Don’t let the Keynesians Wreck the Recovery

Among his many gifts, John Maynard Keynes had a flair for self-advertisement. By giving his 1936 book of new economic ideas the title of The General Theory of Employment, Interest and Money, he deliberately echoed the name that Einstein had chosen over 20 years earlier for his theory of relativity. Economics might be a human science rather than a natural one, but Keynes’s message was that it could still aspire to the rigour and modernity of scientific endeavour.

According to numerous accounts, the policy impact of The General Theory was greatest in the field of public finance. Whereas before Keynes governments were convinced that they should balance their budgets, afterwards they accepted that the budget position should be used to stabilise the business cycle and to secure higher employment. In the 1950s and 1960s Keynesian fiscal activism was often praised as one of economics’ greatest contributions to the happiness of mankind. The old budget-balancing principles were mocked as little better than the tribal customs of out-of-date finance ministries, whereas Keynesianism could boast of its scientific credentials.

But there was a problem. A large budget deficit implied a big increase in the national debt and debt holders needed to be paid a rate of interest. Of course the larger the debt, the higher were the interest payments. Even worse, in the Britain of the 1970s runaway inflation pushed up the nominal rate of interest to unprecedented peaks. Investors had therefore to be paid interest rates well into the teens, to persuade them to buy current issues of government debt. As the stock of debt rose because of persistently high deficits, and as maturing low-interest-paying government securities were rolled over into new high-interest-paying equivalents, the burden of interest payments soared.

The Thatcher government decided that enough was enough. The growth of public debt had to be checked. In the 1981 Budget the government raised taxes in order to reduce the budget deficit, even though the economy was in a bad recession. A move back towards a more balanced budget position was seen as essential, regardless of Keynes’s intellectual legacy. To many economists in British universities, this so-called “tightening” of fiscal policy would reduce spending power, undermine demand and output, and destroy jobs. At the prompting of two leading figures in the Cambridge economics faculty, 364 university economists wrote a letter to The Times in protest against the 1981 Budget. They were accusing Treasury ministers not just of folly, but of ignorance of the best thinking on the subject, which in their view was the thinking that came from Keynes’ General Theory.

Given their elevation of economic principles to scientific status, the Keynesians saw the 1981 Budget almost as a laboratory experiment. Not only did they believe that an increase in the budget deficit stimulated aggregate demand and that a reduction in the deficit restrained it. They were also confident that the budgetary stance was one of the most powerful influences — perhaps even the most powerful single influence — on economic activity. The letter from the 364 warned that “present policies will deepen the depression”, and threaten “social and political stability”.

Famously or notoriously, depending on one’s viewpoint, the 364 were wrong. To quote Nigel Lawson, who would become Chancellor of the Exchequer in 1983, the timing of the recovery was “exquisite” in refuting the 364’s prognoses. Demand and output started to move upwards in the second quarter of 1981, just as the debate about the Times letter was at its most intense. Although unemployment remained high for some years, the economy gathered pace and in the late 1980s entered another boom. If this was a laboratory experiment for Keynesian economics, its results suggested that the textbook formulas were flawed. Old-fashioned principles of sound finance returned to favour in the UK, while the ratio of public debt to gross domestic product fell to manageable levels. For more than 25 years Keynesian fiscal activism was ignored or even forgotten.

But university economists continued to teach Keynesian macroeconomic as if nothing had happened. Sure enough, in Britain many academics realised from the sequel to the 1981 Budget that something was wrong with Keynesianism or, at any rate, with the naive versions of Keynesianism which emphasised the blessings of fiscal fine-tuning. But in the American East Coast universities — notably the Ivy League establishments — the UK’s 1981 Budget was too parochial an event to justify rewriting textbooks and lecture notes. Such influential figures as George Akerlof and Robert Shiller of Yale, Paul Krugman of Princeton and Joseph Stiglitz of Columbia, all now Nobel prize laureates, continued to teach that an increase in the budget deficit adds to aggregate demand and a decrease deducts from it. They also derided monetary economics, and pooh-poohed the notion that changes in the rate of growth of the quantity of money could have important effects on demand, output and employment.

When the Great Recession hit in late 2008, the overwhelming majority of top-notch American economists were clear about the right agenda. They advised the newly-elected President Obama to implement a big boost to government spending and a large widening of the budget deficit. According to data from the International Monetary Fund, in the three years to 2010 the USA’s budget deficit (after adjusting for cyclical influences on it) soared by 6.5 per cent of national output, by far the most aggressive fiscal easing in American peacetime history. Some of the measures, including tax cuts for the middle classes, were temporary. If the red ink being spilt at the state and local government levels is added to the Federal deficit, the total public sector deficit in 2010 and 2011 was well above 10 per cent of national output.

The merits of the lurch into deficit are a matter of debate. But hardly anyone doubted that the peak deficit numbers were unsustainable, not least because some of the biggest buyers of American government debt were foreigners (including the Chinese) and the long-term geopolitical consequences of ever-rising external indebtedness were unpalatable. From 2010 some of the so-called fiscal “stimulus” was withdrawn. Initially the Keynesians did not make a fuss, but at the end of 2012 the big temporary tax cuts were due to be rescinded. On unchanged policies, a drastic fall in the budget deficit was in prospect.

Indeed, as a proportion of national output, the size of the USA’s deficit reduction would be similar to that seen after the 1981 Budget in the UK. Like the 364 more than three decades earlier, hundreds of American Keynesians warned about the dangers of an alleged “fiscal cliff”. Unless the tax cuts were restored, they envisaged a sudden plunge into the abyss for the American economy in 2013. Stiglitz told the Daily Telegraph that the cut in the budget deficit might push the world’s biggest economy back into recession. In his words, “It’s unambiguously the case that these measures will slow down growth . . . There is a significant probability of going into a recession.” Krugman joined the jeremiahs, although he thought the phrase “austerity bomb” was more expressive than fiscal cliff. In November 2012, only two months before the tax increases were to come into effect, former US Treasury Secretary Larry Summers judged that “the fiscal cliff must be avoided”.

But major tax increases were implemented and the US budget deficit did fall sharply. We now have all the important macro data for 2013. What happened? The answer is that the American recovery chugged along much as before, as if it couldn’t give a damn what Professors Krugman, Stiglitz and Summers thought about the matter. Exquisitely (to recall Nigel Lawson’s word), the increase in real domestic final sales was higher (at 2.6 per cent) in the year to the final quarter of 2013 than in the preceding year (2.2 per cent). On the Krugman/Stiglitz/Summers analysis the plunge down the cliff face ought to have been most terrifying in the third and fourth quarters of 2013. In fact, these two quarters saw strong demand growth relative to their neighbours.

As with the 364’s doom and gloom about the 1981 Budget, the hundreds of American Keynesians’ gloom and doom about the fiscal cliff proved unjustified. Once again, Keynesian fiscalism was wrong.

The International Monetary Fund’s statistical department has done a particularly good job over the years in preparing data on fiscal and monetary policy for dozens of countries, and putting the numbers on a comparable basis. However, under Olivier Blanchard, its chief economist since 2008, its macroeconomic analysis has veered too far in the Keynesian direction. Not only was he in the Krugman/Stiglitz/Summers camp on the fiscal cliff (which he characterised as “potentially an enormous shock”), but he also saw it as one of his responsibilities to condemn George Osborne’s commitment to a smaller budget deficit in the UK.

In April 2013, when the outcome of the USA’s cliff drama was not yet known, he rebuked Osborne for fiscal austerity. According to Larry Elliott in the Guardian, Osborne was “under mounting pressure to moderate his austerity strategy after the IMF went public with fears that the pace of budget cuts is too severe for Britain’s ailing economy. The fund said it would be holding talks with the chancellor about his tax and spending plans in the wake of gloomy forecasts that subjected the UK to the biggest growth downgrade of any developed country for 2013 and 2014.”

So here too was a showcase experiment. Indeed, Blanchard’s anxiety about the UK’s fiscal stance was a late instalment in an intellectual soap opera that had been begun in 2010, when Osborne first made clear that deficit reduction would be one of his priorities, even perhaps the main priority of his Chancellorship. The Keynesians, who — as we have seen — had been dormant for a generation in Britain after the 364’s humiliation, started erupting like a newly active volcano. An explosion of letters to the editor, research papers and pamphlets renewed the debate on fiscal policy, while new books proclaimed Keynes as a resurrected messiah.

The Keynesians applauded Gordon Brown when in 2007 and 2008, at the start of his premiership, he gave a big boost to public spending; they continued through 2009 to endorse his government’s vast budget deficit. So Osborne’s commitment in mid-2010 to an eventual balancing of the budget came under sharp attack. Keynes’ biographer, Lord Skidelsky, was very much to the fore in the ensuing intellectual battles. (Skidelsky and I held a debate on these issues, under the title “What would Keynes say now?”, in the December 2009 issue of Standpoint.) 

Economics commentary in the Financial Times has veered all over the place in recent decades. In the 1970s Sir Samuel Brittan, who might be described as the George Orwell of financial journalism, became its most acclaimed contributor, and was widely regarded as a champion of the free market and a trumpet-blower for monetarism. (His weekly column defended the 1981 Budget.) But in 1996 Martin Wolf was appointed chief economic commentator. Wolf has changed the paper’s direction, and in the financial crisis of recent years the Financial Times has been firmly left-of-centre and Keynesian. Skidelsky and Summers have been given a lot of space.

In April 2011, a few weeks after Osborne’s second Budget, Wolf criticized its deficit-reduction plans in frankly Keynesian terms. In his view the Conservative government’s apparent determination to lower the deficit year by year was “a huge gamble”. Just like the 364 three decades earlier, Wolf believed that the consequence would be a withdrawal of demand in each and every year that the deficit was being cut. That could lead to a deflationary disaster since the economy had been weak “even before the fiscal squeeze”. Wolf sided with the arch-Keynesian Larry Summers, who had just said at an academic conference in Bretton Woods that the UK had embarked on an “experiment” that “is not going to work out well”.

One puzzle about the revival of Keynesian fiscalism in the Great Recession is that its advocates seem not to have noticed the lessons of recent economic history. Perhaps Summers can be excused his seeming ignorance of the 1981 Budget debate since it did not take place in his own country, but Wolf must have heard about the letter from the 364 and the subsequent polemics. He had also been on the Financial Times in the mid-1990s, when a fiscal retrenchment similar to that of the early 1980s had been accompanied by a healthy economic recovery.

Given that ample evidence to demonstrate that deficit cutbacks could be combined with above-trend advances in demand and output, Summers’s labelling of Osborne’s programme as an “experiment” and Wolf’s characterisation of it as “a huge gamble” must be described as strange. The counter-argument is simple, that reductions in public spending can be offset by increases in private spending, leading to strong net growth. Of course, increases in private spending do require a benign macroeconomic environment, but experience suggests that the crucial conditions for that are steady growth of the quantity of money and a supportive banking system. The stance of fiscal policy is neither here nor there.

Anyhow, the four years since Osborne’s adoption of fiscal austerity have seen rising demand and output in Britain, and remarkably high growth of employment. As after the 1981 Budget and the USA’s early 2013 fiscal cliff, reductions in the budget deficit have been consistent with the net creation of new jobs. (A drop in public employment has been exceeded by increases in private employment.) If the Keynesians want to regard Osborne’s fiscal policy as another laboratory experiment, fine, and let them again eat their words. They were vocal, even outspoken, in condemning a nation that wanted to have stronger public finances, and once more their forecasts have proved invalid.

To give the IMF its due, it has acknowledged openly that it was wrong. This year British economy is expected to enjoy the fastest rate of growth among the advanced nations, with an almost 3 per cent output gain. At a press conference in Osborne’s presence in June, Christine Lagarde, the IMF’s managing director, conceded that “we clearly underestimated the growth of the UK economy”. She even granted that “the planned fiscal adjustment this year is appropriate”. But Lagarde is a talented politician-cum-international-bureaucrat, not a professional economist, and — like most movers and shakers of her kind — she blows with the wind. Can any of the economists — Summers, Krugman, Wolf and so on — accept that they have been in error?

Martin Wolf has had the opportunity to review his contributions to the debates in a recently-published book, The Shifts and the Shocks: What we’ve learned — and have still to learn — from the financial crisis (Allen Lane, £25). The title implies a certain modesty, suggesting that Wolf still has not reached equilibrium in his views on these difficult questions of public policy. But, as regards fiscal policy and Osborne’s “huge gamble”, Wolf has learned nothing. George Osborne himself is not mentioned. There are snide remarks about “expansionary fiscal contraction” in chapter seven, plus the implausible claim that fiscal retrenchment in 2010 was “premature and unwise”. But there is no hint of apology or rethinking.

The truth is that Wolf’s April 2011 article was not about fiscal policy in the one year of 2010, but about Osborne’s five-year strategy which stretched out to 2015/16. The phrase “huge gamble” referred to the planned multi-year programme of fiscal restraint. In the event the fiscal consolidation has not been as substantial as originally envisaged and a large deficit remains. In 2009/10, the final year of New Labour, public sector net borrowing was just over £150 billion. This had come down to £98 billion in 2013/14, but the latest numbers suggest that the 2014/15 outturn will still be above £100 billion. Nevertheless, the IMF calculates that the budget position (cyclically-adjusted) has been “tightened”, in Keynesian language, by almost 5 per cent of GDP since 2009. The Osborne “fiscal tightening” has indeed been of much the same size, relative to GDP, as that in the five years to 1986, which led to the protests from the 364 30 years ago. Like them, Wolf has been wrong in expecting deficit reduction to result in persistent recession.

How should Osborne or his successor handle the public finances after the next general election? Will the Autumn Statement on December 3 put down some markers? A clear message comes from the 1981 Budget, the 2013 fiscal cliff and the Osborne reversal of Brown’s so-called “fiscal expansion”, three episodes which come as close to laboratory experiments as is possible in the human sciences. The next Chancellor must not be dissuaded from action to lower the deficit by Keynesian bluster that such action will inevitably weaken demand and destroy jobs. He or she must pledge a return to a balanced budget, even if contrary advice is given by the Financial Times. The Financial Times remains a massively influential newspaper with much interesting writing, but its chief economics commentator has become too fond of wearing his Keynesian heart on his left-leaning sleeve. 

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