Europe Jumps Off the Keynesian Bus

President Obama is the victim of bad advice and misinformation. From his advisers, the Democratic caucus and the New York Times, he hears that markets have failed and the country needs more government spending to increase consumer spending. He is told that any plan to reduce government spending and the deficit will bring on another recession and even a new Great Depression. And he repeats the foolish claim that, since the rich spend a much smaller proportion of their incomes, it is good for the country to raise their tax rates.

Nonsense. After Britain's new government announced a multiyear program to reduce government spending, the pound rose against the dollar and the economy continues to expand across the board.

The simple-minded views used to justify more government spending fail to recognize that people are not dumb beasts.

In the euro area, Germany has reduced the growth of government spending to bring down the budget deficit. Following the recent announcement of a credible, long-term German program to reduce future deficits, the euro appreciated strongly against the dollar. Forecasters expect a surge in second-quarter growth when it is reported later this month. A rebound in construction and investment in machinery and equipment shows renewed optimism.

The Obama program and its advocates reflect the views of 1950s-era Keynesians, but ignore the major development in economics of the past 40 years. Modern economics differs from the past by carefully integrating expectations about the future into dynamic economic models.

The simple-minded views used to justify more government spending fail to recognize that people are not dumb beasts. Told that the government will spend more, many will expect to pay higher taxes in the future.

Investors will ask what taxes will be when today's investments earn returns two, three or more years in the future. If the spending is as wasteful as the failed 2009 stimulus, the economy will continue to stagnate and investment will be deferred.

The billions spent after passage of the 2009 stimulus had a modest economic result at best, because the money was mainly a redistribution of income that did not induce growth. Replacing state budget deficits with federal deficits has a "multiplier" effect of nearly zero.

The teachers whose jobs are saved recognize that the benefit lasts one year. They are unlikely to buy a new car or a new house. Temporary benefits like temporary tax cuts do not produce sustained growth.

Meanwhile, the unsustainable debt held by foreigners that has built up over past decades must be serviced. That requires increased exports. Instead of wasteful programs, the administration should offer a credible plan to reduce spending and current and future budget deficits. As in Germany and the U.K., that will reduce uncertainty about future tax rates and encourage investment.

Right now, businesses are investing to reduce costs for health care and employee benefits by increasing labor-saving capital. That maintains profits despite continued slow growth, but increases layoffs and unemployment. They see what the administration and Congress do, and they protect themselves as best they can.

Policy makers can reduce uncertainty about future costs by putting a moratorium on new regulation unless it is approved by a supermajority of Congress. Meanwhile, there has to be a recognition that bashing business and blaming the Bush administration for economic problems create less confidence about the future and are counterproductive. They do nothing to end high unemployment.

Allan H. Meltzer is a visiting scholar at AEI.

Photo Credit: White House Photo by Pete Souza

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