Can Invading a Small Third-World Country Stimulate the Economy?

by Polly Cleveland

Reviewing Reinhart and Rogoff's This Time is Different in the May 13 issue of the NY Review of Books, Paul Krugman and Robin Wells assert that, "…history can offer some evidence on the extent to which Keynesian policies work as advertised." After brief comments on work by the IMF and others, they proceed:

"An even better test comes from comparing experiences during the 1930s. At the time, nobody was following Keynesian policies in any deliberate way -- contrary to legend, the New Deal was deeply cautious about deficit spending until the coming of World War II. There were, however, a number of countries that sharply increased military spending well in advance of the war, in effect delivering Keynesian stimulus as an accidental byproduct. Did these countries exit the Depression sooner than their less aggressive counterparts? Yes, they did. For example, the surge in military spending associated with Italy's invasion of Abyssinia was followed by rapid growth in the Italian economy and a return to full employment."

WHAT? If this is the best case to be made for "Keynesian" economics (as opposed to what Keynes might have meant in his General Theory)--then it's past time to look for a new paradigm.

But let's assume Krugman and Wells are serious. What's the evidence, what's the logic and what's the alternative?

Start with Italy. If Italy really did recover quickly, crediting the Abyssinian invasion (1935-36) is still just a post hoc argument--no proof of causation. Besides, Mussolini was a very busy man--building new infrastructure, reorganizing Italy's notoriously corrupt and ineffective government along fascist lines, even supposedly making the trains run on time. Maybe Il Duce did some good for the Italian economy. But then we don't really know, as he tightly controlled the news and the statistics.

The "Keynesian" logic, as best I can explain it, holds that a crash makes people too frightened to spend money. Instead, they all try to save. This creates a downward spiral, in which lack of demand for goods leads to more decline, and more decline leads to more fear and more futile efforts to save. If the government steps in, borrowing and spending--no matter on what--that will reverse the downward spiral and restore the economy to normal.

An alternative paradigm runs as follows:

In ordinary economic times, businesses invest by combining labor, natural resources and capital equipment to produce goods and services. These goods and services then are consumed by the owners of the labor, resources and equipment, completing the little circle shown in Chapter One of every macro textbook. Money flows around the circle in the opposite direction, as businesses pay the owners, allowing them to buy the output. Public services and infrastructure--like schools and sewers--enhance production.

If something interferes with production, then there's less to consume. The shortfall must be rationed, --directly by rationing coupons, or indirectly by inflation, or by cutting off credit to marginal businesses, which in turn lay off workers. It's that simple.

What might interfere with production? Obviously natural disasters, like floods, earthquakes or volcanoes, or manmade disasters, like wars or oil spills--disrupt production. Less obviously, bad public investments like bridges and highways to nowhere also disrupt production; workers, resource and capital owners get paid--but the process creates no goods for them to buy. Military spending likewise fails to deliver the goods to compensate the producers. That's why nations at war institute rationing--to prevent inflation.

Even less obviously, bubbles disrupt production. As in the recent housing bubble, land appreciation makes homeowners feel they're getting richer so they don't need to save and invest. Simultaneously, housing and related industries build too much housing--with the same effect on the economy as bridges to nowhere or stockpiles of useless weapons. There's a shortage of goods people want, and that shortage must be rationed somehow.

When Wile E. Coyote runs off a cliff, he doesn't fall until he looks down. A housing bubble bursts when investors begin to look down, as in 2007, and recognize the growing mismatch between expectations and supplies. By the time the crisis hits, the damage has been done. (It's now conventional to blame the crisis on machinations of Madoff or Goldman, but the bubble made those machinations profitable, and hid them for years.)

So if invading a small third world country won't stimulate the economy, what will?

The "Keynesian" paradigm completely disregards the quality of government spending, borrowing and taxation. We need policies now to get production back on track. Priority should go to supporting small business, which provides the most employment and production per dollar invested. That means at the least making credit available and mitigating that great job-killer, the payroll tax supporting Social Security. (See my prior pieces on "Deficit Hawk, Progressive Style.")

Hey Paul and Robin, time to ditch the "Keynesian" paradigm and start over!

Please consider donating to Dollars & Sense and/or subscribing to the magazine (both print and e-subscriptions now available!).
4/29/2010 07:45:00 AM