Since President Obama’s re-election the American financial press and world stock markets have been anxious about the so-called “fiscal cliff”. This is the sharp fall in the US budget deficit that would occur in 2013 on present policies, which include the cancellation of tax cuts dating back to George W. Bush’s presidency. The Congressional Budget Office has estimated that next year these policies would lead to a fall in the deficit of over $500 billion, roughly half of the existing budget gap. Keynesian textbook orthodoxy says that the projected deficit reduction represents a severe tightening of fiscal policy, which will withdraw spending power from the economy and so reduce demand, output and employment.
But will it? The thinking behind modern fiscal policy was first developed in Keynes’s 1936 General Theory, particularly in its Chapter 10, and with far more clarity in his 1939 essay, “How to Pay for the War”. The essence of Keynes’s message was that taxation and government spending should be varied to influence the total level of expenditure. By according government a benign role in managing the economy, Keynes’s ideas were plausible and attractive to “the socialists of all parties”, to quote one of Hayek’s better-known phrases. For many economists in the world’s top finance ministries, Keynesian textbook orthodoxy is the textbook orthodoxy today. In their view, if a downturn in the economy threatens, the budget deficit must be increased. Further, to advocate strong action to cut the budget deficit in a recession is economic illiteracy, even madness.
However, the textbook maxims of Keynesian fiscalism do have their critics. Towards the end of his life these included Milton Friedman, the redoubtable champion of monetarism and the free market. In January 1996 two British economists, Brian Snowdon and Howard Vane, interviewed Friedman in his San Francisco apartment. They asked him: “In the light of your work on the consumption function and monetary economics in general, what role do you see for fiscal policy in a macroeconomic context?” His rebuff to the Keynesian consensus was trenchant:
None. I believe that fiscal policy will contribute most if it doesn’t try to offset short-term movements in the economy. I’m expressing a minority view here, but it’s my belief that fiscal policy is not an effective instrument for controlling short-term movements in the economy.
By implication, enthusiasm for fiscal activism in macroeconomic management is always a mistake, while the current alarmism about the fiscal cliff is unjustified. However, Friedman never wrote a rigorous paper on the relationship between changes in the budget deficit and demand. Part of the trouble may have been that dissection of the Keynesian argument required detailed statistical work which, late in life, Friedman was reluctant to undertake.
Technically, the right concept in a test of Keynesianism is the change in the budget deficit that is attributable to policy. In practice there is the complication that the deficit is buffeted around by the effects of the business cycle on tax revenues and expenditure. These cyclical effects need to be stripped out of the calculation, to arrive at the cyclically adjusted or “structural” budget balance. Fortunately, in the last few years the International Monetary Fund (IMF) has devoted resources to estimating structural budget balance numbers for all the world’s major economies, including the US. Do these numbers endorse the government activists or the fiscal sceptics? Who is right, the Keynesians or Friedman?
Let us be more precise about the hypothesis. The Keynesians would be proved right if decreases in the structural budget balance (that is, increases in the budget deficit or reductions in the surplus) were associated with above-trend growth. Economists have a highfalutin’ way of checking whether growth is above or beneath trend, when they refer to “the output gap”. The Keynesian hypothesis, in short, is that the structural budget balance and the output gap ought to change in opposite directions. When growth is above trend, output exceeds its trend level or is less beneath its trend level, and the change in the output gap is positive. (I apologise for the jargon, which to a degree is unavoidable.) Numbers for the output gap are also prepared by the IMF.
In my book Money in a Free Society (Encounter Books), there is a chapter on Friedman’s critique of fiscal policy, which included a box with the IMF data for changes in the US structural budget balance and the output gap going back to 1981. I found clear evidence in support of Keynesianism in only five years, less than a fifth of the period of 28 years from 1981 to 2008 inclusive. There were twice as many years in which the structural budget balance and the output gap moved in the same direction, which contradicted Keynesian thinking.
We now have four more years of data, and the 2012 outcome is more or less known. Some revisions have also been made to the data for the 1981-2008 period, although these are minor. The accompanying box (right) gives the numbers for the 32 years from 1981 to 2012 inclusive. Does the addition of the Great Recession period help the Keynesians? The answer is, no, quite the reverse. In the 32 years we still have five years (1983, 1984, 1985, 1991 and 1992) in which the structural budget balance and the output gap changed in opposite directions by significant amounts, in line with the Keynesian view. But we now have no fewer than 14 years in which the structural budget balance and the output gap clearly moved in the same direction. We might call these the anti-Keynesian years, while the balance of 13 years that have an unclear pattern or insignificant numbers of under 0.5 per cent of GDP might be called non-Keynesian. In the last three decades the anti-Keynesian and non-Keynesian years have outnumbered the Keynesian years by more than six to one.
My message is both basic for the debate on the fiscal cliff and totally at variance with the fundamental premise that underlies it. The historical record shows that since 1980 there have been almost three times as many years in which policy action to reduce the budget deficit has been associated with above-trend growth, or increasing the deficit has come with beneath-trend growth or falling output than not. More succinctly, the data imply that—if Obama and Congress fail to agree on anything—the plunge in the budgetdeficit will be positive for demand, jobs and employment in 2013. The fiscal cliff is good for economic expansion, not bad. So not only Keynesians like Joseph Stiglitz, but the entire circus of international macroeconomic pundits have been talking rot.
Facts are facts. It is the august and heavyweight IMF that prepared the data in the box. (I am not saying that the IMF agrees with my interpretation.) Moreover, when the flesh and blood of personalities and events are added to the IMF’s statistical skeleton, Friedman’s derisive attitude towards fiscal policy rings true. The US economy did go into a double-dip recession in 1982, even though it coincided with the first big Reagan tax cuts and a huge widening in the deficit; the Clinton presidency saw the peace dividend that followed the end of the Cold War, with consequent large falls in defence spending and the budget deficit, and yet these were years of strong growth; and George W. Bush may have been a Republican president, but in his first term he indulged in Keynesian reflation which did not stop the bust after the dotcom bubble. There has been a recurrent pattern in which fiscal restraint is associated with-or, at the least, consistent with-positive results for demand and employment.
Something is wrong with the Keynesian textbooks. But what? Why is fiscal policy useless? Several possibilities have been suggested in the literature, the most prominent academic idea being the “Ricardian-equivalence theorem” put forward by the Harvard economist Robert Barro in a celebrated 1974 article. The guts of Barro’s argument are that a nation cannot make itself better-off by increasing its public debt. If people are rational and forward-looking, they must allow for the extra taxes required to service any additional debt as well as the boost to their pre-tax incomes from the interest payments to them. Fiscal policy is therefore futile.
Friedman himself tended to highlight a different set of propositions. His emphasis was on the financial side-effects of budget deficits. In his words: “A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.” The objection is particularly effective if an increase in the public sector deficit creates strain in the financial markets and pushes up bond yields, which causes a decrease in private sector borrowing and investment.
However, another line of thought may have been more relevant in the first Obama term, a period in which—speaking bluntly—the fiscal stimulus disappointed its supporters. (Hiscampaign team in the presidential election is reported to have outlawed use of the word “stimulus” because it was invariably met by belly-laughs.) Arguably, the basic flaw in Keynesian fiscalism may have been to overestimate the importance of actions by the state compared with the effects of the private sector’s adjustments to changes in the quantity of money. Salient features of the Great Recession have been turbulence in the banking system and marked instability in monetary growth. Whereas the US quantity of money (on the broadly-defined M3 measure) grew at an annual rate in double digits in the three years to mid-2008, it was then unchanged for the three years to mid-2011.
One of my themes in Money in a Free Society was that changes in the quantity of money have powerful impacts on asset prices, notably the values of corporate equity (the stock market), and ofboth residential and commercial property. In the year to the end of 2008, the incipient monetary squeeze caused the net worth of the US household sector to plummet from $66,057 billion to $53,457 billion, or almost 20 per cent. If the value of someone’s equity portfolio and real estate assets drops by 20 per cent, it is inconceivable that his or her spending will be unaffected. Suppose that in 2009 American households made an attempt to rebuild assets to the end-2008 level, by increasing their savings by a mere 3 per cent of their end-2008 net worth. Then spending would be slashed in 2009 by $1,600 billion, which is more than 10 per cent of US GDP, anamount that overwhelms any likely fiscal policy changes.
Whatever the reasons, naive Keynesianism-the Keynesianism of Samuelson’s famous textbook, latterly rehashed by Stiglitz, Paul Krugman, Larry Summers and others-has been refuted by the last three decades of American experience. The evidence is that significant reductions in the budget deficit can be reconciled with above-trend growth in demand and output. The US public finances may plunge over the fiscalcliff in 2013, but that will not mean the end of the recovery. The media hullabaloo about the fiscal cliff is disproportionate and unjustified. As long as the banking system is expanding, and the quantity of money is rising steadily, the American economy ought to enjoy steady progress over the coming year.