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What Would Keynes Do, Indeed?

Former Bush economic advisor N. Gregory Mankiw wrote, in What Would Keynes Have Done? in the New York Times on Sunday, that it's a terrible time for the government to expand deficit spending in the manner being talked about by the Obama Administration.

Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security and Medicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.

Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. "In the long run we are all dead," Keynes famously quipped.

The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.

It's hard not to see this column as a kind of CYA piece by a guy whose advisee might wind up fighting it out with Hoover for worst economic mismanagement, ever. But I don't have to say that, because writing in today's issue of the Times, Paul Krugman in Deficits and the Future makes the case for the Keynesians. He states the obvious: if the government were to cut spending or hold it where it is, what would happen to the economy? Tightening fiscal policy would only create the sense that we're in for a very long depression, and nobody will spend money then.

As he says:

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn't just a hypothetical argument: it's exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era's deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

The game the U.S. must play, Krugman says, is to spend money well, so that we can dampen the depression we're already in, and be better positioned when we come out.

By the way, Krugman puts a large hole in Amity Shlaes' whole argument in The Forgotten Man (see my review) by noting what most economists think really caused the 1937 drop -- FDR trying to bring the budget back into balance too quickly. We're in no danger of a balanced budget any time soon, probably not during Obama's term. The same would almost certainly have been true in a McCain administration.

I'm not going to say Krugman is right, and huge stimulus-driven deficits the right answer -- like unhappy families, economic messes are each unique. But since the U.S. remains the world's money mattress, we could certainly spruce up big chunks of our infrastructure now, and hope that it helps us create a deficit-busting economy again over the next decade.

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