Do the facts matter? The Austerity Fail!


Another in the series of findings that suggest a balanced economy leads to better economic results from an article I wrote for YC Magazine and posted on the site here.


I have reproduced the original article from

This post is a reprint from YC Magazine February 2014  Politics section — The Democratic Commentary, page 50, by John Sharp.

Short summary — conventional “neoclassical” economic theory predicts that government policies of austerity should best cure a recession while preventing inflation. Five years of actual results suggest this is false — countries whose policies led to larger deliberate stimulus and larger safety net payments have recovered faster from recession.

The article then points to Professor Narayana Kocherlakota, who was appointed to the US FED as a proponent of austerity to prevent inflation, a respected economics academic who had firmly supported the “fresh-water” economics school belief that massive stimulus and “printing money” would lead to massive inflation. Since that has not happened, though the theory suggests it MUST, he actually now questions the old orthodoxy.

He is a rare economist willing to examine real outcomes and try to make his theories match reality. To save our economy we need more like him. Keep a watch for Professor Kocherlakota’s name in the news, for he is attempting to push the FED (and Congress) in directions that produce real economic growth.

Economics and stimulus – is there reality beyond our beliefs?

Opinion polls of ordinary Americans find them deeply confused on the place of economics in government, even being accused of engaging in “magical thinking.” In the abstract many will say they want smaller government and a balanced budget, yet still insist that government must maintain social security, spend more on defense, and “keep hands off my Medicare.” Even when pollsters force the issue by asking people to choose between programs and budget cuts, many insist that the government should and must do both!

The old post World War II consensus was that the Federal Government could act as an economic stabilizing force, by funding programs that promote economic growth (GI Bill, National Science Foundation funding of college and high school science, VA and FHA loans, development of Nuclear Power, funding basic research that produced the Internet and electronic components, the basis for the Silicon Valley computer industry), and programs that built the US infrastructure (airports, hospitals, Interstate Highway, sewage treatment), etc.

People also believed that during recessions government should “prime the economic pump” by spending more on projects, giving the unemployed money to spend on basics, extra funds to states to keep policemen, firefighters, and teachers employed, etc. This generally was known as “Keynesian Economics,” and provided government tools to assist in recovery from recessions.

However during the 1970s a strong opposing economic theory (sometimes called the New Classical Economics) developed at the University of Chicago and insisted the Keynesian model was flawed. This view began to dominate the teaching of Economics departments and to become part of the GOP economic philosophy. For example, Professor Eugene Fama in 2009 in Bailouts and Stimulus Plans argued that:

If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.

In contrast the Keynesian theory says that with demand depressed by recession, money retained by the private sector will not be spent as quickly as during prosperity. Because sales are down, workers will be laid off. Revenues will decline, as will taxes collected. Without Federal help, most states will fire workers. Estimates are that over 700,000 public employees, about half of them teachers, have been laid off since 2008. This further reduces purchases, lengthening the recovery period. So under recession conditions fiscal stimulus will not take money from the private sector, since demand is so low they rationally are not expanding. The best way to “reboot” the economy is through government stimulus. Under recession conditions such expenditures grow the GDP while not shoving out private investment, which will remain low until the economy improves.

Which approach gives a better description of “reality” could in principle be settled by focused studies. The point of an economic theory is to make predictions, forecasts, of what will happen under various economic conditions and thus help describe public policies that will shorten a recession, reduce unemployment, boost economic activity and grow tax revenues.

In general a number of serious studies giving results that support the Keynesian position have changed few minds! The difficulty is a very human one: scholars (and politicians) become believers in what they have learned, tend to talk only with folks who already believe as they do, and thus have difficulty in changing their views. We now have five years of new studies describing the impact of government actions on the recovery from the 2007 major recession; we still have economic theory gridlock with few convinced by new studies to change their views.

An exception might be Narayana Kocherlakota, President of the Minneapolis Federal Reserve Bank (FED), considered one of the world’s foremost macroeconomists. As a professor he signed an open letter in September 2008 expressing “great concern” about the government’s efforts to save financial firms from collapse, and another in January 2009 opposing the Obama administration’s fiscal stimulus plan. Fellow economists helped get him appointed to the Fed because he opposed stimulus.

After he joined the Fed, his speeches focused on the expected exponential growth in inflation, given stimulus activities and a large Federal deficit. Contrary to his prediction, inflation slowed. Professor Kocherlakota then began to question why his theory gave bad forecasts. He became more open to counter-arguments. He recently announced that he is now convinced his earlier theories were wrong; instead low demand keeps unemployment high and inflation low. Thus he flipped from a supply-side classical economist to more of a Keynesian one, suggesting we have many tools to accelerate economic recovery that we must now use.

The economic debate thus continues. Getting the “right” policies that improve the economy will get more people back to work faster. If Keynesian principles speed recovery, we have the power to end the current Congressional gridlock and put more people back to work.

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