"In 2013 economists at the IMF rendered their verdict on these austerity programmes: they had done far more economic damage than had been initially predicted, including by the fund itself. [..] In the 1920s Britain had sunk into an economic slump. The first world war had left prices higher and the pound weaker. The government was nonetheless determined to restore the pound to its pre-war value. In doing so, it kept monetary policy too tight, initiating a spell of prolonged deflation and economic weakness. [..] The British government [..] espoused the conventional wisdom of the day—what is often called the “Treasury view”. It believed that public spending, financed through borrowing, would not boost overall economic activity, because the supply of savings in the economy available for borrowing is fixed. [..] In 1931 Baron Kahn, a British economist, published a paper espousing an alternative theory: that public spending would yield both the primary boost from the direct spending, but also “beneficial repercussions”. If road-building, for instance, took workers off the dole and led them to increase their own spending, he argued, then there might be a sustained rise in total employment as a result. Kahn’s paper was in line with the thinking of John Maynard Keynes, the leading British economist of the day, who was working on what would become his masterpiece, “The General Theory of Employment, Interest and Money”. In it, Keynes gave a much more complete account of how the multiplier might work, and how it might enable a government to drag a slumping economy back to health. [..] The book is filled with economic insights. Yet its most important contribution is the reasoning behind the proposition that when an economy is operating below full employment, demand rather than supply determines the level of investment and national income. Keynes supposed there was a “multiplier effect” from changes in investment spending. A bit of additional money spent by the government, for instance, would add directly to a nation’s output (and income). [..] Keynes thought this insight was especially important because of what he called “liquidity preference”. He reckoned that people like to have some liquid assets on hand if possible, in case of emergency. In times of financial worry, demand for cash or similarly liquid assets rises; investors begin to worry more about the return of capital rather than the return on capital. Keynes posited that this might lead to a “general glut”: a world in which everyone tries to hold more money, depressing spending, which in turn depresses production and income, leaving people still worse off. In this world, lowering interest rates to stimulate growth does not help very much. Nor are rates very sensitive to increases in government borrowing, given the glut of saving. Government spending to boost the economy could therefore generate a big rise in employment for only a negligible increase in interest rates. Classical economists thought public-works spending would “crowd out” private investment; Keynes saw that during periods of weak demand it might “crowd in” private spending, through the multiplier effect. Keynes’s reasoning was affirmed by the economic impact of increased government expenditure during the second world war. [..] In a story in Time magazine, published in 1965, Milton Friedman declared (in a quote often attributed to Richard Nixon), “We are all Keynesians now.” But the Keynesian consensus fractured in the 1970s. Its dominance was eroded by the ideas of Friedman himself, who linked variations in the business cycle to growth (or decline) in the money supply. Fancy Keynesian multipliers were not needed to keep an economy on track, he reckoned. Instead, governments simply needed to pursue a policy of stable money growth. An even greater challenge came from the emergence of the “rational expectations” school of economics, led by Robert Lucas. Rational-expectations economists supposed that fiscal policy would be undermined by forward-looking taxpayers. They should understand that government borrowing would eventually need to be repaid, and that stimulus today would necessitate higher taxes tomorrow. They should therefore save income earned as a result of stimulus in order to have it on hand for when the bill came due. The multiplier on government spending might in fact be close to zero, as each extra dollar is almost entirely offset by increased private saving. [..] The economic experience of the 1970s seemed to bear out their criticisms of Keynes: governments sought to boost slow-growing economies with fiscal and monetary stimulus, only to find that inflation and interest rates rose even as unemployment remained high. [..] These attacks, in turn, prompted the emergence of “New Keynesian” economists, who borrowed elements of the freshwater approach while retaining the belief that recessions were market failures that could be fixed through government intervention. [..] The most prominent included Stanley Fischer, now the vice-chairman of the Federal Reserve; Larry Summers, a former treasury secretary; and Greg Mankiw, head of George W. Bush’s Council of Economic Advisers. In their models fiscal policy was all but neutered. Instead, they argued that central banks could and should do the heavy lifting of economic management: exercising a deft control that ought to cancel out the effects of government spending—and squash the multiplier. Yet in Japan since the 1990s, and in most of the rich world since the recession that followed the global financial crisis, cutting interest rates to zero has proved inadequate to revive flagging economies. [..] The practical experience of the recession gave economists plenty to study, however. Scores of papers have been published since 2008 attempting to estimate fiscal multipliers. Most suggest that, with interest rates close to zero, fiscal stimulus carries a multiplier of at least one. The IMF, for instance, concluded that the (harmful) multiplier for fiscal contractions was often 1.5 or more. Even as many policymakers remain committed to fiscal consolidation, plenty of economists now argue that insufficient fiscal stimulus has been among the biggest failures of the post-crisis era."
