Keynesians In Retreat?

‘The letter of protest to the Guardian from 79 left-wing economists might indicate that the Keynesians are losing the argument’

Economy Marketplace
Signed, sealed, delivered: Thomas Piketty, one of 79 signatories of a letter protesting Osborne's economics (photo: Universidat Pompeu Fabra)

Are budget surpluses good or bad for a nation’s economy? In George Osborne’s first term as Chancellor of the Exchequer, action to reduce the UK’s budget deficit restored fiscal sustainability and was consistent with economic recovery. In his Mansion House speech on June 10, he therefore suggested that new legislation should be introduced to entrench budget surpluses “in normal times”.

Osborne’s proposal is a shift in official rhetoric, but it is far from being a radical new departure. The commentariat has forgotten Gordon Brown’s insistence on “prudence” at the outset of his Chancellorship. A “Code for Fiscal Stability”, no less, was laid before Parliament under section 155 of the 1998 Finance Act and remains on the statute book.

Its substance is that the fiscal position should be “sustainable over the long term”. Brown was vocal about his “Golden Rule”, that the current budget (the budget excluding capital items) should be in balance or surplus over an entire business cycle, and the “Sustainable Investment Rule”, that any borrowing to finance investment should not cause public debt to rise too quickly. Osborne’s planned new legislation has much the same import as Brown’s Code for Fiscal Stability. With a few words tweaked on the dividing line between current and capital expenditure, they would in fact be identical.

The Code excited little controversy 17 years ago, but Osborne’s latest ideas soon provoked a letter of protest from 79 prominent left-wing economists in the Guardian. The signatories included Thomas Piketty, the celebrated author of Capital in the Twenty-First Century, and David Blanchflower, who served on the Monetary Policy Committee between 2006 and 2009. Comparisons are inevitably being drawn between the letter from the 79 and another much-publicised predecessor, the letter to The Times from 364 economists in March 1981. Like the recent letter to the Guardian, it was a response to a clear long-term commitment to sound public finances from a Conservative government, as well as to meaningful and allegedly painful short-term austerity to reduce the budget deficit. Further, in both cases the letter-signing economists would characterise themselves as “Keynesians”, meaning that they believed fiscal policy should be used to regulate demand, output and employment.

Has the case for “expansionary fiscal policy”, as the Keynesians term it, gained traction over the years? The recent letter to the Guardian was put together more quickly than the 1981 letter, but it is striking that the number of signatories has dropped by almost 80 per cent. Someone new to the subject might form the impression that the Keynesians are losing the argument.

The Keynesians are in retreat mostly because of facts. In the UK so-called “fiscal austerity” under the Conservatives both in the 1980s and today has been accompanied by above-trend growth in demand, while in the US President Clinton’s large cut in the budget deficit in the 1990s was reconciled with obvious economic prosperity. Whatever the textbooks say, reductions in budget deficits are often associated with healthy economic expansion and rising employment. But the Keynesians might still justify attention if their theoretical analysis were elegantly expressed and presented with conviction. Unfortunately for them, the letter to the Guardian was a mess.

Until now the case for Keynesianism has turned on the core doctrine of the 1936 General Theory, that aggregate demand is a multiple of investment. Extra government spending — supposedly, magically — has the property of causing output to rise by a multiple of itself. But the Guardian letter drops the multiplier fantasies and instead refers to “the principle of sectoral balancing . . . that, if one sector of the economy lends to another, it must be in debt [sic] by the same amount as the borrower is in credit [sic]”. 

Let us be nice to the 79, and allow them to reposition the words “debt” and “credit” so that their key sentence makes logical sense. Even then, the Keynesians are going nowhere with this proposition, which is known technically as the “flow-of-funds identity”. True, one agent’s debt is another’s credit. But so what? Debts and credits may cancel out, but someone owns the houses, cars, lorries, machinery and so on that we can see around us. People are net owners of capital assets, while their net worth is much higher than debt. Changes in the value of assets (because of house price and stock exchange movements) are many times larger — and far more important to macroeconomic outcomes — than any sector’s change in indebtedness, including the government’s fiscal balance. The Keynesians might have some residual plausibility if they could organise their thinking properly, but it seems from their letter to the Guardian that they cannot even do that.