The twentieth century produced many pernicious ideas. Keynesian economics may not be the worst, but its capacity to misled governments remains potent. Despite numerous historical examples of abject failure, advanced economies gave Keynes another go in response to the current global crisis.
The results have been dismal. During the current crisis, several countries have blown up their fiscal deficits in the hope that growth would return. All have been cruelly disappointed. Growth has stagnated. In Europe, the consequences of this policy experiment have most damaging. Stimulus efforts carried the single currency to the brink of disintegration. In Ireland, Portugal and Greece, large deficits have brought utter ruin. Spain, the Netherlands and Italy are all teetering on the brink of the abyss.
If it were true that running up a deficit could spur sustainable growth then Greece - with its 16 percent of GDP deficit in 2009 - should have been growing at a stratospheric rate. This point also holds the for UK. Since 2008, the UK has recorded deficits of between 8 and 11 percent; historically unprecedented deficits, and yet the economy has recorded two recessions in four years.
Simply put; higher fiscal deficits are not associated with higher growth rates. This empirical regularity should have been sufficient to deter politicians from engaging in fiscal stimulus. Sadly, it did nothing to deter policy makers from doing something stupid in order to be seen by electorates as doing something.
The boiler-plate justification for a Keynesian policy response is that the economy is suffering from a lack of aggregate demand. This lack of demand requires government intervention in the form of tax cuts, public expenditure increases and rising deficits. The evidence for this lack of demand usually takes three forms; high unemployment rates, a large output gap and falling household consumption.
In the case of the UK, this lack of demand hypothesis is highly questionable. Lets start with unemployment. It is true that the unemployment rate is high, especially so in the case of young people. Yet, we also know that inward migration continues unabated. Many hard working migrants are coming to the UK, finding work, and settling here.
This sits very uncomfortably with the idea that there is a lack of demand for workers. What is true, however, is that many young people prefer to claim benefits rather than take low paid employment. We can argue the merits of this decision, but lets leave that debate for later. The main point is that a high level of measured unemployment does not mean that the economy is suffering from a lack of demand.
Does a large "output gap" - the difference between actual and potential output - imply an lack of aggregate demand? Potential output is never directly observed; it has to be estimated. The easiest way is to look at past growth rates and extrapolate where we would be if the recession hadn't happened. This simple method suggests that currently output is about 15 percent lower than where it should be. In other words, the UK output gap is huge, and therefore there is substantial "lack of demand".
However, if past growth rates were generated by unsustainable activities like huge asset bubbles and massive credit growth, then the post crisis growth slowdown might reflect a fundamental structural change in the economy. Estimating the potential output using past growth will massively over estimate the size the output gap.
There is one very compelling piece of evidence suggesting that the current output gap is actually quite small - inflation. If the gap were large and there were lots of unemployed resources, then there would be downward pressure on prices. Do we see that today? Nope. What we see in the UK right now is the fastest inflation rate in any large advanced economy.
So what about household consumption? What is the story there? It is true that household consumption has been very weak of late. Does that imply a lack of demand?
In a narrow accounting sense it does. Less household consumption means lower aggregate demand. However, accounting relationships tell us nothing about household behaviour. Looking at the way that fiscal policy is behaving right now, with its huge deficits, rising debt and unjustifiable expenditure to GDP ratios, a rational household might think that this unsustainable mix of Keynesian polices can only lead to one place; higher taxes, slow growth and ultimately a massive crisis.
What would a rational household do? It would understand that it will be poorer in the future, and that it would be prudent to cut back expenditures and save more. In other words, the expansionary fiscal polices create uncertainty and risk that lead households to reduce consumption and aggregate demand. Fiscal deficits and higher public expenditures are not the solution, they are the cause of the problem.
There is only one answer to the UK's current mess. The government needs to balance the books; and the sooner the better. This is not to say that the adjustment will not be painful. Make no mistake, there will be short run output losses. However, the sooner the fiscal policy is on a sustainable trajectory, the quicker growth will return.
Keynesian economics is a pernicious idea. Whenever it has been tried, the most it has achieved is a temporary upward blip in the growth rate. Ultimately, it leads to slow growth, higher debt levels, lower investment, and higher inflation. It prolonged the great depression during the 1930s. It failed to jump start growth in Japan despite almost 20 years of pump priming demand. It royally screwed this country in 1970s and it is doing it again today.
9 comments:
It's an issue of too much democracy and not enough - paradoxically.
In adopting Keynsianism the Govt has been able to postpone the worst effects of depression thus it lessens the sense of seriousness, urgency and the understanding of the sacrificial levels of duty required of the electorate.
It makes the economic prospects far worse for us in long run. All to garner votes and court favourable headlines in the short-term.
On the other hand - those of us who do understand what is wrong have no say and no representation. And so it is that the very attitude that got us into this situation is the one being rewarded now (high spend/high debt.)
We are in denial. There needs to be a great economic shock to bring us out of it.
If not then the only way we'll ever be aware of just how far we've fallen is when we holiday/Skype to those places which haven't declined.
The real failure in economic policy comes from the guy nobody even mentions these days. When was the last time you heard somebody defending Milton Friedman or even monetarism? The idea that a central banker tweaking monetary policy wholly divorced from fiscal policy has become indefensible. But that does not mean people don't follow it. Here in the UK we are seeing that in effect as King bumbles his way from one quarter to the next whilst Osborne leads government down a cliff.
But of course nobody calls it Friedman policy. Instead you hear about austerians these days. The gurus of austerity that revived Hayek from decades of obscurity since he didn't win the academic argument against Keynes. This is the true policy being applied in Europe as Germany and France impose austerity packages on to Greece and Ireland. The past two weeks we have read of how the Spanish economy is slowing down. Should we be surprised that the austerity packages of the Rajoy government are slowing down growth? Of course not. The relation is direct and clear.
As to examples like Japan and some of the policies of the EU and UK, we should remember that giving free money to banks is not Keynesianism. Bailout money handed to Greece is immediately redirected to its creditors. There is no Greek bailout, just a bailout of financiers who lent to Greece. The real Greece has been hit by subsequent austerity packages and is under a needlessly prolonged stagnant climate. Osborne should take note. Academics certainly are, and the picture being painted is not pretty. Neither was Labour's increase of debt during growth a good example. Both sides of the UK parliament have been running counter-cyclically to what Keynes prescribes, so this isn't a good example of a failure of Keynesianism.
A proper Keynesian approach would not sink money into ailing banks as we saw in Japan and recently on both sides of the Atlantic. And one problem of that is that western nations that have been eroding their own workforce don't have the means to use Keyne's policies to the fullest. At least they can't respond as quickly.
Finally the US. Can we believe that the US has been following Keynes advice? No way. Friedman was king over there. For nearly two decades Alan Greenspan, a monetarist, ran the Fed. Greenspan also showed some partisan leanings, berating Clinton over deficits and then letting GW Bush run wild with the red ink. But Keynes is still so distrusted that a lot of the federal stimulus money ended up filling the gap left by the cuts taken at state level.
So I do not see evidence that Keynesianism is a consistent abject failure nor that it has dominated the policy landscape of the past decades. It is by no means perfect, but the idea that all reckless government spending is Keynesian is unfounded.
Giving money to bakers to piss away on gambling for themselves is not the answer. There need to be a way of getting banks to work for their client and if they actually make money for their client they can get paid, old fashioned maybe but until we fix this we are up the creek without a paddle.
Droog
What exactly do you men by Keynesianism?
Webster
When government spends on things that lead to an increase in employment. Keynes' work was aimed at influencing the economy so that people would gain employment. Giving money to zombie banks or to young unemployed Britons do not count as Keynesian policies.
What are central governments in the UK investing on? Infrastructure? No. More schools? No. Renewables? No. Both Labour and Conservatives have abandoned the idea that the central government can influence the economy in those ways.
Now you may believe the private sector is better at doing that kind of investment. Guess what, Keynes thought so too! He wanted the private sector to be the bigger beast. But he believed government could have a positive effect.
The cowardice of the private sector today is proving him right. Just look at how poor lending to UK businesses has been since 2007. Why aren't banks lending? Why isn't private business taking advantage of the workforce?
I agree with Alice that the UK would benefit from a serious revamp. I disagree with her that Keynesian policies can't be a part of that. The main problem with the UK regarding employment is that due to the pursuit of various bank-friendly policies over the decades it has priced its workforce out of the global competition. As a result the governments--no, more like the UK itself--had to relax credit controls and hand subsidies of all kinds to keep consumer demand going. The credit ruse is mostly over. The subsidies/welfare ruse is collpasing.
Turning back the clock on this would not be easy. But getting people employed is part of the solution. So why would private businesses employ Britons when other nations have cheaper labour? This is why government spending can work, because it could focus on employing local labour.
@Droog: the days when spending on infrastructure would necessarily reduce unemployment are gone. Keynes was writing in the 30s, when it was perfectly possible for the State to say 'We want to build something here' and just get on with it, and employ massive amounts of unskilled labour to build it. They could go from a decision to starting work pretty fast.
Doesn't work that way now. Look how long its taking to get this new high speed railway line even agreed upon, let alone started to dig any soil. Then all the people employed would have to be skilled operatives. You don't build a railway with picks and shovels nowadays, but with massive pieces of construction equipment, and skilled electronic and mechanical engineers. You don't let Darren (no GCSEs and an ASBO) loose on a big digger that cost hundreds of thousands, or ask him to wire up a signalling system.
All a big increase in infrastructure spending by the State would do would be to drive up the wages of construction workers to high levels as companies competed for the existing pool of skilled labour, leaving the unskilled underclass untouched, and make nice fat profits for the construction companies, as they would know they could charge what they liked as the State was paying.
Then of course you end up with nice bridges that go nowhere (Japan tried all this in the 90s and 00s), lots more government debt, and still the economy on its knees. Please do read up about Japan's experiences over the last 20 years. They had exactly the same sort of debt fuelled bust that we have had, and they have tried all the things we have either done, or being suggested - QE and infrastructure spending being the main ones. And still the Japanese economy flatlines, and their population crisis looms ever nearer. Just like us.
We need to change the record, or the song will turn out exactly the same.
Japan's macroeconomic woes are familiar to me. Their picture is still better than the UK's (or the US's). Their unemployment rate during the 90s was never above 6%. We're around 8% right now and Japan are below 5%.
What would you rather have: Japan's bad macroeconomic numbers and higher employment or the UK's bad numbers and higher unemployment? The case remains that nothing being done with this austerity is aimed at increasing employment. It's about being to borrow more. You want young people off welfare? Fine, what should they do? They can't all be bankers.
No, but they can't all be construction workers either. What happens to our newly qualified JCB operator when the contract to build a nice new bridge or road somewhere has finished? Can the economy sustain such a level of construction work ad infinitum? Or are all the newly qualified and employed construction workers just going to have to go on the dole again when the State runs out of holes to dig (or money to pay for it)?
The problem with the UK economy is structural. It has been so distorted by the effects of firstly the massive boom in house prices, and the consumerism that accompanied it (most of it based on increased amount of personal debt) and latterly by the State continuing to borrow and spend like no tomorrow, that we cannot in any way see what the economy should look like under a more long term equilibrium. We have become used to a certain level of living standards that were (and are not) sustainable by the economy operating without a massive debt boost. We cannot 'kick start' the economy and get back to 2007 levels of spending and wealth because they were a mirage, based on spending borrowed money. To get back to an equilibrium level in the economy we will have to retrace our steps by about 10-15 years.
Like it or not that is what will happen.
Actually I don't disagree with that last bit and I would go further. Anything that entertains increasing the UK's manufacturing base is looking at going back decades, not just 15 years. And yet, what options are there that don't involve this? And more importantly why can't the UK do it?
Not every nation exporting to the UK is the jaggernaut that China is. The UK imports cars from Germany, lights from the Netherlands and Italy, wind turbines from Denmark, heat pumps and lorries from Sweden, etc. Sweden was rated the most competitive nation a couple of years ago. So when I hear people say the UK can't rely on manufacturing as part of its economy I don't buy. Not everything comes from China.
Of course one quick way to compete with this nations is to let the pound sink to the level of the Euro (provided the crisis in the continent doesn't sink the Euro to abysmal depths which I know is too much to hope for). But weakening gives palpitations to financiers and those whose money isn't primarily coming from wages, so the mere thought of a competitive rate of exchange is blasphemy.
So instead we play the game where we hang on til other nations fail first, which makes lending to the UK less risky by comparison and nothing changes for now.
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