A Familiar Siren Song

Old Keynesian ideas on fiscal policy that we thought had been put to bed half a century ago always seem to make an unexpected comeback during times of economic crisis and unfortunately, this crisis is no different.

Recently, economists, politicians and others have been singing a familiar song, including making bold claims about large government spending multipliers, hailing the reemergence of Keynesian economic models, and criticizing calls for fiscal consolidation (that is, the reduction of government deficits and debt accumulation). The fact that this way of thinking has consistently done more harm than good to the economy is forgotten or at least ignored.

Born during the Great Depression of the 1930s, Keynesianism is the assertion that aggregate demand—measured by total spending of government, households, and businesses—is the most important driving force in the economy. Keynesians contend that government stimulus spending can, therefore, stabilize a country’s ailing economy and help it achieve full employment and price stability.

The latest push for Keynesian “solutions” is coming at a time of unprecedented and unsustainable growth in government spending and public debt in response to the economic crisis induced by COVID-19.  As policymakers face the challenge of consolidating the nation’s fiscal finances back to sustainable levels, they will inevitably face staunch opposition from the Keynesian critics of fiscal consolidation.

The standard Keynesian argument against reducing government spending and deficit is that doing so reduces aggregate demand and therefore slows economic growth. As a result, Keynesians argue, reducing government spending can cause recessions.

The Keynesian theoretic orientation stands in direct contrast to mainline economic theories that emerged over half a century ago. Economist James Buchanan had previously sought to explain how debt-financed spending today, as opposed to tax-financed spending, was akin to shifting the tax burden forward in time. By financing current spending through borrowing, current taxpayers experience artificially low tax rates that are offset by higher taxes paid in the future to gradually reduce the debt.

In the 1970s, economist Robert Barro published an article in the Journal of Political Economy theorizing an idea similar to that of Buchanan, but ultimately coming to a different conclusion. Barro asserted that when the government finances its spending through borrowing, forward-looking economic agents will internalize these changes when making decisions about consumption, savings, and investment.

In challenging the Keynesian orthodoxy, mainline and new classical economists steered the economics of public debt financing away from Keynesian theories in the 1970s. This shift in economic thought occurred on an international scale. Even the socialist prime minister of the United Kingdom proclaimed at a Labour Party Conference in 1976, “You cannot now, if you ever could, spend your way out of a recession.”

Among economists specializing in fiscal consolidation research, the non-Keynesian view of public debt financing has become known as the “expectations view,” in which an action today presages certain actions in the future. One study from the early 1990s explains the key characteristic of the expectations view:

“Nonstandard effects of fiscal policy are explained by the role of current policy in shaping expectations of future policy changes. . . . A cut in government spending induces expectations that future spending and therefore taxes will be significantly lower.”

Over the past three decades, there has been a growing literature observing episodes of fiscal consolidation and how spending-based adjustments effect changes in consumption and investment.

One of the earliest studies attempting to answer this question is by Italian economists Francesco Giavazzi and Marco Pagano. The authors observed episodes of fiscal adjustment in 10 developed countries in the 1980s to determine whether the Keynesian view or the expectations view does better at explaining the effects of fiscal adjustment on private consumption. Contrary to the Keynesian view that reductions in government expenditure contract aggregate demand, thereby increasing unemployment and dampening business investment, the authors observe how positive effects of deficit-reduction resulting from a future outlook might outweigh any negative Keynesian effects. The authors conclude that “Strong actions to reduce a budget deficit may boost demand and growth, not just in the long run but even over the phase of the fiscal consolidation.”

A prominent Italian economist, the late Alberto Alesina, found the same dynamic at work in more than a dozen studies on the subject over a period of more than two decades. Contrary to the Keynesian view that fiscal adjustments are contractionary, the results of every one of Alesina’s studies suggest that consolidation achieved primarily through spending reductions often have expansionary effects.

The newest addition to the academic literature on fiscal consolidation is a 2020 working paper by John Cogan, Daniel Heil, and John Taylor (all of the Hoover Institution) that considers an illustrative fiscal consolidation in the United States. The authors run a simulation where the debt-to-GDP ratio is lowered to pre-pandemic levels and find that the consolidation plan boosts short-run annual GDP growth by as much as 10 percent and increases long-run annual GDP growth by about 7 percent.

What is arguably most significant about this latest study is the channels through which output is driven higher after the consolidation takes place. The main reason that output rises in both the short and long term is that consumption rises significantly. The authors note,

“Because households are forward looking, they expect of higher after-tax incomes in the future. The increased consumption offsets any other demand side effects. That the change in policy is announced and is thereby known is important for this result.”

As the US economy recovers from the COVID-19 economic crisis and public debt levels outpace national economic output, policymakers should avoid returning to the outdated Keynesian ideas of fiscal stimulus and public debt financing. By instead acknowledging the expectations view and decades of academic research, we should be wary of the ways in which continued deficit-financed spending will stifle our economic recovery.

It is time policymakers put outdated Keynesian ideas to bed and look to consolidate the nation’s fiscal finances with the guidance of proposals offered by Hoover’s Cogan and like-minded economists.

Image Credit: Ulysses and the Sirens (1880)/Getty Images