Until a few years ago, economists of all persuasions confidently proclaimed that the Great Depression would never recur. In a way, they were right… …After the financial crisis of 2008 erupted, we got the Great Recession instead. Governments managed to limit the damage by pumping huge amounts of money into the global economy and slashing interest rates to near zero. But, having cut off the downward slide of 2008-2009, they ran out of intellectual and political ammunition. Economic advisers assured their bosses that recovery would be rapid…. But then it stalled in 2010…. It is now pretty much agreed that fiscal tightening has cost developed economies 5-10 percentage points of GDP growth since 2010. All of that output and income has been permanently lost… [and] made the task of reducing budget deficits and national debt as a share of GDP much more difficult….

That should have ended the argument. But it did not. Some economists claim that governments faced a balance of risk in 2010: Cutting the deficit might have slowed growth; but not committing to cut it might have made things even worse.

The Keynesian remedy, the argument went, ignored the effect of fiscal policy on expectations. If public opinion believed that cutting the deficit was the right thing to do, then allowing the deficit to grow would annul any of its hoped-for stimulatory effect. Expecting that taxes would have to rise to “pay for” the extra spending, households and companies would increase their saving. Fearing sovereign defaults, bond markets would charge governments punitive interest rates on their borrowing.

And here was the clincher: By committing themselves to fiscal tightening, finance ministers gave themselves scope for some fiscal loosening. Proclaiming fiscal virtue enabled them to practice fiscal vice. They could create a fiscal illusion by cutting less than they promised. Most finance ministers did exactly that.

This is part of the mess into which macroeconomics has gotten itself. Once beliefs and expectations are introduced into economics, as is surely reasonable, the results of fiscal policy become indeterminate. Too much depends on what people think the results of the policy will be. In the economists’ lingo, policy results are “model-dependent.”

The Nobel laureate economist Paul Krugman has poured scorn on what he calls the “confidence fairy,” the claim that fiscal policy must command the support of the bond markets. But to show that actual policy made things worse does not mean that a better policy was actually available. The right policy’s success may depend on the public’s expectations of its effects. The unanswered question is why the public should have the wrong expectations.

Vir: Robert Skidelsky