Keynes explained the dynamics of an economy in a prolonged period of high unemployment more than 70 years ago in The General Theory. Unfortunately, it seems that very few of the people in policymaking positions in the United States or Europe have heard of the book. Otherwise, they would be pushing economic policy in the exact opposite direction that it is currently headed.

Most of the wealthy countries have now made deficit reduction the primary focus of their economic policy. Even though the United States and many euro zone countries are projected to be flirting with double-digit unemployment for years to come, their governments will be focused on cutting deficits rather than boosting the economy and creating jobs.

The outcome of this story is not pretty. Cutting deficits means raising taxes and/or cutting spending. In either case, it means pulling money out of the economy at a time when it is already well below full employment. This can lower deficits, but it also means lower GDP and higher unemployment.

This might be okay if we could show some benefit from lower deficits, but this is a case of pain with no gain. Ostensibly, there will be a lower interest rate burden in future years, but even this is questionable. First, the contractionary policy being pursued by the deficit hawks will slow growth and lead to lower inflation or possibly even deflation. It is entirely possible that the debt to GDP ratio may actually end up higher by following their policies than by pursuing more expansionary policy.

In other words, we may end up with smaller deficits and therefore accumulate less debt, but we may slow GDP growth even more. The burden of the debt depends on the size of the economy and in the scenario where we do more to slow GDP growth than the growth of the debt, then we end up with a higher interest rate burden, not a lower one.

The other reason why we may not end up with a lower interest rate burden is that we need not issue debt to finance the budget deficits. Countries like the United States and the United Kingdom that control their central banks can simply have the central banks buy up the bonds used to finance the deficits. In this story, the interest payments on the bonds are paid to the central bank, which is in turn refunded to the government. This means that there is no interest burden created by these deficits.

If that sounds impossible, then it's necessary to pick up Keynes again. The economies of Europe and the United States are not suffering from scarcity right now. They are suffering from inadequate demand. This means that if governments run deficits, and thereby expand demand, the economy has the capacity to fill this demand. The decision of central banks to expand the money supply by buying bonds simply leads to an increase in output, not to inflation.

The idea that there is some direct link between the money supply and inflation is absurd on its face. Do any businesses raise their prices because the Fed has put money into circulation? How many businesses even have a clue as to how much money is in circulation? In the real world, prices are set by supply and demand. If any business tried to raise their prices just because the Fed has put more money into circulation they would soon find themselves wiped out by the competition – at least as long as we are in this situation of having enormous excess supply.

This story should be old hat to those who have studied Keynes. In a period of high unemployment, like the present, governments can literally just print money. Not only will this put people back to work, this process can also lay the basis for stronger growth in the future by creating better infrastructure, more energy efficient buildings, supporting research and development of clean energy and improving the education of our children.

Unfortunately, our political leaders don't give a damn about mundane issues like unemployment and economic growth. It is far easier for them to bandy silly clichés about fiscal responsibility and generational equity, even though the policies they are pushing are 180 degrees at odds with anything that will help our children or grandchildren. Their main concern is push policies that keep the financial industry happy. And 10 million unemployed never bothered anyone at Goldman Sachs, just ask Fabulous Fab.

- Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR) http://www.cepr.net. He is the author of Taking Economics Seriously [http://mitpress.mit.edu/catalog/item/default.asp?ttype=2&tid=12083] and False Profits: Recovering from the Bubble Economy [http://p3books.com/falseprofits/].

--This article was originally published on May 17, 2010 by The Guardian Unlimited [http://www.guardian.co.uk/commentisfree/2010/may/17/keynes-danger-deficit-reduction].