A misguided missile.

• Author: Moller, Jorgen Orstrom

Why did the Obama stimulus fail to lead to a significant increase in aggregate demand? Deleveraging of debt by households and lack of non-financial corporate investment.

How things have changed! When I studied economics in the 1960s, debt was a non-issue. The acknowledged textbook was Richard A. Musgrave's The Theory of Public Finance: A Study in Public Economy, published in 1959. To the best of my recollection debt was a peripheral theme. Any student venturing into public debt risked being classified as slightly weird or at least having lost his or her orientation in the world of economics.

The U.S. public debt-to-GDP ratio was below 60 percent and falling, after having peaked in 1946 when war financing brought it to a level of 121 percent.

We were taught Keynesian economics and learned the virtue of fiscal stimulus in case aggregate demand was insufficient to ensure full employment. But the high priest himself did not, writing in 1930 and 1936, devote much attention to debt for the very reason that even after President Roosevelt's launch of the New Deal, the public debt-to-GDP ratio did not go much above 40 percent until 1941. In Britain where Keynes lived, public debt/GDP peaked at 181 percent in 1923 to fall steadily, passing below 150 percent in 1937 to reach 110 percent in 1940. Debt was manageable, and more than that, it actually fell over the Great Depression.

But four things taught by Keynes are carved in stone. The economy does not by itself move towards full employment equilibrium, we talk about the real economy, what matters is aggregate demand, and fiscal stimulus is applied to compensate for a fall in private demand.

Faced with unemployment, fiscal stimulus does the trick only if aggregate demand goes up. A partial analysis looking at the immediate impact on investment and/or consumption of public demand boosting and/or lower taxes is not interesting. It comes to nothing if the private sector (consumers and investors) reacts adversely, offsetting the positive impact of the initial public stimulus. Reading the analyses and comments over several years on the American Recovery and Reinvestment Act of 2009, amounting to U.S. $831 billion, this very simple lesson seems to be forgotten. Did the fiscal stimulus serve its purpose to compensate for falling private demand, keeping aggregate demand high, or did it not compensate for the fall in private spending, allowing aggregate demand to fall?

GDP fell in 2009 by 2.8 percent, rose in 2010 by 2.5 percent, and petered out in 2011 with 1.8 percent growth, to go up in 2012 only to fall again in 2013. These growth figures show that the American Recovery and Reinvestment Act actually managed to keep aggregate demand more or less at an unchanged level (slightly up), but failed in another respect. Fiscal stimulus is a temporary phenomenon, not a permanent one. The private sector must be convinced that the economy is back...