Keynesians like Paul Krugman and Simon Wren-Lewis have been working overtime in defence of their beliefs. The anti-Keynesian attack began before Christmas, when U.K. Chancellor of the Exchequer George Osborne wrote in the WSJ that Keynesians wanting more spending and more borrowing “were wrong in the recovery, and they are wrong now.” The attack continued when John Cochrane penned a WSJ opinion piece denouncing the efficacy of government stimulus. In it, he pointed to the fact that the US has grown despite austerity as proof that deficits are not only useless but harmful.
Krugman began his rebuttal by stating that demand is affected by many variables. In a word, he reminded everyone that correlation is not causation: just because growth was positive while the government retrenched doesn’t mean that austerity was responsible for, or even helped, this growth. Somewhat bizarrely, he then uses a scatter plot showing a negative correlation between changes in government spending and GDP growth to “prove” his point. In other words, he channels the very same correlation method he debunked in the first place.
A similar incoherence pervades Mainly Macro, where Simon Wren-Lewis defends the Keynesian position with an epic display of circular logic. Wren posts a graph showing how growth would have been greater without austerity, which starts, amazingly, from the assumption that austerity hampers growth.
The problem is that both sides can’t scientifically prove their arguments. Perhaps it’s this desire for “proof” that explains Krugman’s recent return to what us finance types call Garbage In Garbage Out (GIGO) New Keynesian models. Krugman’s goal is for these models to strengthen his policy proposals with a good dose of math. In fact, these models no more prove his position than New Classical (RBC) models prove the case against stimulus.
All of this begs the question: are Krugman and other Keynesians after scientific rigor or public credibility? Economic policy, after all, is about winning a debate. And it’s often easier to win a debate with complex models and graphs that show clear correlations than it is through common sense. The Keynesians know this because this is what their enemies have been doing for years. They saw first hand — with open, incredulous mouths, I’m sure — how the correlation study in Reinhart and Rogoff’s This Time Is Different was used to justify the disastrous austerity program unleashed on peripheral Europe.
For me, economics should be based, first and foremost, on common sense. Common sense is the only proof of the efficacy of Keynesian deficit spending that we should ever require.
Common sense is what leads me to believe, for instance, that the “stimulus doesn’t work” argument is absurd. This argument is premised on the idea that any increase in government spending will be exactly (or mostly) offset by a decrease in private sector spending. Why would the private sector do this? Because rational individuals will expect the government to raise taxes in the future to repay its debt. So if the government increases deficit spending by $100, the private sector will decrease spending by $100. Stimulus, in other words, will have no effect on demand.
Krugman demolished this concept — what economists call “Ricardian Equivalence” — by pointing out how it fails even on its own terms. Even if people behave like this, he argues, government deficit spending (at least the short and sharp kind) would still boost demand.
But Krugman shouldn’t have felt the need to tackle the idea on its own terms. People simply don’t behave like this. It’s common sense. Its terms, in other words, are ludicrous. I have friends from all walks of life, and I can say that not a single one of them takes the government deficit into account when deciding how much to spend. Even the ones who work in financial markets — the ones who see deficit news daily — don’t take the budget into account when deciding how many bottles of Bolly to spray into their Saint Tropez swimming pool.
The only element of Ricardian Equivalence that makes sense is in regards to a tax-cut stimulus. Since people interact with taxes very closely, it is easier to see how they might react in the way described above: by saving the tax cut in anticipation of a future tax rise.
But government deficit spending? Come on.
The irony is that Keynesian stimulus has enough real problems for anti-Keynesians to attack without having to resort to intellectual mysticism. There is the problem of miscalibration — what’s too little stimulus, what’s too much stimulus? As well as the problem of government waste — do we really need another bridge to nowhere?
Another problem with Keynesian stimulus, one that’s often overlooked, is philosophical. In our current monetary system, there are times when government deficit spending, often on an enormous scale, is an absolute necessity. And it’s this necessity that impedes our right to choose the size of government we want.
To explain, let’s imagine a country that has just suffered a financial crisis and requires a deficit equal to 10% of GDP to prevent catastrophic unemployment. For this to occur, we would need a government large enough to swiftly implement this level of stimulus. And in a country suffering from secular stagnation, these deficits may well be needed in perpetuity. In other words, voters are no longer choosing between a big government and a small government, but between a big government and a crashing economy.
This cost of Keynesian stimulus, and the many others I discuss in my book, are just some of the reasons we should consider adopting a neutral monetary system. Under neutral money, regardless of whether the government is big or small, or in deficit or surplus, demand is always at the full employment level.