Are We All Keynesians Again?

The stimulus measures adopted in late 2008 and early 2009 are excessive and largely of the wrong kind. It would have been better to accelerate desirable structural changes, such as permanent tax reform, which improve incentives for individuals and businesses.

The unfolding global economic debacle has led many governments, including our own, to reach into their policy toolkits for fiscal stimulus measures. In doing so, they have revived fiscal policy as a counter-cyclical tool, which was so much in vogue until the early 1970s that Richard Nixon famously declared ‘We are all Keynesians now.’

Are we all Keynesians again?  At first sight, fiscal pump priming might appear to have a lot going for it in current conditions: inflation is receding; spare capacity is increasing, at least in the major developed economies; and the crisis in the banking system is weakening conventional monetary policy.

Even so, the revival of activist fiscal policy ought to be highly controversial because the 1970s and 1980s saw a new consensus emerge that it was ineffective or even damaging. The lessons from that era remain valid today but are being ignored by governments desperate to prop up sagging economies. 

The criticisms of counter-cyclical fiscal policy can be summarised as follows:

• Stimulus measures do not have the ‘multiplier’ benefits often attributed to them. Temporary and one-off handouts fail to stimulate consumer spending because households are guided more by notions of their permanent income and wealth. In the current climate, temporary windfalls are especially likely to be saved, not spent.
• More broadly, increased government spending ‘crowds out’ the private sector in various ways, resulting in multipliers of less than unity and perhaps close to zero; even when there is spare productive capacity. The mechanisms of crowding out include Ricardian equivalence, interest rate and exchange rate effects of increased government borrowing, supply side responses, and damage to private sector confidence.
• The timing of the policy action is often wrong. The lags are such that by the time a stimulus package has its effect, the need may have passed. Even if that does not turn out to be the case this time, history suggests that policy makers will keep stimulating for too long.
• Although meant to be temporary, stimulatory measures typically become entrenched and enlarge the role of government. When the stimulus is eventually withdrawn, higher government spending remains and taxes are increased. To some this is benign, but to others bigger government is harmful to economic efficiency and growth. Historically, wars, depressions and other cataclysmic events have set the scene for a permanent enlargement of government.
• Stimulatory measures are often of a kind that distort resource allocation and impose lasting economic efficiency costs. Governments that are in a mood to increase spending in a hurry attract sectional interests and fail to subject proposals to proper scrutiny in the public interest.

The collapse in private sector confidence in recent months is a critical factor in the downturn. Fiscal stimulus will not on its own restore confidence. It may even deepen and prolong the damage if it creates such large fiscal deficits and levels of public debt that strong corrective measures will be needed in the future. At best, a stimulus will reduce the scale of production and job losses pending restoration of conditions for a sustained recovery.

The strength of Commonwealth finances carried forward from the boom provided opportunities for a credible and effective loosening of fiscal policy in Australia. Instead, the stimulus measures adopted in late 2008 and early 2009 are excessive and largely of the wrong kind.  It would have been better to accelerate desirable structural changes such as permanent tax reform, which improve incentives for individuals and businesses.

In the United States, which holds the key to the global downturn and recovery, public finances are already a shambles with record post-war deficits, federal debt at 40 per cent of GDP, and a huge unfunded future liability for social security and Medicare entitlements. Coming on top of this, the new administration’s fiscal stimulus package seems destined to be of little short-term benefit and will compound the structural fiscal weakness, which portends serious longer term problems.

The administration should concentrate on restoring the banking system to health.  The restoration of confidence hinges on a return to some semblance of normality in the banking system. Unorthodox uses of public funds such as those we have already seen may be part of the solution, but such measures differ from orthodox fiscal stimulus.

There are many reasons for us not all to be Keynesians again, even if we all were – as Nixon asserted – forty years ago. The challenges to short-term fiscal activism in the intervening period were profound and have not been overturned by the current global economic debacle. Discretionary fiscal stimulus can be beneficial in limited circumstances, but the obstacles to its successful use are formidable, and the benefits at best modest.

(This is an extract from a CIS report Are We All Keynesians Again? by Robert Carling)

Robert Carling is a Senior Fellow at the Centre for Independent Studies. He was Executive Director, Economic and Fiscal at the New South Wales Treasury from 1998 to 2006. He was a senior official with the New South Wales Treasury until 2006 and prior to that with the CommonwealthTreasury, the World Bank and the International Monetary Fund. He holds academic qualifications in economics and finance from the London School of Economics and Political Science, Georgetown University and the University of Queensland.

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