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.
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