In response to one of my posts on austerity, the magnanimous “Lord Keynes” quoted me and then responded like so:
(3) Murphy shows himself incompetent in even understanding basic elements of Keynesian economics. He asserts:
“First let’s consider the deficit as a % of GDP, which is how Keynesians typically evaluate stimulus in the 1930s.”
Um, no, they don’t, Murphy – at least not serious Keynesian economists. How Keynesians “evaluate stimulus in the 1930s” will be find in E. Cary Brown, 1956. “Fiscal Policy in the ’Thirties: A Reappraisal” (American Economic Review 46.5: 857–879): it does not evaluate stimulus in terms of some crude citation of deficits. There is a reason why. It is not the size of a budget deficit per se that will show you if a budget is expansionary or contractionary in terms of fiscal effects. It is perfectly possible to have a budget deficit and have contractionary fiscal policy (as in Ireland and Greece today).
At this I was taken aback–perhaps I invented this notion that Keynesian economists evaluated fiscal policy in the 1930s on the basis of budget deficits?
But no, that wasn’t it. It took me a few minutes to hunt it down, but I distinctly remember reading Christina Romer on the matter. After all, it was her incredibly misleading claims about Hoover vs. FDR that led me to pen this article.
Anyway, Christina Romer–a “serious Keynesian” I would like to think–said the following, not in her personal journal after throwing back a few beers, but in prepared remarks to the Brookings Institution, in March 2009 when she was the new head of the Council of Economic Advisors and was touting the Obama stimulus package. Here’s what she said:
One crucial lesson from the 1930s is that a small fiscal expansion has only small effects. I wrote a paper in 1992 that said that fiscal policy was not the key engine of recovery in the Depression. From this, some have concluded that I do not believe fiscal policy can work today or could have worked in the 1930s. Nothing could be farther than the truth. My argument paralleled E. Cary Brown’s famous conclusion that in the Great Depression, fiscal policy failed to generate recovery “not because it does not work, but because it was not tried.”
The key fact is that while Roosevelt’s fiscal actions were a bold break from the past, they were nevertheless small relative to the size of the problem. When Roosevelt took office in 1933, real GDP was more than 30% below its normal trend level. (For comparison, the U.S. economy is currently estimated to be between 5 and 10% below trend.) The emergency spending that Roosevelt did was precedent-breaking—balanced budgets had certainly been the norm up to that point. But, it was quite small. The deficit rose by about one and a half percent of GDP in 1934. One reason the rise wasn’t larger was that a large tax increase had been passed at the end of the Hoover administration. Another key fact is that fiscal expansion was not sustained. The deficit declined in fiscal 1935 by roughly the same amount that it had risen in 1934. Roosevelt also experienced the same inherently procyclical behavior of state and local fiscal actions that President Obama is facing. Because of balanced budget requirements, state and local governments are forced to cut spending and raise tax rates when economic activity declines and state tax revenues fall. At the same time that Roosevelt was running unprecedented federal deficits, state and local governments were switching to running surpluses to get their fiscal houses in order. The result was that the total fiscal expansion in the 1930s was very small indeed. As a result, it could only have a modest direct impact on the state of the economy. [Underlined emphasized in original, bold added by RPM.]
Now let me anticipate the obvious: Lord Keynes is going to look at the above quote and say, “Duh, that’s exactly what I said Murphy, you need to look at the output gap before determining how big a stimulus is needed. Man you Austrians are dumb.”
I hope sympathetic readers will see why, by the same token, I look at the above Romer quote and conclude: Duh, that’s exactly what I said. Christina Romer showed us that when assessing whether a government is providing stimulus, we look at the deficit. A rising deficit means rising stimulus, and a falling deficit means falling stimulus. So if we’re trying to tell whether other governments applied more Keynesian stimulus in the recent crisis compared to the US, one obvious metric is to compare the respective government budget deficits. This, after all, is how Romer compared Hoover to FDR, and FDR-1933-1936 vs. FDR-in-1937. (The fact that her Hoover/FDR comparison is bogus, is beside the point.)
UPDATE: Oops, to see Romer’s take on what happened in 1937, you need to read her Economist piece from June 2009, where she wrote:
The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.
However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.
So again, when Romer wants to give us an idea of how contractionary these measures were, she shows us how much they reduced the deficit as a share of GDP. This is what led me to say that Keynesians typically evaluate fiscal policy in the 1930s by looking at the deficit as a share of GDP. Romer didn’t say, “Sure, the deficit as a share of GDP went up, but the output gap rose even more, so therefore it was fiscal contraction.” No, she said such and such reduced the deficit by 2.5% of GDP, exerting significant contractionary pressure. I.e. we know there was significant contractionary pressure, because the deficit fell sharply as a share of GDP.