The end of the great stimulus experiment

“Finance ministers of the world’s leading economies have been so spooked by the sovereign debt crisis that they have decided they can no longer wait until economies are growing strongly before they remove fiscal stimulus . . . The communiqué of the meeting made clear the G20 no longer thought expansionary fiscal policy was sustainable or effective in fostering recovery because investors were no longer confident about some countries’ public finances.”
—Financial Times, June 5

So the great Policy Panic is over: born of the financial crisis of 2008, expired in the fiscal crisis of 2010. Let Lord Keynes’s body be returned to its grave at last.

Drummed up by a coterie of ideologues and opportunists and embraced with predictable fervour by politicians whose chronic inability to balance the books was suddenly evidence of vision rather than incompetence, the rage for deficit spending was accommodated by a great many others who knew better but shrugged that “we have to do something.”

Such was the strength of the Policy Panic that few could stand in its way. It could only spend itself in the same way as every previous wave of enthusiasm for fiscal stimulus had done: with rising interest rates and runs on the currency in the short term, and higher taxes and inflation as the only probable effects in the longer run. Apparently, no one told the Greeks about the “multiplier.” Certainly no one told their creditors.

Hence the G20’s dramatic U-turn over the weekend. The stimulus experiment is officially at an end. They are not even pretending to believe in it any more.

The mystery is how it ever got started. There’s a reason Keynes was dead, after all. It had in part to do with 40 years of intellectual spadework, in which were relaxed the highly restrictive assumptions of the model that so dazzled the world in the 1930s. If you assume an economy that is open, rather than closed, to trade and capital flows; if investment responds to the rate of interest, rather than being a mere figment of investors’ “animal spirits”; if, most critically, economic actors are influenced by their expectations of government actions and their likely consequences, rather than fixating myopically on the present, then you will get very different results than the ones Keynes foretold.

That Keynesianism was largely discredited by the 1970s had as well to do with practical experience. Long before the failure of the Japanese experiment in the “lost decade” of the late 1990s and early 2000s—surely the most sustained application of fiscal stimulus on record—there was the spectacular crack-up of François Mitterrand’s “dash for growth” in the 1980s, the “winter of discontent” under Britain’s Labour government in the 1970s, the Great Society, followed by the Great Inflation, in the United States under Johnson and Nixon.

In every case, policy makers ran up against the same inescapable problem of scarcity that is at the root of all economics. Put simply, the money has to come from somewhere. Whatever funds you “put in” to the economy by government has first to be “taken out” of it. Borrow at home, and you displace private spending with public—the “crowding out” phenomenon. Borrow abroad, and you run into balance of payments difficulties: foreigners can only lend you the dollars they earn from trading with you. Borrow from the central bank, “print money,” and you bring on inflation, with all of its destructive impacts.

All of these have come into play in the present crisis, either in actual effect or, hardly less significant, via the expectations of investors. Indeed, the debt disaster has done much to vindicate one of the dodgier-sounding arguments against fiscal stimulus, known as Ricardian equivalence: the notion that economic actors are so rational as to understand that any money the government borrows now will have to be repaid with higher taxes later, and thus act in such a way—reducing spending, putting off investment—as to offset any initial stimulus. Turns out they needn’t be as far-sighted as all that: already the talk, everywhere, is of higher taxes. Today’s deficits are not just tomorrow’s taxes, but today’s.

And even if you thought deficit spending was the answer to a problem of insufficient aggregate demand, it was hard to see what relevance it had to the credit crisis, which was primarily a problem of supply. As the economist John Cochrane, of the University of Chicago, has written, imagine if several major oil refineries blew up at the same time, leaving gasoline in short supply: “Stimulating people to drive around would not revive gas sales.” All it would do is drive up gas prices. Substitute banks for refineries, and the point becomes clear.

What prevented the crisis from becoming a depression was not fiscal stimulus, but monetary: first, to shore up the banking system—the real “lesson of the Depression”—and second, to prevent a scarcity of liquidity from strangling the economy at a time when people were hoarding cash. That’s demonstrably true in this country, where the recovery had already begun by the second quarter of 2009, long before any of the fabled shovels had hit the ground. If the argument was that central banks, having dropped interest rates near zero, had “run out of bullets,” that, too, has been discredited.

But surely fiscal stimulus, even if it was of no direct benefit, might have had a sort of placebo effect? If nothing else, might not the sight of all that government spending have boosted confidence? Tell it to the Greeks.