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

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!

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

  • Dear Colleagues

    I was studying “Keynesian” economics at Cambridge 50 years ago. I have been in the USA for more than 40 years, and always distressed by the lack of understanding of what Keynes was all about.

    Keynes did not “completely disregard” the quality of government spending, borrowing and taxation … in fact Keynes was very clear about the need for savings and investment, not simply taxing (or not) and spending by government.

    But this conversation is not particularly important at the present time because science and technology today is in a very different place than 70 odd years ago. So also, accounting and economic metrics are in a different place, and in my view fatally flawed. They are all about money profit, stockmarket prices and GDP growth, while the big issues of the day are about the social commons, the sustainability of the our technologies to serve nearly 7 billion people, huge needs not being satisfied for perhaps 4 billion people while competent people are unemployed. Capital markets need to be able to allocate capital where it is really needed, not merely where some people can earn a fast buck.

    Knocking down is not a sensible idea … allocating resources to building things we need to build social value for the planet is a very good idea. Please come into the 21st century!

    Peter Burgess

  • Completely agree! And regarding Krugman, my respect for his economic acuity has been weakening over the last several months (China and all) but this is the last straw. Krugman has nothing helpful to offer us. It is beyond the pale to argue that military invasion can serve as a Keynesian stimulus. Even if military spending does stimulate the economy, we cannot build a world that works for everyone by condoning invading and killing some as a way to create jobs and secure basic needs for others.

  • Was Abyssinia’s economy stimulated, too? Somehow I doubt it. As for Italy, I agree the opportunity cost of militarization and war is still an opportunity cost. -jb

  • Great work on highlighting the immorality that underpins Keynesian destruction-as-stimulus nonsense. The time has absolutely come for an end to demand-side management. There’s nothing progressive at all about counter-cyclical Keynesian doctrine. It’s an inherently conservative, static-world approach that seeks to prevent change and maintain the current order by preserving the demand for current production despite changes in the composition of that demand.

    But the real Keynes never actually bought into this, which is why he resisted so-called “stimulus” in 1937 Britain despite 11% unemployment. Instead, Keynes was more-or-less a socialist, seeking to turn all “investment” over to the state and “euthanize the rentier”.

    The 1960s helped a new generation of progressives break away from the historic love of war and foreign adventures that had been a hallmark for the progressive era leadership from Teddy to Wilson to FDR to Truman to JFK & LBJ. That was a good move. The warmongers became neocons.

    Maybe, just maybe, the green movement will break progressives away from the pro-consumption, anti-savings dogma of John Maynard Keynes where ditch digging, waste and war is “stimulus”.

    Paul Krugman isn’t the conscience of a liberal. Or he shouldn’t be.

    Great blog post.