05/21/2013 11:27 am ET Updated Jul 21, 2013

Government Failure vs. Market Failure

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Chuck Lane's got an interesting piece out today about austerity and Keynesian stimulus that leads to a smart, simple policy recommendation (and for the record, "simple" is a beautiful word when it comes to policy).

Lane's argument, which suffers a few serious empirical oversights I'll get to in a moment, is that while Keynesians rightly call for temporary deficit spending to offset private sector contractions, politicians ignore the temporary part. The politicians like spending and dislike taxes, so they'll neglect to shut off the stimulus spending once the bona fide expansion is underway.

A good solution for that is to set triggers based on real variables to shut off your stimulus, as the Federal Reserve has done, announcing that wind down will commence (roughly) when unemployment goes below 6.5 percent or inflation about 2.5 percent.

What's the empirical problem? In fact, policy makers have shut off the stimulus -- and far too soon! The Recovery Act has gone the way of Monty Python's parrot, as has the payroll tax break. States have cut back on extended UI benefits and the sequester is taking a further whack at UI, despite historically very high levels of long-term unemployment.

In that regard, the reason I like Lane's trigger solution is that were it in effect, these stimulus measures would still be switched on.

Moreover, the fact that budget deficits are counter-cyclical (economy tanks, they go up and vice versa) poses a broader challenge to Lane's thesis. A simple correlation between annual deficits (as a share of GDP) and the unemployment rate is a pretty large -0.73, suggesting adjustments of the type Lane worries about are in fact made (as unemployment goes up, the deficit/GDP "goes down"-becomes more negative). Of course, part of this is the ebb and flow of "automatic stabilizers," i.e., the safety net. But take them out of the picture and the correlation is still a significant -0.53.

Still, structural budget deficits -- the type that go up even in expansions -- exist, so Lane's got a point. Though here too, it's worth noting that long term pressures have far more to do with the unsustainable pace of health care costs than the politicians' pet cats and dogs implicated in Lane's rap.

In fact, I would amend Lane in a way with which he might agree. Keynesian spending often really is temporary. What lasts forever are foolish, unnecessary tax cuts and tax expenditures (i.e., spending by another name).

Putting it all together, if Lane is saying that austerity never comes, he's demonstrably wrong -- see Europe and especially the U.S.. But if his point is that Dick Cheney allegedly said "deficits don't matter" and meant it, and that we're stuck with asymmetric tax policy -- taxes get cut, but almost never go up -- then he's on to something.

This post originally appeared at Jared Bernstein's On The Economy blog.