There are currently three schools of thought on how best to address the current global crisis.

One takes the view that it is all due to “more expensive financing”- not due to decreased demand. Peter Auer, Raphael Auer and Simon Wehrmuller want to rely exclusively on reducing the high cost of obtaining external funds, which accounts for most of the decline in employment in US industry since August 2007.

A second group, like Tyler Cowen and John Taylor, do see a strictly limited role for fiscal policy. For example, Taylor wants to respond with a Bush-like scenario, such as a permanent tax cut. It rejects the idea of an increased spending stimulus because “expectations of the future that are now built into decision in virtually every market” (the Ricardo effect).

Cowen believes that when monetary aggregates are falling, because of either a credit crunch or a liquidity trap, a fiscal boost can keep aggregate demand from deteriorating. Today, we are seeing a contraction in both credit and in the shadow-banking sector – so we cannot expect the benefits of monetary expansion to kick in quickly, even over six months.

Yet some fiscal packages are lousy. They tend to hinder the pace of adjustment and recovery – e.g. cutting back on “welfare”, such as generous middle class welfare (much of which would be retained as savings) or of steps to strengthen unions and to keep real wages high (which could make it harder for the unemployed to get back to work).

They want to confine the fiscal package to reductions in taxes and investing in suitable infrastructure which are worthwhile on their own terms. Other than that, it is best to limit measures directed at the financial sector.

A third type of view – one which is most widely held - comes from many people like Paul Krugman. He argues that, while freeing financial markets will certainly help, at this point we also need a big fiscal package. He points to the 1933 Keynesian Open Letter to Roosevelt, in which he advocates new infrastructure spending. While Keynes admits that in the USA it is more difficult to improvise the vast program of public works, “the risk of less speed must be weighed against those of more haste”. Krugman also advocates other spending and taxation measures and rejects Christina Romer’s (now tapped to run Obama’s Council of Economic Advisers) against fiscal expansion: he quotes her as saying that “the budget should be balanced over the medium term, but not each and every year and not in exceptional circumstances”, including running budget deficits.

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The Rudd Government has now embraced the argument that the Budget may soon turn into a deficit if the global financial crisis gets any worse. Mr. Rudd said that “if Australian economic growth slows further— it would be responsible (where necessary) to use a temporary deficit to begin investing in our future infrastructure needs, including hospitals, schools, universities, TAFES, ports, roads, urban rail and high speed broadband”.

Apart from introducing low-gestation infrastructure spending, Mr. Rudd also needs to announce a substantially higher level of Newstart Allowances. These benefits can be reduced later when the labour market has recovered.
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