One of the biggest myths in modern economics is the misguided belief that a fiscal stimulus can prevent a recession, or at least reduce its depth and length. Nothing can be farther from the truth.

The Austrian school of economics (founded by Carl Menger and later popularized by the work of subsequent economists such as Ludwig von Mises, F.A. Hayek, Murray Rothbard, to name a few) has provided sufficient evidence to show that a fiscal stimulus, contrary to popular opinion, actually aggravates a recession. This is documented in Rothbard’s classic America’s Great Depression, where he provides a step-by-step explanation of how the then government’s fiscal stimulus package (popularly known as the New Deal) pushed the US economy into prolonged depression in the 1930s.

Illustration: Jayachandran / Mint

A more recent example is the protracted depression in Japan even till today, despite all kinds of fiscal stimuli and quantitative easing to prop up the economy throughout the past decade.

Yet, the recent Group of Twenty summit in November showed strong preference for aggressive fiscal stimulus packages, which they believe will prevent the current recession from getting uglier. But what is the rationale behind advocating such a fiscal stimulus? It is the belief that the suffering of the global economy today is due to “under-consumption" and massive fiscal stimuli are needed to stimulate consumption and discourage savings at any cost.

The common-sense argument against this chain of logic is as follows: If reckless consumption (in the absence of adequate savings and the perverted incentive of abnormally low policy interest rates) caused the problem in the first place, should such consumption be further encouraged in times of distress? Or, how can the source of a problem be a solution to the problem as well? After all, two wrongs can never make a right, can they?

The economic argument against the “under-consumption" theorists is that during an economic downturn, it is the capital goods industry that suffers more than the consumer goods industry. Why? This is explained by the Austrian business cycle theory.

Given a level of money supply, interest rates can only come down if savings in an economy increase, which means foregoing current consumption for some future period of consumption. An artificial lowering of interest rates without an increase in genuine savings causes both consumption and investment demand to rise sharply, creating an illusory boom. On the one hand, the low interest rate discourages households from saving and, in fact, provides incentives to increase their consumption binge. On the other hand, entrepreneurs are misled by bank credit inflation (abnormally low interest rates) to invest too much in higher-order capital goods, the demand for which is not there in the first place as the economy’s time preference still lies in goods of present consumption and not in goods of future consumption.

In other words, the tampering of the free market interest rates forces entrepreneurs investing in higher-order capital goods to misjudge the demand for their goods in the future, which leads to overproduction, or what the Austrian economists call malinvestments.

Subsequently, when boom turns to inevitable bust, undoubtedly, some part of these malinvestments have to be liquidated. But a part of this investment demand can still be sustained if the economy shifts towards lower consumption and higher savings and investment preferences. A tax cut and a reduction in fiscal deficit by reducing wasteful expenditure can free resources in the hands of both households and the investment community, which can help raise private (both corporate and household) savings, supporting private investments and thus resulting in a speedy recovery.

The Keynesian fiscal stimulus policies that are being advocated today run contrary to this thesis. Governments all around the world are going in for billions of dollars in fiscal stimuli to encourage consumption.

Any increase of taxes and government spending will discourage savings and investment and stimulate consumption, since government spending is all consumption. The increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favour of consumption. More consumption and less saving aggravates the shortage of saved capital even further and push the economy toward depression.

A common refrain that is heard today in almost all circles is that these are unusual times and hence fiscal rectitude has to be sacrificed in order to save the world from an apocalypse.

What most people fail to realize is that it is in these unusual times that the governmental non-interference in the economy’s recovery process is called for even more than at any other time.

Taking a contrarian position, in the form of more government interference through providing fiscal stimulus packages, will unfortunately push the global economy into a massive depression, the very outcome that these policies are expected to prevent.

Kaushik Das is an economist with Kotak Mahindra Bank. These are his personal views. Comment at