A Contradiction in Keynesian Fiscal Policy

Posted: May 06, 2012 12:01 AM

There’s an internal contradiction in the way that Keynesian-oriented economists and policymakers address the federal budget situation. I’ve noticed it over and over. A passage in a Washington Post op-ed today by Mohamed El-Erian of Pimco captures it perfectly:

[T]he U.S. fiscal situation requires a carefully designed and well-timed overhaul to make government finances more efficient and fairer—among other things, combining immediate stimulus with a credible set of medium-term tax and entitlement reforms and a sustainable effort to reduce the deficit over time.

El-Erian seems to want more deficit-fueled “stimulus” now, combined with a “credible” plan that would reduce the deficit later on. We hear similar things from administration economists and centrist and liberal budget experts all the time.

Yet how can a Keynesian administration or Keynesians in Congress ever make a “credible” medium- or long-term commitment to deficit reduction? As soon as the next recession hits, they will demand ripping up any previous deficit-reduction deal so that they can stimulate aggregate demand some more.

To Keynesians, the short run is always more important than the long run, so it’s impossible for them to have a “credible” long-run commitment to deficit reduction. Even today, prominent Keynesian economists are demanding more “stimulus,” but the economy is not in recession and the budget deficit (which is “stimulus” to Keynesians) is already over $1 trillion.

What happens if the economy slips into recession in 2013 or 2014? The Keynesians would surely break any budget deal and push for a $2 trillion deficit.

Everybody knows that federal policymakers usually break prior deals on discretionary budget caps and agreed-to entitlement cuts. The dominance of Keynesian-minded policymakers and advisers in Washington these days further reduces the believability of any long-term budget deal that policymakers may come up with.

Thus, the best way for policymakers to be truly “credible” on deficit reduction is to start cutting spending right now. Then cut spending more next year, and chop it further the year after that, and then keep on going.