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The Internal Contradiction of Short Term Stimulus.

  • Written by Syndicated Publisher No Comments Comments
    August 22, 2011

    The debate over whether or not continued deficit spending should be pursued is often characterized as a choice between the short term beneficial effect of Keynesian stimulus as against the long term growing, and ultimately unsustainable, government debt to which continued stimulus would contribute. If one accepts the view, propounded by Keynes’ biographer Lord Skidelsky, that “The government…is the only agency that can prevent total spending in the economy from falling below a full or acceptable employment level. If private spending is depressed, it can restore total spending to a reasonable level by adding to its own spending or reducing taxes” then the choice is indeed a conundrum.Proponents of the position articulated by Lord Skidelsky have advocated a form of “jam today” approach; pursue fiscal stimulus today, but pair it with a commitment to impose austerity during the “medium term”. This is thought to be an elegant solution that enables the government to nurse the economy back to growth without jeopardizing its solvency. It implements Keynes’ recommendation that “The boom, not the slump, is the right time for austerity at the Treasury.”

    This view, however, assumes there to be a reliable relationship connecting increases in aggregate spending to increases in employment; that is the point of the quote from Lord Skidelsky above. The absence of such causality would undermine the case for deficit spending. In its absence, government might boost GDP, for a time, without increasing employment, in which case the recovery would be “jobless” and its only accomplishment would be to boost measured output for a few more quarters while further burdening government with debt. It is one of the salient facts of our current situation that, in the US at least, such a linkage appears not be operative as it is experiencing a jobless recovery.
    John Hicks’ Doubt
    One can find, within the citadel of Keynesian theory, an explanation for why this may have occurred. Sir John Hicks, the creator of the “IS-LM” model which has served as the core of Keynesian economics since he published it in 1937 [1] , came to question the implicit linkage between spending and employment embodied in his model. In a 1980 article [2] , Sir John recognized that the decision to hire in response to an increase in demand depended upon expectations about how permanent would be the increase in demand; “An excess [of demand] which is expected to be quite temporary may have no effect on input [hiring]; it is not only the current excess, but the expectation of its future which determines action”. Sir John had rediscovered the insight of the great 19th century political economist John Stuart Mill that “demand for commodities is not demand for labor”.
    Sir John uncovered an irony at the very center of the Keynesian approach. An economic downturn may be caused by a decline in confidence triggering a decline in private spending, but in order for Keynesian stimulus to generate employment, a certain level of “Animal Spirits” is required; businesses will only hire if they expect demand to last. In our present predicament, the imperative to begin reducing government debt in the not too distant future places in question a belief that current deficit spending will lead businesses to conclude the boost in demand will be long lasting.
    What to Do Now
    In spite of this, many economists persist in calling for more stimulus, primarily because they cannot think of what else to do, which more reflects the paucity of their imaginations than any real limitations. One obvious place to look is the constraining effects the accumulation of financial market and homeowner mortgage debt –built up in the run up to the crisis and made worse by the subsequent collapse in real estate values – has imposed on economic activity. The need of banks to hoard capital to cover losses and to meet tougher anticipated future capital requirements has led to the first protracted decline in US bank lending since the Great Depression. The ill effects of foreclosures and destruction of household wealth on consumer spending place a major drag on economic activity. Until something is done to restructure the balance sheets of the banking and mortgage sectors, growth and employment are unlikely to fully recover, regardless of the buoyancy of Animal Spirits.
    Keynes, above all economists, understood the role that expectations play in determining employment and, were he to consider our predicament, he may well question the efficacy of Keynesian stimulus. He would likely lead the search for other approaches, for, as he famously replied to an interviewer questioning the constancy of his views “When the facts change, I change my mind. What do you do, sir?”.

    [1] ‘Mr. Keynes and the Classics’, Econometrica,, April 1937.


    [2] ‘IS-LM –an Explanation’, Journal of Post-Keynesian Economics, Winter 1980-1.


    The Sceptical Market Observer: Animal Spirits and Unemployment.


    About The Author – Luc Vallée

    Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.