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Outlook is not fair, we need more stimulus

2010-07-06 10:33

Outlook is not fair, we need more stimulus

We all seem to know that failing to learn history's lessons dooms us to repeat them, so you have to wonder why so many smart people seem to make the same economic mistakes.

For the latest example, let's go back to Jan 5, 1938, when a famous cartoon was published in the London Evening Standard.

It pictured the residence of Prime Minister Neville Chamberlain at 10 Downing St, emblazoned with the logo, "Downing St. Temple of Sunshine". A dozen officials stand in front, all half-naked, wrapped in towels, next to a sign saying, "Today's weather report - set fair indefinitely." Walking along Downing Street is a man under an open umbrella who is admonished by the officials - "the feller ought to be ashamed: encouraging rain". That man is John Maynard Keynes: written on his umbrella is the phrase, "anti-slump precautions".

The cartoon followed a letter that Keynes wrote to the Times four days earlier, in which he said that British military spending was the main force keeping up employment, while blaming Franklin Roosevelt for cutting spending and bringing on Round Two of the Great Depression in the US.

"Examples abound in all parts of the world where public loan expenditure has improved employment: and I know of no case to the contrary," Keynes wrote. "Does anyone doubt that employment would decline if public loan expenditure on armaments were to cease tomorrow?"

Keynes' view ran counter to the so-called Treasury view, expressed by the semi-naked officials in Low's cartoon. That view held that fiscal policy has essentially no effect on the economy and unemployment, even in the depth of recession. Increased government spending, according to that view, crowds out an equivalent amount of private spending or investment. In short, it has no net impact on the economy.

History proved Keynes correct. In contrast to the US, the UK didn't experience a slump at the end of the 1930s, because of the increased level of fiscal stimulus as a result of re-armament spending.

Yet the crowding-out view seemed to be held by a number of the countries at the recent G20 summit, especially by the UK and German governments. It appears now that even French President Nicolas Sarkozy is on board and plans to implement draconian austerity measures.

This position stands in contrast to the US view that committing to reduce long-term deficits is appropriate only if it's not at the price of short-term growth.

It is much more likely that public expenditures, rather than crowding out private spending, are promoting it.

The view of the anti-stimulus crowd is that public spending cuts and tax increases now will somehow quickly return us to steady growth and lots of private-sector hiring.

Recovery is under way, the slump is over, so let's start shrinking the over-reaching state and put an end to all that profligacy. Markets are self-correcting, so we must deliver what the markets want or we will become Greece, it is argued.

It's not a very convincing argument. Austerity can spook the markets if it compromises growth, as it has in Greece.

In a subsequent letter to Roosevelt in February 1938, Keynes explained that premature curtailment of public-works programs had driven the US back into recession in 1937 because of an "error of optimism". It seems to me that there is a very real danger that German Chancellor Angela Merkel, UK Prime Minister David Cameron, Sarkozy and their underlings are being overly complacent and are also in danger of making a huge error of optimism.

There is a significant probability that these leaders will make the biggest macro-economic mistake since the 1930s, which might push us into what economist Paul Krugman has called the Long Depression, equivalent to the depression that followed the financial panic of 1873.

The signs of weakness are in plain sight. Banks are still not lending, which can compromise growth. Money supply growth is sluggish around the world. There is little or no potential to lower interest rates, which are close to zero almost everywhere except Australia.

Central banks are reluctant to do more quantitative easing, as they remain wary of their effects and there is little room to cut interest rates more. And there is even dangerous talk from some inflation nutters that it is time to start raising rates, which would make matters worse.

It doesn't look like net trade or investment is going to drive growth, and the consumer is beginning to run scared once more.

Consumer confidence last month dropped both in the US and UK, and the outlook doesn't seem promising: The index measuring consumer expectations for the next six months in the US fell in May to 71 from 85, while a comparable yardstick in the UK declined to 93 from 105. Consumer data in Europe paints a similar picture.

All is not set fair. It's time for more stimulus, not less.

David Blanchflower, a former member of the Bank of England's Monetary Policy Committee, is professor of economics at Dartmouth College and the University of Stirling. The opinions expressed are his own.


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