Deficit hysteria debunked: in the long run, Keynes was right

In aiming for a deficit in 2013-14, Treasurer Wayne Swan has made a future surplus more likely. AAP

Recent years have demonstrated the enduring strength of a core Keynesian insight: deficit spending may result in higher growth and enable states to move more quickly into surplus. In this light, Australian Treasurer Wayne Swan faced a paradoxical dilemma in designing his most recent budget. If he had aimed for a surplus, the result might have been a bigger deficit. In aiming for a deficit – even one totalling less than 2% of GDP – Swan has probably made a surplus more likely.

To understand this paradoxical relationship requires recognising the unique nature of a “macro” perspective on the economy. Indeed, this can be seen as one of John Maynard Keynes’ most important contributions. Keynes recognised that, Adam Smith’s arguments for an invisible hand notwithstanding, individuals often act in ways that are rational from the micro or private perspective, but irrational from the macro or public vantage point. For example, Keynes asserted that a “paradox of thrift” meant that if everyone on their own tried to increase individual savings, the result would be collectively reduced savings.

John Maynard Keynes. Wikimedia Commons

Keynes argued that this paradox stemmed from the relationship between consumer demand, aggregate income, and the pool of potential savings. If everyone tried to save more, everyone also would spend less – resulting in less funds being available for collective saving. The same logic applies to the above arguments regarding deficit spending. If the government cuts spending, the result will be to reduce the aggregate demand necessary to increased national income, in ways that ultimately stand to deprive the government of the revenue necessary to fund the deficit.

Indeed, in recent weeks, evidence in favour of such a Keynesian position has increasingly pointed toward a resolution of the revived post-global financial crisis “great economic debate” over these matters. In the aftermath of the global financial crisis, some countries – the US and Australia most notably – adopted aggressively Keynesian policies as a means to ensure continued demand and growth. In contrast, the Euro area and UK have been marked by a shift toward austerity, as a means to ostensibly ensure economic confidence and foreclose the possibility of any revived inflationary pressures.

From the perspective of 2013, we now have a partial verdict on “who was right”. Australia can take comfort – Keynesian policies have been broadly vindicated. In a broader sense, as noted in the recent Economic Report of the President authored in the US by the President’s Council of Economic Advisers, in states that have pursued the economics of austerity, the result has been continually declining growth. In contrast, the US and Australia have each experienced real economic advances.

Speaking to the implications for the government accounts, the non-partisan US Congressional Budget Office sharply cut its deficit forecast for the current year by $200 billion, raising expectations of the smallest US deficit since the GFC, estimated at only 2.1% of GDP for 2015.

The debate has more recently been marked by revelations of shoddy scholarship by once-leading economic lights like Harvard professors Ken Rogoff and Carmen Reinhart, who famously erred in characterising the historical relationship between rising debt and falling growth, inadvertently omitting strong performers like Canada, New Zealand and Australia from their calculations. More important, however, than any of their spreadsheet errors was their lack of theoretical insight, as they failed to recognise that the relationship is best seen as one of reverse causality: rising debt does not cause falling growth, so much as falling growth causes rising debt.

In the end, perhaps the best thing to do is simply to look at the history of the US economy, which has since 1950 been in surplus only for nine years – and in deficit for 54 years – over a period of fantastic growth. The economic costs of deficits would seem, on reflection, to be overrated.