Johann Hari: Cameron's solution doesn't add up

Fiscal stimulus is the only effective way to hurry along recovery

The Arctic wind of a depression is colder with each passing week. There's still an air of unreality: can dole queues really swell and economies really shutter like they did in the history books? Is there a way out? It is here, in the falling darkness, that the differences between the main political parties – too narrow for too long – are becoming plain.

There is a deep disagreement between Labour and the Tories about what governments can and should do now. To understand this, we need to look at a seemingly esoteric debate between the parties about what happened in the last global depression. There are two contradictory stories about how the Great Depression ended. They provide dramatically different road maps for 2009 – so it's essential to figure out which is right. The winning side will determine your chances of losing your job and your home.

The dominant story in the public mind is of President Franklin Delano Roosevelt's success. It goes like this. Like Obama, FDR comes to power with the American economy haemorrhaging jobs. He believed that, if private industry is withering, the government has to take up the slack by large public spending programmes. He set millions to work preserving green spaces and rebuilding the country's infrastructure. He thought it was necessary to borrow and spend in the short term to prevent complete and more costly collapse later. Use government to counter the economic cycle, rather than leaving us all to drift out to sea on it.

This is Barack Obama and Gordon Brown's story too, as they launch their own fiscal stimuli. Brown says pointedly: "The great New Deal innovations shaped the future of progressive politics across the world." Their favoured analogy is of jump-starting a failing car, rather than let it whimper to a halt on the road.

But at the height of Reaganism, a small number of right-wing economists began to tell a different story about that time. They argued that the American people had been wrong: the New Deal actually made the Depression worse. By borrowing and spending so much, the government created a climate of uncertainty. This made investors hold on to their money – prolonging the despair. It didn't restore private investment, it "crowded it out". So in a depression, all government can do is cut back its own spending and wait for the business cycle to recover. The only effective way for government to hurry this along is a monetary stimulus: altering interest rates and the quantity of money in the economy in an attempt to increase demand.

This is David Cameron's view. His preferred analogy is of a household budget: you cut back your spending when times are hard, and so should the government. Anything else is waste. His Siamese twin George Osborne argues that "monetary developments were a crucial source of the recovery of the US economy from the Great Depression. Fiscal policy, in contrast, contributed almost nothing to the recovery before 1942". (In an attempt to find political cover, he has found a single anomalous Obama adviser who believes this, and quotes her). At the core of this case is a stark fact: unemployment was still at 13 per cent in 1937.

Which is true? The reality of FDR's rule is more complex than either story admits – but the lessons vindicate one set of principles resoundingly.

It's almost forgotten now, but FDR ran for election promising a balanced budget and big spending cuts. By the time he assumed the Presidency, however, public protests against the economic collapse were so huge that he was forced to change course and launch his public spending push. The result? Unemployment began to slide down from its 25 per cent peak.

But then, in 1936, FDR wobbled. He listened to the people making the fiscally conservative case and slashed spending. Unemployment rose again – producing the spike in unemployment that people like Osborne now perversely cite as evidence that the New Deal didn't work. But the reality stands. When FDR spent, unemployment fell. When FDR cut back, unemployment rose.

Yet perhaps the clincher is the answer to a bigger question: how did the Great Depression end? It didn't stop with Cameron's suggestion: slashed spending, slashed debt and slashed government activity. It ended with precisely the opposite: the vast fiscal stimulus of the Second World War. The government sent debt soaring to its highest levels in US history (until today) in order to spend more than ever before. It set up the longest boom in US history.

To check my understanding of the implications for British politics, I called this year's Nobel Prize-winning economist, Professor Paul Krugman. He told me he was "shocked" by hearing David Cameron's economic statements in favour of "tightening the government's belt" in a recession. "It's pure Herbert Hoover," he says. "In fact, it reminds me of Andrew Mellon [Hoover's Secretary of the Treasury], who said the [government] response to the Depression should be to 'liquidate labor, liquidate stocks, and liquidate farmers'."

Many of Cameron's statements are "just wrong", Krugman says. For example, Cameron says Britain can't afford a fiscal stimulus because we are going into the recession with the highest debt of any developed country. "But that's not true. Britain is at the lower end of the middle of developed countries [when it comes to national debt]. Less than the US, much less than Japan or Germany or Italy." He is worried by the incorrect lessons Cameron has drawn from the 1930s. "Renouncing a fiscal stimulus when private spending is contracting is strange. Governments have very few tools at their disposal, and Cameron wants to not use them." So are you saying our recession will be much worse if we follow Cameron's advice? "Yes. For sure."

This is our choice now. Obama and Brown will have to be pressured hard to make their stimuli much bigger, and to focus them less on propping up old corporations and more on building a new low-carbon economy. They will make many mistakes. But, as FDR put it, "Better the occasional faults of a government that lives in a spirit of charity than the constant omission of a government frozen in the ice of its own indifference".

j.hari@independent.co.uk