The Keynesian Versus The Monetarist: A Lost Decade

The FT's chief economics commentator debates Standpoint's columnist Tim Congdon on the Great Recession, austerity, and the proper use of fiscal policy

Martin Wolf

The monetarist Tim Congdon has attacked me and other Keynesians in two recent articles in this publication (“Don’t let the Keynesians wreck the recovery”, December 2014, and “Keynesians fear the US fiscal cliff. I don’t”, January/February 2013). These comments deserve a response.

In some circumstances, fiscal policy is indeed unusable. Greece was in this predicament in 2010. Is fiscal policy always unusable or even damaging? No. Mr Congdon is, in particular, wrong about the UK since 2010.

Mr Congdon makes a general point and a more particular one. The general point is that there is no connection between fiscal policy and economic activity or, maybe, fiscal tightening is even expansionary. He supports this broad proposition by noting the absence of a consistent relationship between changes in the cyclically adjusted fiscal balance and the “output gap”—a measure of economic slack—in the case of the US over the past three decades.

My response is: so what? How should one estimate the effect of a particular policy change when many other changes to policy and economic behaviour are occurring? The only sound approach is to estimate an econometric model in which account is taken of as many of the relevant factors as possible. When this is done, the evidence is clear: other things being equal, fiscal contraction is contractionary.

The only question is over the size of the multipliers—that is the relationship between changes in fiscal policy and in economic activity. Standard estimates suggest that they lie somewhere between a low of 0.5 and a high of 1.5 in recessions. The range is wide. But there is no doubt about the direction of the impact.

Why, then, is there no clear relationship between changes in fiscal policy and activity much of the time? The answer is that other things are often not equal. Monetary policy may be one important offsetting change. Sometimes, the indirect effects of fiscal tightening on confidence may offset the direct effects on demand, particularly if there are doubts about the sustainability of the public finances.

Whether or not fiscal expansion is expansionary depends on circumstances. My judgment about the role of fiscal policy after the Great Recession of 2007-08 was specific to that exceptional event.

So what justified my calls for exceptional fiscal support? The answers are straightforward: the recession had been huge; both nominal and real interest rates on government debt were exceptionally low; the financial system was in crisis; monetary growth had effectively halted, despite the efforts of the Bank of England; and the global economic environment was extremely poor, especially in the eurozone, the UK’s biggest trading partner.

In these circumstances, the priority was a rapid recovery. That meant going slow on fiscal austerity, while using monetary policy as actively as possible. For this reason, I argued that the coalition government’s emphasis on the need to eliminate the structural fiscal deficit in the current parliament was a risky and unnecessary gamble. In particular, I argued, there was no need either to impose a significant upfront increase in taxation or to slash public investment. On the contrary, never would the UK enjoy a better opportunity for a big increase in investment in infrastructure.

Mr Congdon insists the recovery the economy has experienced shows I was wrong. Indeed, he suggests, if George Osborne, the Chancellor, had listened to people like me, the recovery might even have been wrecked.I reject these charges, for the following reasons:

First, the alternatives to relying at least partly on fiscal policy were highly problematic. A striking feature of the post-crisis UK experience, for example, has been the stagnation of broad money. (In November 2014, Mr—broad money—was 5.4 per cent below its level in January 2010.) Given this, the strength of demand has surprised me and ought to surprise Mr Congdon.

Second, according to forecasts from the Office for Budget Responsibility (OBR), continued rapid growth now depends on driving the indebtedness of the household sector to record highs: it is forecast to be 184 per cent of income in 2020, up from the pre-crisis peak of 169 per cent. This may not worry Mr Congdon. It worries me.

Third, this has still been the weakest recovery for a century. In the fourth quarter of 2014, the UK economy was just 3.4 per cent larger than it had been in the first quarter of 2008, the pre-crisis peak. In 2014, GDP in the UK was at least a sixth below its pre-crisis long-term trend. Indeed, real GDP per head will probably match 2007 levels only in 2016. This will have been a lost decade.

Fourth, the economy has also performed far worse than was forecast in June 2010, just as I (and others) warned. The OBR then forecast that the economy would expand by 11.1 per cent between 2010 (the government’s first year in office) and last year. The latest data show growth of just 6.7 per cent over these four years, even though the starting point was a deep recession.

Fifth, contractionary fiscal policy did indeed lead to contraction. Using a standard model, the OBR concludes that the coalition government’s discretionary fiscal policy decisions reduced GDP, relative to the trend in potential output, by about 1.7 per cent in 2011-12 and the same again in 2012-13, by 1.5 per cent in 2013-14 and by about 1.2 per cent in 2014-15. Moreover, this analysis implausibly assumes away any longer-term negative impact of the persistently weak output.

Sixth, while recent jobs performance has been remarkable, that is the mirror image of the collapse in growth of labour productivity. If the latter had not occurred, unemployment would be far higher than it now is. This was good luck for the policymakers, although only in the short run.

Seventh, the recovery began when it did at least partly because structural (or cyclically-adjusted) fiscal tightening slowed dramatically. The IMF shows a tightening in the structural general government financial deficit from 8.4 per cent of GDP in 2010 to 3.8 per cent in 2013. The structural deficit is then estimated at 4.1 per cent in 2014 and forecast at 3.6 per cent in 2015. GDP grew by just 1.6 per cent in 2011, 0.7 per cent in 2012 and 1.7 per cent in 2013, while the structural deficit was being slashed. Then, in 2014, it picked up, to 2.6 per cent, as the structural tightening slowed, as I would have expected.

Eighth, the government did not deliver the elimination of the structural deficit within one parliament it promised, as Mr Congdon himself notes. Back in June 2010, the OBR forecast that cyclically-adjusted net borrowing would fall from 8.7 per cent of GDP in 2009-10 to 0.8 per cent of GDP in 2014-15. The latest forecast is for cyclically-adjusted net borrowing of as much as 4.2 per cent of GDP in 2014-15.

Finally, the economy would not have been “wrecked” if the government had not promised the austerity it ended up only very partially delivering. We know that, because long-term interest rates are today extraordinarily low, despite the failure of the government to deliver its promises, as shown in the huge overshoot of public net debt (now expected to peak at 81 per cent of GDP in 2015-16, far above the 70 per cent in 2013-14 forecast in June 2010), and despite the uncertainty about policies after the next election.

Mr Congdon’s arguments do not stand up. A different path, with tax raises postponed until the recovery was well-established and a bigger programme of public investment, would not only have been perfectly safe, but would have given the economy a substantially stronger recovery. What the UK has experienced, instead, is a poor recovery, though the remarkable stagnation in labour productivity ameliorated the adverse impact on the welfare of the population.

Moreover, to his credit, Mr Osborne displayed appropriate flexibility when it became obvious he could not achieve his goal for the structural fiscal deficit at reasonable cost. Flexibility in response to experience is a virtue. Mr Congdon should try it.

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