Stimulating Stuff: Is a Keynesian approach the way forward?
Professor Vito Tanzi
Friday 8th April 2012: Is fiscal stimulus the answer to our economic woes? Or would it make things worse? Here Vito Tanzi gives a flavour of his forthcoming Politeia publication for our series ‘Recession or Recovery?’
There has been a great debate in western economies: is the best solution to the present economic problems a Keynesian stimulus so that public funds are used to stimulate employment and investment?
While some of the world’s influential economists like Krugman advocate such Keynesian stimulus as a tool for recovery, the case is not self evident for economies who look to stimulus when their fiscal balances are poor or unsustainable, as so many today are. Indeed deficits at times reach double figures (the Eurozone’s is around 6 per cent and Germany’s is around 4 percent). National debts often exceed 80 percent of GDP in the Eurozone and UK economies. Stimulus interventions would simply increase those deficits and debts, making it far harder for the worst-off countries to borrow money at affordable interest rates, so increasing even further the deficits. It is highly questionable whether they would do much for economic recovery.
Indeed, historically, there is no evidence that stimulus intervention has worked for any western economy with high fiscal deficits and unsustainable public debt. The evidence from Japan over a number of years indicates that such stimuli did not work.
Moreover, the evidence from different sectors is worrying. When a government intervenes to ‘stimulate ‘ the economy with fresh spending it creates a bubble. After the bubble has burst it often exacerbates an existing imbalance, as happened with the financial sector and the housing sector in the US and other countries. There, the sad consequence has been rising unemployment and a sharp drop in average property prices.
What then is the best ‘exit’ strategy so western economies can change direction towards recovery? We hear a number of options from the US, the UK and Eurozone capitals, ranging from doing nothing-but waiting, to increasing the levels of stimulus to boost employment or investment.
The evidence however, from a range of countries which have ‘been there before’ (Sweden Finland, Canada) is that cutting deficit and debt as rapidly as possible over time is the best strategy for recovery, as long as these cuts are accompanied by major structural reforms, as happened in those countries. This means cutting public spending programmes and increasing their efficiency. But it does not necessarily mean abandoning the social objectives western countries want, like good education and healthcare which can be provided with far lower levels of public spending to GDP provided structural reforms are introduced.
In the longer term, western economies should aim to fulfil the functions of modern governments and meet social expectations with levels of public spending to GDP that could be around 35 per cent of GDP, the levels of Switzerland Australia and others today, countries recognised as having amongst the highest standards of living and best social indicators.
*Vito Tanzi’s recent book, Government versus Markets, the Changing Economic Role of the State (Cambridge 2011) was published last year. He has served as Director of Fiscal Affairs at the IMF.