EDITOR'S note:

Should governments increase spending to maintain economic growth in recession years? Renowned economists Paul Krugman and Richard Layard say yes in "A Manifesto for Economic Sense" late last month. Shawn Mesaros, managing director of Pacific Asset Management, disagrees in a statement sent to Shanghai Daily. The following is a condensed account of their arguments.

Manifesto: More than four years after the financial crisis began, the world's major advanced economies remain deeply depressed, in a scene all too reminiscent of the 1930s. And the reason is simple: we are relying on the same ideas that governed policy in the 1930s. These ideas, long since disproved, involve profound errors both about the causes of the crisis, its nature, and the appropriate response...

The causes. Many policy makers insist that the crisis was caused by irresponsible public borrowing. With very few exceptions - other than Greece - this is false. Instead, the conditions for crisis were created by excessive private sector borrowing and lending, including by over-leveraged banks. The collapse of this bubble led to massive falls in output and thus in tax revenue. So the large government deficits we see today are a consequence of the crisis, not its cause.

Shawn Mesaros: Government, not consumers, is responsible for effectively "subsidizing" the poor behavior of consumers. Banks are nothing more than recipients of the Federal Reserve policies.

In fact, these policies created a self-reinforcing policy response at the state and local level to where tax policies favor the trend in rising home prices, rising home equity, lowered borrowing costs, thus much higher retail sales which policy-makers knew was poor policy, but now, having bitten the apple, they could not resist the temptation to throttle the market with more leveraged products. After all, leveraged transactions have the capacity to create GDP numbers.

Then we see Fannie Mae and Freddie Mac who were again, set up in the "Great Depression" as a lender of last resort, yet these same entities became the dumping ground for everything toxic during an economic boom. Federal policy drove these failures.



Manifesto: The nature of the crisis. When real estate bubbles on both sides of the Atlantic burst, many parts of the private sector slashed spending in an attempt to pay down past debts. This was a rational response on the part of individuals, but - just like the similar response of debtors in the 1930s - it has proved collectively self-defeating, because one person's spending is another person's income. The result of the spending collapse has been an economic depression that has worsened the public debt.

The appropriate response. At a time when the private sector is engaged in a collective effort to spend less, public policy should act as a stabilizing force, attempting to sustain spending. At the very least we should not be making things worse by big cuts in government spending or big increases in tax rates on ordinary people. Unfortunately, that's exactly what many governments are now doing.

Mesaros: The Manifesto authors continue asking government to give away money, soak up all excess capacity, and stabilize the bloated system by borrowing against the same taxpayers who will be harmed for many future generations with debts in order to provide appropriate solutions to what is clearly a crisis of too much debt.



Manifesto: The big mistake. After responding well in the first, acute phase of the economic crisis, conventional policy wisdom took a wrong turn - focusing on government deficits, which are mainly the result of a crisis-induced plunge in revenue, and arguing that the public sector should attempt to reduce its debts in tandem with the private sector. As a result, instead of playing a stabilizing role, fiscal policy has ended up reinforcing the dampening effects of private-sector spending cuts...

Deeper and deeper in debt

Mesaros: When the government goes deeper and deeper in debt, taxes go higher and higher since taxpayers pay for everything government does. The Manifesto authors would have us believe that when we go deeper into debt, we recover faster. This is false.

One cannot invest and save more when one is continuously paying off ever larger mountains of debt. We would suggest that the laws of physics continue to apply in economics. If you want to see a faster growing economy in real terms, the first rule is to save and invest more at the consumer level.



Manifesto: Moreover past experience includes no relevant case where budget cuts have actually generated increased economic activity. The IMF has studied 173 cases of budget cuts in individual countries and found that the consistent result is economic contraction. In the handful of cases in which fiscal consolidation was followed by growth, the main channels were a currency depreciation against a strong world market, not a current possibility. The lesson of the IMF's study is clear - budget cuts retard recovery. And that is what is happening now - the countries with the biggest budget cuts have experienced the biggest falls in output.

Mesaros: The Manifesto authors are accurate here. The IMF studies are most centered on emerging economies and smaller countries.

And using the same 173 case studies, the manifesto authors fail to also admit that these studies demonstrate the largest decline in GDP resulting from absolute reduction in government spending occurs in countries where government makes up a very large percentage of GDP. Embrace big government, and then never let them stop spending or you get a big drop in GDP.

Both Greece and Spain had about 7 percent unemployment before the financial crisis. The result of "austerity" aka "less government spending" was truly astonishing.

About 25 percent unemployment in just 36 months. Did non-government demand drop off that much? NO. What was the cause of that rise in unemployment? Government sponsored businesses and government employees no longer received free credit card cheese. They were fired or the businesses, long since without economic benefit, disbanded for the epic failure of capitalism that they would have represented.



Manifesto: ...as spending rose between 1940 and 1942, output rose by 20 percent. So the problem in the 1930s, as now, was a shortage of demand not of supply.

Mesaros: The Manifesto authors forget that between 1929 and 1942 consumer credit actually contracted for about 11 years before bottoming ahead of World War II. Consumers had saved money, they had invested money, and it set the stage for a wonderful period of economic expansion in the United States.

As we would expect, the Manifesto authors explain this 20 percent rise in output as "government spending" only and not actual taxpayers working and producing anything.