Life After Debt
In this month's market upheavals in the United States and Europe, we are witnessing the end of a seven-decade economic experiment. But does anyone have any clue what comes next?

...Yet this story is not quite as simple as Keynesians would like to think -- and the events of 1938 are not the only historical example that can be brought to bear on current events. If Keynesians can point to the impact of wartime spending on the economy, austerity advocates can point to the retreat from it, after both world wars. In 1918 and 1945, both the United States and Britain found themselves with very high public debts and economies that had been artificially boosted during the war as a result of deficit spending and loose monetary policies. Their average budget deficit in the last year of war was 25 percent of gross domestic product (GDP). Yet within two years after the end of the wars, both countries had returned not just to sustainable levels of deficit, but to surplus. This was a far greater level of fiscal tightening than anything contemplated nowadays, and it was achieved exclusively through spending reductions.

The outcomes of these post-war retrenchments are instructive. In three out of the four cases of British and American post-war adjustment, the economies initially shrunk, but then started a period of strong and sustained growth with low unemployment. (The exception is Britain after World War I, which entered a decade-long economic depression in many ways as severe as America's in the 1930s. The difference here is in monetary policy: While the United States countered post-war inflation with interest rate hikes that brought prices back to 1919 levels but no lower, Britain made a concerted attempt to deflate prices to pre-war levels so as to get back onto the gold standard at the old parity. In other words, it attempted an "internal devaluation" like the one now being prescribed for the uncompetitive peripheral countries of the eurozone -- and the result was disastrous.)..