The Bocconi boys take on Keynes

‘If the Bocconi boys’ work is correct, three generations of macroeconomic textbooks should be binned and the fiscalist element in Keynesianism has become intellectual junk’

Tim Congdon

Whatever the defects of public sector provision, government expenditure is a component of aggregate demand, and the government’s supply of health, education and other services is part of national output. Does it not then follow inevitably that cuts in government expenditure reduce aggregate demand? Is not a clear implication of fiscal austerity, with measures to curb the budget deficit, that restrictions to government services lead to less national output?

Indeed, standard university macroeconomics instruction makes the questions more pointed. A key message of the textbooks—following the massively influential chapter 10 of Keynes’s 1936 General Theory of Employment, Interest and Money—is that aggregate demand is a multiple of so-called “autonomous expenditure”, where autonomous expenditure is the sum of investment and public spending. It follows that reductions in public spending result in falls in aggregate demand which are several times larger than themselves. Chapter 10 even surmised that the multiplier might take a value between five and ten. In other words, if the British government takes £10 billion off its expenditure, it sets in train an adjustment process that in a few quarters takes £50 billion or £100 billion off aggregate demand.

As is well known, recessions cause tax revenues to weaken and the bills for unemployment benefit to increase, and therefore are associated with a widening of budget deficits. Politicians unacquainted with university teaching might think they should limit such deficits by trimming public spending. If Keynes’s conjecture and the associated textbooks are right, an austerity-prone government led by ignorant politicians of this sort is crazy. Here is the often-repeated argument from Keynesian intellectuals—notably Paul Krugman in the New York Times, and Martin Wolf and Lord Skidelsky in the Financial Times—that government spending must be sustained in recessions, and damn the consequences for the budget deficit and public debt.

But Keynesian macroeconomics is only theory. It may have conquered the textbooks and university teaching in the English-speaking world in the two decades from the General Theory’s publication. However, that is not a practical test of the doctrine. Earlier this year three Italian economists—Alberto Alesina, Carlo Favero and Francesco Giavazzi—published a book called Austerity: when it works and when it doesn’t, which examined the results of fiscal austerity in a vast empirical sample. To be specific, it looked at “200 multiyear austerity plans carried out in 16 OECD countries . . . from the late 1970s to 2014”.

The message of the data in Austerity is utterly different from that of the ideas in chapter 10 of The General Theory. Alesina, Favero and Giavazzi compared the effects of trying to curb a budget deficit by raising taxes and cutting public expenditure. Tax-based austerity is accompanied by reductions in national income and output larger than the tax increases, which echoes Keynesian thinking. But the outcomes of expenditure-based austerity are sharply inconsistent with it. The sample considered by Alesina, Favero and Giavazzi says that the most likely result of a £10 billion cut in public expenditure in late 2018 is a reduction in aggregate demand in 2019 of only about £4 billion, with the negative effect disappearing by 2021 and 2022. It is even possible that expenditure-based austerity in 2018 is followed by higher aggregate demand three or four years later, a phenomenon labelled “expansionary fiscal contraction”.

Alesina, Favero and Giavazzi have all taught at Bocconi University, a private university in Milan which has been the alma mater for many of Italy’s top business people. The relevance of the analysis in their own country, which has public debt approaching 140 per cent of national product, is obvious. The top Keynesians in the English-speaking world are of course bewildered by and angry about the Bocconi conclusions. A fair comment is that theorising about fiscal policy, and about the whole subject of national income determination, is in turmoil. Some of the Keynesians refer to Alesina, Giavazzi and their colleagues as “the Bocconi boys”, recalling the phrase “the Chicago boys” used to denigrate the Chicago-trained economists who organised economic policy in President Pinochet’s Chile. The truth is that—if the Bocconi boys’ work is correct—three generations of macroeconomic textbooks should be binned and the fiscalist element in Keynesianism has become intellectual junk.

The wider consequences for social and political debate are also profound. Chapter 10 of The General Theory culminated in Keynes’s superb polemic against sound finance. Famously, it remarked that ancient Egypt with its pyramids and the Middle Ages with their cathedrals were lucky always to have objects of wasteful public expenditure which would sustain employment come what may. The polemic culminated later in a recommendation for “a somewhat comprehensive socialisation of investment”, so that autonomous expenditure could be regulated by the state to deliver full employment.

Many economists (including myself) are puzzled by the Bocconi results, and wonder whether they will stand the test of rigorous professional data investigation and future experience. But their body of evidence is a compelling refutation of naive Keynesianism. It is perhaps not surprising that in the last few years of his life Keynes himself was equivocal about the extreme fiscalist message drawn from The General Theory by some of his disciples. 

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