Following the debate over "austerity" in Europe these past few weeks has led me to wonder if we are witnessing once again how historical mythology gets created. By stating it this way I realize that I am siding with those who positioned themselves squarely opposed to Krugman's 'accounting' of contemporary policy history and the so-called 'savage cuts' that have been experienced in Europe.
But as Angela Merkel said, she is "astonished" by the debate and that her pro-austerity position has become controversial. The point is not about saving for savings sake, she points out, "It's just about not spending more than you collect. It's astonishing that this simple fact leads to such debates."
My own position would be far more extreme than Merkel's. I would argue that we have been living in the economics of illusion for several decades in Europe and the US, and that the price of the illusion is long term economic growth due to fiscal irresponsibility.
Let me provide an example from another field in economics that might make the positive point very clear. Economists of all stripes can admit that there are differences in the endowments that people are born into this world with. Some may deem these different endowments as unjust. So unjust in fact, that we may desire to address these differences through public policy decisions. But this is where the interesting discussions should begin. There is little doubt that active government policy can through confiscatory policies and redistribution address the differences in endowment, but the trick is can they do so in a way that does not distort the structure of relative prices and thus distort incentives for the various players of the economic game of life. These distortions will result in new problems that have associated costs that must be accounted for in any serious discussion of the costs and benefits of the original policy to address the differences in the endowment.
Now lets switch back to the macroeconomics of the economics of illusion. For decades the social democratic governments of the West have followed an economic policy of demand management that relies significantly on using the budget to balance the economy and foresaken any concern with balancing the budget. This has produced an unsustainable fiscal situation in Europe and the US. See on this the special issue of The Economist (March 17, 2011) and/or Vito Tanzi's Government Versus Markets: The Changing Economic Role of the State (Cambridge, 2011), or the brilliant work of my colleague Richard Wagner, Deficits, Debt and Democracy: Wrestling with Tragedy on the Fiscal Commons (Elgar, 2012).
What the economics of illusion does is continually paper over economic disturbances with short run policies that provide the appearance of economic viability, but with the cost of distorting incentives for long run economic growth. This was hidden for a few of the decades after WWII because of technological innovations. As I have repeatedly argued here and elsewhere, if the Smithian gains from trade, and the Schumpeterian gains from innovation continue to outpace the stupidity of government policies, then economic growth will continue to happen to such an extent that tomorrow's trough will be higher than today's peak. But tomorrow's prosperity will not be as great or as generally shared as it otherwise would have been. In short, the economics of illusion just kicks the granade down the road.
Those who are champions of the economics of illusion will insist that in the long run we are all dead, and that the growth we did experience because of Smithian and Schumpetrian forces was not due to those activities but instead due to the judicious use of government management of the economy. There are facts and counter-factuals that go with these theoretical disputes, and in the process there are mythologies created.
Herbert Hoover was as much of a laissez faire president as Barack Obama has been or the leaders in Europe have been. From a free market perspective, the steps taken since 2007 have turned a market correction into an economy wide crisis and then a global crisis. Those steps were anything but "do nothing", and they were taken first by a Republican President and then pursued further by a Democratic President. We have never given "nothing" a chance. But mythologies need to be created in order to tell neat historical tales. Laissez faire Hoover is replaced by activist FDR and the nation is saved.
Is Krugman the new Arthur Schlesinger? A creator of mythologies that serve his ideological interests and distort the historical record as well as the economic arguments deployed at the time. He is smart enough, and he is positioned well enough to successfully control the conversation.
See Steve Horwitz's FEE essay on this as well as Steve's earlier CATO piece (linked to in the FEE essay).