Krugman's old-Keynesian fairy tale

Here's an excerpt from a longer and much-more-detailed piece by GMU's Veronique de Rugy in Reason. If you want more, click on the link and read the whole thing!

Across Europe, governments are announcing new austerity packages of spending cuts and higher taxes rather than Obama-style stimulus spending. In response, American economists such as Paul Krugman and Brad DeLong are warning that these policies will throw Europe back into a depression and should be avoided at all costs in the United States.

"The next time you hear serious-sounding people explaining the need for fiscal austerity," Krugman wrote in The New York Times in July, "try to parse their argument. Almost surely, you'll discover that what sounds like hardheaded realism actually rests on a foundation of fantasy, on the belief that invisible vigilantes will punish us if we're bad and the confidence fairy will reward us if we're good."

Of course, that's in contrast to the proven fairy tale that "stimulus" works wonders on an economy.

One crucial point Krugman leaves out is that most European Union member states have no alternative. Countries that rely heavily on foreign investors--such as Greece, France, Ireland, Italy, and Spain--must cut spending to avoid being shut off from the global capital markets.

Contrary to common belief, investors don't judge sovereign default risks based on public debt as a percentage of gross domestic product. Instead, bond professionals grade on a curve, assessing one country's fiscal behavior against another's. When investors lose confidence in a government's fiscal rectitude relative to its competitors, they withdraw, and the snubbed country suffers. Capital being a scarce good, the result is increased interest rates and a higher price for debt....

The notion that austerity is bad and stimulus is good rests on the Keynesian theory that if government spends a lot of money, that money will create more value in economic growth. This purported increase in gross domestic product is what economists call the "multiplier effect." It's a nice story, but like most fairy tales, it has scant basis in reality...

In a 2010 paper published by George Mason University's Mercatus Center (where I work), economists Robert Barro and Charles Redlick showed that in the best-case scenario, a dollar of government spending produces much less than a dollar in economic growth--between 40 and 70 cents. If that was the rate of return on our private-sector investments, America would soon cease to be a leading economic force....

The data released by the Bureau of Labor Statistics in June, then, were bad news. (See the chart.) They showed that since the passage of the stimulus bill, the private sector has lost 2.55 million jobs while the federal government gained 416,000.

The understandable temptation to take action in a time of recession should not lead lawmakers down unproductive paths. Stimulus by government spending doesn't work. European and American governments have tried it without success. Now is the time to tighten spending, no matter what some American economists might say....