When economic crisis struck the advanced economies in 2008, almost every government – even Germany – introduced some kind of stimulus programme, increasing spending and/or cutting taxes. There was no mystery why: it was all about zero.
Normally, monetary authorities – the Federal Reserve, the Bank of England – can respond to a temporary economic downturn by cutting interest rates; this encourages private spending, especially on housing, and sets the stage for recovery. But there’s a limit to how much they can do in that direction. Until recently, the conventional wisdom was that you couldn’t cut interest rates below zero. We now know that this wasn’t quite right, since many European bonds now pay slightly negative interest.
Still, there can’t be much room for sub-zero rates. And if cutting rates all the way to zero isn’t enough to cure what ails the economy, the usual remedy for recession falls short.
So it was in 2008-2009. By late 2008 it was already clear in every major economy that conventional monetary policy, which involves pushing down the interest rate on short-term government debt, was going to be insufficient to fight the financial downdraft. Now what? The textbook answer was and is fiscal expansion: increase government spending both to create jobs directly and to put money in consumers’ pockets; cut taxes to put more money in those pockets.
But won’t this lead to budget deficits? Yes, and that’s actually a good thing.
An economy that is depressed even with zero interest rates is, in effect, an economy in which the public is trying to save more than businesses are willing to invest. In such an economy the government does everyone a service by running deficits and giving frustrated savers a chance to put their money to work. Nor does this borrowing compete with private investment.
An economy where interest rates cannot go any lower is an economy awash in desired saving with no place to go, and deficit spending that expands the economy is, if anything, likely to lead to higher private investment than would otherwise materialise.
It’s true that you can’t run big budget deficits for ever (although you can do it for a long time), because at some point interest payments start to swallow too large a share of the budget. But it’s foolish and destructive to worry about deficits when borrowing is very cheap and the funds you borrow would otherwise go to waste.
At some point you do want to reverse stimulus. But you don’t want to do it too soon – specifically, you don’t want to remove fiscal support as long as pedal-to-the-metal monetary policy is still insufficient. Instead, you want to wait until there can be a sort of handoff, in which the central bank offsets the effects of declining spending and rising taxes by keeping rates low. As John Maynard Keynes wrote in 1937: “The boom, not the slump, is the right time for austerity at the Treasury.”
All of this is standard macroeconomics. I often encounter people on both the left and the right who imagine that austerity policies were what the textbook said you should do – that those of us who protested against the turn to austerity were staking out some kind of heterodox, radical position. But the truth is that mainstream, textbook economics not only justified the initial round of post-crisis stimulus, but said that this stimulus should continue until economies had recovered.
What we got instead, however, was a hard right turn in elite opinion, away from concerns about unemployment and toward a focus on slashing deficits, mainly with spending cuts. Why?