The economic debate is polarized because the policy paradigm is changing

The great domestic policy challenge of our time will be to navigate the divide between those who accept the paradigm of change and those who seek to deny it

If even economists can't make sense of the debate, can the rest of us?
Henry Kopel
On 17 May 2012 09:59

Economic policy is often a subject of lively debate, but today’s battles over the economy seem especially polarized.

In Europe, the debate over (future) austerity versus continued high levels of spending and borrowing has just unseated governments in France and Greece.

In the U.S., a similarly impassioned debate looms as a centerpiece of the 2012 Presidential campaign.  In states like Wisconsin and New Jersey, incumbent governors’ efforts to trim the growth of current spending and scale back ballooning pension obligations have ignited bitter, partisan battles.

One might expect economists to help make sense of these debates. But economists – even the Nobel prize winners – appear just as divided as the general public.

On the one hand, Nobel laureate and New York Times columnist, Paul Krugman insists that the $800 billion fiscal stimulus enacted by the U.S. Congress in 2009 was far too small to remedy America’s recession. On the other hand, Nobel laureates Edward Prescott and James Buchanan warned in 2009 that more government spending would not improve America’s economic performance.

Perhaps unfairly, such disputes echo George Bernard Shaw’s aphorism that “If all economists were laid end to end, they would not reach a conclusion.”

How then to make sense of this divide? One approach is to examine the current debate within its broader historical context, namely, the evolution of the Keynesian/welfare state paradigm. Since the end of World War II, that paradigm reflected the governing policy consensus among the Western democracies.

It is helpful to recall from the 1940s, the concerns animating politicians and economists on the eve of victory.  Having endured a decade-long depression before the war, many feared that peace and demobilization risked a return to the bleak economic landscape of the 1930s.

Preventing a return to that landscape became the priority for post-war domestic policy. Building on earlier initiatives like America’s “New Deal,” the Western democracies enacted and expanded a variety of social welfare and insurance programs. Expanding social welfare spending gained substantial support from the popularization (among policymakers) of John Maynard Keynes’s “General Theory of Employment, Interest, and Money,” published in 1936.

Against prevailing economic theory, Keynes argued that markets do not always ‘self-correct,’ and deficit spending in recessions can trigger a virtuous cycle of spending, investment, and economic growth.

Through the 1950s and 1960s, the Keynesian/welfare state paradigm seemed to be validated by unprecedented economic growth and middle class prosperity. But as often happens with social change, consensus became orthodoxy, and orthodoxy spawned vested interests, which continually pushed to expand the initial policies.  Between 1950 and 2010, social welfare spending ballooned from a modest share of government spending to the largest part of the budget.

A few figures are illustrative.

In 1962, the major U.S. social support programs – social security, and housing and farm subsidies – totalled 23 percent of the federal budget (about $25.5 billion in 1962 dollars). In 2010, the major social support programs – all the foregoing plus Medicare and Medicaid, enacted in 1965 – totalled over 70 percent of the budget (about $2.4 trillion in 2010 dollars).

In 1965, U.S. defense spending was 7.4 percent of gross domestic product (GDP), while Medicare, Medicaid, and social security were just 2.5 percent of GDP (about $23 billion in 1965 dollars).  In 2012, the defense share had declined 40 percent, to 4.5 percent of GDP, but the medical plus social security program share was up 400 percent, to almost 10 percent of GDP (over $1.5 trillion in 2012 dollars).

In 1960, the total U.S. national debt was $286 billion, equal to $1,562 per person.  In 2012, the national debt is over $15 trillion, equal to $50,000 per person – and $138,000 per working American.

Worse, with the ratio of working to non-working Americans still declining, the amount of Medicare, Medicaid, and social security spending is projected to explode.  Just 15 years from now, those three programs plus interest on the debt will consume all – repeat, all – federal tax revenue.

Not a dime of revenue will be left for national defense, domestic security,job training, education, research and development, environmental protection, national parks, or other federal commitments.

The fifty states are hardly better, staggering under $2 trillion in unfunded pension obligations.  And other than Germany, most Western democracies face similar fiscal dead ends.  Without painful, major change, all are headed towards insolvency.

What went wrong?  At least four factors seem apparent.

First: unsustainable expansion. The welfare state has greatly expanded beyond its early conception. For instance, under President Roosevelt, the social security eligibility age was not far from average life expectancy. Today, life expectancy exceeds the eligibility age by more than 20 years. Similarly, the strongly pro-union Roosevelt declared that “collective bargaining, as usually understood, cannot be transplanted into the public service.”  Now, most state and local workforces are unionized – and unlike private sector workers, many make little or no contribution to their generous health and retirement benefits.

Second: overconfidence in the paradigm.  Recent scholarship questions the common narrative that the New Deal was, and Keynesian stimuli are, effective tools of recovery from recession.  The government’s own figures from the 1930s show unemployment never dropped below 14 percent, and often was higher.

Further, a central tenet of Keynesian economics – that through a “multiplier effect,” each dollar of government spending triggers more than a dollar of economic activity – is increasingly subject to question.

A 2010 study by the National Bureau of Economic Research concluded that, in countries characterized by free trade, floating exchange rates, and high national debt – sound familiar? – the multiplier is zero.  That is, fiscal stimuli do not work in this context.

Third: unexpected cultural changes.  At the inception of the modern welfare state, a heavy social stigma accompanied taking welfare, having children out of wedlock, and refusing to marry the mother of one’s children. The disappearance of those stigma raised significantly the utilization and hence the costs of welfare programs, while also reducing their effectiveness at reducing poverty – especially among children, the most innocent victims of those changes.

Fourth and finally: demographic changes.  In 1965, the U.S. had 5.1 workers for every retiree collecting social security.  In 2000, that figure fell to 3.4 workers per retiree.  The ratio will sink to 2.5 in 2020 – so even without benefit increases, the program cost per worker will be double the 1960 cost.  Similar gloomy statistics hang over the even more costly Medicare program.

Taken together, these changes and reassessments mark the end of the Keynesian/welfare state paradigm – at least in anything like its present form.  The French and Greek electorates may say no, but the tide of history says yes, major change is inevitable.

The polarization of contemporary economic policy debates reflects the divide between those who accept this paradigm change, and those who seek to deny it.  Successfully navigating this change is the great domestic policy challenge of our time.

Henry Kopel is an attorney with the U.S. Department of Justice in Connecticut.  The views here are his own, and do not reflect the views of the Justice Department

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