From Niall Ferguson at The Financial Times:
To those of us who first encountered the dismal science of economics in the late 1970s and early 1980s, the current debate on fiscal policy in the western world has been – no other word will do – depressing.
It was said of the Bourbons that they forgot nothing and learned nothing. The same could easily be said of some of today’s latter-day Keynesians. They cannot and never will forget the policy errors made in the US in the 1930s. But they appear to have learned nothing from all that has happened in economic theory since the publication of their bible, John Maynard Keynes’s The General Theory of Employment, Interest and Money, in 1936.
In its caricature form, the debate goes like this: The Keynesians, haunted by the spectre of Herbert Hoover, warn that the US in still teetering on the brink of another Depression. Nothing is more likely to bring this about, they argue, than a premature tightening of fiscal policy. This was the mistake Franklin Roosevelt made after the 1936 election. Instead, we need further fiscal stimulus.
The anti-Keynesians retort that US fiscal policy is already on an unsustainable path. With the deficit already running at above 10 per cent of gross domestic product, the Congressional Budget Office has warned that, under its Alternative Fiscal Scenario – the more likely of the two scenarios it publishes – the federal debt in public hands is set to rise from 62 per cent of GDP this year to above 90 per cent by 2021. In an influential paper published earlier this year, Carmen Reinhart and Kenneth Rogoff warned that debt burdens of more than 90 per cent of GDP tend to result in lower growth and higher inflation.
The Keynesians retort by pointing at 10-year bond yields of around 3 per cent: not much sign of inflation fears there! The anti-Keynesians point out that bond market sell-offs are seldom gradual. All it takes is one piece of bad news – a credit rating downgrade, for example – to trigger a sell-off. And it is not just inflation that bond investors fear. Foreign holders of US debt – and they account for 47 per cent of the federal debt in public hands – worry about some kind of future default.
The Keynesians say the bond vigilantes are mythical creatures. The anti-Keynesians (notably Harvard economics professor Robert Barro) say the real myth is the Keynesian multiplier, which is supposed to convert a fiscal stimulus into a significantly larger boost to aggregate demand. On the contrary, supersized deficits are denting business confidence, not least by implying higher future taxes.
And so the argument goes round and around, to the great delight of the financial media as the dog days of summer set in.
In some ways, of course, this is not an argument about economics at all. It is an argument about history.
When Franklin Roosevelt became president in 1933, the deficit was already running at 4.7 per cent of GDP. It rose to a peak of 5.6 per cent in 1934. The federal debt burden rose only slightly – from 40 to 45 per cent of GDP – prior to the outbreak of the second world war. It was the war that saw the US (and all the other combatants) embark on fiscal expansions of the sort we have seen since 2007. So what we are witnessing today has less to do with the 1930s than with the 1940s: it is world war finance without the war.
But the differences are immense. First, the US financed its huge wartime deficits from domestic savings, via the sale of war bonds. Second, wartime economies were essentially closed, so there was no leakage of fiscal stimulus. Third, war economies worked at maximum capacity; all kinds of controls had to be imposed on the private sector to prevent inflation.
Today’s war-like deficits are being run at a time when the US is heavily reliant on foreign lenders, not least its rising strategic rival China (which holds 11 per cent of US Treasuries in public hands); at a time when economies are open, so American stimulus can end up benefiting Chinese exporters; and at a time when there is much under-utilised capacity, so that deflation is a bigger threat than inflation.
Are there precedents for such a combination? Certainly. Long before Keynes was even born, weak governments in countries from Argentina to Venezuela used to experiment with large peace-time deficits to see if there were ways of avoiding hard choices. The experiments invariably ended in one of two ways. Either the foreign lenders got fleeced through default, or the domestic lenders got fleeced through inflation. When economies were growing sluggishly, that could be slow in coming. But there invariably came a point when money creation by the central bank triggered an upsurge in inflationary expectations.
In 1981 the US economist Thomas Sargent wrote a seminal paper on “The Ends of Four Big Inflations”. It was in many ways the epitaph for the Keynesian era. Western governments (not least the British) had discovered the hard way that deficits could not save them. With double-digit inflation and rising unemployment, drastic remedies were called for. Looking back to central Europe in the 1920s – another era of war-induced debt explosions – Professor Sargent demonstrated that only a quite decisive policy “regime-change” would bring stabilisation, because only that would suffice to alter inflationary expectations.
Those economists, like New York Times columnist Paul Krugman, who liken confidence to an imaginary “fairy” have failed to learn from decades of economic research on expectations. They also seem not to have noticed that the big academic winners of this crisis have been the proponents of behavioural finance, in which the ups and downs of human psychology are the key.
The evidence is very clear from surveys on both sides of the Atlantic. People are nervous of world war-sized deficits when there isn’t a war to justify them. According to a recent poll published in the FT, 45 per cent of Americans “think it likely that their government will be unable to meet its financial commitments within 10 years”. Surveys of business and consumer confidence paint a similar picture of mounting anxiety.
The remedy for such fears must be the kind of policy regime-change Prof Sargent identified 30 years ago, and which the Thatcher and Reagan governments successfully implemented. Then, as today, the choice was not between stimulus and austerity. It was between policies that boost private-sector confidence and those that kill it.