My readers wanted to know whether there exists historical evidence and an economic analysis that actually refutes them. The answer is yes. Keynesians still push the old fallacy that deficits stimulate employment and growth; that any deficit reduction, especially, with a very high level of unemployment, will slow an economy and lengthen the dole queues. Okay: first, there is no correlation between interest rates and deficits, and that goes for savings too. Secondly, the Keynesian view that deficits are needed to stimulate growth and employment is nonsense.

Deficits occur when spending exceeds revenue. Basically there are only two ways by which governments can finance deficits: borrowing money or printing it. Now government borrowing can drive up interest rates, it also directs savings from private investment to government consumption. (Monetary expansion can also drive up interest rates and lead to capital consumption). What these Keynesians obviously had in mind was not genuine borrowing but monetary expansion, i.e., inflation. Inflation funded deficits create balance of payments problems and distort the pattern of production which can also lead to stagflation.

(The irony here is that those who are now laughing at those economists’ predictions do not realise that since Howard became PM M1, a measure of money supply, has grown by 104 per cent. In other words, Howard’s economic policy has been very Keynesian indeed, though I very much doubt that Keynes would have approved of such a massive monetary growth¹).

The discredited Keynesian argument is that a deficit reduction cuts spending and hence reduces “effective demand”: therefore budget cuts increase unemployment. This is truly insufferable nonsense. To begin with, deficit cutting per se has no effect on aggregate spending. If the government cuts the deficit by raising taxes — which it doesn’t hoard — or cutting spending — much more preferable — the result is to change the composition of aggregate spending, not its magnitude.

Let history be our guide on this matter. Between 1945 and 1947 the US government slashed Federal spending from an annual $95 billion to $36 billion per year — a $59 billion cut in two years. This was a staggering 62 per cent reduction. Instead of the economy spiralling into a depression with 8 million unemployed, as predicted by Keynesians, including Samuelson, it boomed. And let us not forget the Keating surplus that accompanied a 3.25 per cent annual increase in employment. (In fairness to Keynes he did not support these predictions).

What it boils down to is that opponents of deficit cutting have no valid economic or social case. However, Howard’s defence of his budget policy was incredibly sloppy and wrong in several parts. (The same goes for his defence of deregulated labour markets). His claim that eliminating the deficit would automatically cut interest rates was not supported by history or economic theory. For example, from 1931 to 1940 America ran an average deficit of 3.6 of GNP but during the period 1934-1940 the average rate of interest on commercial paper was 0.77 per cent; 1936 saw the deficit rise to 4.4 (its highest level during the 1930s) and interest on commercial paper fall to 0.75 per cent².

The 1930s was a period of accumulating deficits and falling interest rates for the US; Australia was not much different. Britain, however, managed to get low interest rates while running only one deficit in the whole period. The problem is never deficits but spending. Governments cannot spend without taxing. The more they spend the more taxes they must raise.

Spending is the enemy and it is time that fact was stated loud and clear. Eliminating budget deficits will do nothing to bring home to the electorate the damaging consequences of excessive government spending. The cruel irony is that big-spending policies are self-defeating. The real tragedy is that it takes so long for this to become evident. Some people, however, never learn. Do they, Mr Rudd?

1. In January 1937 Keynes was warning that unless deficits were curbed inflation would emerge. And this is when unemployment stood at 11-12 per cent. T. W. Hutchinson’s opinion provides some interesting comments on this subject. (T. W. Hutchinson, Keynes vs. the ‘Keynesians’…?, Hobart Paperback, Institute of Economic Affairs, 1977).

2. If a country runs deficits while industry remains deeply depressed and the prospect of recovery is dim or nonexistent then it’s unlikely that interest rates will be forced up. Although American interest rates remained low Robert Higgs, economist and economic historian, found that during the 1930s net private investment fell by $3.1 billion. (Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression, Three River Press New York, 2003). Lester Chandler, a Keynesian economist, observed that the “failure of the New Deal to bring about an adequate revival of private investment is the key to it6s failure to achieve a complete and self-sustaining recovery of output and employment”. (Ibid.) There is also Benjamin M. Anderson’s indispensable Economics and the Public Welfare, LibertyPress, 1979 first published 1949. This provides a concise and detailed account of some of Roosevelt’s disastrous policies.

Rightwing bloggers should learn that though mocking Keynesians is an easy task, actually refuting them is a very different matter.

Gerard Jackson is Brookesnews’ economics editor

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