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.