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February 17, 2013, Sunday

America’s self-inflicted economic problem

At a time when the whole world is waiting for the second Obama administration to show more leadership in global affairs, the mood in Washington is full of gloom and doom because of the approaching budgetary crisis. It is hard to understand why the US will soon have to implement automatic cuts in federal spending, unless you are familiar with the austerity narrative versus the “growth and spending” club.

The Republicans in Congress are firmly in the austerity camp. A bit of history about John Maynard Keynes is necessary to understand the Democrat's position. Keynes, the most influential economist of the 20th century, proved that the main goal of governments facing recessions should be to stimulate the economy. This was the main lesson of the Great Depression of the 1930s, during which Western governments exacerbated the recession by tightening fiscal and monetary policy in order to balance the budget. The logic of the governments was to calm the markets instead of stimulating demand. Keynes, however, prioritized the real economy instead of the markets dominated by what he called “animal spirits.” He insisted that it was necessary to stimulate the economy by government spending in times of stagnation. This required counter-cyclical fiscal expansion. Fiscal expansion and increased spending eventually would revive aggregate demand and put an end to unemployment and recession.

History proved Keynes right during and after the Depression. The post-World War II order led to the supremacy of Keynesian economics. In fact, the period from 1945 to 1975 is often referred to as the “Keynesian consensus” -- a consensus based on a legitimate role for government spending and a commitment to the welfare state, full employment and economic growth. This 30-year supremacy came to an end because of inflation. The Keynesian consensus unraveled in the mid-1970s because of the oil shock that quadrupled energy prices from 1973 to 1979. This external shock to Western economies created high inflation and slowed down the economy. Despite considerable fiscal expansion, a combination of stagnation and inflation -- “stagflation” as the economists called it -- became the norm in the late 1970s both in Europe and the US.

The result was the emergence of Milton Friedman and his monetarist paradigm. Friedman's Chicago School argued that what the world needed was a return to basic free-market principles with laissez-faire capitalism. Sound budgets and smaller, less interventionist governments had to roll back the welfare state and its addiction to fiscal expansion. There was also a preference for monetary policy and supply-side economics over fiscal policy and demand stimulation in order to tame inflation. With Ronald Reagan in the US and Margaret Thatcher in the UK, Friedman's monetarism found its political testing ground. Under Thatcher and Reagan, Anglo-Saxon capitalism based on the principles of Adam Smith made a spectacular comeback.

Today the Republican Party, in particular the Tea Party camp within Congress, makes a strong case for less government spending and more room for market dynamics. They seem totally oblivious to the fact that what saved the US economy in 2007 was once again the Keynesian dynamics of government spending. First under Bush and later under the Obama administration, a strong stimulus package saved the US financial and banking sector from total collapse. It was nothing less than Keynesian economics that stopped the current recession from turning into a “great depression.”

The Republican Party needs to understand that cutting the deficit is not an economic policy in itself. America needs growth now. It can address the deficit once the economy starts growing again. The Clinton era during the 1990s proved this is feasible. The decision to go for sequestration now with across-the-board spending cuts will slow down the economy right when things are slowly picking up. America cannot and will not show global leadership as long as it is plagued by bad economic policies and self-inflicted wounds.

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