Flawed Keynesian Analysis Based on Confused Terminology

Larry Summers is a former US Secretary of the Treasury and is now a professor at Harvard. He is also an unabashed Keynesian who apparently will use any means to support ongoing stimulus. His latest nonsense was published by the Financial Times on Monday, April 30^th on page 11, “Growth not austerity is the best remedy for Europe.”

He might as well have added apple pie and mom into the headline. Notice that austerity means stern, severe in appearance, uncompromising, forbidding. Clearly austerity does not sound like anything you’d like to dance with on Saturday night at the Player’s Pub in Bloomington Indiana. Growth is just the opposite. We all want to grow – what could be better than growth in spirituality, wealth, height, etc. I tend to grow around the waist line but let’s not go there.

So saying you are for growth and not austerity doesn’t take a background like Summers’. So what is he really saying? Basically he is saying that he wants even more stimulus in Europe. How can I conclude that?

Let’s get back to the term, growth. Growth has two definitions or meanings. First, growth has a very general meaning in macroeconomics. We say the economy grew by 2.2% last quarter because the value of real GDP in the first quarter of 2012 was higher than the value produced in the fourth quarter of 2011. It was higher by about 0.55% but when we annualize the figure it becomes 2.2%. Economic growth according to the general definition simply means a rising real GDP. To say that growth is the best remedy makes no sense. It makes no sense because one has to explain what will cause the growth. Will the strong European growth be induced by Adam Smith’s invisible hand? By another round of monetary expansion? By more government spending or tax cuts?  By imposing supply-side economics or restructuring?

His article is pretty clear that the solution is more spending during a time of large government debt. He clearly discounts any value from supply-side programs, “there will ultimately be a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programs.” But he is very clear that he is NOT recommending any supply-side programs now.  Those are not seen as generating growth but as something to do later. He explains that income is driven by demand. Austerity is bad because it drives down spending, income, and the ability to pay off creditors. He boldly says austerity makes it impossible for a country to pay its debts. More spending, in contrast, makes it possible. Is this convoluted or what?

Really this is what the former Secretary of the US Treasury is telling us. Let me repeat it.

• Spending less makes the debt problem worse

     ·      Spending more is the best way for a debtor country to pay off its debts.

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I hope he explains this to the investing public. They will be fascinated. When Spain decides to have much bigger deficits, Summers predicts investors will all join in a chorus of gumbya as they buy as many Spanish bonds as they can find. Seriously, nowhere in his article does he even raise the possibility that spending more in Europe could elicit a very negative response from world investors that would shake even the Sagrada Familia.

There is more to this that bond vigilantes. Growth has a second meaning in macroeconomics. Economic Growth Models are used by economists to explain what causes a country’s GDP to grow in the long-run. These models do NOT focus on short-term fluctuations. You might wonder how fast the US economy is going to growth in the next 10 years.  The US CBO thinks the US will grow by about 2.3% per year between 2011 and 2021. See this at page 2 of  http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12039/economictables[1].pdf

Many of us would have a little more interest if Summers’ title was referring to this definition of growth. Why? Because if he is referring to longer-term trends, then this brings us a little closer to a meaningful policy interpretation. That is because most long-term growth models explain and predict a country’s economic growth with concepts like labor growth, capital growth, and productivity (see page 2 of the above link for this kind of detail). These long-term growth models usually are devoid of any demand-side variables like government deficits or money growth. Thus, to achieve a higher sustained rate of growth policy needs to focus on ways to improve labor supply, capital supply, innovation and anything that might make labor and/or capital more productive.

We do not usually associate monetary or fiscal policy with the sustained growth of labor, capital, and productivity.  Monetary and fiscal policy are Keynesian inventions used to fine-tune aggregate demand temporarily. What I refer to in past blogs as restructuring or supply-side policies – and the things Summer’s mentioned as policies that we can try later – these are the things that are usually associated with creating higher sustained levels of economic activity.

So if we want to get out of our current slow growth trap the answer is not more spending. The answer is more supply-side policies designed to improve outcomes in labor markets, capital markets, efficiency, and innovation. But there is one more point. Clearly austerity is an important part of a supply-side approach. If we want more growth then we need more austerity, not less. Why do I say this? After all, I quoted definitions above that describe austerity as something pretty ugly. The answer is that it sometimes takes something ugly to get to the other side of your problems.

Yes, spending less will probably create predictable downside short-run changes in spending and incomes and employment. But many countries have already ventured into this phase and will soon be emerging. Spanish unemployment is deplorable but Spain has encountered these kinds of unemployment levels before and lived to see a better day. It is like the reformed smoker who gets half-way through his prescribed regime only to smoke a couple of Camels to celebrate his month of abstinence. They should stick with the austerity so its benefits have time to work.

What is not consistent with Summers’ ideology and he never mentions is the well-known remedial affects of austerity. Why would a country ever be willing to go through austerity? You don’t do it for fun. You do it because it addresses what is wrong with your country. If financial excess caused the recession and knocked the government’s finances out of whack, then one has to reverse the financial excesses. Europe is trying to create financial regulations to address private financial excesses. But it makes no sense to address private finances while you are making government debt dramatically worse. Shifting financial excess to government excess can only work for a while. To heal, a country must convince the world and its own citizens that it will pay its debts.

Convincing the world of this financial improvement means that creditors will accept more reasonable interest rates. It means that companies will be able to borrow and invest more profitably. It means foreign investors will be more willing to invest in the economy. It means a lot of good things that can only improve growth. But austerity might not be enough. Combining austerity with supply-side remedies would be a powerful double punch that will support both short-term and long-run economic growth. Summers could not have the prescription more wrong! We need more austerity, not less. We need supply-side policies now, not later.