A new “voodoo”?

Greg Hannsgen | August 22, 2011

The early phases of the 2012 presidential election season have already brought us a great deal of debate on fundamental economic policy issues. Greg Ip, in the Washington Post‘s PostOpinions, writes about the views of a number of Republican candidates (pointer via Economist’s View). Are they believers in the “voodoo economics” that many recall from past elections–tax cuts for the wealthy that supposedly spur growth and reduce deficits and at the same time?

Not according to Ip. He describes a risky, and somewhat novel, approach to economic policy emerging in this year’s political rhetoric. This approach rejects policies that have reduced the severity of the business cycle since the Great Depression.  Ip skewers the politicians’ critique of these Keynesian policies, which blames the country’s economic problems on excessive government action:

Many Republicans consider the tepid economic recovery an indictment of Keynesianism, and use the word as an epithet, as in “Keynesian Utopia” (Sarah Palin) or “Keynesian bubble” (Ron Paul). They argue that aggressive fiscal and monetary stimulus have made things worse by generating uncertainty among firms and investors, and that austerity would put things right.

They almost surely have it wrong. Uncertainty about fiscal and monetary policy was also rampant in the early 1980s: Taxes were cut and raised repeatedly and the Fed tried, then abandoned, efforts to target growth in the money supply instead of interest rates. Yet after a sharp recession in 1981-82, the economy took off, primarily because the recession had been induced by high interest rates and, once rates fell, demand sprang back.

….But weak U.S. growth primarily reflects the difficulty of stimulating demand through lower interest rates at a time when the private sector and the financial system are trying to shed debt — exactly the sort of liquidity trap Keynes identified in the 1930s. Other countries have experienced similar stagnation in the wake of financial crises. As for austerity boosting growth, the International Monetary Fund has found that far more often it does the opposite: Cutting the deficit by 1 percent of gross domestic product raises unemployment by 0.3 percentage points. The effects tended to be worse when they were not offset with lower interest or exchange rates.

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