The Great American False Dilemma: Austerity vs. Stimulus

Dear Readers: I’m currently writing a long-form post twice a month now for Chris Martenson’s excellent wesbsite. Accordingly, I’ll be publishing the first (and free) part of these essays here at Enjoy. — Gregor


“Like the issue of…’Is it better to have austerity or stimulus?’ Well, the basic problem there is that we’re not having a quality conversation on the subject.” –Ray Dalio, Bridgewater Associates, on the Charlie Rose program, October 20, 2011

Probably no American city better illustrates the trajectory of post-war US growth than Los Angeles. With its ganglion of highways (built when oil cost $14 dollars a barrel) and its never-ending boulevards that, having replaced vast acreages of citrus, now light up the night sky, the City of Angels spent 40 years blowing past its old pre-war borders and filled up an entire geological basin with infrastructure.

The scale of this expansion can be seen in this very helpful satellite photo from NASA, which captures a sweeping view of Los Angeles County. For example, Hollywood, a common reference point for most Americans, is reduced to a small village from this perspective; a mere data point, if you will, as the greater metro region cascades without interruption 100 miles to the east.

Even more awesome to contemplate is that much of this landscape is duplicated to the south, as well, through Orange and San Diego counties. Indeed, nearly 7% of US population lives in the five large counties of southern California, with counties like San Bernardino having exploded from 200,000 people after WW2 to over 2 million today. Unfortunately, what was long accepted as a triumph of growth the past 60 years has now become a rather burdensome and exceedingly expensive system to maintain.

I bring up the case of Los Angeles because there is currently a rather tribal, oppositional, and, of course, very heated debate taking place in the US right now that roughly frames the solution to our problems as a choice between Austerity and Stimulus. For this debate to have meaning, we need to consider how economic policies will actually solve the problems currently endured in a mega-region like Los Angeles. Unemployment, food stamp use, and energy costs have leapt ever higher here since the 2008 crisis. Moreover, the seeds of these trends were already showing up before the infamous Autumn of 2008. How would either a new phase of belt-tightening or reflationary policy actually affect southern California?

When we witness the clash between the Austerity and Stimulus camps, on the surface there is the appearance that a true debate is taking place between diametrically opposed economists. For example, Austerity folks correctly note that our economy has been badly weighted towards consumption for some decades. They want to clear out the excesses, let the malinvestments fail, and elect an overall path of acute economic pain in order to reset the system. Stimulus advocates find such plans completely unnecessary, if not downright masochistic. Armed with a more humanistic approach, Keynesians want the government to run large deficits to help the private sector deleverage, which of course could take years.

A late 2010 article in the FT by Gavyn Davies illustrates this point. From the viewpoint of sectoral balances, government deficits show up as “savings” on the balance sheet of the private sector. Of course, this is a deduced accounting identity and may not actually tell us much at all about whether the private sector is becoming healthier. I will probe further into this data later on in the essay. But first, the Gavyn Davies chart from the Financial Times: The most important graph of the year:

From the standpoint of a global macro economist, this is my nomination for the most important graph of the year. (See the end of this blog if you wish to suggest alternatives.) It explains why the world’s largest economy, the US, has defied the pessimists by mounting a decent recovery in 2010. It also explains the behavior of the government deficit and shows why it has so far been easy to finance this deficit.

This is the essential argument made by Keynesians and adherents to MMT (Modern Monetary Theory). The US is a monopoly issuer of its own currency, and while inflation is a risk, default (per se) is not. While interest rates are low during deleveraging in the developed markets (DM), why not ease social and economic pain through further borrowing? After all, as the chart implies, the private sector will simply use this spending to repair its own balance sheet. Once a tipping point is reached, then the private sector can start taking on new credit, increasing tax revenues to government, and thus knocking down the debt incurred during the recession (or depression). What’s not to like?

Meanwhile, a great example of the austerity argument comes from Ron Paul, who recently released his plan to dismantle several federal government agencies, end the wars, and consequently chop a full trillion out of the annual budget deficit. Those in favor of such fiscal shock and awe are also persuaded by the view that government spending “crowds out” the private sector, and that government misallocation of capital nearly always exceeds the private sector’s similar mistakes.

Frankly, I am sympathetic to the sincere urges on both sides of this debate. Why not conduct reflationary policy indefinitely, at least as a humanitarian exercise? That is the plea I detected in a recent Martin Wolf column, Time to Think the Unthinkable and Start Printing Again. And also, why not end the wars, kill off a number of regulatory agencies, and promote the growth of small business? Is it not clear that the Project of Empire has greatly deprived the US domestic economy of badly need infrastructure, transport, and educational investments?

Internal to this debate, however, are a number of shared assumptions about the free market’s ability to allocate resources—and the economy’s ability to create supply of those resources—given the proper encouragement from both policy and price signals. Namely, both sides are in near-complete agreement their prescription will not only deliver the US economy back to growth, but also to trend growth–an eventual rejoining, if you will, to the pre-2008 trend.

This is partly why this essay kicks off with a recent quote from Ray Dalio, founder of Bridgewater Associates, who correctly identifies that the situation we face is perhaps much more complex than can be solved by an entrenched, oppositional argument. Dalio is known for describing the economy as a machine that operates according to certain realities. I agree. Moreover, Dalio has also suggested repeatedly that once you understand how the machine operates, you no longer have to be so surprised all the time. Indeed, the last three years have been a true marvel, given how many people refuse to accept we are not in a post-war recession, but rather a debt-deflation depression. Do economists know how the economy actually operates?

As tough as I can be on the economics profession, I actually think most economists understand very well how the economy operates. But here is the problem: Their understanding has been rendered increasingly obsolete by the emerging problem of resource scarcity and the resistance of our built environment to an easy or quick energy transition. In other words, economists typically no longer have a solution for Los Angeles, or for Southern California. Or, for that matter, the United States.

It’s quite clear that advocates on both sides of the current debate truly believe that the US can return to a growth path. Equally, they share an assumption that the supply of energy will adhere to a shift in the supply curve, which means simply that more supply or substitutes will be brought to market if the price level is sustained at high enough levels.

As the chart above shows, however, neither the steady advance of energy prices into 2008 nor the ensuing three years brought on new, usable energy sources that could reduce energy expenditures for Americans. But there is no mystery as to why Americans, having to spend more for energy and thus less on consumption and investment, have faced persistently high oil prices. We have a built environment that’s designed for liquid fossil fuels. And the expected shift in the supply curve for oil has not occurred.

Earlier this month in the Harvard Business Review, in our response to Dan Yergin’s faith in future oil supply and healthy, industrial economies, There Will Be Oil, But At What Price?, Chris Nelder and I wrote:

Yergin wants to have it both ways: He wants us to believe that the market will bear the high prices required to keep supply increasing against the backdrop of mature fields — which are declining by 5% per year — while at the same time asserting that prices will remain low enough to engender continued economic growth. This, we submit, is impossible.

A rather serious problem in the ability of Developed Economies to coherently allocate resources started showing up well before the 2008 crisis. This status quo, made in part by policy mistakes, credit creation, and the energy limit, still remains today. Crucially, neither stimulus nor austerity will dislodge this status quo. Unless, of course, by austerity we mean to intentionally collapse the system, or if by stimulus we mean to engender a runaway inflation that will eventually yield the same result.

Even if you agree that the US economy has gotten itself into a badly misaligned place, ripping one trillion dollars out of its center is hardly going to “free up” resources or immediately engage the private sector in replacement activity. Equally, throwing more trillions at the economy in its current condition may serve to heighten, not dampen, inequality. As we have seen already, while stimulus may have put a break on systemic collapse, it has likely perfected the status quo. I agree very much with Paul Brodsky’s remarks earlier this month in his essay On Media Coverage of the Protestors:

For those of you who self-identify as progressives, you should re-think your defense of the current system. Money printing is a terribly regressive tax on the working and middle classes. Those with higher incomes and access to credit remain able to maintain their demand for inelastic goods and services, as well as maintain their ability to service debts, while lower wage earners, those with less access to credit, and those losing jobs as the real economy shrinks, are suffering. For those of you who self-identify as “free-market conservatives”, you should also re-think your support of the current system. “Free markets” are compelled to de-leverage presently, not to re-leverage. A more laissez faire regulatory environment and lower taxes do not address the fundamental problem, which is an abundance of credit that re-distributes wealth from the factors of production to the leveragers.


In Part II: How The Coming Decline Will Play Out, I provide fresh data on California’s economy and skewer the deductive accounting illusion that government deficits are allowing Americans to reduce their debts. I also show that free market failures are already occurring in the US economy. Austerity programs, from our current juncture, would do nothing but remove portions of the system at a time when the economy is not able to organically produce new economic flows. This would only serve to cripple the economy further, forcing it to contend with our crisis from an even lower starting point.

What the system needs instead is a more targeted transition process, not a radical simplification (Joseph Tainter’s term for collapse). Nevertheless, you can expect the sterile debate to continue, with the newest iteration of stimulus advocates now promoting NGDP (nominal GDP) Targeting. There is no question that capital markets, in the short term, absolutely love stimulus, because it allows existing economic flows to extend themselves temporarily. However, underneath this, all of the poor allocation of existing resources continues apace, and this is the central explanation for why the economy cannot create jobs: The connection between needs and actual production is badly broken.

Click here to access Part II of this report (free executive summary; enrollment required for full access).


  • Hi, Gregor- Excellent discussion, and thanks for taking mmt seriously. You are right that printing money isn’t intrinsically the answer, as long as it is being given to the same people- the banks, the rich. The fundamental problem that Keynes, and indeed Marx pointed to is inequality, as you touch on. Thus printing only would have a point if it is targeted to direct job creation and other spending the builds jobs and future-oriented public goods, like education, green energy, etc and so on. An economy of the rich is a banana economy.

    On the other hand, I think chart 2 here weakens your resource point substantially. If these few-percent rises in energy costs were killing us, then the middle period, where the cost share dips to 9%, should have had immensely stimulatory effects. But it didn’t. The chart shows that the dog (economy at large) wags the tail (energy costs), not that the tail wags the dog. 

    There is no question that we need to get off fossil fuels, for much better reasons than the purely economic. In economic terms, a substantial carbon tax would have a relatively small effect, while dramatically rebalancing the price and market position of fossil sources.

  • Anonymous

    What do you presume is the effect of the dreaded “money printing” here, which causes it to be a “regressive” tax?  That it causes price rises without increasing aggregate nominal income/spending?

  • Anonymous

    Great article that hits the key points.

    I want to add that stimulus spending used to buy a TV set made in china shows up as GDP but it doesn’t help anything.

  • Anonymous

    Gas prices steadily increase since 2008

    It goes without saying that as fuel prices increase so does the price of everything else.
    So how are earnings holding up?

    Bureau Of Labor Statistics: Hourly earnings falling

  • Anonymous

    What’s the point?  It would be highly surprising if the expected path of US aggregate demand was not positively correlated with commodity prices.  If QE raises the expected growth of aggregate demand, then you would expect commodity prices to go up also.

    If the Fed deliberately suppresses nominal demand growth every time there is a commodity price spike, which feeds higher headline CPI, how will that help energy transition?  I would say it does the opposite, e.g. if the effect is that everybody expects the Fed to prevent oil going to $150 again.

    The distributional impact of rising commodity prices is not the Fed’s
    problem.  I would say it is a fiscal problem, though I’m sure many on
    the right would deny that.

  • I like the longer articles, excellent!

    More of your voice coming through.


    As you know, I favor an energy-infrastructure form of Keynesian spending as it is the only tactic that would bring forth energy resources in the form of conservation. However, the larger point of this post should not be missed: monetary tactics that would have worked in the resource-abundance era will not work now. Redistribution of societal wealth into a much more sane distribution is something I agree with very much. But, it will not solve the economic problems in a way that so many believe (Reich, Stiglitz). The US economy faces a triple problem: a built environment aligned to liquid fossil fuels, high priced liquids fossil fuels, and a gini coefficient that would make a banana republic proud.

    Something very important should be pointed out here: leading economists on the Left are absolute believers in the market’s ability to efficiently allocate resources. They do not believe in market failure as much as they might claim. They only differ with economists on the Right in negligable ways. The difference, very minor, is makes by partisanship. Delong, Thoma, Krugman, Stiglitz, et al are all children of Adam Smith. Big time.

    I will make a prediction: we will see the day when Krugman, because he’s so damn smart and clever, will finally piece together his understanding of resource scarcity to his Keynesianism and have a big, ah-hah moment. 🙂



    Cheaper resources are not brought forth by the mere act of money printing, or reflationary policy. That is the point.



    That’s the problem with this particular energy transition. Higher prices–and especially volatile prices–for oil are not helping to trigger transition. There is a widespread faith in price to redirect behavior. This is understandable. However, I believe in market failure and I don’t believe in the power of price–at this juncture.


    That’s the problem with this particular energy transition. Higher prices–and especially volatile prices–for oil are not helping to trigger transition. There is a widespread faith in price to redirect behavior. This is understandable. However, I believe in market failure and I don’t believe in the power of price–at this juncture.

  • Anonymous

    Impedant, it’s easily feasible for US aggregate demand to stay flat while commodity prices increase.  The dollar is a reserve currency.  Stimulus money and QE can leak out and become demand anywhere in the world.

  • Anonymous

    There probably is a price that would convince the world to build a new energy infrastructure, we just haven’t hit it yet.  When Hitler occupied the Rhine it didn’t trigger WW2.  Neither did his occupation of the Sudetenland and later Czechoslovakia.  But when Hitler invaded Poland it forced the allies to swing into action.  Maybe $4 gasoline and 10% unemployment isn’t enough to change attitudes.  Maybe it takes something like $10 gasoline and 20% unemployment.


    I agree and I like your analogy. But ten dollar gasoline and 20% unemployment, if it does start to trigger energy transition, will not result in a resurrection of the economy we once had–as measured in industrial output. That economy was funded by the most dense energy source: oil. The next one will be funded by more diffuse, less dense sources. 

    I have written some on this difference, and I will say again that I think the quality of life may even be higher in such a world of lower industrial output, primarily because it will be a slower economy. Also, as humans we are free to measure the economy using different terms, scales, frames. So, we are free to measure the economy in terms of life expectancy, infant mortality, and health.

    In some sense, energy transition is largely the problem of stranded infrastructure, and a long period of lower output as many who have assets tied to the old economy see their wealth decline. For those who’v not accumulated wealth, yet, it’s not “as much” of a problem.



    Hey Steve. Thanks so much.


  • Anonymous

    So you believe the Fed can raise nominal spending, but that it would result in (or be due to) purely price movements, rather than an increase in real output?  And that you are worried about the distributional impacts of the price movements?  I think you should separate those two arguments; the Fed cannot and should not worry about distributional impacts of particular price changes.

    Scott Sumner has written about supply shocks better than I could, so I won’t try to paraphrase:


    Yes, I don’t agree with the NGDP Target advocates at all. However, the “way” in which I disagree does not conform at all to any habitual criticism the FED receives from the Right, Inflationistas, etc. I have a big picture view about the economy as a biophysical system that renders monetary policy subordinate to its limits.

    My previous post on the FED and decline:



  • Anonymous

    No advocate of NGDP targeting will say that monetary policy provides a “quick fix” for structural issues which prevent or slow real output growth.

    But I don’t follow your segue into the debt-deflation argument. Debt contracts are almost all nominal, and are not linked to output growth (real GDP) per se. Ensuring growth of nominal incomes is perfectly sufficient to service debt contracts. This is one of the key benefits of targeting NGDP in the face of a supply shock.

    A period of fast growing nominal incomes is sufficient to lower the debt/income ratio – and also of forcing real losses on creditors who have misallocated capital; a “debt jubilee” by fiat, if you like. That is true even if there is no simultaneous growth of real output.