There is an old joke that if you laid down all the economists in the world from end to end, you still wouldn’t reach a conclusion. It is certainly a tragedy that as the western world finds itself in the biggest economic mess since the 1930s, the economics profession is unable to articulate clear policies to resolve the problems.
Up until the 1930s, politicians did not see themselves as particularly responsible for the economy. The government’s finances were managed in the same way as any other family unit, in that you made sure that spending did not exceed income, and borrowing was only acceptable to cover the cost of emergencies like wars. Foreign exchange rates were all fixed by adherence to the gold standard and it was considered a shameful act to devalue.
This went wrong in the 1930s when the 1920s financial boom led to a banking crisis the following decade. As the banking system sought to deleverage its balance sheet, asset prices fell and unemployment soared. Wages fell but economic recovery did not come because the economy was in a Depression and companies and individuals did not have the confidence to spend. It took the economic genius, John Maynard Keynes to show how capitalism could get stuck in this Depression mindset with low growth and low interest rates. His solution was that governments should take advantage of their high credit status to borrow the excess savings that were being created by the lack of confidence and go out and spend them to kick-start an economic recovery. He always expected however that once recovery had returned, then governments would seek to run budget surpluses so that the extra borrowing was repaid and hence temporary.
Post-war politicians however focussed on the ideas that (i) budget deficits were now good for the economy and (ii) they had the power to manage the economy to deliver full employment, and ignored the idea of running budget surpluses in the good times to offset the deficits that should be run when bad times hit. As the decades wore on, the politicians promised their people more goodies from public spending, budgets only got balanced in economic boom conditions and the size of the governments’ debts relative to the size of their economies rose steadily.
Recent academic work (Rheinhart & Rogoff) has shown that as the Debt to GDP ratio nears 90%, the capacity for economic growth diminishes markedly. The Western world is at or past these limits and finds itself there just as the next 1930s style banking crisis has hit it. The standard Keynesian response of government borrowing and spending is now either not available since markets are unwilling to lend to some governments because they have lost their strong credit status, or not palatable since it is likely to damage longer term economic growth prospects.
In general the right-of-centre politicians (Merkel, Cameron, Romney) stress the need to get government deficits and debt under control, so as to retain the long term confidence of financial markets. This austerity agenda does nothing for short term economic relief however. The left-of-centre politicians (Hollande, Milliband, Obama) stress the standard, Keynesian policies of spending in the short term to enable recovery to occur. The problem here is that financial markets might only provide the funds at an unacceptably high interest rate, and trigger a wider debt crisis.
The positions of both sides contain important truths, but the arguments display the divisions between economists. Japan, over the last 20 years, can be used as an example to prove each is wrong. The Keynesian response of government borrowing and spending has not led to sustainable economic recovery but has led to a Debt to GDP ratio now of over 200%. However this massive debt burden has also not led to a financial market crisis (yet), as Japanese savers have been happy to lend to their government for miniscule returns.
A Nobel Prize, a place in history and the gratitude of the world surely await the economist who can untangle all this and provide the solution to our current problems.