Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Hysteria In The Time Of Austerity: Stimulus V. Austerity

Prior to the Great Depression, economists conceived of their field as something bordering on a perfect science; capitalism, so it was thought, had proven to be an economic system devoid of major inefficiencies. This point of view, bolstered by the bull market of the 1920s, abruptly disintegrated at the end of that decade, leaving economists aghast at the approaching Great Depression

With traditional monetary policy ineffective, it took a fresh and invasive look at the capitalist system, most notably by John Maynard Keynes, to understand the challenges that capitalist economies faced. In his General Theory of Employment, Interest and Money, Keynes attributed the depression to a lack of private sector demand, which could only be made up by increased government spending. It was the role of the government, said Keynes, to stimulate the economy. This basic idea comprised the policy prescription taken by America and Britain during the 1930s and 1940s.

As memories of the Depression dwindled, economic thinking shifted away from Keynesianism. The efficient markets hypothesis, which conceives of markets as being rational, gained traction. After World War II, monetary policy was effective in combating economic challenges, including soaring inflation of the 1970s. Keynesian fiscal policy no longer seemed necessary and soon fell out of favor.

The success of economics as a field was again trumpeted, with major thinkers touting the merits of economic policy for balancing employment, inflation and growth. The back patting extended in to 2008, with a number of esteemed economists ardently believing their profession to have reached a pinnacle. Complex and beautifully crafted mathematical models conjured up just the right prescriptions to indefinitely maintain the goals of central banks.

And then the housing bubble burst. And global credit markets dried up. And unemployment skyrocketed. And unmanageable sovereign debt engulfed Europe. The Nobel garnished makers of those mathematical models appeared worryingly close to cosmeticians caking on layers of make-up to conceal a severely scarred truth. With the Fed lowering interest rates near the zero-lower bound, monetary policy met its limits. And thus our story begins.

*****

Austerians, who believe that in a recession government should cut deficit spending and make room for private sector investment, faced off against Keynesians, who believe that recessions represent an absence of private sector demand; the government, according to the Keynesians, must increase deficit spending to stimulate the economy. Which policy is the right one is currently at the heart of economic debate.

Although the Austerity v. Stimulus debate is not a new one, the global economic community has yet to reach a consensus on which is really most effective. Context often compounds clear-cut conclusions, and many adherents-in either camp-have a shifty penchant for exaggerating contextual differences to resuscitate their beleaguered ideology.

If the economic elite were to come together to organize an experiment wherein two countries of similar context were to receive two different policy responses during a recession-austerity for one and stimulus for the other-ethical review boards would be spinning like tops trying thwart it. Which country you believe would be the dead guinea pig depends on your perspective. But it's clear that one of the countries would suffer unnecessarily.

Sometimes, however, the most seminal of experiments occur naturally. Despite their differences, the economies of the United States and the United Kingdom are similar in a number of important ways, including having and borrowing in their own currencies. While the relationship is not 1:1, those who would downplay the similarities will have a fairly conspicuous agenda.

And so the experiment begins. With the inauguration of the coalition government, the United Kingdom began to invoke fiscal austerity; they reneged on Labour's stimulus program, which saw GDP growth at 2.5% annually, in favor of across the board spending cuts.

George Osborne, Chancellor of the Exchequer, instituted an aggressive policy of deficit reduction and tax increases, effectively foisting contractionary policy on an already sclerotic economy. Government spending, he argued, would crowd out private investment, thereby thwarting further growth and prolonging recession. The answer was simple: curtail government spending.

How has this turned out for the UK? Well, last year its economy shrank .1%, a far cry from the .8% growth it had projected. The most recent report from the Office of National Statistics revealed that the UK narrowly avoided consummating its ongoing flirtation with a triple-dip recession. Despite lowering its growth forecast for 2013 from 2% to 1.2%, Osborne maintained that "it's a hard road but we are getting there. Britain is on the right track. Turning back now would be a disaster."

Quite at odds with Osborne, the National Institute for Economic and Social Research has attributed the UK's sustained depression and its worsening outlook to austerity. Although most European countries followed a path of austerity, some of them are now beginning to shy away from it, after years of negative growth and rising unemployment.

Portugal recently announced a far-reaching stimulus package. Italy's new Prime Minister has promised to curb austerity programs and begin stimulus. Most notably, perhaps, the IMF has had an about-face with regard to austerity. Christine Lagarde, Managing Director of the IMF, recently impugned the efficacy of Osborne's deficit reduction plan, warning that cuts are likely hampering growth and prolonging recession.

Moreover, IMF Chief Economist Olivier Blanchard stated that Osborne is "playing with fire" by remaining on a path of austerity. Blanchard, once a proponent of Britain's austerity plans, conducted a review of previous IMF projections. He found that countries that engaged in austerity notably underperformed IMF projections of growth. Conversely, countries that took a more Keynesian approach, like the United States, tended to outperformed IMF projections. After reviewing the findings, Blanchard has advanced the IMF's evolving viewpoint on austerity, stating that raising taxes and cutting spending succeed only is dragging out depression.

*****

Two notable papers serve as the academic pillars for austerity: Alesina and Ardagna's Large Changes in Fiscal Policy and Reinhart and Rogoff's Growth in a Time of Debt. Both have been championed as a coup de grace to Keynesianism. Both have been ignominiously refuted.

When we distance ourselves from the dizzying political discourse and focus on the differential outcomes over the last five years, it's clear which side of the Austerity v. Stimulus debate has triumphed. The United States, with its comparatively more Keynesian approach, has had a comparatively stronger recovery.

According to critics of the Obama Administration, the United States was supposed to be Greece by now. Interest rates were meant to have skyrocketed, deficits to have rapidly expanded, large capital outflows to have abounded and the dollar to have deteriorated. But none of this transpired. Instead, GDP growth averaged 2.1% since 2009, compared to .9% in the UK. Unemployment is trending downward and is projected to reach 6.5% by next year, and the deficit is expected to shrink to 4% of GDP by 2014.

More than 5 years into the Great Recession, the verdict is clear. The IMF, the World Bank and the WTO have all warned that austerity will hamstring growth and exacerbate unemployment. They were able to look at the data objectively and come to sensible policy recommendations based on empirical evidence.

Yet Austerians cling to their a priori judgments and increasingly refuted ideologies. They refuse to acknowledge the role austerity has played in hindering recovery. We're hoping to resuscitate our injured guinea pig, but the wheel of death spins on.