Back to Econ 101?

Both the American and the British economies are slowing again. It would be generous to say we are heading for a double dip recession; in many ways the recession never ended. British and world GDPs remain lower than they were four years ago. Maybe, just maybe, despite the possibility of Greek default, the fragility of French banks and the decline in global trade, we are at the bottom of the trough and things are finally going to get better. The reason for my optimism: more and more of our smarter economists and government officials are recognizing that austerity is not a quick fix for recession, and that fiscal and monetary stimulus is necessary if the world economy is to escape from a self-perpetuating feedback loop.

Our problem, after all, is lack of demand. Four years ago, we spent more than we earned; now consumers are paying off debts incurred during the bubble instead of incurring new ones. On an individual level, this is very sensible but as my deferred spending is your lost sale, on a societal level it can be very destructive. Since firms aren’t selling all their stock, they have no reason to invest, to expand, to hire. Since workers fear for their jobs, they will be even more cautious about spending. And since fearful workers are keeping their wallets closed, fearful firms will fire more workers, forcing demand even lower.

Back when I studied Econ 101, we were taught a simple solution to this sort of feedback loop: government deficit spending. When society’s productive capacity far exceeds its aggregate demand, government should hire men to dig ditches and others to fill them, thus putting money in their wallets, which they will spend, which causes goods to be purchased, which stimulates the private sector, which will in time cause firms to hire workers again, thus breaking the feedback loop.

Deficit spending works. After all, it was the second world war that brought the world out of the Great Depression, and war is even less productive than digging and filling ditches. In 1939, US unemployment was nearly 20 per cent. In 1944 it was close to 1 per cent. And the debt incurred to fight the war (much higher as a percentage of GDP than anything ever since) was paid off without much trouble. As long as growth exceeds the interest rate, paying off debt is relatively painless.

It is all quite obvious, and yet the coalition here, Obama and the Republicans in the US, and German central bankers have been telling us that, despite the lack of demand, despite our high unemployment, our public sector deficits are our biggest problem. Financial markets tell us something very different. Bond yields are as low as they have ever been in human memory. This is the time for increased government spending.

Austerity has failed to revive the economy. The IMF, a top economist at the Bank of England, and Martin Wolf all are telling us to try the opposite medicine.  Let us hope our leaders listen to them.