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Keynesian Economics: Mail Call...

Reading Keynes:

Dear Professor,

I'm a student at Florida State University, and I've recently taken up a second major in economics after reading a few books by Keynes. You're an often-quoted person in the "blog-o-sphere," and I note your review of Keynes's Tract on Monetary Reform on the Berkeley website.

I've been having trouble getting straight answers from people on campus - generally, an Austrian-aligned bunch - about whether or not Keynes was correct about deficit spending during depressions. By that, I mean whether deficits will provide at least a temporary boost in output and employment. I've heard that the effects can vary based upon whether the spending is long-term or short-term. (I may be thinking of the wrong economist, but I believe Edward Prescott demonstrated this difference.) I was wondering: What is your opinion on this?

Thank you very much,


Well, it depends. For example, in Argentina in 2001, Stanley Fischer argued that increasing Argentina's budget deficit would increase expectations of inflation and capital flight, would cause a collapse in private investment, and so you would lose more than you gained--that a more "stimulative" fiscal policy would actually cause not an addition to but a collapse in demand and employment.

At the same time, Joe Stiglitz argued that reducing Argentina's budget deficit would do little to increase investment in the short run, would throw people out of work thus reducing their incomes, that reduced incomes would cause reduced spending and higher unemployment, that higher unemployment would deepen the political crisis, and that a deeper political crisis would accelerate capital flight, reduce investment, and lead to a collapse in demand and employment.

The terrible thing is that, as best I can tell, I think that they were both right: that increased deficit spending in the 2001 Argentine depression would have made things worse, and that reduced deficit spending in the 2001 Argentine depression would have made things worse.

When can deficit spending in a recession help?

  1. When it is part of a stable and sustainable structure of economic policy, so that nobody fears that it is the beginning of a process of rampant inflation or expropriation. In that case deficit spending will have no deleterious effects on investment, and to the extent that it gets more money into the hands of those who are temporarily short of cash it will boost demand and employment.
  2. When things are already so bad (as in 1933 and 1934) that there is no investment anyway: if business confidence is already at its nadir, deficit spending cannot do any harm by reducing investment, and does good by putting people to work and boosting their incomes and their demand.

You thus see that my view is closely related to (but not identical to) the short-run long-run distinction you draw. The longer-run are deficits, the more likely they are to cause a crisis of private-sector investor confidence. The shorter-run are deficits, the more likely they are to be part of a stable, sustainable structure of economic policy.