Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right. After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition.
Economic advisers assured their bosses that recovery would be rapid. And there was some revival; but then it stalled in 2010. Meanwhile, governments were running large deficits – a legacy of the economic downturn – which renewed growth was supposed to shrink. In the eurozone, countries like Greece faced sovereign-debt crises as bank bailouts turned private debt into public debt.
Attention switched to the problem of fiscal deficits and the relationship between deficits and economic growth. Should governments deliberately expand their deficits to offset the fall in household and investment demand? Or should they try to cut public spending in order to free up money for private spending?
Depending on which macroeconomic theory one held, both could be presented as pro-growth policies. The first might cause the economy to expand, because the government was increasing public spending; the second, because they were cutting it. Keynesian theory suggests the first; governments unanimously put their faith in the second.
The consequences of this choice are clear. It is now pretty much agreed that fiscal tightening has cost developed economies 5-10 percentage points of GDP growth since 2010. All of that output and income has been permanently lost. Moreover, because fiscal austerity stifled economic growth, it made the task of reducing budget deficits and national debt as a share of GDP much more difficult. Cutting public spending, it turned out, was not the same as cutting the deficit, because it cut the economy at the same time.
That should have ended the argument. But it did not. Some economists claim that governments faced a balance of risk in 2010: Cutting the deficit might have slowed growth; but not committing to cut it might have made things even worse.
The Keynesian remedy, the argument went, ignored the effect of fiscal policy on expectations. If public opinion believed that cutting the deficit was the right thing to do, then allowing the deficit to grow would annul any of its hoped-for stimulatory effect. Expecting that taxes would have to rise to “pay for” the extra spending, households and companies would increase their saving. Fearing sovereign defaults, bond markets would charge governments punitive interest rates on their borrowing.
And here was the clincher: By committing themselves to fiscal tightening, finance ministers gave themselves scope for some fiscal loosening. Proclaiming fiscal virtue enabled them to practice fiscal vice. They could create a fiscal illusion by cutting less than they promised. Most finance ministers did exactly that.
This is part of the mess into which macroeconomics has gotten itself. Once beliefs and expectations are introduced into economics, as is surely reasonable, the results of fiscal policy become indeterminate. Too much depends on what people think the results of the policy will be. In the economists’ lingo, policy results are “model-dependent.” 1
The Nobel laureate economist Paul Krugman has poured scorn on what he calls the “confidence fairy,” the claim that fiscal policy must command the support of the bond markets. But to show that actual policy made things worse does not mean that a better policy was actually available. The right policy’s success may depend on the public’s expectations of its effects. The unanswered question is why the public should have the wrong expectations.
If fiscal policy is in a muddle, so is monetary policy. Central banks have tried to avoid the confidence fairy by printing money – technically, by buying government bonds on the secondary market. The extra money is expected to percolate through the economy, quickening activity. The European Central Bank has just started a €1.1 trillion ($1.17 trillion) bond-purchase program to bypass the German veto on fiscal expansion.
But the effects of so-called quantitative easing also depend on expectations. If giving businesses extra cash makes them more confident, they will spend more. If they mistrust the policy, they will hoard the cash.
The results of quantitative easing in the United States and the United Kingdom have been equivocal. Governments, it is true, could get their money cheaper as yields fell. But banks were not lending the money made available to them, partly because they used it to pay down their own debts, and partly because of low demand for loans.
The main positive effect of quantitative easing was on asset prices – chiefly financial assets. But greater wealth for the rich does not necessarily produce much extra spending. It does increase inequality and threaten asset bubbles, which could lead to a new financial crash.
So we enter the post-crisis era without any settled view on the right macro policy for either recovery or prevention of future meltdowns. Great hopes are pinned on better financial regulation to stop excessive credit creation. But what is “excessive”? Will central banks continue to target 2% inflation? Or should they rely on a “nominal income” target? What should the new fiscal rules be, and how – in the eurozone – should they be enforced?
Economists debate whether market economies are naturally stable. As a Keynesian, I firmly believe that market economies need to be stabilized by policy. But Keynesians have to face the uncomfortable truth that the success of stabilization policies may depend on the business community having Keynesian expectations. They need the confidence fairy to be on their side.