WASHINGTON, July 25, 2015 − In his July 23 New York Times column, Nobel Prize-winning economist Paul Krugman makes a feeble attempt to justify even greater increases in federal government spending. He says this action is necessary and based on a “resurgence” of economists who follow the Keynesian view on government fiscal policy. This resurgence is led by a group of economists from MIT.
In 1962, Keynesian economists persuaded President Kennedy to cut taxes and increase spending on social programs to stimulate the economy and reduce unemployment. These actions, they said, would increase total demand in the economy, which would, in turn, lead to economic growth.
But what about the increase in the deficit and the public debt that these actions would create? No problem, the Keynesians answered. The debt is owed primarily to other Americans and we can always increase taxes to reduce the deficit if that turns out to be a problem. Besides, unemployment is a more serious problem.
Although the actions Kennedy took did stimulate the economy and eventually reduced unemployment, the resulting increase in demand without an appropriate increase in supply led to the severe and debilitating stagflation problem that dominated the U.S. economy throughout the 1970s.
“Stagflation” is generally understood to be a combination of economic stagnation and inflation, creating an economy characterized by a high rate of inflation and a low rate of growth, exacerbated by high unemployment.
Krugman proceeds to note that, beginning in the late 1970s, and continuing through the 1980s, economists led by Milton Friedman convinced elected officials in the Reagan Administration that deficits are bad for the economy, declaring the only way to solve the stagflation problem was to reduce deficits, deploy monetary policy instead of fiscal policy to stimulate the economy and take action to not only increase demand but also to increase supply.
The result of those actions, which were implemented in 1981, was a 26-year economic expansion (with brief hiccups in 1991 and 2001) characterized by steady growth, low inflation and plenty of job opportunities for those who were prepared to take advantage of them.
Unfortunately, a series of actions taken by the federal government beginning in the 1990s, geared toward increasing the U.S. homeownership rate from a healthy 63 percent of households to 70 percent of households, eventually culminated in a dramatic increase in low downpayment and no-downpayment “liar loans” to unqualified buyers who predictably defaulted in massive numbers. This resulted in a severe financial crisis, which directly led to the steep “Great Recession” that took hold from late 2007 to 2009.
To get out of the recession, the government and the Federal Reserve employed both aggressive monetary and fiscal policies. Ultimately, neither approach has proved very effective, given that the now six-year-old recovery has continued to be extremely weak by historical measures.
Unemployment fell, as the current administration is fond of noting. But the apparent drop in unemployment has occurred mostly because people stopped looking for work and took advantage of the increase in government spending and subsidies that allowed them to collect unemployment payments for extended periods, a cushion further increased by a substantial jump in food stamp eligibility and use, greater welfare expenditures and low- or no-cost health care.
Keynesian economists like Krugman advocated for a massive $1 trillion increase in government spending that was also supposed to stimulate to economy. That stimulus effect simply didn’t happen. The result was an economy that grew at less than a 2½ percent annual rate, dating from the recovery that was supposed to have begun in mid-2009. By way of comparison, for the four years following the more severe 1981 recession, the economy grew at a 4½ percent annual rate.
The deficits incurred by the current administration were so large that the public debt increased from about $11 trillion to over $18 trillion and will grow by another almost half of a trillion this year, but with little corresponding economic growth.
Krugman, like the big government MIT economists, argues that, contrary to the free market view, vastly increasing the money supply would not lead to inflation. Krugman argues these economists are correct since the money supply has exploded and inflation remains mild, even with our current tepid growth.
The real reason for that is because vast increases in the money supply will only cause inflation if the money is able to “multiply” through the banking system. This happens primarily through the money creation function that occurs when banks grant loans.
However, because of the draconian new Dodd-Frank bill, originally meant to rein in big-bank abuses but effectively cutting off loans to all but the wealthiest companies or individuals, lending fell dramatically, reducing inflation pressure in the short term. But what about the long term? And what about the average American who needs a loan and now cannot get one?
The problem with the Keynesians’ view is that it is a short-term solution that creates long-term problems. Spending money that the government does not have could stimulate the economy, but deficits do create problems in the long term. Keynes said to just spend the money. He said it didn’t matter how the money was spent. Just spend it, even if you have to hire workers to “dig holes and fill them up again.”
While that may stimulate the economy today, by paying people who do not produce output, the long-term result is an increase in demand with no increase in supply. That leads to higher prices and no increase in output, or stagflation, the same trap the country endured in the 1970s.
While stagflation may take some time to happen this time around, especially in the environment the current administration has created, it will eventually happen. Likely, it will occur after the current administration leaves office, so another president will be blamed for it.
By the late 1970s, the majority of economists came to understand the imbalances created by Keynesian economics and moved away from that methodology. Today, however, Krugman and the MIT crew want us to return to the early 1970s, which will likely produce the same negative economic environment in our own times.
Experience says that we shouldn’t do it. Logic tells us that continuing to spend money that we don’t have will eventually lead to serious problems, just as we encountered over 40 years ago.