The Guardian, January 20, 2014
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French President François Hollande startled many of his supporters last week, along with fans of evidence-based economics everywhere, when he rejected modern economics in favor of the sayings of an early 19th-century French economist. After winning the election on a platform that the government needed to fill the gap in demand created by the collapse of asset bubbles, Hollande repeated the old line from Jean-Baptiste Say that "supply creates its own demand."
While the appeal to French national pride may be touching, it is completely out of touch with modern economics. His plan to cut spending will have serious consequences. We should have known at least since Keynes that economies can be subject to prolonged periods of high unemployment due to inadequate demand. The problem is that the private sector does not necessarily generate enough demand to buy back everything it produces, leaving large numbers of workers unemployed and vast amounts of productive capacity sitting idle.
From an economic standpoint this is an incredible waste of resources. Economists often concern themselves with distortions created by quirks in the tax code or barriers to trade, but the losses from having an economy operate below full employment dwarf these inefficiencies. In the United States alone we are looking at more than $5tn in lost output to date, as a result of the downturn. The losses would be even larger inEurope where economies are operating much further below their levels of potential output.
From a social standpoint, the costs are even greater as millions of people are needlessly denied the opportunity to work. This often has devastating outcomes for unemployed workers and their families. There is considerable evidence linking unemployment with alcoholism and suicides. There is also a growing body of evidence that there are serious life consequences for the children of unemployed workers.
Additionally, a prolonged period of high unemployment has a lasting impact on the economy's productive capacity. A recent study by the Federal Reserve Board estimated that potential GDP has fallen by more than 7% ($1.2tn a year) due to the economic downturn. If this study is correct, we will be throwing an amount equal to the entire discretionary portion of the budget (both military and domestic) into the garbage every year long into the future because we failed to adequately stimulate the economy following the collapse of the housing bubble.
The problem is that we do not know how to boost private sector demand. The basic Keynesian story of spending money sounds simple, but it also happens to be right. In an economy that is constrained by inadequate demand, the need is for more spending. That may not typically be the case – the economy may typically be supply constrained – but it is demand constrained right now. This means that if the government spends more money on education, healthcare, research or infrastructure, it will boost the economy and put people to work.
If there was any doubt on this point, there is much new research to back it up. A meta-analysis of recent research on the topic by Sebastian Gechert showed that the overwhelming majority of studies found that government stimulus was effective in boosting the economy in a downturn. The International Monetary Fund, which is hardly known as a hotbed of anti-capitalist thought, has produced several compelling studies showing that countries that stimulated their economies more in this downturn have achieved stronger growth.
There is no longer a serious debate that stimulus will lead to more growth contrary to Mr Hollande's 19th-century platitude. Nor is there reason to fear that France and other countries might fall off a debt cliff. The warnings about the dangers of going above a 90% debt-to-GDP ratio proved to be the result of an Excel spreadsheet error and some over enthusiastic proponents of austerity. In short, there is no economic reason for France to be cutting back social spending at a point when its economy has enormous excess capacity.
Unfortunately, economics apparently plays little in role in determining economic policy in France and most other countries these days. For this reason, it is likely that Hollande will get most of his proposed cuts put into law. These cuts will directly hurt people, slow growth and cost jobs.
Remarkably, the cuts will likely be viewed as a success by the business press and much of the public. The reason is simple: France is likely to show decent growth in 2014, in spite of the cuts.
Economies do not shrink forever. After years of cutting back, governments across Europe are relaxing austerity, at least modestly. The same is true in the United States. This will be a net positive for growth everywhere, including France. As a result, even if Hollande's cuts may lower growth below what it otherwise would have been, he will still have some positive growth and job creation for which he can take credit.
In this sense, Hollande can be seen as similar to the pagan priest making sacrifices to the sun god at the winter solstice. When the days start getting longer again, the priest can boast about the success of the sacrifice to the sun god. The big difference is that, unlike Hollande, the priest's sacrifice didn't make things worse.