After the French elections and the victory of the left, it is hard to avoid the impression that the backlash against fiscal austerity will now lead to a new wave of growth-oriented Keynesian expansionism.
The French electorate has a reputation for strong anti-globalization and anti-market inclinations. But in many ways, the French vote was also a victory for basic macroeconomics. John Maynard Keynes, the most influential economist of the 20th century, proved that the main goal of governments facing recessions should be to stimulate the economy -- not to balance their budget in order to calm the markets. 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 instead of stimulating demand.
According to Keynes, this goal of stimulating the economy in times of stagnation requires counter-cyclical fiscal expansion. Fiscal expansion and increased spending eventually revives aggregate demand and puts an end to the slowdown. This obvious historical lesson, learned the hard way in the 1930s, led to the supremacy of Keynesian economics in the post-War era. In fact, the period from 1945 to 1975 is often referred to as the “Keynesian consensus” -- a consensus based on a commitment to the welfare state, full employment and economic growth.
But all good things eventually come to an end, and the Keynesian consensus unraveled in the mid-1970s because of the oil shock that quadrupled energy price from 1973 to 1979. This external shock to Western economies created high inflation and slowed down the economy. Despite considerable fiscal expansion “stagnation” became the norm in the late 1970s both in Europe and the United States. 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 United Kingdom, 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. The new era was all about small government, deregulation, lower taxes, lower spending and privatization. With the end of the Cold War and the takeoff of global finance and capitalism even in China and Russia, hubris set in. Fukuyama famously claimed that we had reached “the end of history.”
Yet, once again, all good things had to come to an end. First the Asian crisis in 1998 and, 10 years later, the financial crisis in the United States led to a revival of Keynesian economics. The pendulum was slowly swinging back to the need for fiscal stimulus, stronger regulation and more effective governance. First under Bush and later under the Obama administration, a strong stimulus package saved the American financial and banking sector from total collapse. It was nothing less than Keynesian economics that stopped the current “great depression” from turning into a “great depression.” However, as the crisis spread to Europe with the sovereign debt dilemma, the consensus went in the opposite direction. A great part of the problem was Germany's aversion to inflation and fiscal expansion. According to German monetary orthodoxy, the crisis in Europe was triggered by too much spending and borrowing, mainly by the so-called club-Med countries like Greece, Spain, Italy and Portugal. As a result, “recovery through austerity” became the main mantra. With the election of Socialist François Hollande this mantra will now be tested. In effect, the victory of the left means the end of “Merkozy,” the Franco-German axis that has enforced the austerity regime of the past two years.
So what's next? This emerging polarization between growth versus austerity is in many ways a false debate, because Europe needs both. It is clear that France cannot spend its way out of recession. There will have to be structural reforms that will improve the performance of the economy and reduce the size the inefficient welfare state. But now is not the time. Instead of teaching how to swim, first there is a need to save the patient that is drowning. This will require stimulating the economy while simultaneously signaling to nervous markets that reforms will be implemented as soon as demand picks up and unemployment goes down. Instead of an either austerity or growth debate, pragmatic common sense is required.