As an undergraduate student, I initially was taught the simplistic version of Keynesian economics as expounded by Paul Samuelson in his classic textbook. Keynes, according to Samuelson, advocated the use of fiscal policy (spending and taxes) to counter the effects of business cycles, When the economy veered towards a recession, such as in 2008, government should increase spending and cut taxes to stimulate demand.

Even in the most simplistic and favorable model for pro-active fiscal policy, several questions arose. How much should spending be increased? In what areas should spending be increased? Similarly, which taxes should be reduced and by how much? How quickly could government change spending and taxes and how long before the changes impacted demand? Could a pro-active and counter-cyclical fiscal policy be timed to have its maximum impact at the right time?

As we moved on from the simple model, I learned that the net effect of fiscal stimulus likely would be muted by rising interest rates (government might have to borrow to finance any resulting budget deficit) and possibly an appreciation of the currency (higher interest rates might attract inflows of capital). Unless, the fiscal policy were supported by accommodating monetary policy that would limit the increase in interest rates, fiscal policy might be totally ineffective. But accommodating monetary policy would lead to the expectation of higher rates of inflation and this in turn would lead to higher interest rates.

The theoretical attacks mounted against pro-active Keynesian policies by neo-conservative economists who opposed any expansion of government in the economy. Fiscal policy could not work because of the so-called Ricardian equivalence. Taxpayers could not be fooled. They would recognize that taxes would have to rise in the future to pay off the debts accumulated during recessions. Thus, consumers (i.e. taxpayers) would cut back on their spending now in order to build up their wealth to pay the higher taxes in the future.

A pro-active fiscal policy might even have negative impacts on demand. Deficits and growing debt could have serious negative effects on confidence. Countries might hit a debt wall and not be able to borrow further. The prospect of defaults, sharply higher interest rates and massive tax increases would shatter confidence and result in consumers cutting back on their spending and business cutting back on investment.

In the extreme, governments should abandon any efforts to engage in counter-cyclical fiscal policy. Any such effort would fail and only make the economic situation worse. Better that governments focused on fiscal responsibility – balanced budgets and a smaller role in the economy.

Of course, the real Keynes would have countered these arguments by emphasizing that a recession would more likely have a negative impact on confidence than would the appearance of a budget deficit. Indeed, if fiscal policy did succeed in the short run to augment demand, confidence might be boosted and reinforce the fiscal actions. Confidence is not buttressed by rising unemployment rates and lower sales volumes.

Who is right?

Fortunately, we now have an interesting experiment underway. Many European governments have been spooked by rising budget deficits and therefore have introduced measures to rapidly reduce and eliminate their deficits. On the other hand, the US has not yet succumbed to the pressures of neo-conservative economists and their political brethren. Reducing the deficit is being deferred in the US.

The paths of the economies in Europe and the US over the next few years might help resolve the debate. Thus far it appears as if the pro-Keynesian camp is winning. The US economy is continuing to grow, while more countries in Europe are slipping back into a recession. Time will tell.

The opinions expressed in this blog are personal and do not reflect the view of either Global Brief or the Glendon School of Public and International Affairs.