More spending: our economic poison and panacea

Subtitle: The battle between John Maynard Keynes and F.A. Hayek

DURING THE global financial crisis, we were told by governments that the best way to fix the world economy was to increase spending. This sounds simple enough given that increased government spending and lower interest rates can be used to boost output, but it is only a partial truth.

John Maynard Keynes is the poster boy for governments everywhere because he prescribes a simple medicine for broken economies, more spending. The story runs like this: in uncertain economic times people save more money which makes sense for each person individually but leads to reduced spending overall and therefore lower firm revenues and lower economic growth. The only way out of this unhealthy spiral of saving is for the government to step up to the plate and increase the circular flow of money by spending on public works, digging ditches, war, fixing broken windows, or pretty much anything.

F.A. Hayek is the voice of reason who provides us with the other side of the story. Increased government spending (and quantitative easing) is not the solution to the problem and may actually make things worse because it continues to reward the malinvestments made during the boom years. The argument is that governments should play a limited role because propping up poor businesses and investments is not the best way to encourage strong and sustainable economic growth.

As you can guess, Hayek is not popular among the fat cats in public office because allowing businesses to fail during hard economic times will most likely lead to a sharp increase in unemployment (albeit temporary) and this will be very politically unpopular.

We should ask ourselves though, do we actually believe in the capitalist system? And if we do, what is the legitimate role of government in that system?