Fortunately, Thatcher decided to listen to her adviser and do the opposite of the Keynesian prescription by shrinking the budget deficit during a serious recession. This counterintuitive policy was a success, setting the country up for more than a decade of strong real growth accompanied by low inflation.
Walters got a knighthood for his service, and he returned to Johns Hopkins to attempt to educate young graduate students (of which I was one) on the complexities of making national economic policy.
A firm monetarist, Walters argued that increased government spending (or reduced taxes) would cause expansion of the real economy only under a fairly limited set of economic conditions. Probably most relevant to the United States' current situation, he argued that Keynesian fiscal policy such as the stimulus package would work only if the public believed the government was capable of efficiently managing the economy.
Walters maintained that a major signal of a government's ability to manage the economy is its debt as a proportion of gross domestic product. If the debt-to-income ratio is perceived as growing uncontrollably, then increased government spending (or reduced taxes) could actually worsen a contraction.
The announcement of a widening budget deficit when the national debt-to-income ratio is already high would increase uncertainty about a government's ability to manage the situation, Walters believed. Businesses and households would increasingly fear that the government's stimulus attempts would be ineffective, forcing it to deal with booming debt by raising taxes, defaulting on government bonds or commitments (such as Social Security), or inflating the economy.
Businesses and households would rationally respond to these fears by reducing investment and consumption to save more as insurance against the possibility of future hard times. As a result, the national economy would stall as contractions in business investment and household consumption more than offset government stimulus spending.
This could result in a downward spiral: The deficit spending of a stimulus program leads to further economic contraction, to which the government responds with another stimulus program that causes the economy to fall even further, etc.
Will Obama's fiscal stimulus vindicate Keynes or Walters? In the United Kingdom in 1980, the national debt was 48 percent of GDP, compared to 41 percent in the United States in 2009, when Obama took office. Now U.S. debt is expected to reach 67 percent of GDP by the end of this year - the highest ratio since the 1950s.
While the data aren't always clear, it's difficult to describe the U.S. economy's reaction to the stimulus bills of the last two years as anything but weak. Have we crossed from the world of Keynes into that of Walters?
Frank R. Gunter is an associate professor of economics at Lehigh University. He can be reached at firstname.lastname@example.org.