A highly tangible outcome of the global economic crisis and its first stage, the so-called Great Recession, has been the deleveraging underway by households and businesses throughout major advanced economies. In the United States and United Kingdom, consumers who boosted consumption on the basis of easy credit as opposed to higher disposable incomes are now tightening their belts and battening down the hatches. The predictable result has been a decline in aggregate demand. This is where the neo-Keynesians enter the fray, preaching the gospel of mega-deficit spending by governments.
The classical economic theory as developed by John Maynard Keynes holds that in times of severe economic contraction in the private economy, it is permissible for the sovereign to go into debt and increase spending to compensate for the falloff in consumer and other private sector expenditures. The rationale is that this short-term increase in the public debt will retard the rise in unemployment, limit the impact and duration of the economic recession and in the long run lead to overall better economic performance, with limited effect on the ratio of public debt to GDP. Though advocates and opponents can offer differing views on the historical validity of Keynes and his counter-cyclical concepts of sovereign intervention in the economy, there is no doubt that his theory is intellectually cogent and based on a serious analysis of economic problems, particularly in regards to the Great Depression of the 1930s. However, is the current wave of unprecedented sovereign indebtedness equally cogent? If John Maynard Keynes were still alive, he would likely take issue with the massive tidal wave of red ink being unleashed by politicians as their antidote to the global economic crisis.
Though John Maynard Keynes is portrayed as a deficit-loving interventionist, in reality he was not. What is left out of the description of his theory in regards to counter-cyclical fiscal policy is that Keynes also believed that in times of relative prosperity sovereigns should create budget surpluses. He belief was that booms and busts were an integral characteristic of modern capitalism, and that the accumulation of reserves during times of plenty would enable governments to engage in temporary deficit spending to combat a severe recession, without creating the long-term danger of exploding national debt to GDP ratios. This is an aspect of Keynes’s views on fiscal policy that has been conveniently forgotten by the modern interpreters of Keynesian economics.
Since World War II, the U.S. has seldom run balanced budgets. If generally accepted accounting principles were applied to official U.S. federal government budget reports, which require taking into account future liabilities for Social Security and Medicare, then during this period the United States has always run large fiscal deficits, even during times of relative economic prosperity. What this means in reality is that the conditions laid out by John Maynard Keynes for allowing a sovereign to engage in deficit spending during a recession, namely building budget surpluses during periods of economic expansion, have never been adhered to.
During the Great Depression, the U.S. government did engage in substantial deficit spending within the framework of the New Deal, but with a ratio to GDP far lower than what is currently occurring on President Obama’s watch. This fiscal policy was engaged in with a cumulative national debt to GDP ratio nowhere near the current level, and with a large base of domestic savers prepared to buy U.S. government debt, in contrast with the present day reliance on foreign buyers of U.S. Treasury Bills.
If John Maynard Keynes were alive today, I suspect he would be horrified at the manner in which his economic theories have been distorted, and the likely outcome of such fiscal profligacy.