The Post-Crisis Data Is In, and It’s Not Kind to Keynesian Thinking

Anders Aslund of the Peterson Institute recently made an interesting argument about Europe’s winners and losers. In a critique of Paul Krugman’s advice to Europe’s political leaders, he compares economic performance of the southern European laggards to the northern countries and, in particular, the Baltic states.

Aslund concludes that:

Today, the record is clear. The countries that have followed [Krugman’s] advice and increased their deficits (the South European crisis countries), have done far worse in terms of economic growth and employment than the North Europeans and particularly the Baltic countries that honored fiscal responsibility.

He also links fiscal adjustments to structural reforms:

Thanks to greater structural adjustment, the growth trajectory is likely to be higher in countries that quickly and enthusiastically embrace these reforms than elsewhere. Accordingly, the three Baltic countries that suffered the largest output falls at the outset of the crisis because of a severe liquidity freeze returned to growth within two years and have, over the same period, enjoyed the highest growth in the EU. By contrast, Greece, with its back-loaded fiscal adjustment, as recommended by Krugman, has suffered from six years of recession.

By comparing past reforms to recent growth, Aslund takes a sensible approach. But he focuses mostly on the tiny Baltics and secondly on continental Europe, which begs the question:  What about larger countries everywhere?

Let’s have a look.

We start with every country that has both a global GDP share of greater than 0.25% in 2007 (pre-global financial crisis) and sufficient data on fiscal balances and growth. This is 47 countries. We then divide the group into a European sub-group (23 countries) and a non-European sub-group (24 countries). For each sub-group, we compare real GDP growth for 2010 to 2012 (post-GFC) to the average structural budget balance for 2008 and 2009 (during the GFC).

Here are the results:

growth and budgets chart 1

growth and budgets chart 2

Not only is there a positive relationship between stronger public finances during the crisis and faster post-GFC growth, but the relationship holds both within and outside Europe. (For those who like statistics, the F-stat for the European regression is significant at 99.9%, while the other regression is significant at 90% but not 95%.)


We have two observations. First, the results may help explain why Keynesian pundits resort to nonsensical arguments. They often claim that poor performance in countries attempting to contain public debt proves austerity doesn’t work, which is like deciding your months in rehab stunk, and therefore, rehab is bad and heroin is good. A more honest approach is to compare fiscal actions in one time period with results in later periods, after the obvious short-term effects have played out. But if Keynesians did that, they would reveal evidence that fails to support their advice.

Second, the effects discussed by Aslund don’t receive enough attention. As Tyler Cowen (who gets credit for the pointer) wrote, Aslund’s perspective “is underrepresented in the economics blogosphere.”

And that includes our wee blog.

Regular readers know that we’ve presented research on long-term fiscal policy effects. (For example, see our historical study of 63 high government debt episodes, or our Fonzie-Ponzi theory.) We’ve also argued that the short-term consequences of fiscal tightening, often said to support Keynesian policies as noted above, actually do just the opposite. (Consider that fiscal tightening is motivated by today’s massive debt burdens, and these happen to be explained best by Keynesianism – the deficit spending policies of the past that hooked economies on unsustainable finances in the first place.)

But until now, we haven’t offered research on intermediate-term effects – horizons of 2-5 years as in the charts above. And this evidence supports Aslund’s conclusions. Policymakers should heed his argument that “front-loaded fiscal adjustment quickly restores confidence, brings down interest rates, and leads to an early return to growth.”

(Click here for the country-by-country data that was used in the charts.)

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2 Responses to The Post-Crisis Data Is In, and It’s Not Kind to Keynesian Thinking

  1. RYaN says:

    But, Keynes said that surplus is mandatory when there is growth!

    • ffwiley says:

      True, he occasionally said that, but it doesn’t happen in real life, does it?

      One problem is that interventionist policies typically move growth that would have otherwise occurred in the future into the present, so that once policymakers attempt a tightening it throws the economy into recession. At that point, you get more stimulus and deficits become chronic. (The monetary version of this is more obvious – see our Escher economy post – but active fiscal policies have the same problem with payback.)

      Another issue is that today’s politicians are more likely to get re-elected when they lift spending and lower taxes. Back in the old days, politicians were also expected to balance the books, at least outside of wars and recessions. That’s no longer the case, thanks largely to Keynesian economists preaching that deficits are nothing to be afraid of.

      Also, just to be clear on my use of the term, Keynesian economics only shares a few ideas with Keynes’ “general theory,” most importantly the ideology that public policies should be continually adjusted in response to the business cycle. (In fact, Keynes wanted to fully socialize the overall amount of investment spending, which hasn’t happened in Western democracies.) Keynesian academics rely on models that have consistently failed, but instead of being discarded, they simply get rebuilt on different assumptions and retain the “Keynesian” label. Keynesianism is a poorly understood term partly for this reason.

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