Evidence

“However beautiful the strategy, you should occasionally look at the result.”

Winston Churchill

Sooner or later arguments over policy must actually refer to the real world. England,Portugal, Ireland ,Spain and Greece have adopted policies favored by traditional conservatives in the US. Some of the countries are in crisis because of government squandering financed by borrowing, others by real estate and financial bubbles in the private sector (England, Ireland, and Spain) It may be useful to examine the preliminary results of following these policies. Is fiscal austerity a path to prosperity when starting from a position of financial crisis and severe recession?

The short answer is no. All of the countries listed are in deep recession (in fact one could argue that Greece is in a depression) and recovery is not at hand. Recovery is a complicated process and requires two sets of policies. The first one is aimed at recovery and the second one focuses on sustainability. Once you dig out, you want to stay out.

The shovels are monetary and fiscal policies designed to increase total spending and encourage sustained growth. This task is trickier than it sounds because one must account for the affect of actions on the spending response of the general population to policy actions. This induced effect imposes limitations on the effectiveness of policy. It is possible but not entirely plausible, that private sector, consumers in particular, could take actions that offset fiscal stimulus or fiscal contraction. Evidence for this would be private saving varying inversely with the budget surplus or deficit. This would indicate that changes in consumer spending would act to offset government fiscal policy. This argument is made by some conservative economists. All that is lacking is evidence. The growth in deficits during the Reagan and Bush2 Administrations were not accompanied by increased personal savings rate but by more consumption.

It seems clear that if private sector actions do not fully offset the effects of increased public expenditures or tax cuts the federal actions will increase or decrease total spending, hence GDP. Historical evidence suggests that monetary and fiscal policy do make a difference but not immediately and not of the magnitude once thought. Tax cuts are not totally spent, federal expenditures are generate less additional spending than once thought and the creation of bank reserves do not immediately increase lending by significant amounts. Evidence has tempered views on policy effectiveness. But, less effective does not mean ineffective.

Those who argue that economic healing can only occur through a natural process (Austrian Economists in particular) do not have evidence on their side. If one reviews the evidence on the rate of economic recovery from the Great Depression among the western economies the evidence is strong for proactive intervention. Countries that left the gold standard recovered faster, and those countries that were most expansive in their monetary and fiscal actions recovered more rapidly. The United States and France were among the slowest to recover and followed the most conservative monetary and fiscal policies.

Ben Bernanke the Chairman of the Federal Reserve is a student of the Great Depression and was profoundly influenced by Milton Friedman and Ana Schwartz’s history of monetary fluctuations (A Monetary History of the United States 1867 to 1963). That study provides ample documentation of the Federal Reserve’s policy errors during the Great Depression. In their view, the Fed’s initial monetary restriction in the 1929-33 time period converted a recession into the Great Depression. Their continued conservatism hampered the ensuing recovery. The Chairman’s own academic research has reinforced the Friedman/Schwartz study.

It must be admitted that many of the New Deals economic proposals were economically incoherent ( a view shared by Keynes) and represented  experimentation without theory. But many of the infrastructure and direct employment programs were stimulative, they were just insufficient. For example, the deficits in Reagan’s first term averaged about 4% of GDP. The New Deal peacetime deficit only averaged about 2.6% of GDP. How far we’ve come.