The Keynesian Versus The Monetarist: Time To Re-Read Keynes

A key achievement of Keynes’s General Theory was to guide economists towards better organisation of their analysis of the economy as a whole (“the macro-economy”). Crucially, national income was set when aggregate demand was equal to aggregate supply. A number of conditions had to be met for this to hold, including equality of investment with saving, and equality of the demand to hold money balances with the quantity of money created by the banking system. 

I am sorry if my opening paragraph in reply to Wolf’s comment is dry as dust; it ought to be familiar to readers who have had the misfortune to have endured a university macroeconomics course. But basic ideas have to be recalled if we are to make progress. The core debating issue between us is, “Does an increase in the budget deficit increase aggregate demand?”. In my two Standpoint articles on the subject (“Don’t let the Keynesians wreck the recovery”, December 2014, and “Keynesians fear the US fiscal cliff. I don’t”, January/February 2013) I focused on this question. I demonstrated that, over the last 30 years in the US, the answer is “No, for the great majority of the time.” An analysis of the UK data yields much the same conclusion.

Keynesians like Martin Wolf (as well as Paul Krugman, Larry Summers, Robert Skidelsky and many others) believe that a systematic and reliable link holds between an increase in the budget deficit and expansion of demand. Their theory is contradicted by the evidence and is wrong. They criticised George Osborne in 2011 when he committed the UK to a medium-term programme of budgetary restraint. Because their theory is wrong, these criticisms have proved misguided. Contrary to their warnings, a recovery has occurred in association with a significant reduction in the budget deficit. Moreover, the UK pattern under Osborne has been seen many times, both in other countries and in the UK’s own past. 

Plainly, my concern was about the effect of policy on aggregate demand. Wolf does not address the evidence or my argument. Much of his comment is instead about the disappointing performance of aggregate supply since the Great Recession. Output growth has indeed been weak compared to that in other recoveries in the last 70 years, largely—as Wolf observes—because of “the remarkable stagnation of labour productivity”. But this has no bearing on the matter we are debating, namely the ability of fiscal policy to influence aggregate demand.

I cannot see anything in Wolf’s remarks that constitutes a meaningful reply to my points. Let us slightly rephrase the key question into, “Does an increase in the budget deficit—due, say, to a rise in government spending unaccompanied by higher taxes—increase demand and output?”. Consider a plausible reply from an intelligent layman, someone who has had the good fortune not to have endured a university macroeconomics course. He might say, “It depends, but a possibility is that the extra government spending is offset by less spending by the private sector.” Further, if the extra government spending were large and the rise in the deficit were to an unsustainable figure, he might conjecture that the reduction in spending by frightened, unhappy and conservative-minded private-sector companies and individuals would exceed the extra spending by the state. (Think of Greece, Portugal and Ireland in the Great Recession.)

Wolf’s attitude towards evidence is casual, but in the last few years he has read some of the headlines of the newspaper for which he is chief economics commentator. He is aware of Greece, Ireland, and so on, and he does say that fiscal policy can sometimes be “unusable”. Fine, but a mere three paragraphs later he refers to “an econometric model” (without specifying which one he has in mind) and proposes that “other things being equal, fiscal contraction is contractionary.” He then proceeds to the claim that “The only question is over the size of the multipliers, that is, the relationship between changes in fiscal policy and in economic activity,” with “no doubt about the direction of impact”. Am I alone in finding it strange that Wolf has “no doubt” about the effectiveness of fiscal policy just a few sentences from an admission that it can be “unusable”? Where, exactly, is the boundary? 

The truth must be established by evidence and work on data, not by mere assertion. In the tragic cases of Greece, Ireland and so on, the fiscal multipliers in the key period were not 0.5 or 1.5, but negative. It is no good parroting the catechism according to Paul Samuelson, whose famous (if rather left-of-centre) textbook translated The General Theory into the form that was taught in those dreary university macroeconomics courses. The debate turns on the relative power of fiscal policy and the “other things” that Wolf wants held constant; it pivots on their relative power in real-world conditions that have been observed in recent experience.

Wolf (and Krugman, Summers, etc) ought to re-read their Keynes and try to understand what their mentor said. Yes, national income is determined by the intersection of aggregate demand and supply, and is in equilibrium only when the demand to hold money is equal to the quantity of money created by the banking system. If the banking system is up the spout, so also is the economy. The stance of fiscal policy is neither here nor there. Money and banking really do matter, and—in real-world conditions in recent experience—changes in the quantity of money have smothered changes in the budget deficit as an influence on aggregate demand.

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