Stimulus v. Austerity (Keynes v. Hayak)

July 15, 2010 Disclosures POSTED IN Economy

During the global economic contraction from late 2008 to the middle of 2009 central governments around the world attempted to boost domestic demand by providing fiscal stimulus. With sagging private demand many countries turned to Keynesian economic theory which states that the government should boost aggregate demand in the short run until private demand can return. Government money was thus injected into economies in order to mute the effects of the economic downturn including potentially higher unemployment levels. This government expenditure on stimulus, in turn, meant that country sovereign debt, already high in many developed countries, increased. Today the ratio of government debt to GDP in many developed countries is at levels not typically seen during peace time.

Gross Government Debt to GDP Source: International Monetray Fund

The expansion of national debt and projected future national deficits has given rise to calls for fiscal prudence and austerity measures to reduce government expenditures. The argument being that increased debt will drive up interest costs forcing the government to borrow at higher rates in the future. High interest rates would also impede business growth as financing terms would drive up the cost of expansion, which would mute future economic growth.

The debate between further stimulus and austerity has already begun in countries around the world. Greece announced earlier this year that measures would be implemented to cut government expenses. Calls for austerity in the U.K. have risen with some arguing it is the right direction to take while other argue that it might “snuff out recovery.”

The argument between continued government stimulus and fiscal discipline is not a new one. During the early years of the Great Depression economists were having a similar debate. They disagreed as to the best way to increase slumping investment and demand. In two letters to the editor of the London Times during the third week of October 1932 economists with opposing views stated their opinion as to what would drive future investment and revive the economy. John Maynard Keynes (an advocate of using monetary and fiscal stimulus to fight the negative effects of the business cycle) and F.A. von Hayek (a defender of classical liberalism and free market capitalism) were opposing signatories in these two letters.

In regards to the contraction of private spending J.M. Keynes and his camp stated:

“when a man economizes in consumption, and lets the fruit of his economy pile up in bank balances or even in the purchase of existing securities, the released real resources do not find a new home waiting for them. In present condition their entry into investment is blocked by lack of confidence. Moreover, private economy intensifies the block. Moreover, the private economy intensifies the block. For it further discourages al those forms of investment–factories, machinery, and so on–whose ultimate purpose is to make consumption goods. Consequently, in present conditions, private economy does not transfer from consumption to investment part of an unchanged national real income. On the contrary, it cuts down the national income by nearly as much as it cuts down consumption. Instead of enabling labour-power, machine-power and shipping-power to be turned to a different and more important use, it throws them into idleness.”

Further J.M. Keynes and his fellow signatories addressed why fiscal stimulus was necessary:

“Some people, no doubt, are stinting their consumption because their incomes have diminished… others because their incomes are expected to diminish… The public interest in present conditions does not point towards private economy.”

In his response, F.A. von Hayek and his fellow economists retorted:

“We are of the opinion that many of the troubles of the world at the present time are due to imprudent borrowing and spending on the part of the public authorities. We do not desire to see a renewal of such practices. At best they mortgage the Budgets of the future, and they tend to drive up the rate of interest — a process which is surely particularly undesirable at this juncture when the revival of the supply of capital to private industry is admittedly urgent necessity. The depression has abundantly shown that the existence o public debt on a large scale imposes frictions and obstacles to readjustments very much greater than that frictions and obstacles imposed by the existence of private debt.”

F.A. von Hayek’s group concluded their letter with a way the government could help the econonomy with out resorting to fiscal stimulus:

“If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital (including restrictions on new issues) which are at present impeding the even the beginning of recovery”

While these economists did not agree on the best way to improve confidence, increase private investment and encourage consumer consumption they did agree about deflation. As F.A. von Hayek stated, “It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one think that deflation is in itself desirable.” Today with deflation an emerging risk in many countries in Europe and in the United States the debate between additional fiscal stimulus and fiscal austerity will surely continue.