Wednesday, July 7, 2010

To Spend or Cut Spending, That Is the Question

Nearly all economists agree about one thing: businesses have capital on hand but are not investing it, which reduces the need to hire more workers. What they seem to disagree about is the reason why businesses are hoarding their capital, rather than investing it. One group believes that the reason has something to do with business psychology, as increasing levels of government debt give rise to concerns about future inflation and necessary tax increases. Another group - the Keynesians, led by Paul Krugman and Brad DeLong, believe the cause is simply lax demand in private markets, which could and should be stimulated by further government spending (at least in large countries with good credit ratings). That is to say, government should  borrow and invest in public-works projects the capital that businesses currently are not investing.

I am not an economist, and I'm especially not a macroeconomist, but the story Krugman, DeLong, and other Keynesians tell rings truer to me than the story told by the deficit hawks. At least it is rooted in a well-established macroeconomic theory (for whatever that's worth).

Whichever side is right, this is not just an idle academic contest. The real-world implications of additional stimulus/public debt versus contraction of  public spending could be enormous. If the Keynesians are right (as I suspect they are), reducing public spending now could lead to a double-dip recession or, at least, a slower recovery. If the deficit hawks are right, further stimulus could lead to higher levels of inflation (of which there is currently no sign), tax increases, and a contagious version of the Greek economic crisis.

As of now, the deficit hawks seem to be prevailing with the politicians. At the recent G20 summit, despite President Obama's arguments to the contrary, the leading economies agreed that reigning in public debt was the paramount concern. If the Keynesians are right, we should expect the economic recovery - especially recovery of labor markets - to be delayed (at least).

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