Keynesians vs Austerians in the wake of the Great Recession:

Great Debates
1

Looks like the Keynesians won that debate in a rout, if we compare results to previous predictions.

*Well going on 10 years later, the evidence is in: The anti-Keynesian forces have been proved conclusively mistaken on every single argument. Their refusal to pick up what amounted to a multiple-trillion-dollar bill sitting on the sidewalk is the greatest mistake of economic policy analysis since 1929 at least.

Let’s take the culprits in turn.

The contrarianism began in earnest in early 2010, when two papers were published apparently finding that austerity — increasing taxes and/or cutting spending to reduce the budget deficit — was actually beneficial. First, economists Alberto Alesina and Silvia Ardagna outlined a theory of “expansionary austerity,” arguing that governments could increase taxes, cut spending, and grow strongly. Meanwhile, economists Carmen Reinhart and Kenneth Rogoff demonstrated an apparent trigger point of a 90 percent debt-to-GDP level beyond which more borrowing would cause economic stagnation.

Both of these papers turned out to have major conceptual problems. Alesina and Ardagna basically cherry-picked their data, using unusual cases in which countries were not suffering a recession or could export their way out of problems. Reinhart and Rogoff got their causality backwards, and even had a humiliating Excel formula error that badly dented their correlation.

More clues that Alesina, Ardagna, Reinhart, and Rogoff got everything wrong can be found in the real world, where the Obama administration’s modest stimulus package, while too small to fix the Great Recession entirely, did make things much better. Conversely, the European countries that subjected themselves to severe austerity regimens saw their employment and production collapse, just like Keynes would have predicted. Greece, in particular, has suffered economic disaster considerably worse than the Great Depression in terms of output and unemployment.*

2

The evidence is overwhelming that there are times of insufficient aggregate demand, which depress output and total spending in the economy.

Nevertheless, that article makes a poor argument. Just one example.

There’s a famous graph from Christina Romer about what the unemployment rate would be “with and without the recovery plan”. The recovery plan passed, and unemployment was higher than even the worst-case scenario with the plan.

Now here’s the problem.

A person in favor of that stimulus, who believes it helped, will think that the idea behind the graph was fundamentally right, it’s just that the size of the downturn was miscalibrated. “We didn’t do enough, given the actual size of the problem.” But a person who doesn’t believe that particular recovery plan helped much is going to look at that same graph and say that “obviously” the plan was useless and that it didn’t do anything. The plan passed, yet the downturn was worse than even the worst-case scenario without the plan. This is the problem with counterfactuals. Comparing Keynesian fiscal policy in Europe to the US isn’t necessarily going to help, either, because monetary policy was also extremely different in the two regions: the ECB, for example, raised interest rates repeatedly even when the economy was still in the shitter. How do you statistically control for that? The author doesn’t even seem to be aware of this issue, let alone fairly compare the two different types of stimulus.

Bottom line here is that the world is complicated, and the way we simplify it inside our heads is going to influence our conclusions. The same pieces of data are going to be interpreted differently by people who look at the world with different lenses.

It’s extremely easy to complain that the outgroup has a bunch of shit lenses, and they need to get their thinking straight. But I could personally say exactly the same thing about most “pop Keynesians”. I can promise you that I’ve looked at the data more than 99.99% of other people. I am personally a firm believer that aggregate demand fell drastically, and there was much more that the government could do, but I still don’t think that particular recovery plan did very much (even tho I do believe it was worth trying). So, how do we find out who’s right? It’s not going to be by cherry-picking a few papers or graphs. I didn’t cite that graph about to “prove” Keynesianism wrong, I cited it to point out how difficult all this stuff is, even for the people who study it professionally.

It would be really, really nice to prevent future depressions.

In order to do that, we need to get people to agree about what’s going on, so that we agree on a solution. This article doesn’t do that. It doesn’t even try. It’s just a victory dance in the endzone. Now, I say all this fluffy stuff, but I’m not actually any good at this persuasion stuff myself. I don’t know how it works. But obviously, it’s pretty important. And the article doesn’t really try.

3

Yeah, I agree with you that a collapse in demand was the problem after the initial crash. We had a housing bubble that popped, and people’s investments were left in tatters and they were paying down debt all simultaneously, and left a huge hole in demand in the economy. I don’t necessarily think the article did a great job or bad job. Books could - and will be - written about how wrong austerity & hard-money policies were during the Great Recession. I think it’s worth pointing out though that one side was almost completely wrong in their predictions, while the other side was either right or only wrong in shades.

When interest rates hit the zero lower bound, then standard monetary policy becomes ineffective. And in ZLB conditions, government can borrow without driving up interest rates. Monetary base can be increased without debasing the currency. And in a world with low demand, austerity is not expansionary. Matter of fact, when rates are at zero, that’s the best time to borrow money and try to induce demand.

I think economists that held that view were mostly proved right. We can talk about the impact of Bush’s TARP and initial stimulus, Obama’s stimulus, or of Bernanke’s QE program, and discussions can be had about how effective or ineffective any of those programs were.

4

You are claiming that the evidence that shows the actual unemployment rate after their policy was enacted being worse than the hypothetical rate if nothing was done shows that they were right in their prediction? The same side that claimed the Federal government sequester would cost 700,000 jobs in 2013 when the actual unemployment rate fell 16%? That is remarkably generous.
What is the evidence that monetary policy is ineffective at the ZLB? The effectiveness of QE even at very low interest rates shows that monetary policy is still effective. The contrast with uneffectivenesss of the Obama fiscal stimulus shows that it is not only still effective but much more effective than the alternatives.

5

I can’t tell if the OP is talking about Austerity, which is a theory of how to right the challenges of a faltering economy facing poor fiscal management, or whether it’s talking about the Austrian school of economics. The two have some overlap, but they are not synomous at all.

I’ve also seen a lot of crowing rom the Keynesianists, which I find predictable but strange. Keynesnism wasn’t followed, or at least wasn’t followed very well, the specific recomendations of Keynes were largely ignored, and the predicted path out of the financial crisis didn’t follow the expectations of Keynesianists at all. Their responses seems to be looking at what did occur and then declaring that they totally meant for that to happen, handwaving over years of painful economic adjustments.

I think it’s worth it to look at two opposing viewpoints on economic recessions to see what they think. To Keynes, recessions were fundamentally psychological. He argued there would be no significant underlying problem in an economy, and therefore a recession was caued by waning confidence causing a self-fulfiling situation. So we required was just a push to restore consumer confidence. The government was the logical group to be responsible for this push.

On the other hand, Freidrich Hayek argued that recessions were caused by bad investments, capacity allocating incorrectly, or optimistism running into madness until the economy was badly bent out of shape - and once credit was stretched to the limit, the reality suddenly cut through optimism and deception like a ray of sunlight burning away a mist. To Hayek, government atempts to spark the economy were doomed; the problems would run deeper and had to be worked out the hard way - but they would be worked out.

Was Keynes right or wrong? Was Hayek?

Well, I don’t aim to resolve an ongoing decades-old debate. For myself, I do think that Hayek was closer than Keynes. It’s pretty obvious that there was a real, deep rot going into the financial crisis, and that it had to be worked out. And the government poured in vast sums of omoney, yet it’s not obvious whether any of it did real good, or whether it was simply temporarily easing the pain with the power of the purse.

Further, something else happened which we did not experience before, and it may be a long time before we truly know the outcome if we ever can: Partly because the crisis was financial, national banks became one of the primary parties taking action. It does seemed to have worked, but potentially at a high cost. The actions taken may have efectively socialized the costs of private malinvesment, while at the same time furthering long-term inequality. But as I said, it’s a pretty unclear topic, and we can’t exactly go back in time to run controlled experiements in this case.

6

I said “standard” monetary policy doesn’t work at the ZLB. The QE program is not standard policy. I supported QE, but it’s not a standard policy by any means.

7

QE is increasing the monetary supply. Increasing the monetary supply is standard policy, the means is just different.

8

Both are partially right. Recessions are caused by a mismatch between demand and supply of money. This mismatch can be caused by malinvestment, such as the housing bubble or poor management of the money supply such as during the Great Depression. However, once they start recessions can be psychologically self sustaining as people are more afraid to invest and unemployment spikes because of the money illusion.

9

QE is widely known as unconventional monetary policy. Here’s an article from the St. Louis FED that talks about it.

10

OK, but the fact that Keynesian policies weren’t followed or weren’t followed well isn’t an argument against Keynesian economics. All that means is that Keynesian policies are not popular politically. It’s a political problem more than an economic model problem.

11

It’s complicated - and real economists (with them shur-fine fancy city-slicker degrees an’ all!) are arguing over this right now.

In this case, Keynesianism was tried, but not necessarily what Keynes advocated. Confused yet? Well, it’s mostly that Keynes himself had real doubts that Democracies would be able to successfully employ his ideas for pumping up Aggregate Demand (i.e., get people working, buying, and optimistic again). The reason is twofold: Democracies are many things, but quick to act they are not, and also if Demand if already being pumped up by all kinds of government programs then more has a very limited impact.

I don’t exactly want to tilt to far to the Hayekian side (which its own issues), yet I do think that both of these problems were on full display following the financial crisis. As far as America goes, by some measures we got precisely zero net economic activity for trying a massive stimulus. Granted, that’s the more pessimistic view - but it’s absolutely possible that was the case, and that’s frightening. It means we may not have the knowledge or control we believed, which is even more frightening.

It’s also possible that it simply wasn’t fast or powerful enough, which is the view of some very well-respected economists ecnomists, though I do not agree. The problem here is that if so, then stimulus needs to be utterly stonking huge… and it’s not at all clear the even U.S. Treasury can manage the kind of debt necessary. Further, if it needs to be done even faster, then we’re running into the practical limits of the political process - we simply can’t find and manage trillions of dollars’ in worthwhile projects in a short span of time.

12

I largely agree. As far as it goes, I’m not generally opposed governments restoring confidence, or even having a bit of long-term deficit financing.

But I worry about a lot of long-term corrosive effects. When any kind of economic hit happens, we almost never have the kind of information available that one might want, and many of the actiosn which feel good in the short term bring on long-term headaches. In that sense, government intervention into markets is a bit like drinking. A little is fine - might even be good for you. But some people find it very hard to avoid drunkeness or even dangerous binges, and the hangovers can be agonizing and difficult to recover from.

But I’m well aware I count as a tedious bore on the topic of government finance.