FORTUNE — After Federal Reserve chairman Ben Bernanke announced the Fed would likely reduce its bond-buying program later this year, some complained that the Fed’s stimulus would still continue unabated. But every serious economist knows policy largely works by altering market expectations. The Fed is clearly taking steps to diminish those expectations.
If QE was working — if it created more value than it cost — why would the Fed reset policy expectations prematurely while unemployment is still at 7.5%, and even higher if you include the underemployed?
The chairman justified his actions by claiming growing optimism, even though last month he said the economy is “suffering just now from a bad attack of economic pessimism.” Despite his now positive outlook, this month’s jobs report was again mediocre; Europe is also back in recession and evidence of a slowdown in China mounts.
These would hardly seem like conditions under which the Fed would choose to reset expectations. Instead, it seems as though Bernanke is finally throwing in the towel on QE.
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Who can blame him?
Radical monetary and fiscal policies have failed to produce a robust recovery in the wake of the financial crisis. Although some Keynesians, such as Paul Krugman, claim the stimulus was too small, the federal government has increased spending by nearly 25% in real terms, and financed that spending with trillion-dollar-a-year deficits for four years and counting. Those deficits have been funded by never-before-seen increases in the Fed’s balance sheet. Make no mistake; the stimulus has been enormous.
Unfortunately, the U.S. economy likely faces a permanent decline in demand in the aftermath of the financial crisis, not a temporary lull. The economy now recognizes there is enormous risk of damage from a run on the banks. Prior to the crisis, the U.S. economy greatly discounted this risk because a run on the banks of the scale seen in the financial crisis had not occurred since 1929. We assumed implicit government guarantees of banks — guarantees that the government made explicit in the financial crisis — mitigated the risk of a run. We were mistaken.
The private sector has permanently dialed back risk-taking, resulting in economic activity to compensate for this now-recognized and as-of-yet-unmitigated risk. That is not to say that the economy cannot grow and reach full employment. It can. But it will grow normally from a lower base without the large one-time rebound typical of most recoveries. Under these conditions, fiscal and monetary policies are likely to have little, if any, positive effect.
Even skeptics of Keynesian economics recognize that increased government spending may prevent a temporary lull in demand from permanently damaging the economy. Layoffs and bankruptcies, which displace workers and companies, permanently lower productivity.
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Avoiding that damage is valuable. As the lull in demand grows longer, however, the cost of avoiding displacement increases while the value of avoiding displacement remains constant. If the fall in demand is permanent — if it stems from a structural problem, for example — displacement is inevitable and cannot be avoided. Increased government spending then becomes an expensive bridge to nowhere that slows rather than stimulates growth.
A permanent increase in government spending merely shifts demand from the private sector to the public sector. At best, the government redistributes consumption from workers and investors. In reality, it taxes, redistributes, and consumes income that would otherwise be invested. Moreover, redistribution reduces the payoff and incentives for work, investment, and risk-taking, which slows growth further. What increase in services the government does produce, it generally produces less efficiently than the private sector. Those factors slow growth. Again, look at Europe. Its contribution to innovation over the last twenty-five years has been anemic.
If there is any doubt whether a permanent increase in government spending can permanently increase demand, one need look no further than Europe over the last thirty years. Private sector growth slowed relative to the United States as public sector spending as a percent of GDP increased relative to the United States.
Proponents of government spending claim Europe’s meager recovery proves austerity has failed. As if Europe’s troubles do not stem from the fact that the euro allowed slower growing countries to consume more than they produced and that this ultimately proved unsustainable. These proponents often cite headlines from a recent IMF study that concludes, “Fiscal consolidation typically reduces output and raises unemployment in the short term,” despite the fact that most all of the study’s data points represent temporary Keynesian lulls. Unmentioned is the fact that austerity includes both tax increases and spending cuts, and that the study finds that “tax increases are much worse for the economy than spending cuts,” that “after a few years, even large (spending-based) fiscal adjustments create growth for the economy,” and that cuts to entitlements do not slow growth.
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It is true that a cut in government spending, once increased, may cause a brief recession. No rational taxpayer will increase their spending until the government cuts spending. The government has little, if any, credibility when it comes to real spending cuts. Most “cuts” are from a growing baseline and often never materialize. After a cut in government spending, private spending will grow back cautiously. Proponents of spending then use the cost of recession, caused by withdrawing from increased government spending, as justification for a never-ending succession of further spending.
In the waning days of his tenure, Chairman Bernanke may have finally come to realize that the Fed’s radical monetary policy, which facilitated deficit spending that was intended to accelerate an economic rebound back to the prior trend line, has been ineffective. The economy is suffering from a permanent decline in demand and needs economic policies that will increase long-term growth.
This requires lower government spending, which mitigates the need for further tax increases and accelerates the accumulation of equity needed to bear the risks that grow the economy.
Ed Conard is a visiting scholar at the American Enterprise Insitute and author of the best-selling Unintended Consequences. He is a former managing partner at Bain Capital.
