Beginning to End the Great Recession

Chancellor Angela Merkel of Germany is in trouble.  So is David Cameron, Prime minister of Great Britain though not as much.  Merkel has an election looming and both have been caught on the wrong side of the most important political-economic issue of the generation, the continuing depression and joblessness plaguing Europe and to a lesser degree the United States.

Economists disagree about what to do.  We often call them political economists in part because their judgments and advice are sometimes couched more in political terms than in the social science of economics.  Thus we have two schools of thought on how to recover from the economic crash.  One school, holding sway mostly in Europe, demands austerity while the other, a mostly American driven idea, call for stimulus.

So far the stimulus advocates can claim better results and if you read Paul Krugman’s new book, “End This Depression Now” you get the unmistakable notion that additional stimulus could do a lot to pull the global economy out of its tail spin.  So why don’t we all stimulate?  Krugman owns a Nobel Prize in Economics and knows what he’s talking about.  He considers himself a Keynesian after John Maynard Keynes, the mid twentieth century economist who invented, more or less, the branch of economics we call macroeconomics which is the obverse side of the coin from microeconomics.

It’s difficult to quantify, but if you’ve had any conversations with regular people, as I have recently, you see the two camps run deep.  The Austerians as Krugman calls them want austerity, smaller budgets, increased savings, less government spending.  The Stimulators think this is exactly the time for government to spend money, deficits be damned.  There will be time later, they say, when the economy is back on its feet, to raise taxes and pay for the spending.

Who’s right?  Each side thinks it is.  And you know what?  Each side is, though only one can be right in the context of today’s economy.  Economists have been famous for this kind of duality, so much so that Harry Truman once got tired of economists speaking to him in the vernacular of “on one hand and then on the other hand,” that he asked his staff to find him a one armed economist.

But back to stimulus and austerity or macro vs. micro.  The austerity people have a clear idea of how to pull out of a personal economic crisis.  Stop spending more than you take in, pay down debt, save a little and you will be out of the woods before you know it.

The macro people say that’s the problem.  We’re not dealing with micro or personal economics but with macro, global economies and they operate differently.  If everyone takes the austerity approach spending will decline and the economy will go into a tailspin.  As Krugman rightly points out, my spending is someone else’s revenue and in a big economy that inevitably drives the spending that results in what I call a paycheck.  That’s why when everyone is not spending either the government picks up on spending for a little while or the economy spins down into a deep hole.

Typically, governments spend on roads, bridges, teachers and other public infrastructure.  They also spend on unemployment insurance.  Unemployed people are a great investment because you can count on them to spend the money they get and spending is what spins an economy up.  Also, in a recession, with construction at low levels, government can get these things at bargain prices again putting money into the economy.  And if you buy productive assets like infrastructure, you have these things to work with as the economy improves.  Government spending is like training wheels, soon you don’t need them and you ride off on your own.  Think of this as investment.

Unlike the U.S. the Europeans have a small problem with infrastructure spending or any other kind of spending.  The spending, if it happened, would occur with German money in non-German countries so the Germans are reluctant to try this approach.  That’s the problem of having a unified currency but a non-unified government where each state is sovereign.  There is also more than a touch of righteous moralizing going on by the haves over the have-nots.

The German conundrum notwithstanding, there is a huge body of evidence from studying the Great Depression of the 1930s onward that shows government spending drives recovery from severe economic crashes.  The body of evidence also shows that failure to spend simply deepens the hole everyone is in.

Krugman and his colleagues would have liked it if the U.S. stimulus had been bigger or if multiple tranches of stimulus had been applied.  The people who say stimulus doesn’t work are the same ones who denied further spending and fought against the original stimulus plan.  All that is water under the bridge.  A kind of social experiment has nonetheless been performed and the economy that was stimulated, even inadequately, is doing much better than the economy with the brakes on.

If that’s not enough, what Merkel sees is that the French just elected Francois Hollande, a Socialist who promised to focus on stimulus and job creation in diametric opposition to Nicolas Sarkozy, a Merkel acolyte.  So we were treated to a delicate face saving about face by Merkel this weekend when the leaders of the G8 convened at Camp David with the unofficial goal of convincing Germany that austerity isn’t working and won’t.

Merkel really likes her policy and is not going to change her mind easily.  But with that election looming, she is at least now saying that austerity and job creation must go hand in hand.  Such is progress in international politics.  One wonders how much faster things would go if Merkel had a chance to see first hand how her policies are affecting millions of people.

(Cross-posted @ Beagle Research, LLC.)