Keynesian Euphoria to Budgetary Restraint

Keynesian Euphoria to Budgetary Restraint

It’s been over 5 years since the heights of the financial crises, and yet the global economy still appears to be in a persisting slump. Albeit of the nascent pick up in economic activity amongst the largest economies, mainly China, US and Europe, unemployment in most parts of the developed world remains high, coupled with meagre growth rates. Observing the policy response to the slow recovery only offers reasons to lament.

Although the US government’s budgetary response to the financial crises was crucial in preventing another 1930’s like depression, fiscal policy in most developed economies then on has done little in encouraging a global recovery. Understanding why fiscal policy has been so ineffective may be the first step in finding the causes of the benign recovery. The typical criticism of fiscal policy provides implausible justifications for the limitations of fiscal policy. Starting with crowding out, interest rates have not risen as a result of increase demand for credit by governments financing their budget deficits. Instead interest rates are at historical low levels and most likely will remain that way in the near future.

Moving to the Ricardian Equivalence, it’s said households respond to decrease government taxes by leaving their consumption unchanged from the current period to the future period as they foresee government taxes will rise in the future. Although more likely then crowding out, there may be a better explanation for the failure of household consumption to pick up. As a consequence of the aggressive fiscal policy used in most parts of the world, federal governments of the major developed countries have now accumulated alarming levels of debt.  Now that its time for the US to pay back some of this debt, its inability to do so has severely hurt household and business confidence. Without medium term fiscal reform its unlikely fiscal policy will have any positive impact on the economy mainly in the US, Europe or Japan.

More importantly the use of expansionary fiscal policy beginning in 2008 has revealed the drag of a Keynesian stimulus on aggregate demand in the more medium term when no real recovery in economic activity follows soon after. Japan’s new Prime Minister Shinzo Abe can take an important lesson from this if his new policies fail to stimulate growth in Japan. Without a commensurate rise in economic activity Abe will only be left with more debt and risks an inevitable default if interest rates begin to rise.

Another possible answer for why fiscal policy has not worked is the developed world may no longer be facing a demand side problem but a supply side one spurred on by high levels of unemployment. With half of Spain’s youth unemployed and a stubbornly high unemployment rate in the US much of the developed world has suffered the degradation of many vital skills within the labour force. As many people have remained without a job they have become increasingly despondent in their chances of finding a job and lost many of their skills which are learnt on the job. Undoubtedly this would have worked to pull the full employment level of output inwards, resulting in lower output and employment in the long run.

So what should governments do? Instead of mindlessly spending money on things that don’t enhance our productive capacity, governments should implement smart policies that allocate scarce funds into programs that help the unemployed develop skills which are sought after and useful. Former RBA official Warwick McKibbin urges the Australian government to take advantage of the almost infinite demand for the $AUS by selling treasury bills with low rates of interest. Importantly, McKibbin recognises the government should back these treasuries with physical investment in infrastructure and other programs that enhance the supply side of our economy. If the US, Europe and Japan followed similar lines and adopt a fresh approach, fiscal policy may in fact help address the persistently high levels of unemployment and spark a global recovery.