A lost chance to overturn Keynes with the fiscal cliff
If free-market economists were serious about their ideas, they would surely be arguing vociferously right now for the economy to plunge over the fiscal cliff. But where are the laissez-faire economists lining up to urge John Boehner to lead his Tea Party tribe in the House to veto all compromise and put our money where their mouths are? They are strangely silent. Instead, the debate is about how Keynesian we should be.
A reminder for those who haven’t read John Maynard Keynes lately, or who have never read Keynes but oppose him anyway out of principle, he was a British math whiz who transformed economics forever with the publication of his “General Theory” in 1936. It suggested three ways to put wind in the sails of an economy in the doldrums. The problem, Keynes suggested, was that there was not enough demand for goods and services, and that governments should take a lead in stimulating spending to encourage business leaders to invest and create jobs.
Keynes’s first prescription was for central banks to make borrowing as cheap as possible with low interest rates. This deters saving and makes new investment in business activity more attractive. Businesses will employ workers who go out and spend their earnings. After studying the roots of the Great Depression, Milton Friedman and Anna Schwarz blamed the economic slump on money being too tight for too long. Such was the fear of returning to the deflationary devastation of the 1930s that successive Federal Reserve chairmen have taken this lesson to heart. Faced with a recession in 2001, even Alan Greenspan, a lover of the free market who flirted in his youth with the Lioness of Laissez-Faire, Ayn Rand, kept money rock-bottom cheap for the whole of the first decade of this century.
In light of the financial freeze of 2008-09, Friedman’s most distinguished disciple, Federal Reserve Chairman Ben Bernanke, an avowed Republican, set out to keep interest rates low to the horizon by buying government bonds in the process known as quantitative easing. Bernanke acted to the horror of fiscal conservatives, who fear the threat of inflation far more than high unemployment.
In the GOP primaries, during his “severe conservative” phase, Mitt Romney joined with every other Republican presidential hopeful in demanding Bernanke’s head. One outcome of President Barack Obama’s reelection is that Bernanke will stay at his post until at least January 2014, perhaps longer, and he will continue to keep money cheap.
The second measure Keynes suggested that would give a shot of adrenaline to a flagging economy ‑ what might be called the Lance Armstrong effect ‑ was to slash personal taxes. Many Republicans, even those who profess a passing acquaintance with economic theory, are under the illusion that cutting taxes was championed by conservative saints like the Austrian Friedrich Hayek. In fact, Hayek was opposed to cutting taxes unless a government was in the black. When asked about Ronald Reagan’s deep tax cuts, he said, “I’m all for reduction of government expenditures, but to anticipate it by reducing the rate of taxation before you have reduced expenditure is a very risky thing to do.”
Democrats and Republicans agree that extending the Bush tax cuts would bolster the economy. They differ only over whether individuals earning more than $200,000 and couples earning more than $250,000 should benefit. Keynes, who made two vast fortunes, wrote little about taxing the rich. He was never, like Hayek, a socialist. His motivation for cutting taxes for the middle class rather than the rich was practical. As the purpose of Keynesian tax cuts is to encourage spending, it is best to concentrate tax cuts on the middle class, who readily spend the cash. The rich save it.
The nonpartisan Congressional Budget Office has waded into this debate and put a price on the president’s pledge to oblige richer Americans to pay more because “those who have benefited most from our way of life could afford to give back a little more.” The CBO suggests that not extending tax cuts to the rich would restrain domestic growth by 0.25 percent, which would mean 200,000 fewer new jobs. This contradicts Romney’s claim during the Denver debate that failing to extend the tax cuts to the rich, whom he claimed to be predominantly job-creating small business owners, would mean 700,000 fewer jobs.
Keynes’s third idea for stimulating a flagging economy was to increase government spending. Just as the government is the borrower of last resort, so it should be the spender of last resort. Neither side in the tussle over the Budget Control Act – the fiscal cliff’s formal name ‑ is arguing for more public spending; both think it is time to start paying down the deficit. They appear to agree on the size of the spending cuts and where they should come from.
Keynes added a corollary to his three means of boosting growth: Do not pay down debt until the economy is booming again. To levy higher taxes when more people are working again would be less painful by spreading the burden. Keynes would likely argue that it is too early to cut public spending, because that would slow an already fragile economy. The CBO spells out what that means. While the fiscal cliff’s automatic cuts and the lapsing of the Bush tax cuts would together reduce the deficit between fiscal years 2012 and 2013 by $560 billion, they would also cause growth to shrink to just 0.5 percent next year. The CBO predicts that leaping off the fiscal cliff would lead to “a contraction in output in the first half of 2013 [that] would probably be judged to be a recession.” In short, the fiscal cliff would prompt a double-dip recession, just as similar policies have in Britain and the euro zone.
There is a lot of talk among conservatives and libertarians about “pushing the government out of the way so the free market can do its work.” Having lost the election, they cannot hamper Bernanke in his Friedmanite boosting of the money supply to head off stagnation. But they could follow Hayek’s example and insist that taxes be allowed to rise and public expenditures be cut starting on Jan. 1.
But where are those voices? Where is the clamor to abandon, as they would put it, Keynes’s “pernicious” influence over economic policy? The same free-market economists were also noticeably absent when Wall Street crashed in the fall of 2008, the financial markets froze, banks went bust and the world peered over an earlier cataclysmic cliff. Perhaps the truth is to be found in the candid remark of the 1995 Nobel Prize winner for economics, Robert Lucas, a leading light in the ultra-conservative Chicago School of Economics, who said in October 2008, “I guess everyone is a Keynesian in a foxhole.”
Nicholas Wapshott’s “Keynes Hayek: The Clash That Defined Modern Economics” is published in paperback by W. W. Norton. Read extracts here.