“the time has been, that, that when the brains were out, the man would die, and there an end; but now they rise again, with twenty mortal murders on their crowns, and push us from our stools” The Tragedy of Macbeth, Act III, Scene iv
In 1936, John Maynard Keynes offered policy makers what appeared to be a wonderful free lunch that would just keep on giving. He suggested that during periods of recession increases in government spending exert an augmented impact on the national economy. Not only is the national income increased by the initial expenditure, but a follow-on increase in consumption expenditures will multiply that impact. Keynesian optimists pressed the case for high multipliers – as high as 2 in many instances. In such circumstances, an increase in government expenditure by x dollars would impact the economy by 2x dollars. According to Keynes it did not matter whether the stimulus was transient or permanent. The multiplier would always apply.
Politicians are rare indeed who will turn aside the temptation to belly-up to a free buffet. So an extended era of persistent budget deficits began.
The first problem with this line of argument is that government spending must (eventually) be financed. It may be financed immediately by taxes, in which case the balanced budget multiplier at best is equal to 1. Or it must be financed by delayed taxes – inflation or the repayment of the debt – in which case any initial positive multiplier will be penalized by a later negative multiplier.
The second problem is that government spending in a recession almost always redirects resources from more productive to less productive activities. It takes income from households that contribute to the national product to those who do not. It takes income from profitable companies to those who have failed the market test. So, in the balanced budget case, the size of the government expenditure multiplier predictably is below 1. Increasing government expenditure in a recession will lower the rate of growth of national income (where growth remains positive).
Western nations learned this harsh lesson and abandoned hydraulic – or old-fashioned – Keynesian economics during the 1970s. Britain’s Prime Minister, James Callaghan expressed open contempt for Keynesian economics during the late 1970s, as his government confronted electoral defeat in the midst of rising rates of price inflation coupled with increasing unemployment rates and economic stagnation.
Macro-economists responded to this empirical defeat by modeling the macro-economy on the basis of rational expectations, initially along New Classical lines and later on New Keynesian lines. The New Classical School effectively removed fiscal multipliers in their entirety. The New Keynesian School struggled to keep them in play, albeit with a greatly reduced impact
Following the 2008 financial crisis, however, a number of influential New Keynesians abandoned their new insights and crawled right back into the rotting old-Keynesian infrastructure. In the United States, these economists persuaded the dying Bush and the emergent Obama administrations to indulge in a pure Keynesian stimulus junket. Economists across the globe followed suit.
Well the evidence is now in, decisively, that the Keynesian multiplier works in reverse, systematically slowing economic recovery, the more so the higher the levels of government injection into the economy.
Arthur Laffer (The Wall Street Journal , August 6, 2012) draws on IMF statistics to re-bury the Keynesian fiscal multiplier. Here are some of his results relating (B) the change in real GDP growth from 2006-07 to 2008-09 to (A) the change in government spending as a % of GDP from 2007-09 :
United States A = +7.3% B = -8.4%
United Kingdom A=+6.9% B =-11.5%
Japan A= +6.7% B= -10.5%
Australia A= +3.3% B= -3.5%
Poland A= +2.3% B= -6.3%
Laffer’s statistics cover many more countries. Always, the positive stimulus is met with a negative impact on growth rate. For the most part, the larger the percentage stimulus, the larger the negative impact on the growth rate.
Whatever our political leanings, these are facts that cannot easily be ignored.