced a “lost decade” of economic stagnation, much as Japan endured through the 1990s ( not that the 2000s were any great shakes). It was a very weird debate.

Both the Nobel laureate economist and the former Treasury secretary agreed for much of the night: the American economy was dead in the water. Moreover, both were quite sure it would remain in that condition, absent another massive dose of fiscal stimulus, i. e. even larger deficits. They differed only in their estimation of whether the American political system could produce it.

At more or less exactly that moment, as we now know, the American economy was stirring to life. The weeks since then have been filled with news of one indicator after another flashing green: retail sales, manufacturing shipments, employment, GDP, the works. The Dow Jones this week touched 13,000 for the first time in five years, even in the shadow of a possible war in the Middle East or currency crisis in Europe. That’s a gain of roughly 1,000 points since the lost decade debate.

Logically, you would think both Krugman and Summers would find this troubling. I don’t think either man would deny the evidence that the economy is growing — even Krugman is no longer predicting a Third Depression ( or is it the Fourth?). Yet you may search in vain for any acknowledgment that it has done so without the elixir of life they were so determined to prescribe.

Perhaps Krugman, at least, would claim that this was in response to previous doses of stimulus: that, far from disproving Keynesian theory, this was actually confirmation of it. Except in all of his previous writings Krugman was adamant that the stimulus had not been nearly enough — that whatever meagre stimulus might have been provided by $ 1.4- trillion federal deficits had been largely offset by cuts imposed at the state and local level.

Even if you did credit a surge in growth in late 2011 to an increase in spending two years before, that’s an awfully long lag: about what you’d expect from the economy on its own steam. Even the most blinkered Keynesian does not argue that economies never recover without such intervention — only that they take too long. As Keynes famously and flippantly argued, “in the long run we are all dead.”

So we can add America post- 2008 to the long list of failed experiments in Keynesian demand management. If deficit spending were the fuel of economic recovery — remember that Keynes insisted it did not matter what the money was spent on, only that it was spent, or rather borrowed — then Greece and Italy ought by now to be rocketing into space. It has not had that effect for them, as it did not for Japan in the 1990s, or France in the 80s, or Britain in the 70s, or the U. S. in the 60s.

Or, for that matter, contemporary Canada. Deficits we have had, and recovery we have had. But the second did not follow the first: it preceded it. The recovery began in second- quarter 2009, long before a federally funded shovel had hit the ground: the budget had only just been passed, after all, let alone implemented. Months afterwards, the Liberal party was still complaining that very little of the promised funds had actually been spent, as opposed to appropriated.

Yet for all the evidence that deficit spending has had little or no effect in stimulating the economy, it has not stemmed the flow of warnings that reducing the deficit can only depress it. In the Toronto Star, Chantal Hebert worries at the impact on Ontario’s economy of a “pileup” of spending cuts in the coming federal budget, on top of the cuts in provincial spending recommended in the Drummond report. The Globe and Mail’s John Ibbitson similarly implores Ottawa not to do “a drive- by” on the economy.

As if to add substance to these concerns, the Canadian Association of Professional Employees, a public sector union, has released a study claiming that, were the federal government to cut spending by $ 8- billion, as it is reportedly considering, it would result in a $ 10- billion reduction in GDP — enough, the union said, to plunge the economy into recession.

Um, no. First, the cuts are to be phased in over several years: even if the government were to cut the full $ 8- billion, an outside estimate, it would not be until fiscal 2015 at the earliest. Perhaps you think the economy is too fragile to withstand cuts of that size — three per cent of federal program spending — now. It’s hardly likely to be then.

Second, even if you accept the CAPE’S estimates of the impact of the cuts — to get a $ 10- billion reduction in output from an $ 8- billion cut in spending implies a multiplier of 1.25; many reputable economists would say it was half that, while others would put it closer to zero — we are talking about an economy that, by the time the cuts are phased in, will be approaching $ 2- trillion in size. $ 10- billion out of $ 2- trillion is one- half of one per cent, or about as much as the economy produces in a day and a half. This is not the stuff of which recessions are made.

Deficits will be cut. There will be no recession. But the Keynesian myth will carry on all the same. In the long run we are all in denial.