Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
- Where is the foundation for fiscal stimulus policy? -

Senior Fellow, RIETI

Revival of Keynesian Economics

The financial crisis has triggered fierce policy debate in Europe and North America. However, my impression is that matters of money and credit are not being discussed adequately in the debate, just as they were not addressed properly in policy debates in Japan in the past.

World-renowned economists and journalists are expressing different opinions in economic newspapers such as the Financial Times and are arguing economic policy in blogs on the Internet. In this debate, the revival of arguments based on Keynesian economics has been truly remarkable. Calls for economic stimulus through public spending and monetary easing were vociferous, especially in October and November 2008 during the panic that followed the Lehman shock. Given the historic nature of the crisis, academic economists who would normally be aloof from policy debate announced rather radical policy proposals.

Websites that often post economists' recommendations include the RGE Monitor, operated by Nouriel Roubini, a New York University professor, and, operated by the Center for Economic Policy Research (CEPR), a network of economists in Europe. Professor Roubini attracted attention as the person who predicted the subprime mortgage crisis and was made famous for his comment (on July 1, 2009) that the worst of the financial crisis had passed, which triggered further rises in stock prices on the New York Stock Exchange. Columns and policy recommendations by economists that are posted on websites like these have a great influence on public opinion in Europe and North America. For example, the Financial Times columnist Martin Wolf often quotes in his column research and policy proposals by economists that have been posted on VoxEU.

Distinguished economists have contributed dozens of policy columns to VoxEU. These columns were then compiled into policy recommendations and published as four e-books from December 2008 to March 2009. The e-books were posted on the VoxEU website to coincide with the meetings of major countries (including the G20 summit) that related to the financial crisis.

It is very interesting that many renowned economists argue for large and quick public spending (and monetary easing), a typical Keynesian position, in their policy columns. However, unless you have majored in economics recently at a graduate school or similar institution, you might not know why this is interesting. The reason is that, under the standard economics framework, widely adopted in Europe and North America, there should be no policy recommendations involving the expansion of public spending. In other words, economists in Europe and North America have, for the past six months, been calling for "heavy public spending" policies that have no foundation in textbooks or their own research. Many laymen might think that if distinguished economists are arguing for public spending, their arguments must have a solid foundation based on many years of academic research. In fact, this is not the case. The distinguished European and American economists have argued not as professional scholars, but as commentators. Their logic and intentions are little different from those of politicians and journalists who argue for public spending, calling for all means necessary to prevent looming unemployment and bankruptcies. I would never have believed that economists in Europe and North America - normally very professional and prudent - would change so much after the Lehman shock. That is why it is interesting.

I need to make a few additional remarks about this point.

Of course, Keynesian economics is accepted as an academic theory. However, the public spending that Keynesian economics argues for, works only as a temporary painkiller that stops the economic downturn from becoming excessive. It does not remove the cause of the financial crisis or resolve the financial crisis itself. Under Keynesian logic, you would not be able to say that fiscal policy will be able to remove the cause of the financial crisis, dispel the widespread pessimism from the market, and reverse the downturn. (However, there have been those arguing precisely that in Europe and North America since the fall of 2008.)

Common Understanding of "Ricardian Equivalence" Forgotten

In the recent framework of New Keynesian economics, the significance of the monetary policy of the central bank is emphasized, and the expansion of public spending is not even an object of analysis (taxation policy is analyzed). "The expansion of public spending is meaningless" is a tacit and common understanding in the theory of New Keynesian economics.

The main reason is that Ricardian equivalence, which asserts that expanding public spending is ineffective, cannot be effectively refuted with today's economic theories. The Ricardian equivalence theorem can be described as follows: If the government increases national income by expanding public spending, the money spent by the government will be paid by the people in the form of increased taxes in the future. Since the people anticipate tax increases, they will increase their savings in preparation for the future tax burden and will reduce spending and investments. Consequently, the fiscal policy will not expand demand.

The argument was so strong that most macroeconomists worldwide did not discuss expansion of public spending in their research (at least before the Lehman shock). Neither Keynesian economists nor neoclassical economists could be said to consider expansionary fiscal policy as a policy for economic recovery in their academic research. (Of course, the expansion of public spending is important for paying for public services, pensions, and disaster responses. However, this significance has nothing to do with economic recovery.)

At the G2 summit in London on April 2, governments in Continental Europe were careful about the expansion of public spending. The attitude of these governments could be said to have followed more faithfully the trends in the economics community in recent years than the governments of Japan and the United States. The Obama administration's public spending boost has been strongly criticized by the Republicans, who argue that the policy will leave future generations with a great burden. The argument could be said to have some merit, at least in the eyes of orthodox economics before the Lehman shock.

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the August 10, 2009 issue of Kinzai Financial Weekly

October 8, 2009

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