Faith-Based Economics

Rob Parenteau has a post at Naked Capitalism commenting on Wolfgang Münchau’s article in the Financial Times.  Münchau argues that policy makers in Europe largely ignored the spillover effects of simultaneous fiscal contraction across the entire eurozone.  Parenteau insists that, at least at the level of ideas, the problem occurs at a much more basic level:

…while this pursuit of simultaneous, multi-year fiscal consolidation can only thwart itself by dragging down growth and dampening tax revenues, thereby leading perversely to still higher public debt outstanding, the problem does not lie so much in failure of policy makers to recognize and take into account the interactive effects of fiscal consolidation across countries. Rather, the truth of the matter is that most of the eurozone policy makers and their erstwhile economic advisors are practicing a faith based economics. They believe in the moral purity of balanced fiscal budgets. They also believe private sector activity will pick up to more than compensate for public sector cutbacks. That is the essence of the Ricardian Equivalence Theory, which is a central theoretical proposition that mainstream economists believe in and teach every graduate student to parrot.

Paul Krugman had a similar reaction:

That said, I think Munchau is being too kind here. European leaders and institutions by and large didn’t even get to the point of devising policies that might have worked in a small open economy. Instead, they went in for fantasy economics, believing that the confidence fairy would make fiscal contraction expansionary.

Parenteau points to presentations he delivered at the Levy Institute’s Minsky Conference in which he assailed this idea of “expansionary contraction” (the idea that deficit-cutting can boost growth) from the standpoint of the financial balances approach.  In his 2010 presentation, Parenteau regrets that the sectoral balances approach, typified by the work of Wynne Godley, hasn’t caught on more in the mainstream—though in journalism he notes the occasional exception from Martin Wolf in the Financial Times (see Wolf’s latest column for just such a flirtation with the financial balance approach.  The heterodox flavor of Martin Wolf’s writing is quite striking, as noted previously.)

You can hear the audio for Parentau’s 2010 presentation here (see Thursday, Session 4); the slides for the presentation are here.